Sigrún Davíðsdóttir's Icelog

Panic politics: the biggest risk in Iceland

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In its Financial Stability reports and other reports the Central Bank of Iceland, CBI, has increasingly been stressing that conditions in Iceland and internationally for lifting controls are optimal. The same is reiterated in the latest status report by the minister of finance on progress in lifting the capital controls. However, if the status report is read closely it digresses intriguingly from what the CBI has been stressing. That poses the question whether the government is really on its way towards easing controls or only obfuscating the matter. This brings the focus to a statement increasingly heard in terms of Iceland and risk: “The main risk in Iceland is political risk”

“Premises for abolishing capital controls could hardly be better than those now in Iceland…,” minister of finance Bjarni Benediktsson said yesterday at the CBI annual meeting. “Consequently, my hopes are that major decisions will be made now in the first half of this year, pointing the way forward. The year of 2015 will be a year of action and solutions in this matter (capital controls).”

In his speech at the CBI annual meeting governor Már Guðmundsson also stressed an imminent action, stressing the unavoidable damages invariably caused by capital controls in the long run.

However, an action must be based on political synergy within the government. As I have often stressed the statements of minister of finance Bjarni Benediktsson and prime minister Sigmundur Davíð Gunnlaugsson on capital controls consistently point in different directions. Benediktsson has stressed the importance of a solution that minimises legal risk, takes as short time as possible and of course does not undermine financial stability. In addition to safeguarding financial stability, Gunnlaugsson has been focused on what Iceland could get out of the estates, recently by arguing for fairness.

In the latest status report by the minister of finance on progress in lifting the capital controls, presented on 18 March, the problem Iceland faces is defined as a balance of payments, BoP, problem. Quite rightly not a word about Icelandic debt burden; debt is not the Icelandic problem. However – and quite interestingly – the report defines this problem differently from the CBI definition. This difference has, to my mind, wide ranging consequences when it comes to understanding what the government really is doing – or not doing – to solve the capital controls.

The Icelandic business community has for a while been complaining loudly about the controls. Once upon a time every word this community uttered was law for the Independence party – but not any longer as seen so clearly from the debate on the European Union, EU and the (failed!) action to break off negotiations. This schism between the business community and the Independence party goes hand in hand with the fact that the party seems to have, possibly irretrievably, lost voters: earlier polling 35-40% it now hovers around 25%, its new normal.

I might well be reading too much into the situation but based on observations of the political realities in Iceland, i.a. the lack of political determination within the government not only regarding capital controls but in general, I very much wonder what the next two years will bring for Iceland in general and capital controls in particular.

A closer reading of the capital controls report

I have already gone through the status report here on Icelog, writing about politics in times of crashing popularity, the government’s popularity that is. There are some statements in the report, which I think give an inaccurate and misleading picture of the BoP problem. As I concluded earlier, the report seems to magnify the problems to be solved re capital controls and minimise what the government can to stabilise the situation, mostly the importance of securing trust.

If the government sincerely wants to minimise the risk of lifting the controls a plan that inspires trust is of vital importance. If that is not done – or worse, if action taken inspire fear and not trust – the outcome will inevitably be disastrous… for Iceland.

But there is one aspect of the report, which I had not paid close enough attention to until I reread it: the definition of the BoP problem. According to the report, the problem consists of three parts: “the offshore ISK problem, difficulties arising from distributions by financial undertakings in winding-up proceedings and potential capital outflows from other parties, including residents.” – Compared to customary definitions this is a somewhat non-standard definition, apparently a home-made one.

In the CBI Financial Stability report I 2014 governor Már Guðmundsson defines the Icelandic balance of payments problem: “…the problem falls broadly into three categories. First of all, the debt service burden on foreign debt is heavy, both this year and in the four years following, and exceeds the foreseeable current account surplus. Second, domestic entities other than the sovereign and the Central Bank still have only limited access to foreign credit markets on affordable terms. Third, the settlement of the failed banks’ estates could add substantially to the stock of volatile króna assets held by non-residents locked in by the capital controls. These króna assets could rise as high as nearly half of GDP if the failed banks’ ISK assets are collected in full and paid to creditors. Iceland has no excess foreign exchange revenues with which to unwind such positions, however.“

As can be easily seen from the above, there is only one source of the BoP problem in common, as defined in the status report and the CBI report: the CBI groups together ISK assets in the estates and the old offshore ISK overhang, the status report keeps it in two separate categories. The status report ignores the debt service burden but has “capital outflows from other parties, including residents.”

How to avoid solving a problem: define so it cannot be solved

Earlier, I had pointed out that the status report seemed somewhat too pessimistic in terms of outflows – trust will matter a great deal when it comes to lifting capital controls. If there is no trust in the plan on lifting or easing controls it will be a catastrophe, as indeed Guðmundsson reiterated in his speech at the CBI annual meeting.

Included in the status report’s definition of offshore ISK is also this:

Investment by non-residents in ISK-denominated domestic securities has increased greatly in recent years in tandem with their participation in the Investment Programme of the Central Bank. Total investment through the Investment Programme from the time it commenced at the beginning of 2012 now amounts to ISK 206 billion, of which ISK 97 billion is invested in bonds and ISK 82 billion in equities. Of this amount, non-resident investors own ISK 134 billion. At the beginning of 2017 the encumbrances on the first investments under the Investment Programme expire; however, these investments did not include an exit ticket. Non-residents have furthermore invested in Treasury securities through the Central Bank’s foreign currency auctions; their outstanding holdings in two inflation-indexed bond series currently amount to around ISK 9 billion. In addition to this, non- residents hold various other domestic assets which can be regarded as liquid or volatile. The conceivable outflow in connection with these assets, however, is subject to high uncertainty.

Adding these investments widens the offshore ISK definition considerably – and consequently the size of the problem. Claiming that all foreign investments in Iceland are volatile is rather stretching it – hardly any country could pay out in one go all foreign investment.

If this is the definition of the offshore ISK problem that the ministry of finance is trying to find a solution to it is not likely that a solution will be found any time soon, a version of the drunken Scot problem. Yes, defining a problem in such a way that it cannot be solved is one way of avoiding to tackle it.

Interestingly, in his speech at the bank’s annual meeting governor Guðmundsson indeed repeated the status report definition, saying the most common BoP definition was looking at funds, which might flow out as soon as controls were lifted. These funds are, he said, in the estates, the offshore ISK and then, contrary to the bank’s earlier definition, potential outflows owned by domestic entities. Problems related to the estates are well documented, he said; secondly, offshore ISK was partly non-volatile though that had to be ascertained and dealt with first, akk perfectly doable, according to Guðmundsson.

The greatest uncertainty is connected to possible outflows connected to domestic entities… Here the most important aspect is trust in Iceland and its financial system at that time, difficult to estimate right now. This will at the same time also impact on possible inflow from foreign entities,” Guðmundsson said.

The governor did not mention it but here it would be important to keep in mind that for the time being interest rates abroad are low, asset prices high – not necessarily an enticing environment for Icelandic entities.

Differently defined problems – but one-size solution

As pointed out earlier the status report concludes with two classic ways of solving BoP problems like the one Iceland now faces: “(i) imposing a haircut on domestic assets when they are converted to foreign currency, or (ii) ensuring that volatile assets are transferred to long- term assets, i.e. extending the term of liabilities. The terms and conditions of such converted assets and liabilities must ensure that they cannot be accelerated or revert to their former status. If this is done, short-term owners of such instruments can be expected to accept a discount (haircut) upon their sale while longer-term investors will profit on them in the longer term.”

These solutions are tailored to the classic BoP problem the CBI has described it earlier: a haircut on ISK assets converted to foreign currency – and binding the volatile assets, as the CBI has already started doing (taken half a step, with the missing half said to be imminent).

However, these two ways do nothing to solve the very elusive problem of “capital outflows from other parties, including residents.” The foreign-owned ISK and the old overhang are a tangible size, which as Guðmundsson said the CBI has worked on and where the methods above are a classic tool to diminish the overhang.

The capital outflows are a potentially large chunk, where haircut and extension does not help. The government is hardly keen on draining pension funds of money, “hair-cutting” debt payment etc. In other words, this problem of outflows has no clear and classic solution. Yes, the oft mentioned exit tax could be used on domestic outflows but at a cost to domestic entities and without targeting the real problem, the foreign-owned ISK.

Who wrote the status report?

The short answer is: I don’t know. As far as I know, CBI staff has mostly written earlier status reports. But on close reading it is difficult to believe that this latest status report is written there. It simply does not fit with what the bank has published earlier. But funnily enough, the conclusion with the two paths as a solution does not fit the problem as spelled out in the status report.

My hunch is that the Ministry of Finance probably got a draft from the CBI but someone else, most likely someone from the advisory committee on capital controls (though hardly Glenn Kim) then finished it, concluding with classic solutions to a BoP but not as defined in the report.

A nerdy quibble over definitions and so what?

It may very well be that I am over-extrapolating on spurious evidence. However, if the forces at large around the status report are leading the process towards lifting the capital controls I cannot see that this process will ever get near to easing or lifting the controls simply because of the lack of clarity. If the status report signifies the thinking of the advisory group it does not bode well for the process.

In addition, the process so far – changes among the advisers, conflicting statements by the government leaders, imprecise messages from the prime minister, broken promises on timing, the difficulty in acting on the Landsbanki bonds agreement, the rather remarkable side process regarding the CBI itself, re-hiring the governor and now planned CBI organisational changes – does not bode well either.

Undoubtedly, lot of ground has been covered within the CBI and in the advisory committee. The work within the CBI is clearly geared towards solving the BoP problem. And undoubtedly the minister of finance and the governor are both keen to work towards easing and lifting the controls. The question is if they will be allowed to work towards solving the BoP problem according to the classic CBI definition or if the goal is the much more elusive problem of finding funds to stem domestic and foreign outflows.

Political unpopularity and panic politics

What are the main risks in a country where the economy is going reasonably well? In terms of Iceland it is clearly the political risk.

Talk about the absent prime minister is constant in Iceland. Quite remarkably he did not show up at the CBI annual meeting – no one can remember that a prime minister has ever ignored the meeting. This week an opposition MP, Helgi Hjörvar (social democrat), pointed out that in the last six months the prime minister has answered only one written question in Parliament. Time and again the prime minister is absent and invisible, keeping the rumour mill running. Erratic behaviour and rather odd remarks is another aspect of the prime minister’s character much discussed privately but rarely on the media.

Alleged break down in communication between the two government leaders is a widely heard explanation of the government’s lack of action in various matters. Although the two have, of course, strenuously denied this it does not quell the rumours; this lack of communication is now taken for a fact among political observers in Iceland.

Looking at the erratic course of the government, shortsightedness, the lack of professionalism (because the civil service is side-lined in important issues) it is clear that the greatest risk in Iceland is political risk.

The government’s astounding unpopularity only seems to add to that risk. Will the prime minister, desperate to prove himself, make use of unconventional measures following his belief that foreign creditors are unjustly and unfairly making huge gains out of ordinary Icelanders? Will he work on wrenching the ownership of Íslandsbanki and Arion Bank, widely thought to be of great interest to him, from the estates? In all of this he apparently has unwavering backing from the darkest corners of the Independence party, visible in the writings of Morgunblaðið, which repeatedly opposes Benediktsson overtly or covertly.

By constantly promising action last year Benediktsson was no doubt trying to put pressure on his coalition partner but his tactic failed. Instead he made creditors feel he was unable to fulfil his intension. But as one observer pointed out Benediktsson has at least withstood all pressure of acting according to the prime minister’s sentiments. Many feel that compared to earlier Benediktsson is strengthened, both from this process and other things. I still feel unable to draw that conclusion, would like to see more tangible evidence.

The question for the coming months is if this government will have the courage to lift capital controls – and, if not in the short run then if indeed this government will ever have the courage. And if it does act regarding the capital controls will it be according Benediktsson’s outlines or will he be pushed to follow panic politics of a political leader who has lost popularity in record time. – It is not difficult to analyse the situation but, as always, forecasting action is infinitely trickier.

