Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?

Today’s du jour word is “guarantee”.

The prevailing belief is that when deposits, loans, or debts are guaranteed by governments, they become fail-safe in absolute terms or the elixir to our financial and economic problems.

No one seem to ask, guarantees with what?

For instance when Iceland recently joined the policy stampede of guaranteeing its banking system, it has been earlier assumed that its government can settle with any calls made on such claims.

Unfortunately, mired with foreign liabilities in excess of $100 billion which dwarfs the country’s GDP of $14 billion and whose current account deficits is one of the highest in the region, it appears that government guarantees would depend from entirely either the kindness of foreigners or from its printing presses.

Courtesy of Danske Bank

Ultimately this means that guarantees need to be backstopped by hard currency which is something Iceland lacks at the moment…

Courtesy of Bloomberg

And because of the shortage of hard currency to pay for imports, Icelanders have begun to hoard on items. This panic buying will drive up consumer goods inflation already one of the highest in the region.

This from Bloomberg, ``After a four-year spending spree, Icelanders are flooding the supermarkets one last time, stocking up on food as the collapse of the banking system threatens to cut the island off from imports.

``Iceland's foreign currency market has seized up after the three largest banks collapsed and the government abandoned an attempt to peg the exchange rate. Many banks won't trade the krona and suppliers from abroad are demanding payment in advance. The government has asked banks to prioritize foreign currency transactions for essentials such as food, drugs and oil…

``There is absolutely no currency in the country today to import,'' said Andres Magnusson, chief executive officer of the Icelandic Federation of Trade and Services in Reykjavik. ``The only way we can solve this problem is to get the IMF into the country.''

Yes, the IMF and Iceland have reportedly been in discussion but have not reached any accord yet (guardian.co.uk).

The unfortunate part is that Iceland which used to be the top in terms of human development as measured by prosperity and “fulfilled life” could suffer immensely from the breakdown of its banking system.

Courtesy of Economist

According to the same report in Bloomberg, ``Icelanders, whose per capita gross domestic product is the fifth highest in the world, according to the United Nations 2007/2008 Human Development Index, will have to tighten their belts.”

Courtesy of Wall Street Journal

And this is unlikely to serve as a short term development as its 320,000 citizens will have to take the onus of bearing the angst from the losses incurred by its banking system. Yet the economy is faced with the immediate prospects of economic contraction, which compounds the dire scenario.

Courtesy of the Economist

Iceland’s agricultural subsidies, the largest among developed economies, could shrink as its government would likely require a sizeable share of its revenues to compensate for the losses.

For the moment, as external funding remains scarce, Iceland risk becoming the “Zimbabwe” of Europe as they would likely have to rely on the printing presses to finance its domestic financial system if foreign funding don’t emerge soon.

So aside from a recession, Icelanders risk facing a profound transformation of even higher taxes, a fall in per capita income, a decline in productivity and deterioration of living conditions.

In short, a potential regrettable “riches to rags” story.

Moreover aside from serving as an example of what happens when a banking system fails, the Iceland experience suggests that the probable next wave of crisis will be one of national solvency issues.

Guarantees can reflect more of political designs than of economic reality.