Download Vilhjálmur Egilsson

Vilhjálmur Egilsson
31 May – 1 June 2007.
RICH OR BANKRUPT? – IS THE CURRENT ACCOUNT DEFICIT
IN ICELAND OVERSTATED?
The Central Bank published their Current Account statistics for 2006 on 6 March.
The main conclusions are that the Net International Investment position of Iceland
was negative by 1,355 billion ISK or 120% of GDP at the end of 2006 and that the
Current account deficit amounted in the year 2006 to 305 billion ISK or 26.7% of
GDP. These figures are alarming and must be a cause of concern for every
stakeholder in the Icelandic economy.
Iceland Statistics came also out with new data in March on the economic
developments in 2006. The estimated GDP growth in 2006 is surprisingly low, or
2.6% compared to more than 7% growth in 2005 and 2004. The main reason for this
lacklustre performance of the economy in 2006 is a fall in the export income from
services of 11.8% after 20% growth of these exports in 2005. These results should
also raise serious concerns. If all the figures are correct, labour productivity fell by
between 2% and 3% last year and the share of wages in the factor income was 72%,
the highest share ever.
Maybe the most interesting observation about Iceland is that the grim reality
described by all these statistics is not perceived in the same way by most market
participants and business goes on as usual. People are still coming to Iceland in
record numbers, seeking employment or as tourists. Most companies in most
industries are doing well, there is practically no unemployment, and expectations are
generally riding high and stock prices have never been higher.
In fact the only real alarming sign is the inflation rate that has been rising in the last
few months even though the 12 months figure has been going down. Monthly price
increases since January have been way too high despite the fall of the price level in
March and it must be a top priority to turn this development around.
I think that it is absolutely necessary to realise the inadequacy of the statistics in
order to understand what needs to be done turn the inflation around and maintain the
high growth rate in Iceland. It is in fact quite difficult to act in a responsible manner if
one feels that the numbers are all wrong that are supposed to form the basis for
decision making in the economy.
I now want to go into some detail on why I think the Current Account statistics are not
at all describing the real position of the Icelandic economy.
The Icelandic financial sector has expanded rapidly on foreign markets in the last
four years. Icelandic investors have invested heavily abroad and have generally
been quite successful. The assets held by Icelanders abroad have increased almost
tenfold in four years and now stand at a multiple of 3.8 of the GDP according to the
Central Bank. This development has brought a drastic change to the Icelandic
economy and there is no particular indication that there will be a halt to the continuing
growth of Icelandic investments on external markets. It seems obvious that the
methods of the Central Bank for collecting and assessing information to produce their
statistics are not sufficient to accurately reflect the extent and nature of the new
reality in Iceland.
There are two basic reasons for this discrepancy between the perceived outcome
and the reality. The first one is that the Bank writes down the value of direct
investments and does not make an attempt to find out their real value. The other
reason is that capital gains are not treated as income in Current Account statistics
but can be shown separately to reflect the changes in the value of assets. For most
normal purposes of a modern financial system capital gains and other forms of
income such as dividends or interest payments are interchangeable. Systematic
disregarding of capital gains is therefore misleading.
The Central Bank estimates that the stock of direct investments abroad stood at
927.9 billion ISK at the end of 2006. This amount is the sum of 755.3 billion of equity
and 172.6 billion of loans granted to related enterprises. If the sum of the flows, or
amounts invested each year, 2003 – 2006 is added to the size of the stock at the end
of 2002 (all adjusted to the same exchange rate) the outcome is close to 200 billion
ISK higher. The conclusion of the Central Bank’s statistics is that a substantial share
of these investments has been lost and written off in the last four years and that
Icelandic investors have continued to invest heavily in equity abroad despite all these
losses.
