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"Iceland is bankrupt. The Icelandic krona is history. The IMF has to rescue us."
Arsaell Valfells, Assistant Professor, Department of Business Administration at the University of Iceland

What's the capital of Iceland? About £4.50 at the moment.

Iceland is an island nation located in the North Atlantic which, according to the CIA World Factbook, is "slightly smaller than Kentucky". Characterised by such natural hazards as "earthquakes and volcanic activity" only some 0.07% of its land mass comprises arable land, and apart from the fact that it possessed "abundant geothermal power" its economy is almost entirely dependent on fishing. (Or at least was, and might be once again.) At the time it formally gained independence from Denmark in 1944 it was the poorest country in Western Europe, and although it enjoyed better times after the end of World War II through the development of its fishing industry (and fought a series of Cod Wars with its British neighbour) overfishing eventually led to economic decline in the 1980s.

It was in 1991 that David Oddsson of the Sjálfstæðisflokkurinn or Icelandic Independence Party became Prime Minister replacing Steingrímur Hermannsson of the Framsóknarflokkurinn or Icelandic Progressive Party. It was under Oddsson's guidance that Iceland began to adopt what might be described as a neo-liberal approach to the economy and began liberalising markets, cutting taxes, and privatising state-owned businesses. What was later called the Icelandic Model appeared to bear fruit after Iceland joined the European Economic Area in 1994, as the country enjoyed strong economic growth averaging around 3% to 4% a year over the following decade, and gave birth to what was known as the Icelandic Economic Miracle as the nation went from being the poorest country in Europe to become the fifth richest nation in the world based on per capita GDP.

Although this period of economic growth was kick-started by the arrival of a number of aluminium smelters attracted by the cheap and abundant geothermal power, the main driver turned out to be the financial sector. Of course Iceland always had a banking system, although it was almost entirely state owned, but in line with its policy of liberalising markets, Oddsson's government decided to deregulate and privatise much of the nation's financial services industry. The two state owned commercial banks, Landsbanki Íslands and Búnadarbanki Íslands were both privatised between 1998 and 2002, whilst the privately owned Íslandsbanki, established in 1990 following the merger of four smaller banks, was allowed to merge with the state owned FBA or Icelandic Investment Bank in 2000, which was itself the product of the merger of three state-owned investment credit funds in 1998.

In 2003 Búnadarbanki merged with a small investment brokerage named Kaupþing or Kaupthing which had gained an investment banking licence in 1997, and adopted the name of Kaupthing Bank, whilst Íslandsbanki later decided to go by the name of Glitnir in 2006. But by whatever name they were known, once freed from previous constraints these three banks went on an "unprecedented borrowing and lending spree", establishing branches in other countries, and acquiring various overseas assets, so much so that between 2000 and 2007 the amount of domestic credit from the Icelandic banking system expanded from 100 percent of GDP to 450 percent of GDP. Their playground was Northern Europe, where they established branches in such financial centres as Amsterdam and London, and brought up other financial services companies in Norway, Finland and the United Kingdom.

Where the banks led, other Icelandic companies followed. Fuelled by lending from the country's banks, an Icelandic supermarket company named Baugur began buying up large chunks of British retailing and ended up as the owners of significant stakes in such established names as the House of Fraser and Hamleys, as well as acquiring a British frozen food retailer that rather ironically went by the name of Iceland. A new breed of Icelandic billionaires emerged, such as Bjorgolfur Gudmundsson, a major shareholder and chairman of Landsbanki, and number 799 on Forbes' list of the World's Billionaires, who did what the super-rich so often do, and bought himself a football club in West Ham FC.

