Today Iceland: Tomorrow Turkey, Hungary, Australia, New Zealand, Spain, U.S.?
The recent speculative attack against the Icelandic currency and the incipient run on its banks is no news (actually a deja-vu as my co-author Brad Setser says) to students of financial crises in emerging market economies; Brad and I wrote an entire book about it. A combination of a large and growing current account deficit, driven in part by a credit boom and an asset bubble (with housing bubbles leading to an excessive growth in real estate investment and an excessive increase in private consumption and fall in private savings) can be deadly if it goes bust and it triggers a domestic and/or international run on a banking system with large foreign currency liabilities and little liquid reserves. The combination of weakening fundamentals and illiquid banks can lead to a panicky currency and liquidity run: we saw it in Mexico in 1994, in East Asia in 1997-98, in Brazil in 1999 and in 2001-2002, in Turkey in 2001. Add to these problems, a fiscal imbalance and high public debt and you may even get a sovereign debt crisis, as in Ecuador, Russia, Argentina, Uruguay.
So, today it is Iceland to be in trouble. But which other economies – emerging or advanced – look in part like Iceland today? The list is clear: Turkey, Hungary, Australia, New Zealand, Spain, United States. What all these countries have had in common in recent years?
First, a large (relative to GDP) current account deficit, a large (relative to exports) external debt and a significantly overvalued exchange rate.
Second, an asset bubble in the housing sector.
Third, a fall in the private savings rate and an increase in the consumption to GDP rate, as well as a boom in real estate investment that are all driven by the housing bubble; these, in turn, lead to a worsening of the current account.
Fourth, a credit boom that has fed this asset bubble and that can make their banking system vulnerable to a housing bust.
Fifth, a partial cross border financing of the current account deficit via the short-term cross border flows to the banking system that currently is mostly in domestic currency (but that in some cases used to be in foreign currency).
Sixth, a relatively low stock of liquid foreign exchange reserves relative to the cross border foreign currency liabilities of the country (the U.S. and advanced economies being an exception as they have little forex reserves but also little foreign currency debt).
On top of all these vulnerabilities, some but not all of these countries - the U.S. in particular - have also a large fiscal deficit.
Thus, is it pure financial “panic” that explains the recent contagion from the Icelandic currency to the currency and debt markets of Turkey, Hungary, Australia, New Zealand? Suddenly, in all these countries investors are realizing that the force of gravity of a large current account deficit eventually dominates the carrry trade of interest rate differentials. It is true that the large current account deficits of these countries and their housing bubbles have been known for a while. But markets and investors have a strange way of sometimes waking up – as they did in Thailand in 1997 – and realize that the problems in one country – Iceland today (Thailand in 1997) - are very similar to those in other countries (East Asia in 1997 and the “usual suspects” above today).
Does this mean that the eventual trigger for the adjustment of the U.S. dollar has arrived? Not yet for the U.S. dollar; but certaintly you see now the beginning of the stress on the currencies of Hungary, Turkey, Australia, New Zealand. The U.S. is only partiallly different: still the dominant reserve currency; still being supported by massive intervention by China, other Asian countries, oil exporters and other emerging economies with current account surpluses; still with limited reserves but also with limited foreign currency debt.
But you can play your luck only for so long, especially when – unlike all these other economies – you also have a large and growing fiscal deficit and you are increasingly financing it with new short term debt that is 100% purchased – on net – by non-residents that are now subject to a serious currency risk. It used to be argued that short term foreign currency debt is dangerous when you have little foreign currency reserves as liquidity runs can occur; while domestic currency debt is less risky as you do not have the same rollover/liqudity risk; it was also argued that, as the currency risk is held by the non-residents holding your local currency debt, no nasty balance sheet effects of a devaluation can occur.
But these argument are probably flawed: if most of your domestic debt is in local currency and is held by non-residents, these investors face a large currency risk. Thus, once they start to expect a large depreciation of your currency, their incentive to hedge their currency risk and dump your assets and your currency becomes very large. Then, both a currency crisis and a run on your assets – be it liquid bank deposits or short term government debt -may occur – with nasty effects on your financial system and the ability of your government to finance itself. So, the fact that U.S., Spain, Australia, New Zealand and now even emerging markets such as Turkey and Hungary are financing themselves in local currency may be of little comfort. Runs on currency and liquid local assets may still occur with severe and disruptive effects on currency values, bond markets, equity markets and the housing market.
