High rates or not?

I translated (and expanded) the post about Iceland prepaying the crisis-money ahead of schedule into Icelandic and posted it on my blog back home. In the wake of it, I got some comments and nudges such as:
- the coupon on the bond isn't 6.0% but "3.something" and then the market adjusts the price to whatever it thinks is appropriate
- 6.0% isn't too bad compared to other countries (I reckon with similar credit rating)
- USD isn't the currency of Iceland, therefore it's only normal that the risk on this USD bond is high

OK, so I went to the Bloomberg terminal here in Exeter (one of the few British universities that has an access to a Blooomberg terminal) and spent an hour looking up international bonds issued by other sovereign countries. This table summarises what I found:

Examples of USD bonds issued by sovereign states and maturing roughly in the same year as the Icelandic bond issued in May. Click to enlarge.

I tried to find sovereigns with similar credit rating and followed Moody's on that - I noted S&P's and Fitch's ratings as well. If I didn't find a bond maturing in 2022 I went for the one closest to that year. All bonds are in USD.

So what is this comparison telling us:
- of the Baa3 rated countries, only Croatia is getting a worse deal than Iceland. The yield on the Hungarian bond is higher than that of Iceland but it receives speculation grade.
- there are three Ba1 (speculation grade) countries that seem to get a better deal than Iceland. Notice especially Uruguay but that bond is sinkable so they should be getting a better deal.
- the yield on the Philippine bond is half the yield on the Icelandic bond, despite the fact that the Philippine bond is two credit notches worse
- many countries with float, managed or not, are getting a considerably better deal than Iceland. So can we really conclude that not having the USD currency as a legal tender is such an important factor?
- apparently, being pegged to the USD isn't so great: Panama is charged higher rates than Peru, Colombia and Indonesia which all have floating currencies. Same goes for the comparison between El Salvador (USD peg) and Philippines (float).
- Go Colombia! Callable (in 2020 if I remember correctly, was foolish enough not to note it down) but all the same getting 2.8%. I wonder why they seem such a good Baa3 borrower, they must be getting the dollar-flow from somewhere to justify that...

I stand by what I said: this bond issuance of Iceland is a badly done job and absolutely not "successful" like the Ministry of Finance held. Iceland shouldn't be paying 6.0% rates if we compare it to other sovereigns. 3-4% is certainly possible, especially if we go for a sinkable bond a la Uruguay.

And by the way, the coupon on the Icelandic bond is 5.875%, which is of course why there was quadruple over subscription. I reckon the underwriters took some fee so the rates in the end were equivalent to 6.0% like the Ministry of Finance announced.

Iceland's prepayment of bailout money

A very quick note on Iceland's prepayment of IMF and Nordic bailout money since I got a few retweets on the matter.

Basically, the treasury is extending its liquidity profile. The cost is higher rate of interest, expectedly so. In May, Iceland issued a 1.0bn. USD bond bearing a rate of interest of 6%, fixed. It matures in 2022. This money is now spent on the prepayment of IMF and Nordic bailout loans, maturing in the next few years. As far as I can figure out, those loans carry a rate of interest of 3.25%.

So, yes it looks good on paper that we're prematurely paying back the money we got in 2008. But we're doing so with even dearer money, almost double as expensive in fact. People may have different thoughts about how much liquidity is needed but no one can deny that interest rates of 6% for a sovereign are, well, high. Mortgage rates in US are considerably lower in comparison and the fact of the matter is that the demand during the bond issuance was quadruple the supply! Well of course, it's a sovereign offering interest rates of 6%! Adam Smith's "prodigals and projectors" come to mind.

More importantly, can we seriously expect the income of the State, measured in USD, to grow on average by 6% per annum? I cannot see how that's going to happen, especially when everybody expects the krona to collapse the moment the capital controls are lifted!

Is anybody whispering "Ponzi" back there? Maybe we should have offered a bit lower rate of interest...

The maturity profile of the Icelandic Treasury, foreign currency denominated debt only (not external debt). The 2022 column is the 6% USD bond, issued last month. From the Central Bank of Iceland.

Greece today - Greece tomorrow?

Now when New Democrazy (sic!?) has won the Greek elections, everybody's eyes are on the Mediterranean. But after a super short bull run this morning everybody seems to be back into the "OK, so what now?" gear. Understandably, since it seems like it is just a question of time now when and how Greece defaults on the current "stabilisation" program. But will it go back, hat in hand, to Troika and ask for readjustments on the bailout or will it just outright default and exit the euro.

Who knows?! But for those of you who might want some clarifications of what the brush strokes of possibilities are, the classic "impossible trinity" might help.

