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COMMENT & ANALYSIS ANALYSIS

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A cruel wind
By Kate Burgess, Tom Braithwaite and Sarah OConnor Published: October 10 2008 19:51 | Last updated: October 10 2008 19:51

For most of the last century, Iceland was little more than a rest stop for North Atlantic fishing fleets trawling the waters between Greenland and the Faroe Islands. Reykjavik, where much of the islands population of 320,000 is based, still feels like a provincial port. Taxi drivers wave to the president and there is a sense that most people are linked by blood, business or politics. But for all its sleepy air, the Icelandic capital has been transformed over the past decade. A headlong expansion into foreign markets brought the country influence out of proportion to its size and made its population one of the richest, per capita, in the world. Now, after a week in which Icelands top three banks collapsed and were nationalised putting more than 20bn ($27bn, 16bn) of depositors money in jeopardy across Europe fame is turning into notoriety. As Geir Haarde, prime minister, warned this week: The danger is real that the Icelandic economy would be sucked, along with banks, under the waves and the nation would become bankrupt. It is a sorry finale to what Mr Haardes predecessors hailed as an economic transformation that turned a poor, isolated community into a powerhouse of banks and entrepreneurs, with global investments ranging from pharmaceuticals to fund management. The island erupted on to the worlds financial stage in the early years of this decade. Icelanders bought up swaths of eastern Europes telecommunications market, some of the best-known names on the UKs high street, including House of Fraser and Hamleys, and much of the Nordic banking system. Inevitably, observers questioned where the money had come from. Tales of strange links to Russia abounded. It is often implied that there is something dubious or shady about the origin of Icelandic financial strength, lafur Ragnar Grmsson, president, said in 2006, commenting on far-fetched explanations of Icelands sudden wealth. Much of the mystery centred around the charismatic figure of Thor Bjrglfsson, even now barely 40, Icelands richest man and founder of Actavis, the worlds fourth largest maker of generic drugs. He began his career by setting up a brewery in St Petersburg, which he sold to Heineken in 2002. The sale earned him $100m. About the same time, Jn sgeir Jhannesson, the youthful chief executive of Baugur, Icelands biggest retailer, suddenly materialised as the unknown acquirer of a big stake in Arcadia, the UK retail chain. In reality, said Mr Grmsson, Icelands success was easily explained. The country had benefited from a fortuitous combination: globalisation and widespread removal of trade and financial controls, together with innovations in information technology that made its geographical isolation irrelevant. At the foundation of Icelands success was aluminium smelting and a well-funded pension system based on the fisheries industry that

Road to deregulation

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Icelands story begins in the ninth century with the arrival of the first permanent settlers from Norway. The volcanic and geologically active island was ruled by Norway, and later Denmark, until 1944 when it gained full independence. The isolated countrys relative poverty was reflected in the fact that until 1973 it was categorised as a developing country by the World Bank because of its excessive dependence on fish. Price-setting was centralised, taxes were high as were tariffs on trade. Imports and exports were both highly regulated. Political power infused the entire financial system, which could hardly be distinguished from the political system, noted David Oddson, the prime minister between 1991 and 2004 who led the movement to deregulate the capital markets and privatise stateowned companies, most importantly the banking sector.

had the money and a new appetite to invest in equities. This coincided with the deregulation and privatisation of the banking system, which allowed the islands banks Kaupthing, Landsbanki and Glitnir (then called Islandsbanki) to diversify away from their traditional bases in farming and fisheries. A class of 30-something business school alumni such as Hreidar Mar Sigurdsson, now chief executive of Kaupthing, the bank that until its nationalisation this week was Icelands biggest listed company, were quick to take advantage of these changes. As one banker says: Kaupthing thought of themselves as the Goldman Sachs of the Arctic. Bankers and businessmen borrowed heavily abroad, invested in each others companies and expanded overseas. When asked where Bakkavor, the Icelandic food company, had got the money to buy Geest a deal that turned Bakkavor into the UKs largest ready-made food company Mr Grmsson said: The answer was very simple: It comes from Barclays Bank. Much of Mr Bjrglfssons backing came from Deutsche Bank. At the same time, the Icelanders began to forge strong links with international entrepreneurs such as Kevin Stanford, founder of Karen Millen, the retailer, and Robert Tchenguiz, the property entrepreneur. Mr Tchenguizs stake in J.Sainsbury and Mitchells & Butlers, the UK pub chain, were bankrolled by Kaupthing. Mr Tchenguiz also joined the board of Exista, the Icelandic insurer that held a 25 per cent stake in Kaupthing. In Iceland, the expansion resulted in a credit boom that in turn fuelled its housing and stock markets. By 2003 Icelands homeowners were among the worlds richest, albeit also among the most heavily indebted.