I have been warning for a while – as Morris Goldstein did – that the new crises in emerging market economies may take a different form from the traditional ones where large stocks of short-term foreign currency debt and low levels of forex reserves could cause a run and an external debt crisis. Instead, runs on the short-term domestic local currency debts of governments and banks could still occur - even in the absence of those traditional external vulnerabilities - and lead to a new type of financial crises. The developing events in Iceland and, possibly, in other emerging market economies, suggest that it was wishful thinking to believe that currency crisies, contagion, financial crises and runs were a thing of the past.
In the meanwhile U.S. policymakers – both at Treasury and even some, but not all, at the Fed – live in this LaLa Land dream that the U.S. current account deficits and fiscal deficits do not matter and that the U.S. external deficit is all caused by a global savings glut or is actually a “capital account surplus” as it allegedly represents the foreigners’ desire to hold U.S. assets. They – and financial markets and investors - may soon wake up from this unreal dream and face a nightmare where the U.S. looks like Iceland more than they have ever fathomed.
18 Responses to “Today Iceland: Tomorrow Turkey, Hungary, Australia, New Zealand, Spain, U.S.?”
ed • March 29th, 2006 at 2:41 am
Hey, I have another candidate country for your list: Portugal. In 2005 it had a c.a. deficit of 7,9%. In 2004 only 5,8%. But amazingly, this numbers where achieved without a proper bubble (growth in 2005 GDP amounted to a microscopic 0,3%) Instead, they had a public deficit of around 7% of GDP. There is a rush of Portuguese workers here in Spain, mainly in construction. In the rumour camp it is heard here (but I cannot confirm) that a very large and growing percentage of the all-euro-area euribor interbank market funds are being absorbed nowadays by Spain banks and S&L (Cajas de ahorros) as very cheap financing for Spain’s mortgage market, which happens to grow at 25% per year, and contributed to a 7,6% c.a. deficit last year. In Spain, net international investment position went to –50% of GDP last year. Those willing to short the dollar better think twice about their alternative currency.
HK • March 29th, 2006 at 3:42 am
The new development in Iceland and New Zealand clearly shows, as you aptly described, the danger of excessive external borrowing (i.e., too large current account deficit), even made in the local currency. So, even if countries avoid the “original sin” or the “double mismatch” which caused (or worsened) currency and financial crises in Latin America and Asia, they may still face similar crises since foreign holders of local currency-denominated debts would try to dump them in order to escape from perceived exchange loss. Two interesting questions arise; whether the US may face a similar crisis, and whether a crisis (or a run) could happen even when debts are owned domestically (i.e., without the current account deficit). On the first, my answer tends to be Yes, eventually, if the present unsustainable current account deficit continues, though that eventuality may be still several years away. On the second, my answer is again Yes, but, since that would be a classical bank run or debt market crisis, the central bank and the government would be able to resolve it (though, with some significant cost). Anyway, we should keep watching those countries, including Iceland and New Zealand (as well as others like the US).
spaniard • March 30th, 2006 at 10:10 am
Nouriel, there is no doubt that the more than 10 year-long expansion of the Spanish economy faces significant sustainability challenges. Yet, the nature of the problems and their likely adjustment are considerably different from those of the countries on your list. One of the obvious differences regards EMU, as this changes profoundly the economic implications and the sustainability of external imbalances. But it is not the only one. The personal savings rate stands at 9,5% of diposable income (IIItr2005), and the national savings rate is above 20%; these figures can hardly be interpreted as a source of future weakness in household´s ability to spend. Then, even if the housing sector has undoubdtedly led growth in the last few years, it has mainly been through investment and employment; the extent of the wealth effect in consumption is estimated as meagre for Spain, and there has not been equity withdrawal. And finally, the bulk of Spain´s foreign debt is not just denominated in euro, but held by euro area residents. These investors do not face a large currency risk. The ability to sustain access to foreign finance in reasonable cost terms depends on return prospects and credit worthiness. And Spanish banks and big companies are showing quite strong balance sheets, profitability and solvency ratios. Of course, there should be no complacency for, even if short term risks are less acute, the medium term economic fallout from a widening current account deficit and a housing boom could be serious. I hope I didn´t sound as the Fed prosperity peddlers. best regards
Goldy Horn • March 30th, 2006 at 3:02 pm
Well,it seems your forgetting the U.K. as it too is running record trade deficits and budget deficits along with a housing bubble ,record mortgage debt ,credit card debt,ultra low savings rate. The U.K bond market was close to inversion last year when the Bank of England panicked and cut rates by 25 basis points then hiked the following month.It looks like the Bank of England have no clue to what the HELL they are doing. The 5 year STERLING/GOLD price tells the whole story.
