Monday, 2 December 2013

The Icelandic Debt Relief

The hottest story coming from Iceland now is the one about the government-initiated debt relief to households. Here is my take on it, focused only on handful of all the questions and issues related to the act itself and, perhaps more importantly, the potential economic development in the future. Especially on that front we have a sea of unanswered questions. Is this going to be inflationary? What about economic growth, unemployment, investment levels, etc.? The balance of payments? Will this help or hinder the abolishment of capital controls?

First some useful links (in English) that I found. They are unfortunately not many... classic Icelandic lack of communication problem... (if you've got some others, please leave a comment):
FAQ on the website of the Prime Minister's Office
The news itself on the same website
Bloomberg - Creditors in Iceland Banks Face Pressure to Speed Up Settlement (by an Icelandic journalist).

The basics
Framsóknarflokkurinn (e. The Progressive Party, PP - they are conservative) promised to carry out a debt jubilee if it would be elected into power in the last general elections. They were. The other half of the coalition is Sjálfstæðisflokkurinn (e. The Independence Party, IP - conservative).

Those two parties did not agree on how the debt should be cancelled. The PP wanted to straightforward cancel it. They were talking about up to ISK 300 billion just before the elections, the actual amount turned out to be half that. The IP thought that cancellation would be impossible since it would either be simply illegal on the grounds of property rights and / or too expensive for the State in case the State was going to foot the bill for cancelling the debt of households. Their take was to use the tax system and create incentives for people to use the 3rd pillar of the pension system - the private pension holdings - to get tax-free additional income to be spent on paying down debt and only to pay down debt.

The outcome is a mix of both. ISK 80bn. (roughly GBP 400 million) of household debt will be outright cancelled. Additional ISK 70bn. are to become available via allowing people to use their 3rd pillar pension savings in the next three years, to pay down their household debts.

So what's the crack? 
Icelandic households will get ISK 150bn. (GBP 750 million) of their household "cancelled", spread over a four year period. I say "cancelled" because they are in fact paying down ISK 70bn. of it themselves, the only thing is that they get to use tax-free pension savings to pay down that part. And that makes perfect sense by the way: why save in an illiquid form at 2-3% real interest when you have debt to pay that charges a 4-5% rate of interest.

The rest, ISK 80bn., will be outright cancelled in four annual instalments although the borrower will feel the positive impact on his monthly payment burden immediately. Each household that has an indexed mortgage, partially or wholly, (check this link to see how indexation of Icelandic mortgages works), specifically declared to buy a property for own use (buy-to-let mortgages are excluded!) will get a maximum of ISK 4 million of the debt written off. Non-indexed loans get no write-off but the tax-free pension savings can be used to pay additionally onto the principal in the future. The tax-free pension savings can also be saved and later used to buy a flat. This is why they say that even current tenants will benefit from the measures. If the household got its debt cancelled via e.g. the 110% measure this will be accounted for and the current write-off will consequently decrease.

The following is a copy-paste from the slides about the measures. The way you should read this is the following. The x-axis is the time when an ISK 15 million mortgage was taken out. The graph (grey area) shows the nominal amount of that debt today (Remember, the principal of indexed Icelandic loans INCREASES in value parallel with the CPI. That's the reason why an ISK 15 million mortgage taken out in e.g. September 2001 would amount to about ISK 25 million today according to the graph). The blue area is the debt after the debt has been cancelled and the light brown (beige??) area is the amount of the mortgage once a 3 year private pension pay-down has been accounted for. So the decrease is read vertically and depends on when the loan was taken out. Click to enlarge.

The principal of an ISK 15 million mortgage and how it is affected by the jubilee, depending on when it is originally taken out

Now, most of the questions, and some answers, about how and why and what for and all that can be found in the FAQs from the Prime Minister's Office. So head over there to read further on how the whole thing is carried out. I would rather spend time on some other issues, such as:

Is this significant?
That depends on how you look at it I suppose. This jubilee is not gigantic in comparison to the debt that has already been cancelled since 2008. On that note, I honestly think this nice info-graphic, which is circulating on Facebook from a group that is politically, well, not keen on the current government, says it all. To give the current government some rightful credit (pun intended): their measures are more significant, by a mile, than the previous government's measures (because they had nothing to do with the pink part of the left column).

Comparison of how much household debt has been cancelled in Iceland since The Crash.
The headline ("heimsmetið") is a reference to the prime minister who said that his government's jubilee was a "world record". The left column is debt that was cancelled during the coalition rule of last government. The colours represent the following: purple (12bn) - special interest benefits, pink (155bn) - correction due to illegal FX-indexed loans (this came through the justice system and had nothing to do with the former government), orange (8bn) - special debt measures, yellow (48bn) - the 110% way (any debt above 110% of your property value was written off), grey (15bn) - increased interest benefits, blue (70bn., the IP's campaign colour) - Tax-free pension savings, green (80bn., the PP's campaign colour) - debt jubilee.

So in comparison to the previous write-off of debt in Iceland, governmentally initiated or not, the current jubilee is not so huge.

However, it is significant from the point of view of proving that this is politically possible! And that's something for other nations to learn from! Jubilees do not need to be a thing of biblical times! (But of course, that does not mean that they are always a smart move!)

But how are they paying for all this?
Right, that's a bit hazy to be honest. The short answer on the list of FAQs on the website of the prime minister's office is a classic nonsense answer that doesn't add any value:

"How is the debt relief financed? The Treasury will collect increased revenues in the next four years to cover the cost of additional state expenditure resulting from these actions. The actions will therefore neither be financed by additional Treasury borrowing nor with the granting of state guarantees."

Right, so the no-bullshit answer is that you're going to increase taxes - or "collect increased revenues..." Then just say it!

Where are they going to "collect increased revenues"? From the old banks. Through taxation. Specifically, they are going to tax the estates of the old banks, i.e. the bankrupt banks since 2008. Their liquidation process is going veeeery slowly, to a large extent because of the capital controls and the tug of war between them and the liquidation process of the old banks: the capital controls hold it back but the estates have to be liquidated in the end before we can abolish the capital controls. Well, that's a nice one: like being a driver with two back seat drivers, one demanding you drive faster and the other demanding that you slow down. Which one are you going to make unhappy?

The government is going to make the old banks unhappy. Besides outright taxation on the them to pay for a debt jubilee for households, they are considering changing laws that would force them to speed up the liquidation process.

I've got two immediate concerns about this.

First, those are two birds in the bush but not one in the hand. Are we definitely sure that they can tax the old banks? This sentence alone from the slides says it all (slide 56): "The committee [behind the debt jubilee] assumes that the measures will be fully funded over a period of four years" (i. "hópurinn gefur sér þá forsendu að aðgerðin verði fullfjármögnuð á fjórum árum.").

Great going guys, I do this all the time as well! I always just book my vacation to French Polynesia and just assume that I can finance it! ISK 80 billion!? Pennies mate, I'll pick them up off the floor one day!

And even if they can tax the old banks specifically (there are some concerns about whether it would be constitutionally possible or not), won't the old banks, which are the main owners of Arion and Islandsbanki, not just pass at least part of the cost onto their customers? Competition in the banking industry in Iceland isn't great you know.

Second: OK, if we can tax the old banks to get cash for a debt jubilee, couldn't we have used the money for something else? Like not practically shutting down the Icelandic public radio? Or pay decent wages to doctors, nurses etc.? Not putting myself up against the debt relief as a principle, just pointing out that we didn't have to spend all the cash on it.

Or maybe we can tax them even more and spend that tax income on something nice!?

But how do they actually do this?
1. The mortgages are split up into "primary" and "secondary" parts.

2. The primary part (about 87% of the mortgage to be written down) is the new debt of the borrower. This loan has the same loan stipulates as the original loan, i.e. same rate of interest, indexed to CPI, etc.

3. The secondary part is interest and indexation free. There are no payments of that debt. Both of the loans are on the balance sheet of the borrower and the financial institution that owns the original loan. The total payment burden therefore contracts immediately and not over four years.

