Friday, 30 November 2012

An Interview with Rás 2 Radio

RUV (the Icelandic equivalent of BBC) interviewed me Wednesday on the cul-de-sac that the Housing Financing Fund is stuck in.

Some of the points I raised:

- HFF has a government guarantee (some concerns have been raised if it is truly bound into law) and therefore, a non-payment of its debt can be considered a default of the Icelandic State
- since the net interest differential has become negative due to mortgage repayments and the Fund's inability to repay its own debts at its own will (the HFF bonds are irredeemable), the Fund has practically become a leech on the State's finances: every 2-3 years, the government has to pump new equity into the fund
- this need to pump new equity into the Fund impairs the prospects of abolishing the capital controls in Iceland as the Central Bank is of the opinion that the public finances must be balanced before capital controls are lifted
- but due to the capital controls, the interest rates in the Icelandic economy as pushed downwards. This gives households the incentive to refinance their mortgages, which they have begun to do (especially with non-indexed loans from the banks)
- this again creates the "leeching" situation of the Housing Financing Fund due to the fact that its bonds are irredeemable. Ergo: we have a potential vicious cycle
- if a non-payment of HFF debt is considered to be a government default, we cannot do much about the bonds which have issued so far. We can however stop issuing more of them! The Chairman of the Housing Financing Fund was asked later the same day about this proposal of mine and he said that although it had not been made official, the HFF's board had already decided to stop issuing more HFF irredeemable bonds. That comment was later watered down by a statement from the HFF board itself.
- the debt rating of the Icelandic State is hampered by the fact that the State guarantee amounts to 950 billion ISK (roughly double the gross tax income of the Icelandic federal government).
- increasing interest rates will not solve the problem of the negative interest rate differential since if interest rates are raised, borrowers will simply default instead, leading to equity problems all the same

The interview can be found here (in Icelandic)

"The Mirror" on Rás 2

Wednesday, 28 November 2012

Icelandic CPI and the money supply

New data on inflation in Iceland were published today. The verdict: 4.5% over the last 12 months.

In some sense, this high (rather mellow on Icelandic standards) rate of inflation is a collateral damage incurred after the bust of the bubble. The money that was created en masse before and during the fantastic bubble formation before the crash is simply still sloshing around, catching too few goods with inflation as a rather expected result.

Basically, we can interpret it as the classic quantity theory of money doing its work - with a bit of lag as one can really expect (I hope nobody truly beliefs that the rational expectations theory applies: even if the money supply is expanded by x% in time period t, it is impossible to realistically expect that people will boost their price expectations immediately, resulting in a full inflation-feedback within time period t as well. However, over a longer time period, maybe a few years, we can expect the price level to slowly respond in more accordance to the MV=PY theory.)

We can throw the data up graphically to understand them a bit better. Here is the rate of inflation and the relative expansion of M3 over a 5-year-period (instead of the annual measure) since 1886 in Iceland.

5-year inflation and 5-year relative expansion of the money supply (M3). Notice that the axes are the same. Correlation: 0.88. Data constructed from various sources. (OECD, Statistics Iceland, Central Bank of Iceland).

We can see that the bump in 1994-2012 (October value) seems a bit out of place since there is a lack of response in the Consumer Price Index. The same applies to the early 20th century bump and the WW2 spike.

The early 20th century bump can be explained with the fact that the banking system was truly developing fast back then and the proper allocation of money brought supply-side improvements, therefore the CPI did not chase the expansion of the money supply as much. Data might be the reason why as well, we never know with data looking so far into the past. The WW2 spike can be explained by the massive inflow of capital from abroad which did not really enter the circulation but was stacked up in the Central Bank in the form of foreign reserves. They were promptly spent - every pound of them! - after the war on the "second industrialisation" in Iceland when the agriculture and fishing industries were modernised with tractors and trawlers. Of course, we went a bit over our head in that episode and the over-investment was, with the benefit of hindsight, monstrous! But at least that over-investment, despite leading to a currency crash in the early 1950s, left us with tractors and trawlers. Not entirely useless!

