Iceland: Rise and Fall of a finance based economy

Tiny Iceland Created a Vast Bubble, Leaving Wreckage Everywhere When It Popped


Many things come to mind, upon reading this very interesting article on how and why the banking system and the country of Iceland collapsed.

Firstly, high interest rates does not usually mean that everything is fine in any country's banking system. If anything, it correctly predicts that there 'may' be some underlying issues that normal investors are unaware of at a time of crisis. Usually, interest rates always rise AFTER a crisis but in case of Iceland, it was prior to the event.

Excerpt:
To a degree, the wealth Iceland enjoyed during the boom years was a mirage. It was conjured by high interest rates, which attracted vast sums of foreign money.

Secondly, pegging a currency to a stronger is usually always beneficial if the country or economy is small or does not have the international clout to raise funds when a crisis hits. Case in point, Iceland. It did not peg its currency nor did it join the Euro but decided to go alone, just like UK. and when the crisis hit, Iceland was totally unable to raise any funds (nor had sufficient reserves) to pay off any of its maturing bonds issued by the Govt or corporates. They also could not stop the foreigners, like Britishers, who had kept too much deposits with Icelandic banks due to high interest rates, from withdrawing. The last straw hit the camel's back, when the British Govt decided to protect its citizens/residents by taking over the local branch/subsidiary of the Kaupthing bank in the UK thus making the crisis in Iceland even worse while doing what it needed to do to protect its own citizens/residents as per its local banking regulations under which the UK branches of Kaupthing bank from Iceland had to adhere to.

Something that connects Middle East is the pegging of their currencies to the USD due to their individually small economic size on a global scale. This is what protected all of them and let them 'hold the value' of their USD assets in the worst financial crisis. I am glad the various Govts in Middle East including UAE held on to their views firmly despite 'advice' and reports from various 'smart' banks/economists and did not depeg their currencies, because if they had, their economies and the currency may have faced the same fate as that of Iceland. I wonder where these economists are these days and what does their analysis says? How come they are not reported in the media any longer?

Excerpt:
What makes Iceland different: It tried to build a global banking center on top of a tiny currency. So when foreign investors tried to pull out -- converting kronur back into dollars or euros en masse -- its currency fell like a rock, spurring more withdrawals.

Thirdly, any economy which rises based on just one industry and that too extremely rapidly, for example, Icelandic banks grew out of nowhere into financial giants in Europe and even other parts of the world since 2000. Due to inexperience of local regulators, bankers themselves, Govt, and high interest rates, a bubble of incoming money - just like US - got created and Icelandic banks thought that this would continue forever. However, that projection turned out be DEAD wrong. As soon as the crisis hit, not only foreigners withdrew all the money but the Central bank of Iceland or any of the banks could not raise even one penny.

One thing that comes out, that whoever - whether a company or a Govt or an individual- if they borrow more and more to keep themselves afloat, it is just a matter of time before they fall down miserably. The whole pack of cards will certainly fall, when no one wants to loan more money or the rating goes down.

Read more from the WSJ:

The Isle That Rattled the World