World Economic News

Iceland Hot-Money Crash Had Global Impact

Following a sudden downgrading by the British rating agency Fitch, there was a crash of the Iceland stock market Feb. 22, revealing the obvious: that Iceland had become a bubble economy. Fitch pointed to the "material deterioration" in Iceland's so-called macroeconomic risk indicators, including the "unsustainable" widening of the country's current account deficit to 15% of GDP. Furthermore, Fitch noted that Iceland is showing imbalances like those in Asian countries before the outbreak of the 1997 Asian crisis. In reaction, Iceland's stock and bond markets were crashing, and the currency, the krona, plunged by 9% in a single day.

Iceland recently had been transformed into a hot-money place similar to offshore centers in the Caribbean. Financial bubbles have been built up on stock markets and in the real estate sector. The stock market was pushed up by 282% between summer 2003 and mid-February, and house prices in Reykjavik had doubled in the same period. On top of hot-money inflows, there had been an explosion of debt in Iceland, pushing up private-sector borrowing from close to zero to 300% of gross domestic product (GDP) within three years. Interest rates in Iceland were pushed up from 5% to 10.75% during the last two years, allowing for the generation of a special kind of "carry trade," that is, investors borrowed in euros—at interest rates around 3%—and then put the money into Iceland bonds at higher rates of return.

Some of the money channelled to Iceland has been used for buying up assets all over Northern Europe. As an example, Iceland retailer Jon Asgeir Johanneson was able to buy up ten retail chains in Britain. Kaupthing, Iceland's largest bank, meanwhile, bought up banks throughout the Nordic region.

In contrast to other financial media, these events were prominently featured by London's Financial Times on Feb. 23 and 24. "A financial crash in Iceland snowballed yesterday, setting off a series of tremors as far afield as Brazil and South Africa," the FT announced. It noted that the "collapse" of the krona and the "generalised sell-off in Icelandic assets" was "sparked by Fitch" and was followed by global panic selling of high-yield bonds: "The crash sparked a sell-off among hitherto strong performing emerging market currencies across the globe, with the Brazilian real falling almost 3% at one point and the Turkish lira, South African rand, Mexican peso, and Indonesian rupiah each losing at least 1%, before recovering later in the session."

Daily Telegraph: 'Global Credit Ocean Dries Up'

This was the headline on a piece by Ambrose Evans-Pritchard in the Daily Telegraph Feb. 24, pointing to the Iceland market crash (see above) as the precursor to the coming global breakdown of the "carry trades" due to rising interest rates. He says: "One by one, the eurozone, the Swedes, the Swiss and now even the Japanese, are turning off the tap of ultra-cheap credit that has flushed the global system for the past year, keeping the ageing asset boom alive. The 'carry trade'—as it is known—is a near limitless cash machine for banks and hedge funds. They can borrow at near zero interest rates in Japan, or 1% in Switzerland, to re-lend anywhere in the world that offers higher yields, whether Argentine notes or U.S. mortgage securities."

Pritchard then quotes David Bloom of HSBC, noting that every single market has been effected by "carry trades." However, "It's going to come to an end later this year and it's going to be ugly." Stephen Lewis of Monument Securities is quoted, saying "There are several hundred billion dollars of positions in the carry trade that will be unwound as soon as they become unprofitable.... When the Bank of Japan starts tightening we may see some spectacular effects. The world has never been through this before, so there is a high risk of mistakes."

Stephen Roach, chief economist at Morgan Stanley, warns that the carry trade is itself, in all its forms, a major cause of dangerous speculative excess. "The lure of the carry trade is so compelling, it creates artificial demand for 'carryable' assets that has the potential to turn normal asset price appreciation into bubble-like proportions," he said. "History tells us that carry trades end when central bank tightening cycles begin," he said, and we are now exactly at this point.

BIS Issues Warning on Looming Disaster

In an address to the European Financial Services Roundtable in Zurich, Switzerland, on Feb. 7, Bank for International Settlements (BIS) general manager Malcolm D. Knight pointed to a dangerous "disconnect" between "major macroeconomic risks present in the global economy" and the financial markets "perception" of a benign risk environment, as indicated by parameters such as risk premiums or volatility indices. The speech is now posted prominently on the BIS website.

