Einhliða upptaka Raunhæf lausn á gjaldmiðlakreppunni? Fundur VÍB 27. apríl 2012
Manuel Hinds April 2012 UNILATERAL ADOPTION: A SOLUTION TO ICELAND S POLICY CRISIS? OR WHY SHOULD ICELAND HAVE A CURRENCY OF ITS OWN?
Agenda 1. Does it make sense to have a domestic currency? 1. The costs of the Krona 3. Myths and realities regarding local currencies 4. The current situation: a. The problem a. Potential solutions 3
DOES IT MAKE SENSE TO HAVE A CURRENCY? 4
The two kinds of money The citizen s money: Citizens expect money to be something that would have value all over the relevant economic space which today is the world and to keep it through time. The Central Bankers money: Central bankers think of money as a means to influence other economic variables. To do so, they have to: Separate Iceland from the rest of the world monetarily Change the value of the domestic money through time That is, to meet their objectives, Central Bankers have to contradict the common sense conception of money They are increasingly unable to do so, all over the world and in Iceland 5
Swimming against history? Historically, trade protectionism and monetary nationalism have tended to coincide In the 18 th century, mercantilism coincided with sharply defined monetary territories, within which the governments frequently devalued their currencies against the precious metals that defined them In the late 19 th and early 20 th centuries trade and monetary policies also coincided, but this time on the side of globalization. Trade liberalization was accompanied by widespread international commitment to a universal monetary standard, gold, which excluded the possibility of the government exercising monetary sovereignty. In the 1930s, in the midst of the Great Depression, protectionism went hand in hand with continuous competitive devaluation. After World War, the victorious powers tried to return to the free trade and the unified monetary system, embodied in the Bretton Woods system. But then, in the last third of the 20 th century, trade was increasingly liberalized, and the world s economy became increasingly globalized in all dimensions, except the monetary one. 6
The hard questions Is there a contradiction between globalization of trade and finance, on the one hand, and monetary sovereignty on the other? If so, what are the consequences for the world economy? For individual economies? For a very small economy like Iceland? Will something give, and if so, which will it be globalization or monetary sovereignty? 7
Exports + Imports % of GDP International Trade in the 20th century What is globalization? 50% The 19 th century globalization split the countries between producers of raw materials and industrial producers In fact, as seen in the graph, the share of imports and exports at the beginning of the 20 th century was much higher than in the middle years of that century 45% 40% 35% 30% Germany Japan It was only in the late decades of the century that this share reached the levels it had in 1913 What is changing the world today is the integration of production processes across the world Productive processes are splitting across the world 25% 20% 15% 10% 5% UK USA Average Globalization is a phenomenon of production 0% 1913 1950 1973 1987 1998 Sources: Angus Maddison, Dynamic Forces in Capitalist Development, A Long Run Comparative View, Oxford University Press, New York, 1991, for 1913-1987, and International Financial Statistics published by the International Monetary Fund for 1998. 8
This is opening huge opportunities for development Particularly to small economies with a highly educated population Which can be inserted in the global economy at a low cost But, to do that, you have to be integrated within the global economy That is, in trade, financially and monetarily Iceland tried to integrate in trade and finance while remaining a separate monetary space It failed Now, rather than integrating with the rest of the world, the Icelandic economy is splitting itself into an ISK space and a foreign currency space The opposite of what is needed And all this just to keep a currency of its own 9
