On glacier bonds and Frankfurters

On the eve of today's elections the newspaper Morgunblaðið (linked to Sjálfstæðisflokkurinn, the "Independence" Party, as are many of the Icelandic media) published a report, translated at NewsFrettir, on the glacier bond problem. See "More euro madness" and "How much is a króna worth?" for the Ministry of Puffins' take on the issue.

Morgunblaðið claims (quite plausibly in my opinion) that the European Central Bank has been left holding 100 billion krónur in these once-cool financial instruments, money which is now trapped behind behind Iceland's currency controls. That's about one-fifth of the total outstanding value of the glacier bonds, according to several estimates seen by the MoP. The ECB accepted the bonds – 57 billion krónur in Íbúðalánasjóður (Housing Finance Fund) bonds, 28 billion krónur in Iceland treasury bills and 15 billion in króna-denominated bonds issed by Dutch bank RaboBank – as collateral for a euro loan to Landsbanki Luxembourg S.A., a subsidiary of Landsbanki h.f. which is now in suspension of payments.

Less plausibly, Morgunblaðið also claims that the interest payments on glacier bonds are driving down the króna exchange rate. Foreign investors are allowed to convert króna interest payments into hard currency under the currency controls; only the principal (capital) is locked into Iceland. But with some 500 billion krónur in glacier bonds, even the interest payments are a significant drain on Iceland's foreign currency. Significant, yes, but nothing compared to Icelandic domestic debt – 4827 billion krónur according to the latest available figures, of which a whopping 60% is denominated in foreign currencies according to the IMF. Although the foreign-currency loans to households (with no foreign-currency income) represent the pinnacle of stupidity, these are only a small proportion of the total: most of these loans are to Icelandic businesses. The hard currency which goes on paying off these loans can't be used for other things, like paying for imports, so the businesses have to buy more hard currency for squidgy-soft krónur, which pushes the value of the króna down.

Don't expect to hear any of this from Sjálfstæðisflokkurinn in the foreseeable future: it's simply more than they could humanly bear, to admit that sold the independence that they pretend to cherish so dearly, all for a fist full of euros (no less!).

IgNobel nominations (2)

(continued from yesterday's post)


Mr. Davíð Oddsson, former Chairman of the Board of Governors of the Central Bank of Iceland, former Prime Minister of Iceland, for his study of the effects of increasing money supply while keeping interest rates high.

The Central Bank of Iceland, like many central banks in Europe, operates its monetary policy by inflation targeting. The target rate for Icelandic inflation is 2.5%: since Davíð took over the helm of the CBI in October 2005, the target has only been met in 2 months out of 29 (it was met in 37 out of the previous 55 months). As is normal in such circumstances, and according to the Taylor rule, the central bank has steadily increased interest rates in an attempt to control inflation, up to 15.5% in September 2008.

However high interest rates tend to restrain economic activity, and so are unpopular with politicians such as Davíð. In order to support the Icelandic economy, the Central Bank of Iceland decided to increase the number of krónur in circulation. It did this by lending money to Icelandic banks on the basis of “newly-issued uncovered securities”, the financial equivalent of IOU notes. (see para. 19 of Iceland's Letter of Intent to the IMF)

In classical economic theory, the effects of an increasing money supply and of high interest rates should cancel each other out. However Davíð discovered that, if the money supply is increased sufficiently – the Icelandic króna M3 increased by 52.7% in the twelve months to September 2008, compared to a GDP growth of 5.0% – it will outweigh the effects of high interest rates. At such levels, the study shows, one finds the classical economic response to “printing money”: that is, inflation, currency devaluation and, eventually, systemic economic collapse.

The study has now been halted at the request of the International Monetary Fund, as there are already sufficient data to include in the new editions of undergraduate economics textbooks.

(data from Statistics Iceland, Central Bank of Iceland)

(to be continued)

Central Bank translation service

Thanks to Mike the UK Nordic Analyst (whatever one of those is) over at IceNews for providing this translation of the main points from the speech of Central Bank Governor Svein Harald Øygard last Friday. It made me laugh out load, so I thought I'd share it with my readership (hi Mum!)

He said
“All efforts should be made to avoid further socialisation of private sector debt”

Which means
“If you think that the Central Bank and Government are going to help you Icelanders pay back, reschedule or even write off, your mortgages, indexed car loans or corporate debts … well you can forget it! We’ve got enough on our plate already with depositor guarantee schemes and ISK bonds due.”

He said
“The negotiation processes in the financial sector and the restructuring and recapitalisation of the banks must therefore be pursued according to plan.”

Which means
“Plan!! Plan? We’re just blundering along being told what to do. As for restructuring the banks it looks as if they will need to come to terms with their creditors. Who cares about the division between “new” and “old” banks? Our foreign bondholders certainly don’t. Let’s hope for the best!”

He said
“As part of this, the foreign exchange exposure and indexed loan exposure of the new banks must be addressed.”

Which means
“I have no idea how the banks are going to pay back their debts, especially those that need to be paid back in foreign currencies! But hell, it’s not my problem – it’s the banks!”

