Is Iceland The Canary In The Mineshaft of Global Financial Contagion?
Sunday, 30. March 2008, 23:13:36
DK Metal writes in an ACTA Briefing:
Iceland: It's A Nordic Hedge Fund Masquerading As A Country And Its Carry Trades Are Now Unwinding Causing Investment Flight
Iceland is described as a Nordic hedge fund masquerading as a country! Like many hedge funds, Iceland is now in trouble. Their central bank was forced to raise interest rates to 15% this week in an emergency move to halt the collapse of the Krona, which has fallen 18% since mid-March as "Carry Trades" have been unwound. Particularly, the unwinding of Japanese Yen positions has been a key factor in the sudden capital flight away from Iceland this month. The Yen's surge in recent weeks has played havoc with the capital in-flows into many countries across the world. While Iceland's inflation target is 2.5%, the February inflation rate was 6.8%.
The Spigot Of Easy Credit Has Been Turned Off, And Now, Interest Rate Hikes And Currency Devaluations Are Raising Inflation
The central bank's rate hike is designed to increase confidence in the Krona, that has slumped and made imported goods more costly. It is now apparent that sovereign central banks cannot manage the "Global Credit Crunch" without severe pain and it would appear that the financial markets and margin calls are calling the shots in the accelerating "Great Unwind near The Speed of Light." This leaves central banks and regulators as front row interactive spectators who are following the markets and NOT leading them!
A Credit Freeze Is Now In Effect Due To Highly Levered Bank's Portfolios Gone Bad
From where did the troubles emanate in Iceland? Banks and the process of financialization. The country's all-conquering banks -- including Kaupthing, Glitnir, and Landsbanki -- pushed the asset base of the Icelandic banking system to a world record of eight times GDP, tapping the global capital markets to launch M&A raids across the UK, Scandinavia and beyond. As access to easy credit all but dried up in the financial markets, the spreads on Icelandic bank debts rose from less than 50 basis points to 800 over a few months. They are now near levels seen in Bear Stearns' debt just before the Federal Reserve's rescue. This raises a critical question: Is the Icelandic government -- which presides over a population smaller than the Canton of Geneva -- big enough to rescue its highly leveraged banks? If the government tries to raise billions in the global markets it would damage its own credit rating. The central bank has just USD 2bn (GBP 1bn) in reserves.
Massive Foreign Debt In The Baltic Nations Have Risen To Astronomic Levels And Are The Impetus For Investor Flight
What happens next? Iceland is not alone in living far beyond its means. The Baltics, the Balkans including Romania, Hungary, Turkey, and South Africa (to some extent) are all in a similar boat as they are all living far beyond their means. History shows that countries which run current account deficits above 10% of GDP for any length of time almost always get into trouble. East Asia's debt crisis in 1997 erupted even before any nation reached double digit deficits. Iceland's deficit is now 16% of GDP. Latvia is at 23%, Bulgaria 21%, Georgia 18%, Estonia 16%, Lithuania 14%, Romania 14%, Serbia 13%, South Africa 7% and Turkey 6%. All these economies have let credit grow faster than what would be considered safe, some exceeding 50% growth a year! The region will need USD 350bn in foreign loans this year to stay afloat. Iceland is one of the first "large deficit nation states" to succumb to investor flight, sending an early warning signal of potential troubles across a great swathe of Eastern Europe, the Mediterranean and across the world.
Central Banks Are Now Responding By Raising Interest Rates Which Fuels Additional Inflation And Freezes Credit For Businesses
Peripheral European economies that depend heavily on foreign investors -- most recently Iceland and Romania -- are left with no choice other than to raise interest rates aggressively to shore up their currencies and to fight rising inflation as financial markets question whether the countries can sustain their debt-fuelled growth. Tuesday's 1.25% rate increase in Iceland, took the key short-term rate there to 15%. Romania's central bank has raised its key interest rate by 0.5% to 9.5% on Wednesday to bolster the Leu. Poland's central bank also raised rates on Wednesday. Hungary is expected to do so on Monday.
The rate increases contrast with the US Federal Reserve's policy of cutting rates in the face of turmoil in financial markets and fears about an economic slowdown. Poland, Slovakia, the Czech Republic and Russia, are in a better position to ride out the storm in global markets, thanks to better-balanced economies, strong inflows of foreign direct investment, and in Russia's case, huge oil-and-gas revenue.
