blue lagoon iceland

Business is booming at the Blue Lagoon. One evening last week at the hot springs on the lava fields above Grindavik, dozens of bathers were still enjoying the warm geothermal waters even as the last trace of daylight faded from a sleet-filled Icelandic sky.

Almost all were foreign tourists, part of a surge in visitors – August’s numbers were up 12 per cent on 2008 – since last year’s bank crash sent the krona plummeting. But the thriving tourism trade, while welcome, is a rare piece of good news amid a mostly gloomy outlook for the storm-tossed island on the cusp of the Arctic Circle.

A year ago on Tuesday, Geir Haarde, then prime minister, went on national television to declare that Iceland faced bankruptcy after the “fairytale” growth of its banking sector met a nightmare end. Over the next two days, all three main lenders – Landsbanki, Glitnir and Kaupthing– were nationalised and the country put itself at the mercy of foreign donors.

Iceland, previously among the world’s richest nations per head, had become the worst-hit victim of the global credit crunch: a laboratory study in how a toxic mix of financial deregulation, free-flowing international capital and a reckless band of “Viking raider” entrepreneurs intent on conquering the world could bring a country to its knees. As such, its progress towards recovery represents another experiment – this time in how to rebuild a shattered economy.

Even without this wider significance, Iceland’s fate carries greater importance than its size would imply. The country vies with Equatorial Guinea for the title of the world’s 100th biggest economy and its population of 320,000 is one-third smaller than that of Luxembourg, the European Union’s smallest member state. Yet in the decade before the crisis, Iceland’s banking sector assets grew to 10 times annual gross domestic product and became a launch pad for frenzied international expansion by the businessmen, also dubbed the “Icelandic oligarchs”, who built the financial empires.

When the edifice collapsed, many European investors suffered collateral damage. This gives foreign creditors a stake in Iceland’s recovery as they try to salvage some of the billions of euros and pounds lost in the rubble. The foreign ministries of Europe and North America are also paying attention as the crisis strains at the geopolitical moorings of a Nato ally that sits in the middle – literally – of the transatlantic alliance.

Johanna Sigurdardottir, who succeeded Mr Haarde as prime minister in February, insists recovery efforts are on track. Healthy banks have been spun out from the failed ones and injected with capital. Control of two of the lenders has been offered as compensation to foreign creditors; and the economy has proved more resilient than expected as the weak currency aids exports.

“We have done better in many ways than people predicted one year ago,” she says. “Unemployment is lower than we feared and the contraction is not as severe.”

The finance ministry expects gross domestic product to contract 8.5 per cent this year, only a little worse than the projected drop in Ireland – another prominent crisis victim – and the unemployment rate is less than in the US and several other developed countries at about 7.5 per cent.

Yet such figures tell only part of the story. The collapse of an overblown banking sector has turned Iceland into one of the world’s most indebted countries, the painful consequences of which have yet to fully materialise. “We are still in the danger zone,” says Jon Baldvin Hannibalsson, a former finance and foreign minister, predicting that the next 12 months will be Iceland’s true “annus horribilis”.

Austerity measures imposed as a condition of the $5.1bn (€3.5bn, £3.2bn) bail-out led by the International Monetary Fund are only now about to kick in, with steep tax rises and spending cuts planned for 2010. A moratorium on home foreclosures is also soon to end, imperilling thousands of homeowners saddled with foreign currency loans they can no longer afford.

Little wonder that few ordinary Icelanders share the prime minister’s rosy assessment of progress. “It’s gone from bad to worse,” said one man stood among a throng of protesters banging pots and pans outside parliament last week as lawmakers arrived for the new session. The crisis – or kreppa, as it it called locally – still looms heavily over life in Reykjavik, with half-built office blocks abandoned and shops almost deserted except for tourists.

For anyone with a stake in Iceland’s future, the past few weeks have not been encouraging. Ms Sigurdardottir’s left-green coalition government has teetered close to collapse amid agonised debate over a controversial deal to reimburse the UK and the Netherlands to the tune of nearly €4bn. Hundreds of thousands of British and Dutch citizens, charities and local authorities had poured money into Landsbanki’s offshore Icesave accounts, lured by high interest rates as the bank expanded overseas.

