What forces determine whether a country can maintain its debt GDP ratio at some

sustainable level.
How would a rise in real interest rates affect a countrys international debt and its debt
GDP ratio. What would a nation have to do to maintain its debt GDP ratio under these
conditions? Use the Iceland case study to illustrate your answers.
Americans may remember that at the start of the 2008 financial crisis, Iceland literally went
bankrupt. The reasons were mentioned only in passing, and since then, this little-known
member of the uropean !nion fell back into obli"ion.#
In 200$ Iceland%s debt was e&ual to 200 times its '(), but in 200*, it was +00 percent. The
2008 world financial crisis was the coup de grace. To set this straight, Iceland%s debt ,as in The
-entral .ank/ was e&ual to 0*1 of the '2) in 200$ and fell to 3$1 of the '2) in 200*,
according to 4orld .ank 5and 2ata6arket7 statistics. In 200+, that percentage reached 8031.
(ow, if by Iceland the author meant Iceland%s banks, then it%s true that the banks% debt was
pretty big9astronomical really9and by 200*, Iceland%s banks did in fact reach + times the
'2), though that%s '2) not '().
Then there%s this: ;The three main Icelandic banks, <andbanki, =apthing and 'litnir, went belly
up and were nationali>ed, while the =roner lost 801 of its "alue with respect to the uro. At the
end of the year Iceland declared bankruptcy.# Again the statement, ;At the end of the year
Iceland declared bankruptcy# is wrong. And the Icelandic kr?nur lost more like 001 of its "alue
compared to the uro any way you look at it. ;-ontrary to what could be e@pected, the crisis
resulted in Icelanders reco"ering their so"ereign rights, through a process of direct participatory
democracy that e"entually led to a new -onstitution. .ut only after much pain.#
Then it says: ;'eir Aaarde, the )rime 6inister of a Bocial 2emocratic coalition go"ernment,
negotiated a two million one hundred thousand dollar loan, to which the (ordic countries added
another two and a half million. .ut the foreign financial community pressured Iceland to impose
drastic measures. The C6I and the uropean !nion wanted to take o"er its debt, claiming this
was the only way for the country to pay back Aolland and 'reat .ritain, who had promised to
reimburse their citi>ens.#
The constituent%s meetings are streamed on-line, and citi>ens can send their comments and
suggestions, witnessing the document as it takes shape. The constitution that e"entually
emerges from this participatory democratic process will be submitted to parliament for appro"al
after the ne@t elections.#
8
Defusing to bow to foreign interests, that small country stated loud and clear that the people are
so"ereign.#
Cirst of all, it%s nai"e to think that Iceland was able to stand up to the I6C. 4ith the I6C pro"iding
emergency currency support, it has had influence in di"erting Icelandic resources back toward
the financial sector. If Iceland had refused to share the I6CEs world"iew, it could ha"e been
denied funds necessary to implement capital controls and stop the =ronaEs tailspin. Cailure to
adhere to the I6CEs demands could ha"e also caused IcelandEs so"ereign credit rating to drop
significantly, which could ha"e isolated Iceland from international capital markets ,despite the
fact that credit ratings agencies, in the wake of 2008, are in need of urgent reform/.#
4hether or not influenced by the I6C, one might note that two of the three banks that Iceland
;let fail# because it couldn%t bail them out ,they were nine times the country%s '2)/, ha"e been
re-pri"atised and there is currently a debate about pri"atising the third. (ot to mention, there%s
the case of AB Frka, in which +8 percent of a publically owned geothermal energy company
was sold to -anadian company 6agma nergy ,now called GAlterra )ower%/, gi"ing it access to
geothermal energy in the DeykHanesbIr peninsula for J0 years with a renewal option for
another J0. Curthermore, while Iceland may seem like a symbol of sticking it to the financial
institutions that brought about the financial collapse, the people really ha"en%t escaped the
burden. According to an F-2 report Iceland has put more money into its failed financial
institutions than any other country e@cept Ireland. Bo in this way Iceland is not a model9the
people in Bpain need not wa"e Icelandic flags.In some places Iceland is held up as being a
model of how to sur"i"e an economic crisis and rebuild society. Cor most Icelanders this seems
totally wrong.
Q5. What forces determine whether a country can maintain its debtGDP ratio at some
sustainable level?
2
How would a rise in real interest rates affect a country!s international debt and its
debtGDP ratio? What would a nation have to do to maintain its debtGDP ratio under
these conditions? Use the Iceland case study to illustrate your answers.
