Lessons from Scandinavia
Confluence Investment Management
By Kaisa Stucke, Bill O’Grady
October 2, 2012
(N.B. This week, due to travel, Kaisa Stucke, Research Associate, is the primary author. For those unfamiliar, Kaisa and I write our Daily Commentary, which is also available via the Confluence website.)
During the late 1980s and early 1990s, Scandinavian nations suffered through balance sheet recessions. Commentators have suggested that U.S. policymakers could use the Scandinavian response to their crises as a roadmap for resolving the current U.S. situation.
As part of our own analysis, we have studied several earlier events to understand the underlying similarities and differences to develop insights into the current event. Even though many analysts call for parallels between the Great Depression and the current U.S. situation, the industrialized country that has come closest to reliving the Great Depression in contemporary times is Finland during the Scandinavian banking crisis in the early 1990s. Finland, along with the other Scandinavian countries, suffered deep systemic crises that culminated in severe and persistent losses in output and employment.
In this report, we will discuss the Scandinavian financial crises of the 1990s, the build-up to the events and the policy response. Our main objective is to draw some generalized conclusions on how a debt crisis usually develops, evolves and ultimately gets resolved. We will compare the Scandinavian experience to the current U.S. situation, and as always we will look at current market ramifications.
Life cycle of a crisis
The life cycle of a banking crisis generally follows a uniform sequence, although some crises may skip a step and some may have additional manifestations. The following is a list of the typical stages of a crisis.
1. A move toward some sort of a regulatory shift occurs (often deregulation of the banking sector). In Scandinavia, deregulation was prompted by the governments’ desire to more efficiently fund increasing fiscal deficits.
2. A rapid expansion of credit follows as the money supply and/or velocity increases.
3. Excess liquidity will look for the greatest return on capital.
4. Asset prices accelerate, eventually exceeding fundamental valuations.
5. A balance sheet recession will occur; prior to the crisis investors increased both the assets and the liabilities proportionally, but as asset prices decline, liabilities remain unchanged.
6. Investors will then increase savings in order to readjust their balance sheets, lowering consumption. As a consequence, the economy will slow, since the supply of money and/or velocity is now declining and a vicious cycle proceeds, whereby falling asset prices force investors to save more and consume less, resulting in prices falling further.
7. To resolve the liquidity and solvency trap, governments often become involved to contain the financial crisis.
8. In the 1980s, given the rigid exchange rate systems, this was often accompanied by a currency crisis. Exchange rates can be fixed for several reasons, either for export promotion, import price suppression or simply tradition. In spite of the motive, a fixed exchange rate increases speculation against the currency, increasing expectations of devaluation.
We will now take a look at how this played out in Finland, Sweden and Norway during the 1990 banking crisis.
Build-up of the crisis
Scandinavian economies were, and still are to a certain extent, more rigidly controlled by the government than other developed countries. The pre-banking recession period in the 1980s saw regulated interest rates, a fixed foreign exchange rate and capital controls. Currencies were overvalued to dampen import prices. The banking sector, in particular, had been subject to strict rules via lending ceilings and high reserve ratios. Scandinavia’s inflation consistently ran higher than most other European countries, resulting in persistent depreciation of the currencies in real terms, even though the nominal exchange rates were pegged. In Sweden, for example, the krona was devalued six times between 1973 and 1982, but despite the central banks’ best efforts, the real depreciation still continued. This in turn increased the likelihood of more depreciation and markets demanded a higher interest rate to accept the additional devaluation risk. At the same time, the country’s finances were weakening, and the public sector ran persistent deficits. The only reason a debt crisis had not occurred earlier was the fact that the banking system was tightly regulated.
Financial markets were not globalized during the 1980s, and the Scandinavian markets, in particular, remained heavily regulated. The government required that banks, insurance companies and other financial institutions hold government and mortgage debt through reserve ratios and lending ceilings. At times, financial institutions were required to hold up to 50% of their assets in the non-interest-bearing bonds, with rates fixed below market rates.