But that leaves the early 21st century bulge in M3 without corresponding reaction in the CPI. Lets zoom down onto the last 18 years.

Same as above but zoomed down onto the 1994-2012 period. Notice that the axes are now not the same (inflation is on the right axis). 

Now, all of the sudden the rather close (judging from the earlier graph) relationship between 5-year change in money supply and 5-year change in CPI brakes down. So what happened to all that extra money? Well, it's still there. It's just not buying goods... yet. In this respect, it is interesting to look at the ratio between money supply and the monetary value of GDP, i.e. the M/PY ratio (the inverse of the velocity of money).

The ratio between the money supply and the monetary value of total production. Will this ratio fall back down to normal heights through a deletion of money (some people want to "go German" in Iceland and adopt a "New Krona" a la Germany in 1948 when they basically wiped out a large part of the money supply to stop hyperinflation from happening - the "Wirtschaftswunder" happened somewhat as a result of that), through higher nominal prices (inflation) or through more production (GDP growth)?

So what will happen? Will the money just "hang around" there doing nothing or will the monetary value of total production increase? And if it does, will the monetary value of total production increase through higher nominal price level - i.e. will inflation happen - or will it happen through more stuff being manufactured - i.e. will GPD growth happen?

Maybe it wasn't such a good idea to allow the banks to create all that money in the early 2000s!

Thursday, 22 November 2012

The Upcoming Problems of Housing Financing Fund

The Housing Financing Fund (HFF) in Iceland is a government sponsored entity that raises money on the capital markets and lends it onwards to Icelandic households in the form of mortgages. The total government guarantee on this fund is 950 billion ISK (58% of GDP and almost two times annual income of the State).

The problem is: the HFF is bleeding, slowly but securely. Consequently, it is a massive threat for the public finances because the government has to bridge the gap whenever its equity position runs down. And today, that position is only 1.4% of total assets.

HFF's accumulated losses since 2008 are 46.7 billion ISK. Its equity is supposed to be above 5% but as already mentioned, it is 1.4% now - down from 2.3% in June.

The government has already pumped 33 billion in new equity into the fund (in 2010) but that was swallowed whole in the fund's participation in the 110% act (you had part of your debt cancelled if your mortgage was 110% of the market value of the property). The fund has also tried to increase its net interest rate premium as we can see on the graph below. All the same, the fund now needs 12-13 extra billion ISK from the government.

The interest rate premium of HFF has increased slowly but securely since 2009. The red line is the fund's interest rate cost (the rate on HFF 44 which matures in 2044), the blue line is the rate it offers its borrowers and the green line the difference there between. The black line is 12 month moving average. 

The reasons for its demise: lack of common sense

The first reason for HFF's troubles is the fact that it is offering a rate of interest which households cannot pay in the long run!

You may have noticed on the graph above that the blue line stands at just above 4%. It stands at 4.2% to be exact. This however is not nominal rate of interest but real rate of interest!

All the mortgages from HFF are indexed - and if you want to know in more detail how Icelandic indexation on mortgages works, check this out - and carry therefore the real rate of interest. The most brilliant thing about the indexation of mortgages in Iceland is that it is not the nominal rate of interest which is upped parallel to the changes in the rate of inflation, but the principal of the loan is changed according to the annual rate of inflation.

So if you have a mortgage from HFF of, say, 1,000,000 ISK you will get it with 4.2% rate of interest. Assume that this is in November 2012. In November 2013 the annual inflation turns out to be 5%. That means that you now owe the HFF a mortgage amounting to 1,050,000 ISK which still carries the 4.2% rate of interest. You do not owe 1,000,000 at 9.2% rate of interest.

The Icelandic indexation basically postpones the full cost of the monthly payment. Instead of demanding that you as the borrower pay the original amount at 9.2% nominal rate of interest, you get a loan, automatically, amounting to 50,000 ISK and are asked to repay it later. This of course happens repeatedly, every single month to be exact (the amount changes of course depending on the rate of inflation).

Now, the trick is that this may not be so bad if the borrower can in reality pay back the loan. But that means the borrower has to find money to repay the original principal and the automatic loans as well which are so conveniently extended to him.

