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October 7, 2008 | 2034 GMT Russia has loaned Iceland $5.43 billion as Iceland’s government works to prevent a financial meltdown set off by its banks’ involvement in the so-called “carry trade.” The loan will help stem Iceland’s liquidity problems, but more significantly, it will give Russia the opportunity to challenge the West in an extremely strategic venue. Analysis Related Link     * Geopolitical Diary: The Credit Crunch’s Effects Outside the United States Reeling from the global credit crunch, the government of Iceland has nationalized two of its biggest banks and has attempted to peg its currency to stop it from entering a free fall. The island nation’s dire economic situation has spurred the Icelandic government to make a formal request Oct. 7 for a $5.43 billion loan from Russia. Icelandic Prime Minister Geir Haarde said Reykjavik has turned to its “new friend” because its more traditional allies have refused to help. Iceland’s status as a banking destination is a recent phenomenon. More famous for its geothermal energy, woolen sweaters and fishing fleet, the North Atlantic nation became something of a banking powerhouse when its banks, which were privatized in the mid-1990s, began looking for investment opportunities abroad. By 2003, Icelandic banks had overgrown the limited domestic lending market — the country’s population is a paltry 320,000 — and launched headfirst into the business of foreign banking. Iceland’s banks then began looking for money to expand beyond their meager domestic capital supply and into new lucrative opportunities. The fundamental problem of Iceland’s capital supply led the banks to use the “carry trade” to supplement their capital pool, which initially only relied on the country’s sizable, but ultimately limited, pension fund. The carry trade involves investors taking out yen-denominated (or sometimes Swiss franc-denominated) loans at the very low interest rates set by the Japanese and Swiss central banks, and then investing the money where interest rates are high and profit margins are considerable. Iceland’s bankers therefore acted as middlemen for the booming real estate market in Europe (mainly in the United Kingdom), relying on cheap yen and francs to cover the speculative bubble abroad. While the carry trade has its advantages, in times of global crisis investors look to cash in the loans and turn to repaying the original yen/franc loans while they are still cheap. This negates the advantage of cheap yen/francs, because as hordes of investors began to turn in their yen/franc loans, those currencies begin to rise — and thus, Icelandic banks that just a short while ago were profiting as middlemen from interest rate differentials now hold huge loans they do not have the assets to cover. Iceland does not have the option of just cutting its losses and letting its banks collapse. The sudden retreat of the carry trade is decimating available capital in Iceland’s domestic market, as well as causing a run on its currency, the krona. Cheap credit brought by the carry trade flooded the tiny market with money gobbled up by real estate and consumer spending. As Icelandic consumer activity slows down, the construction industry and retail have fallen off dramatically. Furthermore, as the carry trade reverses, investors have begun to dump krona to buy yen to repay the original yen-denominated loans, causing a dramatic fall in the krona that was exacerbated by speculative attacks. This is sparking a huge increase in inflation, causing import-dependent Iceland to suffer from higher costs on everything from food to oil. Enter the Russians. While Russia is certainly dealing with an economic crisis of its own, it — along with China and the Middle East oil states — remains one of the few countries in the world that currently possesses cash reserves it can throw around for geopolitical purposes. Its $750 billion reserve fund, dented in recent weeks as the government tries to prop up its own stock market, is still sizable. The $5.43 billion Russian loan will not save Iceland from collapse, but it will certainly stanch some of Iceland’s most immediate liquidity problems. In return, the Kremlin hopes its loan — perhaps only one of many the collapsing Iceland might have to request — will give it increased influence in what is probably the most geographically strategic country in Northern Europe. Iceland straddles the key Greenland-Iceland-United Kingdom (GIUK) gap, likely the most strategic thoroughfare of the Cold War and of the North Atlantic in general. Soviet (and now Russian) nuclear submarines departing Murmansk on the Kola Peninsula to threaten Europe or United States would have to pass through the GIUK gap. The U.S. presence in Iceland was therefore considerable during the Cold War. The United States maintained a Naval Air Station in Keflavik as well as an extensive anti-submarine hydrophone sensor system, called the Sound Surveillance System, lining the seabed in the area. With the end of the Cold War and changes in the U.S. military’s priorities, the GIUK gap was abandoned, and the Keflavik base closed in September 2006. In light of Russia’s resurgence after its August intervention in Georgia, the game plan has changed. The Kremlin is now actively trying to challenge U.S. presence worldwide, and Iceland’s combination of geographical value and current economic collapse offers a great opportunity to gain favors from Reykjavik and irk the Americans. At the very least, the United States will regret ever having abandoned Keflavik. Ultimately, the United States and NATO are firmly entrenched in Iceland. If push came to shove, it would not be difficult for the two powers to re-establish their presence there. Iceland is the only NATO member state without a military, and therefore it is clearly vulnerable to renewed conflict between Russia and the West. That said, the global financial crisis is giving Russia — flush with energy profits reaped over the last few years — a serious opportunity to challenge U.S. interests in yet another key geographical location, while Washington is preoccupied with economic problems of its own.