Artemova Final

Executive Summary
One of the most significant events in the financial meltdown of 2008 is the bankruptcy of Lehman Brothers, money market and international lending froze soon afterwards. Spreads on credit defaults swaps rose significantly and markets hit Glitnir bank first. Closed on foreign short-term credit line and rejected the loan from Central Bank, it was quickly nationalized which prompted the sovereign debt downgrade and abrupt fall of already depreciating krona. Banks leveraged their positions to the maximum which has been very profitable for almost a decade and attracted hot speculative capital with further deregulations of the industry. When Landsbanki and Kaupthing, other major banks received marginal calls and unable meet the obligations before the UK and German depositors put them into receivership and urged for bailout packages from other countries and IMF. The current position of the local currency suggests that Iceland has several ways to pave its way in the future. First, the country can integrate into European Monetary Union with European Banks as credible lenders of last resort or another one, keep the local currency till the economy recovers and transfer all foreign currency in the euro zone.

Economy growth 1994-2007
Iceland used to be one of Europe's least developed countries, and traditionally its industries were focused on fishing and tourism. After 1994 membership in a free-trade zone called the European Economic Area country put in place a comprehensive economic-transformation program that included tax cuts, large-scale privatization, and a big move into international finance. The significant portion of which were deregulations of state-dominated banking sector, and in 2001 the monetary policy was changed to allow the krona float freely rather than have it fixed against a basket of currencies including the dollar and in 2002banks were privatized [1]. Another emerging industry which has a promising future is aluminum smelter. The country uses its geothermal energy to produce aluminum and there have been two major projects Alcan smelter and Nordural which contributed to the export of the country competing with fishing [17]
Table below shows that from year 2000 over the period of eight years, the country growth rate was average 5% which was significant to its European partners at a time. The deregulated markets and interest rates which were double and triple of those in Europe and North America made it possible for a country to leverage its position to a maximum.

Table 1. Iceland Economic Growth 2000-2008 and essential economic variables [13]

table1

The credit rating for Iceland’s sovereign rating was widely used as collateral for refinancing the transactions with Central European bank [2]. Here it was apparent that lack of deposits within the banks could increase uncertainty of the bank if the Iceland rating would be downgraded.

Table 2. Moody’s credit analysis of Iceland

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Currency appreciation
Three main central banks of Iceland Landsbanki, Kaupthing and Glitnir with double digit interest rates on Krona made the inflow of international speculative hot capital available in excessive amounts. The Central Bank had inflation control as its mandated priority. The country was investing heavily in aluminum smelting, inflation was beginning to rise, and the Central Bank pushed up interest rates in response: a rate of 5.3 per cent, in 2003, rose to 14.25 per cent, in 2006 [3]. The extent of currency devaluation which is currently trading .008 ISK/ USD from 74 ISK/USD is presented on the graph.

Figure A. US Dollars (USD) to 1 Iceland Krona (ISK): Currencies and interest rates statistics [16]

FigureA

These rates caused money to pour into the country. This is the speculative trade or hot money that is used more often: someone borrows in a place with a very low rate - Japan, say - then leaves the money in Iceland, in krona, at ten per cent, and enjoys the difference. The result was that the krona, in high demand, rose in value on international markets.
Another sign that is considered to be an indication of unhealthy banks leverage can be assets amounted to ten times that of GDP of the country. Iceland's central bank had only 2 billion euros in foreign currency reserves — while the banks had reached about 100 billion euros in assets — meaning it was effectively unable to fill its role as lender [2].

Figure B. Iceland vs. the United States: GDP per capita, 1975-2006 [4]

FigureBJPEG2

It seems that Iceland government did not encourage the main three banks to take smaller risks and close risk positions which made the stock prices within several years to rise nine fold in dollar terms. The ability to borrow in low yielding currencies and investing it high yielding krona made the whole country an enormous hedge fund.

