from Follow the Money

Iceland: Déjà vu all over again

March 28, 2006

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Currency falls sharply.

Foreign banks cut credit lines.

"Last week ... US investors refused to roll over loans to the country's top three banks." (FT)

Local banks argue that they only thing to fear is fear itself.  Kaupthing:

"The only serious risk this bank faces now ... are persistent misconceptions that are kept alive and thrown at us time and again.  We have to join forces and face this risk upfront to avoid these malevolent remarks about our bank growing into an established cliché and becoming a self-fulfilling prophecy."

They better have lots of liquid foreign assets that they can sell to pay off their maturing debt, as they claim.   Liquidity does matter.

Local analysts claim that vicious foreigners (the Danes apparently know how to offend without publishing a cartoon ... ) don't understand the local economy.   Politicians too.

Iceland's PM Halldor Asgrimsson:

"There can be great hysteria, with people all over the world sitting in front of monitors and computers, and there are all kinds of things being communicated, and at times the action can be too fast for anyone to handle.  .... I am not aware of that Danske Bank has conducted any business to speak of here in Iceland nor that people from that company have any knowledge of this market. I ask: Why are they issuing a report on Iceland? I don't quite get it. Why are people who have never conducted a single interview in Iceland issuing reports on [on Iceland]."

Capital flows to a country that had been the darling of the capital markets (at least a few hedge funds and prop desks) suddenly dry up.

It does have a familiar ring.  At least if you remember Asia's crisis.

Will Iceland experience a sharp recession or just slow down a bit?

Hell if I know.  I haven't been to Iceland since I was six, and even then, I think I was on Icelandic soil for about an hour.  I don't want to be criticized by Iceland's PM.

Though Landisbanki's argument that if net out the transfer of mortgages from the publicly owned Housing Financing Fund, credit growth was only 30% (more than China) is hardly reassuring.

Iceland's economy hinges on the almighty cod (Landisbanksi calls the fisheries sector all important).  In the future, it may hinge on turning geothermal energy into aluminum.    There are some comparative advantages associated with being on a volcanic island in the North Atlantic.  (See Kaupthing bank for a broad overview of Iceland's history, and economy)

But - at least according to the Danes - even if you net out aluminum investment, Iceland's current account deficit isn't small.   And even if Iceland works a bit like the US in one way  - taking on debt to make equity investments abroad - it also works a bit like US in another way - it takes on debt to finance a significant current account deficit.  Iceland's (formerly booming) housing sector may have something to do with its large current account deficit too.  

Iceland's net international investment position is worse than that of the US - 70% of GDP according to Danske Bank, v 25% for the US (according to Setser estimates for end 2005).  But then again, Iceland's export base is a lot bigger than that of the US.  "Trade" was 38.6% of Iceland's GDP v. 11.7% of US GDP in 2002, according to the OECD.   I am not quite sure how the OECD defines trade, but it seems to be close to the average of imports and exports to GDP.

And Iceland doesn't benefit (at least not directly) from Chinese reserve accumulation.   I don't think China has diversified its portfolio quite that much.  Big capital inflows from the US and Europe and Japan to the emerging world get recycled back into the US, not into Iceland.  Iceland may get some of Norway's petrodollars, but probably not many of Saudi Arabia's.    Though who really knows what the Saudis are doing with their money?

Iceland has indirectly benefited from these flows.  To the extent that they kept US and European long-term bond yields low (and the yield curve flat), they encouraged private investors to reach for yield and reach for risk.

But maybe "benefit" is the wrong word.   Iceland also seems (and I would emphasize seems, I really don't know enough to offer a definitive view) to illustrate some of the challenges of managing monetary policy in an era of financial globalization.  Its central bank was concerned about overheating, so it raised rates.  But by offering higher rates than even New Zealand, it seems to have attracted lots of inflows.  And those inflows may have fed an even bigger boom.

Until boom risks turning into bust.

From afar, this looks to be a case where large-scale capital flows helped to destabilize a very small economy - not of stabilizing speculation.   Maybe Iceland should have put some speed bumps up to limit inflows into the banking system when interest rates turned to bust.

Does any of this matter for the US?  Probably not.   Emerging markets seeking to avoid Iceland's fate (or seeking to emulate China's success) don't let their currencies rise and recycle capital flows back into the US market.   The US is a high carry country if you fund yourself in yen, but that carry trade doesn't seem to have unwound.  US rates are rising, Japan's rates aren't (yet). No one sees much of a reason to worry about the United States' current account deficit, even if it is now as high as Mexico's current account deficit on the eve of its crisis.   

As Martin Wolf notes in his most recent (and I think quite good) column:

"Should we stop worrying and learn to love global imbalances? Investors certainly seem to believe this. Even though the US current account deficit reached 7 per cent of gross domestic product in the last quarter of 2005, the real exchange rate has stabilised. But the best time to worry about such trends is when everybody has ceased to do so. Now is such a time."

Of course, the world has not heeded Wolf's counsel on this issue for a long time, and probably won't start now.  Even though the US current account deficit is now as large as Mexico's on the eve of its crisis ...

Update: Roubini thinks Iceland is a potential wake-up call for all countries with credit and housing driven current account deficits ...

General hat tip: "Iceland" from the comments section of this blog.

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