I did not know much about the economy of Iceland until 2 days ago and confess I still only know the basic facts. And unless you are from Iceland or have a specialised interest in North European economies, you are probably in the same boat, my reader. However this issue captured my interest yesterday in light of my recent note an outside chance of US Government bankruptcy linked to the bailout – as I was trying to contemplate its impact.

A small economy: Sure, Iceland is a very small economy, but it is – or was? – a well-off country. Its population is about 300,000 as of mid-2007 but boasting a (purchasing power parity) GDP of $40,400 per head of population. It compares very well to UK’s $35,000 and US’s $45,800 per capita GDP. (source: CIA statistics referred to in Wikipedia, 2007 estimates). For the number-crunchers amoungst you, this is a GDP of $12bn. Another figure quoted sometimes is £20bn. This is calculated using a different method – using an official exchange rate – but is also a valid number.

Days of plenty and the outcome: In the past few years the Icelandic economy has been undergoing a huge boom fuelled by the financial sector. Iceland paid high interest rates so was very attractive to investors. Its banks were finding it easy to borrow heavily from low interest rate countries, and then re-invest in foreign business opportunities (mainly the UK). The BBC described this phenomenon as the carry trade. This development can be seen as a manifestation of the global credit bubble finding another outlet to develop over the past few years.

Huge debts: As the result, Icelandic banks managed to accumulate $120bn worth of liabilities. Depending on the method of calculation, this is either 6 or 10 times the GDP amount and it is a catastrophically high figure. Why is this a problem? Because Iceland does not have the income to service interest payment on such a colossal figure, let alone repay it. So the Government will not be able to bail out everyone who needs a helping hand.

Just a few days ago, the 3rd largest bank Glitnir has been nationalised. The other 2 largest banks are currently running the risk of bankruptcy with no bailout to rescue them.

This was expected: Concerns have been voiced over the past few years over the unsustainable nature of the financial boom and many have been warning this was a bubble that was bound to burst in a nasty way. Well, it has now, triggered by the collapse in confidence following September events across the global stock market. The Icelandic currency, the crona, has now fallen 20% against the dollar in the past few days. Inflation is expected to spiral shortly and shops in the country already warned they won’t be selling imported goods anymore. The impact will hit foreign investors if their loans are defaulted on. In particular, UK investors are vulnerable.

On the plus side for Iceland, its Government finances are healthy, and its the non-financial sector is reported to be solvent. How this small nation will weather an unprecedented global financial storm that has broken over its head in the last few days remains to be seen.

Comments and thoughts on this post welcome.

Copyright 2008 by CuriouslyInspired