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FT.com / Comment & analysis - An unhappy chain of events but nothi... http://www.ft.com/cms/s/26f48316-181a-11db-b198-0000779e2340,... COMMENT & ANALYSISCloseAn unhappy chain of events but nothing is brokenBy David IbisonPublished: July 20 2006 19:56 | Last updated: July 20 2006 19:56Hólmavík, a hamlet in north-west Iceland, has just been voted the happiest place on the island. As Iceland has itself been identifiedin a recent survey as the happiest place on earth, Hólmavik can make claim to being the most joyful town on the planet. But ÁsdísLeifsdóttir, the mayor, greets the cheerful news with indifference.“It’s beautiful and the people are nice,” she says before trailing off uncertainly. But what about the depressing effects of Iceland’ssoaring inflation, high interest rates, plunging currency and housing market bubble? “We’ve noticed it”, she says, “but it doesn’tbother us much”.Such nonchalance says much about Iceland’s so-called economic crisis. Just four months ago, many thought the chilly country wason the verge of financial meltdown after its currency dropped 20 per cent in a matter of weeks and the stock market also lostone-fifth of its value. Dire comparisons were made with Thailand in 1997 or Turkey in 2001.Some commentators went so far as to cite Iceland as a possible starting point for economic contagion as investors fled emerging-market risk in favour of safer havens.But since then, the currency has stabilised, albeit weaker, as have ...

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FT.com / Comment & analysis - An unhappy chain of events but nothi...

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An unhappy chain of events but nothing is broken

By David Ibison

Published: July 20 2006 19:56 | Last updated: July 20 2006 19:56

Hólmavík, a hamlet in north-west Iceland, has just been voted the happiest place on the island. As Iceland has itself been identified

in a recent survey as the happiest place on earth, Hólmavik can make claim to being the most joyful town on the planet. But Ásdís

Leifsdóttir, the mayor, greets the cheerful news with indifference.

“It’s beautiful and the people are nice,” she says before trailing off uncertainly. But what about the depressing effects of Iceland’s

soaring inflation, high interest rates, plunging currency and housing market bubble? “We’ve noticed it”, she says, “but it doesn’t

bother us much”.

Such nonchalance says much about Iceland’s so-called economic crisis. Just four months ago, many thought the chilly country was

on the verge of financial meltdown after its currency dropped 20 per cent in a matter of weeks and the stock market also lost

one-fifth of its value. Dire comparisons were made with Thailand in 1997 or Turkey in 2001.

Some commentators went so far as to cite Iceland as a possible starting point for economic contagion as investors fled

emerging-market risk in favour of safer havens.

But since then, the currency has stabilised, albeit weaker, as have Icelandic shares, although lower. The prospect of an Asian-style

meltdown now seems as remote to international commentators as it does to the isolated but happy residents of Hólmavík.

As Frederic Mishkin of Columbia University, an expert in financial stability commissioned by the Icelandic authorities to assess the

country, commented acidly in his report: “The academic literature on financial instability and the state of the Icelandic economy

indicate [that] comparisons with emerging-market countries such as Thailand or Turkey are not only facile but completely

misguided.”

Now that the skies have cleared, the events in Iceland have come into sharper focus. It is a picture that reveals how hot money,

herd-like behaviour and hasty analysis can combine to wipe out billions of dollars of market value for what later seem to be flimsy –

if not completely mistaken – reasons.

“They [financial industry experts] mostly got it wrong,” says Davíd Oddsson, head of the central bank and former prime minister.

The market was right to conclude that the economy had been allowed to overheat. The currency was overvalued and a

current-account deficit of 16.5 per cent in 2005 was a record high. An inflation rate of 8 per cent had been fuelled by rapid rises in

house prices that topped 40 per cent a year in mid-2005. The central bank’s inflation target is 2.5 per cent. This, many concluded,

meant Iceland must be heading for a hard landing.

Geir Haarde, prime minister, agrees the situation was inflamed by questionable policies, namely tax cuts and a decision to allow

banks to enter the state-controlled housing-loan market. “This was the most important contribution to the inflation problem,” he

says.

In response to that problem, the central bank increased interest rates on 14 occasions since 2004 to their current 13 per cent. This

attracted short-term investors lured by the prospect of high-yielding Icelandic bonds, having borrowed in low-interest environments.

Then in February, Fitch, the credit rating agency, downgraded its outlook for Iceland due to the imbalances in the economy. It was

followed by the rival Standard & Poor’s while a number of investment banks also aired criticism.

This started a spiral effect: the currency weakened, which caught international attention, which drew criticism of the overheated

economy, which prompted the stock-market correction, which stoked talk of a crisis, which triggered more fund outflows.

In academic circles, these occurrences are known as multiple equilibria, meaning a self-fulfilling sequence of actions that combine

to cause severe market movements, irrespective of economic fundamentals. In effect, the fear of the crisis causes the crisis.

Politely but firmly, the Icelandic government and business community set off on an international roadshow to try to set the record

straight. They pointed out that two-thirds of the earnings of Iceland’s main companies were derived abroad, shielding them from a

domestic downturn. This also protects the banks, as does the fact that the household debt service burden has fallen relative to

disposable income in spite of a huge increase in indebtedness.

The country’s pension funds are well funded at 120 per cent of gross domestic product and Iceland has the youngest population of

countries in the Organisation for Economic Co-operation and Development. In addition, a wave of foreign investment in aluminium

and power companies, which for a small economy skewed the current-account deficit, will be completed next year.

According to the central bank, stress testing carried out by the Financial Supervisory Authority “indicates firmly that the commercial

banks’ capital position is strong enough to withstand a significant economic crisis entailing several large shocks in tandem” – a

COMMENT & ANALYSIS

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scenario rather more severe than the one that hit the country this spring. “You don’t need to be concerned,” adds Árni Mathiesen,

finance minister.

As things stand, the economy is forecast by Ingólfur Bender, head of research at Glitnir, one of Iceland’s top three banks, to grow

by 4.5–5 per cent this year, dropping to between zero and 1 per cent in 2007 before bouncing back. The housing market is

expected to correct slightly, and then stabilise.

Hindsight reveals that short-term capital flows, hurried analysis and flock-like investment turned a measured devaluation of

Iceland’s currency into a rout and an anticipated correction in the stock market into near-panic. Policymakers, although retaining

their manners, look far from happy when asked to comment about the wisdom of financial experts. “We understand why they

thought what they thought...But there will be no hard landing,” says Mr Haarde.

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