Banks all over the world have spent much of the few years bingeing on cheap money, but Iceland’s taken the whole thing to quite an extreme. Its big players – the likes of Landsbanki and Kaupthing – have been on an extraordinary borrowing spree, sucking in vast quantities of cash to fund lending and acquisitions across Europe and the UK. The result? This tiny country – home to a mere 300,000 people – has somehow created a financial system nine times the size of its GDP.

And a nasty hangover.

Iceland’s economy is in a lot of trouble

Now the cheap credit that fueled the binge has all but disappeared the banks – and the economy – are in trouble. The stock market has tanked, inflation has soared and the Icelandic Krona has fallen 26% against the euro this year. House prices, which had doubled since 2001, are now falling.

According to the Icelandic Central Bank, the economy will contract by 2.5% next year and 1.5% in 2010. “We are still likely to see a fairly sharp slowdown in the Icelandic economy in the coming quarters and the most likely scenario is for negative GDP growth in Iceland in 2008 and 2009”, says Lars Christensen, chief analyst at Danske Bank.

Lucky then that the alka seltzer is on its way.

On Friday, the Nordic central banks extended an emergency loan facility worth €1.5 billion to their island neighbour designed to shore up the krona, give the central bank some credibility as the lender of the last resort to the banks (which have been under huge speculative pressure from many of the world’s big hedge funds) and begin getting the economy out of its sorry mess. “In times of uncertainty and turmoil the central banks have a responsibility to cooperate to attain their overall objectives,” said Swedish Riksbank governor Stefan Ingves. “The swap agreement is aimed at supporting (Iceland) in its task of safeguarding macroeconomic and financial stability.”

Could this spell EU membership for Icelanders?

It’s certainly served to calm nerves – the krona rallied sharply on Friday – but the whole business has also raised a pretty uncomfortable question for the Icelanders. Can they really go it alone in the global market place or should they begin to think the unthinkable and join the euro?

With fishing accounting for over 40% of exports, Iceland has long had reason to very firmly oppose membership of the EU, and by extension the euro in the past. Just ask any fisherman up and down the west coast of Ireland what he thinks of the EU, and the opening of Irish waters to big Spanish tankers. Magnify his fury by 10, and you’ll get a good idea of what Icelanders, a traditionally independent lot, think of the EU.

But with the economy destabilising and the currency all over the place, support is now growing for the idea. A poll published in April by the Icelandic daily Fréttabladid showed that 68% of Icelanders would be willing to open membership negotiations with the EU, against 55% in February. Membership of the EU would mean that the Icelandic central banks would lose the power to set interest rates. But that may well be a perfectly fair price to pay for a more stable currency. “There is growing evidence that the Krona is a source of shocks, rather than a shock absorber” says one professor of economics at Reykjavik University. “The krona is increasing the volatility of the economy.” This is in part because the majority of durable goods, for example cars and washing machines, are imported into Iceland.

So given that the currency has been taking a kicking, Icelanders are now paying much more for the much needed goods they import. Inflation rose to an annualised rate of 11.8% in April, the highest level since September 1990. And over the past three months, consumer prices have risen 6.4%. That’s equivalent to an annual inflation rate of 28%.

Joining the Euro would mean offering up a decent chunk of sovereignty at the the EU’s altar. But then, given that interest rates in Iceland are running at 15.5% and that in the Eurozone they remain at 4%, it might also offer the suffering Icelanders the hair of the dog they really need right now.

Turning to the wider markets…

On the continent, the German Dax Index increased 69.39 points or 1% to 7225.94. In Paris, the CAC-40 Index closed 64.06 points, or 1.26%, higher at 5142.1.

Wall Street’s Dow Jones Industrial Average was up 1% yesterday to 13,027, as investors wagered that the US economy would avid falling into recession.

Shares of energy companies, including Exxon Mobil, were given a boost by near record high prices for crude oil. The broader S&P 500 Index gained 1.16points to end at 1,426, while the Nasday was down 12.76 points, or 0.5%, at 2,516.

Japan’s benchmark Nikkei closed 0.3% lower overnight, to finish the day at 14,224. In Hong Kong, The Hang Seng Index went up 123.37 points to 25742.23.33.

In London, Brent crude contract for June rose 58 cents to $125.57 while Spot gold hit a high of $913.35 an ounce, its highest since April 23.

Meanwhile on the Forex markets, sterling fell 0.4% to $1.9477 against the dollar and eased 0.1$ to £0.7964 against the euro.

Source: Why Iceland Is Suffering a Nasty Financial Hangover

Bottoms…bottoms…and more bottoms…

Today, we have to open our collar and loosen our tie; we see more bottoms than at the Folies Bergeres.

“What do you call it when the stock of the country’s fifth-largest investment bank trades at $50 on a Thursday and at $3 the following Monday?” asks Jim Cramer. “I call it a bottom.”

Of course, everyone says he saw the bottom in the U.S. stock market in January…and the bottom in the financials when Bear Stearns owners panicked and agreed to sell the firm for $2 a share…subsequently amended upwards.

And look at the U.S. builders – they seem to have bottomed out too. “It can’t get worse than this,” say industry spokesmen. The index has now turned up.