That is going to be a bit problematic for the average household. For even though the real rate of interest on HFF loans are 4.2%, the real wages in Iceland are not growing by that number. They are only growing by 1.1% per annum (since 1989).

So if you look at the households as a whole and consider their debts, which carry the real rate of 4.2%, and their wages, which grow by 1.1% per year, is it not likely that the ratio debt/wages will grow year by year?

Well, yes it is! And so they have! This happens not only because of new non-automatic borrowing but also because the households are given an automatic loan every single time there is inflation: inflation basically funds itself! This really smells a bit like a Ponzi-financed inflation. And that is truly what indexation, in its current form, of mortgages in Iceland is. Some day, a large chunk of this mortgage debt will have to be either refinanced at a rate of interest well below what it is today or simply straight forward cancelled. This is not sustainable!

Household debt in Iceland as a ratio of spendable income. The drop in 2011 can be explained to some extent by the illegal foreign-currency loans and the households' endeavour to use pension savings to repay debt.

The other reason for HFF's bleeding wound is the fact that it cannot pay its debts in advance: the bonds it issues have a no-early-payment clause.

This means that if households decide they want to refinance their HFF mortgages with another one, from e.g. a bank, the HFF will end up with a stack of cash it has no idea what to do with. That stack of cash will of course only yield 0-1% real rate of interest, if that, which is quite problematic for HFF because its issued bonds (the HFF 14, HFF 24, HFF 34, HFF 44 bonds) are irremediable and carry a 3.75% coupon rate.

Blatantly then, the HFF will slowly bleed out. Whatever money the government throws at it will practically be nothing else than a temporary bandage on the negative-net-interest wound which it slowly bleeds equity out of.

Truth is that the Icelandic Housing Financing Fund is in a Wile E. Coyote moment: there is nothing behind it other than the air and the Icelandic government's guarantee. The problem is that HFF cannot be allowed to go bankrupt for if it does it can be interpreted as a payment default of the Icelandic state.

It will be fun to be an Icelandic tax payer in the future! Also, if a condition for abolishing the capital controls is a deficit-free budget, good luck with that with HFF hanging around.

(Icelandic version first published on

Thursday, 15 November 2012

The Prophetical Talents of the Central Bank of Iceland

The Central Bank of Iceland upped its policy rates by 25 points yesterday to 6.0%. Quite frankly, I think they made a bad situation worse by doing so when it comes to the outflow of capital out of the economy and the exchange rate of the krona. But that's another story that I'm going to analyse later.

For now, I'm only going to update the graph that I first posted in The Predictability of Inflation Forecasts. Again, we can see that the inflation forecasts issued by the Central Bank of Iceland are still the same: take the current inflation rate and slowly diminish it towards the inflation target, i.e. 2.5%. No matter the rate of inflation today, it will always be down to the inflation target, or thereabouts, in 6-8 quarters (a phenomenon first pointed out by Fridrik Mar Baldursson at the University of Reykjavik). You seriously couldn't make this thing up!

The Quarterly Macroeconomic Model of the Central Bank of Iceland always predicts that the rate of inflation will move towards the inflation target in 8 quarters or so, no matter the current rate of inflation. The different lines are the inflation forecasts from different Monetary Bulletins of the CBI. The red line is the inflation target, 2.5%.

And has the Central Bank been accurate when it forecasts inflation? Not particularly so. But the inflation forecast of 3Q 2011 seems quite accurate, beside the fact that it's totally off in the beginning. Too bad they've changed their minds too often since then to really appreciate the accuracy of that forecast.

Forecasted inflation according to each Monetary Bulletin and the real measured value

As an example of a seriously flawed forecast, take a look at 2Q12 which came out in May 2012. At that time, they expected annual inflation to be 6.1% and 5.7% in end of 2Q12 and 3Q12 respectively. Notice that they are forecasting inflation for the same quarter (2Q12) as they are issuing it in. The measured annual rate of inflation was 5.4% in June 2012 and 4.3% in September 2012, way off of what was expected. Of course, once they had fed their forecasting model with the updated figures, the forecast was lowered.