The method that the Bank applies writes off the purchase value of equity that is in
excess of book value. There is no attempt made to assess these assets at market
value or even at unadjusted or adjusted historical value. The problem with the
Bank’s conclusion is that no one of these investors has experienced these losses as
real. The Icelandic investments have generally been quite successful even though
some investments have not been as profitable as expected. If a modest general
return of 10% - 15% is added to the investment flows the stock’s real value could
easily have been 1,300 – 1,400 billion ISK at the end of 2006. The real value of
average stock in 2006 could easily have been 1080 – 1150 billion ISK giving a return
of 100 – 180 billion ISK. This return on equity compares with the total return on
equity of 85 billion in the Current Account (which includes also returns on portfolio
investments).
Similar calculations for foreign owned direct investments in Iceland also indicate that
the Central Bank grossly undervalues the real value of the stock at the end of 2006
and the respective return on this equity. According to the Bank the stock of direct
foreign investments in Iceland stood at 499.5 billion ISK at the end of 2006. Just
looking at the flows the stock’s real value should be close to 100 billion ISK higher
and when taking returns into account the stock could easily be at least 170 – 230
billion ISK higher. The return on this equity in 2006 could have been 50 – 90 billion
ISK.
When it comes to Icelandic assets in publicly traded securities the Central Bank
comes up with another puzzle. At the end of 2005 Icelanders held 589.7 billion ISK
in publicly traded stocks. At the end of 2006 this amount had increased to 922.4
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billion ISK. The next thing to read is that the flow of investments into these stocks
during the whole year 2006 was 93.1 billion ISK. So the stock increases by more
than 300 billion ISK and less than 100 billion ISK is due to investments. This should
normally lead to the conclusion that there was a considerable profit from holding
these securities, maybe in the range of 150 billion ISK when adjusting for exchange
rate changes. Not so, according to the Central Bank’s statistics. There are only 85
billion ISK to share between return on direct investments and publicly traded stocks
when the real amount is probably between 250 and 330 billion ISK.
Foreigners held 234.4 billion ISK in publicly traded stocks at the end of 2005 and
355.8 billion ISK at the end of 2006. The amount for the corresponding flow was
81.2 billion ISK indicating that the profit from these portfolio investments was only
minimal after adjustments for different exchange rates. But this is not reflecting the
reality of the Icelandic stock market in 2006 when there was a sizeable increase in
the value of most stocks. The ICEX-15 index rose by 15.8% and the return to foreign
portfolio investors must have been at least 40 – 50 billion ISK. The Central Bank
estimates that the total return of foreign investments in Icelandic stocks, both direct
investments and publicly traded stocks was 100.5 billion ISK in 2006. Looking at the
estimated returns on direct investments and portfolio investments together it would
not be far off to suggest that the Bank is underestimating this amount by 30 – 40
billion ISK.
Icelandic investments in publicly traded foreign bonds are relatively small compared
to other asset forms. This amount was, according to the Central Bank, 106 billion
ISK at the end of 2005 but had grown to 277.5 billion ISK at the end of 2006. The
corresponding flow was registered to be 141.2 billion ISK. Adjusting for exchange
rates there seems to have been a modest return on these investments or around 10
billion ISK. This amount should not be too far from the true amount.
Foreign investments in Icelandic publicly traded bonds are by far the largest
component of the Net investment statistics. Foreigners held 2,153.5 billion ISK in
bonds issued by Icelanders at the end of 2005 and this amount had increased to
3,666.4 billion ISK at the end of 2006. The flow was 1,028.7 billion ISK according to
the Central Bank. Comparing the increase in the stock with the flow and calculating
the corresponding interest rate by looking at the deviation and the average stock
gives the conclusion that the actual income should have been close to 150 billion
ISK. This is not so unlikely because the Icelandic banks are the leading issuers of
these bonds. The Central Bank estimates all interest payments to foreigners to be
162.1 billion ISK in 2006.