Why should Iceland have a currency of its own? To put things in perspective: 2010 New York City s GDP: US$1,283 billions 2010 Iceland s GDP: US$13 billion That is, the economy of Iceland is equivalent to a 1/100th of New York City This is a few blocks of Manhattan, where most of the city s GDP is produced Is it reasonable to try to separate Iceland from the rest of the world monetarily? Is it good to separate Iceland from the international monetary environment? Is it possible to do it? SOURCE OF NYC s GDP: http://www.usmayors.org/metroeconomies/2011/report.pdf. Of Iceland s GDP: World Development Indicators, World Bank. 10
THE COSTS OF THE KRONA 11
The costs of separating the country monetarily while trying to globalize in trade and production Global chains of production are increasingly dominating the world economy Having all the components operating under a single currency increases the efficiency of these operations A small and weak currency, protected with capital flows controls and similar mechanisms, reduces the competitiveness of a player 12
The costs of separating the country monetarily while trying to integrate it financially Increasingly, capital is allocated by the international financial system The international financial system has sophisticated mechanisms to hedge foreign exchange risks between major currencies but not with small currencies This means that having a domestic currency increases the international financial system s cost of operating with Iceland This has become worse after the experience of the last four years Iceland must reduce, not increase the cost of investing here The Krona is a cost that gives no value added 13
12.1.03 7.1.04 2.1.05 9.1.05 4.1.06 11.1.06 6.1.07 1.1.08 8.1.08 3.1.09 10.1.09 5.1.10 12.1.10 7.1.11 The lack of control: quantities Only 20% of total credit is denominated in Krona Close to another 20% is denominated in foreign currencies, which liberates the financial operations from the manipulation of the Krona 60% is denominated in Indexed Kronas, which is another currency, designed specifically to liberate the financial operations from the manipulations of the Krona 70% 60% 50% 40% 30% 20% Iceland: Credit by currency Foreign currency-linked Indexed Unindexed Thus, the Central Bank controls only 20% of the financial operations in the country 10% 0% SOURCE: Central Bank of Iceland 14
Why having a domestic currency? MYTH #1: LOWER INTEREST RATES 15
The myth is that the Central Bank can impose whatever interest rate it wishes The problem is that the population has a different conception of money When the Central Bank manipulates the currency the public adopts a different standard of value for example, the dollar And then calculates the interest rate it would demand in Kronas in accordance with the following formula: Interest rates in Kronas = Interest rates in dollars in the int l markets + country risk + the risk of the Krona against the dollar A dollarized country has only the two first components The third may be very large, and it has been so in Iceland for a long time If they are paid less than this, they take their money away For this reason, the Central Bank has to set the interest rates close to what the market requires to deposit money in the country: sustainable monetary autonomy does not exist in most countries 16
júl.-01 apr.-02 jan.-03 okt.-03 júl.-04 apr.-05 jan.-06 okt.-06 júl.-07 apr.-08 jan.-09 okt.-09 júl.-10 apr.-11 jan.-12 The high premium paid to have people using Kronas Unfortunately the interest rates in foreign currency are not published in Iceland 25% 20% Iceland: lending rates However, the difference between the non-indexed and the indexed credits when the market was free gives an idea of the public s perception of the currency risk As seen in the graph, the mistrust in the Krona during the years of the boom and until the end of 2009 translated into spreads that went up from 5 to 14 percent points 15% 10% non-indexed indexed Spread Current / Indexed Later on the spreads have declined but in the midst of a heavily manipulated market, so that it no longer measures the risk of the currency in a reliable way 5% Paying 7 to 15 percent points of interest just to have a Krona is very expensive 0% SOURCE: Central Bank of Iceland 17