In the mid- to late-1980s, the governments moved to deregulate the banking industry, driven by the rapid development of domestic and global financial markets, which in turn was driven by the rising budget deficits that were financed in the domestic market. The governments wanted to finance their own debt domestically, and removing the regulation made it more efficient to do so. However, not all areas of the market were deregulated; capital controls remained in place, although there were ways to get around them. To counter the risk of a debt boom, reserve ratios were hiked slightly, but the regulators never imagined the scale of borrowing that would follow. Although corporate borrowing was a larger share of the net new borrowing, the increased household borrowing facilitated increasing consumption levels. Domestic interest rates remained higher than international rates and were made worse by the governments’ unwillingness to borrow in foreign currency, requiring an additional rate premium to make up for the currency risk.
In a regulated environment, the banks did not need a risk management system, whereas the new open market required an appropriate and astute risk assessment process. Unfortunately, the race to secure market share didn’t provide the banks with enough time to design appropriate risk management systems.
History of the crisis
In the late 1980s and early 1990s, the expansion started slowing on weakening fundamental values, overvalued currencies and other internal and external shocks, which we will discuss below. The first economy to slow down was Norway, when the government tightened its monetary policy. There were several forces in play that moved interest rates higher. First, international interest rates rose, following German unification. Second, domestic macro policies finally changed to focus on controlling inflation. Asset prices fell for the following two years and a two-year recession ensued in 1988. Finland and Sweden also tightened their monetary policies to combat inflation and maintain the integrity of the fixed exchange rate. As a result, debt servicing costs rose significantly and forced austerity in other spending. Devaluation expectations encouraged speculation and eventually, all three countries were forced to terminate the rigid exchange mechanisms. As a consequence, all three currencies fell significantly in the open market and a recession followed. The Swedish recession lasted for two years, while the Finnish recession lasted for three years. One of the more important and necessary steps in resolving the crisis was the decision to free-float (or essentially devalue) the currencies. This allowed reflation and an export boom.
As the governments hiked interest rates, banks were caught in a vicious cycle of falling asset prices and rising levels of debt. Many banks had trouble making their reserve requirements. Governments had to step in to avoid a banking system collapse. Government guarantees caused a large fiscal deficit and higher real government debt levels, which brought on a public sector debt crisis. Because of the current account deficit, these countries needed a steady supply of foreign financing. Increasing interest rates helped to ensure a supply of international funds, but the overvalued exchange rate made foreign investors less willing to buy local currencies in longer term durations. At the same time, the government had to continually provide liquidity to the banks to support the artificially high local currencies.
There was no outright run on the banks, rather Scandinavian banks saw an unwillingness of maturing note holders to roll them over in the local currency. Bank confidence was waning, contributing to investors’ desire to hoard cash. Although capital restrictions were in place, many investors were looking for ways to get out of the local currency due to devaluation expectations. Given the capital controls, corporations were able to hedge the currency risks more easily, but there were options for even the individual investor to circumvent the capital restrictions. Many wealthier investors found ways around the restrictions, including taking a ferry across the Baltic Sea to Germany with a suitcase full of money. Still, for many individual investors the best option in the high likelihood of a devaluation environment was to hold cash. On the other side of the coin, banks were running into liquidity issues as funds dried up and had trouble fulfilling their capital requirements. Since banks guaranteed many other financing companies, but did not have control over their credit portfolios, the banks now found themselves in a position of holding debt of entities to which they had denied financing.
At the time, Scandinavian countries had no deposit insurance, but in a desperate attempt the governments agreed not only to back the deposits, but debt of all forms. The banking situation continued to deteriorate and the governments bailed out several banks and, for all intents and purposes, nationalized the banking industry. Another important step was for the governments to transfer the bad loan portfolio to a separate bank. Overall, the government followed the principle of saving the banks, but not the owners. The real government debt ballooned. The primary focus tends to be on direct banking bailout costs, but empirical studies suggest that it is the decline in tax revenue during the contraction period and the increasing fiscal policy action to counter the downturn that make up the bulk of the costs.
