investors remain very jittery over Sweden’s potential exposure to currency devaluations in Baltic

TO BE NOTED: From Alphaville:

"Is Eastern Europe on the edge again? Posted by Izabella Kaminska on May 29 09:34.

Edward Hugh over at A Fistful of Euros draws our attention to the following warning over the Baltic region issued by Danske Bank on Thursday:

The event risk has risen sharply in the Baltic markets and we advise outmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

The big fears are mainly focused on Latvia, which following a disastrous Q1 GDP reading of -18 per cent is literally teetering on the edge, according to some commentators. Hugh offers some more context:

Swedish banks have claims in Latvia, Lithuania and Estonia amounting to about $75 billion, according to ING Groep NV, with SEB, Swedbank and Nordea accounting for 53 percent of Latvia’s lending market. Sweden’s central bank raised the amount of euros available for the Latvian central bank to swap for lats to 500 million euros ($670 million) at the start of May. Latvia’s central bank first entered the swap agreement with both its Swedish and Danish counterparts to borrow as much as 500 million euros for lats last December. The Riksbank was to provide 375 million euros and the Danish central bank the remainder.

Latvia has already spent over 500 million euros buying lats this year to support the currency.

Certainly, investors remain very jittery over Sweden’s potential exposure to currency devaluations in Baltic. Shares in both Swedbank and Skandinaviska Enskilda Banken fell sharply on Thursday as the market widely interpreted the Riksbank’s move to rebuild currency reserves as a signal it may be preparing to inject liquidity into commercial lenders.

But while prospective Baltic devaluations may already be having far-reaching effects on Swedish lenders operating in the region, the wider implications: eg. those that a Baltic state could very realistically default some time soon, should now really begin registering as a possibility among investors.

Just how a green-shoot obsessed market would react to such a piece of news is the big question.

Related links:
The Eastern European carry-trade meltdown, reviewed - FT Alphaville
Estonia, nul points - FT Alphaville
Emerging market credit fundamentals deteriorating, S&P says - FT Alphaville

This entry was posted by Izabella Kaminska on Friday, May 29th, 2009 at 9:34 and is filed under Capital markets. Tagged with Eastern europe, Latvia."

And A Fistful Of Euros:

"Danske Bank Warn On The Baltics by Edward Hugh

Danske Bank has issued the following advice to investors:

The event risk has risen sharply in the Baltic markets and we advise utmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

No comment.

The krona fell for a third day after the Riksbank announced the loan, and declined more than any of the 16 most-traded currencies against the dollar and the euro. Stefan Ingves, central bank governor, said in the statement that the financial crisis may be “prolonged”. Since the start of the financial crisis, Sweden has spent 100 billion kronor on swap agreements with Iceland, Estonia and Latvia and on dollar injections into Swedend’s financial system.

Swedish banks have claims in Latvia, Lithuania and Estonia amounting to about $75 billion, according to ING Groep NV, with SEB, Swedbank and Nordea accounting for 53 percent of Latvia’s lending market. Sweden’s central bank raised the amount of euros available for the Latvian central bank to swap for lats to 500 million euros ($670 million) at the start of May. Latvia’s central bank first entered the swap agreement with both its Swedish and Danish counterparts to borrow as much as 500 million euros for lats last December. The Riksbank was to provide 375 million euros and the Danish central bank the remainder.

Latvia has already spent over 500 million euros buying lats this year to support the currency.

Earlier this week the New York Times Economix Blog said the following:

The jury is still out on whether Latvia can do what it takes to rebalance its budget and qualify for the bailout money it received from the International Monetary Fund and the European Union. Take a look at this analysis of Latvia’s situation from Danske Bank, which has consistently offered hard-headed – that is, pessimistic – views of the Baltic nations of Latvia, Lithuania and Estonia. (The bank was also far ahead in calling the disaster in Iceland.)

The most interesting aspect of the story, from a global perspective, was the notion that a default — even by a small country — could trigger a cascade of bad news at a time when the financial situation appears to be easing.

Let us just all hope that this last mentioned “notion” remains just that, “an interesting notion”.

