Nature and Background of Iceland's Financial Crisis

Nature & Background of Iceland's Financial Crisis

November 1, 2008

By: Joseph Allain Lenferna de la Motte

Iceland is an island country in Northern Europe, located in the North Atlantic Ocean between mainland Europe and Greenland. It has a population of about 320,000 and a total area of 103,000 km. Its capital and largest city is Reykjavík.

The settlement of Iceland began in 874 when, according to Landnámabók the Norwegian chieftain Ingólfur Arnarson became the first permanent Norwegian settler on the island. Over the next centuries, people of Nordic and Scottish origin settled in Iceland. Until the twentieth century, the Icelandic population relied on fisheries and agriculture, and was from 1262 to 1918 a part of the Norwegian and later the Danish monarchies. In the twentieth century, Iceland's economy and welfare system developed quickly. In recent decades, Iceland has implemented free trade in the European Economic Area and diversified from fishing to new economic fields in services, finance, and various industries.

Today, Iceland has some of the world's highest levels of economic and civil freedom. In 2007, Iceland was ranked as the most developed country in the world by the United Nations' Human Development Index. It is also the fourth most productive country per capita, and one of the most egalitarian. Icelanders have a rich culture and heritage. Iceland is a member of the UN, NATO, EFTA, EEA and OECD, but not of the European Union.

Its economy, once dominated by fishing and tourism, has been turbo charged in recent years by the spectacular growth and rise to fame of its international banks whose global assets rose to eight times Iceland's $20 billion gross domestic product (GDP).

Yet in recent weeks, Iceland has become a much talked-about financial disaster. Behind the purely financial aspect of Iceland's woes, there is however unfolding in this small, quiet and peaceful nation, a human tragedy of unfathomable proportions. Few are those who have the wherewithal to understand the root cause of the multi-faceted financial, economic and geopolitical woes that have befallen every citizen of Iceland. Icelanders are for the most part unaware of why they are where they are today, what caused such spiraling downturn and what they can do to get out of the hole in which they find themselves.

The uninformed may hastily blame Iceland's financial tsunami on the global nature of the sub-prime meltdown and the resulting liquidity crisis. Yet, nothing is further from the truth. It is ironic that the three major Icelandic banks Glitnir, Landesbank and Kaupthing had no significant exposure to US sub-prime derivatives.

If not, then what caused the perfect storm that hit these Icelandic shores?

In April 2008, Iceland suffered a disastrous blow orchestrated by a handful of international hedge funds that conspired to initiate a speculative short-selling attack on its currency, banking system and stock market. This attack prompted Iceland banks' credit default swaps to surge from 50 basis points in August 2007 to 1,000 at the height of the attack in 2008.

The credit default swap crisis in turn led to a global run on the Icelandic kroner, forcing the central bank to hike interest rates to 15 per cent even as the national currency collapsed against the Euro from 94.8 to 124.1 (-31%) from January to July 2008 and against the U.S. Dollar from 64.4 to 81.8 (-27%) from January to August 2008. Icelandic politicians, central bank governors and politicians accused foreign hedge funds of malign intentions in a manner reminiscent of the Malaysian Prime Minister's accusations against billionaire foreign exchange speculator George Soros who was blamed for accumulating massive profits by shorting the Ringgit at Malaysia's expense in 1997.

Iceland was an accident waiting to happen. Having borrowed heavily in the international capital markets to fund highly leveraged and explosive growth, the country was at the mercy of ruthless, greed-driven, global currency speculators who are always lurking to give the kiss of death to any small country that has high external deficits and are known serial borrowers in the international loan and capital markets. For these speculators the profit motive trumps ethics and compassion when it comes to the business of making money.

Since April, the weakness of Iceland's currency and its economy has led the world's leading speculators, traders and hedge funds to further gang-up against this small nation. The liquidity and foreign currencies banks need to fuel any local economy as well as their own needs have all but dried-up for Iceland. "Liquidity is like a cab on a rainy night. It disappears when you need it the most" warned John Pierpont Morgan a century ago during the Wall Street panic of 1907.

This currency assault on the kroner has done lasting damage to Iceland's financial markets, banking system and the economy in general. To defend the kroner, Iceland has had to raise interest rate causing it to become the highest in Europe (15%) - a disaster for Icelandic banks and borrowers alike. To avoid additional downgrades on its already low sovereign ratings by Moody's, Fitch, and Standard & Poor's, Iceland's central bank needs to boost its foreign exchange reserves. Yet, how can it do so when international confidence in the Icelandic currency has all but waned in light of the negative publicity it received during and after the crisis?

There is currently no active foreign exchange trading for the Icelandic Kroner. Even the central bank's attempt to restart trading at 130 Kroner to €1.00 failed and had to be aborted only one day later when there were no takers.

Increased loan interest costs have led once-profitable-businesses to falter, leading the Reykjavik stock exchange into a vicious bear market that is adding to Iceland's woes and increasing its bankruptcy and unemployment rates. While bankers dispute the exact figure, Iceland's net foreign debt is 200% the country's GDP, and rising. It has been suggested that today the average