Jaimito • March 30th, 2006 at 3:50 pm
Yeah, it is a good idea. Lets pool our savings and organize a run on the Spanish peseta. Sörös made quite few mandeboshkes that way.
layman • March 30th, 2006 at 6:30 pm
what about Brazil? what about Mexico after AMLO?
Iceland • March 30th, 2006 at 7:54 pm
Iceland and the US military have ruptured all military relations; the Americans are pulling out all their troops and military equipment stationed at the former US military base in Iceland. I wonder if this rupture in military relations between Iceland and the US has led to the speculative attack on Iceland’s currency ? Personally I believe the best solution for Iceland now would be to replace the Icelandic Krona with the Euro and to integrate the Icelandic economy fully into the powerful 450 million market of the EU which offers the benefit also of the stable and powerful Euro. Had Iceland been part of the Eurozone they would not have suffered any of this recent economic volatility. Soon we might find that Britain’s currency will also start to wobble and we might all witness the day that Tony Blair and Gordon Brown will make a desperate plea to the ECB’s Trichet to allow Britain to join the Euro before the British pound once again implodes as it did some 15 years ago with George Soro’s help…. As for the departing Americans and the withdrawal of US forces from Iceland ; the solution to the future defense of Iceland is to replace the departing Americans with a squadron of European built Eurofighters and to arm Iceland with a number of French made nuclear tipped missiles. France has a powerful nuclear missile “force de frappe” technology which could easily weaponize Iceland and this gesture of EU support for Iceland’s defense would be a very welcome gesture to fully incorporate Iceland into the Euro and the EU community. Below the link to the story of the withdrawal of all American military assets from Iceland which might have led to the speculative attack (by American hedge funds ?) against the Icelandic Krona. ======================= U.S. to Remove Military Forces And Aircraft From Iceland Base By Josh White Washington Post Staff Writer Friday, March 17, 2006; Page A14 The United States plans to withdraw four Air Force fighter jets and a rescue helicopter squadron from its military base in Iceland by September, a move that will leave the island nation with virtually no military defenses and that has caused diplomatic tension between the two NATO allie http://www.washingtonpost.com/wp-dyn/content/article/2006/03/16/AR2006031601846.html
服装辅料 • March 31st, 2006 at 2:52 am
Abhishek Kapoor • March 31st, 2006 at 5:11 am
I agree with most of what you said.Economies currently boasting their assets which are totally finanaced by foreign money.Domestic savings are very less as compared to the trend shown by emerging economies.But one point which we all are missing is that all economies are knowledge economies which are mostly driven by innovation.So all the countries mentioned above specially US , which spend a lot in R&D, have some domestic intangible assets which are not considered while calculating GDP or deficits.We should take them into consideration and then come up with a prediction. Abhishek Kapoor Irevna Reserach
debtjunkie • April 3rd, 2006 at 6:08 am
Yes, Australia seems headed for a crisis. From about 1999 Australia just did not have the capital to here to fund the housing boom. The massive bulk of the increase in property value was funded from massive overseas borrowing(about $480 billion AUD so far) The bigger problem is that if property values stay where they are without any increase the borrowing MUST increase by about$60 billion each year to fund the normal cycle of buying and selling. The question is at which point in the ever escalating debt will the foreign lenders decide that there is a distinct possibility that they have blown the lot, the reserve bank has no hope of raising interest rates to defend the currency and the dollar will continue to fall. Oh well, say goodbye but don’t send good money after bad!