M1 1998 M4 1998 M7 1998 M10 1998 M1 1999 M4 1999 M7 1999 M10 1999 M1 2000 M4 2000 M7 2000 M10 2000 M1 2001 M4 2001 M7 2001 M10 2001 M1 2002 M4 2002 M7 2002 M10 2002 M1 2003 M4 2003 M7 2003 M10 2003 M1 2004 M4 2004 M7 2004 M10 2004 M1 2005 M4 2005 M7 2005 M10 2005 M1 2006 M4 2006 M7 2006 M10 2006 M1 2007 M4 2007 M7 2007 M10 2007 M1 2008 M4 2008 M7 2008 M10 2008 M1 2009 M4 2009 M7 2009 Since dollarization, interest rates in El Salvador have been the lowest or the second lowest in Latin America and about the most stable ones (the other lines are rates in other countries in LA) 60% Latin America lending rates 50% Uruguay Venez Parag Brazil 40% 30% 20% Ecuador 10% 0% D.R. Hond Bolivia Colombia Panama Mexico Dollarization Paraguay Argentina Peru C.R. Nica Guate El Salvador Chile SOURCE: International Financial Statistics, IMF
M1 1998 M5 1998 M9 1998 M1 1999 M5 1999 M9 1999 M1 2000 M5 2000 M9 2000 M1 2001 M5 2001 M9 2001 M1 2002 M5 2002 M9 2002 M1 2003 M5 2003 M9 2003 M1 2004 M5 2004 M9 2004 M1 2005 M5 2005 M9 2005 M1 2006 M5 2006 M9 2006 M1 2007 M5 2007 M9 2007 M1 2008 M5 2008 M9 2008 M1 2009 M5 2009 Lending rates And the lowest in Central America by a wide margin 35% Lending rates in Central America 30% 25% 20% 15% 10% Costa Rica El Salvador Guatemala Honduras Nicaragua 5% 0% SOURCE: International Financial Statistics, IMF
M1 1998 M6 1998 M11 1998 M4 1999 M9 1999 M2 2000 M7 2000 M12 2000 M5 2001 M10 2001 M3 2002 M8 2002 M1 2003 M6 2003 M11 2003 M4 2004 M9 2004 M2 2005 M7 2005 M12 2005 M5 2006 M10 2006 M3 2007 M8 2007 M1 2008 M6 2008 M11 2008 M4 2009 Lending rates Why having a local currency to have higher rates of interest always? In all the phases of the economic cycle? 30% Dollarized and Non-Dollarized Countries 25% 20% 15% 10% Average Non-Dollarized Latin America Average Non-Dollarized Central America El Salvador Panama 5% 0% SOURCE: International Financial Statistics, IMF
M1 1998 M5 1998 M9 1998 M1 1999 M5 1999 M9 1999 M1 2000 M5 2000 M9 2000 M1 2001 M5 2001 M9 2001 M1 2002 M5 2002 M9 2002 M1 2003 M5 2003 M9 2003 M1 2004 M5 2004 M9 2004 M1 2005 M5 2005 M9 2005 M1 2006 M5 2006 M9 2006 M1 2007 M5 2007 M9 2007 M1 2008 M5 2008 M9 2008 M1 2009 M5 2009 Inside El Salvador the interest rates went down dramatically with dollarization 18% El Salvador: $ and colones rates 16% 14% 12% 10% LENDING RATE COLONES LENDING RATE (FOREIGN CURR.) 8% 6% SOURCE: International Financial Statistics, IMF
M1 1998 M5 1998 M9 1998 M1 1999 M5 1999 M9 1999 M1 2000 M5 2000 M9 2000 M1 2001 M5 2001 M9 2001 M1 2002 M5 2002 M9 2002 M1 2003 M5 2003 M9 2003 M1 2004 M5 2004 M9 2004 M1 2005 M5 2005 M9 2005 M1 2006 M5 2006 M9 2006 M1 2007 M5 2007 M9 2007 M1 2008 M5 2008 M9 2008 M1 2009 M5 2009 In countries with two currencies, interest rates are much lower in dollars than in the local currency isn t that the opposite of the expected benefit? 40% Spread of lending rates in domestic currency to $ lending 35% 30% 25% 20% 15% 10% Chile Dominican Republic Honduras Paraguay Uruguay Peru 5% 0% SOURCE: International Financial Statistics, IMF
Why having a domestic currency? MYTH #2: DEVALUATIONS MEAN HIGHER EXPORTS 23
Real devaluations do not increase exports In Latin America, those who have devalued the more have expanded exports the less With Brazil Without Brazil Real depreciations to the right Data 1995-2002, International Financial Statistics of the IMF 24
The same in developing Europe and Asia Data 1995-2002, International Financial Statistics of the IMF 25
Through time, Japan and Germany Depreciations to the left Source of basic data: International Financial Statistics of the IMF 26
Why having a domestic currency? MYTH #3: MORE STABLE FINANCIAL SYSTEM 27
It is the opposite Currency risks increase the risks of operating in a country considerably In all cases of financial crises in countries with a domestic currency, there has been a currency crisis and this has been the one that has led the crisis Runs on banks happen as people withdraw their deposits to exchange the local currency for foreign money This could be seen in Iceland and in many other countries The currency risk is a major factor of destabilization Unilateral adoption eliminates this risk 28
2003 Jan 2004 Mar 2005 May 2006 Jul 2007 Sep 2008 Nov 2010 Jan 2011 Mar 1 + currency depreciation Inflation rate Inflation Rate Moreover, in Iceland, currency depreciations lead to inflation Currency depreciation and CPI inflation Currency Depreciation and CPI Inflation Jan 2003- Feb 2012 2,5 0,200 0,180 0,250 y = 0,1641ln(x) + 0,0567 R² = 0,8082 2 0,160 0,200 0,140 1,5 0,120 0,150 1 0,100 0,080 1 + Depreciation Rate CPI Inflation 0,100 0,060 0,5 0,040 0,050 0,020 0 0,000 0,000 0 0,5 1 1,5 2 2,5 1 + Currency Depreciation SOURCE: Central Bank of Iceland 29
