A Tale of Two Countries

Once upon a time there were two small island countries with really high standards of living, really boring politics, and highly open financial sectors. Each of them had a pretty concentrated banking sector (one of them had three domestic private banks, the other four) featuring stable banks that offered high rates of return on deposits and investments. Each had an open capital account (meaning that you can move money in and out of the country with no restrictions) and a stable but officially floating exchange rates. The barriers between politicians and banking sector elites were
basically non-existent: politicians and bankers had close personal and business relationships. People from all over the region felt safe investing in these little island countries' assets, and around the world financial analysts praised them for their sound financial and macroeconomic policies. 

In one of them (Country A), though, banks took advantage of what is known as the carry trade: they borrowed at low interest rates overseas, converted those loans into the local currency, then lent out at high interest rates at home. The difference (adjusted for the exchange rate) is pure profit for the banks. So long as the local economy kept going (and so long as they could keep getting those cheap loans overseas) that system would work just fine. Then one day the global economy had a little blip: the subprime mortgage crisis made lenders just a little less likely to lend. So the banks in Country A had to pull back a little on their lending at home to make sure they had cash to pay back their existing foreign debts. But when that happened, the local economy slowed down. Now, the banks found it harder to make back the money that they needed to pay back their loans. Now it wasn't about the carry trade anymore, it was just trying to stay above water. So they lent out a little less and kept borrowing abroad in the hope that the slowdown at home was temporary. It wasn't. The entire system quickly came to a halt, then fell apart. The currency collapsed. The economy collapsed. They had to call in the IMF, which everybody knows is a baaaad sign. The banks are gone, unemployment is through the roof, and the entire economy is left wondering where to go from here.

In the other (Country B), banks decided not to do this. As a result, they chugged along happily during the crisis while financial institutions in Country A collapsed. The overall economy in Country B took a hit due to decreased demand for its exports elsewhere in the world, but it wasn't too bad. No one had to call the IMF. All the banks are still there. 

If you haven't guessed yet, surprise! Country A is Iceland, Country B is Singapore. I would love to have some sort of answer to the obvious question: why did Singapore get it so right when Iceland got it so wrong? One answer is "regulation" but that's just restating the question: why did Icelandic regulators fail so miserably while Singaporean ones succeeded? And remember, both countries have (or if you're Iceland, had) really concentrated banking sectors that had all sorts of irregular links to politics worked closely with the political establishment. One answer is that banks in Singapore are all old family businesses, while banks in Iceland were new and naive. Another is that the bankers in Iceland were idiots and the bankers in Singapore are smart. I'm not sure, but I'd like to know.

5-26-10

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