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Written by Sigrún Davídsdóttir

March 27th, 2015 at 3:41 pm

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Politics in times of crashing popularity

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The Minister of Finance Bjarni Benediktsson has just released his twice-a-year report on progress in removing capital controls. The tone is as if prime minister Sigmundur Davíð Gunnlaugsson did not exist. Another event, distantly related to the capital controls, is a draft Bill by two academics on the future organisation of the Central Bank of Iceland, CBI. The draft is hardly bringing out the champagne bottles since the academics propose that governor Már Guðmundsson, whom the government has been trying to remove ever since it came to power, should remain in office but with diminished power and two deputies. The backdrop to these events if the drastic fall in the government’s popularity, this time hitting the Independence party, buoying the Pirates.

Last year, the government held the CBI in uncertainty for half a year while trying – and then failing – to substitute Már Guðmundsson as the bank’s governor. At the end of that ungraceful saga (see earlier Icelog) he was reappointed but given to understand that the bank’s organisation model would be revised, even before the end of 2014, which might mean his days in office were numbered.

So far nothing has happened until recently that the two academic asked to revise the CBI Act, handed in their proposal. It is safe to conclude that it will not create much happiness, neither in the Ministry of Finance nor in the Prime Minister’s office.

This last week also saw the minister of finance present his spring report on the capital controls. Apart from general remarks on how to lift the controls in an environment suffering from balance of payment problems it is more worrying that the report seems to include some misleading or even factually wrong statements. I am not aware of this happening before, which leads me to believe that there was less input in the report from the CBI, compared to earlier, and more input from those working on lifting the controls. Again, not a good sign.

If the government is going to make a move in either of these two cases, it has to make up its mind soon because the deadline for new Parliamentary proposals, new law or amendments is the end of this week as Alþingi goes on summer recess at the end of May. There is however a legal provision for presenting Bills later requiring an agreement with the opposition. The latest opinion polls also raise the question if the government’s diminishing popularity will push the government to come up with some measures to win voters over. Another test is the fact that strikes and labour market unrest is foreseeable, most agreements will run out now in spring; particularly dark forebodings in these matters.

A sluggish reaction to CBI proposals

The two academics, Friðrik Már Baldursson professor at the University of Reykjavík and Þráinn Eggertsson from the University of Iceland, sent in their proposals on 6 March. Not until 20 March, following news based on the leaked proposals, did the Ministry of Finance publish the proposals. The academics have as yet only filled part of their remit, there is more to come but these proposals cover the most sensitive part, i.e. how to change the organisational structure of the bank. Benediktsson now has to make up his mind as to what changes he intends to make.

The proposals underline that the power given to the governor of the CBI far exceeds power wielded by central bank governors in the neighbouring countries. The two academics propose a board of three governors similar to the structure at the Bank of England where there is one governor and two deputy governors, each heading a special field within the bank.

In addition, the academics propose that Guðmundsson remains in office. If, follwong the ungraceful process last year, the government was planning to remove the present governor from office on the basis of these proposals they certainly do not provide the government with the ammunition for such action.

In Iceland, it is widely thought that the two party leaders want to revert back to the bad old days of continuous political pressure on the CBI with politically appointed governors. The sentiment in the air is that in addition to a governor with the proper professional qualification the government would like to see two more governor by his side, one anointed by the Independence party, the other by the Progressive party.

If the two government leaders find some solution here remains to be seen, also if Guðmundsson will be part of the solution or not. If things move as they mostly have done under this government, i.e. slowly, indecisively and inconclusively, not much will happen re the CBI any time soon. In addition, blatant political interference is much harder in the present day and age than some decades ago. The International Monetary Fund, IMF, has used every report on Iceland since the crisis to emphasis the importance of an independent central Bank.

Capital controls: two possible solutions

The new report by Benediktsson on the capital controls concludes that there are indeed only two possible options in dealing with balance of payment problems akin to those Iceland is now faced with: either by “(i) imposing a haircut on domestic assets when they are converted to foreign currency, or (ii) ensuring that volatile assets are transferred to long- term assets, i.e. extending the term of liabilities. The terms and conditions of such converted assets and liabilities must ensure that they cannot be accelerated or revert to their former status. If this is done, short-term owners of such instruments can be expected to accept a discount (haircut) upon their sale while longer-term investors will profit on them in the longer term.

This is quite correctly a description of classis solutions in countries with similar problems Iceland is dealing with. But this description seems completely unrelated to the political situation in Iceland where politicians, with the exception of Benediktsson, have lately been falling over themselves in outdoing each other in exit tax on the estates in their entirety, ISK assets as well as foreign assets.

The prime minister has earlier talked about the inevitability of the state accruing funds from the estates and “vulture funds” gaining distastefully on Iceland. Lately he has presented it as a principle of fairness that the estate leave funds to the state for the harm the banks caused Iceland.

There is nothing of this tone in the report.

There are however statements in the report, which are either inaccurate or misleading.

The report states: “The estates’ largest ISK assets are holdings in the new banks, in addition to which they own considerable amounts of cash. Distributions by these domestic undertakings to resident creditors will not affect the balance of payments, but distributions to foreign creditors will impact the balance of payments when the distributed assets exit Iceland.” – The fact is that if domestic creditors repatriate their foreign currency distribution this has a positive impact on the balance of payment whereas the impact is negative if foreign creditors move their ISK assets abroad. This will hardly be categoric: not all FX owned by domestic creditors will be left abroad and not all foreign-owned ISK will leave.

Re “possible outflows by domestic parties” the report points out that it is difficult to assess what these outflows could amount to. It quotes the latest IMF report, which guesses that this could be as much as 25% of GDP or ca. ISK500bn; however, IMF underlines that this development very much depends on stability and trust in Iceland, as well as the currency rate. – What this analysis in the new report lacks is to underline how Icelandic action or non-action influences these eventualities.

The same counts for the effect of trust on foreign investment in Iceland. Foreign investment will not leave a trustworthy environment. No country is in the position to pay out all foreign investment at any given time. To set that as a benchmark makes little sense.

The report points out that Iceland faces balance of payment problem, consisting of three part: “the offshore ISK problem, difficulties arising from distributions by financial undertakings in winding-up proceedings and potential capital outflows from other parties, including residents.”

However, this last part, potential outflows from other parties, including residents, differs from the balance of payment problem, as defined by the CBI. In the Financial Stability Report 1 last year the problem is said to consist of three parts: “First of all, the debt service burden on foreign debt… Second, domestic entities other than the sovereign and the Central Bank still have only limited access to foreign credit markets on affordable terms. Third, the settlement of the failed banks’ estates could add substantially to the stock of volatile króna assets held by non-residents locked in by the capital controls.”

For some reason, the new report magnifies the problem and minimises the effect of what the authorities can do to stabilise the situation by inspiring trust.

Political outlook: panic politics or power to the Pirates!

New poll caused a political earthquake last week: it showed the Pirate Party with a following of 29.1%, equivalent to 19 MPs. The party now has three MPs, got 5% in the last election. The Progressive party got 11.6%, the social democrats make a slight gain from previous poll, with 16.3% and Bright Future and Left Green with 9% each. The biggest loser is the Independence Party, falling from 28% in last poll to 23.4%. – This does not seem a freak outcome, the upswing for the Pirates, over 20%, was seen in an earlier poll from a different polling company.

To Rúv, prime minister Gunnlaugsson said that this outcome certainly was surprising but a sudden gain by one party had been happening frequently in the past years and decades. “This is perhaps first and foremost a message that people are now impatient to see the results of what the politicians are working on. However, these results are now starting to be visible however they are measured.”

This result is singularly bad for the two coalition parties. Part of the explanation is no doubt its action to break off accession negotiations with the EU, which cause great and general anger in Iceland where there is not majority for membership but strong majority for bringing the negotiations to an end. Also, the Pirates have been measured and professional in debates, ignoring special-interest groups. The rest of opposition has been fairly lame.

In addition to crashing popularity, the government now has gone through half its mandate period. It is clear that the debt relief, orchestrated by the Progressive party but brought to fruition by Minister of Finance Benediktsson has not helped. Nor has changing direction on the EU negotiations helped. The question is if this crash in popularity will cause the government to turn to panic politics, if it will possibly attempt some drastic measures to gain popularity.

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Written by Sigrún Davídsdóttir

March 23rd, 2015 at 9:45 am

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Landsbanki Luxembourg liquidator ignores French investigation

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As reported earlier on Icelog, the French investigative judge Renaud van Ruymbeke is conducting an investigation of Landsbanki Luxembourg activities in France regarding the bank’s equity release loans. With the investigation ongoing it was assumed that the bank’s liquidator Yvette Hamilius would suspend recovering assets by sending bailiffs to the bank’s customers in France.

This however has not been the case as the Luxembourg Paperjam reports (yet again by Véronique Pujoul who has followed this case diligently) and Icelog has heard. Lawyers for the clients are now asking if this could be seen as both harassment from the administrator and also constitute a contempt of the French Courts with an ongoing investigation where charges have been brought.

Icelog has earlier reported extensively on this saddest part of the Icelandic banking collapse saga. What is truly shocking is the utter and complete disregard Luxembourg authorities have shown the clients who have at length described their dealings with the bank and administrator, i.a. conflicting messages from the administrator on outstanding debt. Part of the scheme were investments, which the clients have questioned as they got more understanding of them as well as being kept in the dark about the administrator’s handling of the investments.

Instead, the Luxembourg state prosecutor has, without any investigation, placed himself firmly on the side of the administrator by claiming that the clients were only trying to evade paying back their loans. This behavior by a public prosecutor in a European country is utterly inconceivable.

Although investigations into the banks are ongoing in Iceland, with serious charges and severe prison sentences, Luxembourg has done nothing to investigate the Icelandic operations in Luxembourg, i.a. that of Landsbanki. Yet, the Icelandic investigations show that in many of the worst cases, such as in the so-called the al Thani case, the schemes were partly planned and carried out in the Icelandic banks in Luxembourg. In many cases, the alleged and proven criminal wrongdoings by the Icelandic banks could not have been done without their Luxembourg operations. Yet, Luxembourg ignores the banking problems in its own front yard.



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Written by Sigrún Davídsdóttir

March 20th, 2015 at 12:52 pm

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Iceland is no longer accession country – protests tonight

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“… the Icelandic Government wishes to clarify further its intentions. The Government of Iceland has no intentions to resume accession talks. Furthermore, any commitments made by the previous Government in the accession talks are superseded by the present policy.

This is part of a letter, which the minister for foreign affairs Gunnar Bragi Sveinsson handed over today as he met with Edgars Rinkevics, who currently holds the Presidency of the European Union. According to the letter the Government of Iceland decided at its meeting last Tuesday that Iceland is no longer is a candidate country to EU membership and asks the EU to act accordingly. However, Sveinsson emphasized the importance of relations and cooperation between Iceland and the EU and Iceland’s commitment to the EEA Agreement.

Tonight, there will be protests by Alþing, the Parliament, to be continued over the weekend. Opposition MPs claim that even with its strong majority the Government did not dare to pass this through Alþing. One MP, Birgitta Jónsdóttir from the Pirate Party, says this will be the beginning of the end for the Government. Regardless of what opinion people hold on the EU the fact that the Government took this decision without conferring with Alþing shows that this Government is ready to bypass the parliamentary process.

Árni Páll Árnason, leader of the social democrats, pro-EU party, says this decision, taken without any consultation and behind closed doors shows the Government’s insecurity and fear of the people. By choosing this method the Government is trying to bypass democratic rules. In spite of the letter Alþingi’s mandate to negotiate accession still stands. “This only shows that the Government does not have a grip on its task.”

The Government tried last winter to end the EU negotiations but incurred great protests, which put an end to its effort. Opinion polls show that although there is not majority for Icelandic EU membership clear majority of Icelanders want the negotiations to be brought to an end, followed by a membership referendum.


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Written by Sigrún Davídsdóttir

March 12th, 2015 at 7:42 pm

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Iceland, capital controls and the drunken Scot problem

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Friday 6 March Central Bank of Iceland changed rules for offshore króna investment in order to prepare for lifting capital controls. Restricting the investment possibilities might seem only to increase the króna pressure, not lessen it but this step is a first step or half a step: further measure for binding these funds or attracting them with good offers will follow. This is a step in the right direction – but only if other measures follow. And so far, there is nothing to indicate that there is any rapprochement in diverging views on how to solve the ISK problems of the estates of the old banks. The problem is that the government seems to be looking for a solution that does not exist – and this is very time-consuming as the Scot looking for a penny where he had not lost it found out

Foreign-owned króna, or offshore króna, was the original problem, which on November 28 2008 called for capital controls. At the time, this overhang amounted to 44% of GDP but has since dwindled down to 15%. The rules regarding investment of offshore ISK have now been changed.

