Iceland Recovery? Capital Controls and Devaluation Backfires…

Well Iceland’s supposed recovery seems to have been truncated as policies of capital controls and devaluation appears to have backfired.

From the Bloomberg:

Iceland’s private sector is running out of cash to repay its foreign currency debt, according to the nation’s central bank.

Non-krona debt owed by entities besides the Treasury and the central bank due through 2018 totals about 700 billion kronur ($5.8 billion), the bank said yesterday. The projected current account surpluses over the next five years aren’t estimated to reach even half of that and will equal a shortfall of about 20 percent of gross domestic product.

Kaupthing Bank hf, Glitnir Bank hf and Landsbanki Islands hf defaulted on a combined $85 billion in October 2008 after running out of cash to sustain their debt-funded expansions. The collapse plunged the economy into its worst recession in six decades, forcing the government to seek an International Monetary Fund bailout to stay afloat.

For now, the controls are still helping Iceland manage its debts by rationing payments. That means the largest foreign refinancing risk, which stems from repayments on two Landsbankinn hf bonds totaling 296 billion kronur, won’t destabilize the economy.

“Repayment of this debt is currently under capital controls,” said Benediktsdottir. “So we can use the capital controls to actually manage the outflow of those repayments. By doing so, we can keep both financial and currency stability.”

If Iceland capital controls have been "helping" manage debts then the private sector won't be running the risks of non-payment of foreign currency debt.

 

Iceland reportedly allowed her insolvent banks to go bankrupt, the Iceland’s President even bragged about this as I earlier showed. 

But the reality is that Iceland’s government bailed out the central bank by raising the amount of debt 5 fold where the latter has been heavily exposed to foreign creditors. 

The USD-Icelandic krona

The central bank bailout has been implemented with rigorous capital controls and devaluation, which mainstream mercantilists cheered as the magic wand for Iceland’s recovery.

Unfortunately for devaluation proponents, inflationism’s magic works only over the interim or the short term, where long term costs have now become apparent.

At the Geo-Graphics Blog of the Coucil of Foreign Relation (CFR). Benn Steil and Dinah Walker shows of the boom-bust cycle and the economic backlash (via relative underperformance with her peers) from a supposed devaluation based miracle…

Here it is, folks: Iceland, whose currency lost half its value against the euro in 2008, vs. Estonia, Latvia, and Ireland, all of which were euroized or pegged to the euro over the entire period . . .

 

In the updated figure, Estonia comes out on top, by a lot – well above Iceland, which performed no better than Latvia or Ireland, even using a starting date chosen by Krugman to make Iceland look as good as possible.

Yet Iceland “success story” now comes with a likely imitation of the Cyprus bailin model as the Iceland government mulls to remove its blanket authority for large depositors as well as depositor haircuts.

Notes the Zero Hedge, (bold original)

Following the crisis in October 2008, Iceland's government declared all deposits in domestic financial institutions were 'blanket' guaranteed - an Emergency Act that was reafrmed twice since. However, according to RUV, the finance minister is proposing to restrict this guarantee to only deposits less-than-EUR100,000. While some might see the removal of an 'emergency' measure as a positive, it is of course sadly reminiscent of the European Union "template" to haircut large depositors. This is coincidental (threatening) timing given the current stagnation of talks between Iceland bank creditors and the government over haircuts and lifting capital controls - which have restricted the outflows of around $8 billion.

Interventionism and inflationism only works to the benefit of the political class and their favored constituencies, while the rest of the society suffers…

Yet this has been to be the global trend

Iceland’s Recovery Model: It’s a story of how to fool people

Sovereign Man’s impressive contrarian Simon Black argues against the Iceland Recovery Model which he sees as a “complete lie”. (bold mine)

Yet unlike the bankrupt countries of southern Europe, Iceland dealt with its economic emergency in a completely different way.

Politicians here are proud that they never resorted to austere budget cuts that are so prevalent in Europe.

They imposed capital controls. They let the banks fail. And, as is so commonly trumpeted in the press, they ‘jailed their bankers and bailed out their people.’

Today, Iceland is held up as the model of recovery. Famous economists like Paul Krugman praise the government for rapidly rebuilding the economy without having to resort to austerity.

This morning’s headline from The Telegraph newspaper sums it up: “Iceland has taken its medicine and is off the critical list”.

It turns out, most of these claims are dead wrong.

For example, they say in the Western press that Iceland bailed out its people and jailed the bankers.

Not exactly. A few bankers were investigated and charged with fraud. The CEO of one of Iceland’s biggest failed banks was even convicted, and sentenced.

Now, how long of a sentence does someone get for railroading his nation’s economy? Life? 30-years? 10-years?

Actually nine months. Six of which became probation.

Meanwhile, the government ended up taking on massive amounts of debt in order to bail out the biggest bank of all– Iceland’s CENTRAL BANK.

This was a bit different than the way things played out in the US and Europe.

In the US, the Fed conjures money out of thin air and funnels it to the government.

In Iceland, since the Kronor is not a global reserve currency, the government had to go into debt in order to funnel money to the Central Bank, all so that the currency wouldn’t collapse.

As a result, Iceland’s state debt tripled, almost overnight, in 2008. And from 2007 until now, it has increased nearly 5-fold.

Today, the government is spending a back-breaking 17.3% of its tax revenue just to pay interest on the debt.

And this is real interest, too. Iceland’s central bank owns very little of the government debt. The rest is owed to foreign creditors… putting the country in an extremely difficult financial position.

At the end of the day, the Icelandic people are responsible for this. They were never bailed out. They were stuck with the bill.

Meanwhile, although unemployment in Iceland is low, wages are even lower. And the weak currency has brought on double-digit inflation.

So while people do have jobs, they can hardly afford anything.

This is most prevalent in the housing market, most of which is underwater. Interest rates have jumped so much that many Icelanders are now on negative amortization schedules, i.e. their mortgage balances are actually INCREASING with each payment.