Take, for example, a country such as Iceland in 1999. The medium term sustainability of the debt
of the country was highly unlikely and the country looked like it was insolvent. The explosive
growth of Icelandic firms has been financed by aggressive borrowings by Icelands three largest
banks and the total external debt of the economy is now more than times !"#, i.e. the
economy is highly leveraged. The negative debt position is partially explained by investment in
new power plant capacity, the rapid expansion of Icelandic firms abroad, high levels of outward
$"I, young population, consumer spending and, perhaps, misleading accounting.
In any case, it seems clear that the global credit crunch hit Iceland at a vulnerable time. Icelandic
banks, consumers and firms are suddenly faced with a falling currency and prohibitively high
borrowing costs. "oubts have been cast on the governments ability to support the Icelandic
banks, simply due to the fact that the combined balance sheets of the three largest banks were
%%&' of !"# at the end of ())&. The vulnerabilities of maintaining an independent monetary
policy have also become clear and debate has been vigorous on how to better defend the
currency or, alternatively, to adopt a stronger currency. !overnment officials point to a debt*free
government, healthy banks and a flexible economy as key buffers, but recession seems likely.
If foreign +public debt is very high, the market will price the probability that the debt may not be
serviced in full and in time. In this case, the level of interest rates and interest spreads on the debt
will reflect the possibility that ,partial default may occur. -uch as risk of default implies that the
risk*ad.usted interest rate on the debt will be higher than under no default risk and higher interest
rate will trigger a more rapid accumulation over time of a given stock of debt. -uch an increase
in spread may trigger a perverse debt dynamics in which, if the country tries to service its debt in
full at current high spreads, debt ratios grow even if the country+government is following policies
that are sound. -uch preserve dynamics becomes a serious issue for countries that are in a crisis
and being borderline between being insolvent and illi/uid. 0s there is broad uncertainty about
whether there is insolvency, markets will react to any increase in the ob.ective probability of
default by increasing the spreads on the country+government debt and thus worsening the debt
dynamics of the country+government. 0n otherwise solvent agent may thus be thrown in an
insolvency region if real interest rates on the debt become too high.
Currency Policy
Icelands currency remained strong during the countrys pre*crisis expansionary period in spite
of its enormous current*account deficit because of the large inflow of foreign funds. 1ith the
collapse of the banking system, that inflow stopped and the krona went into free fall. The decline
intensified the countrys economic problems. 2any households and businesses held foreign*
currency indexed debts that exploded in domestic cost. 0s noted above, the government worked
to minimi3e the economic harm from this development by forcing banks to restructure their loans
in domestic currency.
$
Icelands currency policy also includes the use of strict capital controls which make most
transnational capital movements illegal. These controls have blocked an estimated 4% billion,
roughly e/ual to ) percent of Icelands !"#, from leaving the country. 5ad the government not
taken action, the resulting outflow would no doubt have led to a complete currency meltdown.
Thanks to the controls, the krona, although lightly traded, soon strengthened and then stabili3ed.
Housing Policy
The government took strong steps to minimi3e the threat to household finances caused by the
collapse of the housing bubble and to restore stability to the housing market.
The government then introduced several new initiatives designed to provide more long term
relief. These lowered household debt and mortgage interest payments as well as provided support
for housing alternatives and renters. $or example, the government first pursued a strategy of
encouraging householders to directly negotiate write*downs with their lenders, often with the
assistance of an ombudsman. !iven the slow progress, the government introduced a debt*
forgiveness plan that wrote down underwater mortgages to 11) percent of a households assets.
To ensure that working people were the main beneficiaries of the plan, the amount of relief was
tied to the value of a modest house and family si3e. 2ore detailed financial examinations were
available for households in especially serious financial trouble, with the possibility of greater
write*downs.
Social Policy
The Icelandic government faced a serious fiscal challenge as a result of the crisis, with its budget
deficit rising to 16. percent of !"# in ())9. Impressively, it reduced overall spending and the
deficit to (.6 percent of !"# in ()11 while simultaneously strengthening key social programs.
$or example, the government increased unemployment benefits over the years ())& to ()1) and
also lengthened the period during which workers could receive unemployment benefits from
three to four years. In addition it significantly boosted the means*tested social assistance
allowance and the minimum pension benefit.
7ver the same period, the government also increased subsidies for mortgage interest payments
by 1)%.1 percent, far outstripping the 8).9 percent increase in mortgage costs. This increase
raised the average household subsidy for interest costs from approximately 16 percent to ()
percent of the total interest cost. 2oreover, the interest rebates were largely targeted at working*
class households, which meant :that about a third of the interest cost of lower and average
income households was paid by the government in ()1).;
3