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SKARBECK: Iceland offers case study of economy out of control

September 5, 2009

Nowhere else on the stage of global economics was financial boom and bust more surreally scripted than in the small isolated country of Iceland.

At the turn of the century, the Icelandic government privatized the country’s banking system and, by 2003, young and aggressive bankers saw their opportunity to enter the arena of world finance. Within five years, Iceland’s bank assets skyrocketed from only a few billion dollars to more than $150 billion, or nearly 10 times the country’s gross domestic product. One economist called it the most rapid expansion of a banking system in the history of mankind.

Borrowing at initially low interest rates, Iceland’s bankers went on a leveraged buyout spree across Scandinavia and Britain. As asset values rose, the perceived wealth of Iceland multiplied. In three years, Iceland’s income per capita tripled and its stock market rose eightfold.

Interest rates in Iceland began to rise from about 5 percent in 2003, eventually peaking at 18 percent in late 2008. For a while, the rising rates helped sustain capital flowing into the country’s three largest banks. The country’s currency, the krona, also was rising and Iceland became a major beneficiary of world currency trading.

Investors poured money into Icelandic bank deposits playing the “carry trade.” This involved borrowing money in a cheaper currency, such as the yen at 3 percent, and investing in a higher-yielding currency such as the kronur, thus earning the spread. Icelandic fishermen, some of whom had become stockbrokers, flocked into these positions along with other investors throughout the world.

Michael Lewis, the witty financial writer, penned an April 2009 article about Iceland in Vanity Fair titled, “Wall Street on the Tundra.” Lewis began by describing an interview he had with an International Monetary Fund official in October 2008, who told him, “You have to understand, Iceland is no longer a country. It is a hedge fund.”

By 2007, Icelanders owned 50 times more in foreign assets than they owned in 2002. And then, like all bubbles are wont to do, Iceland’s financial system began to implode. In the spring of 2008, the central bank raised interest rates to 15.5 percent to stem the decline of the krona, which had sunk 20 percent in value against the euro. By September, inflation was soaring over 14 percent, and for a country that imports just about everything except fish and geothermal heat, the rising costs pushed the economy toward recession. Yet, the central bank still forecast this as an “adjustment towards a sustainable equilibrium.”

The end came swiftly, with bank debt of eight times GDP and foreign investors accelerating withdrawals as the krona went into a tailspin. On Oct. 9, 2008, the government shut down the stock market and seized the last of the three Icelandic banks. Iceland was, for all practical purposes, bankrupt. Bonds of Iceland’s banks traded for 3 cents on the dollar.

The story of how this country with a land mass the size of Kentucky and a population of 320,000, about the size of Cincinnati, rose and fell will be studied ad infinitum. Lewis relates that you periodically hear a Range Rover blow up in Reykjavik as owners look to collect insurance money. Former bankers cling to $500,000 homes with $1.5 million mortgages.

In signs it has begun to address its financial sins, Iceland recently voted to repay $6 billion (over 15 years) it had borrowed from the United Kingdom and Netherlands to make whole depositors who lost money in the failed Icelandic banks.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressedare his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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