Cracks in the Ice

Katrín Pétursdóttir knows what treasure lies in the pile of skinned fish carcasses before her, and the investment needed to extract it. Seventy years ago her grandfather founded LÝSI, a fish processing company, which last year produced 6,000 tons of fish oil and $30 million in revenues with just 100 employees. In 2005, Pétursdóttir built a gleaming $4 million factory, and she has plans for a $7 million expansion to keep up with the growing demand among health-minded consumers for omega-3 fatty acids. But financing these ambitious plans may prove problematic, with Iceland mired in its first recession since 1992 and interest rates at 15.5% — the highest in Europe. "Our banks aren't so keen on lending right now," she says. "It's not a good time to chase money."

As the latest flashpoint in the global financial crisis, Iceland is nursing a familiar sort of economic pain in a typically cool way. Over the past two years, the country's banks enjoyed extraordinary growth by borrowing heavily on international capital markets, leading Iceland to rack up a $2.7 billion current-account deficit, equivalent to 16% of its GDP; the comparable figure even in the notoriously indebted U.S. is only 5%. In January banks worldwide clamped down on loans in response to the global credit crunch, and investors began to worry that Icelandic banks had leveraged themselves too aggressively. Rumors swirled that the banks would default and that Iceland's central bank, with its modest $2.5 billion reserve, would be hard-pressed to bail them out. As investors pulled out of the market, the Icelandic krona fell by 27% against the U.S. dollar, the cost of insuring Icelandic debt soared to record levels, and inflation surged, hitting a 20-year high of 12.3% in recent days. That bleak combination has created a widespread perception, trumpeted in the world's financial press, that Iceland is melting.

But to Icelanders — from cab drivers who recite economic statistics to Prime Minister Geir Haarde who travels the world calming investors' nerves — the hysteria appears overblown. "What you'd expect to see out of these windows is fire," says Finnur Oddsson, managing director of the Iceland Chamber of Commerce. Instead, he peers out at a $138 million construction project at the University of Reykjavik. Iceland, he points out, has been in this situation before. In early 2006, credit agencies criticized Icelandic banks for their lack of transparency and reliance on international capital markets. Analysts' opprobrium drove the krona down by 25% against the dollar over six months. Yet Iceland never defaulted on a single loan, signaling a disconnect between foreign perception and domestic reality. "We learned our lesson: we need to tell our story," says Árni Mathiesen, Iceland's Minister of Finance. "Other people are more likely to tell the wrong story or misinterpret it."

This time around, the government and the banks are doing everything they can to dismantle the caricature of Iceland as a victim of its own excess, and instead portray it as the target of a financial conspiracy. Prime Minister Haarde has accused international hedge funds of deliberately spreading rumors to create a banking scare, so they could profit by "hook or crook" from wagers that the currency or stocks would tumble. In April, Iceland's Financial Supervisory Authority launched an investigation into an unconfirmed story that back in January, hedge-fund managers had hatched a plan to bet against the currency over drinks at a posh Reykjavik bar.

Iceland gets some support for its conspiracy theory from Richard Portes, an economist at the London Business School. In March, after he published a favorable report on Iceland's economy, Portes says a senior figure at a major hedge fund phoned him. "He spent half an hour trying to tell me the Icelandic banks were in terrible shape and that the country was a disaster area," he recalls. "Apparently I was risking my reputation by saying anything different." But not everyone responds to Iceland's plight with sympathy. Eileen Zhang, an Iceland expert at ratings agency Standard and Poor's, says cries of "Foul!" mask the country's feckless expansion: "Whether you call it an attack or you call it arbitrage, Iceland has put itself in this vulnerable position."

She has a point. Prior to the 2006 crisis, analysts warned that Iceland — where Land Rovers and private jets seem to outnumber the nation's 308,000 people — was growing too quickly, and that excessive consumption would cause the economy to overheat. Yet the nation's three largest commercial banks — Kaupthing, Landsbanki and Glitnir — continued to exploit their then strong currency and cheap credit to buy banks in Denmark, Norway and the U.K., as well as British retailers like House of Fraser and Moss Bros. They amassed foreign assets equivalent to 800% of the nation's GDP, the highest ratio of any country in the world. Meanwhile, their dependence on global capital markets to fund this shopping spree left the banks vulnerable to the whims of investors. By early 2008, the combination of a risk-averse global financial climate and possible speculative attacks on the krona meant that Iceland could no longer run itself like a hedge fund. Says Paul Rawkins, an analyst at Fitch Ratings: "The global credit crunch undermined their business model."