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On Europe: To Iceland from Hong Kong

By David Ibison

Published: March 28 2008 18:33 | Last updated: March 28 2008 18:33

In August 1998, I was the business news editor of the South China Morning Post, an English language newspaper in Hong Kong, and can remember sitting at my desk when an e-mail arrived from a well-connected old friend that contained just one word: “Clang!”

In my reply, I asked him what he was talking about and received this back: “The bear trap is about to shut.” This did not help much, though all was to be revealed minutes later.

First, some background. Hong Kong reverted from British to Chinese rule in July 1997 and its currency, the Hong Kong dollar, and its stock market came under attack from speculators in the aftermath.

The Hong Kong dollar is pegged via a currency board to the US dollar and the speculators – hedge funds and proprietary trading desks of investment banks – had analysed the way this worked and devised a typically clever way to play it.

The complicated details of how they tried to break the peg are not the point here. Suffice to say, they were putting pressure on the system and profiting from short positions on Hong Kongs stock and futures markets.

Instead, the point is to assess whether there are any lessons to be learned for another small island economy, Iceland, from the manner in which the Hong Kong Monetary Authority, the central bank, acted to protect its currency and run the speculators out of town.

Before getting there, the question of whether Iceland is under speculative attack needs to be addressed. On this the jury is out, though a case can be made to say that speculators do appear to form part of what is going on.

Briefly, Icelands economy has grown rapidly and this expansion has created macroeconomic imbalances such as a current account deficit of 16 per cent of GDP in 2007 and annual inflation of 6.6 per cent in February, well over the Central Banks target of 2.5 per cent.

These factors, alongside the aggressive use of leverage by its main banks, has undermined investor confidence, sending its stock market lower, depreciating its currency by over a fifth this year, and further stoking inflation.

In response, the central bank this week imposed an emergency interest rate hike of 1.25 percentage points to a record 15 per cent.

No one denies Iceland faces significant hurdles. But the question remains: to what extent are these economic fissures being widened and exploited by professional speculators?

The authorities in Iceland are thought to be taking a close look at this very subject. Specifically, they are assessing the ways in which the credit default swap market for Icelands banks may have been manipulated by a few players. It is not a formal investigation, more a curious probe, though its findings could change this.

The CDS market is a proxy for investors fears that Icelands banks will collapse. Spreads in the market have ballooned from about 50 basis points in August 2007 to more than 700, indicating a very high level of fear about their viability.

The suspicion is that speculators are exerting undue pressure on the relatively illiquid CDS market for Icelandic banks in the knowledge that the higher the spread goes, the more the fear of a banking collapse will spill into the stock and currency markets.

Thus, the temptation for speculators is the following trade: pressure the CDS market to widen spreads and profit by shorting the stock and currency markets.

Is there evidence to suggest this is the case? There is some. Firstly, the spreads in the CDS market massively outweigh the banks fundamentals. All of Icelands banks are, by international standards, healthy.

Second, and here we enter slightly odder territory, there are suspicions in Iceland that negative news surrounding the banks has been deliberately played up by those with a vested interest to do so. Such fears have been communicated via a news hungry media addicted to headlines such as “Iceland melts”.

So back to Hong Kong. Under speculative attack, the HKMA conducted a massive $15bn intervention in the stock market, equivalent to about 8 per cent of its capitalisation.

It simultaneously intervened in the money markets and futures markets and made clear there was more to come if needed. The market soared and anyone with a short position was very badly burned.

Could not Icelands government consider something similar? If it truly believes that the countrys economic and banking fundamentals do not justify the present weakness in its market and currency – and that it is the plaything of speculators – why not spring a bear trap and conduct a similar intervention by buying a sizeable chunk of the market?

It might even profit from it. The HKMA not only ran the speculators out of town, but has since doubled its money.

What is the Icelandic for clang?

Sjá hér.