Last week saw a considerable rally in equity markets and only time will tell if it turns out to be a short covering rally or a more fundamental turn for the better. In economics the value of stock markets does matter as in recent years economists have been able to measure genuine wealth effects from such moves. These wealth effects can then influence consumption and the overall economy. However in the current world situation the economy also faces varies headwinds and it is one of these that has particularly affected Iceland and Eastern Europe which I wish to discuss today.
I noticed whilst I was reading the Herald Tribune on holiday an article on Iceland. It mentioned that a court decision had ruled that some loans taken out in Iceland are in effect illegal ( there are some suggestions that this was previously so but that it had not actually been enforced as the relevant law dates from 2001). The Icelandic Supreme Court ruled in a decision on June 16th that loans indexed to foreign-currency rates were illegal in three cases involving private car loans and a corporate property loan. The decisions may mean that borrowers with such loans are only obliged to repay the principal in Icelandic Kronur. This matters because against the likely currencies for such loans ( Japanese Yen and Swiss Franc) the Icelandic Kronur has dropped by around a third since the credit crunch fully hit in the autumn of 2008. To be more specific Iceland’s currency has lost 30 percent against the Swiss franc and 40 percent against the Japanese yen over this period.
This decision if it is enforced means that there are losses from these loans which must be taken in the main by the Icelandic banking sector. The Icelandic Central Bank has estimated that debt denominated in a foreign currency is 350 billion Kronur (2.2 billion Euros) in household/domestic lending and 3.2 trillion Kronur (20.2 billion Euros) in corporate borrowings/lending. This of course is the same Icelandic banking sector which her government spent a lot of money bailing out and recapitalising costing around 5 billion Euros.
Putting the scale of the problem another way the Icelandic Central Bank estimates that four out of 10 households took out loans denominated in foreign currencies to buy cars. And 80 percent of Icelandic homes have mortgages with payments either directly linked to inflation or denominated in foreign currencies. The reason that I include mortgages linked to inflation is that the fall in the Kronur has raised inflation too. It has been estimated that one in six Icelandic mortgages now represents more than 60% of the households take home pay. Ouch.
These numbers acquire even more significance when one considers that the Icelandic population is approximately 302,000. She has had considerable burdens to try to sort out as a result of her failed banking sector but many problems remain for her in my view. Not only are there the problems above but a month or so ago the European regulator the EFTA Surveillance Authority ordered Iceland to repay the 3.8 billion Euros lost by UK and Dutch depositors in the failed Icesave bank, rejecting claims that Reykjavik is not legally responsible for the money. I note that Paul Krugman wrote on Iceland recently and implied that things were in the circumstances going well whereas I feel that new troubles may be accumulating and that such a conclusion is premature. It is becoming a feature of the credit crunch that (so-called) solutions often bring up new problems.
The Cause of this the Carry Trade: What is it?
This particular strategy has turned up in a lot of areas over the past decade and in all of them I can think of it has in the end gone bust. However returning to its definition it usually involves borrowing in a foreign currency because the interest rate in that currency is lower. This is why the Swiss Franc and the Japanese Yen are involved because over the recent past their interest rates have been and indeed still are very low in international terms. Japanese overnight money is at around 0.1% and her ten-year government bond yield is at 1.2%. So as we stand in terms of pure interest cost it is still attractive to borrow in Japanese Yen. If we go back in time to the middle of the last decade we can see why such deals may have looked good. In 2006, when the Bank of Japan’s policy rate was 0.25 %, Iceland’s benchmark reached a peak of 13.3 %. Making 13% a year before costs is tempting isn’t it?
The flip side of such an arrangement is the capital risk which is represented by the danger of a fall in the exchange rate. Of course one may also benefit from a rise in the exchange rate but in general terms the reasons for the interest rate differential are usually associated with a fall in the exchange rate. Accordingly you might say that a carry trade has within itself the seeds of its own destruction and this is often how it turns out. As more and more investors join in the game it becomes ever riskier as it becomes harder for them to get out. It is a fact that a natural human feeling,safety in numbers, is in fact a serious danger in a carry trade.Also foreign exchange markets have an uncanny habit of spotting such things and putting them under pressure. As I shall explain below this trade went much wider than Iceland.
Eastern Europe and the Swiss Franc
I wrote on about the issues facing the Swiss National Bank and the Swiss Franc on the 10th June. Well today I will discuss one of the causes of this problem and something which has its own problems which are spread around central and eastern Europe. Borrowing in Swiss Francs was spread much more widely than just Iceland. To a considerable extent, the strong growth of private consumption over the pre-Credit Crunch years in some Eastern European countries such as Hungary and Poland was financed by borrowing. Given the relatively high interest rates in these countries, households increasingly opted for a cheaper alternative and found it in foreign currencies such as the Euro and the Swiss Franc. Austria too has a large number of loans in denominated in Swiss Francs which were taken out to either finance consumer spending or as mortgage loans. The usually foreign banks which granted these loans mostly refinanced themselves in Swiss Francs as they were unwilling to take on a currency risk. So back in the middle of the last decade we had in effect a depressing influence on the Swiss Franc as borrowers in Austria, Hungary, Poland and Iceland amongst others denominated their loans in it.