He said
“With declining domestic demand, there will be resources available to service the country’s accumulated debt.”

Which means
“All income from our productive output will be used to pay our foreigner creditors. So frankly we’re not going to have anything to spend on ourselves. Domestic demand? Don’t make me laugh! Bread and water if you’re lucky!”

He said
“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.”

Which means
“Impatient investors? Why are they impatient? Because their bonds have matured and they want their money back – NOW! If we did pay them it would wipe out our currency reserves. Does anyone have any ideas?”

He said
“Negotiations for bilateral loans, other negotiation processes, and the IMF review should be completed shortly.”

Which means
”The IMF et al are holding back the latest tranche. We need money. We’re descending into poverty. HELP!”

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.

More euro madness

So now Sjálfstæðisflokkurinn (the Independence Party to English speakers) have decided they want Iceland to adopt the euro after all… Not to join the European Union, at least not when they answered the questionnaire posed by the Reykjavík Grapevine (maybe they've changed their minds on that one as well…), but simply to decree that the euro will henceforth be the currency of Iceland.

The idea isn't a new one – indeed it dates from long before the current financial crisis. The response from the European Commission and the European Central Bank has been a consistent "no", most recently from Commissioner for Enlargement Olli Rehn in January 2009 and from ECB board member Jürgen Stark in February 2008. Before the kreppa, it was usually the bankers who were keen to adopt the euro, which makes it all the stranger that Sjálfstæðisflokkurinn should choose to put aside its traditional reticence just now, with less than a week to go until the parliamentary elections. Perhaps they think it will somehow make them sound "pro-European", or perhaps they just think it's more sensible than talking about adopting the Norwegian krona. It is more sensible than talking about adopting the Norwegian krona, but not by much.

How would this currency changeover come about? Well let's imagine that a Sjálfstæðisflokkurinn government were to decide to change the króna, not for the euro but for gold: one króna being worth a couple of thousandths of a gram of gold. It's not a silly as it sounds: it is the equivalent of the gold standard used by most major economies from 1946 to 1971. First the government buys enough gold to compensate the holders of all the króna banknotes in circulation, some 22 billion krónur. Then it simply insists on selling all Icelandic exports for gold – that would make the fish market in my native Grimsby a much more glamorous place! – and offers to pay for imports in gold. Not everyone would accept gold in return for sending goods to Iceland but, so long as imports were roughly equivalent to exports, the Central Bank of Iceland could sell some of the gold to buy dollars or euros or Thai bahts or whatever to pay for imports.

At first sight, it looks feasible to change the króna for another currency, based on that analysis. After all, the international reserves of the Central Bank of Iceland amount to some 383 billion krónur, more than enough to buy back all the krónur banknotes and still have plenty left over. But it ignores the fact that the "money" in circulation is much more than physical notes and coins, and, in the case of Iceland, not all of it is held by residents who can easily be subjected to exchange controls.

Accurate figures are hard to come by, but most estimates I've seen of the "glacier bond" problem put it at around 500 billion krónur. These are foreign investors who have lent money (in krónur) to the Icelandic government, the Íbúðalánasjóður (Housing Finance Fund) or the Central Bank of Iceland. They are being paid back in krónur when the bonds or certificates of deposits mature but, since last November, they cannot convert those krónur into foreign currencies, only reinvest the money within Iceland. If Iceland were to adopt the euro, these bonds and certificates of deposit would have to be repaid in euros, and the CBI simply doesn't have that much foreign currency at the moment.

No country has unilaterally adopted the euro in the way that Sjálfstæðisflokkurinn proposes. Several countries outside the EU use the euro as their currency, but this was because they didn't have their own currency when the euro was introduced. Take Andorra for an example: before 1999, it used both the French franc and the Spanish peseta. When those currencies were abolished in 1999, all Andorran assets and liabilities in France and in Spain were automatically converted into euros; when euro notes and coins were introduced in 2002, the French and Spanish notes and coins circulating in Andorra were exchanged for euros at the respective central banks. On the other hand, Andorran banks cannot turn to the European Central Bank if they get into difficulties, as Andorra is not a member of the EU or the eurozone.

Sjálfstæðisflokkurinn's idea is not just unworkable, it is sheer intellectual dishonesty. This party – whose membership is around 25% of the Icelandic electorate and which has been the most voted party for most of the last century – seems to believe that the nation belongs to them and that they have a god-given right to govern. I can only hope that ordinary Icelanders will take the opprotunity to send it to the outer reaches of the political wilderness next Saturday.

***UPDATE*** (Tuesday 21 April)

• NewsFrettir reports the comments of Professor Kristjan Vigfusson, saying that Sjálfstæðisflokkurinn's proposal is unrealistic.
• Economic Disaster Area reports that Sjálfstæðisflokkurinn is plastering Reykjavík with posters announcing their mad idea.

***UPDATE*** (Friday 24 April)

• J. Halldór in Morgunblaðið seems more optimistic about Sjálfstæðisflokkurinn with this cartoon. Only time will tell.