The Yen Carry Trade Has Fueled Current Account Deficits, And Its Unwining Is Causing A Shortage Of Credit Needed For Business To Stay Afloat
The Turkish Lira is another enigma. How it has stayed so high for so long is thanks to the "Carry Trade." Until now Turkey has been the darling of the "Yen Carry Trade," for example, offering irresistible yields to Japan's army of house wives and investors. There are huge imbalances in the economy. The current account deficit is nearly 8% of GDP, and the chief prosecutor is trying to shut down the government. Last week the court moved to ban the ruling Islamic AKP party, as well as the president and prime minister, for alleged breach of the country's secular laws. Turkey has a foreign debt of USD 275+bn. Turkish companies may have great difficulty raising some USD 50bn of fresh loans needed this year to stay afloat.
Now Currency Torture That Comes With The Unwinding Of The Yen Carry Trade Is Causing Real Levels Of Debt To Ratchet Up Fast
The other side of the "Carry Trade," borrowing in foreign currencies, has also been in vogue in the euphoria of the credit bubble. For example, most mortgages in Hungary over the last two years have been in Swiss francs, with the Balkans and Poland not far behind. This is now turning into slow torture. The Swiss Franc has risen 5% against the Euro since October. The real level of the debt is ratcheting up fast. Foreign debts have reached 122% of GDP in Latvia, 101% in Estonia and 73% in Lithuania, mostly in Euros. For now the debtors are shielded by fixed exchange rates in Europe's ERM system, but this could make the shock even worse should the currency pegs start to snap. There is now a real risk of global financial contagion from Iceland as it increasingly looks like the canary in the mineshaft!
Written by DK Matai, Chairman, Asymmetric Threats Contingency Alliance (ATCA) & The Philanthropia,
Linked In Response by Hjortur provides the Icelandic response
I'm not an economist but I am Icelandic and I would like to point out a few things. First of all, Iceland can not be compared to Eastern Europe or the East Asia's debt crisis in 1997. For one, Iceland is one of the wealthiest nations in the world and was rated with the best living standard in the world on UNDP Human Index this year (I guess they don't take the weather into their calculations). We have excellent infrastructure, a very stable political environment, almost non existing corruption and a flexible economy.
As you pointed out, Iceland is a small nation which makes it more vulnarable for all swings, both up and down. The large deficit can partly be explained with the construction of the Karahnjukar dam and aluminium smelters, huge construction projects which have had a noticable effect on the Icelandic economy. This deficit seems to be turning now.
The Icelandic banks have been a leading power in the expansion of the Icelandic economy and most of their assets are in the UK and Scandinavia today. It is worrying how much the spread on the Icelandic bank debts have rose but that seems to be caused more by fear about the size of the Icelandic economy than any hard data. It has been proven that the Icelandic banks have more solid foundations than most of the other Scandinavian banks and they can in no way be compared to Bears Stearn. The Icelandic banks do not have any "toxic paper" which is the biggest problem in many other banks.
The Icelandic banks are well funded for now and are capable of holding out the current situation for quite some time. The spread on the bank debts have been going down again this week and the stock market has had it's best week ever, correcting the red weeks before easter. This indicates that investors now believe that the bottom has been reached and are buying what they can at this low rate. For foreign investors, the weakening of the Krona and the markets have actually made Icelandic stock a very attractive buying opportunity.
My Response And Suggested Investment Application
Iceland use to trade cod for its economic well being; but booming financial services has made Iceland’s 300,000 citizens to be ranked as some of the richest in the western world: one can say the whole country and its people were financialized.
As Ruth Sutherland in the Observer relates since 2000, it's banks have been a laboratory for highly leveraged investment services and now the credit crunch has sent the value of its currency down against the Euro.
It would have been much better for Iceland to stay with its traditional industry -- fishing, rather than have its economy become unbalanced by the high-speed growth of the banking sector, as well as to incur a massive current account deficit, which has become a major factor in an increasing credit drought turning down a local mortgage based housing boom, and vast expansion in consumer and business borrowing; definitely, the whole economy has been operating like a hedge fund. Yes, Iceland's companies have been able to borrow cheaply to engage in both at home, as well as in an overseas expansion drive. Now, Iceland as a country is going to follow the same path as many hedge funds have gone -- into oblivion.