Two days after Mr Haarde’s address, the UK deployed anti-terror laws to freeze Icelandic assets in a vain attempt to save citizens’ money. But the move succeeded only in hastening the collapse of Iceland’s financial system and sparking a diplomatic dispute that has sapped political energy in Reykjavik for much of the past year.

The Icesave issue is crucial because the IMF and the Nordic countries that also contributed have refused to release additional funds until Iceland settles its dispute with the UK and the Netherlands. An IMF review, which must take place before more is disbursed, has been delayed since February. “The Icesave issue is of huge importance to us because most of our recovery efforts hinge on a solution being found,” says Ossur Skarpheoinsson, foreign minister. “If we are not able to solve this, it would perhaps mean that a political crisis would be added on to the financial crisis.”

Iceland’s new government struck a deal with its UK and Dutch counterparts in June but parliament refused to ratify it amid public fury over the terms. Critics said the repayment plan, equivalent to about half the island’s annual GDP, would penalise taxpayers for the recklessness of a private bank and stifle recovery by loading the country with debt.

Lawmakers finally approved the deal last month – but only after adding a series of conditions to limit annual payments and open the possibility of future renegotiation. The UK and Dutch governments have signalled opposition to some of the changes, threatening to send the dispute back to square one.

Arni Thor Sigurdsson, chairman of parliament’s foreign affairs committee, hopes the UK and the Netherlands will agree to a compromise. “It is not in their interests for the government to fail because that would make it less likely that they would ever get their money back,” he says.

But the issue has sapped the authority of Ms Sigurdardottir’s coalition at a time when strong leadership is needed to push through unpopular budget cuts and further financial restructuring. Instead, the government finds itself struggling to paper over internal divisions while the conservative opposition, ejected from power in disgrace after the crisis, is exploiting anger over Icesave to revive its fortunes. “The government has ended up looking like amateurs who went up against the tough, skilful British and Dutch negotiators and came back with a rotten deal,” says Mr Hannibalsson.

The dispute has poisoned attitudes towards the wider world. From the highest levels of government to ordinary citizens, Icelanders feel bitter about the IMF and other European countries for implicitly siding with the British and Dutch by linking aid to Icesave. “The IMF and the [European Union] are being used against us,” says Ogmundur Jonasson, the former health minister whose resignation in protest over Icesave last week nearly brought the government down.

Complaints are hardly unusual from countries forced into the straitjacket of an IMF rescue programme. But as the wealthiest and most developed country to receive support from the IMF in recent times, Iceland provides a test of the fund’s ability to work with nations hit by crisis.

“I think if we get rid of the IMF, and the sooner the better, we will rise to our feet again,” Mr Jonasson adds, accusing the fund of imposing excessive and hasty budget cuts that will hurt Iceland’s long-term competitiveness. “They are behaving like an economic police force acting in the interests of foreign creditors rather than the best long-term interests of Iceland.”

Much of the hostility is focused on the EU as a eurosceptic opposition succeeds in channelling public anger towards Brussels.

Ms Sigurdardottir, an advocate of EU membership, hoped the crisis would encourage Icelanders to seek greater economic stability within the 27-member bloc – and eventually the eurozone. In July, she overcame divisions within the government to secure a narrow parliamentary vote in favour of starting talks with Brussels: a formal application was lodged days later. But public support for accession has eroded sharply since and polls show a clear majority opposed. “Iceland as a nation has become more inward-looking for the time being,” says Mr Skarpheoinsson.

Mr Hannibalsson warns of a creeping “paranoia” in politics, highlighting calls by some opposition members to seek closer ties with Russia and China. Moscow was the first foreign power to rush to the aid of Reykjavik last October, with a €4bn loan a day after the crisis erupted. Iceland, which served as a mid-Atlantic aircraft carrier for Nato forces during the cold war, has a front-row seat in the increasingly strategic Arctic region.

Almost all Icelanders agree that the country is culturally and politically part of Europe even if they are divided on EU membership. But the mere fact the issue is being discussed shows that everything about Iceland’s future is up for grabs – including its place in the world.

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