Arion Banki hf · OMXICE:ARION

Arion Banki hf — Investor Presentation (2013)

51 slides from Arion Banki hf's investor presentation, 2013

  1. Slide 1: The Future of the Icelandic Króna

    THE FUTURE OF THE ICELANDIC KRÓNA Arion Bank Research

  2. Slide 2: The past holds the key to the future

    The past holds the key to the future 2

  3. Slide 3: Until 1922, the króna was pegged to the Danish króna at par

    UNTIL 1922, THE ICELANDIC KRÓNA WAS PEGGED TO ITS DANISH COUNTERPART AT PAR 1922 1 DKK 1 ISK 3

  4. Slide 4: The DKK/ISK cross now stands at 21

    THE DKK/ISK CROSS NOW STANDS AT 21, WHICH MIGHT NOT SEEM SO TERRIBLE… 2013 1 DKK 21 ISK 4

  5. Slide 5: …Until you're reminded that…

    …UNTIL YOU‘RE REMINDED THAT… 2013 1 DKK 21 ISK 5

  6. Slide 6: The ISK was revalued in 1981 currency reform

    …THE ISK WAS REVALUED BY A FACTOR OF 100 IN 1981 DURING CURRENCY REFORM 2013 1 DKK 2100 ISK 6

  7. Slide 7: The króna has lost 99.95% of its value against the Danish króna

    So the Icelandic króna has lost 99,95% of its value against the Danish króna in 90 years. But why? 7

  8. Slide 8: The short answer: rampant inflation!

    THE SHORT ANSWER: RAMPANT INFLATION! Inflation - YoY 90% Bretton-Woods „Crawling“ peg Fixed Floating Capital 80% exchange Króna controls 70% rate + + Inflation Inflation 60% target target 50% 40% 30% 20% 10% 0% -10% 1946 1976 2002 1940 1942 1944 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968

  9. Slide 9: The short answer: rampant inflation!

    THE SHORT ANSWER: RAMPANT INFLATION! Inflation - YoY 90% 80% 70% This period especially has left 60% some legacy problems in the 50% policy framework 40% 30% 20% 10% 0% -10% 1946 1976 2002 1940 1942 1944 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1978 1980 1982 1984 1986 1

  10. Slide 10: Inflation and devaluations/depreciation have gone hand in hand

    10 0% -20% 100% 120% 20% 40% 60% 80% 1971Q1 1972Q1 1973Q1 1974Q1 1975Q1 1976Q1 1977Q1 1978Q1 1979Q1 1980Q1 1981Q1 1982Q1 1983Q1 Source: Statistics Iceland, CBI 1984Q1 1985Q1 1986Q1 1987Q1 1988Q1 1989Q1 1990Q1 1991Q1 1992Q1 1993Q1 Exchange rate movements, YoY 1994Q1 1995Q1 1996Q1 1997Q1 1998Q1 1999Q1

  11. Slide 11: What does this spell out? Irresponsible monetary policy!

    WHAT DOES THIS SPELL OUT? Irresponsible monetary policy! 𝑀×𝑉 =𝑃×𝑄 Quantity of money Price level Velocity of money Quantity of goods and services offered 11

  12. Slide 12: Inflation is always and everywhere a monetary phenomenon

    WHAT DOES THIS SPELL OUT? Irresponsible monetary policy! ↑ 𝑀 × 𝑉 =↑ 𝑃 × 𝑄 Inflation is always and everywhere a monetary phenomenon. -Milton Friedman 12

  13. Slide 13: The missing piece of the puzzle - unsustainable monetary expansion

    THE MISSING PIECE OF THE PUZZLE - UNSUSTAINABLE MONETARY EXPANSION TO BLAME FOR DEBAUCHING CURRENCY Inflation and exchange rate movements 120% 100% 80% 60% 40% 20% 0% -20% 1972Q1 1981Q1 1994Q1 2007Q1 1971Q1 1973Q1 1974Q1 1975Q1 1976Q1 1977Q1 1978Q1 1979Q1 1980Q1 1982Q1 1983Q1 1984Q1 1985Q1 1986Q1 19

  14. Slide 14: Central Bank adopted inflation targeting in 2001

    To counter these historical developments, the Central Bank of Iceland adopted inflation targeting in 2001 – a policy mandate that has had considerable success in bringing monetary and economic stability to economies globally 14

