I confess I hadn't. My correspondent is right, however; Iceland is extremely interesting and, moreover, topical since Alex Salmond, the First Minister, announced the second stage of his National Conversation aimed at leading us all to vote for in
dependence in 2010.
Iceland, with economic growth averaging 4.2 per cent over the past eight years and per capita GDP now exceeding that of Britain, is one of those "arc of prosperity" small independent countries that Salmond thinks an independent Scotland could emulate. However, the Icelandic economic miracle, if that is what it is, is not easily translatable. It is based on three things. Rising fish prices (fishing is 6 per cent of the economy) have made the fishing industry wealthy. Cheap electricity derived renewably from geothermal sources has dramatically boosted the aluminium smelting industry whose output, if all current expansion plans go ahead, will nearly quadruple by 2010.
The third big boom area, more relevant to Scotland, is financial services. Over the past decade, Icelandic banks have ballooned in size. Partly, this is driven by the increase in domestic wealth and growth in overseas purchases – half of Britain's high streets are now owned by Icelandic companies. But it is also due to overseas investors making use of the historically high interest rates offered by Iceland's banks.
This is called the carry trade – you borrow piles of a low interest-bearing currency such as the Japanese yen or the euro, stuff it into an Icelandic bank account, and the difference between the two rates is enough to earn you pots of money. Iceland's banks, meantime, are able to make use of your deposits to help their own companies and economy grow further.
The banks' growth has been startling. In 2000, their combined assets were equivalent to just under a year of Iceland's GDP. They are now reckoned to be ten times a year's worth of GDP.
A fantastic success story, surely? Yes, it has been, but now things have got distinctly rough. The credit crunch has pushed up the price of borrowing, squeezing Icelandic banks' profitability. World financial markets have suddenly got worried about the banks' ability to repay their debts. As a result, the credit default swap spread, or insurance risk premium, levied on Icelandic bank borrowings has risen from less than 1 per cent last August to over 8 per cent now for two of the biggest banks.
The Icelandic government is outraged by this sullying of their banks' reputations. The fundamentals of their country's economy, it correctly points out, are absolutely sound. Unfortunately, not many people appear to be listening.
The big problem is that Iceland is tiny compared to its banks. Its population is 313,000 and they have a GDP of about £8.5 billion. The markets have begun to wonder if Iceland's central bank and government have enough money to cope if one of the commercial banks ran into the same borrowing trouble that Northern Rock did. The government insists that of course it does have, but again that markets are not convinced and have downgraded the government's credit ratings, increasing its borrowing costs.
These worries have caused the value of the Icelandic krona to plummet, falling about 25 per cent against the euro this year. Apart from that being liable to cause inflation (now including housing costs at 7 per cent) to leap up further, it more than wipes out the gains that foreign savers hoped to make by putting their money into Iceland's banks (they hold about £5bn of UK savers' money). This currency crisis has forced Iceland's central bank to do the reverse of what most central banks are doing to ease their country's banking problems. Instead of lowering interest rates, Iceland has pushed them up to nearly 14 per cent.
What's the lessons for Scotland from this sorry business? Well, the assets of Scotland's two biggest banks total £2,566bn which is, if you include offshore oil and gas output, about 20 times the GDP of an independent Scotland. In other words, an independent Scotland would be twice as exposed to a financial industry crisis as is Iceland. The risk attached to this exposure should not be exaggerated: the combined assets of all British-owned banks are about five times British GDP, and nobody thinks the Bank of England does not have the resources to handle a banking failure.
Scotland's two big banks have also grown organically and by acquisition rather than by the over-indulgence in cheap credit which brought down Northern Rock and overhangs Iceland's banks. Plus an independent Scotland would be part either of the sterling or eurozones, so would not be afflicted by Iceland's currency problems.
Yet, though we may think Scottish banks are safe, no-one these days can categorically state that there is no risk attached to them. In which case, the question becomes this: how would the regulatory scrutiny and central bank back-up that gives investors and lenders reasonable security be given in an independent Scotland?
The short-term answer, I suppose, would be that as Scotland would continue in the sterling zone, regulatory and banking scrutiny would continue to be applied by the Financial Services Authority and the Bank of England. But that is not sustainable in the long-term. Since taxpayers' total exposure to Northern Rock is about £100bn, the cost of rescuing HBOS or the Royal Bank would be many, many times that. No matter how unlikely the need for such a rescue might be, why would English, Welsh and Northern Irish taxpayers want to be exposed to that risk? Sooner or later, political pressures would require Scotland to take on that risk and, as the Iceland example shows, it's a tough one for a small country to manage.
The full article contains 1013 words and appears in The Scotsman newspaper.
