Icelandic Krona and Latvian Lat Case Uncovered Interest Arbitrage

Saturday, October 24, 2009


Executive Summary

According to all the key economic indicators both Iceland and Latvia were hit very hard by the global financial and economic crisis in 2008 and it will take several years for recovery to reach pre-crisis levels. The primary risks that faced Iceland included exchange rate exposure, financial unrest in the banking sector, and lack of foreign capital inflow (OECD). Net exports collapsed as a result of the recession, with imports falling more than 30% from 2008 to 2009. This was caused by the sharp fall in private consumption which was a result of down-sizing banks limiting the availability of consumer credit. During the crisis in 2008 the Krona rapidly depreciated, falling from 62.98 Krona per $US at the end of 2007 to 123.48 Krona per $US at the beginning of 2009 (Pacific Exchange). This caused inflation to rise quickly with the CPI increasing by 12.7% in 2008, posing another hurdle for consumer demand (IHSGlobal Insight). (See graph 1)

At the end of the second quarter 2008, Iceland's external debt was 9.553 trillion Icelandic krónur (€50 billion), more than 80% of which was held by the banking sector (Central Bank of Iceland). The current account was beginning to strengthen, but was faced with a lot of risk from the income balance. Because of the high external debt levels, $142.4 billion in 2008 which was 923.9% of Iceland’s GDP, the payments of interest and dividends had come into question. Because of the large amount of investment in the aluminum industry, the long-term capital outlook looked good. The external debt to exports ratio in 2007 was 4.33%, which was abysmal and does not look to improve through the recession (IHSGlobal Insight).  (see graph 2)

The high level of exchange rate volatility as well as the recent recession has caused the inflation rate to increase dramatically. For Iceland, it is more critical to combat inflation at this point. The trade balance and current account deficit is projected to improve as soon as the recession is over, whereas the inflation rate is more pervasive into the lives of Icelandic citizens (See Iceland currency charts). With this in mind, the Central Bank of Iceland should pursue some policy that will create stability in the housing market and stabilize the volatile Krona. One way to do this might be to join the Eurozone and adopt the Euro. These would effectively lower the inflation rate.

The collapse of Iceland’s króna is the result of a balance of payments crisis. In 2001, Icelandic bank debts rose sharply once the deregulation of banks occurred. The economic crisis unfolded when these banks became unable to refinance their debts. Foreign debt exceeded €50 billion, compared to a GDP of €8.5 billion (about €160,000 per resident). The króna became very overvalued and suffered from the effects of carry trading (Wardell).

Latvia was the fastest progressing and improving economy of all the countries to recently join the European Union. But the impact of the bursting bubble in the housing market coupled with the global recession has caused things to take a turn for the worse. The consumer price index increased by 15.4% in 2008 and the unemployment rate was 22% in 2009. After 2010, when the recovery is supposed to begin, it will be very long and slow. This is because the foreign capital investors who flocked to the country will be much more hesitant to put money into Latvia. Another key issue that faces Latvia is the current peg Latvian currency has on the Euro which artificially makes the Latvian currency very strong (IHSGlobal Insight). If the currency were to come off the peg it would devalue very quickly (See Latvia’s currency charts).

Latvia’s rescue package from the European Union and the International Monetary Fund placed a heavy burden on Latvia to harshly cut spending or face default; a situation that would quickly double the recession and worsen conditions for Latvian citizens. Latvia got into its mess due to foreign direct investment into the housing bubble and high credit risk loans.  Investors felt that Latvia would be a safer investment, since joining the European Union. Capital investment will be very low during 2009 and after the recession (IHSGlobal Insight). $43.3 billion of total external debt in 2008 (128.2% of Latvia’s GDP) is a very high level, but compared to Iceland, Latvia is in a better state.   The external debt to exports ratio in 2008 is 22.6%.  This is a poor position for the future when the external debt becomes due.

Imports have fallen concurrently with exports because of the lack of consumer demand. This has allowed the current account balance to remain relatively stable. Because of a strong income balance and a low export-import ratio, Latvia’s current account posted a surplus in the beginning of 2009, the first since records began in 2000 (IHSGlobal Insight). Since the current account and trade balance are relatively stable and dependent on volume, it is not going to be a critical issue for Latvia to pursue at this point. What is more important will be to combat the high level of inflation which reached its peak in 2008. If the Bank of Latvia and the Latvian government are able to pursue the currency peg it has in place, the peg will remove much of the risk of higher inflation and currency devaluation.