The new amendments to the CBI exemption lists and to the Rules on Foreign Exchange and the Foreign Exchange Act mean that there are now only two option for the offshore ISK to invest in: Treasury bills and one Treasury Bond, RIKB 15 0408. As before, interests earned can still be taken out of the country.

Restrictions might seem counter-productive – but this move is the first one: other investment offers will follow. To Reuters CBI governor Már Guðmundsson said the aim is to reduce the overhang and to induce investors to stay in Iceland when further steps towards liberalisation will be taken. “… it would be very imprudent if we were just to assume that these 15 percent were stable… We will shortly be offering investors alternatives … and these alternatives are such that they will greatly reduce the likelihood of instability when controls are lifted.” Guðmundsson said that further measured will be announced in a “few weeks or very few months.” Minister of finance Bjarni Benediktsson said to Rúv that the work is aimed to finish within the first half of this year.

There have lately been changes in the government’s advisers: now Eiríkur Svavarsson has left. The rumour is that Glenn Kim has not been seen much in Iceland lately. And as before: no official announcement of any changes, neither of Svavarsson leaving or the new member, Ásgeir Helgi Reykfjörð Gylfason, who recently joined the government’s group of advisers.

The focus of these measures is only offshore ISK. Still unsolved are the foreign-owned ISK assets in the estate of the failed bank, admittedly the politically most difficult nut to crack. It seems that instead of using tried and tested measures from other countries with capital controls the government is trying to find a solution that does not exist. Meanwhile, Iceland is trapped in capital controls.

CBI’s new measures – in detail

Those holding RIKB 16 etc are not being forced to give up their holding – but for reinvestment there is nothing on offer except about-to-expire maturity and Treasury bills. The crude choice for the offshore ISK owners is either to use deposits accounts to keep their funds or accept the new double offer of Treasury bills or RIKB 15 0408, which is maturing 8 April. Amongst those who follow things in Iceland the feeling is that the imminent maturity was a significant reason for acting now considering the fact that maturity of a big issuance is in sight.

At the end of January foreign-owned RIKB 15 amounted to ISK18.7bn (might have changed in February since RIKB 15 could be swapped for RIKB 17; now no longer possible). The RIKB 16, maturing 13 October 2016 is a much larger issuance where foreigners owned ISK57.9bn.

The effect of the changes is that offshore ISK holders cannot swap to longer maturity. Longer maturity gives less impetus to leave, creating possible hold-outs and unforeseen behaviour, from the point of view of the CBI. Consequently, whatever the possible offer will be the hold-out problem is less, or so the thought goes. When this future offer comes, whatever it will be, the offshore ISK holders are more likely to participate.

The critical issuance might be the RIKB 19, where the foreign holding is ISK42.9bn – those holding longer maturity are unlikely to make a move since hopefully/most likely the controls will have been lifted by then. Those with shorter maturity might give it a thought to swap into what is now on offer. Those with RIKB 19 are in the tricky situation of having to gauge the likely scenario.

After the RIKB 15 0408 matures now in April offshore ISK holders can only reinvest in Treasury bills. Interestingly, some years ago foreigners were the largest holders of T-bills but there is at present no foreign-owned holding there. This is bound to change. Treasury bills now amount to ISK22.1bn but is expected to rise to ISK30bn at the end of the year. Next Treasury bills’ issuance in on 18 March.

In an interview on Rúv minister of finance Bjarni Benediktsson said that the government was now well on its way to solve the offshore ISK problem and this could be seen as the first steps towards lifting the controls. “These are preparatory actions, which in a short while could result in the offshore ISK problem being behind us.”

Further, Benediktsson said that the investment options was being restricted but nothing was taken away from anyone. The idea is, according to Benediktsson, to eradicate uncertainty and prepare the ground for further action.

Next step: what and when?

There is of course no official answer to the questions above. However, since the guiding idea is to bind funds to hinder instability the offer clearly has to be long maturity bonds – there have long been rumours that the euro bonds might be offered. Remains to be seen.

Apart from what will be offered the question is when. Governor Guðmundsson vaguely talks about few weeks or few months. To Rúv minister of finance Bjarni Benediktsson said the new investment offers were being worked on. “We hope to conclude this part of the matter in the coming months. I would mention the first half of the year in this context. That is what all our work aims at but it would not be responsible to fix exact dates.”

Considering how tortuous the path towards lifting the controls has been so far, in spite of the optimism expressed by Benediktsson and prime minister Sigmundur Davíð Gunnlaugsson when they came to power, it is not advisable to hold one’s breath. However, if the government wants to maintain credibility and trust in these issues, home and abroad, it has to act resolutely and not too sluggishly.

In terms of securing the offshore ISK funds, hindering instability, the measures now are only half a step: these are the restrictions – the offer to go with it, the other half step, is still missing. Until that step has been taken the usefulness of this measure cannot be judged.

Steps so far

Interestingly, Benediktsson talked about the new measures as the “first steps” towards lifting the capital controls. It can be debated which measures have been towards lifting controls but there have definitely been other measures, which merit to be called “steps towards lifting the controls.”

The first plan to lift controls was published in the summer of 2009 in co-operation with the International Monetary Fund as Iceland was then in an IMF programme. The CBI published a new plan in March 2011. The CBI auctions, an important step intended to reduce the offshore IKS, ended now in February.

Another major step was the bonds agreement between Landsbankinn and the LBI, the estate of the old Landsbanki May 5 2014. Although the agreement had been long time in the making Benediktsson, who needed to grant the exemption from capital controls in order to complete the agreement, took until December 4 2014 to grant the exemptions needed. I have earlier pointed out that it seems to have been more the irritation of the UK government, notably (fearsome) Andrea Leadsom, which pushed Benediktsson to take that step rather than any political energy and initiative on the Icelandic side.

The political outlook

There have been certain discernible trends lately in the political debate on the capital controls. Prime minister Gunnlaugsson has lately neither talked about the exact sums, the ISK billions, he claims the state should gain from the estates nor has he talked about vulture funds, as he did earlier. His new reasoning is “fairness:” Iceland suffered from the collapse of the banks, i.e. the banks caused sufferings and now it would be only fair that the banks paid back to the state for the hardship caused.

Apart from this rather narrow retelling of the collapse saga – after all the SIC report gave a somewhat more nuanced picture of a wider failure of public institutions, politicians and banks – Gunnlaugsson has referred to practices abroad, that foreign banks have paid fines to make up for their misdeeds towards society. (In general, the prime minister has become well known in Iceland for his at time rather inaccurate grasp of facts and reality).

Gunnlaugsson has also recently said in an article in Fréttablaðið that the new banks are too big, they got too much assets on too favourable terms, again arguments for the state getting a cut of the estates (an echo of an earlier debate where an old industrialist, Víglundur Þorsteinsson has been making similar claims, see here). On the same day Gunnlaugsson’s article was published, four members of In Defence, the organisation formed to fight the Icesave agreement, wrote an article in Kjarninn.

The four asked if the state is really going to enable foreign investors to run off with the equivalent of a whole year GDP, partly the profit from resurrecting the economy, paid for with the great sacrifice of Icelanders and sky-high loans. Their suggestion is an exit tax of 60%, not the 40% they claim Benediktsson has mentioned (which he has not; on the contrary he has been unwilling to confirm exit tax and much less any percentage). Gunnlaugsson was at the time very close to In Defense, which has neither been seen nor heard for years until now. It is hardly a coincidence that the two articles appeared the same day.

Benediktsson has mentioned the cost to society of the banking collapse but he has never argued for great sums to be gained from the resolution of the estates. In a speech last October he made some general comments on the controls, the topic of an earlier Icelog: Benediktsson want to avoid risk of legal wrangling with creditors and prefers simple and straightforward solutions.

Eiríkur Svavarsson, who now has left the group of the government advisers, was a vocal part of the In Defence group and is said to be close to the prime minister. Svavarsson has not been replaced. There has been no official announcements of this change, nor has there been a formal announcement of the new member, Ásgeir Helgi Reykfjörð Gylfason.

The prime minister has recently expressed his opinion that not too much should be said about the lifting of the controls since that might feed valuable intelligence to creditors. Whether the names of advisers are part of this intelligence, which should be hidden from creditors, is not clear. It does however look strangely lackadaisical that there is so little stringency as to what is announced and what is not.

Lately, members of Parliament have complained about the secrecy regarding lifting the controls, claiming they are kept uninformed. The Ministry of Finance has now published the text of the contract all advisers have to sign, see the text here (in English) with relevant laws on insiders. Interestingly, there is now gardening leave stipulated at the end of the assignment.

Glenn Kim is still in charge of the group, at least in name; some observers close to the process claim he is increasingly distant and not much seen in Iceland lately.

Looking for a solution that cannot be found

In earlier Icelogs I have often referred to an alleged split between the two government leaders as to how to tackle the estates. The two have time and again denied these rumours but the rumours are still alive and kicking. There are also speculations in the Icelandic media that the underlying strive of the government is to be in the position of deciding to whom the banks are sold.

Both government leaders have talked about the need for a holistic solution. Exit tax on all cross border transactions has i.a. been mentioned. The problem here is that this tax would hit all cross border capital, also debt payment of Icelandic entities – and it will not reduce the core problem: the foreign-owned ISK assets in the estates. I have the feeling that this idea has been abandoned: it might in theory bring the much-desired funds to the state (which is actually doing rather well, thank you, and not much wanting, compared to many other European countries) but it is for many reasons unworkable.

As I pointed out to Reuters it seems that these conflicting views prevent the government from acting on capital controls. But it might me more than only conflicting views. After watching one group of advisers after the other working on capital controls I cannot avoid the feeling that the government is looking for a solution that does not exist. A solution that i.a. would bring funds to the state, make it possible for the government to decide who owns the banks and yet be simple and risk-free. Like the drunken Scot looking for his penny under the street lamp because the light is there, though he lost it elsewhere, the government has been using, or squandering time, on a solution nowhere to be found.

This is doubly regrettable because the problems Iceland faces are neither unique nor particularly hard to solve. That is if, instead of looking for a home-grown Icelandic solution, advisers would look for realistic solutions where the gain would be not billions to the state but the trophy of lifting the controls. Instead, while the search for the non-existing solution, Icelandic businesses are slowly being starved of oxygen as always happens in countries with long-time capital controls.

As far as I understand the two government leaders have not reached an understanding as to how to proceed. Their statements on the capital controls and the banks normally point in different directions. The closer to dealing with the estates the more difficult to iron out these divergences and the harder the political cohesion of the government will be tested. As the drunken Scot found out looking for a solution where it demonstrable is nowhere to found is never a promising approach.


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Written by Sigrún Davídsdóttir

March 11th, 2015 at 5:07 pm

Posted in Uncategorised

Cyprus and Iceland: a tale of two capital controls

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Both in Cyprus and Iceland foreign funds flowed into the islands, in the end forcing the government to make use of extreme measures when the tide turned. These measures are normally called ‘capital controls’ which in these two cases hides the fact that the measures used are fundamentally different in all but name. In Iceland, the controls contain the effect of lacking foreign currency, effectively a balance of payment problem – in Cyprus, the controls were a way of defending banks against bank run, i.e. preventing depositors to move funds freely.

It is a sobering thought that two European countries now have capital controls: Iceland and Cyprus; sobering for those who think that in modern times capital controls are only ever used by emerging markets and other immature economies. Cyprus has been a member of the European Union, EU, since 2004 and part of the Eurozone since 2008; since 1994 Iceland has been member of the European Economic Area, EEA, i.e. the inner market of the EU. – The two EEA countries were forced to use measures not much considered in Europe since the Bretton Woods agreement.

Although the concept “capital controls” is generally used for the restrictions in both countries the International Monetary Fund, IMF, is rightly more specific. It talks about “capital controls” in Iceland and “payment restrictions,” i.e. both domestic and external, in Cyprus.

Both countries enjoyed EEA’s four freedoms, i.e. freedom of goods, persons, services and capital. –Article 63 of the Treaty on the Functioning of the European Union prohibits “all restrictions” on the movement of capital between Member States and between Member States and third countries.

