Icelandic saga

Iceland is the credit squeeze writ large, or rather, writ small: after a debt-fuelled boom, the Nordic island is faced with a debt-driven bust, and the risk that market fear will turn a slowdown into a headlong rout. Iceland is likely to suffer a recession in the process of getting inflation back under control, but that need not involve a financial crisis.

The Central Bank of Iceland on Tuesday raised its benchmark rate by 125 basis points to 15 per cent be­cause of persistent inflation. The consumer price index has averaged more than 4 per cent in recent years – far above a 2.5 per cent target – and the central bank has failed to curb inflationary expectations. Iceland is also suffering speculation about its banks and a rapid decline in its currency. The risk is that foreign investors will rush to withdraw, the Icelandic krona will collapse and the economy will contract sharply.

Iceland has had a colossal real and financial boom. An already rich economy grew by 4 per cent per annum; Reykjavik house prices rocketed; the financial system borrowed billions of dollars from abroad; and the current account deficit is 16 per cent of gross domestic product. Iceland was a popular target for the carry trade, with foreign investors buying high-yield krona, and given that Iceland's population is small – about the size of Coventry in the UK, or Pittsburgh in the US – distortions were inevitable.

It does not follow, however, that Iceland must suffer a crisis. Inflation is high and the current account deficit is gaping, but that deficit is down from 26 per cent in the first quarter of 2006, while the government runs a strong fiscal surplus.

Any bank is vulnerable to a run and the size of Kaupthing, Glitnir and Landsbanki in relation to the $4.3bn assets of the Central Bank of Iceland and the country's $17bn gross domestic product makes investors understandably nervous. But the banks have responded to earlier worries about their stability in 2005-06, raising more customer deposits, lengthening the maturity of their funding and increasing their capital. They are now less likely to do a Northern Rock.

None of that will matter if a confidence-driven run takes hold, and it will be all too easy for lending officers in far away banks to decide that Iceland is the kind of obscure risk that they might get blamed for. But Iceland's real economy is sound, and its strengths of fish, tourism, technology and aluminium smelters powered by zero-carbon geothermal energy are well suited to the 21st century. It would be a pity if international market panic made the slowdown needed to control inflation worse than it has to be.

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