Outstanding loans and other receivables by Icelanders to foreigners (except for the
Central Bank’s reserve) stood at 1,104.9 billion at the end of 2005. This amount was
2,204.4 billion ISK at the end of 2006. The corresponding flow was estimated at
777.8 billion ISK during 2006. Running the same exercise for these numbers with
adjustment for exchange rates and also taking likely interest rate margins into
account it is likely that the actual income generated from foreigners to Icelandic
lenders could be 110 – 140 billion ISK. The Central Bank estimates all interest
charges to Icelanders to have been 73.1 billion in 2006.
Outstanding loans and other receivables by foreigners to Icelanders were 684.6
billion ISK at the end of 2005 and 1,332.9 billion ISK at the end of 2006. The flow
was registered at 461.8 billion ISK during 2006. Analysing these numbers it would
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be reasonable to expect the corresponding actual income to be 70 – 80 billion ISK.
These amounts and the estimated actual income to publicly traded bonds should be
compared to the 162.1 billion ISK that the Central Bank estimates to be interest
payments of Icelanders to foreigners. It seems that the Central Bank underestimates
these interest charges by 60 – 70 billion ISK in 2006.
When all the numbers for return on equity investments and lending operations in and
out of Iceland are added together it is obvious that the methods and standards used
by the Central Bank are not working. They are not showing the reality of financial
transactions between Icelanders and foreigners.
The total return on equity and interest charges from lending operations in 2006 is
most likely to be 370 – 480 billion ISK into Iceland and 310 – 360 billion ISK out of
Iceland. The actual balance in 2006 therefore ranges from 10 billion ISK to 170
billion ISK in what financial income of Icelanders from foreign operations exceeds the
financial income of foreigners from operations in Iceland. This is in absolute contrast
with a negative balance of around 100 billion ISK estimated by the Central Bank.
The current account deficit of 305 billion is definitely overstated. The real current
account deficit is probably lower than the 146.7 billion ISK deficit in the trade of
goods and the negative current account balance is in any case grossly overstated.
The negative Net International Investment Position is also overestimated. The actual
net investment position at the end of 2006 could easily be around 300 billion ISK
better than the Central Bank estimates and certainly less than 100% of GDP.
The fundamental flaw of the Icelandic current account statistics can be attributed to
the fact that capital gains, realised or unrealised, are not treated as income. This is
according to the international standards that are applied. So in the case of an
Icelandic pension fund it makes a big difference how it invests abroad and it earns its
income. If a pension fund invests directly in a foreign company and receives
dividends it is counted as income. If the company retains most of its earnings to
finance further growth and this leads to increase in its share prices it is not counted
as income even though the capital gain would be realised. If a pension fund invests
in an Icelandic mutual fund that received dividends from a foreign company it is
counted as income. If the mutual fund is foreign it is not counted as income. If the
pension fund invest in a foreign mutual fund that invest in an Icelandic company and
received dividends it is not counted as income to Iceland but to the other country.
Similar flaws are in the treatment of income from investments in bonds or other debt
instruments. The investment route determines how the same income is treated in
different ways.
My point is this. Capital gains are as much income to a pension fund as dividends or
interest payments. Pension funds use this income and growth in their assets to
increase their payments to their policy holders which spend their income as private
consumption or whatever leading to increased imports and increased current account
deficit.
The argument against treating capital gains as income is presumably that they don’t
reflect return from economic activity. This may be true in some cases but in other
cases it is purely a matter of definition whether income comes in the form of capital
gains or interest or dividends. A company that retains its earnings might as well pay
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them out as dividends and increase its equity with a new stock issue. We can go on
and on with examples.
My next point is this. Capital gains from abroad are as much income to Iceland as it
is to an Icelandic pension fund. The way capital gains are treated in the balance of
payment standard simply does not reflect the realities of a modern day economy or a
modern financial system. The IMF standard is now up for review and it is necessary
to make an effort to gather support for different treatment of capital gains.
Finally I want to make a few points on the implications of this discrepancy between
statistics and reality.
The actual current account deficit in 2006 was probably lower than the deficit in the
trade in goods only. The actual external imbalance of the Icelandic economy in 2006
should be evaluated in that perspective.
