LONDON - As the world suffers a hangover from financial excesses of recent years, the tiny island nation of Iceland has a bigger headache than most.
The Nordic country was until recently lauded for its rapid generation of wealth despite its small stature on the world stage, with deregulation of the domestic financial market in the 1990s fueling a stock market boom that underpinned an acquisition spree across Europe by Icelandic banks and companies.
But that very success could become its downfall. The nation's banking sector has dwarfed the rest of the economy with assets at nine times annual gross domestic product ($19 billion), leaving Iceland heavily exposed to the global credit squeeze.
A decision by the government this week to take over the country's third-largest bank prompted all the major credit ratings agencies to downgrade both Iceland's four major banks and its sovereign, or government, credit rating.
Iceland's krona tumbled 22 percent against the U.S. dollar this week, spurred partly by speculation that the central bank, which has just $5.5 billion in liquid foreign assets, will struggle to bail out any more failing commercial banks after its rescue of Glitnir -- the big four banks have combined foreign liabilities in excess of $137 billion.
"Iceland is a standout case," said Venla Sipila, a senior economist at Global Insight in London, which also downgraded the country's sovereign rating this week. "The situation looks really volatile because it is so dependent on external developments now."
With a population of just 320,000 people, the remote island nation between Europe and Canada has punched far above its weight in recent years, shifting from a mainstay fishing industry to an international investment force.
The Iceland Stock Exchange, or ICEX, was Europe's top-performing exchange in 1994, leaving Icelandic companies with a large liquidity pool. Kaupthing, Iceland's biggest bank, has doubled in size every year since 1996 with purchases including the $1.3 billion takeover of Denmark's FIH bank in 2004.
But the qualities that funded Iceland's expansion in recent years, essentially making it one big Viking hedge fund, are suddenly not as sought after in the current economic climate. Part of problem is that Iceland's tiny size has led to a high level of cross ownership of assets between banks and companies, which creates a house of cards scenario.
Iceland's Prime Minister Geir Haarde has said that the Glitnir bailout is not the end of the banking crisis in Iceland, but he has so far shunned suggestions that Iceland join the euro currency, a step that analysts say could add protection.
In the longer term, Iceland is putting a lot of faith in its growing hydropower and geothermal energy industries to carry it through the credit squeeze and back to growth.
But with a current account deficit out of control, inflation running at more than 12 percent and interest rates at a record 15.5 percent, it has first to ride out a rocky patch.