Storm clouds gather on the horizon

Certainly this development did not go unnoticed in Britain where the talk was of the new Viking invasion. During the course of the twelve months to June 2005 sundry Icelandic companies invested a total of £1.8 billion in Britain. Since this amounted to some £6,000 per Icelander, dark mutterings soon emerged regarding the question of where all this money was coming from. There were various persistent, but of course entirely unsubstantiated, rumours that the whole Icelandic Economic Miracle was funded by Russian mafia money, as it was noted that some of the key players in the Icelandic business community had initially made their money after obtaining ownership of a bottling plant in St Petersburg and selling it on to Heineken for a large profit.

But whatever the truth behind these tales, there were other reasons to doubt that the Icelandic Economic Miracle could continue for much longer. Thanks to the significant economic growth enjoyed by Iceland since the late 1990s inflation became a constant concern. As a result Seðlabanki Íslands, otherwise known as Sedlabanki, the Central Bank of Iceland, pumped up interest rates from around 5% in 2004 to 15% in 2008. However these double-digit borrowing rates simply encouraged local businesses and households to borrow in foreign currency, and provided profit opportunities for those who indulged in what is known as the carry trade.

This was all very well during the years when the Icelandic króna or krona traded in the range of 70 to 90 krona to the euro, however at the beginning of 2008 it fell through the 100 barrier and then in March 2008 it lost almost a quarter of its value in less than three weeks as the rate plunged to 128 per euro. Sedlabanki was forced to push through two interest rate increases in an effort to stem the tide, whilst in the following month, the Icelandic Prime Minister Geir Haarde blamed short-selling by hedge funds for the problem, saying that "We would like to see these people off our backs and we are considering all the options available", and indicated that he was prepared to order direct intervention in the currency and stock markets in an attempt to punish said speculators.

Of course short-sellers only push against doors that open, and this pressure on the Icelandic krona was simply a reflection of the underlying economic challenges facing the nation. As the rating agency Fitch Ratings explained on the 21st February 2006, when it decided to revise its outlook on "Iceland’s foreign and local currency Issuer Default Ratings (IDRs) to negative from stable"; its "Negative Outlook" had been "triggered by a material deterioration in Iceland's macro-prudential risk indicators, accompanied by an unsustainable current account deficit and soaring net external indebtedness".

The problem was not so much the level of public debt, which was actually falling as a percentage of GDP, but rather the amount of private sector debt which was at that time over twice Iceland's GDP. Fitch Ratings further noted that despite this, "Icelandic banks and corporates continue to pursue ambitious expansion plans abroad, accumulating external debt at an unprecedented rate in the process" and that the "banks remain heavily dependent on foreign funding and could ill afford to be shut out of international capital markets for any length of time".

Iceland was therefore a nation with a persistently large current-account deficit which had increased from 10% of GDP in 2004 to 25% in 2006 before easing back to about 17% in 2007; it had large foreign currency borrowings, a high domestic interest rate, and a declining currency. All of which pointed to problems in the future, although there remained those who insisted that the nation would somehow manage to engineer a soft landing.

So long, and thanks for all the fish

When the Global credit crunch first struck no one thought it would be a particular problem for the Icelandic banks as none of them had any significant exposure to the US sub-prime market. Indeed when the Dutch bank NIBC announced that its annual profits had been wiped out by the sub-prime crisis, it was Kaupthing who agreed to buy the company for €3 billion in August 2007. (Although it was later forced to cancel the deal in January 2008, when it became apparent that it faced problems raising the finance.)

Unfortunately the collapse of Lehman Brothers on the 15th September 2008 ushered in a new phase in the Global Banking Crisis. It triggered widespread falls in stock markets across the world as well as a general sense of panic as everyone wondered which bank would be the next to fall. At first glance there was no reason to believe that any one of Kaupthing, Landsbanki, or Glitnir would actually fail as not one of the banks had done anything spectacularly wrong. They faced no significant exposure to the sub-prime market, nor the emerging problem with credit default swaps, none of their borrowers had gone spectacularly bankrupt, and whilst they all might have been exposed to the seriously over-valued Icelandic housing market, any losses that generated would have been small in comparison to the scale of their overseas assets.

