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UNCLAS SECTION 01 OF 02 REYKJAVIK 000267 
 
SENSITIVE 
 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN PGOV IC
SUBJECT:  ICELAND: IT WON'T BE THE BEST PLACE TO LIVE ANYMORE 
 
¶1. (SBU) Summary:  Last year Iceland was rated by the UNDP as the 
best place to live in the world, but the October collapse of the 
Icelandic banking system has triggered a full scale financial and 
currency crisis and delivered a knockout punch for Iceland.  Now 
experts are just beginning to piece together what will happen in the 
economy here and how living standards will be affected.  Already we 
have seen an immediate, rapid rise in unemployment and inflation. 
There is significant trouble with the Icelandic krona and currency 
exchange limits have limited foreign trade on this import-dependent 
island.  As a result, business reps predict 70 percent of Icelandic 
businesses will go bankrupt in the near future.  The best hope for 
the short term is an IMF economic stabilization program awaiting IMF 
Executive Board approval.  However, before the Board can consider 
the package, Iceland must secure $4 billion in other bilateral 
loans, and they are only a quarter of the way there.  The IMF money 
will continue the flow of essential goods to Iceland, but real 
economic recovery will take longer.  Iceland must address the 
creditors of the failed banks to preserve future private sector 
financing again and the only long-term solution we've heard for the 
currency crisis is joining the EU and adopting the Euro.  End 
Summary. 
 
¶2. (SBU) The collapse of the Icelandic financial sector in October 
has triggered an economic crisis, the depths of which are only now 
becoming clear.  Many Icelanders lost all their investments because 
they owned stock in the three banks that collapsed or other 
companies that faltered as a result of the banks.  Those who had 
cash savings in some accounts are unsure if their money is still 
there as many accounts remain frozen.  There has been a rapid rise 
in unemployment in a country that has generally faced labor 
shortages.  The Directorate of Labor reported in September the total 
number of unemployed was about 1.3 percent unemployment, the number 
jumped to 3 percent in six weeks and is anticipated to be 7 percent 
by January.  The Central Bank predicts that at the end of 2009, 
unemployment rates will have reached 10 percent. 
 
¶3.  (SBU) As economic conditions worsen, academics and industry 
experts alike tell Post they expect a brain drain.  Iceland's 
semi-skilled foreign work force is expected to be the first to move 
away and we have seen anecdotal evidence of that departure already; 
the Polish Consulate here estimates that half of the roughly 14,000 
Poles who moved here to work in the construction and services 
industries have left Iceland in the last three months.  As the 
condition of the Icelandic labor market deteriorates Icelanders 
themselves might start thinking about moving abroad.  The Chairman 
the Union of Icelandic Electrical workers stated earlier in the week 
that hundreds of tradesmen (carpenters, electrical workers, 
plumbers, masons) are already preparing to move abroad. The Norden 
Association, an organization that promotes Nordic co-operation, 
reports a large surge of Icelandic interest in their course that 
teaches how to establish oneself when moving to a Nordic country. 
 
¶4. (SBU) Inflation, always a problem here, is also expected to spike 
in the short term despite an overall economic contraction. 
Currently, twelve month average inflation is being measured at 15.9 
percent, and because Iceland is extremely import dependent, 
inflation is directly influenced by the (falling) value of the 
Icelandic krona.  According to the Central Bank's baseline forecast 
inflation will peak at 23 percent in the first quarter of 2009 but 
will have fallen to 5 percent by the end of the year. This sharp 
decline in inflation is based on the assumption of moderate wage 
growth, falling demand for consumer goods, and a stable exchange 
rate. If these assumptions do not hold, then inflation might reach a 
higher level and remain high for a longer time, something Iceland 
hasn't seen since the 1980's. 
 
