Analysis: Icelanders question their lauded economic recovery

Iceland's biggest IT company CCP is what the island needs to leave its economic crisis behind. It is global, growing and employs hundreds but its tale is also one of frustration that echoes concerns about the country's future.

For CEO Hilmar Petursson, Iceland's lauded recovery model that included a sharp currency fall coupled with capital controls may have pulled a $13 billion economy back from the brink after a 2008 bank crash. But it is now a drag on firms like his.

"The economic remedy has now become part of the problem ... We are not building the company as fast as we could from a global perspective," said Petursson, seated at his office in a former fishing processing plant littered with vampire books and a huge games console.

Iceland is growing at 2 percent, faster than much of Europe. But Petursson's comments underscore worries about the recovery's sustainability in a straightjacket of capital controls - coupled with questions over having a currency that one politician compared to the Disneyland dollar.

Growth has been downgraded this year from 3 percent to 2 percent. Inflation is stubbornly high and the central bank has been forced to step up intervention in the currency market to prop up a weakening crown.

Many expected Iceland's recovery to be stronger given the way smaller economies can bounce from deep recessions. The International Monetary Fund had originally forecast annual growth of around 4.5 percent from 2011-2013. It now is under half that.

"Recovery? We're on the road to nowhere," said Vilhjalmur Egilsson, head of the Confederation of Icelandic Employers.

A general election due in April has added to uncertainty with concerns that populism may replace pragmatism as voters tire of austerity. Polls show centre-right parties widely seen as responsible for the crisis may replace a leftist government.

CONTROLLING CAPITAL

CCP, which makes the popular Eve computer game, made around $65 million in 2011. It employs some 500 people globally from Shanghai to Newcastle, more than half of which are in Iceland.

But capital controls imposed after the crisis, making it difficult to buy foreign currency, means financing is hard, as well as getting skilled workers to come to this volcanic island when repatriating savings is nearly impossible.

Petursson talks about strained conversations with Californian equity investors over getting investment returns.

"Sorting out this mess is not an easy job," said the CEO. "But (capital controls) push the energy of this company from this island. If a non-Icelander were to run the company they would go somewhere else. I stubbornly stay here."

The IMF and Nobel laureate Paul Krugman see Iceland as a model of recovery and a lesson for much of Europe. Its decision to act quickly, allowing banks to fail, is held up favorably against the inertia of decision-making in the euro zone.

The impact of its currency fall has been contrasted with the deeper recessions of the Baltics, pegged to the euro. A quick return to growth in the last two years, coupled with relatively low unemployment, has appeared to justify its role model status.

But now there is a sense of fragility.

Many Icelanders say they do not feel modest growth. Outside booming fishing and tourism, businesses complain of stagnation.

Some 80 percent of households are swamped in housing loan debts indexed to inflation. Real salaries are down by around a third since the crisis. Investment is under 15 percent of GDP, a record low. State workers like nurses are raising worries about inflation amid increasing demands for better salaries.

"There are signs a lot is slowing down, stagnating," said Asdis Kristjansdottir, head of research at Arion Bank. "There have been tax increases, uncertainty over capital controls, and political uncertainty with delays in investments."

CURRENCY PROBLEM

There is no doubt Iceland has bounced back from a burst banking bubble when the sector's assets grew to 10 times the country's GDP.

Fitch raised its credit rating in February to BBB, citing an "impressive" recovery. The government has repaid the IMF some $480 million early and brought a more than 10 percent fiscal deficit back to a near balance.

Fishermen who dumped their nets to move into real estate before the crisis are now making money back on boats. Tourism to the volcanic island is sky high.

"All in all Iceland has done as well as can be expected," said Industries Minister Steingrimur Sigfusson. "We are still among the highest performers in Europe. I would rather see 2.5 percent stable growth than 5 percent with a crash and bang."

But a few minutes walk away, central bank governor Mar Gudmundsson says he has a problem. He says the crown, down 17 percent since August, is below a long term sustainable level and putting upward pressure on prices since so much is imported.

"The recovery will be slower this year than we predicted," Gudmundsson told Reuters in his office overlooking Reykjavik bay. "What keeps me awake at night ... is the potential for a spiral between the exchange rate, prices and wages, so you lose control of inflation.

"What keeps me awake is that people promise too much in elections and try to keep their promises."

At the heart of the problem are capital controls. Foreign funds tied up in Iceland amount to about a quarter of GDP, according to the central bank. Economist say it is far more.

If controls are relaxed, many fear a flight out of Iceland that will cause a collapse in the crown and spiraling inflation.

EURO THE ANSWER?

Reports last year that Iceland could adopt the Canadian dollar were not completely idle talk but reflected a sense that the only way out may be to adopt another currency - most likely the euro.

But there is also widespread skepticism about joining the euro. EU negotiations are currently suspended.

"There is more trade in the Disneyland dollar than the Icelandic krona, and that's the problem that everyone trying to lift the currency controls will have to deal with," said Arni Pall Arnason, chairman of the ruling Social Democratic party and a possible prime ministerial candidate.

When Ossur - a maker of prosthetic limbs - delisted from the Iceland stock exchange in 2011 for Copenhagen, analysts saw capital controls as one of the main reasons.

"For the businesses I talk to, the main problem are currency restrictions," said Jon Hakon Magnusson, head of KOM public relations, who advises investors and diplomats on Iceland.

For many private investors, Prime Minister Johanna Sigurdardottir's left-of-centre government is as much to blame with its tax increases and a perceived anti-business stance.

An OECD report in February said there has been little progress on key reforms in the last two years to boost growth, such as opening up fishing to foreign investment.

Magnusson said currency controls, pricing and environmental issues caused Alcoa, the largest U.S. aluminum producer, to drop plans for a new smelter a year ago.

"Many foreign investors I talk to have lost their trust in the government," he said.

There are signs of a backlash. Polls suggest a new government will be formed by the rightist Independence Party, which promises to cut taxes and is skeptical about joining the European Union.

An hour's drive from the capital to the town of Keflavik, dozens of Icelanders lined up for free food aid. People must present rent or mortgage slips and their salary slips. The narrowness of the difference is the measure for qualification.

"There are higher prices and higher debts, things have got worse," said Anna Valdis Jonsdottir, head of the voluntary Family Help project. The number of people coming for free food to her centre has risen this year.

"They are all a long way from this recovery," she said, leaning against dozens of cans of meatballs.

(Additonal reporting by Robert Robertsson. Editing by Mike Peacock)