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Iceland Rocks the World

October 14, 2008
Kip Beckman
Principal Research Associate,
Economic Services
How could a tiny country with a population less than the city of Ottawa provide an additional shock to an already shaky global economy? Welcome to the system of integrated world financial markets where developments in a country that rarely receives any attention at all has suddenly become front and centre in this ongoing crisis.

For centuries, fishing has been the lifeblood that sustained this remote island in the north Atlantic. However, around a decade ago Icelanders discovered that there were fortunes to be made in the financial services industry. Iceland’s banks took advantage of developments in global financial markets and quickly grew in size until the three largest banks in the country had assets 10 times larger than the entire country’s GDP. The banks became highly leveraged and invested in risky U.S. mortgage-backed securities. Iceland’s banks expanded all over the world with an investment bank, Baugur Group, owning positions in retailers including U.S.-based Saks Inc. and the Debenhams department store in England.

Today, Iceland’s banks lie in ruin, a victim of the upheavals in world financial markets that punishes any financial institution that is highly leveraged with exposure to bad debt. In only a few days last week, almost the entire banking system of the country has been taken over by the government. The largest bank, Kaupthing, was seized last Thursday and trading has been suspended on the stock exchange. Iceland’s currency, the krona, has stopped functioning outside of the country and has lost close to 50 per cent of its value in a short period of time. Inflation and debt payments are skyrocketing and trade has been severely hampered in a country that needs imports to survive.

Investors are worried that Iceland’s small government treasury will be unable to back the banks’ huge obligations and may actually default on its sovereign debt. This could have a negative effect on other small debt-ridden countries in the world.

The crisis in Iceland has hit Great Britain especially hard because many Brits deposited their money in Iceland’s banks due to high interest rates promoted by institutions like Icesave, the Internet savings bank that has around 300,000 British depositors. The bank also has 120,000 customers from the Netherlands. The British government has promised to reimburse British depositors in Icesave and has threatened to take legal action against Iceland to recover deposits lost in the failing banking system.

The IMF has a team of specialists in Iceland to examine the crisis and come up with solutions while the country’s prime minister warned that some companies in the country are encountering difficulties transferring funds through British banks.

As Icelanders desert the financial services industry and repair their fishing boats to go back to the sea, Canadians can take some measure of comfort from the fact that our banking system is regarded as the most stable in the world. While we have been hit hard by the ongoing crisis, through no fault of our own, at least we don’t have to worry about Canada going bankrupt.

 


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