Results of the risky leverage of Iceland

Table 4. Risky leverage of Iceland [14]

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Iceland's most pressing need is foreign currency. The island is dependent on imports, and foreign suppliers demand foreign currency for payment. Trade in Icelandic kronur is limited since few investors want to buy it and the central bank has put restrictions on currency trade to prevent a massive outflow of capital.
The Icelandic banking system has nearly $75 billion of foreign- currency debt, according to a research note by the emerging markets research group at RBC Dominion Securities Inc. Iceland's gross domestic product is now projected to contract 8% next year and 2% in 2010 [10].
Currently market watchers say economic challenges await when Iceland lets the krona trade freely. Among the challenges is the threat of a selloff of roughly $4 billion in foreign-owned Icelandic bonds, which could weaken the kronur, driving up inflation. Temporary Provision of the Foreign Exchange Act imposed a lot of restrictions on operations involving foreign currency exchange except direct investments which are not considerable on the scale of all financial instruments employed in the country [8].
Sales proceeds from transactions with króna-denominated financial instruments that take place between domestic and foreign parties and are settled in Iceland must be deposited to the seller’s account with a financial undertaking in Iceland.
“The issue and selling of securities, unit share certificates in UCITS (Undertakings for Collective Investment in Transferable Securities) and investment funds, money market instruments, or other transferable financial instruments is prohibited” if settlement takes place in a currency other than the currency of issue and the Icelandic króna is one of the settlement currencies.
There restrictions on universal loans and their terms of lending with the decrease of first and increase of the second term. Trading of the derivatives is prohibited which will be another factor stabilizing the economy but in the long run can become a potential source of uncertainty for investors ”[10].
One of the main challenges for the country is to use the funds available from IMF and the European Union in the timely manner. The $ 2.1 bln IMF fund aims to decrease inflation by 4.5pc by the end of next year – down from 14pc last month – and restore the value of the krona. Iceland's emergency cash injection is intended to stabilize its currency, bolster the nationalized banks and strengthen its tax system, with repayments likely to begin between 2012 and 2015 [7].

Table 5. IMF loans

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Currently the Bank of England offered 100 Mln pound short –term loan to Landsbanki to help repay the British depositors first [9]. This measure, however, will help to meet the obligations for the bank but will unlikely help shape the future of the bank: the country can’t be using this fund to help financing from it.
The deal with Russia initially thought of as $5.4 bln is still in consideration even though the financial part of it is clear three to five years loan LIBOR+(0,3–0,5)% to stabilize the currency. However, currently, after the approval of IMF loan and Bank of England with $150 mln Russia is considering only $500 mln which is approximately one eighth of the initial amount [15]. There is an opinion that either aluminum industry is attractive to one of the corporations of Russia which can use its chance to expand into northern Europe or even the increase in military presence in the region.
In addition, it is likely to see substantially more defaults and credit crunch in smaller countries and emerging markets. After Iceland's fall, every creditor to other nations with large deficits and substantial external debt must be looking for ways to reduce its exposure. These risks will involve many emerging countries like Russia, Turkey and Eastern Europe, Latin America. Russia's difficulties show that seemingly solvent countries can be high-risk: While the Russian central bank has gold and foreign exchange reserves of $556 billion, the private sector has recently built up an estimated $450 billion of debt [12]. Creditors don't seem to be willing to roll over the debt, so the government is using its reserves to do it. It has already ordered $200 billion channeled through state banks to companies repaying debt. If oil prices fall, a seemingly highly solvent country could quickly look nearly insolvent.

