from Follow the Money

Russia, global lender of last resort? Will Russia bail out the hedge fund of the North ...

October 7, 2008

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A few years ago, analysts looking at the same data that Dr. Krugman highlighted started to call the US a hedge fund. It borrowed short-term in dollars, providing the world wit a safe liquid asset (or it was said) and used the proceeds to buy risky assets abroad -- collecting a risk premium in the process.

That kind of hedge fund is has had a bad run recently. The US -- viewed as a hedge fund -- is structurally "short" the dollar and "long" global equities, as it borrows in dollars to buy assets abroad. It consequently did well when the dollar fell and global equity markets rose, and correspondingly did poorly when the dollar rises and global equities fall. Unless something changes, the United States net international investment position will deteriorate quite sharply this year.

The US as hedge fund metaphor actually never quite worked for the US -- as the US was borrowing as much to finance a current account deficit (current consumption) as to finance the purchases of assets abroad. It actually was a better description of Europe (which also is having a bad week) in general and the Eurozone in particular. The Eurozone attracted large inflows and used the resulting inflows to finance equally large outflows, not a large current account deficit.

But no national resembled a high-living hedge fund quite as much as Iceland. Its big banks and big firms had enormous international liabilities and enormous international assets -- at least in relation to Iceland’s small economy. And for a while, Iceland used the profits from its intermediation to live very well, running a large current account deficit. In that sense, it also resembled the US.

Suffice to say it is a very troubled hedge fund.

And it has apparently turned to Russia -- yep, Russia -- for emergency financial support. Iceland’s prime minister claimed to have no choice. Iceland’s friends, he claimed, all turned Iceland down (maybe they were too busy rescuing their own banks). The FT reports

Geir Haarde, Iceland’s prime minister, said on Tuesday that the country’s “friends” had not offered financial assistance to his country, forcing it to seek a capital injection from Russia.

Iceland earlier revealed that Russia had agreed to provide the country with a €4bn ($5.4 bn) loan as the crisis-hit country set about shoring up its foreign exchange reserves, although Russia’s deputy finance minister, Dmitry Pankin, later said no agreement had been reached. Iceland’s currency, the krona, rallied on the news wiping out losses made on Monday and earlier on Tuesday.

“We have throughout this year asked many of our friends for swap agreements and for other forms of support in these extraordinary circumstances,” Mr Haarde said. “We have not received the kind of support that we were requesting from our friends. So in a situation like that one has to look for new friends.” Iceland’s central bank said its Russian counterpart had provided €4bn on a four-year deal, with interest set at 30-50 basis points over the London interbank offered rate. The move follows discussions with other countries in the past few days and emergency legislation passed in Iceland on Monday night that allows the nationalisation of banks.

The central bank also said it would peg the island’s krona to a basket of currencies at a level of 131 per euro effective immediately, to restore confidence in the battered currency. “Iceland has never defaulted on its sovereign debt and will not,” said Mr Haarde on Tuesday.

On Tuesday Alexei Kudrin, Russia’s finance minister, told reporters “Russia takes a positive view of Iceland’s request for a loan and will determine the terms and conditions in negotiations.

It is a strange deal though, assuming there is actually a deal.

Iceland is a member of NATO. The US had an airbase there for a long-time -- in large part to keep an eye out for Russia. During the cold war, the US would ever have allowed Russia to bail out a military ally. And Russia hasn’t traditionally thought of Iceland as part of its near-abroad either. Then throw if the fact that Russia is lending to support Iceland’s new peg -- a peg that I assume will be a peg to a euro-heavy rather a ruble-heavy basket.

The possibility that countries with large reserves might displace the US, the G-7 and institutions like the IMF from their traditional role as the world’s financial crisis managers was one of the strategic changes that I discussed in my Council Special Report was . I am though still surprised by Russia’s move, largely because I assumed that Russia’s current financial troubles would keep it from financial adventures abroad. Russia’s reserves fell by $40b between the end of July and the end of September, though part of that comes from the fall in the dollar value of Russia’s euros and pounds. It almost certainly isn’t pegging to the ruble. Finally, Russia’s central bank has had its hands full -- or so it seemed -- managing Russia’s own crisis. Russia’s government recently indicated it would give long-term (not just short-term) financing to Russia’s big state banks. I guess Russia wanted to show it has enough reserves to play offense as well as defense.

I consequently wouldn’t characterize this move as "stabilizing." It may help Iceland -- but it also destabilizes the world’s existing architecture for crisis management. The IMF has plenty of cash. It could have been at the center of an international effort to support Iceland, though the Fund’s rules and Iceland’s small size likely would have implied that the other Nordic countries and perhaps all of Europe would have needed to lend along side the Fund.

Or, I guess, Norway could have used its sovereign fund to bailout Iceland’s government and its banks --

Certainly lots of countries (Russia, Kuwait, Australia) have been using their sovereign funds to support their domestic banks recently.

Nor is Iceland the only small country with lots of external debt. Dubai looks rather like a real-estate heavy hedge fund ... with lots of short-term liabilities and long-term, rather illiquid assets. I would bet though that it will turn to Abu Dhabi rather than Russia for help.

Suffice to say the world is changing rapidly ...

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