Prices January 2010 % of 2001 The same happens in Latin America 440% Inflation and currency depreciation, 2001-2009 Inflation has always been correlated to nominal currency depreciation in Latin America 390% As shown in the adjoining graph, this was so during 2001-2009, the period during which El Salvador has been dollarized 340% Argentina The correlation between currency depreciation and inflation is likely to be much higher because the rates of inflation of Venezuela and Argentina are likely to be much higher 290% 240% Chile Peru ES Pan Venezuela y = 0,7538ln(x) + 2,5634 R² = 0,5016 Uruguay 190% 0% 50% 100% 150% 200% 250% 300% 350% 400% Exchange rate January 2010 % of 2001 SOURCE OF DATA: Author s calculations based on data from World Development Indicators (World Bank) 30
M1 2001 M4 2001 M7 2001 M10 2001 M1 2002 M4 2002 M7 2002 M10 2002 M1 2003 M4 2003 M7 2003 M10 2003 M1 2004 M4 2004 M7 2004 M10 2004 M1 2005 M4 2005 M7 2005 M10 2005 M1 2006 M4 2006 M7 2006 M10 2006 M1 2007 M4 2007 M7 2007 M10 2007 M1 2008 M4 2008 M7 2008 M10 2008 M1 2009 M4 2009 M7 2009 January 2001 = 1 The Real Exchange Rate has been among the most stable in the region 2 Latin America REER (lower means appreciation) 1,8 1,6 1,4 1,2 1 El Salvador 0,8 0,6 SOURCE: International Financial Statistics, IMF
Deposits in dollars stabilize the system in the midst of crises: Argentina in 2001 Source: Central Bank of Argentina 32
In Ecuador, the run on banks stopped when the country was dollarized Source of basic data: International Financial Statistics of the IMF 33
Why having a domestic currency? MYTH #4: THE LENDER OF LAST RESORT 34
The crucial question: Where was the Central Bank as lender of last resort during the crisis? Who was the real lender of last resort? The IMF Why? Because to be a lender of last resort, an institution must be able to lend in the currency that people are demanding This currency was dollars, independently of the currency in use in the banking system Since the Central Bank cannot print dollars, it had to borrow from the IMF to satisfy the demand The crisis was not just financial it was primarily a currency crisis 35
2008 Apr 2008 Sep 2009 Feb 2009 Jul 2009 Dec 2010 May 2010 Oct 2011 Mar 2011 Aug 2012 Jan -100 0 100 200 300 400 Millions of Krona Net Foreign Assets, Krona Billions To give credit to save banks, the Central Bank needs dollars Central Bank: Domestic credit and Net Foreign Assets 800 Central Bank 800.000 700 700.000 600.000 500.000 600 500 y = -1,0504x + 552,34 R² = 0,607 400.000 300.000 Net Foreign Assets Net Credit 400 300 Net Foreign Assets Linear (Net Foreign Assets) 200.000 200 100.000 100 0 0-100.000 Net Credit, Krona Billions SOURCE: Central Bank of Iceland 36
2008 Apr 2008 Jun 2008 Aug 2008 Oct 2008 Dec 2009 Feb 2009 Apr 2009 Jun 2009 Aug 2009 Oct 2009 Dec 2010 Feb 2010 Apr 2010 Jun 2010 Aug 2010 Oct Krona, Billions The Central Bank is not a Lender of Last Resort It is a borrower of last resort This is because during a crisis the public does not trust the local currencies 450 400 350 300 Central Bank of Iceland Withdraws deposits in local currency to convert them into foreign currency For this reason, when the Central Bank prints money to support the banks, it either borrows in dollars or loses reserves Thus, the lender of last resort is a myth 250 200 150 100 50 Net Credit Liabilities to foreigners It is the same as in a dollarized economy 0 SOURCE: Central Bank of Iceland 37
des.-87 jún.-88 des.-88 jún.-89 des.-89 jún.-90 des.-90 Credit in pesos million NFA in dollar million Bank of Mexico All financial crises in developing countries Have been accompanied with, and were actually triggered by, currency crises 140.000 120.000 30.000 25.000 People withdraw their deposits from the bank not to put them under the mattress but instead to buy foreign exchange dollars in Latin America and Asia 100.000 80.000 20.000 15.000 For this reason, when the central bank prints local currency to help the banks, it immediately loses international reserves 60.000 10.000 Total Net credit in pesos Net foreign assets in $ For this reason, central banks cannot save banks with money they print they are not lenders of last resort they need dollars. 40.000 5.000 That is why the IMF has leverage during a crisis 20.000 0 These pages show some examples chosen at random. The graph shows the case of Mexico during the Tequila 0-20.000-5.000-10.000 SOURCE OF DATA: Author s calculations based on data from IFS 38
