08 October 2008

Iceland - The Next Credit Crisis Casualty?

"Motorcrash" by The Sugarcubes

Felix Salmon at Portfolio has been keeping up on how the credit crisis is affecting Iceland's banks, currency, and sovereignty:

We know that credit ratings agencies made enormous errors over the past few years when it came to rating structured products. And of course it's never easy to rate leveraged institutions, like banks, which are susceptible to runs. But what about the more conventional credits, like sovereigns?

Last year, Moody's briefly gave all of Iceland's major banks, including Glitnir, a triple-A rating, on the grounds that if they ever got into trouble, the Icelandic government would bail them out. After much ridicule, Moody's changed its mind. Clearly, it was silly to treat Iceland's banks as though they were just as creditworthy as the sovereign.

Fast-forward to today, and Iceland has indeed bailed out Glitnir. But here's the thing: Iceland's credit default swaps are now suggesting that the sovereign itself is a distressed credit.

Iceland's situation deteriorated further yesterday. The Times of London's headline says it all:

Terror as Iceland faces economic collapse

Iceland's troubles even made the New York Times:

Farther away, Iceland, one of the world's hardest-hit countries from the credit turmoil, fell deeper into crisis as the government halted trading in all financial stocks after the banking sector neared collapse.

The country suffered a fresh downgrade of its credit rating Monday after the government sought to assert sweeping new powers to intervene with troubled banks. Facing a cash squeeze as foreign investors withdraw their money, the government also urged its pension funds to repatriate money in an effort to reel in more cash.

Iceland is so desperate, they are looking to Russia for assistance:

Iceland said Tuesday that it was seeking a $5.4 billion emergency loan from Russia, had pegged its currency to an index and had taken control of one of its largest banks as the North Atlantic island struggled to keep its economy afloat.

Iceland's prime minister said the talks about a loan began "some months ago." But the situation of the country's banks and economy deteriorated so rapidly over the last two days that a loan agreement became urgently needed.

would prefer Iceland turn to the IMF for its bailout, instead of Russia:

A E4bn loan from Russia might make financial sense – although Russians might think otherwise given Moscow's shaky finances. But it would create strategic ructions. Iceland is a NATO member, but Russia would want something in return for a loan equal to almost a third of the tiny state's GDP. The US would fret this could eventually mean a Russian military presence in the North Atlantic.

Much better would be a loan from the IMF. This too would come with strings attached, but they would be sensible and financial rather than strategic and dangerous. Stiff inflation targets and budgetary constraints are needed anyway to resuscitate Iceland's battered economy. An alarmed US may well pressure the IMF to offer a good deal. Unless it wants to become a pawn in a geopolitical power play, Iceland should welcome the fund with open arms.

Felix Salmon makes Iceland's troubles relevant to you and me, by suggesting the Dow's 500-point sputter could be traceable back to the North Atlantic:

Could the imminent collapse of tiny Iceland help explain the whopping 60-point fall in the S&P 500 today, to below 1,000? Maybe -- we've had many big failures in this credit crisis so far, but we haven't had the implosion of an entire European economy -- one which is home to systemically-important international banks, too. That kind of thing could cause stock-market jitters at the best of times; right now, I can easily see how it's good for 500 Dow points.

The release of the Fed minutes and Bernanke's interest-rate cut speech should have otherwise given the markets some upward momentum. Perhaps there's something to Salmon's assertion. Or perhaps Iceland's crisis is just one of many contributing factors to the market's malaise.

Nevertheless, this is another hole in the decoupling argument. And it's worthwhile keeping tabs on how Iceland's crisis plays out.

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