  15. Slide 15: Systemic flaws in the Icelandic policy framework

    Unfortunately, the long history of irresponsible monetary policy has led to systemic flaws in the Icelandic policy framework, which in turn make it difficult to maintain inflation at target and even cause monetary policy to become counter-productive 15

  16. Slide 16: Flaw 1: Widespread indexing of household debt

    FLAW 1: WIDESPREAD INDEXING OF HOUSEHOLD DEBT Household debt in Q4 2012 - as % of GDP 5.4% 1.1% 12.4% 3.6% 86.9% Inflation indexed FX indexed Nominal Overdraft Other 16 Source: CBI

  17. Slide 17: Flaw 2: Very low public tolerance of rises in unemployment

    17 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1970Q1 1971Q2 1972Q3 1973Q4 1975Q1 1976Q2 1977Q3 1978Q4 1980Q1 1981Q2 1982Q3 Source: Directorate of Labour 1983Q4 1985Q1 1986Q2 1987Q3 1988Q4 1990Q1 1991Q2 1992Q3 1993Q4 Unemployment rate 1995Q1 1996Q2 1997Q3 1998Q4 2000Q1 2001Q2 2002Q3 2003Q4 2005Q1 2006Q2 2007Q

  18. Slide 18: Flaw 3: Fiscal policy out of step with monetary policy

    FLAW 3: FISCAL POLICY OUT OF STEP WITH MONETARY POLICY Contribution of public expenditure to GDP GDP growth and taxes growth 2% 9% 9% 39.5% 8% 8% 39% 1.5% 7% 7% 38.5% 1% 6% 6% 38% 0.5% 5% 5% 37.5% 0% 4% 4% 37% 3% 3% 36.5% -0.5% 2% 2% 36% -1% 1% 1% 35.5% -1.5% 0% 0% 35% 2000 2001 2002 2003 2004 2005

  19. Slide 19: Flaw 4: Unfavorable policy trade-offs

    FLAW 4: UNFAVORABLE POLICY TRADE-OFFS Standard devation of inflation and output in 15 Efficient monetary policy frontiers industrial countries 3.0 10 9 Sandard deviation of inflation (%) 2.5 ICE 8 Inflation variability (%) 2.0 7 6 1.5 5 4 1.0 3 ICE 2 0.5 1 0.0 0 0 0.5 1 1.5 2 2.5 3 0 1 2 3 4 5 6 Out

  20. Slide 20: Flaw 5: Disanchored and backward looking inflation expectations

    FLAW 5: TOTALLY DISANCHORED AND BACKWARD LOOKING INFLATION EXPECTATIONS One year inflation expectations vs. actual inflation 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Businesses' inflation expectations Household inflation expectations Market expectatio

  21. Slide 21: Flaw 6: Very high and asymmetric exchange rate pass-through

    FLAW 6: VERY HIGH AND VERY ASYMMETRIC EXCHANGE RATE PASS-THROUGH Exchange rate pass-through Reaction of 580 Icelandic firms surveyed - cumulative effect of 1% depreciation on inflation - (share of firms in %) 0.5 80% 70% 0.4 60% 0.3 50% 40% 0.2 30% 0.1 20% 10% 0 Iceland 42 country sample (OECD and 0

  22. Slide 22: Flaw 7: Small open economy with high financial integration

    FLAW 7: SMALL OPEN ECONOMY WITH VERY HIGH LEVEL OF FINANCIAL INTEGRATION Financial integration - ratio of foreign assets and liabilities to GDP, average 2000-2010 1200% 1000% 800% 600% 400% 200% 0% 22 Source: CBI

  23. Slide 23: Single policy lever with severe transmission defects

    During the free floating inflation targeting regime, the CBI used a single policy lever, the lending rate, with severe transmission defects, which led to extremely high domestic interest rates when global risk appetite was high and liquidity abundant. Sounds like a recipe for a crisis? 23

  24. Slide 24: It was!

    It was! 4 Arion banki~_

  25. Slide 25: The economy began to grow very fast in 2004

    DUE TO VARIOUS FACTORS, THE ECONOMY BEGAN TO GROW VERY FAST IN 2004… GDP growth - % change, YoY 15% 10% 5% 0% -5% -10% 25 Source: Statistics Iceland