Meanwhile, Swedish media seem to be treating the devaluation as almost a “fait accompli” - those of you who don’t speak Swedish can try putting this and this through your Google translator if you are interested."

The results are an overwhelming rejection of the conservative, pro-business Independence Party

TO BE NOTED: From the WSJ:

"Associated Press

REYKJAVIK -- Iceland's leftist government was headed Saturday for a strong victory in the country's general election, according to preliminary results.

Early results showed that a left-wing coalition made up of the Social Democratic Alliance and the Left Green Movement has won 35 out of the 63 seats in parliament.

The two parties are part of a caretaker government that took office in February after public protests about Iceland's economic collapse toppled the previous conservative administration. The left-wing coalition is led by interim Prime Minister Johanna Sigurdardottir.

The results are an overwhelming rejection of the conservative, pro-business Independence Party, which headed a coalition government last fall when the banking system failed. For the first time in the party's 70 years history it is not the largest party in the parliament.

Sigurdardottir was in an upbeat mood at the election party.

"The nation is settling the score with the neoliberalism, with the Independence Party, who have been in power for much too long," she told supporters. "The people are calling for a change of ethics. That is why they have voted for us."

The results represent a strong victory for Iceland's pro-European Social Democratic Alliance. The Left Green Movement, which has traditionally opposed closer ties with the European Union, has performed slightly worse than expected, leaving the Social Democrats a chance to lead a parliament with a pro-European majority.

"It (the results) gives the Social Democrats a strong position and puts pressure on the Left Green Movement," said political analyst Egill Helgason.

The Social Democratic Alliance has won 22 seats in parliament with 33% of the votes counted, while the Left Green Movement has 13 seats with 19.9% of votes, early results show. The Independence Party has 15 seats with 22.5% of votes.

The centrist Progressive Party has nine seats with 12.8% of votes and the Citizens Movement has four seats with 8.2% of the vote. Around 38% of all votes have been counted so far.

The global financial crisis washed up hard on the shores of this volcanic island of 320,000 people. After racking up massive debts during years of laissez-faire economic regulation and rapid expansion, the country's three main banks collapsed within the space of a week in October.

The government sought a $10 billion International Monetary Fund-led bailout and the country's currency, the krona, has plummeted.

Unemployment and inflation have spiraled and the IMF has predicted that the economy will shrink by about 10% in 2009, which would be Iceland's biggest slump since it won full independence from Denmark in 1944.

Iceland's election commission announced the early results Saturday night shortly after polls closed around the country."

the developments in currency markets as a result of moves by major central banks towards quantitative easing

TO BE NOTED: From the FT:

"Carry trade makes a comeback

By Peter Garnham

Published: March 27 2009 15:50 | Last updated: March 27 2009 15:50

A rebound in global equity markets appears to have prompted the return of a familiar investment theme: the carry trade.

The strategy, which involves selling lower-yielding currencies, such as the yen, to fund the purchase of higher-yielding assets elsewhere, was popular among investors ahead of the financial crisis.

The strategy rests not just on interest differentials, but also on stability in asset markets since a sharp fall in the value of an investor’s target investment can wipe out any yield advantage of funding through a low-yielding currency.

Indeed, the turmoil on financial markets saw investors scramble to unwind carry trades as asset prices plunged. This deleveraging sent the yen sharply higher.

Against the dollar, the yen has risen 8 per cent since the collapse of Lehman Brothers in mid-September last year.

It’s rise against the higher-yielding New Zealand and Australian dollars has been more acute, rising 18 per cent and over 28 per cent respectively. But analysts say the rally in global equities has paved the way for investors to return to the carry trade.

Since hitting a 13-year low on March 6, the benchmark S&P 500 index of US stocks has notched up three straight weeks of gains, helped by the aggressive fiscal and monetary policy stance of the US authorities.

Some investors believe that the equity market sell-off has run its course.

Larry Kantor, head of research at Barclays Capital, says after the rally in markets over the past few weeks, the question foremost in the minds of investors is whether it is sustainable or yet another false start.