Also at the same time, the European exchange-rate mechanism started breaking apart, affecting the Scandinavian currencies. The Swedish central bank raised overnight interest rates to as high as 500% to attract foreign funding and keep domestic deposits in play. The countries still had fixed exchange rates, meaning that their currencies were held artificially higher than their actual value. Given the market devaluation expectation, more domestic and international depositors refused to hold investments in the local currency. Needless to say, if the governments had not had a general bank asset guarantee in place many banks would have run into liquidity constraints. Also, since banks saw significant foreign currency outflows, the central banks made a deposit from the foreign exchange reserves into banks.
Specifically by country, Sweden was heavily indebted before the crisis, but the majority of its debt was concentrated in the private sector, with foreign currency-denominated debt exposure very low. In fact, the reason Sweden was able to climb out of the crisis so quickly was that this was essentially a local-currency crisis, and the central bank was able to reflate. Also, by letting the currency depreciate, Sweden generated an export boom. The Swedish economy was tilted heavily toward higher value-added products, which in turn boosted household incomes and corporate profits. Currency devaluation played a key role in stimulating growth and reflating asset values.
Finland’s experience was comparable to Sweden’s, since the overall level of indebtedness was much higher and the crisis was essentially all in the private sector. The real economy suffered, with the unemployment rate peaking at 17.6% and never reaching the pre-recession low again. The Finnish markka dropped 35% against the dollar between 1992 and 1993. This large devaluation triggered an export boom.
Norway’s crisis differed from those in Sweden and Finland, due to the large effect that oil prices have on the economy. Oil prices were relatively depressed during the period, also suppressing the recovery. But the asset price increases were proportionally smaller than in the other two countries, which also made the recession milder.
By studying recessions of the past we are better able to identify the usual symptoms of a financial crisis and its sequence. There are some common characteristics between the Scandinavian banks and the current U.S. experience. First, asset price declines were steep and prolonged in both cases. Second, unemployment and output fell significantly and swift government action was able to shorten the output collapse to a certain degree. Unemployment remained elevated in both cases and it seems that both instances saw increasing structural unemployment. Third, the real value of government debt rose, on the back of falling tax revenues and increasing bank bailout costs. Looking at the Scandinavian experience, government debt stayed high for a decade. Fourth, Scandinavia was experimenting with new monetary policy actions to combat the crisis, and although not all of the actions were new globally, they were novel for the countries involved. The U.S. is also experimenting with new kinds of policies, many of which have not been tested to the current extent.
However, the experiences of the Scandinavian crisis may not be transferable to larger countries. A major player in the recovery was the currency devaluation, but the U.S. dollar’s status as the reserve currency makes it very hard, if not impossible, to devalue. This is a perfect example of how smaller countries have a tool at their disposal that larger countries cannot use, namely the ability to devalue and then export their way out of the slump. Interestingly enough, one option for the U.S. to reflate is to become trade isolationist.
Although the Scandinavian governments were quick to act, the authorities today arguably have more flexible monetary policy frameworks, mostly due to less rigid exchange rate regulation. However, this crisis was regional in nature, and the current crisis is harder to balance due to the fact that it is global. The lessons are especially hard to apply to the U.S., given its status as the importer of last resort.
During the early days of the U.S. financial crisis in 2008, the option of nationalizing the banking system, á la the Scandinavian way, was considered. To some extent, the U.S. did a similar practice with the Resolution Trust Corporation in the early 1990s. However, both the Obama and Bush administrations rejected that outcome, fearing the banking system of the U.S. would be too large to manage. Political opposition would have been strong.
Overall, what the Scandinavian situation shows is that a small country can devalue and export their way out of a balance sheet crisis. That option isn’t available to the reserve currency country, or any large economy, for that matter. The rest of the world could not function if the U.S. decided to run an export-promotion policy similar to what the Scandinavians ran, simply because the rest of the world could not absorb all the exports. The lesson of how the Nordic nations got into trouble is worth noting; however, the policy prescription doesn’t work for the U.S.
Bill O’Grady and Kaisa Stucke
October 1, 2012
This report was prepared by Bill O’Grady and Kaisa Stucke of Confluence Investment Management LLC and reflects the current opinions of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
(c) Confluence Investment Management