júl.-75 jan.-76 júl.-76 jan.-77 júl.-77 jan.-78 júl.-78 jan.-79 júl.-79 jan.-80 júl.-80 Net Foreign Assets in $ billion Net credit in peso billions Central Bank of Chile The same effect in Chile during the early 1980s 5 1.200 As in Mexico, when the Central Bank started to lend to the banks, its net reserves went down rapidly 4 1.000 3 Like Mexico later in the tequila and almost simultaneously in the 1980s, Chile had to borrow heavily from the IMF, the World Bank and the IDB to cover the depletion in reserves, which in turn was caused by the printing of pesos 2 1 800 600 Net foreign assets in $ billion Central bank credit in pesos billion 400 0-1 200-2 0 SOURCE OF DATA: Author s calculations based on data from IFS 39
des.-86 jún.-87 des.-87 jún.-88 des.-88 jún.-89 des.-89 jún.-90 Dollar million Bolivares million And exactly the same in Venezuela and all other countries with crises The Central Bank needs dollars to print the pesos it lends to the banks to save them 12,000 10,000 Central Bank of Venezuela 1600,000 1400,000 1200,000 Without dollars, the central bank would lose its reserves and, as in Indonesia in 1997-98 and Ecuador in 1999-2000 the price of the local currency would get into a free fall Thus, the central banks need dollars to save the banks exactly as in dollarized countries 8,000 6,000 4,000 1000,000 800,000 600,000 400,000 Net foreign assets in $ Net central bank credit in bolivares Thus, countries with local currencies do not really have a lender of last resort except for the IMF 2,000 200,000 0,000 0,000 SOURCE OF DATA: Author s calculations based on data from IFS 40
The same happened in Thailand and Indonesia: to give credit during the crisis, the central banks had to borrow dollars Source of basic data: International Financial Statistics of the IMF 41
And in Ecuador Source of basic data: International Financial Statistics of the IMF 42
Why having a domestic currency? MYTH #5: YOU NEED ENORMOUS AMOUNTS OF MONEY TO DOLLARIZE 43
Not true What you have to replace with dollars when you dollarize is only the monetary base the currency in circulation plus the deposits of the banks in the Central Bank. The deposits of the population in the banks (those included in M1, M2 and M3) is not liquid. They have been invested by the banks in loans, which have become assets like, say, houses, planes, etc. These assets will, hopefully and with time, generate the liquid resources that will be used to repay the loans with interests. What is needed is to purchase the monetary base with dollars and denominate by law all the assets and liabilities of the banking system in dollars, so that the liquidity that will be generated in the future will be denominated in dollars. That is the way it was done in Ecuador, El Salvador and in Europe when the Euro was introduced (the European Central Bank created euros only enough to buy the monetary base in each euro country). 44
Why having a domestic currency? MYTH #5: DOLLARIZED COUNTRIES LOSE HUGE AMOUNTS OF INCOME FROM SEIGNIORAGE 45
In Iceland the seigniorage is negative Seigniorage is the income accrued to the government (the seignior) from the privilege of issuing money in its territory When issuing money, the Central Bank borrows real resource from the population for example, when exchanging local currency for foreign money. Seigniorage is the difference between the annual income and expenditures incurred by the Central Bank in the operation. The income flows from the interest payments that the Central Bank gets from depositing the foreign currency abroad. The expenditures have two components: Coins and bills: the annual interest on the resources used to produce them. Deposits of the banks in the Central Bank: Central Banks pay interest rates on these deposits. The seigniorage is positive only if these are lower than those paid for their reserves. In Iceland this part of the seigiorage and the total seigniorage are strongly negative. Eliminating a negative seigniorage through dollarization would be an economic gain. 46
The current situation THE PROBLEM 47