Meanwhile, look at the Chinese stock market. As predicted in this space – remember, lines of people in Shanghai waiting to open up brokerage accounts? Thousands of new accounts being opened every day? Share prices up 500% in two years? Now, the Chinese stock market has collapsed. The FXI – a kind of Dow Jones Industrial average for the Shanghai market – fell from 220 to 120, a loss of 45%.

It wasn’t the only one. Both Japan and India fell 31%. And Vietnam must have felt as though it had been hit by another Tet Offensive – stocks are down 53% since October. (Colleague Manraaj Singh swears this is a buying opportunity for the Vietnam Fund…more about that some other time.)

But now…all these markets seem to be going back up. Have we seen the bottoms?

And what’s this – gold, our favorite metal went down to $887 or thereabouts, then bounced back over $900. And yesterday, gold added another $9. Have we seen the bottom in the gold market correction too? A lot of people are betting on it…

Look around you; you’ll see bottoms everywhere. Yesterday, prices on just about everything were rebounding. The euro rebounded against the dollar. Asian markets rose. Wheat, soy, rice prices – all on the way back up. The CRB index rose too.

(Even base metals have gotten so precious that a front page report in today’s International Herald Tribune tells us that thieves are stripping the lead off of church roofs in the UK.)

About the only thing that didn’t bounce yesterday was oil – which was off a bit, but still holding over $100. Yes, dear reader, it looks to us as if oil found its bottom at around $100, which is a remarkable thing.

Even in volatility, it looks like a kind of bottom has been found – meaning, volatility is decreasing…markets are calming. As they say on Wall Street…the bottoms are in…

…or are they?

George Soros wonders:

“We had a good bottom,” Soros said yesterday in an interview in New York, referring to the rally in stocks and the dollar after JP Morgan Chase & Co. agreed to buy Bear Stearns Cos. on March 17. “This will probably not prove to be the final bottom,” he said, adding the rebound may last six weeks to three months as the U.S. moves closer to a recession.

*** Soros had a new book released online yesterday: The New Paradigm for Financial Markets (Public Affairs, 2008). He explains the causes of the current meltdown, which he traces to the big turnaround in 1980…when U.S. President Ronald Reagan and U.K. Prime Minister Margaret Thatcher came to power and borrowing ballooned.

Hmmm…sounds familiar. That is what we have been saying too – that people got the wrong idea about the free market. They thought it was a panacea. As long as you reduced taxes and regulation, they believed, you could get away with murder…or at least leverage.

Not so. Capitalism is not a system that makes people rich. It’s a moral system…not really a financial system at all. And like any moral system, it’s fuzzy at the edges and difficult to master. Where does the Atlantic stop and the Jersey shore begin? No one can tell you exactly. And no one can tell you where, exactly, one person’s rights begin and another’s stop. Does a landowner really have an unencumbered right to enjoy the usufructs of his property…knowing that his ancestor stole the land, even fair and square, from the local natives? Does an airline have the right to fly its jumbo jets into an airport…regardless of the noise pollution it causes to the local householders? Would motorists have the right to drive gas-guzzlers if the planet really were headed for a global climatic disaster? Who knows? All you can do is do your best…trying to respect other peoples’ property…and other peoples’ freedom to do what they want…and trying to hold people to their agreements and obligations. Some people get rich; some people get poor. Some people lose; some win. But mostly, grosso modo, the free market gives people what they’ve got coming.

*** While George Soros believes the advanced markets of the West will begin heading down again in a few months, he thinks that some emerging markets will continue going up. He’s heavily invested in India, for example, where he believes “the fundamentals remain good.”

In other words, capitalism still works. But the winners in this capitalistic world are not necessarily those who blather on about freedom and market economies.

Soro’s former sidekick, and our old friend, Jim Rogers, says he wouldn’t put a dime in India. He sold all his emerging markets, except China. The Middle Kingdom has very little political freedom. According to the theorists of the Reagan/Thatcher era…China as it is today couldn’t exist. Political freedom was thought to be inseparable from economic freedom. And economic freedom was considered essential to growth and prosperity. But there it is – China! What to make of it?

Jim is so sure that China will be the world’s next super-power, perhaps replacing America as the leading hegemon of the planet, that he has insisted that his daughter learn to speak Mandarin. Practically from the day she was born she’s had a Chinese nanny.

So colleague Manraaj Singh is good company. He has faith in the emerging markets too. His favorite Asian market is Vietnam, also a communist country…the one that booted out U.S. troops 40 years ago and imprisoned America’s candidate for president, John McCain.

But yesterday, Manraaj was not talking about Vietnam. Instead, he had this to say about U.S. Treasury Secretary Paulson’s visit to China:

“In a press conference in Beijing, he said that he emphasised to the Chinese government the benefits of more efficient capital markets as a device that could ensure ordinary citizens received an “adequate” return on their savings…and that’s when I burst out laughing!