5. Annually, the State buys back 25% of the original amount of the secondary loan from the financial institution (hence the fact that this will take four years to finish). This is roughly ISK 20 billion annually, hence the total ISK 80 billion write off. The debt is then written off. The income to fund this is meant to come from the estates of the old banks themselves.

What about the economy?
The government estimates that with all this they will manage to get household debt below 100% of GDP. Such a debt level is still quite high and may still be a barrier to economic growth and financial stability, especially since interest levels in Iceland are stupefyingly high in comparison to other economies.

Nevertheless, this should help. Analytica, a consulting company back home, reckons the effects of the jubilee will be the following for 2014 only:
- economic growth: +0.1%
- inflation: +0.1%
- current account balance: -0.2%
- consumption: +0.4%
- investment in new properties: +2.0%

My take in short
Now, there are some good things about this measure.

First of all, they did it! Jubilee is here, well done guys! You proved this is politically possible and economically this does not seem to be an absolute nonsense. So this opens up the possibility of doing this in other countries. Whether that would make economic sense has to be discussed for each economy. Some very indebted households will feel quite relieved and this will have positive impact on the economy although the impact may be short lived (see more why below). The tax-free pension part of it all also makes perfect sense and simply boils down to the fact that it is not smart to save on 2-3% rate of interest when you owe debt bearing 4-5% rate of interest.

But I do have to admit that I have concerns, besides the obvious ones like the taxation issue (which may well enough not be so important). There are a few reasons why.

First, the primary loan, or the new loan, that the borrower has to pay off will still be indexed, just like the original loan that now is being partially written off. We will therefore still have all the negative effects of indexing mortgages in Iceland, including more volatile inflation, higher inflation, higher rate of interest, lesser effectiveness of the monetary policy and the risk of having to have another debt jubilee in 10 years time or so.

Second, and closely related to my first concern: although there is no direct increment in money supply because of the measures we can, I believe safely, assume that not only will we have some potential demand-pulled inflation immediately in the wake of all the jubilee but increased credit demand as well (especially if we have an increase in moral hazard due to all this: will people take on more debt because they anticipate another debt jubilee in the future?). As the increased credit demand will be met with new loans that increase the money supply we will end up with further inflation pressures. And because the principal of indexed debts will grow with more inflation we will get some, or even all, of the "jubileed" debt back. The Central Bank will also respond with an interest hike to try to hold credit demand back. That will hit the borrowers with non-indexed loans as their interest rates are potentially readjusted upwards. (More effective and sensible way of limiting credit growth and inflation would be to impose direct credit controls and connect them to the banks' own net holdings of liquidity in foreign currencies. But I doubt the Central Bank will go down that road: you can't teach old dogs how to sit).

Why, oh, why did they not make it compulsory to change the new primary loan into a normal non-indexed loan? A golden opportunity to get rid of this pest that indexed mortgages are has been wasted!

Third, although the net assets of the old bankrupt banks will contract (assuming everything goes according to plan) we will still have "considerable" pressure on the balance of payments because of increased consumption and demand. Now, of course, part of the reason for those measures is to revive household consumption. But if we will get into even further riskier waters with the balance of payments than we are in, doesn't that just signal that the exchange rate is too strong? And imagine what will happen when and if the exchange rate goes down: inflation goes up, principal of debt grows back, we're back on square one.

So again: why, oh, why did they not abolish indexation parallel to those measures?!

Fourth, and this is perhaps my most serious concern. We haven't fixed the institutional drawbacks of the Icelandic economy. Besides still having the indexation on mortgages, we still have a high self-imposed rate of interest stemming from the pension system. (It is regulatory required to get a real rate of return of 3.5% and it controls assets equal to about 120-130% of GDP. What do you think will happen to the long term rate of interest with such gigantic buyer of financial liabilities who demands a high minimum rate of interest. Has anybody heard of monopsony?). We also still have high short-term rates, to a large extent because of the indexation.

So I fear that the net effects of this debt jubilee will not be significant in the long run. At least from an economic point of view. Politically, this may fuel some fires, even in other countries where over-indebted populations may be nudged to demand jubilee there as well. In some cases those potential jubilees might make sense. The taboo of debt relief has just been delivered a blow. Maybe we can actually discuss it in a more sensible manner from now on and not with cries coming from both sides.

That is all well and square, but when it comes to the Icelandic economy, I fear we will only have short spurts of economic bounce back. It is not enough to cut the leaves of the weed, we need to dig out the roots as well.

Wednesday, 30 October 2013

Household debt and house prices

Steve Keen has an article on household debt and house prices in multiple countries, using BIS data. Since Iceland is not on the list - and we arguably had a housing bubble - I sat down and did the same (or at least similar) analysis on Icelandic data. Sources are the Central Bank of Iceland, Registers Iceland and Statistics Iceland.

First, the real (CPI deflated) house prices.

Real house prices in Iceland, monthly data.

Now let's see what happens when we add the household debt data.

Keen uses the acceleration in household debt and the change in house prices. The idea is that acceleration of household debt, which is mainly mortgages, should be like a jolt of energy into the housing market. More mortgages (increased acceleration) means more purchasing power and more purchasing power means more demand which should push up house prices. So the acceleration in the level of household debt should be correlated with the change in house prices. If the correlation is high it is a sign that changes in house prices are primarily driven by new mortgages rather than "fundamentals" of any kind.

In the case of Iceland we've got data back to 1997, limited by quarterly national accounts. We can stretch the data back to 1994 when the index for house prices is first published but I'm using quarterly data here.

Icelandic household debt acceleration and change in house prices

The second graph here above makes perfect sense until about 1Q 2008. Then we can see a great divergence between the two series and after October 2008 there is all sorts of nonsense going on.

The likely reason for the apparent non-correlation after October 2008 is that the data is all messed up. When the new banks were established they got a free book-value haircut on the existing debt of up to 30% or even more. The great profits of the banks since the collapse is to a large extent due to the banks clawing back this haircut in their books: a credit contract worth 10,000,000 ISK (nominal value) was booked, when the banks were established, at 6,000,000 ISK and then revalued, in steps, up to e.g. 9,000,000 ISK, creating a nice 3,000,000 ISK profit in the books.

It's the October 2008 haircut which is the reason for the massive drop in debt acceleration around that time. The second drop in 2010 is probably due to the fact that FX-indexed loans were deemed illegal and the banks had to write them down to a large extent. Meanwhile, the divergence in early 2008 is at least partially explained with the fact that by that time the ISK was collapsing and FX-indexed loans, the same which were later found to be illegal, were rocketing up in nominal value.

So data problems are probably the reason why the correlation doesn't make any sense after 2008. Until 3Q 2008 the correlation is as we would have expected it from Keen's idea. And the value: 0.56. If we want to be selective and skip the last three quarters of 2008 when the ISK was collapsing at the fastest pace the correlation goes up to 0.74. That's high but still lower than some of the coefficients that Keen has in the case of other countries.

And today? Well, the banks began offering non-indexed mortgages (majority of mortgages in Iceland is indexed to the CPI) in 2009 and they really took off in 4Q 2009 according to data from the CBI. A large share of new mortgages is now non-indexed but their share is fluctuating somewhat. As far as I'm aware of no official data series exists which shows their share at all times.

We could check out the correlation between household debt acceleration and house prices from e.g. October 2008 or December 2009 but we would still have to deal with the rather bizarre drop in the data in 2010, probably caused by the FX-indexed being found illegal. If we however check the correlation only from 4Q 2010 we get this:

Household debt acceleration and change in house prices since 4Q 2010. Correlation: 0.85


Now, this is guesswork and should be taken with a pinch of salt! I do not know when exactly the banks book their losses due to the illegal FX loans, I'm guessing, from the data itself, that it's before 4Q 2010. Furthermore, this is less than three years of data so we should be careful in trusting that the correlation will stay there forever. Also, since the CPI includes house prices and the CPI affects the nominal value of indexed mortgages we should expect to see correlation through that link as well. Finally, correlation is not causation and all that - and this applies to the previous graph as well.

All the same, this feels intuitively too comfortable to outright deny it. It at least seems that the current housing market in Iceland is driven first and foremost by new credit being created by the banking system. I wonder how important fundamentals, such as wages, really are.

Oh, well! Back to work!