Both countries attracted foreign funds but different kind of flows. While the going was good the two islands seemed to be thriving on inflows of foreign funds; in Iceland as a straight shot into the economy, in Cyprus by building a financial industry around the inflows. Yet, in the end the islands’ financial collapse showed that neither country had the infrastructure to oversee and regulate a rapidly expanding financial sector.

It can be argued that in spite of the geography both countries were immature emerging markets suffering from the illusion that they were mature economies just because they were part of the EEA. As a consequence, both countries now have capital controls and clipped wings, i.e. with only three of the EEA’s four fundamental freedoms.

The “international finance centre”-tag and foreign funds

Large inflows of foreign funds are a classic threat to financial stability. At the slightest sign of troubles the tide turns and these funds flow out, as experienced by many Asian countries in the 1980s and the 1990s. Capital controls are the classic tool to resume control over the situation. None of this was supposed to happen in Europe – and yet it did.

Although not on the OECD list of tax havens Cyprus has attracted international funds seeking secrecy by inviting companies with no Cypriot operations to register. After the collapse of the Soviet Union money from Russia and Eastern Europe flowed to the island as well as from the Arab world. Even Icelandic tycoons some of whom grew rich in Russia made use of the offshore universe in Cyprus.

The attraction of Cyprus was political stability, infrastructure, a legal system inherited from its time as a British colony and the fact that English is widely spoken in Cyprus. By the time of the collapse in March 2013 the Cypriot banking sector had expanded to be the equivalent of seven times the island’s GDP. This status did also clearly limit the crisis measures: president Nicos Anastasiades was apparently adamant to shelter the reputation of Cyprus as an international finance centre arguably resulting in a worse deal and greater suffering for the islanders themselves (see my article on the Cyprus collapse and bailout here).

Iceland also tested the offshore regime. Under the influence of a growing and partly privatised financial sector the Icelandic Parliament passed legislation in 1999 allowing for foreign companies with no Icelandic operations to be registered in Iceland. Although it could be argued that Iceland enjoyed much the same conditions as Cyprus, i.e. political stability etc. (minus an English legal system), few companies made use of the new legislation and it was abolished some years later.

But Iceland did attract other foreign funds. Around 2000 a few Icelandic companies started their shopping spree abroad. The owners were also large, in some cases the largest, shareholders of the three main banks – Kaupthing, Landsbanki and Glitnir. The banks’ executives saw great opportunities for the banks to grow in conjunction with the expanding empires of their main shareholders and largest clients. By 2003 the financial sector was entirely privatised, another important step towards the expansion of the financial sector.

In addition, the Icelandic banks had offered high interest accounts abroad from autumn 2006, first in the UK, later in the Netherlands and other European countries, even as late as May 2008. Clearly, Icelandic deposits were not enough to feed the growing banks. They found funding on international markets brimming with money. In 2005 the three banks sought foreign financing to the amount of €14bn, slightly above the Icelandic GDP at the time. In seven years up to the collapse the banks grew 20-fold. In the boom times from 2004 the assets of the three banks expanded from 100% of GDP to 923% at the end of 2007.

The Icelandic crunch: lack of foreign reserve

At the collapse of the Icelandic banks in October 2008 Icelandic króna, ISK, owned by foreigners, mostly through so-called “glacier bonds” and other ISK high interest-rates products amounted to 44% of GDP. These products, popular with investors seeking to make money on high Icelandic interest rates, had been flowing into the country, very much like “hot money” flowing to Asian countries during 1980s and 1990s.

Already in early 2005 foreign analysts spotted funding as the weakness of the Icelandic banks. In. February 2006 Fitch pointed out how dependent on foreign funding the Icelandic banks were. In order to diversify its funding one bank, Landsbanki, turned to British depositors in October 2006 with its later so infamous Icesave accounts. The two other banks followed suit. In addition, the banks were supporting carry trade for international investors making use of high interest rates in Iceland.

Steady stream of bad news from Iceland during much of 2008 caused the króna to depreciate drastically. After the collapse foreigners with funds in Iceland sought to withdraw them. On November 28 2008 the Central Bank of Iceland, CBI, with the blessing of the IMF, put capital controls in place (an overview of events here). IMF’s favourable stance to capital controls was a novelty at the time; not until autumn 2010 did the Fund officially admit that controls could at times solve acute problems as indeed in Iceland.

It was clear that the CBI’s foreign reserves were not large enough to meet the demand for converting ISK into foreign currency. What no one had wanted to face before the collapse was that the CBI could not possibly be a lender of last resort in foreign currency.

The controls were from the beginning on capital, i.e. capital could neither move freely out of the country nor into the country. The controls were not on goods and services, hence companies could buy what they needed and people travel but investment flows were interrupted (further re the controls see here).

The migrating króna problem

The core problem calling for controls was and still is ISK owned by foreigners, i.e. offshore ISK, but the nature of the problem has changed over the years: the original carry trade overhang has dwindled down to 16% of GDP, through CBI auctions where funds seeking to leave were matched with funds seeking to enter. Now, the major problem is foreign-owned ISK assets in the estates of the three banks, i.e. owned by foreign creditors who, without controls, would seek to convert their ISK into foreign currency.*

As outlined in CBI’s latest Financial Stability report, published last September there is a difference between the onshore and the offshore ISK rate: 17% in autumn 2014, about half of what it was a year earlier. These and other factors indicate that the non-resident ISK owners, i.e. those who owned funds in the original overhangs, are most likely patient investors; after all, interest rates in Iceland are higher than in the Eurozone. Although these investors cannot move their funds abroad the interests can be taken out of the country.

The classic problem with capital controls as in Iceland is that the controls – put in place to gain time to solve the problems, which made them necessary – can also with time shelter inaction. With the controls in place the urgency to lift them disappears. Over time, controls invariably create problems as the CBI pointed out in its latest Financial Stability report: The most obvious (cost) is the direct expense involved in enforcing and complying with them. But more onerous are the indirect costs, which can be difficult to measure. The controls affect the decisions made by firms and individuals, including investment decisions. Over time, the controls distort economic activities that adapt to them, ultimately reducing GDP growth. 

The main ISK problem is now nesting in the estates of the three collapsed banks where the problem, as spelled out in the CBI’s last Financial Stability report , is that “…settling the estates will have a negative impact on Iceland’s international investment position in the amount of just under 800, or about 41% of GDP. This is equivalent to the difference in the value of domestic assets that will revert to foreign creditors, on the one hand, and foreign assets that will revert to domestic creditors, on the other. The impact on the balance of payments is somewhat less, at 510, or 26% of GDP.

The balance of payment, BoP, problem could be solved in various ways, i.a. through swaps between Icelandic creditors who are set to get foreign currency assets from the estates, sales of ISK assets for foreign currency and write-down on some of the ISK assets. In addition there are tried and tested remedies such as time-structured exit tax where those who are most keen to leave pay an exit tax, which is then scaled back as the problem shrinks.

The political stalemate

In March 2011, under the Left government in office from early 2009 until spring 2013, the CBI published Capital account liberalisation strategy, still the official strategy. The strategy is first to tackle the offshore króna problem outside the estates, which has been done successfully (judging by the diminishing difference between the on- and offshore ISK rate) through the CBI auctions. That part of the strategy has now come to an end with the last auction held on 10 February.

The next important step towards lifting the controls is finding a solution to the foreign-owned ISK in the bank estates. Their creditors are mostly foreign financial institutions, either the original bondholders or investors who have bought claims on the secondary market.

As indicated above there are solutions – after all, Iceland is not the first country to make use of capital controls while struggling with BoP impasse. However, as long as the political unwillingness, or fear, to engage with creditors prevails nothing much will happen.

When the present Icelandic coalition government of Progressive party (centre; old agrarian party) and the Independence party (C) came to power in spring 2013 it promised rapid abolition of the capital controls. So far, the process has been a protracted one with changing advisers, unclear goals and general procrastination. There has at times been an echo of the belligerent Argentinian tone, blaming foreign creditors for the inertia in solving the underlying problems; importantly, the Progressive party has promised huge public gains from the resolution of the estates, which it seems to struggle to fulfil.

In its concluding statement in December 2014 following the Article IV Consultation IMF points out that the path chosen in lifting the controls “will shape Iceland for years to come. The strategy for lifting the controls should: (i) emphasize stability; (ii) remain comprehensive and conditions-based; (iii) be based on credible analysis; and (iv) give emphasis to a cooperative approach, combined with incentives to participate, to help mitigate risks.” The “cooperative approach” refers to some sort of negotiations with creditors, which the government has so far completely ruled out.

It is important to keep in mind that the estates of the banks, by now the major obstacle in lifting the controls, are estates of failed private companies. The banks were not nationalised and the state has no formal control over the estates. However, as long as the ISK problems of the estates are unsolved the winding-up procedure cannot be finished and consequently there can be no payouts to creditors.

The winding-up procedure will either end with bankruptcy proceedings, which majority of creditors are against, or with composition agreement, which the majority seems to favour. Crucially, the minister of finance has to agree to exemptions needed for composition, which means that the government is indirectly if not directly responsible for the fate of the estates.

The political tension regarding the controls is between those who claim that solving problems necessary to lift the controls is the main objective and those who claim that no, this is not enough: the state needs and should get a cut of the estates.

Finance minister Bjarni Benediktsson has strongly indicated that his objective is to lift the controls whereas prime minister Sigmundur Davíð Gunnlaugsson has allegedly been of the latter view. He has recently been supporting his views by stressing the great harm the banks caused Iceland reasoning that pay-back from the banks would be only fair. This simplified saga of the banking collapse is in conflict with the 2010 report of the Special Investigative Committee, SIC, which spelled out the cause of the collapse as regulatory failure, failure of the CBI and political failure in addition to how the banks were funded and managed.

The government has Icelandic and foreign advisers working on these issues. But as long as the government does not make up its mind on what direction to take nothing moves. Meanwhile Iceland is effectively cut from markets, which makes the financing cost high, in addition to other detrimental effects of the capital controls.

The Cypriot crunch: bank run

The run up to the Cypriot banking collapse in March 2013 was a sorry saga of mismanaged banks, mismanaged country and the stubborn denial of the situation ever since Cyprus lost market access in May 2011. But contrary to Iceland, there has been no investigative report into the collapse, which means that in Cyprus hardly any lessons can be drawn yet from the calamities.

Data from the European Central Bank, ECB, shows that deposits were seeping out: in June 2012 they stood at €81.2bn. In January 2013 they were €72.1bn, down by 2%, in February at €70bn, 2.1% month on month and in March €64.3bn. According to the Anastasiades report (written at the behest of president Anastasiades, leaked to NYTimes and published in November 2014) €3.3bn were taken out of Cypriot banks March 8–15, the week up to the bail-in.

This was an altogether different situation from circumstances in Iceland ensuing from the collapsing banks. Cyprus, part of the Eurozone, was not struggling to convert euros to other currency but it was struggling to convince those holding funds in the Cypriot banks not to withdraw them and move them abroad.

As Iceland, Cyprus was trying to maintain a banking system far larger than the domestic economy could possibly support under adverse circumstances. By the end of 2011 there were 41 banks in Cyprus: only six were Cypriot; 16 were from EU countries and tellingly 19 were non-EU banks. It was clear to regulators that the size was a risk but they maintained that both regulation and supervision was conservative enough to counteract the risk, as bravely stated in a report by the Ministry of Finance on the financial sector in Cyprus. – Ironically, Cyprus had to seek help from the troika just a few months after these assertive words were written.

The controls were put in place with the full acceptance of the troika, i.e. the IMF, the EU Commission and the ECB. “The Enforcement of Restrictive Measures on Transactions in case of Emergency Law of 2013” as the capital controls measures were called by the Cyprus Central Bank, CBC, restricted i.a. daily cash withdrawal to €300 daily, no matter if directly or with a card, or its equivalent in foreign currency, per person in each credit institution. Cheques could not be cashed.

Trade transactions were restricted to €5,000 per day; payments above this sum, up to €200,000 were subject to the approval of a Committee established within the CBC to deal with issues related to the controls. For payments above €200,000 the Committee would take into account the liquidity buffer situation of the credit institution. Salaries could be paid out based on supporting documents. Those travelling abroad could only take the equivalent of €1,000 with them.

The roadmap for abolishing them came in August 2013, again with the full blessing of the troika. There was no time frame, only that the measures would be “in place for as long as it is strictly necessary.” They would be removed gradually and with prudence, always with a view on financial stability. First the restrictive measures on transaction within Cyprus would be abolished and only subsequently could the restrictions on cross-border transactions be lifted.

