Speculators trying to crash Iceland's currency

On a gloomy North Atlantic evening in January, a group of international hedge fund managers gathered in the stylish bar of 101 Hotel in downtown Reykjavik at 8pm for a drink before dinner. They had been flown to Iceland by Bear Stearns, the US investment bank that two months later had to be rescued. Bear had organised the excursion to discuss the bizarre state of Iceland’s economy. What transpired at this dinner has entered into legend within Iceland’s close-knit financial community.

An executive who works with a big Icelandic bank recalls: “Upon entering the bar I was approached by one of the hedge fund managers. He informed me that all people in this party – except for him, of course – were shorting Iceland.” The executive says the fund manager described Iceland’s profit-making potential as the “second coming of Christ”.

“As dinner progressed – some people actually decided not to eat at all but just sit at the bar – and more drinks were downed, the conversation and questions started to get more hostile and short positions openly declared,” the executive says.

What started as an alcohol-fuelled evening has become a full-blown investigation by Iceland’s Financial Supervisory Authority into an alleged speculative attack by hedge funds on Iceland’s currency, banking system and stock market. Jonas Jonsson, director-general of Iceland’s FSA, says the authorities are “searching whether some parties have systematically been distributing negative and false rumours about the Icelandic banks and financial system in order to profit from it”.

Mr Jonsson admits such cases are “difficult to ascertain and prove” but adds that “we would not be using our time if we didn’t think there was a good reason to investigate”. He is concerned that funds may have been “front-running” – taking trading positions on the basis of privileged information, in this case their own forthcoming negative reports.

The stock exchange is also examining its trading records and will send anything suspicious to the FSA. “There is nothing wrong with taking short positions. But if false rumours have been spread around the markets, that, in my view, is a clear case of market manipulation,” says Thordur Fridjonsson, president of the exchange.

Details of the investigation are confidential, but the authorities are expected to pay close attention to movements in the credit default swap markets for Iceland’s banks. Spreads in these markets – a proxy for investors’ fears the banks will collapse – have ballooned from about 50 last August to more than 1,000, indicating a very high level of fear about their viability.

The suspicion is that speculators exerted undue pressure on the illiquid CDS market in the knowledge that the wider the spread went, the more fear of a banking collapse would contaminate the stock and currency markets. There are also concerns about the way rumours were spread about the alleged reliance of Iceland’s banks on internet deposits, which triggered reports in UK newspapers that such deposits could be withdrawn rapidly.

Icelandic economy

The chief executives of the three main banks, Landsbanki, Glitnir and Kaupthing, made clear in interviews last week there is no evidence this is the case, despite the negative publicity about Iceland. They firmly believe such rumours were started deliberately in order to spark fears of a run on their overseas deposits.

Iceland’s most senior officials have declared open war on the speculators. David Oddsson, governor of the central bank and former prime minister, says: “There is an unpleasant odour of unscrupulous dealers who have decided to make a last stab at breaking down the Icelandic financial system.”

Concern that hedge funds are profiting from spreading malicious rumours is not limited to Iceland. In recent weeks, the Financial Services Authority in the UK stated that it would not tolerate market abuses after rumours of liquidity problems at HBOS’s hit the British bank’s stock price. Ireland’s financial regulator is also examining unusual trading patterns in its market, while Lehman Brothers, the US bank, told the Securities and Exchange Commission it had been the target of malicious rumours after its shares plunged on speculation that it faced a cash shortage.

Sympathy for US investment banks may be hard to find these days but the image of tiny Iceland, with a population of just 313,000, battling to protect its economy against the sharpest minds in global capitalism has captivated the local population and global market practitioners alike.

Fame of a sort was achieved when Ben Bernanke, chairman of the US Federal Reserve, was asked about the alleged attacks on Iceland during testimony to Congress, a development greeted with bewildered pride in Reykjavik. “We’ve made it,” commented one senior Icelandic banker ironically.

These events serve as a testament to Iceland’s transformation from fishing-based backwater to northern European tiger economy. Icelanders have certainly grown richer. Its economy may be the smallest in the Organisation for Economic Co-operation and Development, with a gross domestic product of about $20bn (£10bn, €13bn) but GDP per capita income is approximately $60,000, among the highest. Private jets swoop into Reykjavik’s airport bearing home-grown billionaires, while black Range Rovers purr through the capital’s streets amid a forest of cranes.

