How an Inflated Currency Rate is Chasing off Icelands Smart Economy - The Reykjavik Grapevine

How an Inflated Currency Rate is Chasing off Icelands Smart Economy

How an Inflated Currency Rate is Chasing off Icelands Smart Economy

Published March 10, 2006

Smart economy has long been a buzzword among Icelandic media, politicians and industry leaders. All parties agree that creating conditions where high-tech industry can flourish is a matter of the utmost importance for the future of the nation’s economic growth. For a country like Iceland, which has based its economy on limited natural resources, it is vital to be able turn human resources and intellectual capital into an economic advantage. The Irish economic miracle has been upheld as a glowing example. But now it seems as if the high exchange rate of the Icelandic króna is chasing off Icelandic high-tech companies.

“We feel like we’re being ripped off,” says Reynir Harðarson, creative director and co-founder of the computer game manufacturer CCP, makers of Eve Online. We have been discussing the product and the prospects of his company for a while. A company that employs over 80 people in Iceland. A company that successfully launched a massively multiplayer online computer game with over 100,000 subscribers and became a major player in the gaming industry.

Harðarson is venting his frustration over the current economic landscape, which has plagued exporting industries, hitting IT and other knowledge-based companies like CCP hard. This is causing Harðarson’s considerable frustration.

“In 2005, our annual turnover was 770 million ISK. If the exchange rate between the dollar and the Icelandic króna had been the same as it was in 2004, our turnover would have been over 850 million ISK.”

His complaints are echoed throughout the business community. Especially among companies in the vaguely defined knowledge industry, which more or less make money exporting goods and service. Over the last few years, the Icelandic króna has been an extremely strong currency, maintaining a very high rate of exchange. The US dollar has been devalued over 40% against the Icelandic króna in the last three years, causing problems for many companies, since the US is one of Iceland’s biggest exporting markets. This development has cut deeply into the profits of exporting companies, making export of Icelandic goods more a question of national pride than good business.

For companies like CCP, the results have been disastrous.

“All our income is in dollars, but all our expenditure is in Icelandic krónur,” Harðarson says. “When we started this project, the exchange rate was about 85 krónur to a dollar. For a while it went as high as 115 ISK. Today it is around 65 ISK. It is difficult to start with a business model, built on certain premises, and then your profits are cut substantially due to exterior circumstances that have nothing to do with us.”

High-Tech Industrialisation

A knowledge economy (also referred to as a smart economy or in Iceland commonly as high-tech industry) is a loosely defined term. It applies to companies that manufacture goods that require a great deal of technical knowledge and research. According to the common criteria used by OECD and Eurostat, fields that spend more than 4% of the annual turnover on research and development should be considered high-tech fields. In 2004, high-tech industry was responsible for 3.9% of Icelandic GDP. It was also responsible for 7% of the nation’s export income, compare that to the 0.6% it created a decade ago, and you’ll get an idea of how fast the field is growing.

The Celtic Tiger (a nickname coined by Morgan Stanley investment bank to describe the rapid economic growth in The Republic of Ireland with an analogy to the economic boom in Singapore, South Korea and Hong Kong, commonly referred to as the East Asian Tigers) has been the hallmark among nations that have embraced the knowledge economy. In the last decade, Ireland has been transformed from one of the poorest countries in Western Europe, to the being the second highest GDP per capita earner in the European Union.

The Irish government made a conscious effort to attract knowledge-based companies and high-tech employers with law and tax reforms and stimulate the education system with investments. The result was a rush of IT companies, such as IBM, Dell, Gateway, Microsoft, Intel, Apple and Google, which chose to invest heavily. During the period between 1991-2003, Ireland received an average of around 7% increase in GDP, peaking at 11.1% in 1999. Unemployment fell from 18% in the late 1980s to 4.2% in 2005, the lowest mark in the EU, while wages went up, and foreign debts went down.

In 2005, the Federation For Icelandic Industries (FII) issued a report on the future of high-tech industry in Iceland. According to the report, Iceland has a choice between two alternatives as grounds to its economic system. Either to compete with nations with lower wages in basic and heavy industries, or create conditions where high-tech industry can flourish. Not surprisingly, the FII recommends the second option. The added value and salaries of jobs in high-tech industry are considerably more than in basic industries.