Meanwhile, home prices have been falling dramatically.

So each year, mortgage balances are going up, and home values are falling. Hardly the picture of recovery.

The freshly elected Prime Minister is now promising everyone relief from their mortgage debts via a special state ‘debt correction fund’.

The only problem is that the state doesn’t actually have any money to do this… and they’re running a budget deficit every year.

The only way this can happen is if Iceland defaults… which is becoming a much more likley scenario.

A few years ago, Iceland’s banking system was nearly 10 times the entire country’s GDP. And it collapsed. You don’t paper over a crisis of that magnitude with a few years of good PR.

Despite being so widely reported by the mainstream financial media, Iceland is not a story of model economic recovery. It’s a story of how to fool people. And for now, it’s working…

They’re not in the EU or on the euro, so they’re relatively isolated in their fiscal troubles. This implies that default is inevitable.

And when that happens, Iceland will be shut out of international debt markets and be FORCED to pull out all the stops to attract foreign investment.

Few charts to support Mr. Black’s claim

Iceland’s debt to gdp has skyrocketed from less than 30% to nearly 100% of gdp over the past few years. 

This serves as another great and wonderful example of how rapid and dramatic changes on what previously seemed as a “sound fundamentals”, which in reality had been masked by credit inflation,  deteriorate in the face of a crisis.

Iceland’s external debt tells of the same story: previously low debt levels spiked in the advent of a crisis. (charts from tradingeconomics.com)

“Low” external debt and “low” government debt to gdp has been the stereotyped justification for populist “sound” statistically based "fundamentals" which in reality has been propelled by unsustainable credit inflation…sounds familiar? 

Nonetheless today’s ‘don’t worry,  be happy’ crowd can be seen in Iceland’s recovering 10 year bond yields

Iceland’s stock market (chart form Bloomberg.com) has also shown signs of recovery, partly due to PR campaign and also from the global credit easing policies.

“Complete lie” have hardly just been an Iceland story but a conventional dynamic as revealed by the growing disconnect between global financial markets, which essentially stands on Ben Bernanke’s and central banker’s promises and the real economies.

It’s a falsehood which the financial and the political world gladly embrace as sustainable framework.

To paraphrase John 8:32 “…and you will know the truth, the truth (economic reality) will set the markets free.

Iceland’s Recovery: Hardly about Currency Devaluation

Alan Reynolds at the Cato Institute blog explains, (italics original, bold mine)

Iceland’s recent devaluation was highly orthodox policy condition for wards of the IMF (strings attached to a $2 bn. loan). Unfortunately, such devaluations often backfire by inflating commodity costs, interest rates and the burden of foreign debt. The Icelandic krona fell from 64 to the dollar in 2007 to 123.6 in 2009, before strengthening with the economy to nearly 116 in 2011.

Since oil, grains and metals are priced in dollars, the 2008-2009 devaluation inflated Iceland’s cost of production and cost of living.  Inflation rose from 5.1 percent in 2007 to 12 percent or more in 2008 and 2009; real GDP fell by 6.8 percent in 2009 and 4 percent in 2010.  Faced with a collapsing currency, the central bank interest rate was hiked to 18 percent by October 2008.  It could have been worse.  If Iceland’s Supreme Court had not nullified loans indexed to foreign currencies in June 2010, devaluation would have doubled the cost of repaying foreign debt.

Devaluation was supposed to boost GDP by making imports costly and exports cheap, thus narrowing the trade deficit. The current account deficit did fall after 2008, but that always happens when recessions slash imports. Ireland had a current account surplus from 2010 to 2012 without devaluation, even as Iceland’s current account deficit was still 7-8 percent of GDP.

Iceland’s economy grew by 3.1 percent in 2011 when the currency appreciated and the budget deficit was deeply cut to 4.4 percent of GDP.  Devaluation explains the previous spike in inflation and interest rates, but little else. 

Iceland’s statistical growth recovery following the 2008-2011 crisis.

Some notes from the above:

Devaluation policies serves the interests of political agents and their affiliates, allies or cronies than of the general economy.

The devaluation panacea oversimplifies a complex economy operating spontaneously on millions of independently moving parts. The natural result from such conflict: policy failure.

The devaluation snake oil therapy, which operates on the principle of getting something for nothing, also deals with solving short term quandaries that comes with larger long term costs.

Bottom line: Micro issues can hardly be resolved by using macro tools which mistakenly sees the economy as a mechanical machine. Individuals think and act on purpose. Macro economic policies assume otherwise.

Iceland’s recovery has largely been allowing for markets to clear (by not saving banks), and importantly, by the reversal of inflationist policies.

For Iceland, Canadian Loonie is Better than the US Dollar

From Globe and Mail (hat tip Zero Hedge)

Iceland’s newfound love for the loonie is sparking a wave of controversy, from Reykjavik to Ottawa.

For 150 years, the rest of the world has shown scant interest in the Canadian dollar – the poor cousin to the coveted U.S. greenback.

But now tiny Iceland, still reeling from the aftershocks of the devastating collapse of its banks in 2008, is looking longingly to the loonie as the salvation from wild economic gyrations and suffocating capital controls.

Canadian ambassador to Iceland Alan Bones had planned to deliver remarks to a conference on the future of the Icelandic Krona, making it clear that if Iceland decided to adopt the Canadian dollar, with all its inherent risks, Canada was ready to talk.

The actual adaption to non-US Dollar reserves for the banking system represents as more evidence of the ongoing erosion of the foundations of the US dollar standard.

For now, intentions to shift signify as just that--proposals to act. Nevertheless, anxiety over the untenable state of the today's currency platform appear to be snowballing. Once a tipping point has been reached, then the decline will be pronounced.

Will Falling Population (Demographic Time Bomb) Lead To A Reversal Of Globalization?

Lately I have encountered several commentaries suggesting that the “demographic time bomb” (falling population) will pose a risk to globalization by creating imbalances that would lead to political upheavals.