Concerning macroeconomic risks, Knight focussed on the U.S. external deficit, which has doubled to $800 billion in the last five years: "It is hard to believe that such an unprecedented flow of net savings from 'poor' to 'rich' countries can represent a sustainable global equilibrium. At some point, this highly unusual pattern will have to change." Another area of concern is the present "valuations in housing markets," which "have risen to historically high levels relative to rents in some countries."

Knight concludes: "Several major macroeconomic risks are at high levels and rising: at some point, global imbalances will begin to adjust. If these higher risks were being reflected in signs of increased volatility in financial markets (that is, if they were being priced in), then one could perhaps be reasonably confident that the risks were being properly recognised, and therefore managed, by markets." However, this is just not the case. What makes matters worse are certain trends in financial markets that require a more complex risk management. Here, Knight emphasizes the rapid growth of credit derivatives, the "rising counterparty risk in lending to hedge funds," and "growing concern about liquidity risk. Some markets are increasingly dominated by players that would not necessarily be able to maintain liquidity in adverse market conditions."

"All this means that stress tests, scenario analysis, etc., are more important than ever in determining how to respond to potential abrupt adverse changes in the financial environment.... Perhaps the biggest challenge is to work out how the different risks in the current period might interact. What I have tried to suggest is that the disconnect between macroeconomic risks and the unusually low levels of volatility that prevail in financial markets is currently one of the biggest challenges for the senior management of large private sector financial institutions."

Eurozone Has Unsustainable Imbalances

According to the Spanish central bank, Spain's current account deficit has exploded by almost 60% during the first 11 months of 2005, compared to the previous year. The 11-month deficit reached 60.7 billion euro, equivalent to 7.3% of Spain's gross domestic product (GDP). In relative terms, Spain therefore has surpassed the notorious Anglo-Saxon deficit countries (Australia: 5.9%, US: 5.8%, Britain: 3.4%) and now runs the highest current account deficit among all OECD countries.

The Spanish trade deficit in the first 11 months of 2005 amounted to 63 billion euros as imports were rising by 11.4%, while tourism stagnated. Imports were rising not only due to a higher oil bill but also due to a 14% increase of capital good purchases, in particular from Germany. The import boom is going along with a sharply rising indebtedness of Spanish households and the economy as a whole, and the buildup of a huge housing bubble.

At the same time, the German trade surplus is reaching all-time highs—162 billion euro for 2005. At the same time, Germany's domestic economy—in particular sectors like construction or retail—remain in depression conditions. Before the introduction of the euro, such imbalances could have resulted in a gradual devaluation of the Spanish currency and an revaluation of the D-mark. Under the single currency regime, these balancing mechanisms no longer exist and the trade/current account imbalances are going to grow further.

The credit boom and the respective growth of money supply in the Spanish economy are basically equivalent to the printing of euro notes in Spain to buy up goods from other eurozone members for free. A senior German economist noted that this situation is "utterly, absolutely unsustainable" and that we might soon see calls for the establishment of certain punishment funds for deficit countries, which could be the first step towards the break-up of the euro.

Iraq Oil Production Falling Fast, May Collapse

Iraq's oil production, which stagnated through 2004 and most of 2005 at 80% of Saddam Hussein-regime levels, has fallen steadily since September, all the way down to 1.48 million barrels per day, less than 60% of pre-invasion production. The Wall Street Journal warned in an article on Feb. 21 that the problems could get still worse, and become self-feeding, leading to breakdown. Already the three years' low production in Iraq is one of the major oil "interruptions" since World War II, helping the Cheney Task Force keep oil prices sky high. And the U.S. is contributing to the chaos. The U.S. Occupation demand that Iraq slash internal gas and gasoline price subsidies in September, led to the Iraqi Oil Minister's quitting, and he has not been replaced. The Iraq Oil Ministry hasn't spent any money for repair or infrastructure contracts since. There is almost no new drilling of wells going on. Kurdistan in the North, and SouthOilCo in the South, are making their own deals with foreign oil companies for sales. And the U.S. has withheld the import of some American equipment that could stabilize or improve wells.

The situation, says the Journal, "raises questions about the country's ability to keep its petroleum industry from spiralling further into disrepair."