Iceland has been the investor's darling for corporate investment with the construction of Dam and Smelter, as well as a destination for interest rate differential investment borrowing in the euro to invest in the krona and other high-yielding currencies.
Once having benefiting from yen carry trade, as well as a domestic carry trade, these are now unwinding raising havoc: it's like an accordion that has expanded and is now contracting. Iceland's banks are heavily invested in illiquid and highly leveraged assets.
It's as the Economist.com relates: "Yen carry trade investors are choosing to deleverage -- reduce their market positions in order to repay their debts. Deleveraging by hedge funds was blamed for the sharp fall in commodity prices that followed news of the Fed's latest interest rate cut. It may be that hedge funds decided to reduce their riskiest positions after the central bank indicated that it was still worried about inflation; a belief that the Fed was “asleep at the wheel” had previously been pushing raw materials prices up and the dollar down".
"The problem with deleveraging is that it can create a self-perpetuating cycle. Tighter credit standards lead investors to sell assets, forcing down prices and making other lenders nervous about the creditworthiness of their borrowers. It can also cause some panicky price movements, as sellers, fearing further losses, unload their assets at almost any price."
"As banks tighten credit, businesses and consumers will face pressure to cut spending (witness the latest fall in American durable-goods orders). The economic effects of that restraint will then feed back to the markets. “The Fed may have underwritten the solvency of the banks (temporarily) but the economic problems haven't gone away,” says Peter Oppenheimer, a strategist at Goldman Sachs."
Iceland's external debt is more than 500 per cent of the country's GDP -- Iceland is heavily indebted to the rest of the world; and its annual inflation is 8.7 per cent.
For a number of factors, credit default swaps, which establish risks on banks going from insolvency to bust, have risen to horrific levels Iceland's banks; these banks are seen as the most unsafe in the developed world as their CDSs exceed those of Bear Stearns, BSC, before it went bust; it's reasonable to say that Iceland's banks are the Bear Stearns of the North Atlantic.
Island's banks have been aggressively invested overseas; and now that investment has gone toxic. Island's central bank has moved to ease interbank money market conditions with the issue of transferable certificates of deposit, and announced changes to the collateral regime covering banks’ access to central bank liquidity or lending and has issued a statement that those overseas investments do not constitute a basis for reserves; while this change will considerably lighten the reserve requirements of those banks that operate branches abroad, its a tacit admission of bank insolvency.
Every single one of Iceland's central bank's moves has been that of draining liquidity out of the investor side of the investment system; Iceland's central bank's actions have really not good long-term for the stock market investor.
The recent current Island's stock market rise is not a bottom; but simply a short selling opportunity; there will be no riding it out for the investor, housewife or kid down the block -- for anyone.
Iceland is the canary in the investment coal mine, the current experience warns investors both in Iceland and everywhere to forgo bank accounts, stocks and bonds; this being confirmed in a rising Libor which warns of global bank insolvency.
And now, Britain's Financial Services Agency, FSA, has come out with a warning to savers that foreign banks offering British savers high interest rates are riskier than High Street institutions. In the past 18 months banks from Iceland, a country with a similar population size to Coventry, have secured £6 billion of British savings in internet bank accounts offering high interest rates. Jonathan Chapman, the FSA's head of financial capability, warned that customers could be placing themselves outside British deposit protection schemes if they saved with foreign banks. "We'd encourage savers when considering an investment to talk to the providers in the first instance to get an understanding of what the compensation arrangements are, should the very unlikely event of a firm getting into trouble, actually occur," said Mr Chapman.
The investment maxim here is that given the risk of bank and investment banker insolvency globally, one does not want to hold monies in any local currency; the smart thing to do is to invest in gold, as a remedy for rising inflation and deflating asset prices caused by leveraged bank debt, Yen Carry Trade disinvestment, credit freezes, downward ratcheting of Treasury Bonds, and skyrocketing credit default swap spreads.
One should even consider placing gold coins in a Swiss Bank safe vault, dollar cost averaging purchases of gold at BullionVault.com and investing in a gold ETF, such as GLD, and using credit margin to go short Islands banks Kaupthing, Landsbanki and Glitnir if these are still up in value.