The controls have since gradually been eased and by May 2014 all domestic restrictions were indeed fully eliminated. On 5 December 2014 i.a. the limit for travel abroad was sat at €6,000, from previous €3,000 and business activity not subject to approval was sat at €2m. With the last change, on 13 February, those travelling abroad can now take €10,000 with them. Transfers of funds abroad were increased from the December limit of €10,000 to €50,000. The island’s pension funds are still subject to capital controls.

As in Iceland, abolishing, for unspecified time, one of the EEA’s freedoms was to be in place only for a short time. Until late 2014 it seemed as if the Cypriot capital controls might be entirely abolished by the end of that year. That did not happen. The last bit remaining is the politically tough one.

The task for Cyprus: overcoming the political hurdles

With the domestic restrictions abolished the IMF Staff report in October 2014 for the Article IV Consultation pointed out that the “external-payment restrictions” in Cyprus have to be relaxed in a gradual and transparent way. “…owing to the short deposit-maturity structure, significant foreign deposits (close to 40 percent of the total), large reliance of BoC (Bank of Cyprus) on ELA (Emergency Liquidity Assistance), and the lack of other market funding, external restrictions remain in place. While restrictions do not apply to fresh foreign inflows into Cyprus, they limit outflows, hampering trade credit and affecting overall confidence.” If the external restrictions remain in place they can damage investors’ confidence and consequently foreign direct investment, FDI.

As in Iceland, the main Cypriot problems stem from political tensions, which “could have adverse implications for confidence and the recovery,” according to the IMF. The key obstacle in Cyprus is lack of progress in addressing non-performing loans, NPL, staggeringly high in Cyprus at 37.9% of total gross loans in 2014. Debt-restructuring framework, including i.a. a foreclosure legislation and insolvency regime is still a lingering political problem. Further, banks need to restructure and build capital buffers, critical to lift the remaining restrictions.

Visiting Cyprus in early December I was told that the work on the NPLs was about to be finished and a new insolvency framework would be in place by the end of the year. It is still not in place, a sign that the politial tensions have not eased. In spite of all that has been done Cypriots have lost trust in their banking system: almost two years after the collapse it is estimated that the islanders keep up to 6% of GDP at home, under their proverbial mattresses or wherever people stash cash.

The political test for Cyprus and Iceland

Both islands face a political challenge lifting capital controls.

In 2012 the CBI published a report on Prudential Rules Following Capital Controls, thus outlining what is needed once the capital controls have been lifted. This is greatly facilitated by the fact outstanding work of the SIC. Consequently, life and prudence after the controls are lifted has been staked out.

Iceland is however struggling to throw off shackles of nepotism, even more so under the present government than for quite a while: personal connections seem to matter more not less than before. Lifting the controls will test the times, if they are new times with accountability, transparency and fairness or the old times of nepotism, opacity and special favours.

Cyprus stands harrowingly high on the Eurobarometer corruption index and it suffers from lack of stringent analysis of what happened, making it difficult to draw any lessons, i.e. on how regulation needs to be improved, failures at the CBC etc. Cyprus authorities have some way to go in order to win trust with the islanders. The fact that no public inquiry has been held into the collapse, no investigation, no report written adds fuel to the already low trust. I have earlier written that Cyprus with high unemployment and contracting economy bitterly needs hope.

Both Cyprus and Iceland will have to show that they understand what happened and how it can be prevented from happening again. The exit from capital controls for both these islands will depend on political decisions, which will shape their next decades.

*I have blogged extensively on Icelog on the capital controls in Iceland. Here is the latest one, on the politics. Here is one from end of last year, on i.a. the various possible solutions. I have at times blogged on Icelog on Cyprus or compared Iceland and Cyprus. Here is a collection of blogs on Cyprus, i.a. two on the topic of Cyprus, Iceland and capital controls. – This post is being cross posted on A Fistful of Euros.


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Written by Sigrún Davídsdóttir

March 6th, 2015 at 12:33 am

Posted in Iceland

Fearsome Leadsom: moi handbagging? No, just a bit stern

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In an interview with The Independent, Economic secretary to the Treasure Andrea Leadsom tells her version of how minister of finance Bjarni Benediktsson agreed to release money from Landsbanki estate. I had earlier written on what I had heard:

Regarding Landsbanki the delicate act is how to treat the main priority claimant, the UK deposit guarantee scheme. Economic Secretary to the Treasury Andrea Leadsom allegedly did not mince her words when talking to Benediktsson on his visit to London in autumn. He thought he was coming for a collegial meeting over drinks but instead got an almighty dressing down from the fearsome Leadsom. There are even rumours that the Secretary was waiving a legal writ already penned. All of this is rumours rumours and nothing more.

Now to The Independent:

(Leadsom) recounts the story of how, last autumn, she met Iceland’s Finance Minister, Bjarni Benediktsson, to persuade him to hurry up and pay back the couple of billion pounds that the UK spent on helping bail out one of the country’s banks.

“It was a friendly drink and chat. He was charming and agreed the money would be paid back,” she says. Then a couple of days later a well-known Icelandic blogger wrote that Bjarni Ben, as the dashing minister is known at home, had been looking forward to a “collegial meeting” with the economics secretary. Instead, the blogger reported, what he got “was an almighty dressing down from the fearsome Leadsom. There are even rumours that she was waving around a legal writ.”

A Leadsom handbagging, then? “No,” she laughs. “I was a little stern but I didn’t think I had been that hard. But he paid up and we’ve now recovered £1.36bn from the Landsbanki estate in Iceland, which operated as Icesave in the UK. We’re now in talks about getting the last £700m.”

This story now lives on in the minister’s new nickname; as The Independent adds “the minister now to known as Fearsome Leadsom”… And I now know that I am “a well-known Icelandic blogger”…

I recounted the story in my overview mid November of where the things stood with the capital controls. Not much has happened since, except for a meeting in December between the winding-up boards and their advisers with the government’s advisers, Icelandic and foreign.

The only concrete thing that the government has done, so far, towards lifting the controls is agreeing to the Landsbanki bonds agreement. As I understand, Landsbankinn, the new bank, and the Landsbanki estate had assumed they would get the government’s acceptance to their agreement in early May. That acceptance did not come until December 4. I assumed at the time that this showed Benediktsson now had an upper hand in his struggle in getting prime minister Sigmundur Davíð Gunnlaugsson to follow his line regarding the capital controls.

As is now clear, what really secured the end of the sorry Landsbanki bonds saga was not Benediktsson’s political clout or Gunnlaugsson’s understanding of the importance of passing the Landsbanki bonds agreement. No, it was a lady’s sternness, albeit a UK government minister, on the day of collegial drinks when fearsome Leadsom earned her name.

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Written by Sigrún Davídsdóttir

March 5th, 2015 at 10:58 am

Posted in Iceland

Capital controls and political stalemate

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For the time being the topic of capital controls in Iceland seems shrouded in silence. Yes, recently yet another MP banker was added to the controls steering committee, the prime minister mentioned the controls in a speech without maligning creditors or talking about the billions the state could derive from the bank estates. In other words, so far so little, which means that little is changing from what it has been.

“Lifting the capital controls is the single most important issue for Iceland,” prime minister and leader of the Progressive party Sigmundur Davíð Gunnlaugsson said in a speech recently. Gunnlaugsson has mostly just made stray comments on the controls, lately far from his earlier so belligerent tone and no mention of the funds that could be derived from the estates.

The force minister of finance and leader of the Independence party Bjarni Benediktsson seemed to be putting into control-lifting late last year seems to have seeped out of him as he could not deliver on his promise: to present a plan by the end of 2014.

There is now little apparent energy behind this issue. Compared to same time last year the progress is that there are now foreign advisers working on capital controls and a new steering committee, the third such advisory group. In addition to hiring foreign advisers Benediktsson’s major achievement last year was pulling through the Landsbanki bond agreement. But instead of being the agreement being first it has remained the only step so far.

“I fully expect something to happen regarding the capital controls after the next election, in 2017,” was the wry comment from one Icelandic observer some days ago expressing the sentiment that this single most important issue seems to be devoid of all political urgency. The third Thursday in April is the Icelandic first day of summer when parents give their children something seasonal for summer presents such as a ball to play outside. Spring might also be the time when some next step might be taken towards lifting the capital controls.

The young and yet so lethargic power-players

The left government, in power from spring 2009 until spring 2013, surely got some things done such as targeted debt write-down for households, steering Iceland through an IMF program and dragging the country back to growth already by mid-2011. However, it was consumed by infighting and was its own worst enemy. Following this government an energetic government focusing on growth of opportunities and ideas, as well as growing the economy would have been a great asset.

A government led by two young coalition leaders – the youngest ever prime minister and a young minister of finance – seemed indeed very promising. However, in many ways the duo seems be heading towards the past rather than the future. The language of the prime minister’s tends to echo patriotic language harking back to the mid 20th century. New appointments often seem to smell of nepotism and old ties.

The Icelandic media has at times focused on the prime minister’s somewhat erratic behaviour; apparently he often goes on un-announced trips abroad. He has the habit of making remarks that then turn out to be factually wrong or misleading. Words seem to come very easy to the prime minister but all too often the substance is doubtful.

With the prime minister as a comparison Benediktsson strikes a more serious and competent tone and demeanour. His approach is conciliatory and he seems widely liked, except by the old guard in the party who still mourns the, perceived by them, golden age of Davíð Oddsson. It has been apparent time and again that Morgunblaðið, with Oddsson as its editor-in-chief seems to side more with Gunnlaugsson than Benediktsson reflecting that the paper is owned 50-50 by companies with ties to the Independence party and the Progressive party. A powerful person in the latter camp is Þórólfur Gíslason, a relative of Oddsson. (If blood ties matter or not is unsure but most Icelanders will see this as relevant).

The two coalition leaders come from families at the heart of the Icelandic power structure. Benediktsson’s family is the core of the Independence party story of power. His namesake, the brother of his grandfather (if my genealogy does not fail me) was a legendary leader of the party from 1963 to 1970, the party’s glorious age. “It’s not enough just to carry this name,” one Independence voter remarked sardonically. Gunnlaugsson’s political family ties only goe back a generation: his father was briefly an MP and his business interests allegedly rose from political connections.

Political deadlock

Although the government tension is not apparent on the surface the tension shows in the fact that amazingly little seems to get done. The government is i.a. hovering as to breaking up the EU membership negotiation or not. A recent example is a draft proposal for a new Act on fishery management, expected to be introduced to Alþingi before its summer recess; the proposal’s course is now uncertain. Another topic is the Interconnector, i.e. a cable connecting Iceland to the UK: UK has shown interest in buying Icelandic electricity but the government seems unable to act on this interest, i.a. due to deep-running political and interest divergences on this issue.

On the whole, the government is seen as moving slowly, even remarkably slowly, considering that is has a strong majority and no internal opposition, at least not on the surface. It is also blessed with an opposition, which for a long time seemed to be waking up every day from a crushing defeat the previous night. Only recently the leaders of the Left Green and the social democrats have made a bit of a splash in the political debate.

There are no apparent explanations as to why the government is so lethargic. It is not so much words as action that “don’t come easy:” the prime minister is good at making speeches about the promising future of Iceland but moving beyond the words is difficult.

As one source in the Icelandic business community said there are plenty of examples in the world of countries with natural resources and other advantages that still do not manage to harness what they have. “Capturing the possibilities doesn’t happen automatically.” In Iceland, it seems not to be happening at all.

The latest polls show that the government now has support of 36.4% of the voters, compared to 34.1% end of January and 34.8% mid January. The top line figures are Independence party 25.5%, compared to 24.9% earlier and the Progressive party 13.1%, compared to 12.7%. Hovering around 25% is the Independence party’s destiny now, far from the around and above 40% at the time of Benediktsson’s namesake in power, last seen in the elections in 1999, 40.7%, under Oddsson’s leadership. – The fractioned opposition, four parties, are not moving the voters much.

Yet another committee

Following the meeting between the Winding-up boards and their advisers with the government’s advisers in December the feeling was one of cautious optimism among creditors. At the time, Benediktsson had for months boldly been announcing “a plan” by the end of the year.