Here are two:

From Neil Howe and Richard Jackson in Global Aging And The Crisis Of The 2020's (bold emphasis mine)

“Rising pension and health care costs will place intense pressure on government budgets, potentially crowding out spending on other priorities, including national defense and foreign assistance. Economic performance may suffer as workforces gray and rates of savings and investment decline. As societies and electorates age, growing risk aversion and shorter time horizons may weaken not just the ability of the developed countries to play a major geopolitical role, but also their will.”

From Morgan Stanley’s Spyros Andreopoulos and Manoj Pradhan in ‘Ten for the Teens’(bold emphasis mine)

“The increase in macro instability comes at a time of major demographic transition in most DM and many EM economies. As populations become older, the demand for economic security - stable jobs, pensions - increases. This tension between higher instability and increased demand for security is likely to find its political expression in a backlash against globalisation. So far, the benefits of globalisation - higher income levels for most, i.e., the large middle class - have outweighed its drawbacks - increased competition and job instability. This has kept the globalisation show on the road until now. As this balance tips because the preferences of the middle class shift towards more security/stability, globalisation is likely to stall or reverse.”

There seems to be two separate issues here: unsustainable welfare states and globalization.

However the comments above attempt to make a connection which, for me, looks tenuous and confusingly premised on the fallacious ‘aggregate demand’.

Protectionism Equals Security?

Here is how I understand this: stripped out of the spending capacity due to old age, and with a government hobbled by fiscal straitjacket, the lack of demand (from both the private and the public) means slower economic growth which likewise would extrapolate to a political milieu that shifts from risk appetite (globalization) towards demand for ‘security and stability’ (protectionism), or in short, political stress.

For instance the Morgan Stanley tandem does an incredible turnaround, ``So far, the benefits of globalisation - higher income levels for most, i.e., the large middle class - have outweighed its drawbacks - increased competition and job instability. This has kept the globalisation show on the road until now.”

Are they suggesting that people who benefited from globalization will eventually bite the proverbial hand that feeds them? Are they suggesting too that people will see “security and stability” from lower incomes?

Will protectionism or restricting market activities make goods and services needed by the ageing society abundant and affordable? To the contrary, protectionism will only highlight on the shortages and the exorbitance of these economic goods that should lead to even more instability.

Murray N. Rothbard refuted this age old fallacy, he explained, (bold highlights mine)

It is difficult to see how a decline in population growth can adversely affect investment. Population growth does not provide an independent source of investment opportunity. A fall in the rate of population growth can only affect investment adversely if

-All the wants of existing consumers are completely satisfied. In that case, population growth would be the only additional source of consumer demand. This situation clearly does not exist; there are an infinite number of unsatisfied wants.

-The decline would lead to reduced consumer demand. There is no reason why this should be the case. Will not families use the money that they otherwise would have spent on their children for other types of expenditures?

Thus the problem of declining population can be helped by accepting immigrants or adopting to greater social mobility or the globalization of labor and by even more free trade.

We shouldn’t underestimate how people adjust to the new realities from the current underlying conditions. Importantly, we shouldn’t write off productivity of the senior citizens too (why? see below).

Illusion Or Reality?

Next would be the issue of welfare states. Once society realizes that the welfare state has been unsustainable, will people fight violently to retain the status quo (even if this is recognized as not possible) or will they cope up with the new reality?

The former would fall as part of the entitlement mentality engendered by excessive dependency or the moral hazard from political distribution while the latter will likely result from the realization that there’s no free lunch.

And perhaps in the realization that bellicosity won’t further society’s interests, they may opt for the latter (accepting harsh reality) than the former (live in a charade). And any political tensions from the succeeding reforms would signify as symptoms of ‘resistance to change’ than from a key reversal of political sentiment.

In the context of abrupt political-economic transitions from a crisis, Iceland’s violent riots from her financial crash of 2008 didn’t mechanically translate to close door ‘security’ based policies, as Iceland remains “moderately” economic free (44^th), according to Heritage Foundation, even as the crisis did have some negative impact on her economic freedom ratings (due to higher taxes and government spending).

From Heritage Foundation

The point is that the notion that crisis will instigate a radical reversal of people’s sentiment from openness to protectionism seems likely misguided.

Today, Iceland has shown signs economic recovery and has even applied to join the European Union (aimed at achieving more financial and trade openness, aside from social mobility)!

Protectionism likewise did not spread like wildfire in 2008, as earlier discussed.

Ignoring Technology

Another factor would be technology.

While it may true that fertility rates may be going down (upper window), it is often ignored how the advances in technology has continually enhanced people’s living conditions.

From Google Public Data

Global Life expectancy (lower window) has lengthened from 50 years to 68.95 years over the past 50 years. Japan reportedly has some 41,000 centenarians (over 100 years old)! [But I won’t be lucky to live this long, because of my love affair with beer]

And if futurist Ray Kurzweil is correct, people’s life span may extend to 120 years (by 2030) or even more (180 years) as rate of technology advances accelerates.

Again Murray Rothbard on the importance of technological advancement

“technological progress, is certainly an important one; it is one of the main dynamic features of a free economy. Technological progress, however, is a decidedly favorable factor. It is proceeding now at a faster rate than ever before, with industries spending unprecedented sums on research and development of new techniques. New industries loom on the horizon. Certainly there is every reason to be exuberant rather than gloomy about the possibilities of technological progress.”

In short, should these advances occur then all demographic projections should be thrown to the garbage bin, as they are falsely premised and would be rendered irrelevant.

The basic problem with mainstream insights is that people are treated like unthinking automatons. And because of this they’re most likely wrong.

The ultimate threat to globalization is inflationism and not demographic trends.

Iceland's Eyjafjallajokull Volcanic Eruption In Pictures

Fantastic photographs from the recent volcanic eruption of Iceland's Eyjafjallajokull.

Find more pictures in Boston.com's The Big Picture (click on the link)

Iceland's Devaluation Toll: McDonald's

Recently we dealt with The Evils Of Devaluation. And Iceland should be a good example.

