ECMI Commentary No. 7
31 May 2006

European Capital Markets Institute

Iceland: Big lessons from a small country?
By Charles Gottlieb1

Global monetary policy is tightening. Following Japan’s return to an inflationary
environment, liquidity is getting scarce and investors are increasingly discriminating
risks. So-called ‘carry trades’, which ensured high return for little risk, are no longer
sustainable, as interest rate indicators of the Triad countries are pointing upwards.
Such macroeconomic movements pose worrying problems for open economies that
financed their external dependence with ease in the environment of excess liquidity
that prevailed over the past five years.
Such monetary contraction can be problematic for small open countries that rely
heavily on external financing, especially on portfolio investments. In fact, for such
economies, the interest rate leverage is rather ineffective in luring foreign
investment. Therefore recent evolutions have caused great concern for small
economies such as Hungary, New Zealand and Iceland, which traditionally trade a
considerable fraction of their GDP and rely heavily on external financing to finance
their current account deficits. In stress situations or when the macroeconomic
situation unwinds, those countries are among the first to be exposed to external
shocks, and face considerable macroeconomic volatility. The experience of Iceland
is particularly relevant as some indicators echo to some extent the school-case
scenario of a capital account crisis, and furthermore deliver a similar picture to that
of the United States’ situation.
Iceland, a small open economy in the twilight of external volatility
Iceland’s economic performance is impressive. Unemployment is almost nonexistent; the economy has followed a process of economic diversification away from
its traditional industries (i.e. fisheries) towards high value added activities (i.e.
banking, biotechnology and software industry)....

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