Unofficial announcements following the meeting were that everything should be in place to proceed early in the New Year. In his end-of-year interviews and statements the prime minister, in his freewheeling mode, drummed up the optimism by first talking about “a plan” soon, then by the end of January. This has to be seen in context with statements after coming to power in summer of 2013 as to how easy and quick the lifting of the controls would and could be.

The only thing that January brought was a new committee. As earlier, Glenn Kim is the chairman. Others are Benedikt Gíslason, adviser to Benediktsson, and Eiríkur Svavarsson, by now veterans in this field, together with Sigurður Hannesson from MP Bank, a close friend of Gunnlaugsson and two from the CBI, Ingibjörg Guðbjartsdóttir and Jón Sigurgeirsson.

Gíslason used to work at MP Bank and now just recently MP bank’s chief legal officer, Ásgeir Helgi Reykfjörð Gylfason (this long names are uncommon in Iceland) has been added to the committee.* The CEO of MP Bank is Gunnlaugsson’s brother-in-law but as the bank stated in its press release on Gylfason it is proud that the bank’s expert are sought to work on such important issues.

Svavarsson, Hannesson and Gylfason are seen as close to the prime minister. Sigurgeirsson is close to the governor of the CBI, who shares a good understanding with Benediktsson. Apart from speculations of intimacy and allegiance, it is worrying that none of the Icelandic lawyers on the committee has any international experience.

This is the third group set up to work on the capital controls. The feeling is that previous groups have broken apart because of differences of opinion on how to approach the resolution of the three bank estates, a necessary step towards lifting the controls.

What could come next, apart from more procrastination?

Glitnir has made news in Iceland following a leak that Íslandsbanki might be sold to Middle Eastern investors. Earlier, Chinese interest had been in the air. Certainly, selling Arion, owned by Kaupthing, and Íslandsbanki would make a composition easier.

The estates have had plenty of time to calculate a positive outcome. Although no decision was announced for a next meeting after the December meeting it is expected that another meeting will or would follow soon.

Some weeks ago Víglundur Þorsteinsson, an old businessman who lost his company into bankruptcy following the banking collapse, made allegation about wrongdoing regarding the splitting up of the banks, i.a. that creditors had profited unduly. This was not the first time he stated these claims and he has never found any serious support for them. This time the prime minister sided with him, saying this should be investigated.

Brynjar Níelsson, an Independence party MP, got the task of reviewing the claims, which he did by utterly rubbishing them. It is not clear if the prime minister will see this case as a reason to move slowly regarding the estates, probably not, but his support to Þorsteinsson was much noted.

As far as is known the new group is working on proposals towards lifting the controls. The two coalition leaders have often spoken about a “holistic solution,” a “framework” etc. Considering the fact that the two estates ripe for composition, Kaupthing and Glitnir, have very different problems – Kaupthing with no ISK assets beyond its ownership of Arion but Glitnir with ca. ISK100bn in addition to Íslandsbanki – the framework might turn out to be of a general nature so as to accommodate tailored solutions for the estates.

The much discussed exit tax might be pressed for, in order to get the funds the prime minister seems to think can be had from the estates. However, as I have pointed out earlier exit tax does not solve the ISK problem, unless used in a targeted way, as did Malaysia in the late 1990s. Possible solutions have been dealt with in earlier blogs.

The business community is up in arms about the stalemate on controls but the voters do not really sense the effect of the controls, meaning there is only a moderate pressure on the government to act. As pointed out earlier it seems that the two coalition leaders do not proceed on the controls because they really are at loggerheads on how to go about it. There really is no longer anything unknown in this issue. It has all been mulled over, no stone is unturned. What is lacking are decisions, not more analysis etc.

At the core of that dispute is really if lifting the controls is a gain in itself or if Benediktsson is willing to help Gunnlaugsson find a way to lift the controls in such a way that he, the prime minister, can proclaim victory.

*As reported earlier, the appointment of Sigurður Hannesson was first announced by MP Bank, not confirmed by the government until days later. Now the saga is being repeating by appointment of Gylfason: the bank announced his secondment on February 13 but no official announcement has yet been made by the Ministry of Finance. Another indication of the lackadaisical attitude for formalities.

Follow me on Twitter for running updates.

Written by Sigrún Davídsdóttir

February 24th, 2015 at 5:32 pm

Posted in Iceland

Cyprus: an island in search of a saga to learn from

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Why do the inhabitants of an EU country prefer to keep cash amounting to ca. 6% of GDP hidden at home? Badly burnt after the banking collapse in March 2013 Cypriots neither trust their government nor banks to keep their money safe. After following from afar the events in Cyprus I recently visited the island. Many Cypriots feel that the banking collapse is now only history and no point thinking about it. But that is far from the truth: as long as neither Cypriots nor the other EU countries know the whole Cypriot saga it can neither provide lessons nor a warning; and the mistrust lingers on. In addition to a public investigation of what really happened and why, write-downs of household debt and a functioning insolvency framework Cypriots desperately need one thing: hope for the future.

Crisis-stories are a plenty in Cyprus and the islanders are more than willing to tell them. During the traumatic days in March 2013 when the banks were closed for ten long days people called the Central Bank of Cyprus, CBC, crying. “The bail-in wasn’t fair because it hit depending on with which bank you were banking,” one Cypriot said. “And look at what it’s done to us, all the empty space in the centre,” said the owner of a small business. “One of my clients,” said a man working in finance, “had a loan of €5m and €7m in deposits. Next day, he still had a loan of €5m but only €100,000 in deposits.” The client, of course, banked with Laiki Bank, also known as Cyprus Popular Bank and Marfin Popular Bank. Then there was the man on the beach in Paphos, selling boat trips. He now owns 500,000 shares in Bank of Cyprus worth quite a bit less than the €500,000 on his account until his funds, together with all other deposits above €100,000, were converted into shares.

In March 2013 Cyprus stared into the abyss of financial collapse. In order to qualify for a €10bn Troika loan, the absolute maximum the Troika – i.e. the European Union, EU, the European Central Bank, ECB and the International Monetary Fund, IMF – was willing to lend, Cyprus had to raise €5.8bn. After the Eurogroup threw out its first rescue plan, which included a levy on guaranteed deposits, i.e. less than €100.000, the Cypriot Parliament rejected a levy on non-guaranteed deposits only. Instead, the Cypriot government grabbed deposits above €100,000 in Laiki to merge it with Bank of Cyprus where non-guaranteed deposits were turned into shares.

From the Cypriot point of view it seems unfair that whereas Cyprus had to find own funds other hard-hit European countries – Ireland, Greece, Portugal and Spain – got Troika loans to bail out banks. The overwhelming feeling in Cyprus is that the island’s 1.1m inhabitants and an economy contributing 0.2% of the euro zone economic output was too small and insignificant to matter to the Troika. Abroad lingers the suspicion that Russian money in Cyprus were unpalatable to the Troika.

However, the reason for the misery seems more complicated and closer to home: the government of Demetris Christofias was adamant not to enter a Troika programme; a noble aim in itself but the government’s manoeuvres to avoid it seem less noble. CBC officials fed incomplete if not misleading information to the ECB. Fragments of this story have emerged only recently, not from the two attempted public enquiries but from a secret report done at the behest of president Nicos Anastasiades, later leaked to the New York Times.

“People want answers,” one Cypriot said but so far, there are few answers but plenty of questions, the most pressing being why there is no strive to do a proper investigation on the events leading to the drama in March 2013. The Special Investigative Committee, SIC, set up in Iceland after the Icelandic collapse in 2008 would be an ideal inspiration.

The story of the Cypriot collapse has many intriguing aspects. One of them is the sale of Greek branches of Cypriot banks, i.a. Bank of Cyprus Greek operations; another is the purchase of Greek sovereign bonds (mainly from German banks, which had a high exposure on Greece) by Cypriot banks, possibly seeking high-risk high yield investment to cover earlier disastrous lending.

Below, two further aspects are scrutinised: why the bail-in happened and why the Troika accepted, though only for some hours, a crisis levy on guaranteed deposits.

The rumours before the collapse and the hope that this time, it would be different

As in Iceland, the Cypriot banking sector was far too large – seven times the island’s GDP – for Cyprus to support it on its own. Its destabilising core was Laiki Bank,. The bank had for a long time offered higher interest rates than other banks; only ever attractive to risk-takers and naïve investors who do not recognise it as a warning sign. In the summer of 2012 the Cypriot government attempted to solve the Laik problem by nationalising the bank.

With Ireland, Portugal, Greece and Spain struggling there had been little focus on tiny Cyprus but its problems were evident to anyone who bothered to look. After the nationalisation of Laiki there were talks with the Troika in late summer and autumn 2012 as to what should be done. No one, least of all the Cypriots, expected any drama. My Cypriot contacts kept telling me that the talks would no doubt end quietly in a negotiated bail-out of some sort. After all, Cyprus was a small economy, the Troika had by now some practice in dealing with failing banks threatening an entire economy; and there was also a growing awareness that private debt should not be shifted on to the state. Compared to the on-going Greek drama his would go well, I heard.

There were however rumours that this time it would indeed be different. In January 2013 Landon Thomas wrote in the New York Times of “Questions of Whether Depositors Should Shoulder the Bill:” officials in Brussels and Berlin were said to be working on “a controversial plan that could require depositors in Cypriot banks to accept losses on their savings. Russians, holding about one-fifth of bank deposits in Cyprus, would take a big hit.” Truly a radical departure from bailouts in Portugal and Ireland and a haircut, albeit only after an earlier bailout, in Greece – so far, bank deposits had been held sacrosanct.

Considering the delicate situation CBC governor Panicos Demetriades gave a rather remarkable interview to Wall Street Journal on March 5 2013 where he rejected the idea of haircut on depositors. Instead, he aired the idea of a “special solidarity levy” on interest income, which could give the state an annual income of as much as €150m – a risible sum compared to what was needed – but hoped that privatisation would gather €4.5bn. Alex Apostalides lecturer at the European University Cyprus has recently written about an encounter with Demetriades on the fateful 15 March 2013: when asked, Demetriades said that any haircut on deposits would be a catastrophe for the banking sector.

At the beginning of 2013 all the Cypriot political energy was in the presidential election campaign. But some were more aware than others that something might happen; there are still rumours of people who emptied their bank accounts just before the bail-in. ECB data shows that deposits were seeping out. In June 2012 they stood at €81.2bn. In January 2013 they were €72.1bn, down by 2%, in February at €70bn, 2.1% month on month and in March €64.3bn. According to the Anastasiades report €3.3bn were taken out of Cypriot banks March 8–15, the week up to the bail-in.

Capital controls, i.e. limits on amounts taken out from deposits or moved between deposits, were part of the package in March 2013. Yet, money did allegedly seep or even flow from certain deposits in spite of the controls. In Cyprus stories are told of private jets clouding the skies over Nicosia on and after 18 March, carrying neck-less black-clad men accompanying their angry-looking masters to the banks; all returned smiling with bursting hold-alls. List with names of people said to have taken out money in spite of the controls circulated in the media. – All of this is part of the still unwritten report of what really happened.

What seemed like good idea at the time: ‘un-guaranteeing’ the €100,000 deposit guarantee

On Friday March 15 2013 the Eurogroup met in Brussels at 5pm after markets closed. In the wee hours of March 16 the Group published a statement and its representatives held a press conference. The statement itself was short but not sweet, at least not for the Cypriots who had hoped and believed that their island would be assisted like other troubled euro-countries.

The press release stated (emphasis mine in all quotes):

The Eurogroup further welcomes the Cypriot authorities’ commitment to take further measures mobilising internal resources, in order to limit the size of the financial assistance linked to the adjustment programme. These measures include the introduction of an upfront one-off stability levy applicable to resident and non-resident depositors. Further measures concern the increase of the withholding tax on capital income, a restructuring and recapitalisation of banks, an increase of the statutory corporate income tax rate and a bail-in of junior bondholders. The Eurogroup looks forward to an agreement between Cyprus and the Russian Federation on a financial contribution.

The Russian loan never materialised any more than a Russian loan promised to the governor of the Central Bank of Iceland as the Icelandic banks collapsed in October 2008. Cyprus’ relationship with Russia was long-standing Iceland was not known to have any particular relationship with Russia, which meant that this promise seemed very much out of the blue. However, just as the Christofias government was against a Troika programme the governor and a few others were equally against seeking assistance, in Iceland’s case from the IMF.