Tuesday, 16 July 2013

Icelandic Pension System: Only 700 billion missing

The FSA in Iceland recently posted a new set of figures regarding the pension system back home. The bottom line: only 674 billion ISK missing (i.e. the total actuarial position is negative by 674 billion). That translates into just over 39% of GDP which is an improvement from the 2009 figure when the gap was a considerably worse 50% of GDP. So even if the current situation is bad - good luck finding money nearly equal to the whole government's, local and state, income for a whole year! - it isn't as bad as four years ago.

Or is it?

The Icelandic pension system is often held up high as one of the best ones in the world (at least in Iceland). Again, looking at other pension systems, I suppose this is true but that's not because the Icelandic system is so great but rather because most other systems are so bad! At least Iceland had the wits to store some of the pension-tax that is collected from its citizens, creating somewhat of a buffer for the public finances once the baby-boomers retired and their grandchildren entered the tax... sorry... labour force. Consequently, we have assets in the system worth around 129% of GDP (which, taking the deficit into the account, means that we, and our unborn children, have promised ourselves to pay ourselves pension worth 168% of GDP... we just don't have the money to do so... yet... but that's a problem for future generations, right?)

Not doing too bad in comparison to many others. Bankrupt by 700 billion ISK all the same.

Seemingly slowly recovering

The second graph above might give the impression that the system is recovering after the 2008 crash. What it doesn't show however is that the funds cut down the benefits of their clients by 130 billion already by year end 2011. So the majority of the improvement in their actuarial position comes from these cuts. The 2012 improvement is certainly helped by a convenient increase in domestic stock prices at the end of the year.

What's wrong?

The fundamental problem of the Icelandic pension system is that it implicitly promises a rate of return that is impossible to get in the long run. This rate of return is around 3.5%. Nobody in fact knows it for sure for it hinges on the development of factors such as wages and expected longevity. And since nobody knows for sure how exactly those factors will change, the only thing we can do is to estimate the needed rate of return to fulfil the pension promises. And the best estimate: 3.5% real rate of return per annum. Consequently, this figure is in the actuarial accounting for the pension system to try and keep balance between the future cash flows that will affect the asset side of their balance sheet on one hand and the liabilities side on the other.

But think about this: in an economy with limited resources and in fact where the annual GDP growth is already below 3% on average, is it realistic to promise a 3.5% rate of return on your pension assets?

If the impossibility of this promise doesn't immediately pop up in front of your eyes, think of it this way: would you trust a person who promises to pay you a 3.5% real rate of return on the funds you are going to lend to her when you expect that this person will only earn 3.0% real rate of return on her investments?

If I would show up at the bank with such an investment plan, I should be rightfully laughed at and tossed out!

The beauty however of macroeconomics is that we can run such an unrealistic system for quite a while by racking up gross debt - owed by the households themselves, firms and the state - in the early stages of the system. The newly created debt will act as somebody's income and spur increases in asset prices, consequently improving the balance sheets of those who hold the assets in question. So while the debt increases, the system will report a rate of return higher than the growth of GDP. In the end however, the debt burden brings the system down and it collapses. This is why I've repeatedly called the Icelandic pension system a Ponzi scheme.

That is the essential problem of the Icelandic pension system: it promises more than it can deliver. On top of that comes the very important side effects of pushing the rate of interest in the Icelandic economy upwards. This happens due to the funds' gigantic size in the economy while they demand such a high rate of return on whatever they buy: to fund an investment project, it is not unlikely that at least some of the money will come, one way or the other, from the Icelandic funds which demand a 3.5% rate of return. Consequently, the rate of interest is pushed upwards, killing the economic recovery.

I only realised this in 2010 and went public (e.g. here, here, and here) with this rather blatant truth once one just stops and thinks about it. Already in 2010 I repeatedly warned that the system needed reform to lower the dreaded 3.5% minimum rate of return. I also warned that if the pension system would not be reformed, the rate of interest would stay too high and kill off any gross investment in the economy. It wasn't done and, as expected, the level of gross investment in the economy hit a historical low! The high rate of interest, pushed upwards by the pension system, was one of the culprits.

We would have had a proper recovery if the pension system had been reformed

The Icelandic Pension Fund Association publicly replied and said I was wrong. One of the foremost specialists on the system, Bjarni Thordarson (who has now passed away), claimed my stating of the case a "nonsense" (i. dómadagsrugl). The president of the Icelandic Confederation of Labour, Gylfi Arnbjornsson, thought that my "misunderstanding" about how the system worked was becoming "awkward".

Now, finally, we have news that they are going to do something about it: the system is being reformed although it seems as if they are mainly going to reform it such that the government-backed up part and the private part will be coordinated with each other. They are going to jack up the pension age from today's 67 years though. Overall, reports are still hazy and the final plan has not been formalised.

Let's wait and see and hope that they will actually improve the system but not just reform it.

Thursday, 27 June 2013

UK & Iceland GDP comparison

After the recent GDP figures from ONS, the general reaction was rather pessimistic. FT had e.g. this tweet and article:


True, this doesn't look good. In fact, after the revisions, UK GDP volume is now further below its top before the financial crisis than Iceland's GDP is. The following graph is based on data from ONS and Statistics Iceland. The top is given the value 100 (3Q07 for Iceland but 1Q08 for the UK). Chained volume measurement, seasonally adjusted (yes, the Icelandic data are SA although they don't look like it).

Back on track: Iceland is edging closer to its GDP volume top before the crisis. The momentum is also stronger.

Iceland's GDP is now 0.4% closer to its top before the crisis than UK's GDP compared to its top. Then again, Iceland had its top two quarters ahead of the UK.

But - there is always a "but" - this is a volume measurement. And although economics teach us to think in volumes and real measurements, we arguably do not rely on barter (and never did) in our commerce. We use money and money is different between economies: try paying with Queen's money in Iceland and you'll be a laughing stock (I've tried, the guy just grinned at me) just as you will be if you try using the ISK in the UK.

So what happens if we price the volume produced in the same currency, say the GBP. That comparison makes sense: we could be producing the same volume as before the crisis but is it worth the same?

The UK volume is already priced in pounds so no need to handle that in a special way. But the Icelandic volume measure uses the ISK as a measurement stick and that measurement stick has changed significantly since before the crisis. If we measure both of the volumes in GBP, the following graph is the result.

Still long way to go: measured in GBP, the Icelandic GDP volume does not seem to be edging must closer to its previous height

Notice the drop in the Iceland data in 2006. This is the "Geyser crisis", a short wake up call to the fact that we were in a bubble. But it did not last long; politicians and prominent businessmen claimed everything was peachy, the housing bubble restarted (held up with exchange-rate linked loans which have now been deemed illegal) and the banks kept on growing. Then, finally, the party ended.

To my British friends I say: sure, you're not in the best of situations. But if it makes you feel better, you're not in the worst.

Monday, 24 June 2013

How much household debt was cancelled? Update

In April last year I wrote about how much of Icelandic households' debt was cancelled. Now, we've got new info on the topic.

And the amount: 247.5 billion ISK. This figure comes from the Icelandic Financial Services Association in their comment on the new government's 10-step plan of general debt relief to Icelandic households (they don't really comment on it, they are going to wait until the government actually describes how they're going to do this).

What are the sources and the reason for the debt relief so far? The IFSA comment has a handy table to show us (my translation). The left-most column is mine as I thought it would be informative to note where the initiative for each part came from. In the cases of where I've put "Legal System" it is due to rulings regarding the illegality of certain credit contracts, first and foremost ISK denominated debt that is indexed to the exchange rate. That sort of indexation is illegal in Iceland since 2001 (though it did not stop the contracts to be created during the height of the credit party). Finally, do note that the figures due to ruling 600/2012 (a supreme court ruling regarding the illegality of certain exchange-rate indexed loans) are estimates and not entirely realised as of yet.

The total debt relief to Icelandic households, 2009-3Q2012.



Despite this nearly 250 billion ISK relief, Icelandic households are still pretty indebted. In the newest Financial Stability report, the Central Bank of Iceland estimated that the outstanding household debt amounted to around 110% of GDP. That is roughly the same ballpark as Ireland is playing in - although the Irish are not paying a 4-5% real rate of interest on their debt as Icelanders do.

