Saturday, November 1, 2008

An Icy Breeze - Ajit Chaudri IRMA Alumni


A 2-Pager by Ajit Chaudhuri

Introduction: Readers of my generation may remember the novel "Running Blind" by Desmond Bagley - a good book made better for its introducing the reader to a small[1] island nation nestling just under the Arctic Circle. Iceland occasionally popped up in the news after that - from its location as somewhat in between Moscow and Washington and therefore a good place to hold contentious discussions[ 2] during the cold war years to the exploits of the singer Bjork. Readers of human development indexes would know Iceland as a country that combines wealth with equity[3], travel addicts for its mountainous and volcanic interior and for whale watching, and scientists for its energy policy[4] and research on genetics[5]. And hardcore Olympics watchers this August, such as yours truly, would have followed the country's men's handball team trying to win its first every gold medal (they lost in the final and settled for silver).

Iceland burst into the news again last week as the first nation-casualty of the current financial crisis! Its banking system has broken down, its currency is in free fall, and it has moved from being a wonderful example to a horrible warning - all in one week. What happened? Why? And what are the lessons to be had?

What happened? The first indication that it was not only banks going under and that an entire nation was in deep s--- was on 7th October, when the Icelandic government made three announcements -

1. That it was abandoning its efforts to peg the Icelandic Krona at 131 to a Euro.

2. That it would nationalize the country's three largest banks - Kaupthing, Landsbanki and Glitnir.

3. That it was in the process of obtaining a loan of Euro 4 billion from Russia.

The British were the first to react! Upon not getting a guarantee protecting British deposits in the banks, Gordon Brown announced the freezing of Icelandic assets in Britain on 8th October and used anti-terrorist legislation to do so. Other countries with a significant Icelandic banking presence followed suit. The Icelandic Krona dropped in a day to 340 to a Euro and then went into free fall. There was no sign of any money from Russia, and Iceland's Prime Minister Geir Haarde backtracked to say that the loan was still being negotiated.

Why? How did a country fall so far so fast? Iceland had traditionally been dependent upon fishing - its location and lack of neighbours give it a natural advantage in this field. Somewhere in the 1990s, the government decided to liberalize the economy - starting with the banking sector. Banking prospered, and soon found that Iceland's demographics did not match the banks' growth ambitions. Aggressive expansion followed - into the UK, the USA, the Netherlands and Scandinavia. Deposits were attracted by high interest rates[6], which were in turn forced up by Iceland's high inflation - about 14 percent in the 12 months up to September 2008. They were successful! IceSave, an Internet banking subsidiary of Landsbanki, had about 300,000 depositors (about Iceland's population) in the UK. Landsbanki's owner, Bjorgolfur Gudmundsson, became a billionaire and Iceland's second richest man (after his son) and went on to indulge in typical billionaire stuff like buying an English football team.

And then, the sub-prime crisis happened and banks stopped lending to each other. Icelandic Banks, like other banks, were unable to roll over their loans - and with a combined foreign debt of about seven times Iceland's GDP, a falling currency (thereby increasing the value of foreign debt in Icelandic Kronur), and a high inflation rate (thereby adding momentum to the falling currency), they were particularly exposed. This is normally where a central bank would step in and play the role of a lender of last resort - but this was not possible here with the debt being so much more than the size of the national economy.

What's going to happen? Difficult to say, with events still unfolding every day! Can the USA play guarantor, as it has chosen to do with its own banking system? Possible, but it does relegate Iceland to Puerto Rican status. Can the European Union? In the long run, Iceland may see value in joining the Euro - but not right now, Iceland's current ruling party and opposition are both anti-EU and anyway the EU is unlikely to be interested. On the other hand, the fundamentals for Iceland are intact - the fish haven't gone anywhere, there are still no aggressive neighbours, and its human capital remains among the best in the world. Its currency was considered the world's most overvalued[7] and could do with a correction. The tourism industry is already benefiting from Iceland being a less expensive place to visit. I would bet on a large loan (from Russia?), a circumspect recovery, less flirtation with neo-liberal concepts, and, for the West Ham United fans among you, Mr. Zola not getting funds for a major expansion this January.

What are the lessons here? The first is a sobering note for all the insurgent elements in India who are looking to break away - running a small country requires more than the ability to fire an AK-47 and suck up to fringes in the Pakistani and Bangladeshi armies. You have to run an airline, maintain a central bank and a currency, and develop a football team for world cup qualifiers. And when large fish decide to screw you, you have to lie down and take it - witness Geir Haarde's comment when Gordon Brown used anti-terrorist legislation to send Iceland into a tailspin, a mere 'this is not a friendly act'. Iceland may be the richest, whitest and most progressive country on the planet, but when the fertilizer hits the fan who cares - the world can afford it to fail.

The second is more worrisome in the Indian context. Policy makers choose between enabling growth and fighting inflation. Policies that enable growth, such as low interest rates, more circulation of money and larger fiscal deficits, tend to be inflationary and to reduce the rupee's value. And policies that fight inflation, such as high interest rates, squeezed money supply and circumspect government spending tend to curtail growth. It is an interesting tightrope walk and one that is not so much of an issue in times of high growth and low inflation - this was the case over the past few years but is not the case now. The Indian government had reacted to the difficulties faced by people because of rapidly rising prices by taking anti-inflationary measures. The priorities appear to have u-turned in the aftermath of the financial crisis, and all hands are now on the pump that looks to maintain high economic growth and protect the integrity of the country's financial systems. In effect, they have chosen the interests of those with businesses, jobs and bank accounts over those who use a significant proportion of their earnings to buy food. Given the number of elections scheduled over the next year, I am yet to decide whether this is brave or foolhardy.

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[1] An area of 103,000 square kilometers (about half the size of Gujarat) is inhabited by about 300,000 people (about my neighbourhood in Delhi)!

[2] The Strategic Arms Limitation Treaties were negotiated here in the seventies, and the Fischer vs. Spaasky chess match was played here in 1972.

[3] It is among the richest and least corrupt countries in the world, has the highest participation of women in parliament, has the lowest Gini Coefficient (i.e. has the least inequality of income among its citizens) and the best social safety nets - a model in every way.

[4] Heating is free to all households and is from harnessing geothermal energy.

[5] Iceland has a homogenous population with few immigrants and family records from the time of the Viking settlements in 874 AD, a perfect situation for the study of human genes.

[6] Typically, Icelandic Banks offered 15.5 percent interest on deposits compared with standard rates of 5.5 percent in the UK and 4 percent in the Eurozone).

[7] "The Big Mac Index", The Economist issue of 1st February 2007.

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