Interestingly, neither the press release nor the statement specified what ‘an upfront one-off stability levy’ implied. Those present at the 4AM press meeting were ill at ease and unwilling to spell out the action. Christine Lagarde director of the IMF only talked of “burden sharing.”

According to Reuters, citing an unnamed source, Cyprus “agreed a one-off levy of 9.9 percent to apply to deposits in Cypriot banks above 100,000 euros and of 6.7 percent for deposits below 100,000 euros…”

With this fundamental diversion from earlier policies the Eurogroup agreed that an EU country could touch deposits below the guaranteed €100,000. In other words: depositors in EU now knew that in a financial crisis their guaranteed deposits were no longer untouchable.

Whether a momentary mental black-out or a wish to try something unorthodox this solution evaporated over the weekend. The statement released following a Eurogroup phone conference on Monday March 18 carried a very different message:

The Eurogroup continues to be of the view that small depositors should be treated differently from large depositors and reaffirms the importance of fully guaranteeing deposits below EUR 100.000. The Cypriot authorities will introduce more progressivity in the one-off levy compared to what was agreed on 16 March, provided that it continues yielding the targeted reduction of the financing envelope and, hence, not impact the overall amount of financial assistance up to EUR 10bn.

Given the fact that the Eurogroup had less than 48 hours earlier agreed to a levy on guaranteed funds the word “continues” does not quite rhyme with the earlier statement.

The banks remained closed on the following Monday, March 18 2013 as the Cypriot government under president Nicos Anastasiades, only in power since March 1, struggled to get a grip on failing banks – and to find another solution when the original idea lost its sparkle.

In a rare display of tense irritation the ECB issued a statement on March 21 saying that the ECB governing council had “decided to maintain the current level of Emergency Liquidity Assistance (ELA) until Monday, 25 March 2013. Thereafter, Emergency Liquidity Assistance (ELA) could only be considered if an EU/IMF programme is in place that would ensure the solvency of the concerned banks. – As far as is known, this is the only time the ECB has ever issued a statement acknowledging the end of ELA.

The Cypriot banks remained closed until March 28. When they opened again there were capital controls in place to prevent a run on the banks – and depositors in Laiki and Bank of Cyprus had been singled out to carry the cost.

In hindsight, it is profoundly interesting that the Eurogroup, ECB and the IMF did indeed agree to levy on guaranteed deposit. Allegedly, the Germans were not happy but agree they did. In the end, things did change in the coming days. A general levy was voted down in the Cypriot parliament. The Cyprus collapse did not happen over a few days in March but over almost two years, from May 2011 when the island lost access to markets. The course of events cannot just be explained by panic.

Indeed the bail-in was no panic solution but had been in the making for more than half a year; only the Cypriots did not know it.

A pact with the offshore devil

Since slamming a levy on guaranteed deposits truly was a novel idea the short struggle to ram this measure through merits attention, also because it can be argued that it was indeed a much fairer financing of the crisis solution than the one used.

According to much of the media coverage the idea of a levy on guaranteed deposits came from the Cypriot government. However, sources close to these events have indicated to me that the EU commission, attempting to merge various and to some degree conflicting points of view, originally suggested a levy on guaranteed as well as non-guaranteed deposits. The preposition was that Cyprus had to fund a big part of the rescue package, banks have heaps of money on deposits – and a small percentage levy is a relatively painless way for a state to spread the burden in a crisis.

The various parties to the talks were advocating various solutions. IMF advocated the full resolution of the two banks, Laiki and Bank of Cyprus and did not seem to be opposed to a bail-out. The Anastasiades government was looking for a traditional bail-out programme apparently unaware that the Christofias government had worked on a bail-in (more on that below). The Commission was looking for a middle way where wealth tax could perhaps fill a gap if needed but sensed that a bailout was out of the question.

The country needed to raise €5.8bn in order for the Troika to lend the €10bn needed. It was a matter of arithmetic how to juggle the percentage so as to land on the right sums; it proved a struggle as Reuters recounted on 18 March. President Anastasiades and his team refused to go above 10% on the uninsured deposits and settled for 9.9%. These deposits amounted to €38bn, insured deposits were €30bn which meant that €2bn had to be taken off the latter if the government held onto 10% being the pain threshold; ergo, the percentage had to be respectively 6.75% and 9.9%.

Non-Cypriot officials wanted the percentage on the guaranteed deposits to be lower, even considerable lower. Already at the meeting the feeling was the Anastasiades was sheltering the island’s offshore status, ignoring the interest of ordinary Cypriots.

The political reaction in Cyprus drew the attention from the fact that after sleeping on it the Eurogroup woke up realising that the levy would ‘un-guarantee’ the guaranteed €100,000. The original plan must have come with some convincing reasoning (from the EU Commission, right?); otherwise, it would not have gone through. For sure, it worked like magic – but struck by daylight the carriage was again a pumpkin.

“The guaranteed deposits turned out to be EU’s sacred cow,” one source said. In a certain sense, for every country crisis is utterly unique, not in the general mechanism, but in the outward detail. If Cyprus had indeed accepted a levy on guaranteed deposits the EU would have been in a difficult position: it would have had to argue that Cyprus was an utterly unique case.

In order to reach the necessary sum of €5.8bn 15% levy on the uninsured deposits would have done the trick. But on an island, which lives – and has lived well – from its off-shore status and the foreign funds it attracts the government baulked at taxing the non-guaranteed deposits too heavily so as not to drive these funds elsewhere. That was the cost of the Cypriot pact with the offshore devil.

Laiki: the core of the Cyprus problem

In the euro-crisis context the bail-in was a remarkable solution but as can be seen from the Anastasiades report it was, quite remarkably, not a new idea. It had been in the making for some time, at least from autumn 2012, and was closely connected to the core problem: Laiki. The report traces the drafting of a new bank resolution framework, which rested on using deposits in an insolvent bank in a bail-in.

The desperate state of the Cypriot economy was exposed when Cyprus lost market access in May 2011, much due to Laiki Bank owned and managed by Andreas Vgenopoulos. Laiki was diligently issuing bullet loans to Vgenopoulos’ companies. Bullet loans are familiar to those who have studied the operations of the Icelandic banks where they were issued to large shareholders and other favoured clients. The Icelandic bullet loans to these clients were either constantly rolled over or refinanced, rarely paid back. The bullet loan wonder on a balance sheet is i.a. that in spite of not being paid back they are not non-performing.

One insistent question for Cypriots is why the CBC and other Cypriot authorities allowed Laiki to operate as it did and for so long. By summer 2012 the Cypriot authorities had run out of excuses and justifications for continued assistance to Laiki, to the ECB and others. Instead of investigating Laiki’s operations, the bank was nationalised, hook line and sinker and no questions asked.

It is a pertinent question when the CBC realised that Laiki was a dead bank. There were leaks in Cypriot and Greek media in autumn and winter 2012 on the severe state of Laiki, allegedly known to the CBC. Even sending staff to be questioned by a prosecutor CBC focused on investigating the leaks, not the issues they raised.

Nationalising Laiki increased the state’s liabilities; the EU and the IMF were uneasy, as expressed at a Eurogroup meeting 12 September 2012 in Cyprus. Laiki was in a sorry state and it was dragging down another weak bank, Bank of Cyprus. The government continued its delay-tactic, thereby taking the entire banking sector hostage.

The Troika held a meeting 9 November 2012 in Cyprus but could not reach an agreement with Cyprus. By now, Cyprus was, quite literally, living on borrowed money, straight from the ECB: on 15 November 2012 ECB’s Emergency Liquidity Assistance, ELA, to Cypriot banks, i.e. Laiki, amounted to €11.9bn.

The Troika’s patience was evaporating fast: when president Demetris Christofias visited Brussels 22 November he was informed the ECB would stop the ELA immediately. The following day finance minister Vassos Shiarly said the government had now agreed to the terms of the “Memorandum of Understanding on Specific Economic Policy Conditionality.”

The birth of a brutal and unfair solution

The November 2012 MoU was full of good intentions. But the direction taken was not new. During the Troika meeting in Cyprus in June 2012 those present had agreed that the core of the Cypriot problem was an over-extended financial sector, which the feeble island economy could not support. Consequently, an alternative way to recapitalisation had to be found but the question was how.

In a 2 July 2012 letter ECB stated, referring to its opinion on legal support for Laiki, that the best way was to use a fully-fledged bank resolution tool, as outlined in Directive proposal, COM (2012) 280 final adopted in June 2012, for bank resolution where the cost was not being borne by tax payers, adopted in June 2012 and later developed into a Bank Recovery and Resolution Directive.

Hence, amongst those working on the coming Cyprus banking rescue operation it was already clear by the summer of 2012 that Cyprus could not expect anything like the other troubled euro countries. The assessment circulating, i.a. from Fitch, was that Cyprus needed €10bn in financial aid, 60% of GDP.

The three key objectives of the MoU were “to restore the soundness of the Cypriot banking sector by thoroughly restructuring, resolving and downsizing financial institutions, strengthening of supervision, addressing expected capital shortfall and improving liquidity management; to continue the on-going process of fiscal consolidation in order to correct the excessive general government deficit” by reducing current primary expenditure, maintaining fiscal consolidation i.a. by increasing the efficiency of public spending, enhancing tax collection and improve the functioning of the public sector; structural reforms to support competitiveness.

As the MoU shows Cyprus was not stingy with its promises, i.a. : “With the goal of minimising the cost to tax payers, bank shareholders and junior debt holders will take losses before state-aid measures are granted. Before any state recapitalisation is granted, the Central Bank of Cyprus will require a conversion of any outstanding junior debt instruments into equity for the purpose of protecting the public interest in financial stability, including by implementing voluntary or, if necessary, mandatory subordinated liability exercises (SLE)… the necessary legislation will be introduced no later than [January 2013]. The Central Bank of Cyprus together with the EC, the ECB and the IMF will monitor any operation converting junior debt instruments into equity.”

The innocent-looking clause in the November 2012 MoU, which the Cypriot government was arm-twisted into accepting, was a further foreboding of the bail-in to come: The authorities will introduce legislation establishing a comprehensive framework for the recovery and resolution of credit institutions, drawing inter alia on the relevant proposal of the European Union.

The Anastasiades secret report concludes that it was clear from summer 2012 that the legal tools being forged would prevent a bail-out, forcing Cyprus to rescue its financial system with own resources, i.e. a bail-in:

However, the perception which prevailed was that neither the government nor the CBC adequately understood this context. Moreover, no one admitted to know or have heard about the bail-in before the Eurogroup of 15 March 2013. The fact that the government, the state and its institutions acted as if they could not comprehend what was going on in order to disguise their inadequacy… ultimately proved to be a very effective policy to avoid taking responsibility. The reality is that as early as 6 November 2012, the CBC Governor, Panicos Demetriades, informed the ECB President, Mario Draghi that the resolution law was almost done, three whole weeks before the MoU of 25 November. …

From the moment the two major banks would pass into the hands of the Resolution Authority, the CBC should have to act within the given legislative framework and to provide solutions which would not bear any burden to the taxpayer. The law in itself was prohibiting the bail out and was legalizing the bail-in.

The law, legalising a bail-in, was supposed to be passed in January 2013 but the Cypriot government and the CBC continued the delay game. After being reassured that short-term financing need was covered, the Eurogroup finally accepted to wait; it seemed clear that the final agreement on a programme would have to wait until after the election in February.

When the Anastasiades government came into power March 1 2013 neither the out-going government nor the CBC presented it with the draft for the resolution law. Accordingly, the new government seems to have intended to negotiate a bail-out as in previous Eurozone crisis countries. The old powers and the CBC kept quiet, making it look as if the bail-in was all the work/fault of the new government – or that is at least how the story is told in the Anastasiades report. The Resolution of Credit and Other Institutions Law of 2013 was published 22 March 2013 as part of the crisis measures.

The Anastasiades report shows that though panicky the decisions taken over the fateful days in mid March were no last-minute solutions. The Christofias government had been planning a bail-in, i.e. a self-financed salvation or refinancing of the banking system – and it was vehemently against entering a Troika programme.

The “punishment for the Russian connection” theory and other speculations

In hindsight – always a great vantage point – a one-off levy on deposits, even a tiny sliver on guaranteed deposits, would have been a lot less painful to Cypriots in this time of great crisis. But the political reaction in Cyprus was such that the government stepped back and abandoned any general levy. “The measures chosen did not punish risk-takers but made some people poorer completely by chance,” one source said.

