Iceland pays price for rapid economic growth

[October 04, 2008]  LONDON (AP) -- As the world suffers a hangover from the financial excesses of the past few years, the tiny island nation of Iceland has a bigger headache than most.

The Nordic country was until recently lauded for its rapid generation of wealth despite its small stature on the world stage, with the deregulation of the domestic financial market in the 1990s fueling a stock market boom that in turn underpinned an acquisition spree across Europe by cash-rich Icelandic banks and companies.

But that very success could become its downfall. The country's banking sector has grown to dwarf the rest of the economy with assets at nine times annual gross domestic product of 14 billion euros ($19 billion), leaving Iceland heavily exposed to the global credit squeeze.

A decision by the government this week to take over the country's third-largest bank prompted all the major credit ratings agencies to downgrade both Iceland's four major banks and its sovereign, or government, credit rating.

Iceland's krona tumbled 22 percent against the U.S. dollar this week, spurred partly by speculation that the central bank, which has just 4 billion euros ($5.5 billion) in liquid foreign assets, will struggle to bail out any more failing commercial banks after its rescue of Glitnir - the big four banks have combined foreign liabilities in excess of 100 billion euros ($137 billion).

"Iceland is a standout case," said Venla Sipila, a senior economist at Global Insight in London, which also downgraded the country's sovereign rating this week. "The situation looks really volatile because it is so dependent on external developments now."

With a population of just 320,000 people, the remote island nation located smack between Europe and Canada has punched far above its weight in recent years, shifting from a mainstay fishing industry to an international investment force.

The Iceland Stock Exchange, or ICEX, was Europe's top-performing exchange in 1994, leaving Icelandic companies with a large liquidity pool. Kaupthing, Iceland's biggest bank, has doubled in size every year since 1996 with purchases including the $1.3 billion takeover of Denmark's FIH bank in 2004.

Another standout success was retailing investment group Baugur, which has expanded from just one domestic discount store in 1989 to a company that owns or has stakes in dozens of major retailers - including enough to make it Britain's largest private company - and employs more than 50,000 people.

But the qualities that made Iceland attractive to foreign investors and that funded its expansion in recent years, essentially making it one big Viking hedge fund, are suddenly not as sought after in the current economic climate.

A major concern is that some of Iceland's banking system liabilities will migrate on to the government's balance sheet.

Part of problem is that Iceland's tiny size has led to a high level of cross ownership of assets between banks and companies, which creates a house of cards scenario.

"There is still a number of cross shareholdings ... which increases the risk of contagion," said Alexandre Birry, a director at Fitch Ratings in London.

Those worries were highlighted by the decision of investment firm Stodir, which has a major stake in Glitnir, to apply for temporary protection from its creditors after the nationalization.

Complicating the web, just hours after Stodir went under, it had been due to take a 39 percent stake in Baugur.

The high risk that the crisis could spread like wildfire lead to a flurry of rumors earlier this week that Baugur would be forced to sell some of its many overseas businesses to survive.

That prompted the usually tightlipped company into a rare public statement to reassure investors that while market conditions are tough "it is business as usual."

"Baugur would like to state for clarity that its assets are based in the United Kingdom, Scandinavia and the United States and as such have no exposure to the Icelandic economy," said Gunnar Sigurdsson, the company's CEO. "At the same time the funding for these businesses is secure and the vast majority of this funding is through international banks with whom Baugur has a long working relationship."

But, as analysts point out, it is just those connections that could cause trouble as the international banking market catches cold.

There's already been evidence of that with the news that investment bank Straumur-Burdaras has taken control of the overseas corporate finance and securities operations of Landsbanki, the country's second largest bank, for 380 million euros ($525 million).

Kaupthing has also had to fight market rumor, shooting down speculation this week that it was considering the sale of its Danish FIH unit.

The krona is also suffering from a withdrawal by a falloff in what are called carry trades - where investors borrow cheaply in a country with low rates, such as Japan, and invest in a country where returns, and often risks, are higher.

Iceland's Prime Minister Geir Haarde has said that the Glitnir bailout is not the end of the banking crisis in Iceland, but he has so far shunned suggestions that Iceland join the euro currency, a step that analysts say could provide a measure of protection.

In the longer term, Iceland is putting a lot of faith in its growing hydropower and geothermal energy industries to carry it through the credit squeeze and back to growth. Aluminum industry products are expected this year to overtake the traditional marine products industry in terms of revenue.

But with a current account deficit out of control, inflation running at more than 12 percent and interest rates at a record 15.5 percent, it has first to ride out a rocky patch that could have serious consequences.

[Associated Press; By JANE WARDELL]

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