¶5.  (SBU) Businesses report significant difficulties regarding trade 
and the currency.  When the U.K. authorities invoked anti-terrorism 
and economic crimes legislation against Icelandic banks and froze 
Icelandic assets on October 8th, virtually all international 
payments to Iceland stopped.  Two days later the Icelandic Central 
Bank established rations of foreign currencies at a fixed price and 
gave priority to importers of food, fuel and pharmaceuticals. 
Importers of clothes, electronics and every other good had to get in 
line for currency.  Post learned of one stationary supply store 
which waited for three weeks to get foreign currency to import 
office paper.  The Confederation of Icelandic Employers told post 
that Icelandic businesses are facing serious difficulties that only 
seem to worsen with each day; on top of the cross-border payment 
problems and restricted access to foreign currencies, Icelandic 
companies' standing with their suppliers abroad has suffered 
greatly.  Virtually all transactions have to be pre-paid.  Adding to 
the pain, many businesses took out loans in Japanese yen, which has 
appreciated 136 percent against the krona and resulted in increases 
in payments.  The Federation of Trade and Services predicts 70 
percent of businesses are expected to declare bankruptcy in the near 
future if the currency crisis is not solved. 
 
¶6. (SBU) For the short term, the IMF assistance is supposed to 
 
REYKJAVIK 00000267  002 OF 002 
 
 
provide foreign currency to support re-floating the krona and 
stabilize foreign trade, however the IMF deal is not assured.  The 
IMF announced on Oct. 24 a $2.1 billion loan provided that 
Icelanders raise nearly $4 billion more; thus far they have secured 
loans of just over $1 billion from Norway, Poland and the Faroe 
Islands.  Every day the press speculates who is to blame for no IMF 
deal, with the clear favorite the U.K. (reportedly blocking the deal 
until a resolution is created for the failed Icelandic banks in the 
U.K.)  As we understand it, the IMF deal is essential to solving the 
immediate currency crisis.  The Head of the Research Department at 
Kaupthing Bank reiterated to Emboffs that it is of vital importance 
to establish a sound currency market in Iceland.  He said that once 
the krona is floated again, it will devaluate further, but no one 
knows by how much; the main fear with lifting restrictions in the 
currency market is that of a domestic run, with Icelanders selling 
krona to get foreign currencies.  This seems to indicate that 
currency restrictions will remain in place in some form even if the 
IMF loans are approved. 
 
¶7. (SBU) Addressing longer term conditions will require resolving 
the issues with creditors and depositors and the long term strength 
of the currency.  The British IceSave account holders are still 
grabbing the headlines, but behind the scenes there are many 
creditors lining up.  Post met with a lawyer representing American 
bond holders with $3.5 billion invested who plainly stated that if 
Iceland does not take a transparent and fair path with creditors, 
investors will never come back.  This concept is beginning to be 
discussed in the media; the most prominent proponent is the head of 
the Confederation of Employers, who advocates giving the creditors 
ownership of the banks as a way of preserving Iceland's future 
access to credit.  Most business representatives and economists we 
talk to do not see a medium or long term solution with the Icelandic 
krona.  Everyone seems to feel the joining of the EU and the 
adopting of the Euro is not only inevitable, but necessary for long 
term economic survival. 
 
¶8. (SBU) Comment: The situation here is still fluid, but as the 
consequences of this crisis continue to play out, we could start to 
see the development of a permanently unemployed class, which is 
historically unknown here.  Iceland has always had reverse brain 
drain, where young people are educated abroad, but return to raise 
their families.  This will likely no longer be the case and young 
Icelanders abroad will stay there and those who can move away from 
Iceland will.  Foreign travel, very common in recent memory, will be 
restricted by financial constraints.  Once the current stocks of 
consumer and luxury goods are depleted, there will not be a 
replenishment to the same level as before.  In short, Iceland faces 
the very real prospect of the rapid undoing of two decades of robust 
prosperity and a whiplash-inducing return to scrimping and saving 
unknown since the 1980s.  This already bitter pill will take on a 
new edge if the public holds to its current view that this disaster 
is the fault of vindictive foreign parties (e.g, the British). 
 
van Voorst