Iceland: Left in the cold

News stories about Iceland, when they reached the outside world at all, used to follow a rustic prototype -- covering stories such as the annual Borgarnes sheep mass, which took place as usual this year on October 7. However, in the past decade the financial press has taken more of an interest in the tiny county (with a population of 312,000) because of its daring economic policy -- Iceland, through heavy borrowing and ambitious investing, achieved remarkable growth rates and became one of the richest countries in the world in per capita terms. Analysts spoke in approving terms of the ‘Nordic Tiger’, a low-tax, low-regulation country run like a giant hedge fund.

The analysts are somewhat quieter now. The country has became a prominent casualty of the credit crunch, threatening savers and shoppers across Europe (as well as worrying a few football fans).  The banking sector, in pursuit of its investment goals ran up 100 billion dollars of liabilities, far in excess of Icelandic GDP of 14 billion or so. Faced with a faltering credit environment this year, ratings agencies (and more than a few speculators) identified that the banks would struggle to finance their debt, and that the economy, in a symbiotic relationship with the banks, was threatened too.

Faced with a run on the Icelandic Kronor, the government raised interest rates to punishing levels. As the credit crisis worsened, the country’s three dominant banks -- Kaupthing, Glintir and Landsbanki -- were taken over by a reluctant government, under the terms of emergency legislation passed on October 6. At first, the government had hoped to employ gentler measures -– merely offering liquidity to Landsbanki in exchange for a stake -– but faced with disbelieving markets, it took harsher action. The tone has been pessimistic, with Central Bank Governor David Oddsson noting that “The state will not inject new capital into [Glintir] unless there is actually a bank."

Stock markets have been closed since October 9, and faced with vertiginous falls in the currency the government has tried to impose a currency peg to the euro. Markets called Iceland’s bluff, noting the central bank’s tiny reserves, and in the face of speculation the peg lasted two days before being abandoned.

The government and central bank have sought financial assistance to resurrect it, but EU countries have not opened their wallets. Sweden and the United Kingdom have acted, but only to protect their savers. Norway has lent a little, and Icelandic pension funds have offered to make patriotic investments in the country, but the sums offered are far less than required. In one of a number of emotional press conferences, Prime Minister Geir Haarde decried Iceland’s abandonment by its ‘friends’, and announced a search for ‘new friends’, sending Icelandic officials to Russia to negotiate a loan.

In spite of commentary, the request to Russia is unlikely to mark a shift in grand strategy for the strategically-placed island. Even if Iceland wanted to teach Europe a lesson, Russia is a poor choice of patron -- faced as it is with falling commodity prices and a financial crisis of its own.

However, the move does have implications for countries smaller than the firms they contain (Switzerland might be another example, overseeing troubled banking giant UBS). Iceland’s example teaches that, while there are some banks too big to fail, there are some countries whose financial collapse the world is prepared to countenance.