Carry trading geysers a risk for Iceland

he s

he surface of things, Iceland appears to be on the road to recovery. However, trouble could be bubbling under the country’s crust.

On 17 August, it took the decision to raise its main interest rate by a quarter point to 4.5 per cent, the first such move since the country’s banks collapsed in 2008.

But just how wise is this move? With this increase in interest rates, the Icelandic central bank has stated that it wishes to revive the carry trade, whereby institutions borrow in low yielding currencies and carry the funds into higher-yielding markets such as the Icelandic krona.

There are a number of reasons why this should set alarm bells ringing for investors.
In the years preceding the 2008 implosion of the Icelandic banking system, its financial sector bloated massively as the Icelandic government artificially raised interest rates in order to encourage investors to borrow in cheaper sterling, dollars and euros and dump this money into Icelandic assets. But this was not without risk. When the Icelandic krona eventually depreciated against these foreign currencies, some investors were hit with sizeable losses.

So, with other countries also engaging in this why was the kroner a more attractive target than others? At its peak in March 2008, monthly inflows of kroner investments hit 1.2 trillion (£6.5bn), despite Iceland’s GDP for the entire year being only 1.5 trillion kroner. But despite investors knowing they were playing with fire, Iceland had a big draw compared to other high yielding assets – implicit agreements by the Icelandic government and the IMF that they would prop up any failing bank and so the perceived exchange rate risk was reduced.

With Iceland’s credit default (CDS) swap rates so low, just 3 years after its banking sector crumbled into the tundra, it appears that we are seeing a return of the under-pricing of risk which allowed Icelandic banks to rack-up foreign currency denominated liabilities and drove speculation. “With 5-year CDS spread of 67 basis points between the EU average and Iceland, on the surface it can appear to be the better option,” says Brenda Kelly, market strategist at CMC Markets. “You have to wonder if European banks and other financial institutions see that as a sufficient margin given recent history?”

Iceland’s bankruptcy wreaked havoc on the Icelandic economy as well as damaging the economies of the UK and others. But as the authorities set out to actively encourage currency speculation again, they appear not to have learnt from the dangers of government intervention, and the damage that can be caused by the manipulation of monetary systems.