Abstract
Hamid Raza and Gylfi Zoega address the issue whether the causes of financial crises in Iceland can be found locally, within Iceland, or in world capital markets. They explore the role of capital inflows in generating a stock market boom in Iceland as well as a real exchange rate appreciation. Using a VAR methodology, the authors find that the inflow of capital caused a booming stock market as well as an appreciation of the currency. Moreover, a positive shock to the stock market caused a subsequent capital inflow and appreciation. The results confirm the hypothesis that capital flows and credit generation created the stock market bubble and the overvalued exchange rate that contributed to the pre-crisis economic boom. A sudden stop of these flows made the stock market collapse and the exchange rate lose half its value.
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Notes
- 1.
See Benediktsdottir et al. (2011) on the crash in Iceland.
- 2.
- 3.
Financialisation here is defined as an increase in financial investment compared to the volume of real investments.
- 4.
There is an increase in FDI in Iceland during 2006–2008, where a large proportion of investment was in export projects (e.g. aluminum smelting). However, the scale of the current account deficit was far larger than the sums invested in these export projects.
- 5.
For example, Aggarwal (1981) found a positive effect of US exchange rate on stock prices. Diamandis and Drakos (2011) concluded a positive effect of real exchange rate on stock prices for Latin countries. On the other hand, Goodwin et al. (1992) and Soenen and Hennigar (1988) found a negative effect of US exchange rate on stock prices. Moreover, the results regarding direction of causality are also mixed (see, e.g., Granger et al. 2000; Pan et al. 2007, among others).
- 6.
Before estimating the model, we adjust all the variables for seasonal variations. We then test all the variables for a unit root finding that they are non-stationary.
- 7.
We use trend of annual GDP in order to normalize our measure of capital inflows.
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Raza, H., Zoega, G. (2019). From a Capital Account Surplus to a Current Account Deficit. In: Aliber, R., Zoega, G. (eds) The 2008 Global Financial Crisis in Retrospect. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-12395-6_10
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DOI: https://doi.org/10.1007/978-3-030-12395-6_10
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