Wednesday, 9 January 2013

The non-indexed mistake of the Icelandic government

"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens."
- John Maynard Keynes

I've mentioned before (here and here) that indexation in Iceland is a peculiar beast. In the first post on the indexation I mentioned that the main issuer of indexed (to the Consumer Price Index) securities in Iceland is not the government but households. In most countries, households wouldn't even think of taking a CPI-indexed loan but for a long time there was nothing else offered in Iceland. Normally, it is the government which issues the indexed bonds. We have e.g. the TIPS in the US, the indexed Gilts in UK and many others (see a Wikipedia list here).

We do things differently in Iceland. Off the CPI-indexed bonds registered in the Icelandic Stock Exchange, 83% of them (based on market value) are Housing Financing Funds bonds which are used to finance the mortgages to households through the HFF. The HFF has a government insurance behind it in case of lack of liquidity or equity, but the HFF is nothing else than an intermediary of indexed debt which the households are effectively issuing. And it is the households which have to carry the first part of the burden in case of problems. HFF can e.g. increase the interest rate mark-up and repossess one's house if the indexed mortgage is not repaid before the government's coffers are opened up to bail the bankrupt HFF out of trouble - which has happened recently and will only happen again given the awful financial cold the fund is suffering.

The market value of debt securities in the Icelandic Stock Exchange. The predominant issuer of indexed marketable securities is the household sector through the indexed HFF bonds.

This misallocation of the burdens of indexation creates a perverted incentive for the government and a massive problem in the wake of that which only hits the government itself in the back of its head.

As its debt is predominantly non-indexed to the rate of inflation, the government has limited reason to make sure that price increases are not excessive. Possibly, it might even want to "inflate" its debt away by allowing inflation to be just a bit higher than it would have if the incentive to "inflate away" wasn't there. But of course, too much inflation would lay waste to the balance sheet of households and that is, unfortunately, somewhat what has happened.

Let's take an example. The bailout money the government raised by issuing bonds to investors was, as one can see by glancing on the graph above, almost entirely in non-indexed bonds (this does not include the foreign-currency bailout money we got from the Scandinavian nations, the IMF etc.) The total market value of non-indexed government bonds, partly because of a lower rate of interest but mainly due to new issuances, increased by a spectacular 539 per cent between year end 2007 and year end 2010 when all the savings-bank bailouts were passed and the reconstruction of the financial system was, for the time being, finished. (Not included in this increase is the bond which was issued to strengthen the equity base of the Central Bank of Iceland after it became technically bankrupt (negative or too low equity) for that bond is simply kept in the Central Bank and not on the market.)

Why was the bailout money not raised in the form of indexed government bonds? Was it because the government did not want to carry the full cost of the bailout and instead throw it on the shoulders of households whose debts are to a large extent indexed?

Who knows! But what we do know is that the government has been raising taxes since the collapse to raise money for the bailout. Tax increases, especially VAT and excise taxes, raise the CPI (although they have nothing to with actual inflation!) and that increases the cost of CPI-indexed bonds. "Luckily" for the government, that cost is not in place for it since the debt it has issued in the recent years is, as already highlighted, mainly non-indexed.

But of course, the CPI increases, caused e.g. by higher taxes and possible pet-projects of perverse politicians, affect the indexation of households' debt. So the indexation-cost comes on top of the increased tax burden for households, adding insult to injury. Of course, this all ends up with a record number of delinquencies and defaults, which again means that the HFF suffers losses as well. Those losses are first borne by the households but when they cannot continue paying, the government, originally trying to reasonably inflate its debt away, has to step in and boost the equity foundations of the HFF. Recently, 13 billion ISK of government money were earmarked for the fund. That amount will only grow in the future.

Chart III-7 in the 2012/2 Financial Stability Report by the Central Bank of Iceland

So the government, by issuing almost only non-indexed debt after the collapse, tried to sway away from an important incentive it should face to help keeping inflation at bay. Instead, the government created, intentionally or not, a reason for itself to allow inflation to increase and inflate its debt burden away: the CPI has increased by 25% since October 2008.

But at the same time, increased inflation only increases the debt burden of indexed mortgages and bankrupts the household sector. Then, "what goes around, comes around" and the government experiences unpleasant but repeated visits from the Housing Financing Fund as the bankruptcies of households ruin its balance sheet and it needs more and more equity injections.

Maybe the government should have stopped fooling around long time ago and issue indexed debt contracts instead, thereby joining the anti-inflation team instead of boosting the ranks of the other team? Luckily, it's not too late yet to switch sides!

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