Iceland: Britain's Credit Crunch Scapegoat

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There's nothing like an external enemy to make a country pull together, and Britain, fractious and dissatisfied with its Labour government until recently, has found a fresh foe: Iceland. The tiny country's benign image as a land of geysers and the midnight sun has been swiftly eclipsed by its new incarnation as the mustache-twirling villain of the credit crunch. Britons — from private individuals to local government, charities and public bodies — have deposited some $34 billion in Iceland's financial institutions, among them Landsbanki, which went into receivership this week, and Kaupthing, the country's biggest bank, which was nationalized on Thursday. After the British government used antiterror legislation to freeze Landsbanki assets (these laws were simply "the most efficient mechanism available," a Downing Street spokesman explains), Iceland's Prime Minister Geir Haarde protested. "Not many governments would have taken that very kindly," he said. His counterpart in London appears unabashed. "We will take further action against the Icelandic authorities wherever that is necessary to recover the money," said Prime Minister Gordon Brown.

This isn't Britain's first run-in with Iceland. The so-called Cod Wars over fishing rights in the North Atlantic led to hostile engagements between British and Icelandic fishing fleets and naval vessels, with nets being cut and boats being rammed, ending in the 1970s with an agreement that many British fishermen still blame for limiting their catches. If Brown fails to retrieve British cash from Iceland, a wider swath of the population — all British taxpayers, in fact — will feel the effects this time around. His chancellor, Alistair Darling, promised U.K.-based private investors on Wednesday that the government would cover their full potential losses after IceSave, an Internet subsidiary of Landsbanki that attracted customers with a range of high-interest products, ceased trading.

But there are no such blanket assurances for civic authorities and other institutions that lodged their money with Icelandic banks. The Local Government Association estimates that 108 local government councils have deposited $1.36 billion in Iceland. The councils' claims will be dealt with "case by case," said Hazel Blears, the Secretary of State for Communities and Local Government. She told the BBC that local councils had varying degrees of exposure and indicated that while some might require additional funding, others might just "need extra advice." "I'm not going to sit here today and say that in relation to individual councils, whose circumstances I do not know yet, what action we're going to take," she said.

That comes as something of a surprise to some local councils. There have been warnings since the beginning of the year that all was not well with Iceland's banks. As early as Jan. 30, credit-ratings agency Moody's Investors Service said it was placing on review for possible downgrade Landsbanki, Kaupthing and Glitnir, another Icelandic bank. It did indeed downgrade all three a month later. In July, Kitty Ussher, then Economic Secretary to the Treasury and now a minister in the Department for Work and Pensions, was quizzed by an influential House of Commons committee after newspapers reported that the Icelandic Deposit and Investors Guarantee Fund had insufficient resources to cover its potential liabilities. "Are you satisfied, Minister, that British investors in Icelandic banks are fully guaranteed in the event of a bank collapse, then?" wondered Michael Fallon, the Conservative MP who chairs the committee. "I am satisfied that the law exists to guarantee them, yes," replied Ussher. Fallon persisted: "You are satisfied that the law exists to guarantee them?" "Yes," Ussher replied, "under a combination of European and British law." "So they will get all their money back?" Fallon asked. "That is the legal situation," said Ussher.

Kent County Council, controlled by the opposition Conservatives, tops the list of local government bodies looking to retrieve investments in Iceland: $85 million of its total budget of $4.42 billion is stuck in Icelandic accounts. Nick Chard, the council's cabinet member for finance, says he and his colleagues chose its banks in line with government rules about spreading risk by placing deposits with a range of institutions. Those rules also stipulate that councils should try to obtain as high a return as possible and should always check the credit ratings of the institutions. "At the time of making the deposits [on fixed terms of between 364 days and 2 years], the ratings were good," says Chard. He stresses that the council has no immediate liquidity problems but points out that Ussher made no distinction between private savers and wholesale investors in her evidence to the House of Commons committee.

When the dust settles, the committee might want to revisit Ussher's words and maybe even question the wisdom of the rules governing local-council investments and how local councils interpret them. For the moment, Britons' ire is directed outward: at Iceland's hubris in allowing its banks to expand imprudently. There are also mounting concerns about how Iceland's economic meltdown will affect British Main Streets. Icelandic investment companies also own significant shares in famous retailers such as Debenhams, Hamleys and Oasis, and an Icelandic entrepreneur even owns the East London premiership football club West Ham United.

According to a Westminster source, the British government urged Iceland to apply to the International Monetary Fund for assistance. Instead, Iceland is negotiating a loan from another country accustomed to being regarded as the bad guy by Britons: Russia. With relations between Moscow and London in a deep freeze since the 2006 murder of former Russian spy Alexander Litvinenko, the display of Russian-Icelandic amity helps confirm Reykjavik's status as a British bogeyman. That won't worry the British government at all. In times of crisis, it's good to have friends, but it's even more useful to have enemies.