Sigrún Davíðsdóttir's Icelog

The Icesave outcome for Iceland will, in the end, be hugely dependent on the value of the Icelandic krona since the underlying amount is in foreign currency – and with currency regulation it’s difficult to say what the krona’s real value is. There is, for the time being, a noticeable difference between the ISK on- and offshore rate though the two rate have been converging.

How long the currency regulation will be in place is uncertain. There have been indication from the Icelandic Central Bank that the end of the regulation was in sight but there have also been contrary indication.

In connection with Icesave news on Thursday Reuters reported on these issues:

Analysts welcomed the deal, notably in the context of other positive news about the recovery from a crash that came to symbolize the 2008 global crisis.

“If we can get agreement on Icesave that will be positive for investor sentiment then we might begin to see money flowing back into Iceland,” said Danske Bank economist Lars Christensen.

“What happens when you remove the capital controls? I am getting more and more inclined to think that (the ensuing fall in the crown) might not be as big as feared,” he added.

Iceland imposed capital controls to protect the crown, a move which also locked in foreign investors who had crown assets after several years of high-yielding glacier bond issuance.

The central bank has said it will not make any moves to lift the controls on outflows this year and that no fundamental changes would be made before March 2011.

SEB emerging markets strategist Mats Olausson said there were opportunities for investors.

“I think that solving (Icesave) brings deregulation one step closer and once that happens the onshore and offshore rates are set to converge. Our view has been that convergence will happen closer to the onshore rate,” he said.

He said Icelandic bond yields had already fallen, but that a currency play could bring benefit if there was an appreciation of the crown from its current offshore rate of 240.50 to the euro, toward the onshore rate of 151.80.

“For investors the thing to watch is the timing of deregulation and the opportunity to get into the offshore market. Investors should be very wary about the possible risks, but we think there is potential for a good return when deregulation happens,” he said.

It’s interesting that the two analysts, Christensen and Olausson, think that the krona rate in an unrestricted environment would most likely be closer to the onshore rather than the offshore rate, i.e. there wouldn’t be the crash of the krona as some fear. One of the reasons might be that the adjustment has already happened, that those holding Icelandic assets such as glazier bonds are patient owners, content with the interest rates in Iceland. Although interest rates in Iceland have come steeply down since October 2008 rates are still high compared to Eurozone. The ICB overnight interest rate is now, since December 8, 5,5%.

Lars Christensen became a celebrity in Iceland, or rather a hate figure, in March 2006 when Danske Bank published a research paper titled Iceland: Geyser Crisis. Its negative outlook caused a furore in Iceland with accusations flying of the Danes, who ruled Iceland for centuries until Iceland left the union in 1944, being envious of Iceland’s success and more in that vein. It’s still an interesting read:*

There was indeed a dip in 2006 since Danske Bank wasn’t the only one to spot the warning signs; it was just one of many though Icelanders picked on Danske. Most analysts gave these warnings and the Icelandic banks got into trouble with their refinancing. The European market was closed to them but the US market proved a fresh ground. If that hadn’t happened things might have turned out differently.

The first half of 2007 was yet another boom time in Iceland but it’s a question how much of a helping hands the banks and the main players gave themselves. Allegations of market manipulation are being investigated in Iceland although they seem to be only a part of a general enriching scheme for major shareholders and favoured clients in all the banks. Later, the Icelandic banks got incomprehensibly positive ratings since it seems that analysts, for some reason, started to believe, or wanted to believe, that the Icelandic high wire act wasn’t defying gravity but was sound. They were as wrong as Danske Bank was right in 2006.

*Funnily, the Geyser paper from 2006 doesn’t seem to be available on Danske Bank’s website any longer but I found it on an Icelandic website.

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