Related Reading
Iceland's Financial State In Full Meltdown Mode
Iceland: It's A Nordic Hedge Fund Masquerading As A Country And Its Carry Trades Are Now Unwinding Causing Investment Flight
Iceland is described as a Nordic hedge fund masquerading as a country! Like many hedge funds, Iceland is now in trouble. Their central bank was forced to raise interest rates to 15% this week in an emergency move to halt the collapse of the Krona, which has fallen 18% since mid-March as "Carry Trades" have been unwound. Particularly, the unwinding of Japanese Yen positions has been a key factor in the sudden capital flight away from Iceland this month. The Yen's surge in recent weeks has played havoc with the capital in-flows into many countries across the world. While Iceland's inflation target is 2.5%, the February inflation rate was 6.8%.
The Spigot Of Easy Credit Has Been Turned Off, And Now, Interest Rate Hikes And Currency Devaluations Are Raising Inflation
The central bank's rate hike is designed to increase confidence in the Krona, that has slumped and made imported goods more costly. It is now apparent that sovereign central banks cannot manage the "Global Credit Crunch" without severe pain and it would appear that the financial markets and margin calls are calling the shots in the accelerating "Great Unwind near The Speed of Light." This leaves central banks and regulators as front row interactive spectators who are following the markets and NOT leading them!
A Credit Freeze Is Now In Effect Due To Highly Levered Bank's Portfolios Gone Bad
From where did the troubles emanate in Iceland? Banks and the process of financialization. The country's all-conquering banks -- including Kaupthing, Glitnir, and Landsbanki -- pushed the asset base of the Icelandic banking system to a world record of eight times GDP, tapping the global capital markets to launch M&A raids across the UK, Scandinavia and beyond. As access to easy credit all but dried up in the financial markets, the spreads on Icelandic bank debts rose from less than 50 basis points to 800 over a few months. They are now near levels seen in Bear Stearns' debt just before the Federal Reserve's rescue. This raises a critical question: Is the Icelandic government -- which presides over a population smaller than the Canton of Geneva -- big enough to rescue its highly leveraged banks? If the government tries to raise billions in the global markets it would damage its own credit rating. The central bank has just USD 2bn (GBP 1bn) in reserves.
Massive Foreign Debt In The Baltic Nations Have Risen To Astronomic Levels And Are The Impetus For Investor Flight
What happens next? Iceland is not alone in living far beyond its means. The Baltics, the Balkans including Romania, Hungary, Turkey, and South Africa (to some extent) are all in a similar boat as they are all living far beyond their means. History shows that countries which run current account deficits above 10% of GDP for any length of time almost always get into trouble. East Asia's debt crisis in 1997 erupted even before any nation reached double digit deficits. Iceland's deficit is now 16% of GDP. Latvia is at 23%, Bulgaria 21%, Georgia 18%, Estonia 16%, Lithuania 14%, Romania 14%, Serbia 13%, South Africa 7% and Turkey 6%. All these economies have let credit grow faster than what would be considered safe, some exceeding 50% growth a year! The region will need USD 350bn in foreign loans this year to stay afloat. Iceland is one of the first "large deficit nation states" to succumb to investor flight, sending an early warning signal of potential troubles across a great swathe of Eastern Europe, the Mediterranean and across the world.
Central Banks Are Now Responding By Raising Interest Rates Which Fuels Additional Inflation And Freezes Credit For Businesses
Peripheral European economies that depend heavily on foreign investors -- most recently Iceland and Romania -- are left with no choice other than to raise interest rates aggressively to shore up their currencies and to fight rising inflation as financial markets question whether the countries can sustain their debt-fuelled growth. Tuesday's 1.25% rate increase in Iceland, took the key short-term rate there to 15%. Romania's central bank has raised its key interest rate by 0.5% to 9.5% on Wednesday to bolster the Leu. Poland's central bank also raised rates on Wednesday. Hungary is expected to do so on Monday.
The rate increases contrast with the US Federal Reserve's policy of cutting rates in the face of turmoil in financial markets and fears about an economic slowdown. Poland, Slovakia, the Czech Republic and Russia, are in a better position to ride out the storm in global markets, thanks to better-balanced economies, strong inflows of foreign direct investment, and in Russia's case, huge oil-and-gas revenue.