Greece is as it is on the south side of the triangle, in the euro and with free flow of capital (as can be seen on the capital flight from Greece). If you're in a euro zone economy, you're perhaps more likely than not to think that Greece will stay on the south side (I can't find the link now, but the majority of economists from the euro zone countries don't think it will collapse while the opposite applies to economists from non-eurozone countries). But if they do not stay in the eurozone, how will the get out?

The impossible trinity and Greece. Greece is currently placed on the south side with fixed exchange rates (the euro) and free flow of capital. Doing so, they sacrifice independent monetary policy. But they could go for either the north-east or north-west sides as well. If they choose to adopt the drachma (independent monetary policy) they have to decide whether they will allow the capital to flee (north-east side) or lock it in and then devalue (north-west). If they choose the north-west side, they effectively "go Argentinian" on the bond owners by unilaterally change euro-denominated bonds with drachma-denominated ones. Then, they allow the drachma to fall by 40-60%.

Now, regarding where Greece will be "tomorrow": it's not entirely impossible that Greece will lock down the economy with capital controls. The purpose would be to get out of the euro in a "tranquil" way, not with massive unrest and collapsing internet banks. Yes, it's not permitted to apply capital controls in the EU according to the Four Freedoms but Iceland did it and is still at it. And we're a member of the Four Freedoms contract as well through the European Economic Area. The ESA has said it is OK for us to lock the capital in, at least for the time being because of the systemic collapse, but they did as well state that they effectively could come knocking and tell us to open up any time.

I think most people who think Greece will exit kind of assume that one day the drachma will be recreated, free flow of capital still applied and the new currency allowed to plummet immediately. But why not lock the money in, recreate the drachma and then devalue the currency through the central bank? Is it impossible they will do that in the end?


Anyway, whatever happens the choices the Greeks have are pretty limited. They can either stay in the euro and have a slowly decaying economy or they can rip the plaster off, experience the massive default-pain and then hopefully get back up again later. Judging from the results of the elections, they are still up for the euro deal. Still. But maybe not tomorrow.

The two real choices Greeks have. They can either have the euro and a disastrous economy or adopt a new drachma and have a disastrous economy.

Guess Who's Emerging From The Crisis?

In reply to Krugman's post with the same headline. The graph below is the same as his except the red line is the Icelandic GDP measured in deflated Special Drawing Rights. That measurement of GDP is still far behind the fixed-krona prices.

Obviously, if (when) Greece defaults and exits the euro, the Greek GDP in euros will look somewhat similar right afterwards. But that's "OK", they won't be in a "recession" (two consequential quarters of decreasing GDP) any longer... we would at least hope.

GDP in Iceland, quarterly seasonally adjusted figures. Top value is 100 in both cases, but since the krona began falling before the GDP in krona did, the SDR top is earlier. Notice also the "mini crisis" dip in 2Q06 when Danske Bank and some other more sober analysts declared Iceland's then economic growth unsustainable. The SDR deflator is estimated by using the G7 inflation index issued by OECD. 

Edit: maybe it's time to reconsider the definition of recession. Does it make much sense that the worth of an economy's GDP in foreign currency can collapse by more than 50% and later, when the GDP in the domestic devalued currency begins to come back slowly, considered to be "recovering"?

Still some way to go

A slightly longer time series than in the previous post. Apparently, Iceland has still some way to go when it comes to clawing back the lost economic ground.

Nominal GDP in Iceland, expressed in Special Drawing Rights (the IMF "currency"). Even though GNP in kronas is making its comeback, the same can't really be said about the value of that GNP in foreign currencies. The trend line is for the period 1971 - 2001 (on average, 0.19 billion nominal SDRs added to GNP each year).

So had we followed the trend from 1971 - 2001, we would be producing 8,0 billion SDRs worth of goods and services. Instead, we're at the 7.2 billion mark. And my guess is that we wouldn't be fighting as severe debt bubble at the same time as well.

What I find amazing however is that the trend up to 2001 is linear, which means that the annual growth must have been falling during the time period (otherwise we would see an exponential trend in the GNP data). Notice also that the data above is not corrected for population growth or inflation of SDRs.

When that is taken away, the long term economic performance of Iceland doesn't seem that impressive any more. But I haven't compared this to e.g. OECD or Scandinavian countries or other peers. So I'm going to say the Icelandic performance is bad until I've seen how the performance of other economies is, maybe they are just as defective.

Real GNP in Iceland per capita (nominal GNP corrected for inflation of SDRs and population growth). The trend line is again for the same period as before, i.e. 1971 - 2001. Also, the deflator of SDRs is estimated by using the G7 inflation index published by OECD.

If the data here are roughly correct, the real value of GDP per capita in Iceland in SDRs, i.e. in foreign currencies, is back to its early 1990s level. The debt bubble and the consequential financial crisis wiped out 20 years of economic progress. This is what the Minister of Finance/Agriculture/Fisheries called "throughout confirmation" of the return of economic health.

