Cracks in the Ice

Katrín Pétursdóttir knows what treasure lies in the pile of skinned fish carcasses before her, and the investment needed to extract it. Seventy years ago her grandfather founded LÝSI, a fish processing company, which last year produced 6,000 tons of fish oil and $30 million in revenues with just 100 employees. In 2005, Pétursdóttir built a gleaming $4 million factory, and she has plans for a $7 million expansion to keep up with the growing demand among health-minded consumers for omega-3 fatty acids. But financing these ambitious plans may prove problematic, with Iceland mired in its first recession since 1992 and interest rates at 15.5% — the highest in Europe. “Our banks aren’t so keen on lending right now,” she says. “It’s not a good time to chase money.”

As the latest flashpoint in the global financial crisis, Iceland is nursing a familiar sort of economic pain in a typically cool way. Over the past two years, the country’s banks enjoyed extraordinary growth by borrowing heavily on international capital markets, leading Iceland to rack up a $2.7 billion current-account deficit, equivalent to 16% of its GDP; the comparable figure even in the notoriously indebted U.S. is only 5%. In January banks worldwide clamped down on loans in response to the global credit crunch, and investors began to worry that Icelandic banks had leveraged themselves too aggressively. Rumors swirled that the banks would default and that Iceland’s central bank, with its modest $2.5 billion reserve, would be hard-pressed to bail them out. As investors pulled out of the market, the Icelandic krona fell by 27% against the U.S. dollar, the cost of insuring Icelandic debt soared to record levels, and inflation surged, hitting a 20-year high of 12.3% in recent days. That bleak combination has created a widespread perception, trumpeted in the world’s financial press, that Iceland is melting.

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But to Icelanders — from cab drivers who recite economic statistics to Prime Minister Geir Haarde who travels the world calming investors’ nerves — the hysteria appears overblown. “What you’d expect to see out of these windows is fire,” says Finnur Oddsson, managing director of the Iceland Chamber of Commerce. Instead, he peers out at a $138 million construction project at the University of Reykjavik. Iceland, he points out, has been in this situation before. In early 2006, credit agencies criticized Icelandic banks for their lack of transparency and reliance on international capital markets. Analysts’ opprobrium drove the krona down by 25% against the dollar over six months. Yet Iceland never defaulted on a single loan, signaling a disconnect between foreign perception and domestic reality. “We learned our lesson: we need to tell our story,” says Árni Mathiesen, Iceland’s Minister of Finance. “Other people are more likely to tell the wrong story or misinterpret it.”

This time around, the government and the banks are doing everything they can to dismantle the caricature of Iceland as a victim of its own excess, and instead portray it as the target of a financial conspiracy. Prime Minister Haarde has accused international hedge funds of deliberately spreading rumors to create a banking scare, so they could profit by “hook or crook” from wagers that the currency or stocks would tumble. In April, Iceland’s Financial Supervisory Authority launched an investigation into an unconfirmed story that back in January, hedge-fund managers had hatched a plan to bet against the currency over drinks at a posh Reykjavik bar.

Iceland gets some support for its conspiracy theory from Richard Portes, an economist at the London Business School. In March, after he published a favorable report on Iceland’s economy, Portes says a senior figure at a major hedge fund phoned him. “He spent half an hour trying to tell me the Icelandic banks were in terrible shape and that the country was a disaster area,” he recalls. “Apparently I was risking my reputation by saying anything different.” But not everyone responds to Iceland’s plight with sympathy. Eileen Zhang, an Iceland expert at ratings agency Standard and Poor’s, says cries of “Foul!” mask the country’s feckless expansion: “Whether you call it an attack or you call it arbitrage, Iceland has put itself in this vulnerable position.”

