October 9, 2008

Iceland Takes Extraordinary Steps to Keep Its Economy Afloat A CRISIS IN FINANCE

By Eric Pfanner and Julia Werdigier

Julia Werdigier reported from London.


The government of Iceland has taken extraordinary measures to stave off "national bankruptcy," as the credit crisis tightened its grip on this remote island nation in the North Atlantic.

Banks in Iceland had propelled years of significant growth, lending so freely that their assets ballooned to many times the size of the country's economy. But now the boom has turned to a bust.

In an effort to avoid financial collapse, the government took control Tuesday of Landsbanki, the second-largest bank in Iceland - its second takeover in two weeks. And, in a measure more characteristic of troubled developing economies than one of the wealthiest in the world, Iceland's central bank pegged the currency to a basket of others.

Most surprising, the government announced that it had asked Russia for a loan of euro 4 billion, or about $5.5 billion, to try to keep the economy afloat.

The crisis deepened Wednesday when the government put a large bank, Glitnir, into receivership, rather than nationalize it as initially planned. And Sweden loaned the Swedish unit of the country's largest bank, Kaupthing, $700 million to keep the unit afloat.

Iceland is uniquely exposed to the global economy. Although the country has a population of about 300,000, it has played an outsize role in global trade. The country is highly leveraged in international financial markets, and the total assets of its banks grew from 96 percent of its gross domestic product at the end of 2000 to eight times its GDP at the end of 2006. Some estimates place the current size of the banking sector at more than 10 times GDP.

And Icelandic companies had been aggressively expanding in Northern Europe and across the Atlantic.

The Baugur Group, an Icelandic investment company, for instance, owns the House of Fraser department store chain in Britain, as well as a stake in Saks Fifth Avenue.

Another Icelandic company, the FL Group, now called Stodir, has investments in AMR, the parent of American Airlines.

The boom in the financial sector was a relatively recent phenomenon. The Iceland Stock Exchange was created only in 1985; trading in shares began several years later. Though Iceland has one of the highest per capita incomes in the world, its economy was not long ago rooted in basic industries like fishing.

To stanch the current crisis, the government said it had secured the backing for a loan from Moscow. But Russian officials told the Interfax news agency that no decision had been made. Iceland later acknowledged that its announcement had been premature, saying it had contacted the Russians but had not yet reached an agreement.

The confusion over the status of any Russian funding added to the sense of bewilderment here over the speed with which the financial situation went from bad to worse.

"We are still in the midst of events unfolding, and it's impossible to see where it's going to end up," said Bjorn Gudmundsson, head of research at Landsbanki, the second-largest bank in Iceland, after Kaupthing Bank.

Landsbanki was nationalized Tuesday under new powers rushed into effect by the government.

"We were faced with the real possibility that the national economy would be sucked into the global banking swell and end in national bankruptcy," Prime Minister Geir Haarde said late Monday.

Concerns about the government's ability to support the banking sector have put the currency into a tailspin. The fall in the krona has pushed inflation into double digits, requiring the central bank to raise its benchmark interest rate to more than 15 percent.

Gudmundsson said new funding, like the proposed loan from Russia, was essential to help the central bank keep the currency from sliding further; it fell more than 30 percent against the dollar in September.

The central bank said that it had asked Russia about the loan "some months ago" but that the situation with the country's banks and economy deteriorated so rapidly over the last two days that a loan agreement became urgently needed.

It said that Russia - home to branches of Icelandic banks - would grant the loan for the next three to four years with an interest rate of up to half of a percentage point above the interbank lending rate.

For Russia, a loan would be a way to show its financial power and willingness to help distressed economies.

"It's a PR stunt to reassert Russia's position in the global economy of the 21st century," said James Beadle, a fund manager at Pilgrim Asset Management in Moscow. "But Russia also has a lot of cash it can't use domestically because of the inflation problem."

In Reykjavik, the government reiterated that all deposits in its banks were guaranteed. But the crisis could reverberate in foreign markets where Icelandic banks have set up branches, luring customers with attractive savings rates.

Customers of Icesave bank in Britain, controlled by Landsbanki, were not able to access their money on Tuesday. A note on the bank's Web site did not give any further information.

In the meantime, the deposit compensation unit of the Financial Services Authority in Britain was readying Tuesday application forms for Icesave's 300,000 British customers, who have an estimated pound(s)2.5 billion, or $4.4 billion, in deposits with the bank. Icesave provides only an Internet-based service in Britain and does not have any branches; its depositors are partly covered by the British deposit insurance system.

Customers will probably have to wait a couple of weeks to receive their savings of up to pound(s)50,000, a spokesman at the deposit unit said. Britain recently increased the level of guaranteed deposits to pound(s)50,000, or $87,800, from pound(s)35,000.

But in Reykjavik, the government guarantee seems to have reassured many Icelanders about the safety of their money. There were no signs of people lining up at banks to pull their deposits.

Originally published by The New York Times Media Group.

(c) 2008 International Herald Tribune. Provided by ProQuest LLC. All rights Reserved.