Friday, August 03, 2007

Iceland - Teetering on the brink?

A recent economic paper (“The Global Financial Accelerator and the Role of International Credit Agencies” by Carsten Valgreen, Chief Economist, Danske Bank) asks whether central banks of small countries are losing influence over macro economic policy. By losing influence, he means lack of impact in mitigating climbing interest rates and out-of-whack budgets.

The question he asks is Why hasn't the international market stepped in to rein in these imbalances?

The examples he uses are Iceland and Latvia. Let's talk about the conditions in Iceland since that country is this provincial government's nation-model-hero of the hour.

(Sounds like fun, I know but bear with me for a second - it's relevant.)

The fact is that Iceland is barely escaping the kind of currency crisis that a more vigilant bond market would traditionally have imposed just a few years ago.

Iceland has racked up enormous current-account deficits, running at a remarkable 25-30% of GDP.

NL, by comparison, is running substantial current account surpluses thanks to healthy oil and nickel revenues.

Iceland's companies have been in an acquisitive mood in recent years, borrowing heavily to buy abroad. The country has also used foreign finance to build some large aluminum smelters. As a result, its gross foreign debt is more than five times the value of its GDP.

The GDP is approximately US$16billion which makes the foreign debt about US$80billion. That's US$260,000 per capita.

Our debt? Well, these days it's running about $10billion compared to a GDP of about $19billion* for a ratio of roughly 50% of GDP. And it's already the highest per capita in Canada at roughly C$18,400 per person.

The Central Bank of Iceland has been trying to bring this issue of national debt under control by raising short-term interest rates to nearly 15%. This compares to a local interest rate of 6.5% or so.

Interestingly, the bank's efforts have, if anything, backfired. High rates have made Iceland the beneficiary of the “carry trade”, where investors borrow in a low-yielding currency and invest the proceeds in a higher-yielding one. The conventional wisdom is that high interest rates will be offset by an eventual plunge in the value of its currency.

But that hasn't happened. Iceland now has the worse of all worlds - simultaneous high interest rates and high currency.

So Iceland is now boxed into a situation where they have a debt that is crippling and unsustainable, interest rates that are more than twice of ours and an overvalued currency that's waiting for a collapse back down to more sensible levels.

Sure, let's emulate them because that's the economic model we want to follow.


* Our debt would actually be higher than that is we included our share of the federal debt but we'll leave that out for purposes of this discussion.

No comments: