Reykjavík Under Seige?
It has the world’s highest literacy rate. People live longer in Iceland than any other country. They are supposedly some of the happiest people on earth if you believe a new book out. Here is what is happening to the one of the world’s smallest independent economy and its currency:
1. Inflation is out of control. It’s now at 9%.
2. Central bank interest rate: 15%.
3. Performance of the currency (the krona): -20% against the Euro since the start of 2008.
Who’s to blame? The central bank asserts that it’s the fault of hedge funds and international financier Michael Weist, who operates a currency trading empire out of Malaysia. I am not so sure about the hedge funds, but I would keep an eye on the Weist guy. Sounds shifty.
The central bank really is arguing that international financial players are preying upon a difficult situation in the country and wreaking havoc on the economy. You know, doing wild speculative things that you only see in financial documentaries for people over 18.
But is that really the problem here? Let’s go back and see how the country handled its own finances, and we’ll see if we can trace the line of responsibility for the current problems back to anyone else. In the last 5 years, the three major Icelandic banks issued billions of dollars in cod-bonds.
These are bonds that offered really, really attractive interest payments. Who bought these bonds? International financial players like, oh, say, hedge funds. These hedge funds, as we all know now, sold Japanese Yen and bought high-interest bonds in New Zealand, Brazil, Hungary, and yeah, Iceland. Lots of them in Iceland. Billions of dollars of them. Foreign debt, in the last 4 years, quadrupled. And you know what these banks started to do when they realized they were on the hook for these huge interest payments?
They hedged their bets. Sounds smart, right? That’s what intelligent traders do.
These banks sold their own currency, the krona, in futures contracts. They entered crazy derivatives deals with leverage and bet against the value of their own currency. When the krona started to fall, they made huge amounts of money and everyone was happy.
At the same time the banks were doing this, the hedge funds that were playing the carry trade game were buying and selling – and some of you already guessed it – credit default swaps (CDS) to hedge their own risk, just in case the Icelandic banks weren’t able to pay the debt.
So, let me get this straight:
1. The Bank of Iceland set the base interest rate high.
2. This attracted foreign capital on a massive scale.
3. This launched the economy into a frenzy.
4. Icelandic banks sold their own currency to hedge the bet.
5. Hedge funds did the same.
6. Now the krona is cratering.
Does this seem like an international monetary conspiracy to you? Was the central bank angry when foreign capital came in and boosted the economy? Why would they be upset when foreign capital is leaving and causing problems for the economy? The same country whose banks created “cod-bonds” to specially attract international hedge funds is feeling the effects of having created the entire mess in the first place. You can choose to raise interest rates, or allow your banks to trade on leverage and create risky financial instruments. You can’t choose the consequences of those actions.
It’s not so different from any losing trader. We love the system we’re using when, with outrageous leverage and sweet euphoria we make tons of money. And we become disenchanted with trading for a living when it all goes wrong. We start to say things like, “It’s not actually possible to trade for a living,” and “My dealer stopped me out,” and so forth.
Maybe, I suspect, we shouldn’t have fallen for the oldest trick in the book, which it seems that even countries are not immune from: we tend to increase our bets and greedily want to accumulate as much as possible now, without regard or attention to the longer term consequences of our selfishness.