In 2001, the Central Bank was made independent, and its new focus was to target inflation.  Exchange rates were allowed to float, which resulted in a temporary devaluation (as seen in the graphs).  In May of 2007, elections were held.  One of the major concerns was a growing amount of huge fortunes gained on investments to a handful of individuals in the upper class.  Iceland had never had any problems with poverty, but there was a growing concern due to the new wealth distribution.  There were also increasing environmental concerns over the economic growth.  The two major parties vying for the government was the center-right Independence Party (which had held the previous office) and the left-green movement.  Exchange rates did not change drastically in May, however towards November 2007, the krona lost almost half of its value.  The country experienced tremendous growth before this time, but from 2003 to 2006, the current account deficit rose from 5% to 27%, and in 2008, Landsbanki, Glitner, and Kaupthing all failed contributing to the devaluation of the currency.  The country could not pay back its external debts, and as a result, the krona lost most of its value (Mandel, Serafin).

Latvia began to peg the Lat to the Euro starting on January 1, 2005.  Since then, the Euro has strengthened compared to the pound sterling and the US dollar; which is why we see a huge devaluation after 2005 in both of these currencies.  In 2001, Latvia’s GDP growth was 8%, one of the highest in Europe, which resulted in a strong currency.  In 2002, their inflation rate was only 1.4%.  In 2003, their budget deficit was only 1.8% of GDP.

In order to carry out uncovered interest arbitrage, we need to find a low interest rate environment from which to borrow money.  Then we will invest in a high interest environment such as Latvia or Iceland.  In our example, we are using 6 month interbank deposit rates found on Bloomberg on October 1, 2008.  In order to carry out this transaction, we can say that the Bank of Tokyo invests 2.65 billion Yen into the Iceland central bank at a rate of 15.975% p.a.  After 6 months, assuming the interest rate is not too volatile; a profit of 192 million Yen can be made risk-free; since the Bank of Tokyo could only achieve a 1.5% p.a. investing in the Bank of Japan.  Due to the volatile movements which made the krona a risky investment during this time, the Bank of Tokyo would have lost 242 million Yen.  However, if the Bank of Tokyo invested in a 6-month forward rate, they would be hedging themselves from the currency volatility, and would be more likely to see a profit at the end of the 6 months.  This is a covered interest arbitrage scenario, indicating the future investment instead of being exposed to the spot rate.

As noted in the diagram, these are extremely risky transactions during this time period, with the failure of large financial institutions, which may have ripple effects on the foreign exchange market.  If an American bank were to make an attempt at arbitraging the difference in interest rates, it would have backfired on them immediately.  On October 1, the KR/$ exchange rate was 109.270.  By December 3, the exchange rate ballooned to 147.709, a 35% change.  If we were governors of Central Banks, it would be very important to try to regulate these arbitrage attempts and encourage covered interest arbitrages.

Iceland’s banks financed domestic expansion with external debt from deposits outside the country and loans on the interbank lending market. Households took on massive debt and the Central Bank issued liquidity loans using uncovered bonds (or, printing money on demand), which led to excessive inflation.

In response to a rise in prices, the Central Bank held interest rates high at around 15%. Due to these high interest rates, investors held deposits of the króna, which led to the increase in Icelandic money supply of approximately 54%, compared to 5% GDP growth. Thus, an economic bubble was created because investors overestimated the true value of the króna. A heavy reliance by the banks on short-term wholesale rather than deposit financing made them sensitive to a liquidity crunch. Icelandic financers leveraged acquisitions on foreign assets and funding was mostly in foreign currencies as the balance sheets of the banks limited the capabilities of the central bank.

The Icelandic banks found it nearly impossible to roll over their loans in the interbank market, as no banks were willing to make new loans and on-time repayment was required. As a last resort, the government usually aids the Central Bank in case they can’t make payments. However, since the Icelandic banks were much larger than the economy, the government could not repay the bank debts and the banks subsequently failed. Iceland’s reserves stood at 374.8 billion. Krónur compared to 350.3 billion krónur of short-term international debt as well as approximately £6.5 billion of retail deposits in the UK towards the end of 2008 (Central Bank of Iceland).

