Iceland Revives Carry Trade as Default Risk Is Below EU

Iceland’s decision to break with global crisis-fighting efforts and raise interest rates this month may presage the return of the very same carry trade that channeled fast money into the country before its banking crisis.

Iceland raised its main interest rate on Aug. 17 by a quarter point to 4.5 percent, the first increase since its banks collapsed almost three years ago. The central bank, which also raised its economic forecast for 2011, is increasing rates as it eases capital controls that have locked in $4.3 billion in krona assets since 2008. The move may revive a trade popular before the crisis: borrowing in low-yielding currencies and carrying the funds into higher-yielding markets such as the krona.

“The central bank has stated that it wants to open the door to the carry trade,” said Asgeir Jonsson, an economist at Reykjavik-based asset manager Gamma. “As greed knows no boundaries, carry traders will always return as long as the yield is favorable.”

Iceland, where a 2008 banking implosion left bond investors trying to recoup $85 billion, can now boast a lower risk of default than the average for the European Union. The central bank signaled this month it may continue to raise rates to support the currency as the U.S. and the euro area resort to emergency easing to keep their economies afloat. Iceland’s rate rise comes as investors are turning to emerging markets to tap into faster growth rates and lower debt levels.

The Icelandic krona strengthened for a second day, rising 0.3 percent to 113.14 per dollar as of 9:33 a.m. London time.

‘Redefining Risk’

Credit default swaps on Iceland’s five-year debt were at 278 basis points on Aug. 26, compared with a 345 basis point average for the 27-member European Union, CMA prices show.

“Investors are redefining risk,” Jonsson said. “Now bonds issued by sovereigns in the emerging markets are more desirable than those of countries such as Italy.”

Iceland’s economy will next year outgrow the euro area and maintain a smaller budget deficit in the process, the Organization for Economic Cooperation and Development said May 25. The island’s gross domestic product will expand 2.9 percent in 2012, compared with 2 percent in the 17-member euro area. Iceland’s government deficit will narrow to 1.4 percent of GDP, versus a 3 percent shortfall in the euro bloc in 2012, the OECD estimates.

‘Road to Recovery’

The island completed a 33-month International Monetary Fund program this month after the Washington-based lender established that all economic “objectives have been met and the country is on the road to recovery,” according to an Aug. 26 statement marking the island’s final review. The IMF praised the central bank’s decision to raise rates as an appropriate measure to tame inflation as import prices rise. Consumer price growth held at 5 percent in August, the highest level since June 2010. The krona has lost 6.5 percent versus the euro this year.

By raising rates “we’re making the Icelandic krona more attractive than it otherwise would be,” said Thorarinn Petursson, chief economist at the central bank.

While higher rates may boost the krona, such tightening won’t “reduce inflationary expectations, on the contrary they could worsen,” said Asdis Kristjansdottir, an economist at Arion Bank hf. Raising rates will instead hurt “the fragile recovery ahead,” she said.

Though Iceland has signaled it needs to keep some form of capital controls in place until as late as 2015, the central bank is already easing the restrictions in phases.

Krona Flows

“The moment the market opens up in Iceland, carry traders will return,” Jonsson said. “Investors’ risk appetite has increased and is increasing and investors are increasingly putting their money into emerging markets.”

Monthly krona flows peaked at 1.2 trillion kronur ($10.6 billion) in March 2008, seven months before Iceland’s biggest banks failed. Iceland’s gross domestic product was 1.5 trillion kronur for that whole year. Flows surged as the central bank pursued a tightening cycle that brought the benchmark rate to 15 percent in March 2008. The rate reached 18 percent that year before the bank finally imposed capital controls to protect the currency from a sell-off after the banks failed. Monthly krona turnover in July 2011 was 5.6 billion kronur.

While the central bank’s Petursson says Iceland is still “quite far away from having to worry about the carry trade,” Jonsson warns the transaction “will begin immediately” once the country opens its capital markets. He’s not alone in voicing concerns.

‘Iceland’s Demise’

“Iceland should be careful when it comes to opening up the doors for the carry trade, as those kinds of transactions played a role in Iceland’s demise,” said Jon Bjarki Bentsson, an economist at Islandsbanki hf. “It would be better if foreigners were drawn to Iceland because of an underlying profitability, not just because short-term interest rates are high.”

Not all analysts agree that the carry trade is a bad thing. Lars Christensen, chief analyst at Copenhagen-based Danske Bank A/S, said speculative krona purchases shouldn’t hurt the economy provided the extra yield the central bank offers exceeds the risks associated with holding the currency.

“Fundamentally it could be a good idea for Iceland to attract the carry trade, if the carry trade reflects that interest rates are higher than the perceived risk by investors,” he said.

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