  26. Slide 26: …With inflation rising way above target

    …WITH INFLATION RISING WAY ABOVE TARGET Inflation 18% 16% Warning ! 14% overheating 12% 10% 8% 6% 4% 2% 0% 26 Source: Statistics Iceland

  27. Slide 27: The CBI used its main policy lever to stem growth

    SO, THE CBI USED ITS MAIN POLICY LEVER TO TRY AND STEM GROWTH CBI repo rate 20% 18% 16% 14% 12% 10% 8% 6% 4% Ok, Cool it! 2% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 27 Source: CBI

  28. Slide 28: Interest rate differential grew huge against low yield currencies

    THIS CAUSED THE INTEREST RATE DIFFERENTIAL TO GROW HUGE AGAINST LOW YIELD CURRENCIES Short-term interest rate differential - 3-month interbank rates 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Iceland/Euro area Iceland/Switzerland Iceland/Japan

  29. Slide 29: Carry trading caused huge inflows of foreign capital

    NATURALLY, CARRY TRADING CAUSED HUGE INFLOWS OF FOREIGN CAPITAL, WITH THE KRÓNA APPRECIATING… Real exchange rate -index 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 29 Source: CBI

  30. Slide 30: …Becoming increasingly volatile…

    …BECOMING INCREASINGLY VOLATILE… 60 day annualized volatility 90% 80% EURISK 70% 60% 50% 40% 30% 20% 10% 0% 30 Source: CBI, Arion Research calc.

  31. Slide 31: Large external imbalances piled up

    …WHILE CORRESPONDINGLY LARGE EXTERNAL IMBALANCES PILED UP Current account balance 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Trade balance Fundamental net factor income Fundamental current account balance 31 Source: CBI

  32. Slide 32: Interest rate hikes didn't stem the expansion at all

    SO THE END RESULT WAS THAT INTEREST RATE HIKES DIDN‘T STEM THE EXPANSION AT ALL Output gap - % deviation from potential output 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% -6% 32 Source: CBI

  33. Slide 33: Influx of hot money made external imbalances larger

    IT MIGHT HAVE EVEN CONTRIBUTED TO AN INFLUX OF HOT MONEY, MAKING THE EXTERNAL IMBALANCES, AND SUBSEQUENT EXCHANGE RATE ADJUSTMENT, LARGER AS A RESULT Exchange rate developments 200 180 160 140 120 100 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 EURISK (left ax

  34. Slide 34: But at least the fall in the exchange rate helped boost exports

    But at least the fall in the exchange rate helped boost exports …right? 34

  35. Slide 35: Exports growing only at an average rate due to supply constraints

    EXPORTS HAVE BEEN GROWING ONLY AT AN AVERAGE RATE DUE TO SUPPLY CONSTRAINTS ON FISHERIES AND ALUMINIUM PRODUCTION – BRUNT OF THE ADJUSTMENT WAS BORNE BY IMPORTS Index of trade volume - 1Y moving average, Q1 2008 = 100 130 120 110 100 90 80 70 60 50 Exports Imports 35 Source: CBI

  36. Slide 36: The króna has to deal with its past in the future

    THE KRÓNA HAS TO DEAL WITH ITS PAST IN THE FUTURE 1. Short term Fix underlying defects of monetary policy 2. Medium term Abolish capital controls 3. Long term Choose appropriate currency 36

  37. Slide 37: The króna has to deal with its past in the future

    THE KRÓNA HAS TO DEAL WITH ITS PAST IN THE FUTURE 1. Short term Fix underlying defects of monetary policy 2. Medium term Abolish capital controls 3. Long term Choose appropriate currency 37

  38. Slide 38: Transmission inadequacies caused bond rates to fall despite rate hikes

    TRANSMISSION INADEQUACIES HAVE CAUSED BOND RATES TO FALL DESPITE POLICY RATE HIKES IN RECENT MONTHS 9% 3.5% CBI MPC raises policy rate by 175 bps 8% 3.0% 7% 2.5% 6% 5% 2.0% 4% 1.5% 3% 1.0% 2% 0.5% 1% 0% 0.0% 01.2012 11.2012 01.2011 02.2011 03.2011 04.2011 05.2011 06.2011 07.2011 08.2011 09.2011 10.2

