THE TINY NATION of Iceland, trying to stave off a financial meltdown, is emerging as a symbol of the forces reshaping Wall Street and financial markets world-wide.
In recent weeks, Reykjavik's stock market has tumbled nearly 20%, and the currency, the krona, has weakened. The country's central bank has appointed a committee to explore its options in the event of a financial crisis, and Icelandic banks have reported that some U.S. lenders are declining to continue making short-term loans to them because of the turmoil. On Tuesday, stocks there fell 4.6%, the biggest one-day decline in 13 years.
With a population of less than 300,000 and fishing as a main industry, the country roughly the size of Virginia might seem an unlikely player on the global financial stage. Yet its problems are the result of fast-changing flows of money world-wide over the past few years, as international investors scrambled for new ways to profit amid sluggish stock prices and historically low interest rates.
In Iceland and a few other countries -- including New Zealand, Turkey and Australia -- investors found a lucrative way to take advantage of those low rates: They borrowed vast sums in places like Japan (where rates are near 0%), and invested the money in places like Iceland, where rates stand at 11.5%. The maneuver, known as the "carry trade," has emerged as one of the most popular hedge-fund strategies in recent years.
But it can leave an economy vulnerable if the speculative money suddenly reverses direction. In one of the first signs of how Iceland's woes could affect other markets, on Wednesday, shares of easyJet PLC fell 9% after an Icelandic investor, FL Group, sold its 17% stake in the British carrier. FL Group said the sale wasn't related to Iceland's problems. But it is raising concerns that Icelandic investors, who went on an overseas buying spree in recent years, might have to sell holdings abroad to cover obligations at home.
The jury is still out on whether it is anything more than a rough spot. Moody's Investors Service last week reaffirmed Iceland's triple-A local-currency debt rating, citing strong government finances that would enable the banking system to weather periods of turmoil. "We believe these concerns have recently been exaggerated," said Joan Feldbaum-Vidra, author of the Moody's report.
Still, some economists say Iceland's woes could be a warning sign for other countries -- perhaps even the U.S. -- that share some of its economic problems, including a large trade deficit, a heavy reliance on the willingness of foreigners to buy their securities, and lending booms that fueled soaring property values. While the U.S. exhibits many of the same financial weaknesses, they are less extreme. In addition, as the world's largest economy, the U.S. enjoys extra leeway. For instance, U.S. Treasurys are considered the safest investment available and are the benchmark against which all other debt is priced.
Iceland's woes reflect how the globe's economic trouble spots aren't necessarily to be found in the developing world anymore. As recently as the late 1990s, poorer nations like Thailand, Russia and Brazil were the flash points. However, today they have turned trade deficits into surpluses and built up the amount of foreign currency they hold in reserve, which protects their own currencies and economies.
"That's a new feature of the global economy," says Nouriel Roubini, an economics professor at New York University's Stern School of Business. "With few exceptions, it's the advanced economies with the biggest economic imbalances these days." In the U.S. economy, Mr. Roubini points to the large trade deficit, and a dependence on foreign central banks to finance the nation's debt, as making it potentially vulnerable to financial shocks.
New Zealand is a case study in how the fallout from deficits and other imbalances like these can differ significantly from country to country. Like Iceland, it is a small economy that experienced an economic boom over the past few years, partly because high interest rates made it a popular place for the carry trade.
However, New Zealand's economy appears to be experiencing a softer landing, partly because inflation seems more under control and because growth in real-estate prices has slowed. The economy has stalled, and the central bank is expected to cut interest rates soon. With lower rates on the horizon, and a weaker currency making New Zealand's exports cheaper abroad, its stock market has moved higher for 13 straight days. It is up 13% in 2006.
In Iceland, by contrast, the flood of foreign money in recent years put its economy on the boil. Housing prices soared, helping unleash a boom in consumption and stoking inflation. By 2004 the economy was expanding at 8.2% a year, a pace usually associated with poor but rapidly developing countries like India or China, not with mature economies. The country was so flush with cash that Icelandic corporate raiders went on a buying spree, taking large stakes in foreign companies, including easyJet as well as United Kingdom retailers Woolworths Group PLC and French Connection Group PLC. But with the carry trade unwinding, Icelandic investors have to find a new source of cash, and some suspect they may be forced at one point to sell off some foreign holdings.
Iceland's troubles started a few weeks ago, when Japan's central bank indicated it would begin taking steps toward raising its interest rates. The prospect of higher rates there -- along with expectations for the same in the U.S. and Europe -- set in motion a chain of events that caused many investors to pull money out of countries like Iceland.
The U.S. is a special case that can't be lumped in with such smaller economies, Mr. Roubini says. Not only is it the largest economy in the world, but the U.S. dollar is the world's reserve currency. "But the U.S. also has a large deficit, a lot of debt and a need for foreign funding," he says. "You cannot say these don't matter."
Iceland was particularly vulnerable because its economy is so small. Therefore, when money started pouring in, it got caught in a vicious circle of rising interest rates: The government had to raise rates faster than bigger countries might have, in order to try to keep its economy from overheating. Those higher rates, in turn, drew more foreign money, forcing rates even higher.
Only four years ago, Iceland was emerging from recession and showed little sign of becoming a hotbed for global speculators. A change in mortgage-lending laws helped reaccelerate the economy. Residential lending had been limited to a state-owned bank that faced restrictions in terms of whom it could lend to.
In 2004, commercial banks began offering mortgage loans at lower rates and with fewer restrictions. Housing prices in the Reykjavik area rose 33% last year, and -- just like many Americans -- Icelanders refinanced mortgages that helped spark a consumer boom. They also invested in stocks: the Reykjavik main stock index surged fivefold from the end of 2002 to February 2006.
With a booming stock market and easy access to cheap loans, Iceland's private sector went on a borrowing binge and grew more in debt. Iceland's external debt, or private and public borrowing from creditors outside the country, is 300% of gross domestic product. For comparison, the U.S. level is about 25% of GDP.
Iceland's current account deficit (a broad measure of trade in goods and services plus certain financial transfers) is around 16% of GDP -- more than twice that of the U.S. Iceland's inflation has jumped to 4.5%, triple its level of three years ago. Danske Bank AS, Denmark's largest bank, calls it a "stunning expansion of debt, leverage and risk-taking that is almost without precedent anywhere in the world."
In February, Fitch Ratings reduced its outlook for Iceland's government debt, sending the krona down 7% over two days. Coinciding with Japan's hints of a new interest-rate policy, it signaled the start of a foreign-investor retreat from Iceland.
(END) Dow Jones Newswires