November 05, 2008

How's that Iceland going?

One of the prominent casualties of the financial crisis so far (if you discount the failure of US banks such as Lehman Brothers) is Iceland.
Jon Danielsson of the London School of Economics wrote a great summary of the Icelandic crisis for the BBC and you have to feel sorry for the 300,000 Icelanders (even though they do hunt whales!) who fell victim to this particular kind of greedy capitalism by their banks and the failure of proper regulation of assets and debt obligations and guarantees by their Government.
But what really scares me are the many aspects of that crisis that are applicable in New Zealand too:
"The key factor in Iceland's failure has been the monetary policy pursued by its central bank, in particular inflation targeting, similar to the UK. [...] Such a policy has a sound foundation in economic theory and is often appropriate for large countries. In the case of Iceland, it was disastrous."
Our Reserve Bank has an identical inflation targeting policy, and we're a midget country too.
"In a small economy like Iceland high interest rates both encourage domestic firms and households to borrow in foreign currency, and also attract currency speculators."
The infamous Belgian dentists and Japanese housewives have been doing brisk business in the NZ$ carry trade over the years.
"This brought large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth.
The speculators and borrowers profited from the interest rate difference between Iceland and abroad as well as the exchange rate appreciation"
Our illusion of wealth is expertly reflected in our recent huge house price inflation. New Zealanders almost never borrow money to invest in income generating companies. Houses are what all that cash went into. So much more comfortable to be a landlord than an entrepreneur.
"These effects encouraged economic growth and inflation, further leading the central bank to raise interest rates. The end result is a bubble caused by the interaction between domestic interest rates and inflows of foreign currency."
NZ interest rates are still among the highest in the developed world.
"The exchange rate was increasingly out of touch with economic fundamentals, with a rapid depreciation of the currency inevitable. This should have been clear to the central bank, which wasted several good opportunities to prevent exchange rate appreciations and build up reserves."
Did our Reserve Bank build up sufficient foreign reserves when the currency was high? Our dollar has certainly tanked recently, despite the high base rate.
"The second factor in the implosion of the Icelandic economy this week has been the size of its banking sector. Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP, with debts to match."
New Zealand has barely any banks it actually owns. The vast majority of our banking is controlled by Australian-owned banks. But our foreign debt certainly is massive (over 100% of GDP) and annual current account deficit touching 10% of GDP. Is our economy robust enough when the foreign creditors come urgently knocking to call in their debts as they may need all the cash they can to cover their positions?
"The original cause of the Icelandic crisis was a combination of inappropriate monetary policy and an outsized banking system. Throughout this year, the Icelandic currency has been falling due to the currency speculators running for shelter. This has caused doubts about the Icelandic economy and its banking sector. What eventually tipped the balance was the current extreme global financial uncertainty, the mishandling of the crisis by the Icelandic authorities and the overreaction of the UK authorities."
All sounds horribly familiar to me. But the end game touches on the positives too:
"Fortunately, the long-run macroeconomic potential is good. Iceland is a natural resource-based economy, with plenty of untapped natural resources and well educated workforce."
There are quite a few lessons to learn by New Zealand from Iceland. And add to that, Iceland can be fast-tracked to European Union membership (as it is already in the EEA/EFTA) if it wanted to. Which makes it all the more urgent to look at our options too.

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