The Yen Carry Trade Has Fueled Current Account Deficits, And Its Unwining Is Causing A Shortage Of Credit Needed For Business To Stay Afloat
The Turkish Lira is another enigma. How it has stayed so high for so long is thanks to the "Carry Trade." Until now Turkey has been the darling of the "Yen Carry Trade," for example, offering irresistible yields to Japan's army of house wives and investors. There are huge imbalances in the economy. The current account deficit is nearly 8% of GDP, and the chief prosecutor is trying to shut down the government. Last week the court moved to ban the ruling Islamic AKP party, as well as the president and prime minister, for alleged breach of the country's secular laws. Turkey has a foreign debt of USD 275+bn. Turkish companies may have great difficulty raising some USD 50bn of fresh loans needed this year to stay afloat.
Now Currency Torture That Comes With The Unwinding Of The Yen Carry Trade Is Causing Real Levels Of Debt To Ratchet Up Fast
The other side of the "Carry Trade," borrowing in foreign currencies, has also been in vogue in the euphoria of the credit bubble. For example, most mortgages in Hungary over the last two years have been in Swiss francs, with the Balkans and Poland not far behind. This is now turning into slow torture. The Swiss Franc has risen 5% against the Euro since October. The real level of the debt is ratcheting up fast. Foreign debts have reached 122% of GDP in Latvia, 101% in Estonia and 73% in Lithuania, mostly in Euros. For now the debtors are shielded by fixed exchange rates in Europe's ERM system, but this could make the shock even worse should the currency pegs start to snap. There is now a real risk of global financial contagion from Iceland as it increasingly looks like the canary in the mineshaft!
Written by DK Matai, Chairman, Asymmetric Threats Contingency Alliance (ATCA) & The Philanthropia,
Linked In Response by Hjortur provides the Icelandic response
I'm not an economist but I am Icelandic and I would like to point out a few things. First of all, Iceland can not be compared to Eastern Europe or the East Asia's debt crisis in 1997. For one, Iceland is one of the wealthiest nations in the world and was rated with the best living standard in the world on UNDP Human Index this year (I guess they don't take the weather into their calculations). We have excellent infrastructure, a very stable political environment, almost non existing corruption and a flexible economy.
As you pointed out, Iceland is a small nation which makes it more vulnarable for all swings, both up and down. The large deficit can partly be explained with the construction of the Karahnjukar dam and aluminium smelters, huge construction projects which have had a noticable effect on the Icelandic economy. This deficit seems to be turning now.
The Icelandic banks have been a leading power in the expansion of the Icelandic economy and most of their assets are in the UK and Scandinavia today. It is worrying how much the spread on the Icelandic bank debts have rose but that seems to be caused more by fear about the size of the Icelandic economy than any hard data. It has been proven that the Icelandic banks have more solid foundations than most of the other Scandinavian banks and they can in no way be compared to Bears Stearn. The Icelandic banks do not have any "toxic paper" which is the biggest problem in many other banks.
The Icelandic banks are well funded for now and are capable of holding out the current situation for quite some time. The spread on the bank debts have been going down again this week and the stock market has had it's best week ever, correcting the red weeks before easter. This indicates that investors now believe that the bottom has been reached and are buying what they can at this low rate. For foreign investors, the weakening of the Krona and the markets have actually made Icelandic stock a very attractive buying opportunity.
My Response And Suggested Investment Application
Iceland use to trade cod for its economic well being; but booming financial services has made Iceland’s 300,000 citizens to be ranked as some of the richest in the western world: one can say the whole country and its people were financialized.
As Ruth Sutherland in the Observer relates since 2000, it's banks have been a laboratory for highly leveraged investment services and now the credit crunch has sent the value of its currency down against the Euro.
It would have been much better for Iceland to stay with its traditional industry -- fishing, rather than have its economy become unbalanced by the high-speed growth of the banking sector, as well as to incur a massive current account deficit, which has become a major factor in an increasing credit drought turning down a local mortgage based housing boom, and vast expansion in consumer and business borrowing; definitely, the whole economy has been operating like a hedge fund. Yes, Iceland's companies have been able to borrow cheaply to engage in both at home, as well as in an overseas expansion drive. Now, Iceland as a country is going to follow the same path as many hedge funds have gone -- into oblivion.
