It is hard to believe, that events in a small country with a population of just 320,000 people could have world wide effect. Flooded with a deluge of information during first 10 days of October, most traders probably didn’t even register what was happening in Iceland. Yet it might have been there, according to some market watchers, where the current financial turmoil began.

Over last few years Icelandic Krona has been very high yielding currency, paying more than 15%. For this reason, it has been popular choice in the “carry” play enjoyed by many traders against mainly Japanese Yen an Swiss Franc. This pushed the ISK to lofty levels, which, in turn, helped fuel the expansion of Icelandic financial sector, especially its banks. The nations three banks established branches abroad, mainly in UK and Europe. Business flourished.

During the “unwind of carry trade” in summer last year, Krona experienced a sell off, which was seen, at the time, as temporary. However things got a lot worse earlier this year, during Bear Stern’s bailout. ISK’s slide continued and was much steeper than any other currency. With financial sector being disproportionately large relative to country’s economy, Iceland started to suffer. In fact, authorities launched an investigation into, what was seen as, hedge fund attack.

The nations three banks, Glitnir, Landsbanki and Kaupthing Bank, found it increasingly difficult to refinance debt over last two months as credit crunch shook the world. One by one banks have become insolvent and had to taken over by the Finance Ministry. Krona plummeted and the country became unable to meet banks obligation, leaving behind shocked investors and depositors. That include hundreds of thousands of people who have accounts in Icelandic banks abroad operations.

During the week of October the 10th, as financial markets were in turmoil world wide, ISK came under even more strain. Losses reached 30-40% against major currencies in just few days. The latest publicly available quote was EUR-ISK at 304, which is completely of the chart. By Friday even central banks stopped making market for Krona and trading has stopped. For all practical purposes this leaves Iceland bankrupt as a nation, first sovereign state to fall victim to this crisis.

In perhaps the most telling example of how far the troubles progressed, United Kingdom threatened legal action against Iceland as a country. The aim of such step is to recover money on UK’s citizens, which is stranded in failed banks. Great Britain could invoke anti terrorism laws in an effort to regain the funds. Such move would leave the small nation isolated in more than geographical sense.

Thankfully, probability of such drastic, panic driven measures is low. It is expected that the government of Iceland will ask International Monetary Fund for assistance. Organization has the funds to help, especially since, in global terms, the sums involved are manageable. In order to qualify for IMS intervention, country would have to accept some harsh terms and conditions. One of them might be very difficult to come to terms with, the future of Krona.

Some people argue that in order to avoid future problems of this magnitude, Iceland should apply for inclusion into European Union and adopt Euro. Since most of laws and regulations of the island nation are already compatible with EU, this would be a relatively painless process. Another option is to peg Krona to Euro. In that case, Iceland would also hand over control of monetary policy, including the setting of interest rates, to the European Central Bank.

Both of these options will be a tough choice for independent minded Iceland. Both of them would also effectively put an end to a freely floating currency. It seems, as of this writing, that Krona’s days are numbered. One less choice for Forex traders, even though little known and understood.

Source by Mike P. Kulej