From the newest Financial Stability Report (Central Bank of Iceland)

Nevertheless, the debt jubilee has of course had some effects; one should expect that when debt amounting to 15% of GDP is cancelled. But the situation is still fragile and we should not expect it to improve as easily as it did in the early 2000s when an investment boom was creating a lot of jobs and wage income.

Icelandic households' ability to live on after-tax monthly income (source: Statistics Iceland)

Tuesday, 11 June 2013

Minister of Finance Comments on the Housing Financing Fund

The new minister of finance, MP Bjarni Benediktsson, spoke with Bloomberg the other day. The topic was the Housing Financing Fund and its "red numbers" as Benediktsson put it.

The most notable part of the interview was when Benediktsson wished that creditors of the fund - the owners of HFF bonds - would be "flexible" if and when HFF would request discussions on changing the stipulations on the bonds. The problem with the bonds is that they aren't callable while the HFF mortgages are (in most cases) and have for the last 3 years or so been refinanced with non-indexed mortgages from the banks. The result: HFF sits behind with high-interest debts which aren't callable and truck loads of cash.

Benediktsson guessed in November 2012 that HFF would need perhaps as much as 200 billion ISK from the state but the Fund operates with an avowed state guarantee. The problem is that there is not a single word about state guarantee for HFF in laws about state guarantees. So while it is the "legal understanding" of Benediktsson (who is an educated lawyer I may add) that there is a state guarantee on the HFF bonds, one can easily argue that there is no such formal backup in Icelandic laws.

This is not the first time a politician comments on the HFF situation. In November 2012, trades with HFF bonds were halted twice. The first trigger was a stampede of sellers in the wake of an article in Viðskiptablaðið ("The Business Newspaper") where it was said that the un-callable bonds would have to be made callable to save the Fund. Not a week later, MP Sigridur Ingadottir, commented on the situation, again with Bloomberg, and said it would be necessary to enter renegotiations regarding the stipulations of HFF bonds. Another stampede followed.

In an interview with RUV (The Icelandic "BBC") in November, I pointed that while the state was regularly pumping equity into the Fund - it has gotten 46 billion ISK from the state in new equity since 2010 - the Fund would be able to pay its debts and bondholders could sleep peacefully. But this constant need to pump equity into the Fund would harm the chances of reaching a balanced fiscal budget. And the problem is that a balanced budget is something that is practically a prerequisite for abolishing the capital controls. Both the Central Bank and new minister of finance, MP Bjarni Benediktsson, know this. Abolishing the capital controls is something that is prominent on the "to do" list of the new government. Benediktsson called the capital controls "a flashing warning sign" for foreign investors, telling them to stay away from the Icelandic economy.

So there is an interesting situation brewing. The new minister of finance knows that one of the barriers that he has to cross in order to facilitate the abolishment of capital controls is to get a balanced budget. What is stopping him from doing that is a potential 200 billion ISK bill that arises due to the avowed state guarantee on the Housing Financing Fund. On top of this come a few election-promises such as lowering taxes and financing a debt jubilee to Icelandic households. Endeavouring to mitigate that problem, he wishes that creditors of HFF will be "flexible" when and if the HFF will request negotiations on the stipulations on HFF bonds.

And who are the creditors of HFF? Mainly Icelandic pension funds (64%). Foreigners hold only 4% of outstanding HFF bonds. Something tells me that Icelandic pension funds will never give back an inch when, not if, negotiations on the HFF bonds' stipulations will happen. Something else will have to give in.

Friday, 26 April 2013

A plea to the future government of Iceland

Statistics Iceland released new figures on the labour market recently. According to them, the unemployment rate in Iceland continues to go down. It has reached 5.7% after having reached almost 8% in early 2011.

The unemployment in Iceland is slowly improving. I guess some nations would not complain too much about the rate of unemployment around 6%. 

But here is the catch: even though the rate of unemployment is coming down, the labour market is not improving much.

Next graph shows my point. We can see that during the boom years, the total working hours (estimated by multiplying number of people at work multiplied with the average working hours) increased sharply. This is to be expected as the real capital investments at the time (housing and dam construction to name just two) demanded a lot of labour. This demand for labour was answered by importing workers from e.g. Eastern Europe and China. 

Then came the crash and the total working hours collapsed along with the real capital investments. But so did the average working hours per individual in the workforce!

Despite the improvement in the rate of unemployment, the labour market does not show any other prominent signs of returning to normal levels. 

One reason why is the fact that not all of the foreign workers went back home. They stuck around, got an Icelandic passport, have assimilated into the Icelandic culture and have become Icelanders. Good for them!

The other more prominent reason is the fact that investment is all but gone! Investment as a proportion of the gross domestic product has never been at lower levels than now. I estimate that in order to get up to the more normal 20% ratio of investment to GDP, we need to expand real capital investments in Iceland by almost half: we currently invest around 245 billion ISK annually but we need 120 billion ISK more.

The level of investment in Iceland is puny compared to the level it should be at. We need roughly 120 billion ISK more to get up to the 20% ratio where we can expect the economy to be neither in an investment bubble a la 2005-2007 nor in a serious slump. 

The normal response of politicians in Iceland to too low level of investment has been to promise a new heavy industry project. An aluminium smelter is the classic!

But the track record of heavy industry investment in Iceland hasn't been that great. The energy is sold at too low prices (that was politics) and the negative environmental effects are affecting the more Thirlwall's Law friendly tourism sector. Basically, in the long run, the positive economic (and environmental) effects are more prominent in other major industries in Iceland. The classic "lets build a new smelter!" is a cheap get-out-of-jail card and shouldn't be used, again, if the long term prospects of the economy are to be held in high regards.

Rather, what is needed, is investment carried out by small companies, especially if they are domestically owned and operating in the export industry (as it would generate a much needed foreign currency income into the economy).

Tourism is an obvious choice, especially as it would generate a lot of long-term jobs (which the construction of yet another smelter does not). The long-term growth prospects of tourism are also excellent as the number of middle-income people, which can afford and want to travel, grows tremendously as the Chinese, Indian and other Asian economies grow (Thirlwall's Law kicks in).

Investing in more energy independence would also boost the long term prospects of Iceland tremendously! We have plenty of energy that can be used to fuel the car fleet of Iceland instead of running aluminium smelters. The net savings of foreign currency (less imports of oil-based fuels) and the consequential easing on the balance of payments constraint would be most welcome.

Other industries are waiting to expand and their expansion would be very beneficial for both the level of employment and the balance of payments: beer and alcohol brewing; computer games and other IT industries; and product development in food stuffs, especially fish and sea food, just to name a few.

But small industries need low level of uncertainty and access to cheap but steady supply of financial capital. And given the high level of uncertainty that is caused by the amount of capital that wants to get out of the economy ASAP, thereby killing the exchange rate and all cost-plans associated with real capital investments but only held back by the capital controls, we cannot be surprised that the level of investment is so low. What has killed investment in Iceland is uncertainty and that uncertainty is caused by the fact that still today, five years after the collapse in 2008, we do not know what will happen to the leftovers of the Icelandic pre-2008 boom. Those leftovers - financial capital - are waiting to get out but held back only by the capital controls.

There are general elections in Iceland tomorrow, Saturday. The most prominent problem of the post-elections government will be to fix the underlying problem of financial capital that awaits its chance to get out of the economy. While that problem is left on the table, employment, investment and the standard of living will not improve.

And beware, there are no easy ways out. Cheating on the problem by either pretending that it does not exist or by assuming that building another smelter - as some politicians unfortunately want to - will fix it will in fact not as what is needed is a long-term sustainable solution where other economically and environmentally friendly industries can maintain the level of investment; building a smelter without fixing the overhang of capital waiting to get out would be like putting a band-aid on a gunshot wound.

So I only have one plea to make to the future government of Iceland: fix the overhang of capital waiting to get out of the economy, get the level of uncertainty down and support small industries in their investment projects. Do this and you will probably be re-elected.