“We believe that the latest rally will have stronger legs, and thus marks an inflection point,” he says. “We are now recommending that investors become more aggressive and take risks across a broader range of assets.”

Hans Redeker, at BNP Paribas, says the performance of equities are important for carry trade investors.

First, reduced asset volatility allows investors to increase the size of positioning which is important for the asset side of carry trades. Second, rising asset prices will reduce deleveraging pressure.

“Deleveraging pushed the yen lower in the autumn and winter, but those days are gone,” said Mr Redeker. “Financial markets look brighter.”

Indeed, the New Zealand dollar and the Australian dollar, the two major target currencies for carry trade investors ahead of the financial crisis have performed strongly so far this month.

Buoyed also by a rally in commodity prices, the New Zealand dollar is up 14 per cent against the yen and 14 per cent stronger against the dollar since the start of the month, while the Australian dollar has climbed 8 per cent against the yen and gained 8.4 per cent against the dollar.

Mr Redeker believes there could be more gains in store, especially for the New Zealand dollar, the favourite currency of Japanese margin traders.

Rising Japanese shares are likely to increase the risk appetite of Japanese retail investors, encouraging them to send funds abroad in search of yield. “Japanese margin accounts are heavily long on the yen and when this position is reversed the New Zealand dollar will benefit most,“ says Mr Redeker.

Steve Barrow, at Standard Bank, prefers to see the developments in currency markets as a result of moves by major central banks towards quantitative easing.

He says one thing noticeable from currency movements is that the “periphery” currencies, such as the Australian dollar, New Zealand dollar, Norwegian krone and Swedish krona, have out-performed the core – or G7 – currencies.

Indeed, since the start of the month, the Norwegian krone is up 9 per against the dollar and the Swedish krona has gained 13 per cent.

All four of those countries, unlike other major economies are expected to avoid debasing their currencies by moving towards quantitative easing.

“We could, of course, throw in emerging market currencies as well although we feel they are a little more dependent on a persistence of recent stock market strength, which leaves us a little uncomfortable,” says Mr Barrow.

He says if currency investors can ride through any temporary stock market setbacks, the best returns are to be had in these periphery countries unless, they too, take the quantitative easing bait."

"if they start to view the pound as Europe’s equivalent of an Agency bond …"

Brad Setser on the wild ride of the dollar recently:

"Only a few days ago, so it seems, it took about $1.25 to buy a euro. Now it takes closer to $1.45 (it was more earlier today, but the dollar subsequently rallied). And — as Macro Man notes — the dollar’s move pales relative to the recent slide in the pound. Not so long ago a pound bought 1.5 euros. Now it buys a euro and change. The Anglo-Saxon currencies haven’t had a good two week run.

Both the US and the UK ( 1 ) had housing and finance centric economies. Both have ( 2 ) significant external deficits. And both are ( 3 ) inclined to use monetary and fiscal policy aggressively to combat a downturn.

But with global trade collapsing, the euro’s rise can not be all that comfortable for members of the eurozone. It isn’t clear that any one wants a stronger currency right now ( THIS MEANS THAT THEIR EXPORTS WILL BE MORE EXPENSIVE IN OTHER COUNTRIES, AND THEY DON'T WANT TO LOSE EXPORT BUSINESS DURING AN ECONOMIC DOWNTURN ). Currencies though are relative prices — and can go up or down amid a global contraction. In theory, everyone could ease monetary policy equally without changing the relative value of any currencies ( THIS WOULD KEEP THE DOLLAR HIGHER ). In practice things rarely work out as neatly ( EXACTLY ).

Dr. Krugman, I would assume, hopes that the euro’s rise puts more pressure on Germany to join a coordinated European fiscal stimulus — with good reason. Germany’s export machine relies on global and European demand. That demand is falling (watch Russian imports for example). And if the euro’s rally is sustained, Germany will soon face an additional headwind. So too will the less competitive members of the eurozone. They are in an even more difficult position if Germany doesn’t lead a coordinated European reflation. ( GERMAN EXPORTS WILL BE TOO EXPENSIVE )

Four other thoughts:

1) Until fairly recently, all the European currencies tended to move in tandem against the dollar. That meant their cross-rates were stable. And it meant that the euro wasn’t as strong as it seemed. The euro was strong against the dollar and the yen, but not against the pound, the Swedish krona, the Norwegian krona and similar currencies. Right now the euro is rising against all the smaller European currencies — not just against the dollar.