Ross • April 3rd, 2006 at 9:18 am
I agree that the housing bubble and large international borrowing by these countries – particulary Australia – to pay for such investments leaves this precariously balanced. But one question; will Australia’s budget surpluses and Superannuation Guarantee (partially resulting in private savings to GDP being about 20%), help stave off any sort of drastic crisis?
pepe • April 3rd, 2006 at 10:32 am
Spaniard wrote: ”Then, even if the housing sector has undoubdtedly led growth in the last few years, it has mainly been through investment and employment; the extent of the wealth effect in consumption is estimated as meagre for Spain, and there has not been equity withdrawal. “ 1. This “investment” consists not of factories capable of producing tradeable goods (China-style), but rather piles of bricks capable of producing only a non-tradeable service (shelter), of which there is an oversupply (3 million empty homes), and rising at a clip of 800,000 a year. Sure it goes under “gross fixed capital formation”, but let’s be honest, you just can’t call it investment. 2. This “employment” is mostly in construction, producing the above. 3. Equity withdrawal Spanish style: 120% loan-to-value mortgages thanks to fraudulent appraisals. Oh, and about household spending, practically all mortgages are variable-rate, so with the ECB on a rate-hike cycle, mortgage payments are about to eat into discretionary spending.
Guest • April 4th, 2006 at 5:18 pm
no se pierda el interesante caso movistar movistar antes de nada siempre hay algo
PierGiorgio Gawronski • April 5th, 2006 at 6:37 am
DEAR NOURIEL, YOU WRITE: ”It was argued that, as the currency risk is held by the non-residents holding your local currency debt, no nasty balance sheet effects of a devaluation can occur.” ”But these argument are probably flawed”: WHY? ”…: if most of your domestic debt is in local currency and is held by non-residents, these investors face a large currency risk. Thus, once they start to expect a large depreciation of your currency, their incentive to hedge their currency risk and dump your assets and your currency becomes very large”. WE ALL AGREE ON THIS, THIS IS NOT THE POINT. ”Then, both a currency crisis and a run on your assets – be it liquid bank deposits or short term government debt -may occur -” THE RUN ON DOMESTIC ASSETS “MAY” OCCUR, OF COURSE, BUT “MAY” IS NOT A FORECAST. A FIRST POINT OF THE DEBATE IS: WILL IT OCCUR? (IT HAS NOT HAPPENED IN 2003-05, FOR EXAMPLE). HOWEVER THE FOLLOWING STATEMENT IS EVEN LESS CLEAR : … with nasty effects on your financial system and the ability of your government to finance itself.” THIS IS THE MOST CONTROVERSIAL POINT, AND ON THIS YOU OFFER NO ARGUMENT, IN THIS PARTICLAR BLOG, TO SUPPORT YOUR VIEW. LET ME ANALYSE IT A BIT MORE. OK, WE HAVE SEEN PLENTY OF FINANCIAL CRISES AROUND THE WORLD DUE TO AN OVERVALUED EX-RATE. BUT (WHEN THE DOLLAR FALLS, BEING THE US UNIQUELY INSULATED FROM NEGATIVE “VALUATION EFFECTS” ON ITS FOREIGN DEBTS), WHY SHOULD THE DEPRECIATION HAVE ANY IMPACT WHATSOEVER ON THE DOLLAR VALUE OF US ASSETS AND ON THE US DOMESTIC FINANCIAL STABILITY? YOUR ANSWER IS “CONTAGION”. FIRST, EVEN ASSUMING THE “HERD BEHAVIOUR” THAT YOU TAKE FOR GRANTED – AND THE “CONTAGION” TO THE DOLLAR VALUE OF US FINANCIAL ASSETS (IT HAS NOT HAPPENED IN 2003-05 AS THE DOLLAR PLUMMETED, QUITE ON THE CONTRARY: PRECISELY AS A STANDARD “PORTFOLIO BALANCE MODEL” WOULD EXPECT) -, THE US COULD SUFFER A DOMESTIC FINANCIAL