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

2. 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

3. … 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

5. Focus of this paper Challenges of carry trade for monetary policy- making 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

6. Understanding the booming economy… Government aims 1.Diversification, rural employment 2.Market liberalisation 3.Lower taxes 4.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

7. … that led to macroeconomic imbalances

8. ... of various forms

9. 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

10. 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?

11. 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

12. Glacier bond issuance

13. Ex ante measure of attractiveness

14. 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

15. 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)?

16. 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?

17. 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

19. 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

20. 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?

21. 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

22. 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

23. 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

24. 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