The brutal battering suffered by the Icelandic economy this year should serve as a shot across the bows of European economies heading into turbulent waters, bankers warn.
A downgrade of the Nordic country’s debt by Fitch on February 21 sparked a massive sell-off of its currency and sent the local stock market reeling. The fallout sent shock waves through markets and slammed a number of currencies including the Hungarian forint, the Brazilian real and the South African rand.
The shock is symptomatic of the sickness in the world economy caused by the notorious global imbalances. Deficit countries have once again been in the firing line over the last couple of weeks as tightening monetary policy in the US, eurozone and Japan squeezed the liquidity that has covered over the current-account cracks for the past three years.
“The world is going to divide up between deficit and surplus countries,” said Arnab Das, head of emerging market research at Dresdner Kleinwort Wasserstein. “Iceland is the best example of this,” he noted in an interview with Emerging Markets.
Halldor Kristjansson, chief executive of Iceland’s second biggest bank, Landsbanki, says that Iceland’s sufferings won’t be repeated because the economy is flexible enough to adjust rapidly through swings in the currency. However, he urges less developed countries to take steps to ensure a similar shock doesn’t plunge their economies into protracted recession. “The only advice we can give to those countries is to have cooperative and strict monetary and fiscal policy – that’s the only way a government can deal with a situation like that,” he said. Central banks must stand ready to move interest rates swiftly, and governments should tighten their belts and put money aside when they can, he recommended.
In addition, the global spillover from the Icelandic stumble earlier this year offers an insight into the complex webs of trades woven by hedge funds across the global economy.
“When a currency like the Icelandic krona is selling off, hedge funds will examine their other carry trades and sell off where they see a weakness,” said Philip Poole, head of emerging markets research at HSBC. Leveraged investors, with little tolerance for losses, may bail out of multiple markets at the same time, he noted.
Governments in central Europe, including Hungary, Poland and the Czech Republic claim to have got the message that markets are going to punish deficits.
“I think this argument further underpins the notion that we can’t wait on these reforms until autumn [when local elections are held], but we need to take action immediately. And action will be taken,” finance minister Janos Veres promised.