By 2004, a few alarm bells were ringing. The central bank worried about the flurry of leveraged buy-outs of listed and unlisted companies, which provide one explanation of the surge in lending by banks. It warned: These transactions have driven up equity prices of several listed companies, including financial companies, prompting the question of what the impact will be should share prices head back down. A year later, the International Monetary Fund urged the Financial Supervisory Authority in Iceland to implement stress tests to assess risks to the financial sector from exchange rate fluctuations and interest rate changes. This is becoming particularly important as banks intermediate a rapidly growing volume of foreign lending, it said. In 2006, the ratings agencies downgraded the banks. Moodys Investors Service blamed the deterioration of Kaupthings domestic operating environment amid rapidly rising interest rates and a falling currency. It highlighted the disruption to the three Icelandic commercial banks wholesale funding operations. Icelands banks responded by increasing overseas expansion and dissolving cross-shareholdings. They diversified their funding and increased the emphasis on deposits, particularly in foreign branches. Landsbanki launched Icesave, its internet bank in the UK, while Kaupthing launched Kaupthing Edge, which earlier this year was taking in 700m a month in deposits. In 2007 Kaupthing began to retrench. It sold assets, slowed lending growth, reduced costs. In January this year it backed away from what would have been the biggest acquisition in its history: a buy-out of NIBC, the Dutch merchant bank. Other banks followed. But it was not enough: the global credit crunch hit home in earnest this year as the cost of funding and overseas liabilities rose, while the currency and asset prices in Reykjavik fell. According to Icelands central bank, the money owed by the banks to foreigners amounted in the second quarter to six times the total value of goods and services produced by the Icelandic

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economy over the year. Meanwhile, inflation has risen, output has tumbled and analysts warn recession looms. Only now are the full consequences of the banks heady expansion into foreign markets becoming clear. Last week the Icelandic government took the decision to nationalise Glitnir, followed swiftly by the nationalisation of Landsbanki. Kaupthing rushed to sell assets and loans around the world to stay in business with knock-on effects on creditors. Mr Tchenguiz lost close to 1bn in 24 hours after he was forced to sell his stakes in Sainsbury and Mitchell & Butlers. But on Thursday Kaupthing, too, was nationalised amid accusations from Mr Haarde (right) that the British governments decision to put Kaupthing Singer & Friedlander, its UK subsidiary, in administration and freeze bank assets was partly responsible for the collapse. The banks demise is making credit markets fear the worst. The cost of insuring against the Icelandic nation defaulting on its sovereign debt has ballooned, with the market demanding upfront payments for the first time since 2002 in the case of Brazil. Simon Johnson, of the Peterson Institute in Washington, says: Iceland is the first time we have seen a real sovereign problem like this the crisis is spreading. An IMF team is now in Reykjavik and analysts widely expect the Icelandic government to ask for help. Lars Christensen, Danske Bank economist, says: There is only one sustainable option and that is the IMF. Sweden has offered a loan to protect Kaupthings Swedish operations. The Nordic central banks are talking about supporting Iceland with further funding facilities. But Icelands efforts to find more widespread support abroad have been hampered by its paucity of significant foreign exchange reserves and high trade deficit. Russia has indicated it might offer a 4bn loan, prompting some raised eyebrows among Icelands Nato allies in the west. Iceland has reassured them that any aid would not extend beyond financial support. Meanwhile, the tone of Icelands relations with the UK has begun to deteriorate to levels not seen since the cod wars of the 1970s. Gordon Brown, UK prime minister, this week spoke of legal action against the Icelandic authorities to recover the savings of 300,000 depositors in Icesave after Landsbanki was declared insolvent. Since then it has emerged that 108 UK local authorities, including Kent county council, had deposits of 800m in Icelandic banks. For council tax payers and savers in the UK it is likely to be a very long time before trust returns. In the words of one UK investor: The Icelandics had better get their fishing rods out. Theyve got a lot of cod to catch to make up for what weve lost. Additional reporting by Gillian Tett
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