April 1, 2006
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 ï¿½ 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 ï¿½hotï¿½ 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 stateï¿½s 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 Kindlebergerï¿½s 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 Icelandï¿½s stable relatively higher interest rates, which gave the Icelanders money to play with. The stage was set for Kindlebergerï¿½s cycle.
Stage two ï¿½ euphoria – happens shortly afterwards, when asset prices begin to rise and all the boats start to lift on the tide. In Icelandï¿½s 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 ï¿½ a pensioner -was solicited by one of the largest banks in the country challenging him to ï¿½liberateï¿½ 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 ï¿½ï¿½godï¿½ï¿½.
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.
Kindlebergerï¿½s 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 Kindlebergerï¿½s 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: ï¿½ï¿½The time to buy is when everyone else is selling, and vice versa.ï¿½