April 1, 2006

Hot money is beginning to melt Iceland's hardy economy

Posted in Banks · 14 comments ·
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Unlike today, when Dublin gets more than four million visitors per year, in the dark days of the early 1990s regular tourists here were few and far between. However there was one bunch who came loyally – almost very weekend. They came to shop because – weird as it may sound now � Dublin was far cheaper than their home town.

They also came to drink because, again, Ireland was a much cheaper place to socialise. They were recognisable by their accents and their friendliness. They were from Iceland, and in pre-boom Ireland, people from Reykjavik were frequent visitors to Grafton Street and its nearby pubs. Some time in the mid 1990s, as Ireland became increasingly expensive, they stopped coming.

This week, Iceland is in crisis. It is on the brink of a currency collapse, money is flowing out, its banks are finding it difficult to keep credit lines open, and an Asian-style crisis appears imminent. But what happened? How could a country full of hardy people known for prudence find itself in such a mess?

The answer is: debt. In recent years, Icelanders started borrowing in huge amounts to finance massive acquisitions abroad. Personal debt rose tenfold and total debt as a percentage of income rose rapidly to 86 per cent.

For a few years, things were moving along nicely. The stock and housing markets roared ahead. As long as global interest rates remained low, Iceland could borrow significant amounts and spend at will. The central bank of Iceland kept interest rates above 6 per cent and this was deemed sufficiently attractive for yield-hungry investors to keep their money in Reykjavik.

However, the sting in the tail is that all this �hot� money can leave as quickly as it arrives and sometimes, the trigger for a change in investor sentiment appears very remote indeed. As we saw in Dubai a few weeks ago, an increase in Japanese interest rates has had a detrimental impact on the Gulf state�s stock market, without anything untoward happening in Iceland itself. So when the Bank of Japan indicated that it would increase rates, investors sold their positions in Iceland. But why? Is there any remote connection between Tokyo and Reykjavik?

No, there is not, but investors borrowed in low-yield yen to put on deposit in high-yield Icelandic krona. As long as Japanese interest rates remain low, this made sense and the Icelandic system got an injection of liquidity. When Japanese rates began to nudge upward, the investors cancelled the bet and took their money out of Iceland with the effect of causing a liquidity crunch. In responses to this liquidity crunch, the Icelandic central bank this week, pushed rates up to 10 per cent which simply scares investors and means that more and more money leaves. So we get a self-reinforcing negative monetary cycle, only months after a self-reinforcing positive cycle.

Iceland is experiencing the tail end of a classic textbook boom/bust credit cycle.

This cycle is best summed up in Charles Kindleberger�s seminal work Manias, Booms and Panics, which was first published in 1947 but is still invaluable reading for anyone interested in credit booms and assets cycles. Kindleberger – a renowned economist – studied many booms in prices from tulips to stocks and houses, and he maintained that all credit cycles follow seven similar stages.

The first stage is the looser credit stage.

All booms start by a change in the credit regime which allows interest rates to fall and liquidity conditions to ease. In Iceland, this happened with the lifting of exchange controls in the late 1990s. This meant that anyone who liked could invest in Iceland and Icelanders could invest anywhere themselves. This allowed investors to take advantage of Iceland�s stable relatively higher interest rates, which gave the Icelanders money to play with. The stage was set for Kindleberger�s cycle.

Stage two � euphoria – happens shortly afterwards, when asset prices begin to rise and all the boats start to lift on the tide. In Iceland�s case, this was mainly evidenced in the Reykjavik housing market.

Everyone becomes delirious, with easy money being made, and suburban Donald Trumps strutting their stuff.

The third stage is the gearing stage.

This is where the banks begin to get in on the act and offer equity release facilities to anyone with a piece of property. We have also seen this in Ireland. Recently, my father � a pensioner -was solicited by one of the largest banks in the country challenging him to �liberate� equity. The man is 75, in no need of the cash and with no visible or prospective means of paying the money back. Yet the bank feels it prudent that he leverage himself up. The gearing stage leads to an avalanche of credit dumping down on the economy and it, in turn, causes values to rocket up further.

The fourth stage is the mania stage, where the euphoria gives way to a type of messianic behaviour where people begin to queue overnight for apartments and all pay homage to the might of the property ��god��.

The fifth stage is the bubble stage, where the pseudo-psychology of the euphoria and mania stages is fuelled by the liquidity of the gearing stage. Prices rise to ridiculous levels and investors start to buy trophy assets rather than sound investments.

At the top end of the market, the big beasts of the market outbid each other publicly for assets they would not have touched at that price only a few months previously. At the lower end of the market, the bubble stage sees investors buying at yields that just about cover the cost of borrowing.