Blatantly, nobody can take a forecast model which always expects inflation to go down to a predetermined figure seriously. All this is even funnier in the light of the Central Bank's self-praise in the "Post-crisis economic development and Central Bank forecasts" box in the newest Monetary Bulletin, pages 10-11. There, the Central Bank praises its November 2008 output growth (contraction really) forecast and says it was "virtually spot-on." This GDP forecast comes from the same model as the inflation forecasts.

Sure, the November 2008 forecast was too bad when it came to GDP growth. But I don't think the Bank is ever going to write the same sort of an egocentric self-praise when it comes to the July 2008 forecast where it foresaw that GDP growth would be -2.0% and -1.9% in 2009 and 2010 respectively. In reality, it was -6.6% and -4.0%. Well done boys and girls, you were so close!!

Furthermore, was the November 2008 forecast "virtually spot-on" when it came to inflation. Maybe it was as the model was accurate when it came to GDP growth. But I'm sorry, it was way off!

Not exactly the same accuracy in the inflation forecast of November 2008 as in the case of GDP growth. Notice that the model expects inflation to drop down to the inflation target in 7 quarters as it always does, no matter the current rate of inflation! 

Wednesday, 14 November 2012

Firms' cash flows

3rd draft of the thesis is done! My supervisor is reading it over and I hope he will be all right with it. Will meet him in two weeks or so, until then, it's time I revive this blog a bit!

Statistics Iceland issued, not long time ago, new data covering the cash inflows of Icelandic firms, based on their VAT reports. The bottom line: the nominal value is back up above pre-crisis levels in 2008 but the real value is still lingering below. There is a steep spike in the real cash flows however so the firms-part of the economy is picking up pace.

This is the nominal value of firms' cash flows. The sample is smoothed out with a running average. Notice the stagnant period in 2001-2003 when nominal cash flows were hardly or not growing at all. That compares to the 10% drop in nominal cash flows in 2009. 

Firms' nominal cash flows

This real cash flows story is another one a bit more frightening. Suddenly, the drop in 2009 has stopped being violent and has turned into a battle for existence!

Firms' real cash flows, 2012 price level

What is curious is to see where the drop comes from. And the answer: from the burst of the housing bubble. On the graph below we can see how industries have rocketed upwards as a share of the firms' total cash flows. At the same time, cars and car repairs have trended downwards for a long time. Most notably however, we can see that after the housing bubble burst, the "construction" has basically disappeared.

Graph shows how firms' total cash flows are split based on what they're doing. The burst of the housing bubble is rather obvious

The burst of the housing bubble is even more blatant in the next graph. Since 1970, the construction of residential housing has never been as low. That is so even if Icelanders are now 319,000 compared to 204,000 in 1970.

Number of square meters in new residential houses and flats, begun and finished, in each year. If you're a carpenter looking for a job, don't come to Iceland!

Of course, we can see on the sectoral cash flow graph that it is the Industries (manufacturing) that have kept the economy alive since the implosion in 2008: total value sold of manufactured goods doubled between 2007 and 2011 (reaching 727 billion ISK in 2011). Most of this comes from manufacture of basic metals (the smelters) but food products and beverages (the fishing industry, we've also become producers of many different brands of beers!) have done their parts as well.

I don't think anyone will deny that the utter collapse in the value of the krona helped industries keeping the economy alive. At the same time, the strengthening of the krona during 2002-2007 can be blamed at least partially for the deterioration of those same industries in that period. In the meanwhile, the housing bubble and the credit mania kept the economy going while the krona was too strong.

Maybe next time I'll check out the data for e.g. France and Spain but both economies had/have a housing bubble (don't tell me Parisian house prices are sustainable!) and then an economic slowdown, Spain in particular of course. Ireland would be a nice comparison as well. Have industries in Spain, Ireland and even France refuelled the economy to the same extent as has been the case in Iceland after the implosion in the housing market? Based on the prominent discussion about the growing current account deficit in France, I'm going to doubt it in case of her - at least until I see the data.