2) Japan is starting too worry about yen strength, not surprising. Renewed intervention seems like a possibility if the yen continues to rise. That shouldn’t be a surprise. Japan tends to intervene heavily when the interest different between the yen and dollar goes away, reducing private market demand for dollars.

3) China has to be pleased by the euro’s rally. Dollar strength translated into RMB strength — and a rising RMB when Chinese exports were slowing (and likely now falling) made Chinese policy makers uncomfortable. There was even talk of moving to a real basket peg — which would have meant that RMB would depreciate against the dollar when the dollar was strong. But I rather doubt that China now wants to appreciate against the dollar to offset the dollar’s renewed weakness against the euro. Right now China is happy to see the dollar and thus the RMB weaken( THAT WAY THEIR EXPORTS DON'T GET MORE EXPENSIVE FOR US ) …

4) Central banks have been big buyers of the pound over the past few years. Reserves were growing, and the pound’s share was rising. Central banks liked its yield( PAID HIGHER INTEREST ) — and the fact that it an easy alternative to both the dollar and the euro. By my count, central bank inflows often were large enough to cover the UK’s current account deficit. Central banks reserves are shooting up, but if they “rebalance” their portfolios they should be big buyers of pounds now — as they need to hold more pounds to keep the pound’s share of their portfolio up as the pound’s value slides.

I’ll be interested to see if they do so — or if they start to view the pound as Europe’s equivalent of an Agency bond …( AND NOT BUY IT AS TOO RISKY )

Notice the Chinese Contradiction:

1) They don't want the dollar to weaken so that they can export to us

2) That's happening because we're printing money

3) Yet, they tell us not to borrow too much from them, and they don't want to spend too much

Problem: On 3, it has to be one or the other

Either we borrow more and they save more

or

we save more and they spend more

"The dollar doesn’t have to go south if all the economies reflate at the same time.”

I like William Gross, so here's a chance to quote him from Bloomberg:

"By Ye Xie

Dec. 11 (Bloomberg) -- The dollar fell to a six-week low against the euro and yen as the cost of borrowing in the U.S. currency tumbled, signaling less demand for year-end funding.

The greenback also dropped after a report showed the U.S. trade deficit unexpectedly widened in October. The Swiss franc dropped against the euro and yen after the central bank reduced its main interest rate to a four-year low of 0.5 percent.

“Dollar liquidity and funding concerns are starting to fade,” said Shaun Osborne, chief currency strategist in Toronto at TD Securities Inc., a unit of Canada’s second largest bank. “These factors have been important sources of support for the dollar in the past few months.”

The U.S. currency fell 1.7 percent to $1.3243 per euro at 8:40 a.m. in New York, from $1.3023 yesterday. It dropped 1.6 percent to 91.28 yen from 92.76. The euro traded at 120.77 yen, compared with 120.78 yen.

The cost of borrowing in dollars for three months in London fell to the lowest level in more than four years. The London interbank offered rate, or Libor, that banks say they charge each other for such loans slid 0.1 percentage point to 2 percent, the lowest level since September 2004, British Bankers’ Association data showed. That’s still one percentage point above the Fed target, up from an average of 16 basis points in the seven years to August 2007, when the credit freeze began.

“From a fundamental basis, there’s a case for avoiding the dollar,” said Adrian Schmidt, a London-based senior foreign- exchange strategist at the Royal Bank of Scotland Plc, the fourth-biggest currency trader. “For the moment the dollar’s on the back foot.”

How interesting.