Last year's meltdown heavily devastated Iceland, an erstwhile prosperous nation but whose banking system recklessly engaged in intensive leveraged based speculation [see last year's post Iceland, the Next Zimbabwe? A “Riches To Rags” Tale? ]

The consequent losses in the banking system prompted Iceland's government to intervene and provide support even when there had not been enough resources to do so. This eventually took toll on its currency, the Krona.

The Krona has devalued or collapsed from 60 to around 140 (chart courtesy of ino.com).

This fueled domestic inflation even amidst a spike in unemployment.

chart courtesy of tradingeconomics.com

Nevertheless Iceland's crisis has prompted one of the world's most prolific fast food chain, McDonald's (NYSE: MCD), to withdraw.

This from Financial Times

``Iceland edged further towards the margins of the global economy on Monday when McDonald's announced the closure of its three restaurants in the crisis-hit country and said that it had no plans to return.

``The move will see Iceland, one of the world's wealthiest nations per capita until the collapse of its banking sector last year, join Albania, Armenia and Bosnia and Herzegovina in a small band of European countries without a McDonald's.

``The loss of the Golden Arches highlights the extent of Iceland's economic demise since the pre-crisis boom years when its "Viking Raider" entrepreneurs turned Reykjavik into an international finance centre and launched a buying spree of high-profile European assets."

The reason...

``McDonald's blamed the closures on the "very challenging economic climate" and the "unique operational complexity" of doing business in an island nation of just 300,000 people on the edge of the Arctic Circle.

``Most ingredients used by McDonald's in Iceland are imported from Germany - leading to a doubling in costs as the krona has collapsed while the euro has strengthened.

``Magnus Ogmundsson, managing director of Lyst, the McDonald's franchise holder in Iceland, said that price rises of at least 20 per cent were needed to produce an acceptable profit. That would have pushed the price of a Big Mac burger well above the $5.75 it costs to buy one in Switzerland, home to the world's most expensive McDonald's, according to the Big Mac index."

Of course somebody's else problem could serve as another person's solution:

It could be argued that this should be healthy as there would be less junk foods.

Or that Iceland will have to rely more on their own.

Again the FT, ``Mr Ogmundsson admitted that some customers were alarmed by the symbolism of such a recognisable brand abandoning Iceland but others have reacted positively. "People are pleased that we will be sourcing more goods locally," he says.

Overall, Icelanders would have lesser choice and diminished privileges from today's modern society. In short, Iceland's living standard has retrogressed.

Government Guarantees And the US Dollar Standard

``At some point, it will become necessary to guarantee failing pension plans, income, Medicare payments, mortgage payments, bank deposits, student loans, commercial paper, insurance policies, jobs, unemployment payments, old age payments, and much else, all at the same time. People will question the worth of shifting massive resources from one set of pockets to another set of pockets. They will see that the government guarantees nothing. It recycles resources it extracts from us back to us. This realization will mark the sunset of belief in federal guarantees.”-Professor Michael Rozeff, The Sunset of Federal Government Guarantees

One of the main objections to the risks of sovereign credit default is the purported faith on government guarantees.

Such belief is representative of unremitting and inexorable dependence in governments as drivers of the economic and financial prosperity. Yet bereft of the lessons of history and the basic principles of economics, never have these people realized that governments EVERYWHERE through the years and through their coercive police and military powers almost always change the rules in the middle of the game, or in accordance to leader’s whims or to fungible political priorities or imposed policies with short term noble sounding relief programs at the expense of negative long term costs or protected a few interest groups in the “name of the patriotism” or have robbed people of their property rights through unjust distributive inflationary policies.

In short, despite the repeated failures to achieve major societal goals, people have come to believe government guarantees mean something.

Yet believing in governments as solution to society’s upliftment could be fatal. What people haven’t realized is that guarantees require real capital or real resources for it to be dependable. Running huge deficits and paying them off with printing press money which can’t be backed by real capital means government guarantees “are not worth the paper they’re printed on” to quote Professor Michael Rozeff.

As we pointed out in It’s a Banking Meltdown More Than A Stock Market Collapse!, Iceland for instance, just last year used to be among the world’s wealthiest economies with a per capita income which was the 6^th highest. As the recent crisis unfolded, the Icelandic government guaranteed the deposits of its financial system and nationalized its overleveraged major banks in the hope to apply the magic wonders of the government wand. Unfortunately, due to the lack of real capital, the country of 320,000 went bankrupt.

Iceland’s banking system which operated like a national hedge fund during the heydays will be paying a pretty stiff price for its misadventures and policy blunders, according to Economist (bold emphasis mine), ``Gross government debt is forecast by the IMF to increase from 29% of GDP at the end of 2007 to 109% of GDP in 2009. Apart from the widening deficit, the increase in debt will result from three main causes: first, the recapitalisation of the failed commercial banks now under public ownership will cost around Ikr385bn, or 25% of GDP; second, the costs of recapitalising the Central Bank will be close to 10% of GDP; and third, meeting the extensive obligations of the failed banks (that is, compensating depositors and other creditors) will cost around 47% of GDP. A sizeable portion of this should, however, be recovered over the coming years as the banks' assets are sold. Nevertheless, there will a large debt-servicing burden on the central government that will have to be met by extensive cuts in government spending or through higher taxes.” Ouch.

The lesson here is that paper guarantees from any government may not even be worth anything unless they are backed by real resources or real capital. The same applies with the US dollar, the world’s preeminent currency backed by full faith and credit by the US government.

The belief that the US dollar is insuperable and is unlikely to seriously suffer from negative repercussions from its accrued reckless and imprudent past and present policies could signify as perilous complacency.