“The solution was to treat deposit holders as investors,” as one Cypriot put it. Indeed, but only deposit holders in two banks took the hit for everyone else; a much more brutal and arguably a less fair measure than a levy.

In the weeks following the Cypriot bail-in there were speculation that the anomalous outcome had been dictated by a lack of trust in Cyprus for allowing Russian funds to flow so freely through the country’s banking system. It is alleged that 20% of Cypriot deposits are Russian; considering the long-standing connections between Russia and Cyprus this does not seem shockingly much.

In addition there are rumours, strenuously denied by Cypriot authorities, that the island’s financial system had been facilitating money laundering. According to persistent rumour the German authorities had commissioned a secret report that showed as much. However, nothing concrete did ever materialise and certainly no German report.

Cypriot officials were very much aware of these rumours and visited some European capitals in January 2013, i.a. Den Haag, to rebut the rumours and explain measures taken in Cyprus against money laundering.

The IMF viewed Cyprus as a unique case because of the size of its banking sector. Germany was in no mood for a bail-out. “Cyprus had irritated the Troika so much,” one source said. The ECB press release on ELA 21 March 2013 proves the point. Christofias had publicly spoken badly of the IMF; his attempts to get loans from China and Russia were not successful.

Essentially, a bail-in had been in the making for a while and seems to be what Christofias and his government had in mind. “It was clear that Cyprus would indeed be different,” on source said. “The obstacles were mostly political.”

Why the Christofias government did aim at a bail-in can only be clarified in a Cypriot SIC report. Perhaps the government saw that as a good way to keep the Laiki story buried, a continuation of the fact that Laiki had been nationalised but neither restructured nor scrutinised. And/or Christofias the communist was content to nationalise it to prove a political point. Fundamental question on the March 2013 events can only be answered in a thorough report. Sadly, it seems that very few Cypriots believe that such a tell-all report is possible on their little island.

No appetite for investigations

The Anastasiades report bears the telling title: Laiki Popular Bank – How a bank’s mismanagement toppled an economy. Laiki was not the only problem in the Cypriot economy but it was the crystallisation of many problems. Some advisers had recommended action on Laiki already when Cyprus lost market access in May 2011 but to no avail. As one source said: “It was a grave mistake not to take Laiki over earlier.”

The Anastasiades report was not intended for publications. It was not the first investigation into the Cypriot banking mess. There was an earlier planned investigation, which as the Anastasiades report stated, “didn’t happen.”

In August 2012 the CBC assigned Alvarez & Marsal, a management and restructuring consultancy, to examine why Laiki and Bank of Cyprus had requested state support, which they got, in total €1.8 bn. The following four points were to be investigated:

  1. Bank of Cyprus’ losses from investing in Greek bonds
  2. The purchase of shares of the Romanian bank Banca Transilvania
  3. The acquisition by the Bank of Cyprus of the Russian bank Uniastrum
  4. The merger of Marfin Laiki with Egnatia and in specific the conversion of Egnatia from a subsidiary of Marfin Laiki to a Cypriot bank

In October 2013 this assignment was in the news, not for the firm’s findings but for its fees: on top of €4.5m it turned out that CBC governor Panicos Demetriades had, without the CBC knowledge, agreed to a further fee of €11m. Nothing has been heard of the report and regrettably the four items above remain unexplained.

As the Anastasiades report states: Now we know why: An investigation into the reasons why the Cyprus Popular Bank requested state support of €1.8 bln, would reveal the disastrous decision taken by the Christofias government to nationalize the Cyprus Popular Bank and this was achieved in collaboration with both CBC Governors, initially Orphanides and later on Demetriades.

The Anastasiades report comes to its own conclusions:

The Cyprus Popular Bank, was insolvent before the haircut of the Greek bonds. After the haircut, the Bank had little chance to survive. The only realistic option for a successful recapitalization was through the EFSF. However, it was impossible to receive funding from the EFSF without entering a programme. Christofias’ government followed a policy of avoiding the programme at all costs. By refusing the programme, Christofias’ government led the entire banking sector into captivity.

What the Anastasiades report spells out quite clearly is how Cypriot authorities, from autumn 2011, led by the various ministers of finance and governors of the CBC kept convincing the ECB that all was well and fine with Laiki. When it was no longer possible to dress the bank up as a solvent company the bank was nationalised. In March 2013 it was no longer possible to plaster over the cracks, the bank was restructured and merged with Bank of Cyprus – at the cost of €5.8bn from deposits in the two banks.

According to the New York Times, Benoît Coeuré executive board member of the ECB was also instrumental in coming up with a collateral plan when there were seemingly no collateral left to support further ELA for Laiki. Cypriot authorities, led by the CBC, conspired to thwart suspicious ECB. This whole exercise left the Cypriot state with €10bn of ELA debt, apparently the cost of trying to save a failed bank.

After the events in March 2013 president Anastasiades set up an investigative committee to examine possible civil, criminal and political liabilities regarding the development in the Cypriot economy and financial sector. The six members were all elderly judges with long careers.

Their report was handed over to the cabinet end of September 2013. It has not been made public. The documents leaked by the New York Times indicate that there is plenty of material that the commission did not make use of. Since this report has not been published it is impossible to say how thorough it is but the general feeling is that the 280 pages did not reveal anything much. The attempts to investigate the events leading up to March 2013 and the aftermath have so far been futile exercises.

Based on available material it seems logical to conclude that the bail-in was part of the Christofias government plan to avoid a Troika programme and possibly the scrutiny that might follow. If the latter was the case all fears have been groundless: regrettably, the Troika has never pushed for an investigation to clarify events.

The fact that Cypriot authorities did everything to hide and deny the dire situation from May 2011 had hardly mellowed the Troika in March 2013 when action could no longer be postponed. But it does not explain the attempt to put a levy on insured deposits.

Being a gateway to offshore structures may not have helped Cyprus. That said, EU and IMF officials are hardly squeamish in these matters: Luxembourg and Malta offer similar environment not to mention the tax structures provided by Ireland and the Netherlands.

What Cyprus needs

The ECB is trying to strengthen trust in the European banking sector. In general, an important step towards creating confidence “is to recognize loans that are bad and write them off, ” according to William White, former economic adviser to the Bank for International Settlements. Non-performing loans have been a major problem in the Cypriot financial sector. I heard in December that with a new insolvency or foreclosure framework this would be resolved.

I therefore find it both surprising and worrying that according to Eurogroup remarks 16 February 2015 the foreclosure framework has still not been finalised but is much needed in order to enable banks to clean their balance sheet and start lending again. This is now the main hurdle in the recovery program for Cyprus.

Household debt is a problem – Cyprus could do with some general measures similar to the Icelandic “110% way” where mortgages were written down to 110% of the estimated value of the property to pull households out of the doldrums of negative equity.

“Confidence in the Cypriot banking sector has not been restored,” one source pointed out. That can i.a. be seen from the fact that many prefer to keep cash at home; as much as 6% of GDP could be under pillows and mattresses.

As so often in countries plagued by corruption everyone is aware of it but it is rarely mentioned except when it surfaces in news. But is indeed a huge problem as can be seen from EU Anti-Corruption Report 2013: 78 % of Cypriot Eurobarometer respondents claim corruption is widespread, EU average is 76 %; 92 % say that bribery and good connections is the easiest way to access certain public services, EU average is 73 %. Among Cypriot business people 64% say corruption is a problem compared EU average of 43 %. And most seriously, 85 % of entrepreneurs think that favouritism and corruption hamper business competition in Cyprus when EU average is 73 %.

Cypriots need to know exactly what happened and when – and so does Europe, if any lessons are to be drawn from the crisis. But most of all, Cyprus needs hope. Parents need to believe there is future for their children on the island. Young people have to see a reason for staying after their education or returning there after studying abroad. A country marred by untold stories, unexplained action and corruption is simply not a good country for growth and optimism – the necessary prerequisite for hope.

*My oral sources are all from Cyprus. In agreement with them they are not identified by position since Cyprus is a small country. – This blog is cross-posted on A Fistful of Euros.


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Written by Sigrún Davídsdóttir

February 17th, 2015 at 3:39 pm

Posted in Iceland

Supreme Court rules in al Thani case: imprisonment confirmed

with 14 comments

“The results today that it is possible to bring complicated financial cases to court and get conviction,” Ólafur Hauksson head of Office of the Special Prosecutor said to Icelog, now that the Supreme Court has ruled in one of the OSP’s major cases, the al Thani case. “Building up the expertise has been a long process but the ruling today demonstrates that setting up an office, which didn’t not exist earlier, was fully justified. No society can tolerate that certain parts of it are beyond law and justice.”

Those four charged were Sigurður Einarsson chairman of Kaupthing board, Magnús Guðmundsson manager of Kaupthing Luxembourg, Kaupthing CEO Hreiðar Már Sigurðsson and Ólafur Ólafsson the bank’s second largest shareholder. Reykjavík District Court had earlier ruled in the case where Einarsson was sentenced to 5 years in prison, Guðmundsson 3 years, Sigurðsson 5 1/2 years and Ólafsson 3 1/2 years. The Supreme Court has confirmed the ruling over Sigurðsson whereas Ólafsson has now been sentenced to 4 1/2 years, Einarsson to 4 years instead of 5 years and Guðmundsson to 4 years.

As detailed in an earlier Icelog the core of the al Thani case were loans to Ólafsson and Sheikh Mohammed bin Khalifa al Thani, a Qatari investor from the country’s ruling family. It is important to notice that the issuing of these loans was the criminal deed in the case – the three Kaupthing managers broke law by doing it and Ólafsson was complicit in that criminal deed.

The story behind the case is that in in September 2008 Kaupthing made much fanfare of the fact that Sheikh al Thani bought 5.1% of Kaupthing’s shares. The 5.1% stake in the bank made al Thani Kaupthing’s third largest shareholder, after Olafsson who owned 9.88%. This number, 5.1%, was crucial, meaning that the investment had to be flagged – and would certainly be noticed. Einarsson, Sigurðsson and Ólafsson all appeared in the Icelandic media, underlining that the Qatari investment showed the bank’s strong position and promising outlook.

What these three didn’t tell was that Kaupthing lent the al Thani the money to buy the stake in Kaupthing – a well known pattern, not only in Kaupthing but in the other Icelandic banks as well. A few months later, stories appeared in the Icelandic media indicating that al Thani was not risking his own money. More was told in SIC report and the SIC recount indicated a fraudulent behaviour. The ruling today has confirmed the doubts, which have surrounded this investment from early on.

Although the case draws its name from Sheikh al Thani he has not been accused of any wrongdoing. He was one of the witness in the case, gave a statement over the phone.

As I have pointed out earlier there is an echo of this investment story in the ongoing investigation into Qatari and Middle East investment in Barclays, which saved the bank from seeking state support in autumn 2008.

The ruling in Iceland is i.a. in stark contrast to how Irish courts have tackled financial crimes related to the Irish collapsed banks. In April last year a court ruled that two former Anglo Irish managers, who had been convicted of issuing loans to prop up the bank’s share price, should not be imprisoned in spite of being found guilty. The judge ruled it was unjust they should go to prison for a criminal deed because they believed they had acted lawfully. Sean FitzPatrick, the bank’s former chairman, was cleared in this case. I find this Irish ruling truly incredible. This loan saga – loans to the so-called “Golden Circle” – has striking parallels in other Icelandic cases, which are being processed.

Icelandic law on financial fraud is in most respect similar to law on these issues in Northern Europe. There is nothing special about the Icelandic situation – except the will to carry out investigations and bringing cases to court. As Hauksson pointed out financial crimes need not be too complicated to be successfully prosecuted – and no part of society should be beyond the reach of the law.

*Update: I have seen some comments that because the four sentenced to prison in the al Thani case are living abroad they are unlikely to go to prison. That is not correct: the fact that they live abroad – in London, Switzerland and Luxembourg – will apparently not change anything. Ólafsson has already said he will come when called to go to prison. That is an unavoidable consequence of the sentencing. 

*Update 25.2. 2015: Ólafsson asked to start his sentencing as soon as possible. According to Icelandic media he is now already in prison at Kvíabryggja, Snæfellsnes, where this sentenced in earlier banking collapse cases have been sent to jail (see here for details of this prison).

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Written by Sigrún Davídsdóttir

February 12th, 2015 at 5:02 pm

Posted in Iceland