“Since the beginning of the decade, the S&P 500 Index has actually fallen by five percent. In China, the benchmark Shanghai A-shares Index is up by 124 per cent – and that’s after falling 43 per cent from its peak in October. They were up 296 per cent at their peak. I think that Chinese investors have seen an “adequate” return on their savings. U.S. investors, on the other hand, probably wouldn’t think so…and neither would the average British investor… the FTSE is down 11 per cent over the same period.”

Interestingly, Asian markets have been hit hard… not by anything they did wrong, but by the sub-prime crisis, which was 100% made in America. The emerging markets have their troubles and weaknesses, Manraaj concedes, but they are fundamentally in better positions than the US, because they have less debt and cheaper operating costs.

*** We mentioned Icelandic bonds the other day. They’re an intriguing investment because yields are exceptionally high. Obviously, wherever you get high rewards, it is a good idea to look around to find out why; there’s bound to be a reason. Mr. Market never gives our favors without strings attached. The cord attached to this particular yield leads right to the krona – which fell 22% last year. Even if you can get an inflation adjusted, or real, yield of 5% on Icelandic bonds, another drop like that in the currency would leave you deep in the hole.

We put the question to a team of investment managers from HSBC. Here is their reply:

“There is obviously a chance that all the pessimism over debt and default is over done and that the bonds are a good buy at these prices. HSBC PB (Private Bank) wouldn’t recommend it as a strategy. The main reason is that our view is that the bust in credit will take a long time to correct and has significantly further to go. The market has to come to a point that it is willing to lend to Icelandic banks again. This is unlikely for the foreseeable future. As I am sure you know the mainstays of the economy are fishing (70% of exports!), aluminum (the country has a developed a large amount of geothermal electricity) and to a small extent tourism – not particularly inspiring given the scale of the problem.

“Rather than re-visiting an old bull market story, such as Iceland, we would prefer to look to the future. That would mean that we would be looking at different sectors which will grow or protect investors money because they are working in high-demand areas. Because the developing economies of Russia, China, Latin America and the Middle East are cash-rich on the back of the commodities boom, we prefer to invest, generally, in those economies.”

*** Finally, speaking of Latin America. We got an update from colleague Horacio Pozzo on what is happening in Argentina (for which we are bound this afternoon):

“Today in Argentina, it’s a holiday, the anniversary of the beginning of the Malvinas War (known in the UK as the Falklands War). But yesterday, I thought for a moment that the holiday had been moved forward. Because my neighborhood bakery and butcher were both closed. The crisis of the countryside has arrived in the city…shortages are beginning to appear.”

The crisis of the country is simple enough to explain: reacting to record grain prices, Argentina’s farmers planted as much as they could. Now, it is autumn in South America…and the crops are being sold. But along comes the government with a tax on grain exports of up to half the proceeds. Naturally, the farmers were hacked off. And then President Cristina Fernandez de Kirchner made an aggressive speech, which made them even madder. Soon, they had mounted a siege operation against Buenos Aires, blocking 400 roads into the capital, hoping to starve the city into submission.”

It was a showdown that threatened violence and disruption. Too bad for the Argentines, who have been enjoying an economic growth rate only slightly behind that of the Chinese. But no day is ever so sunny that politicians can’t find a way to make it rain. We’ve seen that all over the world…and throughout all history. And now in Argentina.

We called our son in Buenos Aires on Friday.

“What’s going on…what’s the latest…if I come down there this weekend, will I be able to get something to eat?”

“Dad, don’t worry about it. This is Argentina. The Argentines are a bit theatrical. But life goes on – at least in this part of the city. Besides, they’ve called off the blockades and both sides have agreed to a 30-day cooling down period. That ought to give them time to figure out a way out of this mess without losing face.”

And so…we’re off…catching a cab…then a plane…trains and automobiles, too!

I admit it, that’s a juicy figure. But I’m wary of it, and here’s why: For years we’ve had the yen carry trade – investors borrowing in Japan at zero or near-zero interest rates and investing abroad where the yield is much higher. A lot of this money found its way to Iceland.

Now people are starting to talk, only half-jokingly, about a dollar carry trade. The greenback’s in a tailspin, so is it a good idea to borrow in the US, where the Fed have cut rates to 2.25%, and stick your money in Iceland?

“No!” says Garry White. “Their economy is crumbling.” Indeed, writing in yesterday’s Telegraph, Ambrose Evans-Pritchard likened Iceland to a “Nordic hedge fund masquerading as a country”. But he warned that there was more to it than that – its economy is in deficit, and as the yen carry trade unwinds Iceland is suffering as investors take their money out.

Add in the fact that the asset base of the Icelandic banking system is now a world record eight times GDP, and there are serious question marks over the country’s investment potential.

“Is the Icelandic government – which presides over an economy the size of Bristol – big enough to underpin its encephalitic banks if push ever comes to shove?” asks a sceptical Evans-Pritchard.

So while there may appear a good case for Icelandic bonds – a currency which has depreciated recently, high rates which, if they come down, spell a nice capital gain – we urge caution.

The Icelandic krona is very volatile, so any gains could by wiped out by currency fluctuations. And we prefer our investments to be underpinned by strong economic fundamentals, something sorely lacking from this story. Of course, you could make a fortune in Iceland… but you could say the same about playing roulette.

From Ben Traynor of Fleet Street Daily