The Collapse Of Iceland

Iceland is on the brink of collapse. Overnight, people lost their savings. Prices are soaring. Once-crowded restaurants are almost empty. Banks are rationing foreign currency, and companies are finding it dauntingly difficult to do business abroad. Inflation is at 16 percent and rising. People have stopped traveling overseas. The local currency, the krona, was 65 to the dollar a year ago; now it is 130. Companies are slashing salaries, reducing workers’ hours and, in some instances, embarking on mass layoffs. The country's banks are practically insolvent and the government has been forced to assume their liabilities. The are reports of people were buying up supplies of olive oil and pasta because supermarkets don't have the foreign currency needed to import more foodstuffs.

Just a year back Iceland’s economy seemed white-hot. It had the fourth-highest gross domestic product per-capita in the world. A 2007 United Nations report measuring life expectancy, real per-capita income and educational levels identified Iceland as the world’s best country in which to live. So, how did this happen? Can an economy crumble overnight? What went wrong in Iceland?

Iceland is an unlikely player on the global financial stage. Iceland had, in a very short period of time, created an internationally active banking sector that was vast relative to the size of its very small economy. Most of the banking system’s assets and liabilities were denominated in foreign currencies like the Euro, the Dollar etc. Money was cheap, so banks, companies borrowed freely. So far so good, but what triggered the collapse? The answer - Lehman Brothers.

Lehman Brothers collapse and the subsequent bankruptcy meant that many money-market funds (funds that invest in short term commercial bonds) who had invested in Lehman's bonds lost money. This led to a loss of trust in the money markets and the interbank market froze. Iceland's Glitnir Bank was among the first casualties. Like fellow Icelandic banks Landsbanki and Kaupthing, Glitnir was solvent, but when foreign short-run credit lines closed, Glitnir had to request a short-term loan from the Central Bank of Iceland, which refused. The government forcibly nationalized the bank. This triggered a sovereign debt downgrade and a sharp further fall in the already depreciated krona. Short-run funding for Glitnir and Landsbanki evaporated. Iceland's currency markets shut down and the krona's value collapsed. The Central Bank tried to peg the value of the krona, but the attempt failed and the peg was abandoned in just a day.

The whole system was basically a house of cards, since long-term loans were being funded by short-term borrowings. When Iceland's lenders refused to roll-over the money they had lent, the banking system collapsed. Iceland built its extraordinary wealth on the crest of the worldwide credit boom and now the crunch is sweeping it away.