Friday, 10 October 2008

Iceland Melts - Will Malta Freeze

10th October 2008
The Malta Independent - Friday Wisdom

This has nothing to do with global warming. It has all to do with realisation that this world has apparently gone topsy-turvy.

Iceland and Malta are islands with roughly the same population sitting at opposite ends of the European continent. Nothing that island states their size can do normally finishes on international news headlines. Iceland has broken this mould.

At a time when financial news are making headlines in Main Street, at a time when financial instability and unprecedented volatility on the main world share exchanges is leaving operators breathless and investors perplexed, at a time when governments are being forced to take unthinkable measures in attempt to stabilise their financial markets, involving investment of astronomical sums of money to recapitalise their banks, offload them of troubled assets and infuse liquidity in money markets, yet tiny Iceland’s financial predicament still manages to make headline news.

This is happening because Iceland is the first western world developed country that is involved in a financial meltdown of unbelievable proportions. What has landed Iceland in such hot water, making this beautiful ice-bound island melt away financially?

In technical terms it is called leverage, in fact leverage in high doses. Leverage is when somebody, a person, a business organisation or a nation state, borrows far more than their economic circumstances can process productively and efficiently. Icelandic banks considered that their country was too small for their ambitions and rather than rely primarily on the deposits they collect domestically they started borrowing extravagantly on the international markets in order to finance the international projects and ventures by Icelandic entrepreneurs that wanted to punch above their weight on international market. Even in Malta we saw an Icelandic company take over a long established pharmaceutical company, which started under Dutch public ownership in 1974.

This brought temporary success and exuberance on domestic Icelandic markets, leading to excessive demand caused by living on easy credit which generated double digit inflation and balance of payments deficit of unsustainable proportions. These macro-economic imbalances weigh heavily even when the international economic background is rosy. When it turns chilly under the weight of a sharp credit crunch, excessive borrowing becomes unbearable as lenders start pulling back their credit lines and banks start losing their major currency i.e. the confidence of their depositors.

Iceland has lost the support of international lenders and its banks would have gone bankrupt if the State did not intervene to take them over and back them up by state guarantees supported by the nation’s balance sheet. Yet the nation’s foreign reserves position is very tight and in order to avoid a shocking depression the government needs to raise several billions of euro in foreign currency loans which are not available on a market suffering a serious credit freeze. Attempts to raise such finance bilaterally from the US or West European governments found no backing as these countries are struggling with their own domestic problems of dysfunctional financial markets.

Iceland had to resort to an unlikely source: Russia. Russia has extensive foreign reserves accumulated by strong balance of payments surpluses resulting from high prices of exported energy. What conditions will Russia impose on Iceland if it agrees to provide the finance requested is yet to be seen. But certainly it is not enviable to be in the shameful position Iceland has landed itself in. Iceland is in a financial meltdown from which it can emerge with difficulty after much pain over several years hopefully without compromising its sovereignty.

Thankfully in Malta we manage a much more conservative banking system. Our banks finance their operations entirely from domestic deposits and command a comfortable liquidity surplus which is deposited with the Central Bank over and above the regulatory reserve requirements. Banks do not lend funds to each other as they all have surplus liquidity so their end of day clearing operations are generally excessive liquidity placed with the Central Bank. Our banks are not exposed to the risk of losing international credit lines. As a nation our foreign borrowing is negligible and although our national debt is substantial this is held by domestic savers who are generally very willing to buy and hold till maturity.

Maltese savers can sleep comfortably in the knowledge that our banks are strong and safe. However Maltese households cannot have the same peace of mind about the cost of energy they are using as from 1 October. Knowing our disposition to cut the cloth to the size of our resources it is likely that if government proceeds with its intention to pass the full cost of energy to consumers many households will have to economise substantially on their heating this winter. Could we be heading for a winter freeze just while Iceland is financially melting away?

Let me state that from an economic point of view it is unhealthy to keep permanent subsidies as they lead to waste of scarce resources. But responsible macro-economic management should ensure that shocks are smoothed to avoid killing the patient rather than teaching him how to handle the new reality. Rather than smoothing government is accentuating the shock.

After pretending it can do magic to keep the surcharge at a ‘low’ 50 per cent in the months before and immediately after the election, now that goals of political convenience have been achieved, the government intends to force us to face harsh market realities and not only pay current contracted prices but also make up for past leniency.

With recession now clearly on the cards oil prices could permanently fall below $100 per barrel of crude and possible go back to $70 in the first half of 2009. The consumer should not be falsely duped by political exigencies and then shocked when reality cannot be avoided any longer. On the contrary responsible management should smoothen the market fluctuations by averaging acquisition price over the whole economic cycle and adjusting prices frequently to avoid one-off big shocks as government has been doing since the season of political convenience expired last June.


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