The fact that the recent crisis has its epicenter in the US and has rattled the foundations of the global banking system aside from disrupting the world trade financing have prompted some governments to explore alternative means of conducting trade outside the US dollar system such as:

1. The recent case of rice for oil barter between Thailand and Iran (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?),

2. Mounting talks about the resurrection of a modern form of Bretton Woods Standard (as previously discussed in Bretton Woods II: Asia Weighing In Too? and in Bretton Woods II: Bringing Back Gold To Our Financial Architecture?),

3. Utilization of a new payment system which uses local currency for trade as in Brazil and Argentina’s Local Currency Payment system. China and Russia has likewise been reportedly mulling to engage in a similar domestic currency based bilateral trade and

4. A pilot form of regional currency standard such as China’s recent proposal to expand the use of its currency as a medium of trade for China, Hong Kong Macau and ASEAN countries (BBC)

So aside from policy induced fundamental deterioration, all these exogenous events serve as ample evidence of the growing vulnerability of the US government guaranteed US dollar standard system.

Mike Hewitt of Dollardaze.org has made a splendid study on currencies where he observes that some 173 currencies are in circulation in the world today.

Yet not all of the existing currencies are widely used or circulated. Mr. Hewitt gives some examples as the “unofficial banknotes of the crown dependencies (Isle of Man and the Balliwicks of Jersey and Guernsey).”

Importantly Mr. Hewitt provides us some very important facts from today paper currency regime (all bold highlights mine):

-The median age for all existing currencies in circulation is only 39 years and at least one, the Zimbabwe dollar, is in the throes of hyperinflation.

-Excluding the early paper currencies of medieval China (and India, Japan and Persia) as well as the majority of paper currencies that existed in China until 1935, there are 612 currencies no longer in circulation. The median age for these currencies is only seventeen years.

Figure 3: DollarDaze.org: Fates of Currencies

-Both war and hyperinflation have each been responsible for the demise of 145 currencies. The Second World War saw at least 80 currencies vanish as nations were conquered and liberated.

-Second only to war, hyperinflation is the greatest calamity to strike a nation. This devastating process has destroyed currencies in the United States, France, Germany, and many others.

As one can observe, paper currencies tend to be generally short lived. Importantly, the fact that war and hyperinflation have been the main proximate factors which has caused most of the world’s currencies to disintegrate depicts that both are related.

To quote Ludwig von Mises in Nation State and Economy,

``One can say without exaggeration that inflation is an indispensable means of militarism. Without it, the repercussions of war on welfare become obvious much more quickly and penetratingly; war weariness would set in much earlier.”

The Icelandic Drama in Video

In our previous post, Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?, we pointed out how the global financial crisis has prompted Iceland's sudden transformation from a rich country to one mired with extreme financial difficulties.

Naturally economic difficulties will always be vented through politics, as this video courtesy of Wall Street Journal shows..

Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?

Today’s du jour word is “guarantee”.

The prevailing belief is that when deposits, loans, or debts are guaranteed by governments, they become fail-safe in absolute terms or the elixir to our financial and economic problems.

No one seem to ask, guarantees with what?

For instance when Iceland recently joined the policy stampede of guaranteeing its banking system, it has been earlier assumed that its government can settle with any calls made on such claims.

Unfortunately, mired with foreign liabilities in excess of $100 billion which dwarfs the country’s GDP of $14 billion and whose current account deficits is one of the highest in the region, it appears that government guarantees would depend from entirely either the kindness of foreigners or from its printing presses.

Courtesy of Danske Bank

Ultimately this means that guarantees need to be backstopped by hard currency which is something Iceland lacks at the moment…

Courtesy of Bloomberg

And because of the shortage of hard currency to pay for imports, Icelanders have begun to hoard on items. This panic buying will drive up consumer goods inflation already one of the highest in the region.

This from Bloomberg, ``After a four-year spending spree, Icelanders are flooding the supermarkets one last time, stocking up on food as the collapse of the banking system threatens to cut the island off from imports.

``Iceland's foreign currency market has seized up after the three largest banks collapsed and the government abandoned an attempt to peg the exchange rate. Many banks won't trade the krona and suppliers from abroad are demanding payment in advance. The government has asked banks to prioritize foreign currency transactions for essentials such as food, drugs and oil…

``There is absolutely no currency in the country today to import,'' said Andres Magnusson, chief executive officer of the Icelandic Federation of Trade and Services in Reykjavik. ``The only way we can solve this problem is to get the IMF into the country.''

Yes, the IMF and Iceland have reportedly been in discussion but have not reached any accord yet (guardian.co.uk).

The unfortunate part is that Iceland which used to be the top in terms of human development as measured by prosperity and “fulfilled life” could suffer immensely from the breakdown of its banking system.

Courtesy of Economist

According to the same report in Bloomberg, ``Icelanders, whose per capita gross domestic product is the fifth highest in the world, according to the United Nations 2007/2008 Human Development Index, will have to tighten their belts.”

Courtesy of Wall Street Journal

And this is unlikely to serve as a short term development as its 320,000 citizens will have to take the onus of bearing the angst from the losses incurred by its banking system. Yet the economy is faced with the immediate prospects of economic contraction, which compounds the dire scenario.

Courtesy of the Economist

Iceland’s agricultural subsidies, the largest among developed economies, could shrink as its government would likely require a sizeable share of its revenues to compensate for the losses.

For the moment, as external funding remains scarce, Iceland risk becoming the “Zimbabwe” of Europe as they would likely have to rely on the printing presses to finance its domestic financial system if foreign funding don’t emerge soon.

So aside from a recession, Icelanders risk facing a profound transformation of even higher taxes, a fall in per capita income, a decline in productivity and deterioration of living conditions.

In short, a potential regrettable “riches to rags” story.

Moreover aside from serving as an example of what happens when a banking system fails, the Iceland experience suggests that the probable next wave of crisis will be one of national solvency issues.

Guarantees can reflect more of political designs than of economic reality.

Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

``The business cycle is brought about, not by any mysterious failings of the free market economy, but quite the opposite: By systematic intervention by government in the market process. Government intervention brings about bank expansion and inflation, and, when the inflation comes to an end, the subsequent depression-adjustment comes into play.” Murray N. Rothbard, Economic Depressions: Their Cause and Cure

While blood on the streets could essentially represent a once in a lifetime opportunity, one must understand too why it requires additional contemplation of the operational dynamics that lead markets to be consumed by fear.