Saturday, 20 April 2013

Islandsbanki's incredible profits

Mbl.is has a story that appears today, 20 April, saying that Islandsbanki, the bank which was founded on the ashes of the old and bankrupt Glitnir bank, has written of 475 billion ISK of customers' loans since it was founded, i.e. in October 2008.

Now, no matter how you look at this, 475 billion ISK is a lot! The GDP of Iceland is around 1,700 billion ISK. So this bank alone has written of debt amounting to 28% of GDP. If we look at the balance sheet of Islandsbanki we learn that its total assets were, at year end 2012, worth 823 billion ISK. That compares to 658 billion ISK in total assets at year end 2008. If we simply assume that the bank has written off just over 100 billion ISK per full year it has been running since 2008, we come to the conclusion that it has written off customers' debt (which are, of course, the bank's assets) worth roughly 1/8 - 1/6 of its balance sheet every year.

What further adds awe to those debt write-off figures is the fact that while the bank has written off 475 billion ISK its net profit after taxes amounts to 93 billion ISK since 4Q2008 until year end 2012.

This is truly amazing! A bank which, every year, writes off debt equal to maybe 12-17% of its total assets but profits at the same time. The figures for the other two major banks - Arion bank and Landsbanki - are similar.

The reason for those amazing figures is the endowment which the banks got at their births. When the Icelandic banks were re-established on the ashes of the old ones in October 2008, their domestic debts (customers' deposits were probably the most important ones) were transferred, intact, from the balance sheet of the bankrupt banks onto the balance sheet of the new ones. In the case of Islandsbanki, it took over the domestic liabilities of Glitnir.

To meet those liabilities, the new banks got domestic assets - consumers' loans, mortgages, corporate loans, etc. - transferred as well. However, knowing that there would be a massive hit on the ability of the debtors to repay those loans, they were transferred with a discount off their face value: a corporate loan of 10,000,000 ISK (face value, i.e. what was written on the debt contract behind the loan) became 6,000,000 ISK on the balance sheet of the bank.

I do not think that anybody truly knows what the discount truly was, the 40% discount here is only an example. But whatever the discount was, it is blatantly obvious on the aggregated balance sheet of the financial system. The figures here below are based on data coming from the Central Bank of Iceland.

Total book-value of loans to domestic parties, all deposit-institutions (mainly banks), ISK, millions.

Notice the drop. It is in October 2008. Somehow, magically, the debt of Icelandic households and companies decreased from 4,891 billion ISK in September 2008 down to 2,177 billion ISK in October 2008. The reason, of course, is that those figures show the book-value of loans and not the nominal value, i.e. the face value of the debt. This easily shows that when the new banks were established in October 2008, they received a huge book-value discount compared to the face value of loans.

This discount has not only been used to write off debt but to show an accounting profit as well. In the case of Islandsbanki, that debt write off is 475 billion ISK since its foundation. This is as expected, nobody ever expected that firms and households would be able to repay the whole face value of their debts. But in the case of its profits, the bank has been able to revalue the book-value of its loans back up towards the face value, showing an increase in assets which is booked as positive revaluation of its asset portfolio, consequently showing a profit. This is why the bank has been able to write off 475 billion ISK since October 2008 while showing a 93 billion ISK profit at the same time.

One would think that writing off debt would ease the debt burden for the debtor. That is of course true. The bad news however is that only a handful of debtors have received too-large majority of the debt write offs, thereby skewing the positive economic effects of debt write offs. The BBC equivalent in Iceland, Ríkisútvarpið, explained already more than a year ago that although, back then, 750 billion ISK had been written off of loans, only five companies got 208 billion ISK written off while all the households got, total, 196 billion ISK written off. Not to mention that the owners of those five companies were familiar faces which many had political and bank-related connections. It's good to have friends!

In the case of Islandsbanki, the bank has now written off 103 billion ISK of households' debt while corporations have gotten away from 372 billion ISK. Much of those write offs have been due to the fact that exchange-rate-indexed loans, which were made looking like they were loans in foreign currencies, were deemed illegal by the supreme court. Consequently, those loans, which amounted to billions, had to be written off or corrected. Of those 372 billion ISK, only 32 billion are due to illegal loans. Most of the rest (319 billion ISK) have been reached through "agreements with Islandsbanki". Of course, we can expect some of those contracts to include e.g. debt-for-equity swaps.

Understandably, the inequality in how write offs took place - only a few (in)famous individuals got most of them - made a spark which is now turning into a flame engulfing the whole blogosphere and the news. The result is that one of the hottest promises before the general elections, which will take place on 27 April, is debt write offs to the households. Majority of parties have promised debt write offs to households and those which do not have been rejected by voters, polls show.

We'll see how that ends. When I was young I learned that the word "politican" is a nine letter word describing an individual who says one thing but does the other.

Monday, 28 January 2013

The Icesave acquittal - Press Release from the Ministry for Foreign Affairs

In light of the acquittal in the Icesave case, I see a reason to post the press release from the Ministry for Foreign Affairs in its totality.

The interesting question which now remains is: are deposits in Europe safe? If e.g. Santander goes bankrupt, will the savers in the UK, which have deposited their savings at the Santander branches in the UK, be repaid? (Amongst other things, it depends on whether the Santander operations in the UK are under the umbrella of a branch or a subsidiary of Santander Spain. It also depends on whether the bank is a member of the UK deposit insurance scheme or not). Likewise, will a German customer of Bankia be repaid if the bank goes bankrupt? Who is meant to save Bankia in case of the need of a bailout: the German government? The Spanish one? Both?

Please, do note that I am not with those words questioning the security of UK deposits in Santender UK or German deposits in Bankia. I am merely trying to explain that the deposit insurance schemes in Europe are far from being fully funded and, in light of the acquittal, NOT automatically backed up by the States' finances.

Surely, the plans on creating a pan-European banking regulator will take this acquittal into the account when its formation will be decided.

Here is the press release (italics are mine):

Iceland welcomes acquittal in Icesave case


The EFTA Court ruling on Icesave rejected all claims by the EFTA Surveillance Authority that Iceland should be declared in breach of the EEA Agreement. The Court rejected the claim that Iceland has breached the Deposit Guarantee Directive or has discriminated against depositors contrary to EEA law. It is a considerable satisfaction that Iceland´s defence has won the day in the Icesave case; the EFTA Court ruling brings to a close an important stage in a long saga.

Iceland has from the start maintained that there is legal uncertainty as to whether a state is responsible for ensuring payments of minimum guarantees to depositors using its own funds and has stressed the importance of having this issue clarified in court. There was, however, no realistic possibility of such clarification until the EFTA Surveillance Authority decided to refer the case to the EFTA Court.

This judgement concludes the procedures with the EFTA Surveillance Authority in regard to the Icesave case. The ruling of the EFTA Court is final and cannot be appealed. This case has been particularly difficult to handle both nationally and internationally, and has occasioned, among other things, considerable delays in the implementation of the Government´s economic programme. Icesave is now no longer a stumbling block to Iceland economic recovery.

It is important to bear in mind that payments from the estate of the failed Landsbanki will continue regardless of the ruling of the EFTA Court. The assets of the estate are now estimated to be 1,517 billion ISK which is approximately 200 billion ISK more than the priority claims which amount to 1,318 billion ISK. Of these priority claims 1,166 billion ISK result from the Icesave deposits while just under 150 billion ISK result from wholesale deposits, including those from municipalities, charities etc. The sum of 660 billion ISK has already been paid out of the estate against priority claims, i.e. around 50% of their total value. Of this 585 billion ISK have gone to claims resulting from the Icesave accounts. This sum amounts to over 90% of the total which the UK and Dutch authorities advanced to cover the minimum deposit guarantee.

It is expected that the Icesave claims will be paid out in full by the actual debtor, the estate of the failed Landsbanki. This outcome results from the implementation of emergency legislation in 2008, according to which deposits were given priority against unsecured claims.

Thursday, 24 January 2013

The Economic Truth on Iceland


The following article is the original text of the articles published on Sintetia in Spain. The Spanish versions can be found here (part 1) and here (part 2), kindly translated by the Sintetia staff. 