Implications for the future

The country should announce a temporary blanket guarantee on all existing bank deposits and debts. This will, in effect, promise creditors that they can safely expect the institutions to function until the recapitalization takes place, and it will help prevent the large flows of funds that could occur as some banks or countries conduct recapitalizations earlier than others. This guarantee should only be temporary (say, for six months). Also, strengthening today's most promising industry is renewable energy will help reduce negative trade balance. The question is whether these projects will still be attractive to investors due to the current situation in the financial market.
The monetary authorities of Iceland together with all the restrictions need to lower interest rates dramatically. More will be needed, and it won't stop the credit crunch within or across countries. More interest-rate cuts will be needed.
The monetary authorities also need to remain committed to provide liquidity into the financial system as long as credit markets and interbank lending remain weak using first of all the bailout package.
In the midterm within the next several years banking sector will become more consolidated with less banks with more diversified loans, also the exposure to country-specific and sector specific risks will have to be reduced. It is possible to achieve with the already increased supervision and regulation from the national government and further involvement of the EU[5]. However, for Iceland the absence of flexible exchange rates could become a challenge in the years to come unless it is compensated by other factor such as flexibility of labor. So, becoming a member of the monetary union of a stronger currency might be a possible solution in the long run since the credibility of krona is in the question.
In the long term, Iceland will likely to integrate in the European Monetary Union which stabilizes the country economy and makes European Banks the last frontier lender. However, Iceland can keep the local currency although foreign currency operations would have to be transferred in Euro area.

Reference

1. Iceland: Corporate finance and banking
Jakob Moller. International Financial Law Review. London 2002. pg. 91
http://www.Factiva.com

2. Moody’s International Sovereign, Moodys.com, April 18, 2008.
www.sedlabanki.is/lisalib/getfile.aspx?itemid=5761

3. The Central Bank of Iceland raises its policy interest rate, Dec, 12, 2006
http://www.sedlabanki.is/?PageID=287&NewsID=1406

4. Events in Iceland: Skating on thin ice? Thorvaldur Gylfason. 7 April 2008
http://www.voxeu.org/index.php?q=node/1033

5. The Icelandic Economy
http://www.iceland.org/media/DKvidskipti/The_Icelandic_Economy_Spring2006_Summary_Edition_250406.pdf

6. Iceland: Currency forecast, EIU ViewsWire. New York: Dec 24, 2008.
www.factiva.com

7. Iceland to get £1.3bn IMF loan
http://www.telegraph.co.uk/finance/financetopics/recession/3254993/Iceland-to-get-1.3bn-IMF-loan.html

8. Temporary Provision of the Foreign Exchange Act www.sedlabanki.is/lisalib/getfile.aspx?itemid=6631

9. Iceland: Landsbanki gets £100m loan to pay UK depositors, by Sam Jones Oct,14 2008
http://www.guardian.co.uk/money/2008/oct/14/savings-banking

10. Iceland Targets Debts And Awaits IMF Loan WSJ. Nov 7, 2008
http://www.collegejournal.com/article/SB122600202441605929.html?mod=todays_asia_economy_and_politics

11. Current Financial Arrangements of IMF
http://www.imf.org/external/np/tre/activity/2009/040209.html

12. In The Line Of Fire: Emerging Markets by Peter Boone and Simon Johnson , Forbes.com , Oct12, 2008
http://www.forbes.com/2008/10/12/gazprom-europe-banks-oped-cx_pb_sj_1012boonejohnson.html

13. Iceland Statistics in short: Economic, prices and finance statistics 2000-2008 Worldstat.org, Apr 18, 2009
http://www.worldstat.org/countries/iceland.htm

14. Balance of payments and foreign debt: Central Bank of Iceland. Apr 20, 2009
www.sedlabanki.is/uploads/files/ar97_v.pdf

15. Ria News (Russian Info Portal on business news and events) Apr 2009.
http://www.rian.ru/crisis_review/20081008/152807051.html

16. Currencies and interest rates statistics: US Dollars (USD) to 1 Iceland Krona (ISK), Apr 19, 2009
http://www.exchange-rates.org/history/ISK/USD/G/180

17. Energy and the aluminium industry in Iceland, Platts Aluminium Symposium, Jan 14, 2003
http://www.lv.is/files/2003_2_6_Platts.THi.doc

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