For an economy the size and sophistication of Iceland, integration to globalization should be a first priority Yet, the country is now split into an economy in Kronas and another in foreign exchange This partition between currencies is preventing the only viable solution to the financial survivability of the country The current account surplus is not enough to service the external debt particularly because there is a potential capital flight waiting in the wings to leave the country The debt in foreign currency could be refinanced and there is interest in direct foreign investors in investing foreign resources in the country However, investors (in bonds and direct investments) do not bring their resources and actually want to leave because of the measures taken or potentially taken to defend the Krona. It is a vicious circle. 48
The current situation THE POTENTIAL SOLUTIONS 49
The first step in finding a solution First, it is necessary to differentiate between the money that the currency wants to use and the financial situation of the banks, the government and the economy in general The country is in this predicament largely because it mixed up monetary policy with prudential and financial policies Monetary and exchange rate policies cannot be used to resolve debt problems when most debts are denominated in other currencies like indexed loans and loans in foreign currencies which is the case in Iceland Having a weak currency only erodes the public s confidence in the ability of the banking system to keep the value of one s resources People will not freely invest in Icelandic financial assets as long as they suspect that part of their resources will be expropriated, either by bankruptcy of the banks or by devaluation of the currency 50
There are many opportunities of profitable investment in Iceland The monetary and financial markets should be able to work unimpeded for these and all other activities in the country Restrictions should exist only in those liabilities of each bank that are tied to compromised assets in that bank (restrictions of payments should exist only for individual institutions, not for the economy or the banking system as a whole.) The transition to this state should be carefully planned to make sure that the system moves toward liberalization as confidence returns to the country 51
The problem: currency overhang and capital controls The need for capital controls is a clear symptom that the incentives to keep deposits and investments in Iceland are not enough The incentives are: The interest rates The real business opportunities The solidity of the currency (low probability of losing money via currency depreciations) The certainty that the government will not introduce obstacles to the free flow of capitals to defend the local currency The capital controls must be removed to give confidence to investors The question is, with Kronas or adopting an international currency? 52
The Krona solution The supposed advantage of a system with a local currency is that the government can devalue it, thus increasing the cost of exporting capital. Yet, in Iceland, devaluation would mean higher inflation, increased value of the debts of enterprises and households because most of them are denominated in foreign currency or in indexed Kronas. Thus, a devaluation would worsen the debt problem while reducing even more the appeal of having capital invested in Iceland. Any government promise concerning the value of the Krona would not have credibility Thus, the only means to increase the appeal of keeping liquid capital in Iceland would be to increase the rate of interest, maybe by 15 percentage points, which would be terrible for the debtors It would bring another crisis 53
The unilateral adoption solution Adopting an international currency would eliminate the currency risk and therefore the currency premium in the interest rate. Eliminating the capital controls would further increase confidence, attracting capital, keeping in place that which is already there, and allowing the government and the financial system to refinance its debts in a sustainable way This would reduce the interest rate that would retain liquid capital in Iceland. Moreover, as recommended before, some temporary restrictions could be imposed on individual banks that are still insolvent or illiquid. These measures would stabilize the economy. As stated before, the transition to this state should be carefully planned to make sure that the system moves toward liberalization as confidence returns to the country 54
Einhliða upptaka Raunhæf lausn á gjaldmiðlakreppunni? Fundur VÍB 27. apríl 2012