The Economic Truth on Iceland
There are truths and untruths in the media, the blogosphere and in the minds of people when it comes to what really happened in Iceland and its, acclaimed, economic recovery. To some extent, it has gotten the stamp of some sort of an economic “Wunderkind” by defying all probabilities and becoming a poster child about how to respond to major economic crises. But to spill the beans already: the picture is not as rosy as it has been painted.

Let’s start with some of the claims. According to a less than a five minute search on the internet, Iceland:
  • -          Screwed the creditors of the banks and let the banks fail, then nationalised them
  • -          Jailed the bankers of the failed banks
  • -          Kicked out the Austerity supporters, the Troika and the IMF in particular
  • -          Gave huge debt reliefs to the public
  • -          Set up capital controls which will be abolished very soon, even as soon as this year
  • -          Is now, consequently, growing and, especially in comparison to debt-laden Europe, doing quite fantastically!
  • -          Furthermore, not only is it growing but the prospects of the future are wonderful

So the lesson, following Iceland’s example, is to let the banks fail, nationalise them, increase government spending, shut the capital inside the economy and give debt reliefs to the people instead of the creditors of the banks.

Too bad this is not entirely according to the truth. Read on and I’ll show you how deep the rabbit hole really goes.

What goes up must come down
There is no need to describe in detail how on Earth this tiny, but very proud, nation managed to allow itself to be turned into nothing else than a hedge fund. In short, the utter majority of the nation was stricken hard by the “This Time Is Different” complex. The people, especially its bankers, considered themselves to be financial geniuses, not the least due to their Viking heritage, and went bonkers borrowing money and buying stuff. “Stuff” included not only general consumption goods and expensive cars but houses and stocks as well. News of stocks and houses were common and the general populace seemed to know awfully lot about which company in the stock exchange had gained most the day before. The equity index in the Icelandic Stock Exchange increased sixfold in four years: more than 50% per year on average!

But as the good advice goes: “when your neighbour buys stocks, it’s time to sell”. Too bad nobody, except a handful of sober persons, realised the truth in this.

The banks and the government
The Icelandic economic collapse in October 2008 was inevitable. No country has ever managed to build up its banking sector up to 10 times the worth of the gross domestic product and lived to tell the tail unharmed. When Kaupthing, the biggest Icelandic bank, went bankrupt it was the fourth biggest corporate bankruptcy in the world’s history! Glitnir’s bankruptcy was number 6 on the list, dwarfing Enron’s which occupied the no. 9 place.  Landsbanki’s failure was just cut short of the top 10, ending in no. 11. 

In a time span of less than a week, more than 90% of Iceland’s banking system, on the scale of assets, went down the drain.

Most of the rest followed in the coming months but was, contrary to the folklore outside Iceland, bailed out by the Government. SpKef and Byr, two savings banks, are cases in point. There, the Icelandic bankers’ gluttony was not lesser than in the case of the big banks. Nevertheless, the government gave them some cash, casting a terrible shadow on Iceland’s image as a country which does not bail out banks. Good thing nobody noticed. SpKef was later assimilated into New Landsbanki (a state owned bank) but Byr ended up in Islandsbanki (New Glitnir).

It is very important to realise one thing: the governments, both the “conservative” one prior, during and after the October crash, and the “left wing” one, which took over after the 2009 general elections, did everything they could – absolutely everything – to try and keep the banks afloat. And of course, the banks themselves tried what they could to save their faces by buying up their own stocks and thereby maintain their price (which, in their case, was quite close to being a market abuse). The savings banks that went off the cliff after the Big Three had closed down their shops were small enough to be rescued by the government but the Big Three in October 2008 were simply too large to be saved. That did not stop the government from trying everything it could do to throw out the safety net, including practically emptying the foreign reserves of the Central Bank when it tried to keep Glitnir afloat.

It was Iceland’s “fool’s luck” not to be able to rescue the banks in October 2008. I don’t want to even consider the cost of rescuing the banks today, it would have been horrible! The 31%-of-GDP public deficit in Ireland in 2011 would have been a laughing stock compared to the gargantuan cost the Icelandic public coffers would have suffered if the banks had been saved.

The jails in Iceland are not full of “banksters”
So the first lore on Iceland – that it intentionally let the banks to bankrupt – is not according to reality. The reality is that the government tried to save them but could not. The one about all the jailed banksters is, well, not entirely true either.

Let’s take two examples:

The Al Thani Plot
Kaupthing famously got the brother of the emir of Qatar, Sheik Al Thani, to buy stock in the bank. Later, The Special Prosecutor (specially founded to deal with white collar crimes) charged the CEO of Kaupthing, Hreidar Mar Sigurdsson, and the chairman of the board of directors of Kaupthing, Sigurdur Einarsson for fraud (Einarsson is the son of late Einar Agustsson, ex Minister of Foreign Affairs and MP of The Progressive Party, the political party which had hands in the sales of Bunadarbanki which was later to become Kaupthing-Bunadarbanki and, in the end, Kaupthing... just an example of how close business and politics were and are in Iceland).

Why the charges of fraud? Well, apparently, the Sheik didn’t pay a dime for the 5% share in Kaupthing Bank, he simply lent his name to the fraudulent act and got 50 million USD for it! The Al Thani case is still in the courthouse but the charge against Olafur Olafsson, the CEO/chairman of the board of directors of Samskip and the third biggest owner in Kaupthing and a member of the team which bought Bunadarbankinn in the beginning, has been dismissed. The charge against Magnus Gudmundsson, the ex CEO of Kaupthing Luxembourg, was also dismissed. But the charges against Sigurdsson and Einarsson stand.

The Exeter Holdings Plot
Exeter Holdings was an asset holding company (we had many!) which was lent 1.1 billion ISK from Byr (the savings bank which got some cash from the government before finally being assimilated into Islandsbanki) which then was used to buy Byr stock of MP Bank and the men in charge of Byr. Then, Byr practically went bankrupt and went, hat in hand, to the government and got some cash from it, as already mentioned.

So Byr was used, just before it went bankrupt, to lend money to Exeter Holdings which then bailed MP Bank and the senior employers in charge of Byr out of their positions in the Byr stock. Very convenient to know that if your stock is just about to become worthless you can just lend some asset holding company ridiculous amount of money and bail yourself out.

The charged (Ragnar Z. Gudjonsson, CEO, Jon Thorsteinn Jonsson, chairman of the board of directors, and Styrmir Bragason, CEO of MP Bank) were originally all acquitted. But then somebody pointed out that one of the judges who acquitted them was connected to Byr: he was the Head of Legal Department in a company whose biggest owner was, you guessed it, Byr savings bank. The case was repeated, now with unconnected judges, and Gudjonsson and Jonsson got four and a half year (Maddoff got 150 years and a fine of 17 billion USD). Bragason is, as far as I’m aware off, still waiting his destiny.

The Exeter case is the most successful case which The Special Prosecutor has carried out. The Al Thani plot is, however, one where the scheme is so complicated that a single misstep by the Prosecutor can ruin the whole case. Another complicated case was the recent “Vafnings case” which was only partially successful for the Prosecutor. For although the charged, Larus Welding, CEO of Glitnir, and Gudmundur Hjaltason, head of Corporate Finance at Glitnir, were found guilty, the case was flawed: the prosecutor’s arguments were not fully according to the subpoena. So they only got 9 months imprisonment, thereof 6 months suspended.

The fundamental factor is that neither the Icelandic justice system nor the laws themselves are ready or meant for white collar crimes of the magnitude that took place before, during and after the collapse. And we certainly do not have an army of lawyers specialised in fighting white collar crimes, contrary to many other countries where experience and knowledge are abound. Combine all this together and the most likely, sometimes unfortunately and sometimes correctly, outcome of the “banksters’ cases” in Iceland is that they walk either entirely free or with only a firm slap on the buttocks. This is so not because they are all innocent but because the justice system is unprepared. This is, somewhat, a learning-by-doing process.

