Is Iceland facing a meltdown?
Investing in high yielding emerging markets is risky - as Iceland’s experience shows. With inflation at 4%, a trade deficit at about 10% of GDP, and, even more frighteningly, total debt at 350% of GDP, Iceland’s economy faces meltdown.
Updated, 7th October 2008: For more on Iceland's financial crisis, see: How Iceland's meltdown affects you
Last week we referred to Ben Bernanke's presiding over the US economy as it slithers steadily towards what Mr Paul Keating might have described as a "banana republic!" For an object lesson in what economic mis-management might lead to, Mr Bernanke need only cast his eyes to the North Atlantic where the Icelandic economy is heading towards "melt down".
Although only small ($13.2bn) the Icelandic economy is comfortably the most over-heated in the OECD area. Since 2003 the upswing has been driven by large-scale energy investments and substantial foreign investment in aluminium production. (The indirect export of thermal energy through aluminium production is the second most lucrative component of Iceland's export sector, behind marine products, with a 20% share).
The consequence of prolonged expansion and an explosion in domestic demand has been a severe deterioration in net exports. The trade deficit currently runs at c10% of Gross Domestic Product (GDP). Furthermore the country's income balance has deteriorated too, owing to increased expenditure on interest and dividend payments as foreign debt and investment flows have increased over recent years. The current account deficit currently stands at 20% of GDP.
This strong growth has also resulted in a tight labour market (unemployment is just 1%, touching lows previously achieved in 1991 and 2000. Deep recessions followed in 1992 and 2001). A constrained labour market has, inevitably, fuelled aggressive wage demands, taking the country's inflation rate to the upper inflation band of 4% in late 2005. The Icelandic central bank has been hiking base rates aggressively in order to cool inflationary pressure. The base rate now stands at 11.5%, following an aggressive 0.75% hike on Thursday 30th March. The country's base rate has more than doubled since May 2004.
On Wednesday 29th March the Financial Times indicated that such high rates engendered a classic carry trade, domestic and foreign banks borrowing more cheaply in dollars, yen or euros and purchase higher yielding Icelandic assets. The economy's parlous state indicates that aggressive carry traders had better rediscover the definition of the word risk.
On top of this macro economic boom debt, gearing and risk-taking has reached record levels. External debt (as reported by Danske Bank) is now 300% of GDP, while short-term external debt is c55% of GDP, or 133% of Icelandic export revenues.
The Icelandic Kronur's earlier strength, by more than 20% in real terms since 2004 had served to forestall economic catastrophe. Given an import / GDP ratio of 45% the currency's appreciation had served to dampen what would otherwise have been rampant inflation growth.
Even though the public finances appear robust (budget surplus running at around 5% above GDP) revenues have been boosted by hitherto strong growth in both the economy and labour market. Despite the urgent need for fiscal policy tightening, the Icelandic government as so far failed to enforce the necessary medicine.
Icelandic economy: Debt
Away from external debt concerns, the domestic macro economic picture looks pretty stretched too. Credit growth to the private sector has exploded from 0 to near 70% year on year. Broader liquidity measures tell the same story; M3 is growing at c22% annualised and in excess of 10% each year since 1998.
Asset markets have benefited too, the Icelandic stock market rising by 300% since early 2004.
Strong credit growth is reflected in debt ratios. Total debt as a percentage of GDP has ballooned to c350% of GDP (a figure which might make even the US quiver), driven by corporate and household sectors. External debt now accounts for in excess of 80% of total debt. Much of it is likely to be denominated in foreign currencies as Icelandic corporations have expanded aggressively across Northern Europe.
Icelandic economy: What Happens Now?
Having established that the Icelandic economy is out of balance one might reasonably ask what might happen next?
Developed financial markets are already on a high state of alert. On February 21 Fitch, the rating agency, downgraded its outlook for Iceland's sovereign debt to negative, sparking frenetic selling in Icelandic foreign exchange, debt and equity markets.
Overseas creditor banks responded in knee-jerk fashion by restricting credit to Icelandic borrowers, reflected in widening spreads on Icelandic Eurobonds.
Furthermore, the Icelandic economy faces a specific liquidity constraint. Short-term debt amounts to six times total Icelandic foreign exchange reserves and 135% of annual exports. The scope for the Icelandic central bank to act is circumscribed by the limited size of its foreign exchange reserves. Thus the Bank's scope to ease the pain caused by an external lending crisis is extremely limited.
Icelandic economy: Liquidity crisis
The central bank's decision to tighten monetary policy indicates that liquidity conditions are clearly going to get tougher. In such circumstances banks might reduce their lending to corporates and households, producing a ripple effect that, at this moment in time, looks likely to result in a (possibly severe) recession.
Tighter monetary policy and negative wealth effect arising from the Kronur's inevitable fall on global currency markets would have an adverse impact on investment and consumption. Whilst nobody can forecast the exact magnitude of any subsequent correction, investors might note that in during the Thai crisis in 1997 and the Turkish crisis in 2001 investments fell by c30%-40%. Given the extent of the Icelandic imbalances a possible fall of this order of magnitude cannot be ruled out.
Equally, household consumption would be expected to be curtailed too. In Thailand and Turkey it declined by 10%-15% and by 5% during the Icelandic recession of 2001. All this might be expected to tot up to a 5%-10% drop in the country's GDP, according to analysts at Danske.
Given the relatively small size of the country's economy, a sharp fall in GDP would feed its way quickly into the public finances. The budget surplus would be expected to turn swiftly into a deficit (as is the way with emerging economies). If the crisis widened to engulf the banking sector (although regional banks are vehemently denying any risk at present) the government would almost certainly end up having to shoulder a good part of the bank's increased debt burden.
Icelandic economy: Contagion
Given that most clients will have very little direct or even indirect exposure to Iceland the impact of the country's economic bust is likely to be limited. The key issue therefore becomes the concern pertaining to the ramifications of Iceland's crisis elsewhere.
With regard to Scandinavia, the impact is likely to be extremely limited. Only 0.6% of Danish exports make their way to Iceland, 0.35% and 0.3% respectively for Norway and Sweden. The financial sector could be adversely impacted, reflecting Icelandic ownership of Scandinavian assets. Were the Icelandic banking and corporate sectors to become forced sellers of foreign assets, to meet overseas debt repayment obligations, some reaction from the Nordic financial markets might be expected, but probably only with regard to specific assets rather than a more wide-spread sell-off.
With regard to emerging markets generally, investors should naturally be wary regarding other high yield markets. However, given the very limited nature of foreign investment positions in Iceland, no over-spill into other emerging markets is to be expected. The very fact that the Icelandic economy is in turmoil should, however, act as a timely reminder to many investors regarding the risks associated with investing in high yielding emerging markets generally (Note that the Icelandic Kronur has slumped by 10% so far this year, making it the world's third worst performing currency. Since the 21st February Fitch warning the Kronur has depreciated by 12% against the dollar).
With that in mind, investors are advised to pay particular attention to those emerging markets with large and potentially unsustainable current account deficits, in particular Hungary, New Zealand, Romania, Turkey (again!) and maybe even South Africa and the USA. Now that would be a shock!
By Jeremy Batstone, Director of Private Client Research at Charles Stanley