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Credit chain breaks at weakest link

Hedge funds are not just investment opportunities open only to wealthy individuals. They also apparently come in the shape of Iceland. Now, pardon the pun, Iceland’s finances are in meltdown and it could be the first country to fall victim of a global credit crunch that shows no signs of abating.

Iceland has been dubbed a “giant hedge fund” because of the way in which the country’s corporate and banking sectors have expanded rapidly on borrowed money to give above average returns. Until the credit crunch, that is. Yesterday, Iceland’s central bank suddenly hiked up interest rates 1.25% to 15% in a bid to restore confidence in its currency and ward off full-scale economic crisis. It may be too late for the country of 300,000 people.

Its central bank blamed “deteriorating financial conditions in global markets” for the rate rise, which smacks more of panic than anything else. Confidence in the Icelandic krona has plummeted this year, falling 22% against the euro, driving up inflation to around 7%. Meanwhile, traders in so-called credit default swaps have pushed the cost of protecting the country’s three main banks’ debt against default sky high.

Iceland’s plight is a sure sign that the global financial chain is breaking apart, with the weakest and smallest going to the wall first. The intervention of the world’s central banks last week, when countless billions of dollars were thrown at the crisis and US bank Bear Stearns was forcibly taken over, is now being seen as the last despairing throw of the financial dice. And it has made no real difference. The cost of inter-bank borrowing has actually risen since that intervention. Banks are still reluctant to engage in inter-bank loans because they are uncertain whether they will ever get their money back.

While the stock markets are behaving as if nothing is amiss, with shares soaring in London, the latest data from the US economy confirms that things are badly awry. US consumers are at their most pessimistic for 35 years and house prices are falling at the fastest rate on record. Prices in 20 large cities fell by 10.7% in January compared with the same period last year.

What these cold statistics manifest is the economic recession that is now gripping America, which has only been staved off in the past by borrowing on a larger and larger scale, both by corporations, individuals and the federal government. When the financial musical chairs stopped last summer, many institutions were left with what used to be “non-performing loans”. This term was used to describe the Latin American debt crisis of the 1980s, where countries like Mexico were unable to repay the interest, let alone the capital, on their mammoth foreign loans.

Today’s financial crisis is a global phenomenon, afflicting every country, large or small. Iceland is the first sovereign state to face meltdown but it won’t be the last. Creating a new, stable monetary and financial system out of this chaos is clearly beyond the capacity of governments and central banks. For real solutions to this crisis, you should read A House of Cards, which we published recently, and then decide to do something about it.

Paul Feldman
AWTW communications editor
26 March 2008

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