Ali’s blog

Mostly quant stuff with occasional digressions

Iceland up the creek

Posted by alifinmath on March 26, 2008

In Tuesday’s FT:

Vigorous growth in financial services and real estate – which accounted for 26 per cent of gross domestic product in 2006, up from 17 per cent in 1998 – underscores a profound change in, and towards, Icelandic business. The country’s entrepreneurs have developed a reputation for bold and highly leveraged aggressiveness, snapping up assets including famous names in UK retailing such as House of Fraser.

A recipe for disaster.

But this transformation has come at a cost. Rapid growth has created imbalances in Iceland’s economy and the global credit crisis has exacerbated fears that the rapid expansion of the economy and the banking system may be a house of cards poised to topple.

These fears have led to a 20 per cent weakening of the Icelandic krona against the euro so far this year, big spikes in the credit default swap (CDS) markets – a form of insurance against non-payment of corporate debt – for Iceland’s main banks and across-the-board stock market weakness. The central bank was forced into an emergency interest rate rise to 15 per cent on Tuesday in an effort to restore confidence in the currency.

This reminds me of “Black Tuesday” in Britain in the early ’90s. Britain was in the European Exchange Rate Mechanism at the time (with the intention of eventually becoming part of the emerging euro bloc), which meant it had to keep the sterling in a narrow exchange rate band against the other EU countries. The rate was artificially high (courtesy of the stupidity of Thatcher and Lawson), and could be maintained at that level only be high interest rates. Soros and other financial vultures started to attack sterling, and on Black Tuesday the chancellor of the day (Lamont) had to increase the rate from 12% to 15%; that same evening he announced the government would no longer defend sterling, which effectively meant the UK was out of the ERM, and exchange rates subsequently were decreased (this allowing for an economic expansion over the next several years). Soros banked about 1bn pounds. I don’t think a 15% rate is sustainable for Iceland, and will probably have a very dire effect domestically.

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