"The ICE’s Dollar Index, which tracks the greenback against the euro, the yen, the pound, the Canadian dollar, the Swiss franc and Sweden’s krona, fell 1.2 percent at 84.449, below the 55-moving-day average of 84.5, as traders took advantage of the low liquidity to test how far it may fall, Hardman said. They will drive the dollar to $1.345 per euro this year, he said.

The dollar has gained 11 percent against the euro in 2008 as the credit-market seizure and $980 billion of losses on mortgage-related securities worldwide led investors to repatriate overseas investments to the U.S. and seek funding in the greenback.

The yen gained versus all 178 currencies tracked by Bloomberg this year as the global recession encouraged Japanese investors to bring funds back home and global equities plunged.

Japan’s currency jumped 21 percent versus the dollar, 34 percent against the euro and 66 percent against Brazil’s real as the financial crisis prompted investors to reverse carry trades, in which they purchase higher-yielding assets funded in countries where borrowing costs are lower. Japan’s benchmark rate of 0.3 percent is the lowest among major economies.

The U.S. trade deficit expanded 1.1 percent to $57.2 billion in October from a revised $56.6 billion in September, the Commerce Department said today in Washington. The gap was projected to narrow to $53.5 billion from an initially reported $56.5 billion in September, according to the median forecast in a Bloomberg News survey of 70 economists.

The U.S. budget deficit in November swelled to $164.4 billion, from $98.2 billion in the year-earlier period, as the government used taxpayer money to shore up the financial system by buying stakes in banks, the Treasury Department reported yesterday. Government revenue fell 4.2 percent, while spending soared 24 percent."

Let's see what Gross says:

"The dollar may extend its decline as the U.S. government increases its budget deficit by spending “trillions of dollars” to revive the economy, said Bill Gross, manager of the world’s biggest bond fund at Pacific Investment Management Co. in Newport Beach, California.

“There’s some risk” for the dollar to weaken, Gross said in an interview on Bloomberg Television yesterday. “It is fair to say other economies are doing much the same thing. The dollar doesn’t have to go south if all the economies reflate at the same time.”

Let's hope for "reflation" ( Another term. Yikes. ) , I suppose.

"We need new safe-fail policies to prevent inevitable institutional failures from snowballing into economic crises.

Here's a pretty good argument for putting Derivatives on an exchange or Clearinghouse from Benn Steil in the FT:

"The global financial crisis is rightly prompting calls for a rethink of how we regulate financial institutions and markets. Most such calls are focused on what might be called “fail-safe” regulations, designed to reduce the risk that institutions will make reckless lending and investment decisions. Even libertarian-leaning policymakers and thinkers, such as Alan Greenspan, are now concerned with the capacity of our globally connected financial system to spread failures of risk management from one institution to another."

I hadn't heard them called Fail Safe Regulations until now, but the point is well taken. We want regulation to keep these kinds of financial crises from occurring. A global approach makes sense to me. No, it's not global government.

"In this crisis, institutions that bought up buckets of complex mortgage-linked securities found themselves facing huge losses as house prices fell. Their counterparts and clients, fearing the worst, provoked the worst by ceasing to do business with them. Others who wrote insurance against their failures-to-pay (credit default swaps) then lost huge sums as well, fuelling the fires of system-wide panic and default. But better regulation of lending standards and risk management, the argument goes, will prevent such systemic problems in the future.

History does not provide much comfort here. In financial markets, there are always new risks to take and new ways for risk management models and procedures to break down. Fail-safe approaches can also go too far: witness Japan in the early 1990s, when heavy-handed government intervention effectively shut down financial innovation. Furthermore, government policy promoting imprudent risk-taking – witness long-standing US congressional support for failed mortgage giants Fannie Mae and Freddie Mac – can overwhelm regulations intended to control it."

I think that the cause of the problem was the search for investments that needed less capital requirements, not the investments themselves.

His two main points I agree with:

1) It's hard to stop financial innovation, since its intent is to evade current regulations

2) Over-regulation is a serious problem

"The key is to supplement prudent fail-safe interventions with safe-fail ones: interventions that recognise that institutional failures will continue to occur and that focus on limiting the systemic damage after they do."