Significantly, the fishing industry’s share of GDP has declined from 16 per cent in 1980 to 6 per cent in 2006, replaced largely by finance, insurance and property, whose combined share of GDP rose from 17 per cent in 1998 to 26 per cent in 2006. However, banking sector assets have grown from about 96 per cent of GDP in 2000 to about 10 times today – the main source of concern about the country.

Perhaps more fundamentally, there has been a profound shift in attitude. Icelandic entrepreneurs have developed a reputation for aggressiveness, snapping up assets in the UK and shocking their consensus-driven Nordic neighbours with an almost American attitude to acquisitions and risk. For a country that was for more than 500 years under the control of Denmark, these developments have unleashed a dormant sense of national pride.

But growth has not been without its costs. Iceland reported a current account deficit of 16 per cent of GDP in 2007, while inflation stood at 8.7 per cent in March – well over its central bank’s target of 2.5 per cent. Iceland’s new rich are feeling the heat. “A Toyota Land Cruiser that cost IKr10m ($140,000, £70,000, €90,000) in January is now IKr13.8m,” says Ulfar Steindorsson, president of Toyota Iceland.

Such factors have undermined investor confidence, sending the stock market lower by nearly 16 per cent this year. The currency has fallen more than a fifth over the same period, further stoking inflation. In response, the central bank this month imposed an emergency interest rate increase of 1.25 percentage points to a record 15 per cent.

Such numbers make for uneasy comparisons and help explain hedge fund interest in Iceland. The country has the second highest interest rates in Europe after Turkey’s 15.25 per cent and its current account deficit puts it in the same league as volatile, high-growth economies in the Baltic and central and eastern Europe. Banking-sector borrowing is also high by international standards.

But these outwardly negative numbers, as Halldor Kristjansson, chief executive of Landsbanki, points out, require further analysis. The current account deficit, for example, is set to contract sharply once exports from new aluminium smelters start in the next few months. This will alleviate pressure on the krona and bring inflation back to within the central bank’s target range next year, it is forecast. Interest rates are expected nearly to halve to about 8 per cent in 2009 as economic growth slows to under 4 per cent.

As for the banks, they have responded to criticism by diversifying funding away from wholesale markets and relying more on deposits. Speaking for the industry, Larus Welding, chief executive of Glitnir, points out they have all diversified geographically and generate more income from a wider range of products, boosting fee and commission income. All are well capitalised by international standards and have survived various stress tests devised by the FSA with flying colours.

Speaking from the modest prime ministerial residence close to the waterfront in Reykjavik, Geir Haarde does not deny the country faces serious hurdles. But he does have a problem with these hurdles being raised artificially by the alleged actions of speculators. “We would like to see these off our backs,” he says. He has made it clear that he is prepared to intervene in the markets.

It is widely expected that Iceland’s central bank will announce – possibly on Thursday – a tie-up with other Nordic central banks to provide support for the banking sector. Mr Haarde also stated that the government, which runs a budget surplus, can easily issue bonds to bolster foreign exchange reserves of just $2.6bn. These moves will ensure the Icelandic central bank can be a lender of last resort in both Icelandic krona and foreign currencies, reducing the risk of a systemic collapse.

All indications are that the measures taken so far are working. The currency is strengthening, spreads in the credit default markets have narrowed and there has been no run on bank deposits. Whether this proves enduring will depend upon the soon-to-be-announced package from the central bank and the government.

But the dust is unlikely to settle quickly. Experts now expect a renewal of a long and tempestuous debate about whether Iceland should pursue membership of the European Union and the eurozone. It is already a European Free Trade Association member, but has shied away from deeper participation, saying it needs an independent monetary policy. This may now have to change. “If Iceland wants to play a role in the wider world then it can’t do it as an independent operation,” says one well-placed commentator.

Significantly, a recent poll revealed for the first time that a majority of people thought EU membership was a good thing and the business community has stepped up its support. Insiders say debate in government on the issue is “at a completely different level” now compared with a few years ago, but that internal party sensitivities make any public discussion tricky.

In the meantime, the economy is gradually tying itself to the eurozone as more companies adopt the euro. Fridrik Mar Baldursson, a professor at Reykjavik University, cautions against this gradual “euroisation”. “The more this happens the smaller the effect of [domestic] monetary policy on prices, wages, demand etc, and that equals more and more instability,” he says.

The undeniable fact is that Iceland is now more internationalised than at any time in its past. While alleged financial speculation is being rightly investigated, the solution to its challenges does not lie in blaming foreigners. In the words of Toyota’s Mr Steindorsson: “Some say ‘Those bastards’. Others say we shouldn’t blame other people for our own problems.”