Dreamland (1)

Draumalandið ("Dreamland" in English) opened in Reykjavík a couple of weeks ago. It's not a fashion store (who'd open one of them in Iceland these days?), it's a film based on the book of the same name by Andri Snær Magnason. The book is available in English, translated by Nicholas Jones and published by Citizen Press, ISBN 978-0955136320.

Both the book and the film tell the story of the Kárahnjúkavirkjun power plant in East Iceland, a 690 MW hydroelectric power station built to serve a new aluminium smelter in Reyðarfjörður… at a huge cost. You can find English comments about the film at the Iceland Weather Report and at Economic Disaster Area. Alda in particular claims it to be "quite possibly the most important Icelandic film ever made".

So what is all the fuss about this documentary (whose subtitled trailer you can find here)? Well the project was (and is) very controversial in Iceland. It has been hailed as the biggest single civil engineering project ever attempted in the country, and lambasted as a pointless destruction of the natural environment. It is far from clear that it will ever make a single króna in profit. But also it has been claimed that it is one of the causes of the kreppa. Aluminium smelting in Iceland is a topic which deserves its own post, so I shall concentrate on the third of these points for today.

The hydroelectric plant was built with immigrant labour and foreign money. It is good for Iceland that it was built with immigrant labour: it would have cost even more had the contractors been obliged to hire Icelanders at the then-going rates! The 2005 estimate of its cost was 90 billion krónur (roughly €1 billion, at the going exchange rates of the time).

Now readers of this blog might see a sign here. 90 billion krónur is a lot of money, but it is far less than many of the sums described here. The glacier bond problem is something like 500 billion krónur; the Icesave "problem" is even larger, roughly 800 billion krónur, but hopefully less serious in the short term as there seem to be agreements not to make too much of a fuss about it.

Let's take the example of Landsbanki. At 30 June 2008, it had:

• 345 billion krónur in ISK deposits, but 1372 billion krónur in loans in Iceland;
• 989 billion krónur in sterling deposits, but only 528 billion krónur in loans in Britain and Ireland.

There are many honest and honourable reasons to object to the expansion of aluminium smelting in Iceland, but the idea that it was responsible for the kreppa is not one of them. The kreppa was created by Iceland's commercial banks sucking money into Iceland, regardless of such schemes as Kárahnjúkavirkjun. White elephants are often born during economic bubbles, and they never help, but it goes too far to accuse this one of having caused the whole financial meltdown.

How much is a króna worth?

A couple of days ago, I commented on Sjálfstæðisflokkurinn's crackpot idea to unilaterally adopt the euro as Iceland's currency. Nobody has pointed out the flaw in my argument, so I will come clean and admit it myself! Iceland can't adopt the euro on its own, at least not yet and not at the current exchange rate.

Today's Central Bank of Iceland selling rate is 168.09 krónur per euro, down 12% since 1 February. On the other hand, if you look at Yahoo! Finance, they quote a rate of 290.66 krónur per euro… The European Central Bank hasn't quoted a ISK exchange rate since 3 December, when it was 290 krónur to the euro. How much is a króna really worth?

Entire textbooks have been written about exchange rate theory: fortunately, we only need to consider a very simple definition here. You'll just have to trust me that we would reach the same results through more complicated theory, but we can just consider that a currency is worth what people are willing to pay for it. This leads to two important conclusions, neither of which you are likely to hear from the mouths of Icelandic politicians.

Firstly, in reality, the króna is worth less than 168 to the euro. It must be, because 168 to the euro is the rate it "trades" at within Iceland, where there are strict controls on selling krónur. If the currency controls didn't exist, more people would want to sell krónur – that's only logical, otherwise there'd be no need for the controls! If more people are selling krónur, it's exchange rate will go down. Hence the CBI exchange rate is artificially high.

Secondly, the króna must be worth more than 290 to the euro. To see why, we need to look at where this exchange rate comes from. Imagine you are a foreign investor who bought a million krónur's worth of Icelandic government bonds when times were good (you would have paid about €11,000 for them). As things stand at the moment, you can't get any of your money out of Iceland. because of the currency controls. You have two choices: either you can be patient and wait for the currency controls to be lifted, or you can sell the bonds onto someone who's more patient than you are. If you sell the bonds, you have to agree a price for them, which is equivalent to setting an exchange rate for the Icelandic króna. The 290 krónur to the euro rate means that people outside of Iceland are selling a million krónur's of glacier bonds for about €3500 (once you've factored out interest payments, etc). Now the people who are buying these glacier bonds don't know when they're going to be able to get their money out of Iceland, so they apply a risk premium: they want to make a profit from their patience, so they buy krónur at an artificially low exchange rate.

In other words, we don't know how much a króna is worth and we won't know until the glacier bond problem is sorted out. We can say that the króna is not worthless. Jokes like "What's the capital of Iceland?"—"About twenty euros and a couple of dried cod." are exactly that: just jokes. The offshore exchange rate, as quoted by the ECB, reached a high of 200 krónur to the euro last November: that's about as good a guess as you're going to get for the real exchange rate, but it's only a guess.

Last week, Finance Minister Steingrímur J. Sigfússon predicted that "it is possible that there will be news about the arrangements of the glacier bonds at the annual meeting of the Central Bank of Iceland" last Friday. I've heard more reassuring politicians… Governor Svein Harald Øygard did indeed speak of the problem: apparently "the Central Bank also reviews selected measures that may allow the most impatient investors locked in by the capital controls to convert their holdings of ISK, in a way that does maintain the currency reserves of the Bank."

Hints of these "selected measures" came out over the weekend. Apparently Norðurál is looking at financing the new aluminium smelter at Helguvík with "glacier bonds". In effect, they propose to exchange ISK-denominated securities for Norðurál bonds denominated in US dollars. An interesting proposal, but the devil is in the details. What will be the exchange rate proposed to holders of glacier bonds? Will it even be made public? Or will this just be another deal between friends of the type which has made Icelandic business infamous over the last few months? In any case, the Helguvík smelter will cost 80–90 billion krónur, less than a fifth of the total value of the glacier bonds: at best, the Norðurál solution will only be a partial one.

A better bet would be to set up currency auctions to allow holders of glacier bonds to liquidate their króna capital. If, at the moment, the Central Bank of Iceland can only afford to pay back, say, €500 million euros to glacier bond holders, it should organise an auction. Investors could offer their bonds to the Central Bank at a given exchange rate and, once the pot of euros is used up, the CBI stops buying. The sellers (ie, bond holders) determine the exchange rate at which they wish to bid, and those who bid the most krónur for each euro get their bonds bought off them. Auctions could be organised every few months until the problem is resolved. That way, the Central Bank gets the benefit of the current offshore speculation on the króna and overseas investors get to put a cash price on their impatience. Don't expect this idea to become reality though – it would require too many people to face up to difficult realities as to the true value of Iceland's currency.