She has a point. Prior to the 2006 crisis, analysts warned that Iceland — where Land Rovers and private jets seem to outnumber the nation’s 308,000 people — was growing too quickly, and that excessive consumption would cause the economy to overheat. Yet the nation’s three largest commercial banks — Kaupthing, Landsbanki and Glitnir — continued to exploit their then strong currency and cheap credit to buy banks in Denmark, Norway and the U.K., as well as British retailers like House of Fraser and Moss Bros. They amassed foreign assets equivalent to 800% of the nation’s GDP, the highest ratio of any country in the world. Meanwhile, their dependence on global capital markets to fund this shopping spree left the banks vulnerable to the whims of investors. By early 2008, the combination of a risk-averse global financial climate and possible speculative attacks on the krona meant that Iceland could no longer run itself like a hedge fund. Says Paul Rawkins, an analyst at Fitch Ratings: “The global credit crunch undermined their business model.”

To restore investor confidence, Icelandic banks and government officials have emphasized their economy’s unflagging strengths in a charm offensive directed at ratings agencies and investors. Iceland is the fifth richest country in the oecd; the prices of its largest exports, aluminum and fish, are at record highs. “The Icelanders are richer than us,” says British economist Portes. “They’re not exactly going to starve.” (Iceland’s gross national income per capita is $39,400, compared to the U.K.’s $35,300.) What’s more, the banks remain fundamentally sound: they have strong deposit ratios and are more profitable than their Nordic peers. First-quarter results suggest the financial climate has started to warm: the three largest banks all reported strong core earnings, with Landsbanki’s rising by 27% compared to the same period last year. On May 16, in a show of support, the central banks of Denmark, Norway and Sweden offered to loan Iceland $2.4 billion in emergency credit, doubling the nation’s reserves; the krona immediately gained 5% against the euro. Iceland’s central bank asked parliament on May 28 to let it borrow up to $6.9 billion so it can better protect the country’s currency and banking system.

Edda Rós Karlsdóttir, a senior director at Landsbanki, says Iceland’s peculiar macroeconomic conditions pose the biggest challenge to maintaining investor confidence. With so few potential depositors at home, the nation’s banks have little choice but to raise capital abroad. Furthermore, the size of Iceland’s economy — the U.S. economy is roughly a thousand times larger — has always made it volatile, partially explaining its much-discussed $2.7 billion current-account deficit. “If my father decides to build a garage onto his house, it will almost show up in national accounts,” she quips. So imagine the impact of constructing two large aluminum smelters from 2005 to 2007. Those projects required the import of generators and other materials, and amounted to 35% of the nation’s GDP. With aluminum prices higher than ever before, those smelters will soon turn profits — and boost national income.

The banks flatly dismiss the notion that the central bank will need to bail out the system. “That’s just unthinkable,” says Ásgeir Jónsson, chief economist at Kaupthing, Iceland’s largest bank. Following the 2006 crisis, banks greatly strengthened their liquidity positions and shifted their liabilities further into the future: on average, newly issued bonds now mature in 2010 or after, rather than within a year. Although Iceland’s major banks had hoped to grow quite quickly this year, they will use their liquidity conservatively as a buffer instead. Meanwhile, to their relief, Iceland’s banks have negligible subprime exposure. Whether through luck or foresight, Glitnir and Landsbanki didn’t buy any of the bad paper.

Despite these strong fundamentals, Iceland has undoubtedly lost some steam — and importers feel it the worst. Úlfar Steindórsson, CEO of Toyota Iceland, says that the depreciated krona raised the price of imported cars by 25% in just a matter of weeks, bringing his booming sales to a standstill. He now predicts year-on-year revenues will end 30% lower. But Steindórsson doesn’t blame the government or Iceland’s banks. “The crisis didn’t start in Iceland — it started in the U.S.,” he says. As he sees it, the international dimension of the credit crunch means that Iceland’s hands are essentially tied. “We can’t move the prices on Wall Street, and we can’t buy all the empty houses in the States,” Steindórsson says. “Those are problems that someone else has to solve, and we just have to wait.” On this isolated island that has endured extreme temperatures and fierce glacial winds for centuries, this bout of economic turmoil is simply another nasty storm that the locals expect to weather.