Indeed on the 19th September the International Monetary Fund published its most recent Article IV Consultation with Iceland. Although this report noted that "global turbulence has taken a significant toll on domestic financial markets" it also "noted that the long-term prospects for the economy remain promising-even enviable", and whilst it also noted of how CDS spreads on the "three largest domestic banks" were approaching 1000 basis points, it spoke approvingly of how they had "sought to strengthen their balance sheets and enhance liquidity buffers". There was not one word that suggested that any of these banks might be on the verge of failure.

They were however all highly leveraged banks whose expansion had been driven by borrowing in international capital markets, and as Fitch Reports had warned back in 2006 they "could ill afford to be shut out of international capital markets". The realisation dawned that whilst the USA might be able to afford to devote some 5% or 10% of its GDP to bailing out its banks, and the British could afford to pump billions into recapitalising its banks, Icelandic GDP was in the order of $16 billion whilst its three commercial banks had combined liabilities in excess of $140 billion, and that the Icelandic government was therefore not a credible lender of last resort. The fear of failure can rapidly become a self-fulfilling prophecy as far as banks are concerned, and so it proved in this case, as Iceland's banks faced increasing problems in re-financing their debt in the markets, and their share prices plunged.

On Monday 29th September the Icelandic government announced that it acquired a 75 per cent stake in Glitnir for €600 million in a rescue operation. It is very probable that the government believed that this would help stabilise the situation, however the krona, which had already fallen to a rate of 142 krona to the Euro on the 29th September, then fell over a cliff as its value halved in a matter of days.

On the 7th October 2008 the Fjármálaeftirlitið or the Icelandic Financial Supervisory Authority announced that it had, "Based on New Legislation", taken control of Landsbanki in order "to ensure Continued Commercial Bank Operations in Iceland". On the 8th October 2008 it made exactly the same announcement regarding Glitnir, notwithstanding the Icelandic government's previous rescue operation, and on the 9th October it was the turn of Kaupthing to be nationalised.

As reported by Bloomberg, the last spot trade in Icelandic krona was transacted on the 8th October at the rate of 340 krona per euro. Trading in the Icelandic krona then came to a halt for the simple reason that there were no more commercial banks left in Iceland to execute any currency trades. When the Sedlabanki managed to get things moving again a week later, it was dealing at 150 krona per euro, although by then an entirely separate offshore market had developed where the rate was 275 to the euro.

Iceland was left negotiating with Russia over a 4 billion euro loan to keep the country afloat in the short term, having rejected the idea of making an approach to the International Monetary Fund presumably for fear of the conditions that would be imposed.

Britain's very own Icelandic banking crisis

Since Iceland was a member of the European Economic Area its banks were entitled to carry on business in any another EEA State by exercising what was called passporting rights. In pursuance of its overseas ambitions Landsbanki had opened a London branch back in January 2005 and in the autumn of 2006 it launched an internet banking service under the Icesave brand name. When the Icelandic government nationalised Landsbanki it took steps to ensure that all of Landsbanki's Icelandic based operations would be "open for business as usual", however despite the fact that its British depositors were just as much customers of Landsbanki as those who held accounts at their Reykjavik branch, they were not extended the same privilege. Neither were the Icelandic authorities forthcoming about the payment of compensation to Icesave's 300,000 or so retail depositors that they were supposedly entitled to. The British government were not happy with this turn of events and promptly decided to use anti-terror legislation to freeze Landsbanki's assets in the UK; a device that was soon extended to cover Kaupthing's assets as well.

Oddly enough the British customers of the Kaupthing equivalent of Icesave, which went by the name of Kaupthing Edge faced no such problems, as depositors in Kaupthing Edge held accounts with the British bank Kaupthing Singer & Friedlander Limited and could therefore rely on the UK Financial Services Compensation Scheme.