Here's "prudent" again, meaning nothing specific, but it will work.

"A case in point is the mammoth global derivatives markets. Despite wild swings in prices, derivatives exchanges have not contributed one iota to market instability. This is because exchange-traded contracts are centrally cleared and trader defaults – which are rare because of continuously adjusted margin requirements – are absorbed by well-capitalised clearing houses. Compare the 2006 collapse of hedge fund Amaranth, whose derivatives exposures were on-exchange, with the 2008 collapses of Lehman Brothers and AIG, both of which had large exposures in non-cleared, over-the-counter CDSs. Amaranth’s derivative defaults had trivial systemic ripples, while those of Lehman and AIG created major shockwaves. AIG invisibly built up huge under-collateralised sell positions on the back of a faulty credit rating. Yet if those contracts had been transacted on a trading platform with central clearing, margin calls would have short-circuited the strategy well before the company’s September collapse. US and European regulators (whose institutions comprise the vast bulk of OTC trading) should require central clearing once volume barriers in a contract are breached. This will not prevent an institution from losing large sums in derivatives trading, but will stop its default from spreading big losses to others that may be far removed from the original transactions."

This is the argument for an Exchange or Clearinghouse. It's pretty convincing to me.

"There are safe-fail macroeconomic counterparts as well. In August 2007, former Salvadoran finance minister Manuel Hinds and I spoke out at a Reykjavik conference in favour of Iceland unilaterally “euroising”. At the time, the country had more than enough foreign exchange reserves to redeem all the krona in the country for euros at the then-current exchange rate. This would not have stopped the three large Icelandic banks from overextending, but it would have prevented national financial catastrophe. Countries that have adopted one of the two main internationally accepted currencies – the dollar (Panama, El Salvador and Ecuador) or the euro (think in particular of Italy, Portugal and Greece) – have effectively eliminated the risk of currency crisis (that is, not being able to pay short-term foreign debts for lack of access to “hard currency”)."

That's interesting. It seems that the choice is between the Dollar and Euro. But eliminating a currency crisis is important.

"If we are wise and fortunate, in the future we will have corporate governance, capital standards and monetary policy regimes that better constrain the dangerous build-up of excessive leverage among consumers, banks and governments. But that is not enough. We need new safe-fail policies to prevent inevitable institutional failures from snowballing into economic crises."

Notice the focus on excess leverage. That's the main point, I believe.

"Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts."

Here's the Danielsson piece on Vox:

"Iceland’s banking system is ruined. GDP is down 65% in euro terms. Many companies face bankruptcy; others think of moving abroad. A third of the population is considering emigration. The British and Dutch governments demand compensation, amounting to over 100% of Icelandic GDP, for their citizens who held high-interest deposits in local branches of Icelandic banks. Europe’s leaders urgently need to take step to prevent similar things from happening to small nations with big banking sectors.

Iceland experienced the deepest and most rapid financial crisis recorded in peacetime when its three major banks all collapsed in the same week in October 2008. It is the first developed country to request assistance from the IMF in 30 years.

Following the use of anti-terror laws by the UK authorities against the Icelandic bank Landsbanki and the Icelandic authorities on 7 October, the Icelandic payment system effectively came to a standstill, with extreme difficulties in transferring money between Iceland and abroad. For an economy as dependent on imports and exports as Iceland this has been catastrophic.

While it is now possible to transfer money with some difficulty, the Icelandic currency market is now operating under capital controls while the government seeks funding to re-float the Icelandic krona under the supervision of the IMF. There are still multiple simultaneous exchange rates for the krona.

Negotiations with the IMF have finished, but at the time of writing the IMF has delayed a formal decision. Icelandic authorities claim this is due to pressure from the UK and Netherlands to compensate the citizens who deposited money in British and Dutch branches of the Icelandic bank Icesave. The net losses on those accounts may exceed the Icelandic GDP, and the two governments are demanding that the Icelandic government pay a substantial portion of that. The likely outcome would be sovereign default."

At least he mentioned the U.K.'s use of those terrorism laws. Mighty classy.

