Presumably because they are a great tool for hauling fish across the Icelandic tundra, Land Rovers were a popular item for the small island nation. They were even more popular as the result of the availability of cheap financing during the pre-crisis boom in credit. The problem was, this cheap financing was provided in foreign currency; the interest rate for euros, pounds and dollars was far lower than that for the domestic currency, the krona. This is all fine and good if your salary is paid in euros, pounds and dollars, but in fact most people in Iceland are paid in krona.
When Iceland's economy went down the crapper, the value of the krona went with it. Since the value of their income had just plunged relative to the value of their debts, many civilized citizens of Iceland were forced to make one of two choices:
- Attempt to pay back their car loans in salted cod
- Do something crazy
"Icelandic Bank: Dear Mr. Ragnar Hjalrnarsson, the monthly payments on your Land Rover are 3 months overdue."
Mr. Hjalrnarsson: *panting furiously, having just run for cover*
"Iclelandic Bank: Mr. Hjalrnarsson?"
"Mr. Hjalrnarsson: Land Rover? What is this Land Rover of which you speak?"
The fine folks in Iceland had resorted to blowing up their Land Rovers to avoid paying them back. Seriously. This is a country that, in 2008, still had a GDP-per-capita of over $52,000.
Why am I re-telling this story? Because the exploding Land Rover is a great metaphor for a currency mismatch: the situation wherein debts are denominated in a different currency than the income used to pay down those debts. Currency mismatches can exist not just for individuals, but for entire economies at the macro level. But since economies can't go around blowing up Land Rovers whenever it comes time to rollover their debts, the consequences can be quite severe.
The most recent example of this phenomenon was in parts of Eastern Europe, particularly the Baltic states, way back in 2007-8. Countries like Latvia, Estonia, Hungary, etc... had a large number of loans outstanding to European banks (i.e. denominated in euros). Many of these debts were also short-term and needed to be rolled over right smack in the middle of the financial crisis (see a more detailed explanation in this old post). That proved problematic, to say the least. As a result, parts of Eastern and Southeastern Europe were among the hardest hit economies in an economic crisis that originated somewhere else.
The currency mismatch is not a problem specific to our most recent financial crisis, however; here is economist Morris Goldstein, speaking in 2007:
".... [S]erious currency mismatch has been a feature of every major emerging-market currency crisis of the past dozen years. It was there in Mexico in 1994–95, in the Asian crisis countries in 1997–98, in Russia in 1998, in Brazil in 1998–99 and 2001–02, in Turkey in 2001–02, and in Argentina in 2001–02.... [C]urrency mismatch provides the best explanation we have for why large exchange rate depreciations in emerging economies have had such costly growth effects. When financial liabilities are mostly denominated in dollars or in other reserve currencies while assets and revenues are mainly denominated in local currency, then a large depreciation of the local currency will result in balance sheet problems that ultimately cause economic growth to nosedive."
Here is Brad DeLong:
"The decade of the 1990s was marked by the sudden emergence of international financial crises. In a typical such crisis, a sudden loss of confidence in the value of a country’s currency by international currency speculators was followed by a rapid rise in the value of foreign currency—in the exchange rate—the threat of large-scale bankruptcies of banks and firms, financial panic, and a sharp severe recession. These crises hit in the Mexican peso crisis of 1994-1995. Then followed the far-reaching East Asian crisis of 1997-1998. The decade ended with crises in Brazil, Turkey, and Argentina."
The currency mismatch is not merely a modern creature - oh no. In the period of unfettered capitalism that characterized the late 19th and early 20th centuries, "hot money" was flowing into what we would now call emerging markets: Southeast Asia and South America. There were quite a few financial blow-ups involving currency and maturity mismatches - the Barings crisis of 1890 being the most famous.
In other words, we need to recognize that the risk of a currency mismatch contributing a major financial meltdown is present in just about every period in which we see capital flowing easily across borders. This leads me to ask one simple, juvenile, question:
Why why why why WHY?
With all this history, why hasn't anyone learned their bloody lesson? Why do we continue to see, to this very day, the potential for instability caused by currency mismatches present - and growing - in a variety of markets. I can think of several factors that play a role:
1) Access - pretty straightforward: you need easy access to international capital markets. This has been easier during certain periods of time (pre-1914, the Great Moderation of the 1990s-2000s, etc) and in certain regions (for instance, small EU members have direct access to foreign lending from other EU members due to the membership requirement for open capital accounts).
2) Import requirements - it is unlikely that many exporters or banks will accept the Papua New Guinea kina in an exchange for the sale of goods & services, for instance. Small economies with non-reserve currencies need to use foreign currencies to purchase the things they need, or borrow the funds they need. This can lead to debts in those same foreign currencies.
3) Lack of trust in the local currency - often domestic borrowers will seek outside financing if the local currency has a history of high inflation, political meddling, or exchange rate volatility.
4) weak domestic capital markets - sometimes domestic borrowers simply cannot raise money domestically. There are any number of elements to this, including: restrictive local banking regulations, lack of expertise, or lack of appetite (see #3).
5) Behavioural/psychological element - it is hard to resist cheap money. Look at the subprime real estate crisis in the United States and you can see how difficult it is for people to resist borrowing irresponsibly (often from irresponsible lenders). The people in Iceland basically did the same thing, and got burned when interest rate on the loans shot up. People tend to overestimate their ability to predict future events.
6) ...what have I missed?
One argument I'm not buying is lack of awareness. As illustrated above, the challenge of currency and maturity mismatches is not new. Policymakers know and appreciate the dangers associated with a country (or many of its citizens) borrowing in foreign currency, particularly for the short-term. But sometimes the problem is an inability to stop hot money inflows & outflows - see the point about access above - and the costs associated with markets who are perceived to have overly-restrictive measures in place for investments.
Why am I bothering with all of this? It is because, even though the crises I've mentioned above are mostly old news, the challenge posed by hot money inflows is as topical as ever. This is part due to the expansionary monetary policies adopted by the United States and other large developed economies to stimulate recovery. I discussed this back in April with this atrociously-titled post, but if anything the trend has become more pronounced in the period since then.
The recent IMF global markets monitor suggests that capital inflows to emerging markets continues to surge, led primarily by portfolio flows to liquid debt and equity markets. In many parts of the world (including parts of Latin America and Asia), the levels of inflows are reaching pre-Lehman levels. It is important to emphasize that this is not foreign direct investment (i.e. the money isn't there for the long-haul).
India is seeing heavy capital market inflows, again mostly in equities and mostly portfolio inflows. China is also trying to keep a lid on domestic credit growth and just recently capped the amount of lending by domestic banks.
In fact, many emerging markets are toying with capital controls as a way to limit volatility. Brazil has done so, and there is speculation (so far un-founded) that Malaysia will follow suit. Brazil was even somewhat successful in getting pro-capital control language in the G20 communique from Korea ("practical tools to overcome sudden reversals of flows," anyone?). The large exporters will also continue to keep large foreign exchange reserves as a buffer - a policy that turned out to be rather justified in recent years, despite the distorting effects it has on global imbalances and the huge opportunity cost.
All of this suggests that the dangers associated with currency mismatches and rapid capital inflows have not gone away. Quite the opposite. Large inflows may be justified in the current environment of strong emerging market performance, but our ability peer into the future is limited. We do not know what is coming next.
We do not know who will be blowing up their Land Rovers next.