Iceland: cold blood needed

Thousands of foreign investors will be turning their attention on Reykjavik on Thursday, when the Central Bank of Iceland issues its new economic and inflation forecasts and decides whether to move interest rates.

Rumours are rife about an imminent financial and economic crisis in the country, which would make it the first national casualty of the credit crunch.  The political and business elite has been at pains to reassure investors that they have enough tricks up their sleeves to avert such a catastrophe, but an emergency interest rate hike by 125 basis points to 15% -- by far the highest in Europe -- last week has done little to calm tempers.

After years of economic boom, which attracted large numbers of foreign investors -- UK investors alone invested over 6 billion pounds in the last 18 months -- and in turn allowed Icelandic banks to make spectacular acquisitions in the Nordic countries and the United Kingdom, the 'Atlantic tiger' is flagging.  Economic growth is cooling, inflation is soaring (6.8% in February), the currency lost a quarter of its value since January and the major banks have been downgraded to negative by the world's leading rating agencies.  The depreciation of the currency makes financing the current account deficit more difficult, as imports become more expensive. A general nervousness in global financial markets, which has made banks reluctant to lend to each other and caused panic among corporate and private investors, exacerbates Iceland's problems.  The government is understandably worried about a run on Iceland's bank by foreign investors, which would mean de facto bankruptcy for the entire country. 

However, not all is lost.  The government has successfully reduced the current account deficit from 26% of GDP in 2006 to 16% in 2007 and the economic slowdown might help rebalance the economy. Moreover, higher interest rates may reduce demand, and thus inflation, while helping to maintain Icelandic banks sufficiently attractive for foreign investors.