In part, it is due to various types of non-bank investor in credit finding themselves facing actual or incipient liquidity pressures. Both as cause and effect, liquidity in the capital markets is impaired. This is apparent in the opening up of a so-called “negative basis” between the spreads on corporate bond and on equivalent credit-default swaps, which unbundle the transfer of credit risk from the provision of funds and so are less affected by liquidity hoarding (Chart 12). A twin-engine financial system? At various times over the past decade or so, it had been argued 5 that the macroeconomy as a whole should be more resilient to shocks to a financial system with “twin engines” – combining capital markets with banking system intermediation of savings and credit. The argument is that when the capital markets are impaired, banking can take more of the burden, and vice versa. I have a good deal of sympathy for this view – but not for all circumstances. It rather overstates the independence of capital markets and banking, as recent developments graphically demonstrate. First, whether through financing the purchase of credit assets by leveraged funds or warehousing portfolios prior to sale or providing “liquidity lines” to conduits and other investment vehicles, the banking system puts its capital and liquidity behind the distribution of credit risk to the wider asset-manager universe. As the official sector stressed over recent years, it is important to be clear about the circumstances in which risk can flow back to the banking system.
The importance of fisheries as a generator of foreign exchange revenue has diminished in relative terms - to less than a half of the total - while the importance of other sectors has risen, such as manufacturing industry, information technology and tourism. In these developments, Iceland is among other things drawing benefits from globalisation to strengthen the foundations of the economy. Foreign direct investment regulations are liberal with the exception that such investment is not permitted in the fishing sector. Foreign direct investment is most noticeable in power intensive industry, such as the production of aluminium, which is based on Iceland’s abundance of untapped renewable energy resources. Recent changes in corporate taxation in Iceland, lowering corporate taxes to among the lowest to be found, serve to attract foreign business to Iceland and encourage Icelandic companies with international operations to favour Iceland as the base of their operations. 2  BIS Review 51/2002  Direct investment by Icelandic companies abroad has risen rapidly in recent years and in a variety of areas, such as fisheries and fish processing, pharmaceuticals, retail commerce and financial services. These developments also benefit the Icelandic economy in the long run as they integrate Iceland further into the global economy, allow Iceland to draw more easily on the experience of others and bring in dividends.