Iceland has been the investor's darling for corporate investment with the construction of Dam and Smelter, as well as a destination for interest rate differential investment borrowing in the euro to invest in the krona and other high-yielding currencies.
Once having benefiting from yen carry trade, as well as a domestic carry trade, these are now unwinding raising havoc: it's like an accordion that has expanded and is now contracting. Iceland's banks are heavily invested in illiquid and highly leveraged assets.
It's as the Economist.com relates: "Yen carry trade investors are choosing to deleverage -- reduce their market positions in order to repay their debts. Deleveraging by hedge funds was blamed for the sharp fall in commodity prices that followed news of the Fed's latest interest rate cut. It may be that hedge funds decided to reduce their riskiest positions after the central bank indicated that it was still worried about inflation; a belief that the Fed was “asleep at the wheel” had previously been pushing raw materials prices up and the dollar down".
"The problem with deleveraging is that it can create a self-perpetuating cycle. Tighter credit standards lead investors to sell assets, forcing down prices and making other lenders nervous about the creditworthiness of their borrowers. It can also cause some panicky price movements, as sellers, fearing further losses, unload their assets at almost any price."
"As banks tighten credit, businesses and consumers will face pressure to cut spending (witness the latest fall in American durable-goods orders). The economic effects of that restraint will then feed back to the markets. “The Fed may have underwritten the solvency of the banks (temporarily) but the economic problems haven't gone away,” says Peter Oppenheimer, a strategist at Goldman Sachs."
Iceland's external debt is more than 500 per cent of the country's GDP -- Iceland is heavily indebted to the rest of the world; and its annual inflation is 8.7 per cent.
For a number of factors, credit default swaps, which establish risks on banks going from insolvency to bust, have risen to horrific levels Iceland's banks; these banks are seen as the most unsafe in the developed world as their CDSs exceed those of Bear Stearns, BSC, before it went bust; it's reasonable to say that Iceland's banks are the Bear Stearns of the North Atlantic.
Island's banks have been aggressively invested overseas; and now that investment has gone toxic. Island's central bank has moved to ease interbank money market conditions with the issue of transferable certificates of deposit, and announced changes to the collateral regime covering banks’ access to central bank liquidity or lending and has issued a statement that those overseas investments do not constitute a basis for reserves; while this change will considerably lighten the reserve requirements of those banks that operate branches abroad, its a tacit admission of bank insolvency.
Every single one of Iceland's central bank's moves has been that of draining liquidity out of the investor side of the investment system; Iceland's central bank's actions have really not good long-term for the stock market investor.
The recent current Island's stock market rise is not a bottom; but simply a short selling opportunity; there will be no riding it out for the investor, housewife or kid down the block -- for anyone.
Iceland is the canary in the investment coal mine, the current experience warns investors both in Iceland and everywhere to forgo bank accounts, stocks and bonds; this being confirmed in a rising Libor which warns of global bank insolvency.
And now, Britain's Financial Services Agency, FSA, has come out with a warning to savers that foreign banks offering British savers high interest rates are riskier than High Street institutions. In the past 18 months banks from Iceland, a country with a similar population size to Coventry, have secured £6 billion of British savings in internet bank accounts offering high interest rates. Jonathan Chapman, the FSA's head of financial capability, warned that customers could be placing themselves outside British deposit protection schemes if they saved with foreign banks. "We'd encourage savers when considering an investment to talk to the providers in the first instance to get an understanding of what the compensation arrangements are, should the very unlikely event of a firm getting into trouble, actually occur," said Mr Chapman.
The investment maxim here is that given the risk of bank and investment banker insolvency globally, one does not want to hold monies in any local currency; the smart thing to do is to invest in gold, as a remedy for rising inflation and deflating asset prices caused by leveraged bank debt, Yen Carry Trade disinvestment, credit freezes, downward ratcheting of Treasury Bonds, and skyrocketing credit default swap spreads.
One should even consider placing gold coins in a Swiss Bank safe vault, dollar cost averaging purchases of gold at BullionVault.com and investing in a gold ETF, such as GLD, and using credit margin to go short Islands banks Kaupthing, Landsbanki and Glitnir if these are still up in value.
Related Reading
Iceland's Financial State In Full Meltdown Mode
WIDGETIZE