Iceland's economic crash hit fast and hard

REYKJAVIK, Iceland -- This is what a rapid financial meltdown can do.

The government seizes banks, leaving shareholders luckless and foreign depositors unable to touch their money. The stock market is shut down. The currency is in free fall, leaving mortgage holders who took out loans in foreign currency paying double. Prices on imported goods are on the rise.

This is the situation in Iceland, where a small, struggling government is even turning to the Kremlin to prevent bankruptcy after it became the first country to succumb to the global financial meltdown in a matter of days last week.

"No Western country has crashed in peacetime as quickly and as badly," says Jon Danielsson, an associate professor of finance at the London School of Economics. "This shows the degree of problems facing the global financial systems and how governments must do all they can to stabilize them."

Other countries should take heed, Danielsson and other financial analysts say. On Thursday, forecasting firm Global Insight listed Hungary and Ukraine as having the most shaky banking systems.

"Both (Hungary and Ukraine) have similarities with Iceland," says Toby Wight, a Global Insight analyst. "The banking sector in both countries is fragile, with high levels of foreign borrowing and high levels of foreign currency loans."

A quick unraveling

Iceland's crash marks the end of a decade-long success story in which the big banks in this tiny Nordic country, which has a population smaller than Wichita's, grew to have assets nine times greater than the nation's entire economic output.

The unraveling has taken place at breakneck speed. On Sept. 29, Iceland's government stepped in to take over the Glitnir bank after the bank failed to obtain loans to cover debts amid the global liquidity freeze.

Last Monday, the Iceland Stock Exchange halted trading in shares of six major financial institutions as the government drafted emergency plans to try to stem the growing debt crisis.

On Tuesday, the government seized Landsbanki bank — guaranteeing Icelanders' deposits but not those of foreigners. That left 300,000 British customers unable to draw about $6.91 billion out of Landsbanki's Internet subsidiary Icesave.

As the country's currency, the krona, sank, Prime Minister Geir Haarde looked to Moscow for a $5.4 billion loan to cover the government's foreign debt and avert bankruptcy. He had complained of a lack of support from other European nations and has shunned help from the International Monetary Fund.

On Thursday, the country's biggest bank, Kaupthing, was seized. Haarde urged savers not to exacerbate the banks' problems by withdrawing large sums.

In addition to rank-and-file depositors across Europe, several companies and governments that were lured by the high interest rates have found their accounts frozen. Among them: the authority that runs London's subway system, which had $6.9 billion in jeopardy.

People like Iens Einarsson, 30, an engineer in Reykjavik, says he's already feeling the pinch caused by the collapse of the krona. He has a mortgage in Danish kroner. "Our payments have skyrocketed," he says. "We'll have to buy less because we won't have any money left after paying our Danish loan."

Others, such as Thrudur Kristjansdottir, 64, a retired postal worker, say rising prices on imports driven up by the deflated krona will alter what they buy. "I'm trying to be more conscious of how I spend," she says. "I'm trying to buy cheaper products."

On Friday, about 200 angry Icelanders protested outside the country's central bank offices in the capital of Reykjavik. They demanded the resignation of David Oddsson, the bank's governor, who as Iceland's former prime minister was an architect of the country's outsize role as a global financial player.

Rapid growth

Iceland enjoyed a stock market boom in the mid-1990s. That and deregulation of its banks sparked rapid growth — not just in the financial sector, which outgrew the rest of the economy, but in construction and housing.

This is no banana republic going bust. The boom gave Iceland among the highest per-capita gross domestic product in the world: $40,400 last year compared with $45,800 in the USA. It's a member of NATO, and Iceland also has strong cultural connections to Europe.

Danielsson, a native Icelander, says that until the crisis, Iceland's banks were relatively healthy, with more capitalization and less toxic assets than at U.S. and British banks. He insists they wouldn't be in trouble now if the Icelandic government had been large enough to bail them out, as the U.S. and Britain are prepared to do.

The fact that the government needs $5.4 billion to keep its foreign accounts balanced shows how dwarfed it was in the face of the crisis. In comparison, the three biggest banks owe a combined $62 billion in foreign currency debt, according to Thomson Reuters.

But Haarde's willingness to go to Russia while rejecting help from the IMF, which has a crisis management team in Reykjavik, worries some people. (Sunday, an adviser to Iceland's Industry minister says he now favors seeking IMF aid.)

Alexander Kliment, a Russian analyst at Eurasia Group in New York, says Russia has a reputation for seeking influence in return for offering money. Having come to the rescue of a NATO country likely appeals to Moscow at a time it is upset by NATO encroachment on the Russian border, he says.

Russia also is eager to gain a foothold in obtaining Arctic energy, and Iceland plans to begin auctioning licenses for oil and gas exploration and development next year. Moscow's investment, Kliment says, "could have an impact on the outcome of those auctions."

It worries some Icelanders, too. But there's a crisis here. "I think Russia wants to get something out of it in the long term," Einarsson says. "But it's no use to be too skeptical about it now."

Contributing: Wire reports. Stinson reported from London.