Iceland on growth path, but hard road ahead

A farmer drives a tractor on Highway 1 west of Vik, Iceland May 28, 2011.

REYKJAVIK (Reuters) - Three years after a banking system crash that epitomised the excesses of the credit boom, Iceland is carefully plotting a course back to growth after an IMF programme of economic fixes.

But like the euro zone countries now on the path of austerity, the small North Atlantic nation faces a long, hard slog, with its banks still in need of repair, debts piling up and currency controls discouraging investment.

"Our main problem is that it is hard to see enough growth in the years to come," said Thorstein Palsson, a former prime minister, now chairman of Icelandic investment bank MP Bank and on the committee negotiating Iceland's entry into the European Union.

Two key problems are that domestic demand is flatlining and exports, despite a depreciation in the value of the crown, are basically unchanged compared to 2008.

The banks, which before their collapse had assets worth 10 times gross domestic product, have been recapitalised, but bad debts still make up about 30 percent of balance sheets. Assets shrank by the end of 2010 to about two times GDP.

The government and the creditors of the collapsed banks own the new banks. This distorts the allocation of capital, with banks unwilling to lend to businesses other than those they own.

"Iceland is going nowhere without an efficient financial market," said Vilhjamur Egilsson, chairman of the Confederation of Icelandic Employers.

Until the banks are divided into 'good' and 'bad' parts -- the latter to manage bad loans -- this is unlikely to change.

But such a move would probably mean a large number of companies, which are being kept in business only because they are bank-owned, would go bust. Unemployment, down from a peak of about 10 percent to six percent, would start going up again.

Meanwhile, many households are already awash with debt.

Chi, married to an Icelander but born in China, has seen his family's monthly mortgage payments nearly double over the last few years despite extending the loan to 70 from 40 years.

He earns less now as a taxi driver than in his former job in logistics at a transport firm, which he lost during the crisis. His wife, a teacher, has seen her salary fall around 10 percent.

"I work nights, I work weekends, I don't see my kids," he said. The family is considering moving to China where they can live rent free with Chi's parents in Shanghai.

But with negative equity of around 6 million Iceland crowns (32,000 pounds), that would mean bankruptcy and rule out being able to work or borrow in Iceland for 10 years.

WHERE'S THE GROWTH?

The government recently said it was focused on export-driven growth, but its plan lacks detailed measures.

MP Bank's Palsson said Iceland should utilise its cheap hydro- and geothermal energy resources to encourage investment, but the centre-left government is lukewarm due to worries about foreign domination of vital natural resources and the environmental impact.

Aluminium giant Alcoa (AA.N) recently dropped long-held plans to develop a new smelter in Iceland.

Finance Minister Steingrimur Sigfusson told Reuters there were opportunities in high-tech industries, data storage and silica production. He said GDP growth of 2-3 percent annually between 2010 and 2013, the broad forecast, would not be bad.

Confidence in the currency is also something Iceland must deal with as it consider plans to end capital controls. Around 500 billion krona-- about one-third of GDP -- of carry-trade money is still locked up in the country.

Move too fast to end controls and the currency could slump again as this money flees its current shackles.

"This is holding back investment and growth," Jon Danielsson, Reader in Finance at the London School of Economics, said at an IMF conference on Iceland's future late last month.

But a freely tradable currency would be a big risk for such a small economy. Interest rates are likely to remain relatively high and hot money may once again slosh in and out rapidly, part of the cause of the 2008 crash.

NO LET-UP

But things could be worse.

"At least we are not Greece," said Sverrir Hermansson, a hotel worker. There, unemployment is rising steadily and looks likely to hit over 16 percent next year.

In August, Iceland exited its $2.1 billion (1.3 billion pound) International Monetary Fund bailout programme and the economy grew 2.5 percent in the first half of the year. That is slow compared to before the crisis, when the economy regularly rose 5 percent a year.

But Greece is likely to contract by more than five percent this year and won't grow until 2013 at the earliest.

Iceland expects a balanced budget in 2014 and returned to the international capital markets in March.

Apart from work on the domestic economy, joining the European Union and the single currency could in the longer term make sense, although the government is wary and the population downright hostile. Also, Iceland still faces a spat with Britain and the Netherlands over $5 billion in debts.

All this needs to be done at a time when Europe, Iceland's biggest trading partner, is facing its worst crisis since World War II, according to German Chancellor Angela Merkel.

"We have to go on and finish the work," said Palsson. "I am afraid that with the IMF now out, the government will relax too much and we will not be able to solve these difficult problems."

(Reporting by Simon Johnson; Editing by John Stonestreet)