The sixth stage is the distress stage, where income from the asset – whether it is rental yield or dividend yields – begins to soften. Savvy investors start to get out in the distress phase. They see little underpinning the market and, as a result, take profits. Initially there are sufficient buyers to take up the slack, but in time, sentiment begins to turn and the overhang of supply on the market makes it impossible for yields to rise.

Kindleberger�s seventh and final stage is when everyone realises that there is no value in the asset. This is what happened in Iceland last week. The rating agencies have downgraded Icelandic debts, money is flowing out and interest rates are rising in response. The currency is falling in tandem with the panic, and share prices across the board are falling.

Iceland, unlike Ireland, is not a member of the eurozone and therefore, its excesses cannot be fudged in the way ours can. Luckily, we do not have to endure the sudden stop/go characteristics of a country with its own currency and exchange rate. In many ways, this protects us, but in others, it desensitises us from the excesses of our own boom. Where do you think we are in Kindleberger�s seven stages? For those of you who are worried and believe that we may be close to the top, maybe selling here today and buying in bargain basement Iceland in the months ahead is the winning strategy.

As Nathan Rothschild famously claimed: ��The time to buy is when everyone else is selling, and vice versa.�


  1. Laura

    Would this perhaps explain why AIB are considering selling
    their entire Irish property portfolio? And why British
    Land, after nearly 2 decades in Ireland, quietly sold out
    some time ago?

    Seems to me that Japan might not be such a bad place to
    invest as it was a few years ago.

  2. JB

    Well, David, judging for your recent articles, the “good
    times” will be over soon for Ireland.

    And, what will we do? I’ll tell you what the Irish will do -
    they’ll do what they do best, that is, run away.

    Back in the seventies Bob Geldof wanted to set up a
    classifieds magazine like Buy & Sell. So, he went to the
    bank manager for a loan who refused him and famously told
    Geldof to “come back when you are 40″. Well, what did our
    Bob do? Did he try to raise the money other ways, say from
    his old Blackrock buddies or family, did he try to get small
    loans from a number of banks/credit union , did he get any
    sort of a job and scrimp and save? No, he did not. He did
    what the Irish always do, and got the hell out of here. What
    was it he once said, and I paraphrase here, “the best thing,
    roight, about Dún Laoghaire, roight, was that the boat left,
    roight, from there,”. Imagine, if Bill Gates, Steve Jobs and
    countless other Americans gave up so easily? Geldof,
    obviously a talented individual, had an opportunity to be a
    leader, but like most Irish people in that situation, he
    only knew one thing to do – run away. Perhaps, after the
    destruction of our social strata from the 1540′s to 1602,
    through to the 1690′s, we don’t have an example to follow.
    We only know one thing, emigrate. Maybe, we don’t know how
    to lead, to set examples.

    The reason I bring this up is that if our economy goes belly
    up, we will have to rely on talanted people, like Bob
    Geldof, who are in a position to change things, if they
    apply and dedicate themselves. And, like David recently
    wrote, in the last wave of emigration, the talented Irish
    left. They abdicated their responsibilities. An act of
    treason in my book.

    What will happen to Ireland, David?

    What is Ireland anyway, a modern European Nation or Backward
    British Province?

    English Language
    English Television
    English Christian and Place names
    English Newspapers,Magazines,Books
    English Accents – listen to the a and o vowels
    English Sports
    English Shops (and distribution/advertising)
    English Food/sweets

    Oh, and don’t forget, it’s now Mum, not Mam or Ma.
    It’s now High Street not Main Street.

    For one week do the following:

    1 Listen to the ads on the radio
    Why are Irish people putting on English accents? Listen to
    the a and o vowles. They seem desperate to make them
    English. Although, the ones in the middle of a word are a
    bit harder for them. And why no Irish accents? Is there a ban?

    2 Read the Irish Times.
    Look out for “in the UK, in the UK, in the UK, in the UK”,
    you get the idea. Note how every single idea the government
    has it has aped from the British government. (When the
    Master moves, the Mick follows!!).
    Everything has to be compared to the UK and referenced to
    the UK. The UK seems to have complete hegemony over us.

    3. Go into a Newsagent/Bookshop (The heart of any country’s
    intellectual life)
    Why are British newspapers/magazines give equal satus
    (position wise) to Irish ones and sometimes even a better
    one? Shocking. How can well allow our intellectual life to
    be taken over like this?
    Now, take a look at the sweets for sale. All British (or
    American via Britian). Can we not create our own sweet
    culture? Take a look the the greating cards. Yes, all British.
    How many jobs are we losing to all this?

    4. Shops
    When your in a shop notice how most of the goods are
    British. Read the labels. Most of them will have a PO Box
    number for Irish consumers. Yes, that’s what we are now, a
    PO Box!

