Iceland and the Global Capital Markets

A case study of the complexity of balancing an open economy in a small country

with the magnitude and movements of the global capital markets.

The last one or two years had been something of a shock to the Icelandic people:
Long used to being ignored in the world, Iceland’s economic situation and its interest rates –
some of the highest in the world recently –had suddenly garnered much international attention.
Now, in the spring of 2006, Iceland’s central bank and governmental monetary authorities were
wondering whether they were seeing the dark underside of globalization and economic growth.
Is this what it felt like to be a small country in a global market?
Iceland’s economy had been growing at record rates in recent years:
Gross domestic product had grown at just over 8% in 2004, 6% in 2005, and was expected to be
still above 4% by the end of the current year, 2006.
While the average unemployment rate of the major economic powers was roughly 6%, Iceland’s
over-heating economy had only 3% unemployment.
But accompanying rapid economic growth in a small economy, inflation raises were rising.
Monetary authorities reacted logically, slowing money supply growth to try and control
inflationary forces.
Tighter monetary policy had increased interest rates. These rising interest rates had a variety
of impacts:
First, Iceland was considered very stable and low risk in the international marketplace. It – the
Icelandic government – had an investment grade credit rating.
So, foreign investors, particularly the money market investors behind the carry-trade made
famous in Japan, found Icelandic money market interest rates very attractive.
Capital from foreign investors, American and European, flowed into the big four Icelandic banks
and money market accounts of all kinds to take advantage of these higher money market rates.
But the carry-trade depends on exchange rates as well as interest rates:
A foreign investor exchanging dollars or euros for Icelandic krona, and then investing in the higher
yielding money market rates in Iceland, must feel relatively confident that the krona will not fall
in value versus their currency by the end of their investment period.
And they did. The krona had actually strengthened consistently against both the dollar and the
euro in 2004 and 2005. By the end of 2005 the krona was stronger against both the dollar and
the euro than it had been since 2000.

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 Exhibit 1: Iceland’s interest rates continue to rise

Exhibit 2: The Icelandic Krona, strengthens, 2003-2005

Exhibit 3: Then Interest Rates & Exchange Rates Suddenly Swing

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 Exhibit 4: And the Icelandic Krona Weakens

Exhibit 5: Throughout 2006 Iceland’s Interest Rates Continue to Rise

Source: Interest rates reported to the International Monetary Fund by Iceland; International Financial Statistics, monthly.

Case Questions

1) Do you think a country the size of Iceland or New Zealand is more or less sensitive to the
potential impacts of global capital movements?
2) Many countries have used interest rate increases to protect their currencies for many years.
What are the pros and cons of using this strategy?
3) In the case of Iceland, the country was able to sustain a large current account deficit for
several years, and at the same time have ever-rising interest rates and a stronger and stronger
currency. Then one day, it all changed. How does that happen?