Riots From Lehman’s CDS Settlement?

One of the stated reasons behind last week’s bloodbath has been attributed to the settlement of Credit Default Swaps contracts from the bankrupted Lehman Bros.

According to Wikipedia.org ``A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" makes periodic payments to the "seller" in exchange for the right to a payoff if there is a default or credit event in respect of a third party or "reference entity"” In essence, CDS contracts function like an insurance where bond or loans are insured by the underwriters “sellers” and paid for by those seeking shelter from potential defaults “the buyers”.

In Lehman’s case its $128 million bonds (Bloomberg) was reportedly priced at 8.625 cents to a dollar which meant that insurance sellers had to pay its counterparties or buyers at 91.375 on a US dollar or cough up an estimated $365 billion (washingtonpost.com) to settle for each of the contracts which covered more than 350 banks and investors worldwide.

Generally this won’t be a problem for banks that has direct access to the US Federal Reserve, except for its booking additional accounting losses. But for institutions without direct channels to the US Fed this implies raising cash by means liquidating assets, hence the consequent selloffs.

Figure 4: New York Times: CDS Market Shrinking But Still Gargantuan

Although the CDS market has been said to decline from more than $60 TRILLION to $54 TRILLION, the sum is staggering.

According to the New York Times, ``The 12 percent decline, to $54.6 trillion, still left the market vastly larger than the total amount of debt that can be insured. The huge total reflects the way the market is structured, as well as the fact that someone does not need to actually be owed money by a company to be able to buy a credit-default swap. In that case, the buyer is betting that the company will go broke.

``Within that huge market, many contracts offset one another — assuming that all parties honor their commitments. But if one major firm goes broke, the effect could snowball as others are unable to meet their commitments.”

In other words if the present crisis could worsen and lead to more bankruptcies of major institutions this could put the viability of CDS counterparties at risk. Hence, it’s not the issue of settlement but the issue of sellers of CDS of defaulted bonds having enough resources to pay for their liabilities.

For instance, while news focused on politicians bickering over $700 billion bailout, the US Congress passed $25 billion loan package (USA Today) to the US automakers. Yet despite this, the S&P raised the risks potential of bankruptcies for the big three; General Motors, Ford and Chrysler (Bloomberg). Presently these automakers have been pressuring the government to release the funds recently appropriated for by the US Congress (money.cnn.com).

Some analysts warn that CDS exposures to GM bonds are worth some $ 1 trillion even when GM’s market capitalization is today less than $3 billion. They suggest that a bankruptcy could entail another bout of market upheaval. Maybe.

While this week’s market riots can’t be directly attributed as having been caused by the Lehman CDS settlement, they may have contributed to it.

Spreading Credit Paralysis

What seems to be more convincing is what has been happening at the world credit markets. Remember this crisis began with the advent of the credit crunch in July of 2007. And after the Lehman bankruptcy, events seem to have rapidly deteriorated.

Credit stress indicators as seen in likes of LIBOR (London Interbank Offered Rate) and TED spread have sizably widened even as the US Federal Reserve introduced a new program aimed at surgically bypassing the commercial market by providing direct funding to affected financial companies by directly acquiring unsecured commercial papers and asset backed securities, called the Commercial Paper Funding Facility (CPFF)

Figure 5: Danske Bank: Commercial Paper and Asset Backed Securities Plunges

As you can see in Figure 5, the commercial paper (CP) market for financial institutions have effectively dried up (see redline) just recently. Aside from the Asset Backed Commercial paper (ABSP) which continues to fall from last year, the CP market’s decline has coincided with the recent crash in global equity markets.

Remember, the commercial paper market is a fundamental source of funding for working capital by corporations. Hence with the apparent difficulties to access capital, the alternative option for companies with no direct access to the Federal Reserve or for companies that have exhausted their revolving capital, is to sell into the markets their most liquid instrument regardless of the price.

This could be the reason why the VIX index has soared to UNPRECENDENTED levels simply because financial companies had NO CHOICE but to monetize all assets at whatever price to keep their businesses afloat!

And this has spread about to every financial center from Hong Kong, Singapore, Japan and others, including the Philippines. According to a report from Bloomberg, ``Rising Libor, set each day in the center of international finance, means higher payments on financial contracts valued at $360 trillion -- or $53,500 for each person worldwide --including mortgages in Britain, student loans in the U.S. and the debt of companies like CIIF in Makati City, the Philippines.”

And this difficulty of raising money today has equally led to hedge funds redemptions especially by institutional investors which may have contributed to the carnage, from Wall Street Journal,

``Larger investors, like pension funds, which had in some instances borrowed money to invest in hedge funds, are pulling out because the credit crunch makes it difficult to raise money.

``Investors can't redeem their money from hedge funds at will; often they have quarterly windows when they can do so. Many investors had until Sept. 30 to tell hedge funds they wanted out. While the funds are typically not required to redeem the money until the end of the year, the redemptions were greater than some funds expected. That caused a scramble to raise cash to pay the investors back. And one quick way to raise cash is often to sell holdings of stock.

Some of these hedge fund liquidations have been even traced to the collapse in Hong Kong’s market (the Hang Seng Index lost 16% week on week), according to Xinhua.net, ``In a sign of redemption pressures on the investment funds, the Hong Kong unit of Atlantis Investment Management said it has suspended redemptions in its Atlantis China Fortune Fund -- a hedge fund with outstanding performance -- due to market volatility.”

Institutional Bank Run

As you can see banks refusing to lend to each other, deterioration in money market, collapse in the commercial paper market, massive hedge fund redemptions and fears of credit derivative counterparty viability could be diagnosed as an institutional bank run.

