The Stunning Collapse of Iceland

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That's because the ramifications of Iceland's meltdown extend far beyond the tiny Nordic country. Over the past decade, Icelanders have taken advantage of low interest rates offered by the country's banks to finance rapid expansion beyond the island nation in numerous industries. Hafnarfjordur-based Actavis, for instance, is now one of the world's biggest generic drug companies.

Perhaps the best known overseas success story is Baugur Group which owns a vast swath of Britain's retail industry (BusinessWeek.com, 8/20/08) and earlier this year built up an equity stake in Saks Fifth Avenue (SKS) in what many figured would become a takeover attempt (BusinessWeek.com, 1/30/08). Although Baugur insists its British retail interests are safe, the collapse of the Icelandic banking system puts massive pressure on already struggling British retailers.

Offering higher interest rates than their counterparts in Britain, Icelandic banks have attracted huge inflows from British investors in recent years. Since its launch in October 2006, Icelandic internet bank Icesave, owned by Landsbanki, attracted $7 billion in deposits from 300,000 British retail investors. When the bank went bust, British Chancellor of the Exchequer Alistair Darling was forced to step in. On Oct. 8 he pledged to guarantee the deposits of all British retail investors in Landsbanki and its subsidiaries. The British government says it plans to sue Iceland to recoup at least some part of the savings of British customers in Icesave.

Forces Sale of Assets

While British retail depositors will be protected, others aren't so lucky. British entrepreneur Robert Tchenguiz lost $1.7 billion in just 24 hours when his property empire collapsed along with Iceland's banking system. Kaupthing had bankrolled Tchenguiz's stakes in British retailer J Sainsbury (SBRY.L) and Mitchells & Butlers (MAB.L) and held the stakes as collateral. When the bank was forced to sell assets in a scramble to deleverage, it called back its loan to Tchenguiz, who had to liquidate his positions to raise the cash.

Other Britons could lose out, too, thanks to higher taxes. That's because local government authorities, charities, and even police departments in England and Wales are believed to have parked an estimated $1.7 billion in Icelandic banks—and if the money disappears as expected, taxpayers will have to ante up to close the gap.

One local government council in Kent is said to have deposited $87 million of taxpayer money in Icelandic banks. The British government has pledged to protect retail deposits made in Icelandic banks—but not those made by institutional investors. So the Local Government Assn. plans to ask the government for temporary tax breaks to give its members some breathing room. At the same time, the British government is using anti-terrorism laws to freeze $6.8 billion of Icelandic assets in Britain. "Not many governments would have taken that very kindly," says Icelandic Prime Minister Haarde.

In 2006, after a currency crisis that hammered the krona, some analysts raised concerns about the high level of leverage in the Icelandic banking system. But many eminent economists and commentators were quick to rush to the country's defense. They noted that Iceland had strong financial regulators, a sound economic environment with low unemployment, and a fully funded pension system. While the country had a large current account deficit, they said, comparing it to emerging economies such as Thailand or Turkey was misguided.

But as Frederic S. Mishkin, a professor at Columbia University and a former economist with the Federal Reserve, noted in a 2006 report titled Financial Stability in Iceland, "If a significant fraction of traders in international financial markets think that Iceland will be undergoing financial meltdown—even if fundamentals don't warrant it—they could create a self-fulfilling prophecy by massively pulling out of Icelandic assets." Mishkin's prophecy just came true.

Capell is a senior writer in BusinessWeek's London bureau .