Iceland, the IMF and the austerity
There are some truths in the story that Iceland objected to the IMF’s original plans of “medium-term fiscal consolidation” as it was worded in the IMF reports on Iceland. However, the objections were rather half-hearted, especially before the “left-wing” coalition government got into power in early 2009. Lilja Mosesdottir, an economist with a PhD in economics from University of Manchester (her thesis: “The political economy of gender relations”) was one of the MPs that were loudest about the possibility that IMF might be applying the knife on the public finances in too large measures. Those objections were perhaps more prominent for the fact that Mosesdottir was, back then, an MP for the Left-Green Party (one of two parties in the coalition government) but left it to protest what she called the servility of the government towards IMF. So not everybody in Iceland was exuberant with IMF’s presence although the “left-wing” government seemed not to care too much.

IMF was however quite happy with how Iceland came out of the crisis, whether that was explicitly thanks to their policies or not. They were in fact so proud of the economic Wunderkind that Iceland proved itself to be – according to them at least, I’m not sure the Johns and Joneses of Iceland would agree – that they threw a conference to highlight the successes of the country. Cannons within the economics world gave speeches and the biggest cannon of them all was probably Paul Krugman.

Contrary to what one might think the conference was not an absolute muddle of self-appraisal and some of the talks were very informative and exemplary (Simon Johnson’s talk was absolutely spectacular!) And IMF did show that it had learned something! For example, it openly and very willingly admitted that capital controls are “in some circumstances” an appropriate reaction to a crisis. That, on its own, was a huge step forward compared to its thinking in the South-East Asian crisis in the late 90’s. You can check out a recording of the conference on the IMF website.

Ah, yes... the debt relief...
Right, let’s get one thing straight from the beginning: the Icelandic households did not receive a massive government-initiated debt jubilee!

What the households got from the government was “The 110% Measure” (if your mortgage was higher than 110% of the property’s market value, you would get the principal marked down to the 110% mark) and “The Abstract Debt Relief” which you were only applicable to enter if you were in “serious” debt difficulties.
The total household debt cancelled due to those government-initiated measures: 49.8 billion ISK. To make any sense out of that figure: the debt of Icelandic households just before the economic collapse in October 2008 amounted to more than 1,450 billion ISK. So the government managed to give the Icelandic households a debt jubilee on 3-4% of their debts. Hooray!

Then came the justice system’s surprise input.

It all started with some individuals trying to figure out what the heck had gone wrong. Somebody stumbled over the fact that foreign-currency linked loans seemed to have been illegal from 2001. That possible illegality had not stopped the banks from creating billions and billions worth of mortgages and car loans to individuals as well as general credit contracts to firms in Icelandic krona but linked to the exchange rate of a foreign currency. This was doubtful at best. In the end, the foreign-currency linked loans were deemed illegal after a fight which still isn’t over (they are still arguing which types of foreign-currency linked loans are illegal).

But here is a wonderful twist for those who think that the government was all into giving the households some debt relief.

After the foreign-currency linked loans had been deemed illegal by the Supreme Court the government stepped in and put into effect a retroactive law that had the effects that the banks got a lot more out of the loans than they should have had. Likewise, the households’ debt was higher than if the laws had not been passed.

Again the door of the court room was swung open and now the laws that the government itself had put into effect were in the bull’s eye. They were finally deemed illegal, exactly because of their retroactivity, and the households’ loans were corrected. And what they got: a correction amounting to 146.8 billion ISK – almost triple what the government gave them and that despite the fact that the “left-wing” government had tried to intervene with a retroactive law.

So in total, the Icelandic households have been given a debt jubilee of 196.3 billion ISK. That’s around 13% of the pre-crisis stock of debt they had, mostly coming from the fight against the illegal foreign-currency loans.

However, despite this cancellation of 13% of the total debt, the stock of households’ debt has grown again. And why is that? It’s not predominately because households have gone back on the spending spree they admittedly were on before the crash. It is because of the indexation of the principal of mortgages in Iceland: if inflation in Iceland is 5% the amount you owe the bank increases by 5% before you pay it back! On top of the rate-of-inflation-adjustment of the principal is a 4-5% rate of interest. 

And since the inflation in Iceland since October 2008 is 25%, one can understand why the debt of households in Iceland is not falling in accordance to what one might think with the 13% jubilee and general debt deflation in mind. In comparison to gross domestic product, households’ debt is now around 117% of GDP (year end 2011) compared to 127% of GDP before the crash.

So I’m sorry, but the (in)famous debt jubilee given to Icelandic households was a mere cough.

‘If I go there will be trouble, and if I stay it will be double!’
We’ve shortly commented on the existence of the capital controls and how IMF had realised that they were a powder keg that could be nice to have in the anti-crisis arsenal. Too bad for the South-East Asian countries they did not realise that earlier.

Generally, capital controls are considered to be a nuisance in economics, although in practice they have shown themselves to be quite an attractive choice when it comes to not only responding to an ongoing crisis but to stop the crisis from happening in the first place. Nevertheless, the issue is slippery and capital controls open up the possibility of malinvestment, favouritism (some get exceptions from the capital controls) and a black market with currency. None are favourable so it’s most often best to get rid of capital controls. At least, their application has to be scrupulously planned!

All this is too bad because the capital controls were erected in a panic in 2008 and now the IMF has, finally, realised that the “short term” nature of them might not be so short term (“while the external position [of the economy] is sound, it is vulnerable to the lifting of capital controls before conditions are right”].
In other words, if we lift the capital controls and allow the exchange rate to drop by maybe 25-50% (as it easily might do, the offshore exchange rate of the krona is about 40% weaker than the capital-controls-defended exchange rate within the Icelandic economy) the economy will go to hell! So much for the economic Wunderkind then!

Sorry, but if some seriously heterodox ointments are not applied to the exchange-rate problem, the capital controls are here to stay! And that’s problematic given their general negative impact on the economy, hence above.

The thing is that the heterodox ointments needed have been proposed already. They are just so heterodox that the government, the IMF and the country’s “Lords of Finance” don’t even want to consider it. This is so despite the fact that the ointments have been applied before in the economic history of other countries with such immediate and lasting improvements that they surprised everybody – except the people who applied them. The German Wirtschaftswunder is an excellent example of the heterodox ointments we are talking about.

But why the recovery?
The question why the economy rebounded has not been answered however. But Richard C. Koo gave the answer to that question two years ago with his “The world in a balance sheet recession” paper. And the answer was this: the Icelandic economy is in a “Lehman Brothers Shock” except of course in the case of Iceland we can say it was in an “Utter Banking Failures Shock”.

The argument is as follows. First, an economy experiences a (mad) debt bubble. When the Ponzi finances inherited in the debt bubble finally prick it, asset prices fall and the economy slows down, the threat is that a major financial institution goes under. That was Lehman Brothers in the United States but in the case of Iceland, it was the whole financial system.

That bankruptcy, obviously, brings a massive blow to the economy and it drops like a stone thrown off the edge of the leaning tower in Pisa. But when the economic panic recedes and commerce returns – people have to eat – the economy slowly bounces back from its lowest panic-ridden point. An exchange crash which brings an increase in tourism helps as well.

That natural bounce-back is the economic recovery of Iceland! There is nothing surprising to the economic growth in Iceland, it is an entirely normal response to an “Utter Banking Failures Shock”: the mere recovery from the absolute panic brings back the growth in output and with it, the economic growth. The problem is that the debts are still there and the underlying foundations can crack anytime.
Koo’s paper is extraordinarily clear on this point: the recovery from the “Utter Banking Failures Shock” is NOT a recovery from underlying debt problems which, in fact, caused the “Utter Banking Failures Shock” in the first place. And given how weak the economic foundations of Iceland really are, Koo’s answer is awfully correct.

Furthermore, is an economic growth of 2-3% something to be thrilled over? In the historical context: not really. But in comparison to southern Europe: most definitely! That’s maybe why the meagre growth Iceland has gained back is causing such a stir.

‘The long run is a misleading guide to current affairs. In the long run, we are all dead.’
So there you have it. The cosy picture drawn of the economic miracle of Iceland has serious stains on it. Despite the fact that the economy has, partially, rebounded to its pre-crisis level, the underlying foundations are so termite-infested that the slightest wind could blow the whole economy to kingdom come! That applies especially to the problem of abolishing the capital controls.

