Posted by: Dirk | May 30, 2008

Iceland: problems with a frozen credit market

Iceland has had a rough time lately, despite being number 1 in the Global Peace Index. Worries are coming from the economic front. Icelandic banks have been working with borrowed money on a large international scale, and now that the banks are suffering from the financial crisis, the central banks is not able to clean up the mess. Drastic measures have been dreamed up:

The ECB therefore opened its discount window to Iceland, allowing it to borrow funds posted against German collateral. As part of the deal Germany gets to annex Iceland for the knockdown price of 2 krona a share – giving it an equity value of $250m – and all but wiping out the country’s shareholders.

Investors are said to be furious, claiming that Reykjavik alone is worth $10bn. The deal is an attractive one for Germany, which has long wanted its own pure fish play and now acquires Iceland’s prime fisheries unit for next to nothing.

Apart from this work of fiction, Sweden, Denmark and Norway have stepped in with an emergency loan. Willem Buiter gets deeper into the central banks balance sheet and covers the story within a very interesting piece on the question Can Central Banks Go Bust?:

With limited foreign exchange reserves and, so far, limited access to other foreign exchange resources (swaps, credit lines, etc.), the Central Bank of Iceland cannot act as an effective lender of last resort or market maker of last resort for a domestic banking system whose lending, borrowing and investment activities are mainly in foreign currencies and whose balance sheet is largely foreign-currency-denominated. This massive mismatch between the currency of the lender of last resort/market maker of last resort and the foreign currency exposure of the banking sector (euro, sterling, Norwegian, Danish and Swedish kroner and US dollar) is unique among developed countries, as far as I know.

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