Iceland weathers market jitters

In Iceland beginning in 2003, large investment projects, based on an abundance of cheap energy, were tightening local labor markets, contributing to robust overall demand, and widening the current account deficit—although they were expected to generate growth and some currency appreciation. As monetary policy was tightened in response to the strong demand, interest rates rose and there was a significant trade-weighted appreciation of the Icelandic króna.

Icelandic banks exploited the interest rate differential by borrowing in euros, hedging their exposure, and lending in krónur. The combination of a rising currency, high interest rates, and good credit quality—the sovereign was rated AAA—also attracted foreign portfolio investors, who financed their long positions in króna debt by borrowing in lower-yielding currencies—the "carry trades." (This was exacerbated by financial innovation—that is, the offshore issuance of króna-denominated eurobonds ("glacier bonds") by foreign institutions that swapped their króna liabilities for the euro liabilities of Icelandic banks.) Yield differentials including exchange rate adjustments were about 9¼ percent in 2003, 7½ percent in 2004, and 18 percent in 2005.

With commercial banks flush with funds and looking for new ways to lend, policy changes encouraged banks in mid-2004 to start competing directly with the government-run Housing Finance Fund for first mortgages. Banks were able to offer more favorable terms than this housing fund, and their lending to households grew by 98 percent in 2004, fueling the rapid rise in housing prices and the associated withdrawal of housing equity through refinancings. This, in turn, underpinned the surge in domestic consumption, further widening the current account deficit.

Iceland's financial changes were enormous. External debt surged. Private sector borrowing tripled between 2003 and 2006, with huge increases in both household and corporate debt. Real estate and equity prices appreciated rapidly, with stock market valuations rising almost fourfold between mid-2003 and end-2005. Eventually, all this led to significant market jitters and pressures on the currency and equity prices in the spring and summer of 2006.

Growth in UK manufacturing slows

Growth in the UK manufacturing sector eased in December, as worries about the credit crunch led to new orders hitting a near two-year low, a survey shows.

The data is likely to boost hopes of another interest rate cut to cushion against an economic slowdown this year.

Firms reported that recent turmoil in financial markets had shaken client confidence, said the Chartered Institute of Purchasing and Supply.

New manufacturing orders fell to their lowest level since March 2006.

The Chartered Institute of Purchasing and Supply/NTC said its purchasing managers' index fell to 52.9 in December, below the 53.6 that analysts forecast and down from the 54.3 recorded in November.

But it remained above the 50.0 mark separating growth from contraction for the 29th successive month.

New orders fall

"Client confidence is still being affected by tight credit market conditions and high cost inflation, leading many to postpone non-essential expenditures," said NTC economist Rob Dobson.

The new orders index fell sharply to 51.7, its lowest since March 2006, from 55.0 in November.

The survey also indicated that the inflationary pressures facing the sector are easing although prices remain high.

Companies have paid higher prices for food products, fuel, metals, paper products, plastics and oil over recent months.

The Bank of England's Monetary Policy Committee cut interest rates to 5.5% from 5.75% last month and many economists expect the central bank to lower the cost of borrowing further in coming months.

"That price pressures appear to be easing as activity slows will allow the MPC to respond to the weaker economic climate by cutting rates," said Paul Dales, at Capital Economics.