The ever deeper integration of the Icelandic financial sector with the global financial
sector increasingly limits the effectiveness of the interest rate tool of the Central
Bank. As the interest rate stays high for a longer period the Icelandic krona loses
market share and economic operators, both the business sector and households,
want to finance their debts in foreign currency. The banks are now marketing ever
more accessible financial products in foreign currency to households and this
development will continue. As the financing of residential housing with foreign
currency debt becomes more common we will also see the financing of construction
of residential housing in foreign currency but this sector is the only sector where
companies generally finance their activities in the Icelandic krona at high interest
rates.
Normally we would expect a rising interest rate in an economy in Iceland to have its
effects on inflation through appreciating exchange rate and decreasing incomes in
the export sectors and sectors in direct competition with imports. The direct effects
on demand are limited because of the low market share of the krona. But what
happens is that the markets lose confidence in the krona long before the appreciating
exchange rate has squeezed enough income out of the export sectors and
unshielded sectors. The exchange rate begins to fall much too soon even with
record high interest rates. This further limits the effectiveness of the interest rate
tool.
Here we have the foundation of what I have chosen to call the “RAISE MORE”
theory. The Central Bank wants to raise interest rates in a typical excess demand
situation to fight against inflation. The currency appreciates but there is still quite
heavy demand pressure and the Bank continues to raise the rates and the currency
appreciates even further. But now the markets lose confidence in the currency which
starts to fall and this leads to continued price increases because of the pass through.
So what can you do? Raise interest rates even more, of course. There is a small
chock when the exchange rate falls but the export sectors and the unshielded sectors
are doing fine. The inflationary bubble subsides but all indicators still suggest high
underlying inflation since the preceding12 months inflation figure will be high for a
long time. So what can you do? Raise interest rates of course. And now the
exchange rates starts to appreciate once more and we have another round. But
under no circumstances can you lower the interest rate. You must always raise it.
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Dealing with inflation is never an easy task and certainly not in an economy like ours
where the market share of the krona is so low and the level of global integration is so
high. We have fortunately not in recent years been subject to large public deficits
generating excess demand and inflation as a consequence. The excess demand in
recent years has had private sources; large business investment projects, huge
increases in construction of residential housing and consumption bubbles due to
rising asset prices particularly housing prices.
Since the interest rate tool of the Central Bank is so ineffective and the public
finances are by most standards in fairly good shape our attention must be turned to
other government actions that contribute to excess demand. The structural changes
on the residential housing market were the leading factor in creating the inflationary
pressures that we are now dealing with, first the higher lending by the state owned
Housing Financing Fund and successively the actions taken by the banks. The
government fund is a market leader and it was unfortunate that the government
decided early this year to increase lending from the Fund again after having cut it
back June last year which had contributed to improved stability on this market. New
actions to stabilise this market are the key to reduce inflation again. The state should
withdraw entirely from this market and allow normal functioning of residential housing
financing.
The other side of this coin is that excess demand is not only about demand but also
about supply. It is necessary to address the structural barriers that hinder the supply
side of the markets in our economy to respond properly to the demand side. The
barriers on the labour market are most important in this context. These barriers must
be further reduced in order to improve the efficiency of the labour market. Icelandic
companies are increasingly held back because of problems with recruiting skilled
staff and new steps in opening up the labour market are fundamental, especially
facilitation of the flow of skilled employees.
My basic conclusion is this. The build-up of Icelandic assets abroad has been
systematically underestimated and the standards for calculating our current account
statistics are not reflecting the real position of the Icelandic economy. There are
other shortcomings in our statistics and it is necessary to understand them in order to
draw the right conclusions and make the right decisions. The Central Bank’s interest
rate policy is increasingly ineffective due to the increased integration of our financial
sector with the global financial world. Increased attention must therefore be paid to
the causes of excess demand and in particular attention must be given to the
residential housing market and supply side of our economy to ensure proper
functioning of the most important markets.
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