Wednesday, March 26, 2008

Iceland's emergency rate hike

In an emergency move the central bank of Iceland has raised interest rates to 15pc this week. Iceland's currency krona has depreciated 18pc since mid-March as a reaction to carry trade liquidations. In good times investors borrow from the lower yielding yen and invest in higher yielding emerging market currencies like the krona. Iceland is one of the premier beneficiaries of this trade. As the spigot of easy credit has been turned of it is feared that flight from emerging markets might spread to other currencies and jeopardize the fragile financial system in these countries. Turkish companies reportedly have difficulties to raise $48bn of fresh loans needed to stay afloat. It is noteworthy though that yen carry trade reacts primarily to interest rate differentials and is not so much dependent on specific conditions in the the credit market. In my opinion this will continue as long as world economies do not go into a tailspin.

Ambrose Evans-Pritchard, international Business Editor, disagrees and submits to The Daily Telegraph:

Iceland contagion may spread far and wide

This spigot of easy credit has now been turned off. The spreads on Icelandic bank debt have risen above 800 basis points, near levels seen in Bear Stearns' debt before the Federal Reserve's rescue. Which raises a thorny question: Is the Icelandic government - which presides over an economy the size of Bristol - big enough to underpin its encephalitic banks if push ever comes to shove?

"There are clearly limits to what the government can do," said Paul Rawkins, an Iceland expert at Fitch Ratings. "If the government tried to raise billions in the markets it would damage its own credit worthiness. In any case, these debts are in foreign currencies. The central bank has just $2bn (£1bn) in reserves," he said.

The banks insist they are well capitalised, with enough liquidity to tide them through to 2009. If the credit crunch subsides, the issue will never be put the test.

Fitch said countries that run current account deficits above 10pc of GDP for any length time almost always come to grief. East Asia's debt crisis in 1997 erupted before any state reached double digits. Iceland's deficit is now 16pc of GDP. Latvia is at 25pc, Bulgaria 19pc, Georgia 18pc, Estonia 16pc, Lithuania 14pc, Romania 14pc and Serbia 13pc. The region will need $337bn in foreign loans this year.

source: Iceland contagion may spread far and wide
Ambrose Evans-Pritchard, The Daily Telegraph

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