    5. Accents
    Listen to the people’s accent. Why are we so desperate to
    have generic accents. Take Pat Kenny for example, he’s
    anyman from anytown, anywhere, anyplace.
    Any, why are Irish (country and Dublin) accents banned from
    TV/Radio.
    Is anyone else disappointed by the charmless and
    characterless accents that Irish people now have?

    By the way, I’m not in any way anti-English. I have worked
    there and found the English to be a friendly and talented
    people. However, we are not English and the only thing we
    will become are provincials, hicks if you will, if things
    keep going the way they are. Provincials are dreadful, nasty
    and charmless people (take Dublin 4 people for example). The
    Irish are a national,ancient people, not some Yahoo’s who
    sprouted up yesteryear.
    I’m am heartbroken and disappointed the way Ireland is going .
    As bad as things were before,as least we had dear old
    Ireland. There was hope of which there is none now.
    Where are out leaders?

  3. Dan Hayes

    David & Co.:

    JB ended his most perceptive comments with the query “Where
    are our leaders?”. I’ll tell all where they are! In the hip
    pockets of the powers-that-be that have been running the
    show since the self-proclaimed Enlightenment!

    Get used to the fact that today you are West Britons.
    Tomorrow who knows what the Davos crowd has in store for
    us.

  4. Pete

    >we do not have to endure the sudden stop/go
    characteristics of a country with its own currency

    I’m sure I remember David writing a few years ago that
    being in the eurozone would lead Ireland into bigger
    economic boom-bust cycles, because we would have no
    control over our interest rates. Now he says the
    euro “protects” us. Are these views inconsistent?

    The text-book end of a boom/bust credit cycle is the
    currency sell-off that Iceland is experiencing. Ireland
    cannot experience that, because the size and stability of
    the eurozone does indeed protect us. Which means that the
    credit boom can continue much longer than it should, until
    it either:

    1. Ends in some other non-textbook way, which will
    probably be even more painful than the textbook ending.
    This would justify David’s apparently inconsistent views,
    as the protection of the euro would indeed have caused a
    bigger boom and bust.

    2. Levels out but doesn’t bust, thanks to the buffering
    protection of the eurozone keeping interest rates low and
    the currency value high despite our excesses.
    This seems quite plasible to me.

    2. Continues for ever. It sounds crazy, but so many crazy
    things ave happened in the Irish economy in the last few
    years, I refuse to be surprised any more.

    JB,
    I wish Ireland really did closely study the UK when making
    decisions. It seems to me that Irelands plods along about
    15-20 years behind the UK, making all the same mistakes.
    If we looked at what they did when faced with varous
    situations, and what did and didn’t work, we might avoid
    some mistakes here.

  5. JB

    Pete,

    So, let me get this straight. You want us to study the UK
    more closely so we don’t make the same mistakes that they do.

    Hmmm. Now, what’s the problem with that statement. Let me
    think for a moment.

    Oh, yes, I’ve got it.

    The UK does everything first.

    So that means we can study what they’ve done and learn from
    their mistakes. Well, by God, if that doesn’t make us
    provincial, I don’t know what does. How can we ever develop
    as a nation, how can we ever develop our own intellectual
    live if all we can do is “study” what ONE other country does.

    In my judgement we should develop our own intellectual life.
    And that means thinking for ourselves. Making our own
    mistakes and learning from them. Not slavishly following the
    UK. Or any other country.

    Pete, where are you from? I’ll hazard a guess and say you’re
    from Dublin?

    They don’t can you Jackeens for nothing you know. (Jack -
    from John – meaning John Bull – een – from the Irish suffix
    ín – meaning little – giving Jackeen – meaning little
    Englishman!!).

    One other problem with your statement Pete. It hardly
    epitomizes the best qualities of the Irish people. Hardly an
    aspiration is it?

  6. Tom Farrell

    So the collective wisdom of this web site is that we are
    heading for the mother of all busts after the mother of all
    booms because:

    1)Our once-off unique position as an open competitive
    economy in a much larger slow-growth economic bloc led to
    the situation that interest rates were/are inappropriately
    low. Europe’s misfortune was Ireland’s gain -> boom created.

    2)We fell for the US consumer model hook, line and sinker,
    i.e. spend and borrow to the hilt -> bubble created.

    3)Rising costs (assets, wages, etc.), lack of real
    productive capital investment (R&D, infrastructure,
    education), and availability of other low-tax EU locations
    has eroded our competitiveness…AND…the larger economies in
    EU are finally starting to move (e.g. Ger) which implies
    rates will rise -> creates the ‘perfect storm’…bubble
    soon-to-be-burst?

    So does all of the naval gazing boil down to one simplistic
    conclusion, i.e. we will boom as long as the big EU
    economies don’t? Seems overly simplistic…even for the
    ‘dismal science’ if I may say so. I’m none the wiser.

    Tom

  7. Seán

    Our current health and agriculture models are borked, but we
    focus most of our our money and energy on bricks and mortar.

