Friday, April 18, 2008

Yet another sign of things to come

Iceland, a Tiny Dynamo, Loses Steam

Arnaldur Halldorsson/Bloomberg News

In Reykjavik, there are jitters about the nation's banks.

REYKJAVIK, Iceland — Life on this rugged, windswept island has always swung between famine and feast — dependent on the fish in its icy waters and the luck of its fishermen.

Reykjavik still looks very much a boomtown. But Iceland is facing its first recession since 1992.

But little could have prepared Iceland for the reversal of fortune it has suffered in the last few months. The country’s long economic boom has ended in a painful bust, with a collapsing currency, rising inflation, double-digit interest rates and predictions of its first recession since 1992.

“As a citizen, you have to wonder what’s going to happen to this country,” said Eggert Benedikt Gudmundsson, the head of Iceland’s largest fishing company, HB Grandi. “We always tend to go to extremes,” he added, as the wind rattled the windows of his seafront office.

To many Icelanders, their country is the victim of foreign speculators, circling like sharks smelling blood. To outside investors, Iceland is the victim of its own excesses.

The trouble began shortly after the New Year, when investors started questioning whether Iceland’s banks were at risk of defaulting on huge foreign loans. As traders speculated against Iceland’s currency, the krona, doubts about the banks mushroomed into a crisis of confidence in the state’s ability to maintain the financial system.

Now the banks — the symbol of Iceland’s metamorphosis from a poor fishing society into the North Star of the global economy, holding assets nearly 10 times the nation’s gross domestic product — are fending off rumors that they may need a bailout. On Thursday, Standard & Poor’s, saying the banks’ problems could make the downturn longer and deeper, cut Iceland’s credit rating.

Few here dispute that the country is in deep trouble, perhaps the starkest national casualty yet of the worldwide credit crisis. Last week, the central bank raised interest rates to a record 15.5 percent to curb inflation and shore up the currency. Since Jan. 1, the krona has lost 22 percent of its value against the euro.

For most of the last decade, this tiny country ran on a high-octane mix of foreign investment — much of it related to Iceland’s energy resources — borrowed money and profligate consumption, turning its 307,000 people into a miniature model of the American economy.

With inflation projected to rise above 8 percent this month and a yawning current-account deficit, Iceland was ripe for a correction. The credit crisis was the trigger.

What makes this setback harder for people to stomach is that while Iceland’s banks borrowed heavily overseas in recent years, they bought virtually none of the American mortgage-backed investments that contaminated the books of American and European banks.

The problems of Iceland’s banks are due mainly to the paralysis in the global credit markets that followed the subprime crisis. Yet rather than being rewarded for their foresight, or simple good luck, the banks are being portrayed by analysts as the string that could unravel the country’s economic miracle.

People here object to what they claim is a caricature of Iceland abroad as a feckless country that used its strong currency to borrow heavily and lured foreign capital because of its high interest rates, setting itself up as a kind of Viking hedge fund.

“If you took what the ratings agencies say about Iceland at face value,” declared Finnur Oddsson, the managing director of the Iceland Chamber of Commerce, “you would look out these windows, and expect to see flames shooting out the top of every office building.”

For now, Reykjavik still looks very much a boomtown, with construction cranes swooping above the skyline, private jets landing at the airport and Range Rovers purring on the cobbled streets.

Mr. Oddsson said the country had robust fishing companies that exported cod and haddock to Britain and Germany. Investors like Alcoa have built giant aluminum smelting plants, which take advantage of the country’s bountiful supply of cheap, clean hydro energy.

Like people in other countries that have been buffeted by global markets, many in Iceland say they believe their woes are being exploited by foreigners. Hedge funds, they say, are spreading malicious rumors about Iceland’s banks in the hopes of profiting from a collapse. The same funds, they say, are shorting Iceland’s currency and stock market, betting that their values will decline.

In an oft-repeated but unconfirmed story, a group of hedge fund managers gathered at a chic bar in Reykjavik for drinks one evening last January and hatched a plan to go after the banking system.

Such conspiracies are hard to prove. Iceland’s Financial Supervisory Authority is investigating trading patterns to see if there was a concerted strategy to sow doubts about the banks.

Iceland has some allies abroad. Richard Portes, a well-regarded economist at the London Business School, published an upbeat report about the financial system, saying the banks were resilient. Others say Iceland’s current-account deficit will ease as new projects, like the Alcoa plant, begin generating income.

Skip to next paragraph
Arnaldur Halldorsson/Bloomberg News

Jon Eyjolfsson, the managing director of a Porsche dealership, said sales could drop 40 percent.

A few weeks ago, Mr. Portes said he got a phone call from the senior partner of a hedge fund, quizzing him about why he wasn’t more negative. He declined to identify the person or the hedge fund.

“I asked him, ‘are you shorting Iceland?’ ” Mr. Portes said. The next day, he reported the conversation to Icelandic authorities, on the grounds that it might constitute market manipulation.

Mr. Portes does not dispute that Iceland’s economy was overheated and due for a correction. A huge investment boom and the privatization of the banks eight years ago left the country with a gaping current-account deficit — $2.7 billion, or 16 percent of its total economic output in 2007 (the deficit is mainly a measure of the gap between imports and exports of goods and services).

By comparison, the current-account deficit of the United States is 5.3 percent.

Iceland’s banks have grown out of all proportion to its little economy. The three largest banks — Glitnir, Kaupthing, and Landsbanki — have expanded into Scandinavia and Britain, bought European banks and even opened branches in China.

Bank jitters set off a milder economic tremor in 2006, after Fitch Ratings changed its outlook for Iceland’s sovereign debt to negative from stable. The krona plummeted, but recovered after the banks took steps to reduce their risk.

This time the markets are in a less forgiving mood. On April 1, Fitch again placed Iceland’s banks and sovereign debt on a negative credit outlook.

“Investors are worried because the banks have no real access to the markets” because of the credit squeeze, said Paul Rawkins, a senior director and Iceland expert at Fitch. “Their next stop will be the government, which would have to bail them out. But the government doesn’t have the checkbook to pay for it.”

Iceland’s government has pledged to support the banks, though it has refused to say how. The central bank has reserves of only $2.5 billion, a situation Mr. Rawkins likens to South Korea in the months before the Asian financial crisis.

For bankers here, such talk is an affront.

“Iceland has never defaulted,” said Bjorn R. Gudmundsson, the head of research at Landsbanki, noting that his bank shunned subprime investments because it deemed them too risky. “It is an absurd discussion because it is almost unthinkable to us that we would default.”

Government officials, however, have entertained that possibility, with talk of borrowing funds to double the central bank’s reserves. Officials say they are putting their faith in the markets, which they say will regain their footing before the banks reach a danger zone.

“Everything seems to be on track for a gradual resolution,” said Thorsteinn Thorgeirsson, a director general in the finance ministry. “A lot of other countries are suffering too.”

Iceland may suffer more than most. The government projected that the economy would shrink 0.7 percent in 2009, after growing 3.8 percent last year. The central bank projects a 2.5 percent contraction in 2009 and 1.5 percent in 2010.

The gloom is starting to fall on stores, where the falling krona makes imported goods more expensive. A carton of Ben & Jerry’s ice cream already costs $10.

At the local Porsche dealer, no customers were checking out the Cayenne sport utility vehicles. Jon E. Eyjolfsson, the managing director, figures his sales will drop as much as 40 percent this year. “People were buying these cars because the krona was so strong,” he said.

His only comfort, he said gamely, is that he also owns the Chevrolet dealership for Iceland.

Original article posted here.

No comments: