Monday, February 16, 2009

Iceland’s Krona

I’d like to comment on a currency that is said to have collapsed last October (2008), and its political system has been in upheaval since. Against U.S. dollars, Iceland’s Krona typically trades in the 1-2 cent range. When I last checked, it is just under half a cent. Iceland’s economy has suffered wild gyrations on the international stage, but here I will try to pull relevant details as it relates to the printed currency, credit, and sales in Iceland.

Iceland’s economy, at first glance, appears strong. The CIA world factbook reports: “Literacy, longevity, and social cohesion are first-rate by world standards.”… “Iceland's Scandinavian-type social-market economy combines a capitalist structure and free-market principles with an extensive welfare system, including generous housing subsidies. With this system, Iceland has achieved high growth, low unemployment, and a remarkably even distribution of income.”

But: Iceland has been on a credit binge. Its external debt is around 50B euros, compared to its GDP of 8.5B euros (numbers vary, probably due to currency fluctuations, but debt remains steady at 6x GDP). That’s huge! With that kind of borrowing, it should be easy to maintain a prosperous welfare state… at least for a while.

With foreign credit pouring in to Iceland’s economy, prices rose. Blogs from foreign visitors complain of the surprisingly high price of meals there, for example. To fight the rampant inflation, the central bank raised interest rates up to 15%, which isn’t a bad return at all, and so the world flocked to Kronas.

Though it has been suggested Iceland’s central bank was rather loose in currency printing, we aren’t seeing wheelbarrows full of cash—or bank notes in the billions and trillions of Krona. This isn’t hyperinflation. This isn't Zimbabwe. This was a Krona bubble.

Eventually there came a crisis of confidence in the banking system, and the Krona was sold off, quickly, by foreigners. Its markets collapsed, and it has become obvious Iceland will not be able to pay back its debt, bonds, or foreign deposits in its international banking system.

So, then where does this leave the Krona? The huge contraction of defaulted credit would strengthen its buying power—prices would fall—if cash and inventory stay constant. However Iceland’s foreign creditors will not walk away easily and a lot of GDP stands to be sent offshore as repayments. Iceland’s markets will be tight for some time. Iceland's balance sheet shows base money expansion (12/31/07: 168B Krona; 12/31/08: 411B Krona; 1/31/09: 376B Krona) which would put downward pressure on its value—but this is unlikely anywhere near the amount of credit lost to the system. So, if we have declining inventories, declining credit, increased cash, but an overall decline in money supply, then prices in Iceland in Krona can go either way and the Krona is likely to remain weak on world markets but still alive at home. I anticipate that any advantage to Icelanders holding Krona, given the shrinking money supply, will be mitigated by upward price pressures due to scarcity of inventory.

Here, the devil is in the detail, and what I’ve presented is a general schematic. This blog attends to the strength of cash in the face of financial turmoil, so the fall of a world currency through a mechanism other than hyperinflation is of interest. More of Iceland’s story will be reported as it unfolds.


East.Bay.Miser said...

...this is one of your longer articles...I'll assume their hosting or ownership of EVE has something to do with it(emotional connection)

SF Mechanist said...

hehe... actually, I signed up for EVE the day I posted this. I've been through tutorial. So far so good. I'm sure CCP appreciates its steady revenue of foreign currency.

But with smaller economies crashing around the world, that have mostly evaded headlines, I do want to broaden the international scope here and post more of those types of stories.