In the meanwhile, the Central Bank thinks the best way to fight a balance sheet recession is to raise the interest rates!

The New GDP Figures

Statistics Iceland issued a new set of quarterly GDP figures for Iceland just before the weekend. The results: 4.2% real growth (seasonally adjusted) between 1Q11 and 1Q12. The Minister of Economic Affairs - or his assistant as the Minister of Economic Affairs is also the Minister of Agriculture and the Minister of Fisheries - immediately wrote an article in the most read newspaper, saying that "the [economic] improvement had been thoroughly confirmed."

Well, yes, there is growth! But not because the government is doing anything about it - it's always easy to have a comparatively better economic situation than during an outright economic collapse - and rather simply because Koo's balance sheet recession bounce-back is in play.

I wrote about in December: the Icelandic economy was in a "Lehman Brothers shock" where the actual bankruptcy effects and the sheer collapse of the financial system had been the main contributor for the collapse in GDP. But once the financial panic cleared out of the system the GDP growth came back, automatically, as the economy calmed down. In the meanwhile, balance sheet recession was inevitable since too much corporate and household debt made it impossible for the economy to grow at a rate that was even close to what it had been growing at before.

I might be fooling myself and under the spell of Galbraith ("faced with the choice between changing one's mind and proving that there is no need to do so, almost everyone gets busy on the proof") but I'm going to stick to that case: the Icelandic GDP growth is due to an automatic bounce-back from the financial collapse and panic and the "thoroughly confirmed" economic improvement is in reality an economy that is burdened with a balance sheet recession.


I've got some points to argue why:

1. GDP growth is considerably lower now than it was before, even measured in ISK. Notice how comparable the quarterly GDP growth figures are to Koo's "Lehman Shock" theory (see next set of figures).

Growth in GDP, measured in ISK, is still below what may be considered as historically normal. The sluggish growth is a sign of a balance sheet recession where debt and debt deflation are holding the economy back.

2. The above GDP growth figures are in the domestic currency. Icelandic GDP measured in Special Drawing Rights (SDRs) is merely the shadow of itself - a 65% shadow of itself to be exact since the value of Icelandic GDP has collapsed by 35% since its top in 2007. Admittedly, this is better than the horrendous 45% collapse straight after and during the collapse but again, that is an automatic bounce-back from the panic and not genuine "thoroughly confirmed" return of economic health.

Icelandic GDP measured in non-CPI deflated SDRs (billions of SDR per quarter). Compare the Iceland's GDP growth figures to Exhibit 16 from Koo's paper

3. Investment is still not coming back, causing historically very high unemployment. I know +7% unemployment may not sound much in the ears of a young unemployed Spanish person but for Iceland, that's pretty high. Those are, as far as I can figure out, numbers that are more or less comparable to U-3 unemployment (no U-6 unemployment figures are available).

Investment as a share of GDP, four-quarter moving average. Investment has hardly bleeped above 15% of GDP while it needs to be much closer to the 20% value to be considered "normal".

4. The debt deflation is quite simply so obvious in the the new Central Bank's data on financial stability that we need not discuss the matter any further. The Icelandic economy is in full-swing debt deflation! And contrary to what the Central Bank might think, raising the interest rates is not the right thing to do in such a situation!!

Debt of Icelandic households, % of GDP. Blue = indexed; purple = FX linked; orange = nonindexed loans, comparable to normal mortgages in Europe; green = overdraft; dark blue = leasing contracts

Number of individuals on list of deferred payments (red line: number of bankruptcies and unsuccessful attached properties)

Debt of non-financial corporates as % of GDP. Blue = CPI indexed; purple = nonindexed, normal loans; orange = FX linked (great idea, lets mostly indebt us in foreign currencies!!)

Debt of non-financial corporates, European comparison (% of GDP). Does anybody know the Icelandic word for "debt deflation"?

So I'm afraid I'm just as bearish as before: the Icelandic economy is in the fastest debt deflation process that I've ever seen. 

The main thing that makes this possible is the around 40% discount the Icelandic banks received as their "birth gift" when they were established in 2008: the loan portfolio was transferred from the old banks into the new ones at a 40% discount which was not forwarded to the borrowers who saw their debts, in many cases, grow in monetary terms due to indexation of mortgages. 

As long as the banks are milking out the discount they received in 2008, the economy will not collapse entirely again. But that's only for the short term. If the debts are not gotten rid off, the problem will persist. And the intrinsic systemic factors lead to ever growing value of debts, due to high interest rates and indexation on mortgages. The financial system has to be reformed bottom up - pension funds and indexation are on the top of the list and close thereafter is the monetary policy - simply because it will not stand the test of time in its current form. The Icelandic financial system is built to collapse, just as it was before 2008.