So here was a clear danger the carry trade was in itself by the size of its operation (relative to a small open economy like Switzerland) an influence on the Swiss Franc exchange rate which made the carry trade look more attractive. Oh dear. So borrowers piled in on a grand scale. Such a position is always vulnerable to an unexpected shock and the Credit Crunch fitted this category. In terms of initial moves the Swiss Franc rallied as Switzerland’s stability appeared very attractive to investors as they became more fearful. By March 2009 the Swiss Franc had rallied 15% against the Euro since the beginning of problems in the autumn of 2007. The moves against Eastern European currencies were faster and larger as over the period August 2008 to March 2009 the Swiss Franc rose against the Polish Zloty and the Hungarian Forint by more than 30 %. This is where my two articles come together as it is in March 2009 that the Swiss National Bank began to try to slow/halt the increase in its currency. My view is that whilst it was operating for domestic reasons it was also operating to stop these loans becoming a millstone around foreign borrowers necks. Perhaps one day we will discover that it was also operating for other central banks.
Did the intervention work?
Sadly not. In March 2009 the Swiss Franc/ Euro exchange rate averaged 1.51. So far this month it averages 1.33. There has been more stability against the Forint and the Zloty but they had fallen by more as an original impact.
Just to add to the list of problems from the carry trade the failed intervention from the Swiss National Bank has cost it on a marked to market basis at current levels somewhere around 7.5 billion Euros.
We do not know how many loans have been hedged or “stopped out” but it is clear that their existence and problems has been a big headache for the Swiss National Bank and indeed the Swiss economy which has to trade with a currency which was 1.60 against the Euro in 2007 and is now 1.34.
The Impact of this on the borrowers
For borrowers who receive their income in local currency, this means significant increases in their interest burden and the equivalent amount of their loan in local currency. So there will have been a depressing recessionary effect on the economies concerned.
The Swiss Francs high level against the Forint is compounding Hungary’s woes as the nation’s borrowers, more than 80 percent of whose foreign loans are in Swiss Francs struggle to service growing debt burdens. Readers may remember that recently in a spectacular own goal Hungarian government officials raised the spectre of a Greek-like crisis in Eastern Europe’s most indebted nation and this put a currency which was improving a little back under pressure again.
After last years 6.3% contraction in her economy and with issues from all her foreign debt Hungary has been forced to negotiate a rescue package of some 25 billion Euros with the European Union and the IMF. Those familiar with the austerity mantra of these two bodies will not be surprised to see that the price of the aid is that she will have to impose a bank tax and public sector cuts.Those measures threaten to hamper growth in Hungary which is the European Union member with the biggest proportion of Swiss Franc debt. So far Hungary the Swiss Franc exchange rate will be a vital factor in her economic future. Nomura estimates that some 2.5% of the 6.3% contaction in the Hungarian economy last year was caused by the rise in the Swiss Franc.
To put a scale on the problem then according to the Hungarian central bank household foreign-currency loans amount to 5.4 trillion Forint, or 67 % of total loans, with 4.4 trillion Forint, or 82 % of them owed in the Swiss Franc. Businesses owe 4.4 trillion Forint in foreign currency, or 58 percent of the total, the data showed. The bank does not break business loans down into individual currencies unfortunately. I have to confess that I find the scale of these numbers somewhat shocking.
Capital Economics has published some estimates for the scale of foreign currency borrowing in Eastern Europe and they are equally disturbing. Foreign-currency loans account for 91 % of total lending in Latvia, 87.1 % in Estonia and 71.8 % in Lithuania and in Romania and Bulgaria, they represent about two thirds of borrowing.
The scale of what has occurred in Eastern Europe and Iceland is likely to be a deadweight on their economies for some time to come. It has if you think of it made them incredibly dependent on investors views on risk and risk aversion. If they get nervous and look for security they may well buy the Swiss Franc which would raise the value of the debt denominated in it. If they retain an appetite for risk then the rise in the Swiss Franc may stop. To my mind this is an incredibly risky position to be in.
Switzerland herself has been affected by something completely out of her control and something which even in the test cases for a small open economy did not appear in economic text books. Foreigners denominating their debts in her currency is something completely out of her control and yet has many and serious implications for her.
For those who believe that regulation alone is a solution to our current problems then Iceland’s law of 2001 has disturbing implications. Imagine how different her future might be if this has been enforced when it was enacted in 2001. The point is that it was not and can we be sure next time will be any different?
I have written today about the impact of these loans on economies and individuals but think of the banks which have made such loans. For example Austrias banks were heavily involved in these foreign currency loans to Eastern Europe and some of the German and Nordic banks were not far behind. If I was constructing a stress test for banks haircuts on foreign currency loans would be in it and I hope that it will be in the euro zone’s stress tests on the 23 rd July.
The underlying theme of today is that there are quite a few problems that remain to be solved and that several years now into the Credit Crunch I still search vainly for governments which are implementing genuine reforms and I fear that a genuine improvement will require them.
UK GDP update
I intend to write in depth on the UK economy tomorrow but want to make a brief comment on todays figures. The headline unchanged figures for the first quarter of 2009 at +0.3% hid some disturbing changes in its breakdown which do not bode well. Furthermore the decline caused by the credit crunch was revised down from -6.2% to -6.4% so in total terms we are worse off. Oh and of course they were delayed which is not entirely reassuring.
As we appear to be losing the good weather I have gone back to last week to find us some better news! The U.K.’s pace of economic growth more than doubled in the second quarter to 0.7 percent according to the National Institute of Economic and Social Research or NIESR. Let’s hope they prove to be correct.