In the past decade, some measures have been taken to ensure the growth of high-tech industry, both through tax and law reforms. The corporate income tax has been lowered from 51% to 18% and capital income tax brought down to only 10%. Laws have been changed in order to simplify the process of establishing companies and an effort has been made to ensure stability in the work market.

But further measures are still needed. The FII suggests that more effort be put into creating investment funds, better support and more investment for education and research at a university level and stabilising the currency exchange rate. The last item is of particular relevance.

The price of the Icelandic króna has climbed at an almost constant rate since 2001. According to Icelandic financial analysts, a key reason for the króna’s continued rise in value is the influx of foreign investment and the import of goods that accompanies the building of the Kárahnjúkar dam and the Fjarðarál aluminium smelter in eastern Iceland. Under normal conditions, this would be regarded as a temporary situation. The demand for Icelandic króna should be reduced as the projects near completion in 2007 and the exchange rate should go down.

But as Iceland looks towards the end of an era marred by tension in the nation’s economy, government officials have unveiled plans to continue development of aluminium with up to three different projects. The fear of recession as the repercussions of the diminished economic activity once the projects are completed has driven government officials to look for ways to prolong the era of development in heavy industry. Negotiations are already underway between Alcan and the National Power Company to deliver energy to an enlarged Alcan’s aluminium smelter in Straumsvík in 2007. Preliminary talks have begun with Alcoa to build a new 250,000-ton aluminium smelter in Húsavík in Northern Iceland in 2010 while Century Aluminium has confirmed their interest in building a new smelter in Helguvík in southwest Iceland starting around 2010 as well. These three projects would push aluminium production capabilities in Iceland up to 770,000 tons, at the cost of roughly 400 billion ISK.

Small Gain – Big Sacrifice

If all of the proposed aluminium projects come to fruition, the combined size of these projects, in terms of costs and production capabilities, is estimated to be double the size of the current project in eastern Iceland. According to a report by analysts from KB Bank, the economic tension, the foreign investment and the increased demand for Icelandic krónur caused by such grand scale projects would inevitably push the exchange rate even higher than it currently is.

“It would affect Iceland’s economy tremendously if all these projects go through,” says Steingrímur Arnar Finnsson, an economic analyst for KB Bank. We are sitting in the bank’s headquarters, discussing a new report on the future growth of aluminium industry in Iceland, which Finnsson co-authored.

“The economy would expand substantially, reaching its top in the years 2009, 2010 and 2011. We would be looking at considerable tension in the economy, which would drive up the price of the króna. That would be very difficult for exporting industries such as the high-tech industry and the fishing industry.”

According to the Finnsson’s report, long-term economic effects of aluminium smelters, once they are in operation, are small. It is only between 30 – 40% of the aluminium’s export value that stays in the Icelandic economic system. The other 60 – 70% is mostly spent on importing the raw material that is required to produce aluminium.

According to another recent report on the effects of aluminium smelters, issued by Íslandsbanki, in 2015, when the projects should be finished, a total 1% increase is projected for the nation’s GDP. The increase in domestic export would be even less, as profits from the aluminium smelters will go to their foreign owners. In other words, the net gain for Iceland, would be less than 1% increase in domestic export value.

Finnsson’s report concludes that it is impossible to maintain the position that future economic growth is dependent on creating a few hundred jobs in aluminium industry.

“If we build several aluminium smelters in a short span of time, we could be sacrificing bigger interests for a small gain,” Finnsson insists. “For many companies the thinking has been: OK, we’ll take the blow now, but if they are looking at another 3-4 years of the same conditions…” He trails off, and after a momentary hesitation, he continues. “That could be very hard for exporting companies. It would not surprise me to hear that companies plan to relocate.”

Runaway Companies

“The government is killing all prospects of further developing high-tech industry in Iceland,” Friðrik Skúlason states. His company, FRISK has successfully been developing anti-virus solutions for companies since 1987 and now employs about 50 people in Iceland. “My company has been run with considerable profit every single year since we started, except for last year when we barely broke even. The only reason for that was the currency rate,” he continues.

