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Generational Dynamics Web Log for 31-Mar-08
Country of Iceland may be close to financial default

Web Log - March, 2008

Country of Iceland may be close to financial default

In an emergency move, Iceland's central bank raised interest rates to 15%.

Iceland's central bank raised interest rates by 1.25% this week to a record 15%, in an effort to support the country's crashing currency.

The statistics are grim. The króna ("krona" or "crown") currency has fallen in value over 30% since January 1 against the euro, over 3% on Friday alone. And inflation has jumped sharply in March to 8.7% from February's 6.8%.

How will raising the interest rate to 15% help the situation? That's because, in the words of Iceland's critics, for the past few years, Iceland has been acting like a hedge fund, instead of a country.

I actually wrote about this early in 2006, with an article entitled "Sudden collapse of Iceland krona portends bursting of 'carry trade' bubble."

At that time, there was some fear that the international "carry trade" was going to crash. After writing that article, I learned that those in the international carry trade are ALWAYS in fear that it's about to crash, so I dropped the subject.

However, this time the fear isn't over the international carry trade, but over possible failure of Iceland's banks.

It used to be that Iceland made most of its income from fishing. But in the last decade, Iceland got into the carry trade business. Iceland's central bank sent interest rates so high -- over 10% -- in order to encourage foreign investors to borrow money from Japan (where the interest rate is close to 0%), and then invest it in Iceland.

In any other country, setting interest rates so high would cause a deep recession, because businesses would not be able to borrow money at those high rates. But Iceland got away with it, because foreign investors would invest in Iceland to take advantage of the high rates.

In other words, it was just another way to abuse credit and make money in the credit bubble. On this web site we've discussed all kinds of abuses -- collateralized debt obligations (CDOs) and lately auction-rate securities (ARSs).

Now we have this additional scheme to make money in the credit bubble -- turning the country into a hedge fund and take advantage of the carry trade.

Now that the credit bubble is deflating, there's a credit crunch, where everyone is hoarding cash.

And so, Iceland's scheme is falling prey to the credit crunch for exactly the same reasons that CDOs and ARSs are failing -- because "cash" means "dollars" or "euros" or "yen," but does not mean Icelandic króna. Many investors now consider the króna to be as risky as subprime mortgage loans. Money is pouring out of Iceland, and the value of the currency is falling rapidly.

Credit default swap (CDS) spreads on Icelandic bank bonds <font face=Arial size=-2>(Source: FT.com)</font>

Credit default swap (CDS) spreads on Icelandic bank bonds (Source: FT.com)

And so the Iceland central bank has raised the interest rate to 15% in a desperate move to attract investors back.

Will it work? Lots of people don't think so. The interest spread on credit default swaps (contracts that "bet" that a company or, in this case, a country, will default) has been been surging so high that it means that investors are essentially betting that Iceland's banks WILL default.

Well, the Fed saved Bear Stearns from default and bankruptcy. Maybe the Fed (or the European Central Bank) will save Iceland from default and bankruptcy. We should soon know. (31-Mar-08) Permanent Link
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Generational Dynamics Web Log for 31-Mar-08 Country of Iceland may be close to financial default

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Generational Dynamics Web Log for 31-Mar-08
Country of Iceland may be close to financial default