Honorary Professor at the Frankfurt School of Finance & Management Thorsten Polleit makes our day to come up with a lucid explanation at the Mises.org,

``What spells trouble, however, is an institutional bank run: banks lose confidence in each other. Most banks rely heavily on interbank refinancing. And if interbank lending dries up, banks find it increasingly difficult, if not impossible, to obtain refinancing (at an acceptable level of interest rates).

``An institutional bank run is particularly painful for banks involved in maturity transformation. Most banks borrow funds with short- and medium-term maturities and invest them longer-term. As short- and medium-term interest rates are typically lower than longer-term yields, maturity transformation is a profitable.

``However, in such a business, banks are exposed to rollover risk. If short- and medium-term interest rates rise relative to (fixed) longer-term yields, maturity transformation leads to losses — and in the extreme case, banks can go bankrupt if they fail to obtain refinancing funds for liabilities falling due.

``Growing investor concern about rollover risks has the potential to make a bank default on its payment obligations: interest rates for bank refinancing go up, so that loans falling due would have to be refinanced at (considerably) higher interest rates.

While banks are protected from depositors run by deposit insurance, what protects banks from an institutional run?

The European Experience

Ireland broke the proverbial ice in declaring a blanket guarantee on a wide-ranging arrangement that covered deposits and debts of its six financial institutions aimed at ``easing the banks’ short-term funding’ (Financial Times) among European countries.

This created a furor among its neighbors which contended that the ‘Beggar-thy-neighbor’ policies risks fomenting destabilization of capital flows. The reason is that the public would naturally tend to gravitate on the countries or institutions that issue a guarantee on their deposits, hence lost business opportunities for those that don’t do so.

Instinctively the radical policy adopted by Ireland evolved into a domino effect; despite the protests, every EU nations followed to jointly increase their savers to €50,000 (breakingnews.ie).

The problem is according to the Economist (with reference to Ireland or to those who initially went on a blanket deposit guarantee), ``it is not entirely clear how governments would pay these bills, if they ever came due. The chances of governments having to make good on all deposits seems remote, but the figures involved are eye-popping. In Ireland, for instance, national debt would jump from about 25% of GDP to about 325% if the value of its banks’ deposits and debts were taken on to the government’s books, according to analysts at Morgan Stanley, an investment bank. Similarly in Germany, national debt would jump to almost 200% of GDP if it included bank deposits (and about 250% if it included all the debts of its banking system). This may explain why interest rates on Irish government bonds have been rising in recent days.” (emphasis mine)

In other words, should losses consume a substantial portion of the resources of Ireland’s banking system, taxpayers will be on the hook and bear the onus for such unwarranted policy actions. As you can see, desperate times call for desperate measures regardless of the consequences. Nonetheless, Ireland expanded its deposit guarantees to cover 5 foreign owned banks (Economic Times India) presumably to avoid the Iceland experience, again despite the objection of most its neighbors.

Yet, strong pressures to guarantee the domestic banking system at all costs have taken a strain on the solvency of its neighbor Iceland.

From the same Economist magazine article, ``While governments on mainland Europe were trying to save their banks, Iceland was trying to save the country after it had overextended itself trying to bail-out its banking system. Its economy had been doing well, but its banks had expanded rapidly abroad, amassing foreign liabilities some ten times larger than the country’s economy, many funded in fickle money markets. Since the country nationalised Glitnir, its third-largest bank, last week the whole Icelandic economy has come under threat. Its currency is tumbling and the cost of insuring its national debt against default is soaring. As of Monday it was desperately calling for help from other central banks and was considering radical actions including using the foreign assets of pension funds to bolster the central bank’s reserves. These stand at a meagre €4 billion or so, according to Fitch, a rating agency, and in effect are now pledged to back more than a €100 billion in foreign liabilities owed by its banks.”

Iceland, a country of about 300,000 population and the 6^th richest in per capita GDP (nationmaster.com), behaved like a hedge fund whose banking system immersed on the carry trade during the boom days. They borrowed short and invested long (overseas) or the maturity transformation (see Polleit) and additionally took on currency risk. In fact many of their home mortgages have been pegged to foreign currencies which has aggravated both the conditions of bankers and borrowers, from the New York Times,

``Some Icelanders with recently acquired mortgages face a double threat. Home prices have been falling, and analysts expect them to decline further. But many of these mortgages were taken out in foreign currencies — marketed by the banks as a way to benefit from lower interest rates abroad, as rates in Iceland rose into the double digits over the last year.

``Now, with the Icelandic krona plunging, homeowners have to pay back suddenly far more expensive euro- or dollar-value of their mortgages — a kind of negative equity, squared.”

Figure 6: Ino.com: Iceland’s Krona Plunge Against the US dollar (left) and the Euro (right)

In addition, Iceland’s guarantees initially extended to only local depositors and did not to cover overseas investors many of which came from UK, hence ensuing threats of lawsuits. But as of this writing Iceland seems to have reached a deposit accord with UK and Netherlands (Bloomberg).

Moreover, another critical problem is that Iceland found no aid from its Western allies even as a NATO member and had to rush into the arms of political rival Russia which promised a loan for €4 billion (US $5.43 billion)! This is a dangerous precedent for central banks. Of course while this might seem like isolated case- in Asia Japan earlier rushed to offer loans to South Korea when the latter’s currency got pounded, aside from eyeing to create a scheme under the IMF to assist EM countries (Japan Times) and the urgency to revive the Asian counterpart of IMF (AFP)- such risks could worsen if the crisis deepens.

With the nationalization of Iceland’s top banks, taxpayers will also be responsible for the realized losses from the outsized liabilities, from which we agree with London School of Economics Professor Willem Buiter who says, ``The acquisition by the government of a 75 percent stake in Glitnir and the recent nationalisation of Landsbanki were therefore a mistake. Rather than hammering its tax payers and the beneficiaries of its public spending programmes, rather than squeezing the living standards of its households through a sustained masstive real exchange rate depreciation and terms of trade deterioration, and rather than creating a massive domestic recession/depression to try and keep its banks afloat, it should now let Glitnir, Landsbanki and Kaupthing float or swim on their own. The interests of domestic tax payers and workers should weigh more heavily than the interests of the creditors of these banks.”

