Iceland’s crisis-management policies are creating the island’s next property bubble less than four years after its banking meltdown threw the economy into its worst recession.

Prices for new homes touched a record last quarter, having surged 40.1 percent since the final three months of 2010, according to estimates by the National Registry of Iceland in Reykjavik. Average house prices have risen 11.3 percent since the market bottomed at the end of 2009, according to central bank data at the end of the first quarter.

Currency controls imposed in 2008 and designed to protect the island of 320,000 from a mass capital exodus are now channeling funds into a market that is showing symptoms of overheating and driving home-loan debt higher. Close to $8 billion in kronur are held by offshore investors unable to get their money out of the country, according to Arion Bank hf economist Thorbjorn Sveinsson. As the government signals restrictions will remain until at least 2015, funds are flowing into one of the few longer-term investment options: real estate.

“If the development continues without interference, this will lead to a property bubble within the next two years,” Asgeir Jonsson, an economist at Reykjavik-based asset manager Gamma, said in an interview. “There’s a greater risk of an asset bubble being created in an economy that is closed off behind capital controls.”

Outgrowing Europe

Iceland, whose 2008 banking default on $85 billion pushed the economy into a recession that lasted through the first half of 2010, is now outgrowing Europe and the U.S. Its gross domestic product will expand 3 percent this year and 3.9 percent in 2013, according to Arion. The economy of the 17 countries sharing the euro will contract 0.3 percent in 2012 before growing 1 percent in 2013, the European Commission said on May 11.

Much of Iceland’s recovery has rested with its “unorthodox” crisis management, according to Fitch Ratings, which restored the island’s investment grade credit status in February.

Iceland’s rebound is now being driven by household spending, a team of Arion economists led by Sveinsson said in a May 21 note. The central bank has raised borrowing costs four times since August, bringing the benchmark lending rate to 5.5 percent. The bank signaled this month more tightening is needed to cool the economy as inflation hovers well above its 2.5 percent target. Consumer prices grew an annual 6.4 percent in April, Statistics Iceland said April 27.

Inflation Accelerates

Faster inflation is adding to risks in the housing market as most mortgages are linked to the consumer price index, meaning debt burdens swell as inflation accelerates. Household debt grew to 270 percent of disposable incomes in 2010, according to the latest figures available from the central bank. That compares with 217 percent a year before the banks collapsed and about 50 percent in the 1980s, according to the bank.

The island’s 1 trillion-krona ($7.6 billion) mortgage-bond market is twice the size of its government debt, according to estimates by Gamma. Bonds sold by Iceland’s Housing Financing Fund make up 68 percent of the nation’s “liquid government guaranteed debt market,” Gamma economist Valdimar Armann said by phone. The yield on the benchmark 2044 HFF bond has slumped about 80 basis points to 2.4 percent since the end of last year.

Many foreign investors bypass the mortgage bond market and buy properties directly, Jonsson at Gamma said.

“Last year, investors finally realized that the capital controls aren’t going anywhere any time soon,” Jonsson said. “That has led to a change in investors perspective, and they’re now moving in greater numbers into longer assets and snapping up properties.”

Apartment Costs

An average apartment cost about 28 million kronur in May, the National Registry of Iceland estimates. That compares with 12.4 million kronur in 2001. The average Icelandic household earned about 4.4 million kronur in 2011, according to Statistics Iceland.

“The exorbitant prices in the housing market, so early after the collapse of the Icelandic economy, are quite shocking,” said Finnur Eiriksson, a computer scientist living in Reykjavik. “I’ve decided to stay in the rental market for some time to come. For anyone that has been shopping around, the drop in property prices after 2008 hasn’t been significant enough.”

Iceland stunned the world with the scale of its 2008 banking meltdown, which sent the krona tumbling as much as 80 percent against the euro offshore in 2008.

Its rapid resurrection subsequently won accolades from economists including Nobel Laureate Paul Krugman, who praised an approach he termed “bankrupting yourself to recovery,” in an opinion piece published in the New York Times in November 2010.

React to Bubble

Now, “the million-dollar question is whether the authorities should do something to react to the bubble,” Olafur Isleifsson, an economics professor at Reykjavik University, said in an interview. “For some time now it’s been expected that the 1 trillion kronur that’s locked in the market behind capital controls would eventually find its way into the property market.”

Credit-default swaps protecting against losses on Icelandic debt touched a four-month high this month, as investors signal they’re growing wary of the risks lurking in the economy.

The cost to protect $10 million of the debt from losses for five years rose to $293,980 annually, as of May 28, from $199,570 last June, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

The difference in default swap rates between Iceland and Germany widened to more than 210 basis points last week, the widest spread in a month.

Curb Lending

The response from policy makers to the risk of a bubble is likely to be to require banks to curb lending, according to Jonsson at Gamma. That approach would still hurt homeowners, he said.

“They could do that by forcing the banks to demand higher equity from individual buyers, which would cool down the market,” he said. “At the same time, the private individuals would be the ones that would suffer.”