CRISIS ONLY IF A LARGE SECTOR OF ITS ECONOMY WAS VERY HEAVILY INDEBTED. YOU SHOULD THEN PROVE THIS TO SUSTAIN YOUR CASE. BUT THE US GOVERNMENT IS NOT YET CLOSE TO INSOLVENCY (COMPARE WITH ITALY AND JAPAN, YOU SEE THERE’S NO REASON TO WORRY ABOUT AN IMMINENT FEDERAL DEBT CRISI IN THE US, (HOWEVER BAD MAY BE BUSH’S RECKLESS POLICIES). THEREFORE YOUR VIEW THAT THERE WOULD BE “difficulties in financing the federal debt” IS HARD TO ACCEPT RIGHT NOW IN 2006. WOULDN’T YOU ALSO AGREE THAT THE PRIVATE FIRMS SECTOR IS FINANCIALLY QUITE (OR VERY) HEALTY RIGHT NOW? SO: THE BIG DEBTOR IN THE US IS THE CONSUMER. TO CAUSE A FULL SCALE DOMESTIC FINANCIAL CRISIS, HOWEVER, WE ALSO NEED A BANKING SECTOR THAT IS POTENTIALLY IN TROUBLE (WHEN THE VALUE OF COLLATERAL FALLS). SO WE FINALLY COME TO THE CRUCIAL POINT OF YOUR ANALYSIS: DO YOU THINK THE US BANKING SECTOR IN THE US IS POTENTIALLY IN TROUBLE IF ASSET PRICES FALL? OR HAS IT AMASSED ENOUGH CAPITAL AND RESERVES TO FACE SUCCESSFULLY THE NEGATIVE FINANCIAL CONSEQUENCES (ON ITS BORROWERS: THE US FAMILIES) OF A US RECESSION? DO YO HAVE A VIEW ON THIS? CONCLUSION. IT SEEMS TO ME THAT THERE ARE MANY “IF” BEFORE ONE CAN AGREE ON YOUR VERY PESSIMISTIC VIEW (HOWEVER SERIOUS MAY THE us FINANCIAL PROBLEMS BECOME IN A FEW YEARS IF CURRENT TRENDS CONTINUE, I.E. IF THE DOLLAR DOES NOT DEPRECIATE SOON). I WILL ENJOY YOUR REPLY. BEST REGARDS
claus vistesen • April 6th, 2006 at 1:39 pm
A bit of FYI … The Economist apparently have some “Rubini-watchers” amongst their editors 
http://www.economist.com/opinion/displaystory.cfm?story_id=E1_GSSNQNP
Anonymous • April 6th, 2006 at 10:43 pm
As an informed FX mkt participant, I can say that all players are becoming more and more sophisticated by the day. All the points above are valid; external debt holders are active in risk management, excess housing inflation is bad for an economy, monetary conditions are tightening and complacency will ultimately be punished. Although there will be short term aberations due to market realities, ultimately, the bulk of betting money will sponsor sound business actions on both a macro government / business level and the follow through on a micro level by the the ability of a population. A USD or GBP crisis may not be imminent, but sound business judgement has us betting against them in a general fashion. What is most desired, is more options to bet with. Pete
Hans Feingold • April 10th, 2006 at 9:09 pm
According to the Central Bank of Iceland they could boost Iceland’s per Capita Income by 4% if Iceland joined the Euro; by joining the Euro trade with the Eurozone would increase by 60%. ==================== CENTRAL BANK OF ICELAND WORKING PAPER No.26 OUT IN THE COLD ? ICELAND’S TRADE PERFORMANCE OUTSIDE OF THE EU The Icelandic Krona acts as a barrier to international trade and that by adopting the euro Icelandic trade with other EMU members could increase by 60%, and that the share of trade in GDP could rise by 12 percentage points which could boost per capita income by about 4% in the long run. We estimate that about half of this effect comes from joining the EU and the other half from EMU membership. These effects would be even larger would the three current outsiders (Denmark,Sweden, and the UK) also become members. http://www.sedlabanki.is/uploads/files/WP-26.pdf
Guest • January 8th, 2007 at 3:52 pm
So, if a person’s networth is in US Dollars at present, should he/she begin shifting to some other currencies or diversify to Euros ?