"The original reasons for Iceland’s failure are series of policy mistakes dating back to the beginning of the decade.

The first main cause of the crisis was the use of inflation targeting. Throughout the period of inflation targeting, inflation was generally above its target rate. In response, the central bank keep rates high, exceeding 15% at times.

In a small economy like Iceland, high interest rates encourage domestic firms and households to borrow in foreign currency; it also attracts carry traders speculating against ‘uncovered interest parity’. The result was a large foreign-currency inflow. This lead to a sharp exchange rate appreciation that gave Icelanders an illusion of wealth and doubly rewarding the carry traders. The currency inflows also encouraged economic growth and inflation; outcomes that induced the Central Bank to raise interest rates further.

The end result was a bubble caused by the interaction of high domestic interest rates, currency appreciation, and capital inflows. While the stylized facts about currency inflows suggest that they should lead to lower domestic prices, in Iceland the impact was opposite."

So, high interest rates in Iceland led to:

1) Borrowing in other countries

2) Other countries buying higher interest investments in Iceland

"The reasons for the failure of inflation targeting are not completely clear, a key reason seems to be that foreign currency effectively became a part of the local money supply and the rapidly appreciating exchange-rate lead directly to the creation of new sectors of the economy."

I thought the reason was very clear: they kept the rates high. As to new businesses sprouting up, welcome to capitalism.

"The exchange rate became increasingly out of touch with economic fundamentals, with a rapid depreciation of the currency inevitable. This should have been clear to the Central Bank, which wasted several good opportunities to prevent exchange rate appreciations and build up reserves. "
This is simply poor investing. It was clear that they rates would change someday. In fact, this is the same exchange rate problem on the other side in Japan. Isn't this that Great Moderation or whatever it's called? Also, lack of capital again? Come on. That's banking 101.

"Consequently, the governance of the Central Bank of Iceland has always been perceived to be closely tied to the central government, raising doubts about its independence. Currently, the chairman of the board of governors is a former long-standing Prime Minister. Central bank governors should of course be absolutely impartial, and having a politician as a governor creates a perception of politicization of central bank decisions.'

That's smart.

"Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP, with debts to match. In normal economic circumstances this is not a cause for worry, so long as the banks are prudently run. Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts."

Now wait a second. What does build up reserves mean? Just the national bank I suppose, so that they can be a lender of last resort. In other words, the private banks swamp or dwarf the national bank. However, saying that Iceland's banks were better than many other banks in the world is slight praise now. It wasn't enough.

"In this crisis, the strength of a bank’s balance sheet is of little consequence. What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. Therefore, the size of the state relative to the size of the banks becomes the crucial factor. If the banks become too big to save, their failure becomes a self-fulfilling prophecy.

The relative size of the Icelandic banking system means that the government was in no position to guarantee the banks, unlike in other European countries. This effect was further escalated and the collapse brought forward by the failure of the Central Bank to extend its foreign currency reserves."

I said earlier this seems obvious, but I guess it isn't. How can you guarantee what's far bigger than you are. I guess you could believe it's fine in normal times when you're dealing with one or two banks at a time.

"If a reasonable settlement cannot be reached and with the legal questions still uncertain it would be better for all three parties to have this dispute settled by the courts rather than by force as now. "

Seems reasonable.

You might want to hire Buiter a little sooner next time, and make the report known sooner.

Yves Smith with some helpful comments on this:

"The article focuses on the role of high local interest rates in attracting hot money inflows, and the author is a bit perplexed as to why inflation targeting failed. Not that I am a fan of economic theory (not that theorizing is bad, theorizing is good, provided you use it to generate testable hypotheses. But most economists seem to just like the theorizing bit) but inflation targeting, while popular, is (from what I can tell) a made up approach. For instance, some economists have criticized it for failing to allow for the role of imports in raising or lowering the official inflation rate. Domestic interest rate policy will have no impact on import prices (save through changes in foreign exchange rates). Increasing interest rates in Iceland, for example, will not slow down inflation on good imported from the EU."

I think we can ponder how useful inflation targeting is from this case.