For IT companies like CCP and FRISK, relocation is no longer a rhetorical concept, but an imposed reality that demands attention. “While the exchange rate of the Icelandic króna is so high, it is very expensive to run a company like ours in Iceland. It is not out of the question that we’ll relocate. It is something we have looked into. When it is a question of hundreds of millions annually, it becomes a very valid question whether we can justify keeping the operation here in Iceland,” says Harðarson of CCP, whose company projects an income of 1.5 billion ISK next year, almost entirely from export.

While some companies may choose to leave entirely, others have suggested that they will not leave, but at the same time, that they don’t see a way to expand their companies in Iceland.

“I would not suggest starting an IT company here in Iceland to anyone. If you have an idea, and want to start a company, the first thing you have to do is leave the county,” he says. “This industry simply cannot grow here in Iceland under these circumstances.”

But although the economic environment is hard, Skúlason does not expect to relocate his company, at least not entirely. “The basis of the operation will probably still be here in Reykjavík, but we have already relocated one department of the company, and if the currency rate stays as high as it is, we might be forced to relocate other departments. Under the current conditions, any future growth of the company will not be in Iceland, it will be abroad.”

Subsidising Power

But it is not only the IT companies that have been hit by the soaring currency rate. Hörður Arnarson is the CEO of Marel hf., a world-leading company in the production and development of fisheries and food processing equipment. The company employs over 360 people and is valued around 16 billion ISK. In a conversation with the Reykjavík Grapevine, Arnarson was very critical of the government’s role in bringing heavy industry to Iceland.

“The main point in this case is that these projects are not on grounds of equal competition,” says Arnarson. “Companies in heavy industry receive a special treatment from the state in favour of other companies. The state’s involvement in these projects is wrong.”

While the government does not directly take part in building power plants, or directly subsidise the operation of aluminium smelters in Iceland, the indirect involvement of the government remains considerable.

The state-owned National Power Company does not pay taxes from its operations, the required rate of return from investments is lower than is expected of private companies and the company receives government insurance on all foreign loans, which guarantees lower interests than other companies can get.

“If this was a private investment, we couldn’t complain,” Arnarson says. “But the playing field is not level. The government is subsidising this branch of industry.”

Like other exporting companies in the high-tech industry, Marel is feeling the effects of the currency exchange rate. “Since all our income is in foreign currency, and all our expenditure in Icelandic króna, the development of the exchange rate has reduced our potential profits, which affects the return of our investors, and the compensation of our workers,” Arnarson states.

“We are not creating the number of jobs that we could be creating here in Iceland. While the conditions here are what they are, we will continue to expand our company on foreign soil,” says Arnarson.

When asked if they would be creating more jobs in Iceland if the economic landscape were friendlier to exporting industry, he replied, “Without a doubt. We would be growing domestically and creating more jobs if the exchange rate was not so unfavourable.”

The Arctic Tiger

Despite boisterous talk of developing more export industries in Iceland, fish remains the nation’s lifeline. Last year, fish products were responsible for 60% of Iceland’s export income. Like other export industries, the fishing industry has been badly affected by the rise of currency exchange rate. The lesson to draw from this is that the nation is overly dependent on fishing industry and needs to build more exporting industries to support the economy.

The question facing Iceland is whether to choose to follow the path of the Celtic Tiger, and other countries such as Sweden and Finland, where the role of more traditional industries such as steel, paper and wood as the basis of the economy have diminished constantly in favour of more high-tech export commodities such as IT service and telecommunications, making them less vulnerable to international fluctuations. Or should Icelanders rather opt for continued build up of heavy industry in competition with countries from the developing world?

As usual, when economics are concerned, there are no simple answers, but rather differences of opinions. Especially when questions are tied to complex political issues involving employment and living conditions in rural areas. But judging from the reality facing companies of the knowledge economy, there is hardly room to do both simultaneously.

Reports mentioned:
High-tech Industry – Future Vision and Forecast
http://www.rannis.is/files/Hataekni_spa_2005_684101049.pdf

High-tech Industry – Development and Position in Iceland
http://www.rannis.is/files/hataekni_stada_2005_1832366632.pdf

The Growth Of Aluminium Industry In Iceland
http://www.rannis.is/files/hataekni_stada_2005_1832366632.pdf

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