NEW YORK (Dow Jones)--Iceland has gotten a bad rap in financial circles in the past few months, but the tiny island country is fighting back.

Not since the days of Viking raiders in the ninth and tenth centuries has Iceland caused so much consternation on the world scene. This time round, it is financial instability, not long ships and battle axes, that is the source of worry.

Faced with criticism from banks and other institutions, mainly because of a large current account deficit, the Icelandic private sector and government are pushing hard to set the record straight. The message that emerges is that nothing is really rotten in the Republic of Iceland, except maybe a traditional Christmas dish that's actually fermented fish.

The brouhaha around Iceland began on Feb. 21, when credit-rating agency Fitch Ratings changed its outlook on Iceland's foreign and local currency ratings to negative from stable.

Fitch cited an "unsustainable current account deficit and soaring external indebtedness" as reason for the change. The Icelandic krona fell by 7% in two days and by more than 15% in a month as several other financial companies and banks sounded warnings about risk in Iceland.

Moreover, the flight of investors from krona-denominated assets reverberated in high-yielding and emerging-market currencies across the globe. Words like "meltdown," and "contagion" began making the rounds, although the acute phase of the sell-off was short-lived and the situation never came close to the crises in Asia, Europe and Latin America in the recent past.

A chorus of voices inside and outside the island in the North Atlantic Ocean now say that the doomsayers don't understood the unique nature and resilience of the Icelandic economy. With a population of 300,000, Iceland is the smallest country in the world to have its own currency and a floating exchange rate. Far from being fragile, the Icelandic economy is in comparatively good shape when judged by a number of conventional economic standards.

"The bottom line is the U.S., Japan and Europe would love to be in Iceland's shoes," said Frederic Mishkin, the Alfred Lerner Professor of Banking and Financial Institutions at the Graduate School of Business of Columbia University in New York.

Speaking at a presentation Wednesday arranged by the Iceland Chamber of Commerce, Mishkin ticked off a number of factors that indicate Iceland isn't headed down a traditional path to financial instability.

Iceland is an advanced country with high-quality institutions; gross domestic product, when adjusted for purchasing power parity, is the fifth highest in the world; net government debt and unemployment are almost non-existent; and labor force participation among older workers is the highest in the world, and among women, the highest in the industrialized world, said Mishkin.

Iceland isn't threatened by a looming pension crisis - a crisis that beckons for most of the industrialized world - because of reforms which began in 1969, he noted.

Typically, Mishkin said, there are three traditional routes to financial instability: financial liberalization with weak regulation and supervision, severe fiscal imbalances, and imprudent monetary policy.

None of these routes describe the current situation in Iceland, he said.


Challenges Ahead

Any comparison to financial issues in emerging market countries is "misguided," he stated. The only thing Thailand and Iceland have in common is the syllable "land" in the names of both countries, he noted wryly.

Of course, neither Mishkin nor Tryggvi Thor Herbertsson, Professor of Economics at the University of Iceland and co-author of the study presented Wednesday, believe everything is perfect in the Icelandic economy.

There are problems, but not of the magnitude that could cause a financial meltdown.

Official Iceland also acknowledges there are rough spots in the country's economic landscape. In its annual Financial Stability report published Thursday, the Icelandic central bank, or Sedlabanki, said the overall finding of its report from 2005 is unchanged this year. Despite rapid expansion and the macroeconomic imbalances that needed to be tackled in the coming years, the Icelandic financial system is broadly sound.

Sedlabanki noted, however, "more challenging waters clearly lie ahead. The adjustment to changed conditions has already begun. It is important to keep a firm course and exercise caution in all respects."

Speaking with Dow Jones Newswires from Reykjavik prior to the release of the report, Ingimundur Fridriksson, Assistant Governor at Sedlabanki, said that while Iceland's current account deficit is, at 15% of gross domestic product, "large any way you look at it," the gap doesn't present insurmountable problems for the country.

A big chunk of the current account deficit stems from imports to the island's aluminum industry as well as the liberalization of mortgage lending regulations in recent years, he said. Those are relatively short-term effects and when factored out, the current account gap would fall below 10%, he said.

The warnings about Iceland's current account deficit leading to instability fail to take into account the "great resilience and adaptability" of the country's economy in rectifying such imbalances, Fridriksson said. As a small economy, Iceland is subject to volatile swings in its current account and has experience in dealing with them. As a counterweight to real instability, Iceland has high wealth and income as well as strong institutions and a strong regulatory framework.


Blame The Carry Trade

Indeed, the February to March turmoil in Icelandic markets can largely be blamed on the infamous villain in the cast of currency-crisis characters - the carry trade. Speculative investors, such as hedge funds, had borrowed money in countries with low interest rates - Japan in particular - and invested it in countries with much higher rates of return.

Iceland had been a particular favorite because its benchmark rates were above 10%, the economy was booming and the krona as well as Icelandic equities were appreciating robustly.

But when the most daring investors began rushing for the exits all at once, the krona and Icelandic equities had nowhere to go but down. While the fluctuations were sever in the short run, they weren't signals of an impending meltdown.

This is something which Moody's Investors Service apparently recognized. At the beginning of April, Moody's said that Iceland isn't experiencing undue risk to solvency or liquidity as a result of recent volatility in the nation's business and financial markets. Moody's rates Iceland triple-A, the gold standard.

"While we have warned of the risks that may accompany increased leverage in the economy, Iceland has our top rating with a stable outlook, and we believe these concerns have recently been exaggerated," said Joan Feldbaum-Vidra, author of the Moody's report.

(Robert Flint, a news editor in the money group, has covered currency markets for Dow Jones Newswires for the past seven years and was previously Beijing bureau chief and chief correspondent in Scandinavia.)

-Robert Flint; Dow Jones Newswires; 201-938-4408; [email protected]
(Terrence Roth in Stockholm contributed to this article.)

(END) Dow Jones Newswires