    1. Food
    - We are slowly poisoning our food supply and environment.
    - We don’t know what a nutritional or healty diet is.
    - Our food production sector is held up by EU subsidy.
    - Our Agricultural output is falling.

    2. Medicene
    - Our health service has become a bureaucratic nightmare.
    - The more money we throw at it the worse it gets.
    - The majority of our doctors learned by rote and have very
    poor diagnostics skills.
    - We are prisoner to a patented medicine industry that
    extorts excess amounts of money from us by focusing on
    treatments rather than cures.

    Its time for radical thinking in these areas, lets sponsor
    ideas from people who can think differently.
    Lets get a real enterprise and research & development
    culture going in Ireland and solve our own problems at the
    same time.
    This will pay us dividends over time – property never will
    do that.

    Why not?

    We’ve got the people.
    we’ve got the money.
    we’ve got the solutions.

    All we need is our community to move away from this so
    called “property investment” mania and apply ourselves to
    creating new oppertunities that produce real wealth and value.

  8. Deirdre

    While researching a presentation for college on levels of
    personal debt in Ireland a few months ago I came across
    this website & I have read with interest the majority of
    articles & comments. The conclusion I have reached is that
    Irish people are aware that this situation we find
    ourselves in cannot continue but are quite content to act
    as if it can & as the Navajo proverb says “you cannot wake
    up a person who is pretending to be asleep”.

    I’m also reminded of a quote by Harold Stephens “There is
    a great difference between worry and concern. A worried
    person sees a problem, and a concerned person solves a
    problem”. I do believe you are only worried, show us some
    concern, our government & banks will not.

  9. Rob

    JB, I have to say you sound like you are carrying a lot of
    anger around with you. Anything positive to say? As for
    the argument about copying the UK – i see nothing wrong
    with implementing policies that have been SUCCESSFUL
    elsewhere. This is simple common sense. Obviously we
    should ignore the policy failures of other countries. We
    are not nor should we aim to be like a North Korea,
    hermetically sealed off from the rest of the world,
    stabbing in the dark with hare-brained schemes. If it
    works, use it. If it doesn’t, discard it. This is the
    essence of globalisation. Let’s not go back to De Valera’s
    isolated Ireland of comely maidens and dancing at
    crossroads. This doesn’t mean we are losing our identity
    either.

  10. JP

    Just a quick observation about Dublin 4. I have lived in
    D4 for 15 years. In that time I have found that the people
    who are the worst offenders in the snob stakes are those
    who arrive from the remotest parts of rural Ireland. The
    first thing they ditch is the country accent. They cover
    any trace of country heritage up lest they be thought of
    as unsophisticated. The native D4 people are, in the main,
    open, courteous and down to earth and shudder at the
    antics of the “country boy/girl done well” scrabbling to
    impress. Its the ultimate joke on our country cousins that
    the are responsible for the D4 phenomenon that they
    despise.

  11. copernicus

    I often wonder when this housing bubble is spoken about if
    the market in the country as a whole is being referred to or
    what. I think there are two markets myself, one inside the
    Pale and one beyond it and at an accelerating rate two
    economies developing, again inside and outside the Pale, one
    being more robust than the other and, therefore, one housing
    market being more robust than the other.

    Dublin is probably creating its own momentum at this stage
    and demographics might be more enlightening than the boom
    and bust cycle in terms of forward planning within the Pale.
    Outside, the reliance on large, globalised employers,
    diminishing rural sustainability (though this has the
    potential to change in the context of peak oil, food
    security and alternative energy production I think) and the
    failure to properly roll out road, social and broadband
    infrastructure all have the potential to cause massive upset
    in the event of a turn for the worse internationally.

  12. copernicus

    I often wonder when this housing bubble is spoken about if
    the market in the country as a whole is being referred to or
    what. I think there are two markets myself, one inside the
    Pale and one beyond it and at an accelerating rate two
    economies developing, again inside and outside the Pale, one
    being more robust than the other and, therefore, one housing
    market being more robust than the other.

    Dublin is probably creating its own momentum at this stage
    and demographics might be more enlightening than the boom
    and bust cycle in terms of forward planning within the Pale.
    Outside, the reliance on large, globalised employers,
    diminishing rural sustainability (though this has the
    potential to change in the context of peak oil, food
    security and alternative energy production I think) and the
    failure to properly roll out road, social and broadband
    infrastructure all have the potential to cause massive upset
    in the event of a turn for the worse internationally.

  13. David Mc Williams

    Thanks everyone for all your comments. I am hosting a
    debate on the property market at Leviathan – a political
    caberet night I host every month. Next one on the first
    thursday in May. I would like to have some new voices
    speak on the boom and its effect on our society. Anyone
    fancy joining the debate. If so, email me to
    info@davidmcwilliams.ie. thanks D

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