Here are some lessons:

-Iceland through its nationalization of banks now suffers from the risks of currency, market, rollover and payment losses having to overextend themselves overseas and whose policies will eventually take a heavy toll on its citizenry.

-It’s not about the interest of taxpayers but of the interest of a few who control and become too entrenched into the system and whose risks has now become systemic.

-The Iceland experience of isolation in times of need reveals that central banks can’t always guarantee assistance to one another.

-In times of turmoil, national policies such as the action taken by Ireland can have negative externality effects- incur immediate political and future economic and financial costs.

-The risks of an institutional bank run which threatens the entire global banking system is clearly a top concern for European banks who seem to be acting out of desperation.

-Blanket guarantees (which had been limited to some countries so far) and nationalization of the banking industry will most likely be the ultimate tool used by central banks when pushed to the wall.

Global Liquidity Shortages and Falling Forex Reserves

In today’s turmoil, foreign currency reserves held by emerging markets appear to have been used as defense mechanism against a shortage of US dollar in the present environment in order to defend local currencies.

As affected US and European banks continue to raise capital and shrink balance sheets by selling assets and hoarding and conserving cash resulting to a lack of liquidity into the system, despite the massive infusion in the system by the global central banks led by the US Federal Reserve, this may also be construed as a symptom of the ongoing ‘institutional bank run’.

Figure 7: yardeni.com: Falling reserve growth

The chart courtesy of yardeni.com shows the declining growth rate of forex accumulation from developing and industrial countries. Since September, the growth rate is likely to have turned negative as more economies use their spare reserves to cushion the fall of their currencies.

From Bloomberg, ``Latin American central banks are being forced to draw on record foreign reserves built up during the six-year commodities rally to stop their currencies from sinking in the worst financial crisis since the Great Depression..

``The worst currency meltdown in Latin America since the emerging-market economic crises of the 1990s is causing companies' dollar debts to swell as well as sparking derivatives losses, and may stoke inflation. The decision to intervene came after central banks in the U.S., Europe and Canada cut interest rates in a coordinated effort to boost confidence…

``Brazil and Mexico join Argentina and Peru in selling dollars. Central banks in Chile and Colombia have so far used derivatives contracts to arrest the decline of their currencies, without touching reserves.

So it’s not just Latin Americans selling their US dollar surpluses but likewise in India ($8 billion in one week-hindubusinessline.com) and South Korea (estimated $25 billion since March).

Moreover current deficit economies including the US are likely to be at greater risks since it would need surpluses from foreign investors to fund the imbalances.

While the US continues to see strong inflows from central banks into US treasuries, our favorite fund flow analyst Brad Setser says that Central banks have either been shifting into US dollars from the euro or their reserve managers have also lost confidence in the international banking system or is moving into the safest and most liquid assets via the treasuries.

As per Mr. Setser. ``I would bet that this is more a flight away from risky dollar assets toward Treasuries than a flight into the dollar.”

Conclusion

I don’t like to sound alarmist, but all the present actions seem to indicate of the genuine risk of a failure in the global banking system. And this probably could be the reason behind why the recent turmoil in the financial markets has been quite intensive and amplified.

So the most likely steps being undertaken by global regulators in the realization of such risks (why do you think global central banks cut rates together?) will be to rapidly absorb or nationalize troubled banks (if not the entire industry) and continue to inject massive liquidity and lower interest rates aside from outright guarantees on deposits and loans in the hope to restore confidence to a faltering Paper Money system. In short, they intend to reinflate the impaired banking system.

Yet even under such conditions we can’t be sure if governments can provide sufficient shelter for the depositors and users of the system if conditions should deteriorate further. Present capital in the domestic system won’t probably be enough when the economic functions (clearing and settlement, payment processing, credit intermediation, currency exchange, etc.) of external banking system becomes dysfunctional, even under the context of our government guarantees (which will largely depend on its balance sheet and the ability for the citizenry to carry more public liabilities). Moreover, the international division of labor will likely be curtailed, leading to societal hardships and risks of political destabilization.

The key is to watch the conditions of the credit spreads, commercial paper and money market. Any material improvement in the major credit spread indicators will likely ease the pressure on regulators and relieve the pressure on most markets. Thus, while the potential for a rebound in the stockmarket seems likely given the severely oversold conditions, the vigor and sustainability will greatly depend on the clearing of the flow of global credit.

But on the optimistic part, the markets have already painfully reflected on the necessary adjustments of prices. While it is doubtful if we have reached the level of market clearing enough for the economic system to be able to pay for its outstanding liabilities given the amount of leverage embedded, it may have relieved additional pressures for a repeat performance of this week’s gore.

Of course, any action that government does which may coincide with a recovery is likely to be deemed as government’s success by liberals, it is not. The markets have already violently reacted.

Next, global depressions are aggravated by protectionism. This means that for as long as globalization in trade and finance can be given the opportunity to work, it may be able to accrue real savings to enough to recuperate the system. Besides, technology can vastly aid such process.

Another, this crisis episode is likely to generate a massive shift in productivity and wealth. The losses absorbed by crisis affected nations will impact their economies by reduced productivity on greater tax obligations. Thus, we are likely to see a faster recovery on economies that survived the ordeal with less baggage from government intervention. That is why we believe that some emerging markets including most of Asia should recover faster.

Moreover it isn’t true that if the banking industry goes the entire economy goes. As example, the Philippines has a large informal economy which is largely a cash economy. True, a dysfunctional international banking system abroad can create economic dislocations which may result to hardships but markets can be innovative.

As a final note, don’t forget that historical experiments over paper money have repeatedly flunked. We don’t know if this is signifies as 1) a mere jolt to the system or 2) the start of the end of the Paper money system or 3) the critical mass that would spur a major shift in the present form of monetary standard.