  39. Slide 39: CBI operating a managed float regime

    THE CBI IS CURRENTLY OPERATING A „MANAGED FLOAT“ REGIME TO COUNTER THESE INADEQUACIES, REALISING THAT THE EXCHANGE RATE CHANNEL IS MORE POTENT THAN THE INTEREST RATE CHANNEL CBI sells 3 m. EUR May 15. EURISK CBI sells 6 m. EUR Mar. 8. CBI sells 6 m. EUR Feb. 18. 185 CBI sells 6 m. EUR Feb. 11. 180 C

  40. Slide 40: Two months of managing currency almost as successful as 18 months of hikes

    TWO MONTHS OF MANAGING CURRENCY ALMOST AS SUCCESFUL AS 18 MONTHS OF INTEREST RATE HIKES Actual inflation and bond market inflation premium 7.0% 6.5% Swift decrease in 6.0% inflation rate and inflation expectations 5.5% on roughly 10% 5.0% appreciation 4.5% 4.0% 3.5% 3.0% Inflation target 2.5% 7-8 YR

  41. Slide 41: Prudential policy levers will probably be introduced

    In addition to managing the currency, a number of prudential policy levers will probably be introduced. The general theme will be increased emphasis on the interplay between financial and monetary stability. These policy levers might include:  Monitoring and leaning against potential asset price bu

  42. Slide 42: The króna has to deal with its past in the future

    THE KRÓNA HAS TO DEAL WITH ITS PAST IN THE FUTURE 1. Short term Fix underlying defects of monetary policy 2. Medium term Abolish capital controls 3. Long term Choose appropriate currency 42

  43. Slide 43: Large stock of money created during the boom

    THE ECONOMY IS STILL DEALING WITH THE LARGE STOCK OF MONEY CREATED DURING BOOM WITHOUT SECURE COLLATERAL – ESSENTIALLY AN ISSUE OF BLANK CHECKS Printing presses and quantity of money 40% 120% 35% 100% 30% 80% 25% 20% 60% 15% 40% 10% 20% 5% 0% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

  44. Slide 44: Large ISK assets are held by foreign entities

    THE PROBLEM THAT NEEDS RESOLVING IS THAT LARGE ISK ASSETS ARE HELD BY FOREIGN ENTITIES Overhang of foreign liabilities - % of 2012 GDP, bn. ISK 70% 1,200 Thousands 60% 1,000 50% 800 40% 600 30% 400 20% 10% 200 0% 0 Liquid ISK holdings of non-residents ISK assets aquired by non-residents through wind

  45. Slide 45: The króna has to deal with its past in the future

    THE KRÓNA HAS TO DEAL WITH ITS PAST IN THE FUTURE 1. Short term Fix underlying defects of monetary policy 2. Medium term Abolish capital controls 3. Long term Choose appropriate currency 45

  46. Slide 46: Possible future currencies

    POSSIBLE FUTURE CURRENCIES 1. 2. 3. 46

  47. Slide 47: 1. Adopt the euro via EU membership

    1. ADOPT THE EURO VIA EU MEMBERSHIP Pros • Credible monetary policy imported overnight • Euro is an international reserve currency • Reduction of exchange rate risk • Reduction of transaction costs Iceland is currently in accession talks with Cons the EU, so by definition adopting the euro is • Losi

  48. Slide 48: 2. Keep the króna, but tackle defects

    2. KEEP THE KRÓNA, BUT TACKLE DEFECTS Pros • Monetary autonomy • Flexible exchange rate All political parties agree that regardless of Cons whether accession talks with the EU • Legacy of inflation and instability continue, Iceland should strive to meet the • Painful and costly to regain credibility

  49. Slide 49: 3. Adopt another currency semi-unilaterally

    3. ADOPT ANOTHER CURRENCY SEMI-UNILATERALLY Pros • Quicker than adopting euro • Credible monetary policy imported overnight • Reduction of exchange rate risk • Reduction of transaction costs Adopting a currency of a neighboring Cons country (such as Canada, Norway or • Losing autonomy United States)

  50. Slide 50: Any option that ensures long term financial and monetary stability will do

    Any option that ensures long term financial and monetary stability will do. 90 years of instability is more than enough. 50

  51. Slide 51: Arion banki

    “« Arion banki

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