How Iceland went from worlds biggest hedge fund to pariah in global markets

Date: Tuesday, January 27, 2009
Author: Larry Elliot,

At the start of this decade Iceland would have made an unlikely candidate for the first sovereign-state domino to fall in the financial meltdown. A country with a population the size of Coventry, it was famous for fish, thermal power, prohibitively expensive alcohol and the odd premier league footballer.

Today the word Iceland conjures up an entirely different impression; a country that turned itself into the world's biggest hedge fund and is now paying the price.

Here's what happened. In the final quarter of the 20th century financial markets were gradually liberalised so that what were once domestic markets became one global market.

In the early part of this decade inflation fell in most of the western world as a result of the recession triggered by the dotcom collapse and the flood of cheap imports into the west from Asia. Interest rates fell in most of the developed world, and in Japan, which had been in almost permanent recession since the early 1990s, they were almost zero. Pension funds had made big losses on their ill-judged investments in new technology shares and were looking to make amends. This phenomenon was known as the search for yield and resulted in a flow of funds from Tokyo to Reykjavik.

Iceland had relatively high interest rates, so investors borrowed heavily in Japanese yen and bought Icelandic bonds. Money flooded into Iceland and its big banks borrowed $120bn (85bn) on the international markets six times the size of the country's GDP. This is the sort of leverage normally associated with hedge funds, which borrow money for their speculative plays. The money was recycled into other European economies, including Britain where Icelandic investors bought up large parts of the high street, and all was well while the bubble continued to inflate.

The financial crash has put paid to Iceland's get rich quick scheme known as the yen carry trade and left Iceland saddled with debts it has no hope of paying without impoverishing its people for decades to come. Given its pariah status in the global markets, the country was forced to turn to the International Monetary Fund for a loan earlier this month, but faces years of austerity.