And although Iceland has clean energy, a happy populace, is growing again (at least for the moment) and many possibilities of being a paradise on Earth for the longer run, it is not that which matters. We must remember what Keynes taught us: “The long run is a misleading guide to current affairs.” And why is that? Because “in the long run, we are all dead.” To say that everything will be fine in the far future is useless if we die before the far future finally arrives.

But did we do something right? Yes, we did!

  • -          We did step up against the IMF and although it was half-hearted at best, it probably preserved most of what could be preserved of the welfare system and the general economic stabilisers of public expenditures.
  • -          We did introduce the debt jubilee and out of principle we must congratulate us for that for even though it was a downright band-aid on an open gunshot wound, it was at least done. So debt jubilees are possible (and quite frankly, some countries need a partial one, whether we want to admit that or not).
  • -          Last but not least: we saved the electronic payment system! To maintain the smooth operation of an electronic payment system in a country whose financial system is falling into atom particles is a terrific feat on its own!

Truth be told, the major lesson Iceland has for other countries is how to keep the electronic payment system alive during a massive financial storm. That lesson has gone completely under the radar and I don’t think a single foreign entity or a central bank has picked it up as of yet! It nevertheless, to a great extent, annuls the “Too Big To Fail” problem for the commercial banking system so the lesson is gargantuan and its worth inconceivable!

I will cover that lesson in more detail in my upcoming book, working title “Bad Economics: How Iceland’s stupid economic policies bankrupted the country” (an excerpt available here). In the book I will explain as well how the completely mad indexation of mortgages works, how the pension system is a major financial illness and why the Second Economic Crash of Iceland is around the corner. 

For the economic Wunderkind has cancer.

Tuesday, 15 January 2013

"Stock prices have reached what looks like a permanently high plateau"

If only that would be true...

Blatant signs are for a classic bubble forming on the Icelandic stock exchange - again! Since the beginning of the year, stock prices have practically reached a lift-off speed and defied the market's law of gravity.

The stock index in the Icelandic stock exchange. Taken from Keldan.is. Click to enlarge.



Why this happens one can only speculate about but a not so unlikely spark is the existence of the capital controls which prevent the Johns and Jonases of Iceland to take their money out of the economy. Investors are therefore locked in, searching for investment opportunities in despair.

Many have parked their money in the banking system with its government backup. Others have funded the increased stock of bonds - especially government bonds as touched upon here - but the market value of registered bonds has risen up to 2,160 billion ISK from 1,390 billion ISK in October 2008. The yield of government bonds has dropped significantly as well, dipping below the yield which would neutralise the actuarial calculations of the Icelandic pension funds but they control around 55% of the total worth of registered bonds in the Icelandic stock exchange. Something tells me that the Icelandic pension funds may not be so eager to hold the too-low-yield-for-them bonds anymore once they will be allowed to invest again abroad.

Other trapped investors have decided to jump on the equities bandwagon, especially after the media began to show the price developments on the stock market some interest (such as here, here, here and here).  Like you can count on women flocking to the shops of Paris during the "soldes" period, investors followed the crowd and poured money into the stock market: the turnover of stocks in the first days of the year 2013 was fivefold the average turnover in 2012. Can anybody smell the "permanency" of this newly found stock plateau?

Nothing lasts forever, all stock runs run out in the long run. But who cares about the long run anyway! In the long run we're all dead and today's politicians (and Lords of Finance) will have managed to throw the burden of steering the economy away from recreating the financial turmoil of 2008 onto somebody else's new and unexpected shoulders. And of course the poor soul who is unlucky enough to be in command at the time of the burst of the bubble will take all the blame.

So jump on the bandwagon, enjoy the Beauty Contest and make money beyond your wildest dreams. Just don't come running back to me when you lose them all.

Wednesday, 9 January 2013

The non-indexed mistake of the Icelandic government

"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens."
- John Maynard Keynes

I've mentioned before (here and here) that indexation in Iceland is a peculiar beast. In the first post on the indexation I mentioned that the main issuer of indexed (to the Consumer Price Index) securities in Iceland is not the government but households. In most countries, households wouldn't even think of taking a CPI-indexed loan but for a long time there was nothing else offered in Iceland. Normally, it is the government which issues the indexed bonds. We have e.g. the TIPS in the US, the indexed Gilts in UK and many others (see a Wikipedia list here).

We do things differently in Iceland. Off the CPI-indexed bonds registered in the Icelandic Stock Exchange, 83% of them (based on market value) are Housing Financing Funds bonds which are used to finance the mortgages to households through the HFF. The HFF has a government insurance behind it in case of lack of liquidity or equity, but the HFF is nothing else than an intermediary of indexed debt which the households are effectively issuing. And it is the households which have to carry the first part of the burden in case of problems. HFF can e.g. increase the interest rate mark-up and repossess one's house if the indexed mortgage is not repaid before the government's coffers are opened up to bail the bankrupt HFF out of trouble - which has happened recently and will only happen again given the awful financial cold the fund is suffering.

The market value of debt securities in the Icelandic Stock Exchange. The predominant issuer of indexed marketable securities is the household sector through the indexed HFF bonds.

This misallocation of the burdens of indexation creates a perverted incentive for the government and a massive problem in the wake of that which only hits the government itself in the back of its head.

As its debt is predominantly non-indexed to the rate of inflation, the government has limited reason to make sure that price increases are not excessive. Possibly, it might even want to "inflate" its debt away by allowing inflation to be just a bit higher than it would have if the incentive to "inflate away" wasn't there. But of course, too much inflation would lay waste to the balance sheet of households and that is, unfortunately, somewhat what has happened.

Let's take an example. The bailout money the government raised by issuing bonds to investors was, as one can see by glancing on the graph above, almost entirely in non-indexed bonds (this does not include the foreign-currency bailout money we got from the Scandinavian nations, the IMF etc.) The total market value of non-indexed government bonds, partly because of a lower rate of interest but mainly due to new issuances, increased by a spectacular 539 per cent between year end 2007 and year end 2010 when all the savings-bank bailouts were passed and the reconstruction of the financial system was, for the time being, finished. (Not included in this increase is the bond which was issued to strengthen the equity base of the Central Bank of Iceland after it became technically bankrupt (negative or too low equity) for that bond is simply kept in the Central Bank and not on the market.)

Why was the bailout money not raised in the form of indexed government bonds? Was it because the government did not want to carry the full cost of the bailout and instead throw it on the shoulders of households whose debts are to a large extent indexed?

Who knows! But what we do know is that the government has been raising taxes since the collapse to raise money for the bailout. Tax increases, especially VAT and excise taxes, raise the CPI (although they have nothing to with actual inflation!) and that increases the cost of CPI-indexed bonds. "Luckily" for the government, that cost is not in place for it since the debt it has issued in the recent years is, as already highlighted, mainly non-indexed.

But of course, the CPI increases, caused e.g. by higher taxes and possible pet-projects of perverse politicians, affect the indexation of households' debt. So the indexation-cost comes on top of the increased tax burden for households, adding insult to injury. Of course, this all ends up with a record number of delinquencies and defaults, which again means that the HFF suffers losses as well. Those losses are first borne by the households but when they cannot continue paying, the government, originally trying to reasonably inflate its debt away, has to step in and boost the equity foundations of the HFF. Recently, 13 billion ISK of government money were earmarked for the fund. That amount will only grow in the future.

Chart III-7 in the 2012/2 Financial Stability Report by the Central Bank of Iceland


So the government, by issuing almost only non-indexed debt after the collapse, tried to sway away from an important incentive it should face to help keeping inflation at bay. Instead, the government created, intentionally or not, a reason for itself to allow inflation to increase and inflate its debt burden away: the CPI has increased by 25% since October 2008.

But at the same time, increased inflation only increases the debt burden of indexed mortgages and bankrupts the household sector. Then, "what goes around, comes around" and the government experiences unpleasant but repeated visits from the Housing Financing Fund as the bankruptcies of households ruin its balance sheet and it needs more and more equity injections.

Maybe the government should have stopped fooling around long time ago and issue indexed debt contracts instead, thereby joining the anti-inflation team instead of boosting the ranks of the other team? Luckily, it's not too late yet to switch sides!