Transcript Slide 1

Seðlabanki Íslands
Carry trade and monetary policy in a very
small open economy: The Icelandic saga
Thorvardur Tjörvi Ólafsson
The Challenges of Globalisation for Small Open
Economies with Independent Currencies
Reykjavík, May 31 – June 1, 2007
What a difference...
• “Iceland is a rock in the ocean surrounded
by fish – take away the fish, and what have
you got left?”
Hans G. Andersen, 1976
… globalisation makes
• Real: market liberalisation, increased
openness (goods, capital and labour)
• Financial: integration, completeness
• Privatisation, expansion and global liquidity
• Monetary: Disinflation, inflation targeting
• Caveat: Inflation expectations not firmly anchored
Economic growth and unemployment
%
10
8
6
4
2
0
-2
-4
1990
1992
1994
1996
1998
2000
Economic growth
Unemployment
Source: Statistics Iceland, Directorate of Labour
2002
2004
2006
Focus of this paper
• Challenges of carry trade for monetary policymaking in a very small open economy
(VSOE)…especially
• …if its business cycle and hence its phases of
monetary tightening and easing are very
misaligned with global markets
• … if the carry trade cycle of build-up and
unwinding of positions in its currency is
unsynchronized with the local business and
monetary policy cycle
• … if inflation expectations are not well anchored
Understanding the booming economy…
Government aims
1.
2.
3.
4.
Diversification, rural employment
Market liberalisation
Lower taxes
Fair housing opportunities
Government policies
1. Investment in aluminium and energy
2. Privatisation of the major banks
3. Lower taxes on households and firms
4. HFF lending rules eased
Booming economy
•
•
•
•
Investment boom
Credit boom
Consumption boom
Asset price (including housing) boom
Global liquidity
… that led to macroeconomic imbalances
... of various forms
Central Bank’s task
•
Bring forth the needed adjustment
– Inflation and inflation expectations to target
– Output to (or below) potential level
– Current account deficit to a sustainable level
•
Types of adjustment
1. Contraction in domestic demand and import
2. Exchange rate depreciation
•
Only former consistent with the inflation
target
Carry trade and the imbalances
•
•
•
The macroeconomic imbalances are the
result of our own policies
Carry trade entered late in the upturn when
interest rate differential became too large
to go by unnoticed by foreign investors
How have carry trades affected the ability
of the Central Bank to unwind these
imbalances?
Glacier bond issuance
• The most popular form of króna carry-trade
activity
• ISK Eurobond issuance started in August
2005
• Total issues approaching 500 b.kr. and
around 370 b.kr. outstanding (32% of GDP)
• Similar to the New Zealand case
• European retail investors the main buyers
Glacier bond issuance
80
B.kr.
% of GDP 2006
36,0%
70
60
50
30,0%
40
30
20
24,0%
10
0
-10
18,0%
-20
-30
-40
12,0%
-50
-60
-70
6,0%
-80
-90
-100
0,0%
A S O N D J
2005
Source: Reuters.
F M A M J
J
A S O N D J
2006
F M A M J
J A S O N D J
2007
Issues
Maturity
Outstanding as % of GDP (right axes)
F M A M J
J
A S O N D
2008
Data until May 8 inclusive.
Ex ante measure of attractiveness
Carry to risk ratio
1,25
1,00
0,75
0,50
0,25
25.01.06
10.05.06
30.08.06
21.12.06
26.03.07
Three month interest rate differential divided by the implied volatility of an
ISK/EUR option
Source: Bloomberg
Glacier bond issuance
• Domestic demand for credit is also an
important driving factor
• Pass-through from Central Bank policy rate
to Glacier bond yields
• When Icelandic households and firms
reduce their borrowing the bond issuance
will decrease
• Icelandic households and firms have been
surprisingly willing to continue to borrow at
these very high rates
Effects of the carry trade
1. Access to credit easier  extended the
life time of the consumption, investment
and housing boom  delayed the needed
adjustment  larger imbalances to unwind
•
A case of increased financial integration causing
excess borrowing (Obstfeld, 1998)?
Effects of the carry trade (cont.)
2. Altered the transmission mechanism of
monetary policy making it more complex
for the Central Bank to unwind the
imbalances
•
•
•
Weakening of the interest rate channel
Strengthening of the exchange rate channel
What about the expectation channel?
Effects of the carry trade (cont.)
3. The exchange rate has become very
sensitive to changes in financial conditions
in funding markets and other high-yielding
currencies
•
•
•
•
Interest rate developments and hence inflation
outlook
Risk assessments
Herding behaviour
Examples: February and May 2006, February 2007
Effects of the carry trade (cont.)
• 4. Stronger financial market infrastructure
– Increased turnover in financial markets
• interbank FX and króna markets,
• markets for treasury notes and T-note classes
– Development of swap market
– Number of market participants increased
– Strengthened the functioning of the Central
Bank’s lending facility
– More reliable yield curve
Monetary policy and carry trade
• Influence on the conduct and effectiveness
of monetary policy
– Reduced the CB’s ability to affect Icelandic
interest rates and asset prices, especially
longer-term?
– Effects on the underlying supply-demand
balances between saving and capital
investment (including effects on premiums)?
– Hindered the Central Bank in unwinding the
macroeconomic imbalances?
Effect on long-term rates and assets
• Increased correlation between long-term ISK
interest rates and global ones
• Carry trade shifts the balance between saving and
investment … but monetary policy can shift it back
(at least to a certain degree)
• Monetary policy must take into account the
downward pressure on short to medium term
interest rates resulting from carry trade inflow
• Well-anchored inflation expectations would help
turn changes in long nominal rates into similar
changes in long-term real rates
Effects on long-term rates
• Communication gradually observed as the
main policy instrument
• “Central Banking as Management of
Expectations” (Woodford)
• Credible, systematic and predictable
monetary policy-making becomes more
crucial
• Increased transparency a vital counter
activity to the challenges of carry trade
Unwinding of imbalances
• High real rates will eventually have their effect on
domestic demand for credit
• Reasonable exchange rate stability since the
turmoil of last year – window of opportunity to
correct the imbalances before the exchange rate
does the job in a more painful way
• The adjustment has started but only slowly
• Magnitude of domestic macroeconomic
imbalances makes the economy vulnerable to
changes in financial conditions
• Magnitude of global carry trades make the
economy vulnerable to shifts in risk assessment
Final remarks
• Challenging for a VSOE to embrace
financial globalisation without well-anchored
inflation expectations
• Carry trade has brought increased
complexity and uncertainty to monetary
policy making in Iceland
• Domestic vulnerabilities and financial
integration
• Increased transparency an effective answer
to these rising challenges