Volatility in the financial accounts and imports should have been limited.  Iceland was importing more than they were exporting, leading to a rapid deterioration of the current account. Iceland’s government should have monitored the various subaccounts, detecting trends and movements of economic forces driving the country’s international activity and set policies accordingly. Drastic restrictions on the ability of capital to flow instantly and across borders should have been implemented. Icelandic banks should not be allowed to freely borrow in the international marketplace. Iceland needs to comply with both domestic and international law while controlling and monitoring ethical domestic policy.

Following the intense privatization of banks in the 1990’s and consolidation after the Russian crisis in 1998 a little over half of the banks in Latvia were foreign owned (mainly by Scandinavian and German banks) (IHSGlobal Insight). Two banks are state owned, but the Latvian government a small stake a little over 5% of banking assets in the country, making its stake not very large (IHSGlobal Insight). After joining the European Union in 2004 the banking sector rapidly grew (especially in the mortgage sector). These household loans were mostly Euro-denominated. In order to maintain this unhealthy lending, Latvian banks took on a lot of foreign debt. As the world-wide economy went downhill, many of the risky loans given out by Latvian banks began defaulting, and refinancing foreign debt on their books became increasingly difficult. At the end of 2008, the government had to rescue one Latvian bank (Bank of Latvia).

The banks face a high liquidity risk caused by the risk that the Latvian currency will be devalued. Also, with investor confidence down, many consumers are withdrawing deposits from banks and taking fewer loans out, making it difficult for banks to function (Bank of Latvia). This has forced the government to actively help banks through bail-outs and other measures. If the government had stepped in before the crisis and created regulation in the mortgage and housing market, this type of bubble may not have occurred. Specifically, regulation should have targeted the quality of loans through more quality credit standards. Also financial regulation on the amount of foreign debt would have helped in this situation. By preventing banks from having such an illogical liquidity structure a crisis like this could have been prevented.


The rating agencies began to question the activities and stability of Iceland’s banks.  This resulted in the Icelandic stock market’s drop throughout the year; but was able to recover after the government imposed reform in the banking sector (Bureau of European and Eurasian Affairs).  In 2006, Standard and Poor’s ranked the krona as AA.  They changed their currency obligation outlook from stable to negative in June, and then back to stable in December.  In October 2008, the rating dropped to BBB-, below investment grade after the currency devalued.  Moody’s had an Aaa rating in 2002, which was held until 2008, at which time it dropped to Baa1.  Fitch rated Iceland as AAA in 2000, then lowered their outlook to negative in February of 2006, and down to BBB- in September of 2008 (Central Bank of Iceland). The high ratings provided by the rating agencies proved to be misleading.  A risk manager should not necessarily base their investments just on the rating agencies analysis.  They should look at external debt, current account deficits, and inflation rates to get a broader picture of the current situation.  These economic indicators might have been a preeminent sign that the rating agencies didn’t take into account.

Since 2006, Latvia’s credit ratings have dropped due to the surging real-estate, consumer prices, and soaring credit.  Also, Latvia’s GDP will shrink 12% this year (Pavilenene).  In 2006, Moody’s rated the Lat as A2 and stable (Latvenergo).  Like Iceland, a risk manager should look at the overall picture instead of just the advice from the rating agencies; such as the liquidity of the banks and the amount of foreign debt the banks were taking on to fund low credit quality euro loans, which strengthened overtime, creating more problems for Latvia.

Iceland has a long way before they restore their credibility. Icelandic people must select a viable new Prime Minister in the upcoming election, one who will relieve those in charge of the Central Bank.  Parliamentary approval is essential to Iceland’s revival. Iceland’s people and foreign investors feel betrayed. Investors believe that Iceland failed to comply with laws by making retroactive changes to its own legislation and practices governing creditor treatment. Parliament needs to treat international creditors and domestic relationships fairly.

Conversely, in order to restore its credibility, Latvia needs to stabilize its political situation. Continuing unrest by labour unions as well as a recent transition of government has caused volatility in fiscal spending. These changes have put the currency in risk of devaluation. To prevent this from happening, Latvia needs to maintain its currency peg and stay on plan to transition to the Euro. It needs to maintain the rescue packages from the European Union and the International Monetary Fund. And for long-term progress and restoration, Latvia needs to focus on infrastructure spending. Without having a stable infrastructure, foreign investors will have a hard time coming back into the country and accepting its credibility.










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Wardell, Jane (7 October 2008). "Iceland teeters on the brink of bankruptcy". Associated Press.

Saturday, October 24, 2009
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