However it soon emerged that it wasn't only retail depositors who faced problems, as the Local Government Association confirmed that 116 councils, police and fire authorities in England and Wales had deposited a total of £858 million in Icelandic banks, including Kent County Council with £50 million and Nottingham City Council with £42 million. At least three hospital trusts also had deposits with Icelandic banks, whilst it was believed that various other public bodies such as housing associations might also have funds at risk, but were simply unwilling to publicise their potential losses. It later emerged on the 16th October that even the Audit Commission, being the very public body which audited local councils, police authorities, housing association and NHS trusts, had £10 million of its own money in Landsbanki. It didn't stop there either, as the National Council for Voluntary Organisations estimated that charities had around £120 million at risk, while a number of universities also admitted that they too, had funds placed with one or more of the Icelandic banks.

Of course, since it was understood that the British government had managed to get its hands on some £4 billion of Icelandic banking assets, it appeared that ultimately none of the above might actually lose anything, although in the meantime the funds remained frozen, and there were fears that a handful of local councils might face difficulties in meeting next month's payroll. The demise of the Icelandic banks also led to the death of two more British banks, with the Landsbanki susbsidiary Heritable Bank (founded in 1877) and Kaupthing Singer & Friedlander Limited (founded in 1907) both being placed in administration by the Financial Services Authority. Neither is likely to see the light of day again.

Iceland may not be the only nation to face its nemesis in the great Global Banking Crisis of 2008. Other nations with persistent current account deficits and large scale foreign borrowings include Turkey, Hungary, Australia, New Zealand, Spain, and of course the USA as well as that other island in the North Atlantic. Indeed many newspapers have begun playing the game of spotting the next Iceland and mentioning various countries such as Ukraine, Estonia, Latvia, Lithuania and even Switzerland.

As far as the population of Iceland is concerned, The Independent claimed that it was 320,000, although the Daily Telegraph gave the figure of 313,000, the CIA had 304,367 as its July 2008 estimate, and the FCO quoted a figure of 309,000 as at April 2007. Similarly various figures are quoted regarding the size of Icelandic GDP of between $14 and $20 billion - variations which are presumably explained on the exchange rate used. The What's the capital of Iceland? joke was borrowed from The Times; the So long, and thanks for all the fish gag originated from the Lex column in the Financial Times. Not that these sources were likely to have been the original author of either.


  • Hannes H. Gissurarsonreykjavik, Miracle on Iceland, Wall Street Journal, January 29, 2004
  • Ian Griffiths, Next-generation Viking invasion, The Guardian, June 16 2005
  • Kim Hunter Gordon, Iceland's cool investment calculation, The Observer, November 20 2005
  • Fitch Ratings revises Iceland's outlook to negative, 21.02.2006
  • Louise Armitstead, Iceland shows cracks as the krona crashes, Daily Telegraph, 23 Mar 2008
  • David Ibison, Iceland threatens direct markets intervention, Financial Times, Apr 1 2008
  • Thorvaldur Gylfason, Events in Iceland: Skating on thin ice?, 7 April 2008
  • Gylfi Zoega, A spending spree, 9 April 2008
  • IMF Executive Board Concludes 2008 Article IV Consultation with Iceland, Public Information Notice (PIN) No. 08/120, September 19, 2008
  • Robert Anderson, David Oakley, Iceland remains in front line of turmoil, Financial Times, October 1 2008
  • Andrew Pierce, Financial crisis: Iceland's dreams go up in smoke, Daily Telegraph, 07 Oct 2008
  • Bo Nielsen, Iceland's Krona Currency Trading Halts as Kaupthing Taken Over, Bloomberg, October 9, 2008
  • Iceland did not want to seek IMF help -G7 source, Thomson Financial News, 10.07.08
  • Sean Farrell, Is Switzerland the next Iceland?, The Independent, 17 October 2008
  • CIA - The World Factbook - Iceland
  • FCO- Country information - Iceland

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