Will Iceland Need an IMF Bailout?

♠ Posted by Emmanuel in , at 10/05/2008 11:18:00 AM
What's a financial crisis without a fast-depreciating currency? In the place of Southeast Asian economies as per the Asian financial crisis, we now have the largely ignored story of Iceland. As the chart above depicts, the Icelandic krona (ISK) has devalued over 50% in little over four months' time and 20% in two weeks' time. Despite the USD being well and truly overbought against the ISK, the Icelandic currency's woes continue. How a lightly populated country few can point to on a map got into such a mess is a very interesting story of globalization.

Like (the area formerly known as?) Wall Street and the City of London, Iceland until recently was a big beneficiary of global liquidity provided by the Chinese and other countries running large external surpluses. Would-be Icelandic tycoons used cheaply available funding to buy up stakes in the rest of the world, especially Merrie Olde England. The Guardian offers a good backgrounder from which this excerpt is taken:
Iceland is on the brink of collapse. Inflation and interest rates are raging upwards. The krona, Iceland's currency, is in freefall and is rated just above those of Zimbabwe and Turkmenistan. One of the country's three independent banks has been nationalised, another is asking customers for money, and the discredited government and officials from the central bank have been huddled behind closed doors for three days with still no sign of a plan. International banks won't send any more money and supplies of foreign currency are running out.

People talk about whether a new emergency unity government is needed and if the EU would fast-track the country to membership. On Friday the queues at the banks were huge, as people moved savings into the most secure accounts. Yesterday people were buying up supplies of olive oil and pasta after a supermarket spokesman announced on Friday night that they had no means of paying the foreign currency advances needed to import more foodstuffs.

This North Atlantic volcanic island, which is the size of Cuba, with a population of 320,000 - the size of Coventry's - is an unlikely player on the global financial stage. It is famous for its fish, geysers and for winning the UN's 2007 'best country to live in' poll. But Iceland built its extraordinary wealth on the crest of the worldwide credit boom and now the crunch is sweeping it away, bankrupting a people for whom the past eight years have been, for most of them and by their own admission, one long party.

The nation's celebrated rags-to-riches story began in the Nineties when free market reforms, fish quota cash and a stock market based on stable pension funds allowed Icelandic entrepreneurs to go out and sweep up international credit. Britain and Denmark were favourite shopping haunts, and in 2004 alone Icelanders spent £894m on shares in British companies. In just five years, the average Icelandic family saw its wealth increase by 45 per cent.

But, as a result of the international banking crisis, the billionaires who own everything from West Ham United football club to the Somerfield supermarket chain, Hamleys toy shops and the House of Fraser, are in trouble and the country is drowning in debt.

Iceland's cheap labour force, the Poles and Lithuanians, have left already - there's little point in sending home such a worthless currency, and the tourist season is over. Iceland is on its own.
As long as global credit flowed freely, Iceland itself became one large hedge fund--with its banks borrowing liberally to invest in equity stakes in European companies. The global credit crunch has seen to it that Icelandic banks cannot find such easy financing, and the now parlous state of Icelandic banks looks set to drag the entire country down via a slumping currency, high inflation, and other not-so-jollies. With a global slowdown in store, it is hard to imagine Icelandic concerns garnering sufficient returns to pay off their accumulated debts. And still things may get worse if Iceland's largest bank, Kaupthing, goes bust, taking Brits down too:
Kaupthing may be headquartered in Reykjavik, some 1,000 miles away from the City of London, but the financial volcano threatening to erupt on the island could send shockwaves down every High Street in Britain. The bank, whose liabilities are several times larger than Iceland's GDP, runs accounts for 150,000 Britons. Not only that, it is a key lender to some of Britain's biggest entrepreneurs, including the top chef and restaurateur, Gordon Ramsay and the property tycoon, Robert Tchenguiz, and bankrolls major retail chains from House of Fraser and Debenhams to Woolworths, Hamleys, Whittards of Chelsea and Karen Millen.

Yesterday the Icelandic government was desperately trying to stitch together a package that would restore confidence in the bank and prop up the country's ailing economy which is teetering on the brink after years of over-expansion by its banks.

Most of the British depositors in Kaupthing are safe - savings in the bank of up to £50,000 are guaranteed by the UK Government. But in Iceland, the population - known for their resilience and stoicism - are panicking. They are rushing to the banks in their snow-topped 4x4s to check that their savings are still there and stockpiling provisions in case the country's rampant inflation heads further out of control.

"Many people are angry. I think it is absurd that we are in this situation," says music student Katrin Hamilton, who has lived in Reykjavik her whole life. "People here are buying more freezers just so they can fill them with groceries..."

Iceland's complicated financial interests are so interconnected – with a small number of key investors owning cross-stakes in each other's institutions [sounds like keiretsu] – that the worst fear is a domino effect which will lead to the collapse of the country's economic system, potentially taking with it any number of high-profile British chains.
Some commentators have mooted that Iceland may soon need an IMF bailout--the first developed country to require one since the UK in 1976. I don't rule it out, and Iceland's fate certainly serves as another cautionary tale against excessive borrowing. Laissez faire, we hardly knew ye.

UPDATE: The WSJ writes that crisis talks over the weekend have yielded plans to raid mandatory pension funds invested abroad thought to amount to $16.5B. (Repatriating these funds would theoretically boost the krona.) Speaking of needing a bailout, the WSJ also says Iceland's forex reserves have dwindled to €2.0B. However, it may approach other Nordic countries before the IMF:
At marathon meetings at a guest house in Iceland's capital on Sunday, bankers and ministers discussed selling pension-fund assets held overseas and seeking assistance from central banks of other Nordic countries to provide liquidity, among other scenarios, according to people familiar with the situation...

Iceland's pension funds, to which private employers and the government are obliged to contribute, are well-funded and together hold about €12 billion ($16.52 billion) in assets, a good portion of it in foreign securities that could be sold to provide liquidity, also bolstering the ailing Icelandic krona.

Using pension plans, in effect, as a sovereign-wealth fund to rescue banks could create risks to future pension benefits. But other options are limited. The Central Bank of Iceland has about €2 billion in foreign-exchange reserves. Standard & Poor's and Fitch Ratings both cut Iceland's sovereign debt rating last week.
UPDATE 2 (10/17): See updated post on how Iceland has nationalized its second-largest bank, pegged its currency, and seeks EUR 4B from Russia.