Iceland’s down, did NZ nearly go too?

Neville Bennett Oct 17/08

Last week was the most cataclysmic in global history. Share markets collapsed as much as in October 1987, and the banking collapse was more dangerous. It was riveting to watch the huge Royal Bank of Scotland share price melt. Iceland crashed, leaving its external depositors in the lurch.

Australian banks were in the frame. I spent some time each day monitoring their share prices, and advising friends that only the Public Trust guaranteed deposits in New Zealand. It seemed possible that Australia and New Zealand could follow Iceland.

Iceland had some external support. The Scandinavians helped, and Russia offered a loan (perhaps in return for Iceland’s magnificent military bases). Who would help NZ, or their Australian cousins?

Why My Interest in Iceland?

New Zealand and Iceland have the similarities of small populations, an independent currency, huge current account deficits, inflation and high interest rates set to attract foreign capital. While both have friends, they are not part of a big currency bloc. They are vulnerable to being the playthings of speculators.

The New Zealand dollar has fallen from nearly 80 c to the US dollar in June to about 60c now (a 33% loss). The Krona is in free-fall, and dependent upon an IMF rescue. In short, Iceland raises question for New Zealand: namely, can small countries with similar problems avoid a banking crisis, currency crisis and debt default?

What happened to Iceland?

When Iceland nationalized or rescued its three biggest banks, the British Government condemned its failure to guarantee British savers deposits in Icelandic banks in Great Britain. Gordon Brown said the move was “effectively illegal and completely unacceptable; he froze the assets using anti-terrorist legislation. More than 80 British local government councils, police, fire services and charities have frozen deposits.

Inflation targeting

Iceland is the first casualty of the credit crunch. Its failure was predicted in my earlier column. Partly it failed because its Reserve Bank has policies (similar to RBNZ) which target inflation. This policy has widespread support in economic theory but was disastrous in Iceland’s case.

In inflation targeting, the Bank raises interest rates if inflation is above its target level and lowers them if inflation is low. Iceland did not have low rates: inflation ran high, sometimes reaching 15%. Its high Interest rates, like NZ’s, encouraged borrowing foreign currency.

This created a path well known in NZ: a large inflow of foreign currency resulted, which increased the exchange rate and created a bubble arising from the interaction of domestic interest rates and forex inflows. A huge current account deficit ensued because exports are over-priced and imports very cheap.

Another factor was the magnitude of the banking system: its assets were about ten times the size of GDP. They were well capitalized but in the last resort could not depend upon the support of a powerful state, An Icelandic government might guarantee a bank: but who would trust that guarantee when it comes from a 300,000 person state? One lesson of the crisis is the crucial ratio between the state and the size of its banks.

Iceland might have survived if it had been part of the Euro bloc. Ireland also had a ferocious run but survived by offering a deposit guarantee. There was no currency issue because Ireland is in Euro.

Spare a thought for the innocent Icelandic people. They assumed housing loans in foreign currency. There was a nice rise in house prices. What now? Payments on loans have increased by up to 50%! Inflation? About 30%! Employment? Mass layoffs. My point is that Iceland is a front runner: who knows whether New Zealand might also be very adversely affected by the crisis?

New Zealand

Iceland and most New Zealand banks have transgressed some rules of good sense. Sometimes you can borrow short, and lend long. This works when the interest rate curve is normal, with short-term interest lower than long-term. But in crises the curve can invert, and short –term rates are higher than long-term. Then short-term borrowers have a tiger by the tail, and the tiger can turn and bite. It bit Iceland.

A key point is that although Icelandic banks borrowed extensively abroad, they lent most of it abroad, and were perhaps careless about hedging. Kiwi banks are not subject to that risk, but they have liabilities of about $130 billion and 60% of that is due in six months or less.

The situation is not entirely dire, as some funding is due from parent banks (mostly Australian). Moreover, NZ banks also hedge their exchange rate risk which is important when the exchange rate changes. NZ banks swap most of their foreign exposure. Nevertheless, a lot of funding is problematic in the short-term, and the RBNZ has warned the banks of their vulnerability in times of a credit crisis.


I would add that Iceland’s gross assets plus liabilities is colossal, especially in comparison to Australasia. It might be noted in another exclusive release of data that New Zealand is more exposed than Australia. Australia’s net foreign liabilities are 61% of GDP, while NZ’s liabilities are 89% of GDP which is 45% higher’ New Zealand also needs to fund a mammoth current account deficit of 8.4% of GDP.

Afterthoughts

Iceland is road kill; the first victim in the credit crisis. Iceland failed largely because it was alone. If it had been part of the Euro area, as Ireland is, it may not have collapsed. The lesson of the present crisis is that New Zealand is also isolated. Australia is also exposed. Last week its banks looked liked dead men walking. Iceland’s failure will put pressure on Australia, Denmark, Sweden, Singapore and Switzerland to lessen exposure to their banks and currencies.

Bullionmark's comment:

Iceland a nation that was ranked the fifth-richest in the world per capita in the United Nations 2007/2008 Human Development Index is now facing chronic shortages of imports including food and clothing. Individual wealth has been decimated. Icelanders who held gold and silver now realise how important precious metals are for wealth protection and as a medium of exchange during a crisis. The Iceland example should be a warning signal to most citizens of the Western world, especially US, UK, Australia & NZ.

"Argentum et aurum comparenda sunt"