Iceland Ponders EU Membership as the Credit Crunch Sinks its Currency

Editor's Note: Despite rising fast financially in the past few years, Iceland is feeling the chilly effects of the global credit crunch - so much so the fiercely independent island nation is considering European Union membership to save its tanking currency. A special report, jointly developed by U.K. affiliate MoneyWeek Magazine and our experts here at Money Morning, explores the pros and cons of Iceland's potential EU membership. For more information on MoneyWeek, please click here.

If you think the credit crunch is hitting the United States and United Kingdom hard, spare a thought for Iceland.

Banks all over the world have spent much of the past few years devouring cheap money, but Iceland's taken the whole thing to quite an extreme. Its big players - Landsbanki Islands HF and Kaupthing Bank - have been on an extraordinary borrowing spree, sucking in vast quantities of cash to fund lending and acquisitions across Europe and the United Kingdom.

The result? This tiny country - home to a mere 300,000 people - has somehow created a financial system nine times the size of its gross domestic product (GDP).

And a nasty hangover.

Now, the cheap credit that fueled the binge has all but disappeared, and the banks - as well as the economy - are in trouble. The stock market has tanked, inflation has soared, and the Icelandic krona has fallen 26% against the euro this year. House prices, which had doubled since 2001, are now falling.

According to the Icelandic Central Bank, the economy will contract by 2.5% next year and 1.5% in 2010.

"We are still likely to see a fairly sharp slowdown in the Icelandic economy in the coming quarters and the most likely scenario is for negative GDP growth in Iceland in 2008 and 2009," says Lars Christensen, chief analyst at Danske Bank A/S.

Lucky then that the Alka Seltzer is on its way.

On Friday, the Nordic central banks extended an emergency loan facility worth
$2.36 billion (€1.5 billion) to their island neighbor designed to shore up the krona, give the Iceland Central Bank some credibility as the lender of the last resort to the banks (which have been under huge speculative pressure from many of the world's big hedge funds), and jump start the economy.

"In times of uncertainty and turmoil, the central banks have a responsibility to cooperate to attain their overall objectives," said Swedish Riksbank Governor Stefan Ingves. "The swap agreement is aimed at supporting (Iceland) in its task of safeguarding macroeconomic and financial stability."

Much Dreaded EU Membership

Iceland's financial rut has raised a pretty uncomfortable question for Icelanders: Can they really go it alone in the global market place or should they begin to think the unthinkable and join the European Union?

With fishing accounting for over 40% of exports, Iceland has long had reason to very firmly oppose membership in the EU.  Just ask any fisherman up and down the west coast of Ireland what he thinks of the EU, and the opening of Irish waters to big Spanish tankers. Magnify his fury by 10, and you'll get a good idea of what Icelanders, a traditionally independent lot, think of the EU.

But with the economy destabilizing and the currency all over the place, support for the idea is growing. A poll published in April by the Icelandic daily Fréttabladid showed that 68% of Icelanders would be willing to open membership negotiations with the EU, up from 55% in February. EU membership would mean that the Icelandic central banks would lose the power to set interest rates. But that may well be a perfectly fair price to pay for a more stable currency.

"What we need in the long run is economic stability, which I doubt we can guarantee in the long run with our current currency," Foreign Minister Ingibjörg Sólrún Gísladóttir told the Wall Street Journal.

Gísladóttir also leads the Social Democratic Alliance party, the only major party that supports membership in the European Union.

The majority of durable goods, for example cars and washing machines, are imported into Iceland. So given that the currency has been taking a beating, Icelanders are now paying much more for the goods they import.

Inflation rose to an annualized rate of 11.8% in April, the highest level since September 1990. And over the past three months, consumer prices are up 6.4%. That's equivalent to an annual inflation rate of 28%.

Using the Euro would mean offering up a decent chunk of sovereignty at the EU's altar. But then, given that interest rates in Iceland are running at 15.5% and 4% in the Eurozone, membership might also offer suffering Icelanders what they really need right now.

How Long Can Iceland Hold Out?

If any struggling small-sized economy can hold out against the financial storm, it's Iceland.

The country is extremely energy efficient. The piping hot water that comes out of the spigot comes directly from the country's wealth of hot springs. 

Its population enjoys nearly free hydroelectric power by harnessing the flow of its natural and manmade waterfalls.

Geothermal power, created by steam under the earth's surface, is so cheap that Reykjavik actually has some heated sidewalks in the wintertime.

And since the country is relatively small - both in size and population - the need for oil for cars isn't nearly as big as other similarly sized European nations. 

The International Monetary Fund ranks the icy island the fourth most affluent country in the world, Vanity Fair reported in its May issue.

But with its banks losing money fast, that status is in jeopardy. Public sentiment is leaning toward falling into the arms of the EU, should the need arise.

Given how much is at stake, the issue will be treated cautiously.

"This is a long-term issue for the politicians to decide," Arnór Sighvatsson, the Central Bank of Iceland's chief economist, told the Wall Street Journal.

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