Sigrún Davíðsdóttir's Icelog

Cyprus is struggling with its capital controls, with no fixed abolition date in sight. Iceland has also discovered that the best way forward is to have a plan with benchmarks but no time limit. Here are some facts on the Icelandic controls, what is at stake and for whom. As Cyprus might find out – and Iceland is already experiencing – the longer the controls are in place, the stronger the forces against abolishing them.

Capital controls come in many shapes and sizes and capital controls in Iceland and Cyprus are of different nature, set to solve different problems. In Iceland, the controls were put in place end of November 2008. At the time, more capital was flowing out of Iceland than could ultimately be converted into foreign currency. The problem stemmed from ISK600bn, €3.76bn, owned by foreigners (or entities abroad), hence the name “offshore krona/ISK” – there was no way the Central Bank of Iceland could find enough foreign currency to convert these ISK investments into foreign currency. Like in Asia in the 1980s these investments, in Iceland called “glacier bonds,” were made to profit from high interest rates in Iceland.

With time, new sources of ISK that need to be paid out in foreign currency have piled up, in total creating a problem amounting to about ISK1200bn, €7.52bn, ca. 70% of the GDP of Iceland. The core of the problem is ISK assets, needing to be converted into foreign currency at some point and kept firmly in place for now by the capital controls. With the controls in place there are various restrictions on movement of assets in out and of the country. I.a., every Icelandic citizen in Iceland has to hand over to the CBI whatever they earn in foreign currency.

The situation in Cyprus, part of the Eurozone, is different. The Cypriot capital controls were needed to prevent a run on the banks, i.e. hindering that deposit holders would empty the banks. Consequently, the controls were more invasive and much more felt, with maximum withdrawal etc. The controls have gradually been eased but there is now, as far as I can see, no certainty as to when or exactly what conditions need to be in place to abolish them.

The laws on capital controls in Iceland expired last year but there is now no time limit. The CBI has certain benchmark needed to be reached.

In Icelandic, one way of describing a short-lived blessing is “peeing in one’s shoes” – it is a quick warmer but the effect does not last and ends up as a messy problem. That is exactly what capital controls are: a quick blessing, which in time turns out to be costly and eventually costlier than the benefits. It is well established that the longer capital controls are in place the greater the damage: they tend to create an asset bubble as too many currency units chase too few investment opportunities, they distort the business environment and eventually they are inductive to criminal behaviour and corruption and – as anecdotal evidence now shows in Iceland: capital controls create unjustified privileges.

The ISK1200bn problem held in place by capital controls

In Iceland, the capital controls now hold three more or less equally large batches of ISK seeking to be paid out in foreign currency. The glacier bonds now amount to ca. ISK400bn, €2.51bn. Those who own them may to a certain degree be patient investors, happy to enjoy Icelandic interest rates, still quite a bit higher than in the Eurozone.

The second ISK400bn batch consists of ISK exposures with direct or indirect state guarantees. The largest part, ISK270bn or €1.69bn, are bonds exchanged between the new and the old Landsbanki when the new one was set up. Other exposures here are loans of state owned companies like Landsvirkjun, the energy company.

The third ISK400bn batch consists of ISK assets in the estates of Glitnir and Kaupthing, which need to be paid out in foreign currency. Ca. 90% of these assets are owned by foreigners but Icelandic creditors like the CBI and Icelandic pension funds own ca. 10% of these assets, meaning that 10% would float back into Iceland when/if these assets (and the estates’ foreign assets) are paid out. It also means that whatever happens to these creditors (i.e. whatever measures used to dissolve the estates and pay out creditors), does not only apply to foreigners but also to Icelandic creditors. And 10% is not a trivial figure in proportion to the Icelandic economy.

In order to lift the capital controls it is necessary to solve the problems that keep the controls in place. This means that in Iceland the size of the problem is roughly 70% of GDP. That in itself would be no mean feat – but in addition, the government (or at least the Progressive Party) has declared that this process has to create a windfall of ca. ISK300bn, €1.88bn, which it wants to use for further debt relief for those who are too well off to have benefitted from earlier debt relief (which so far is the most extensive debt-relief in any debt-hit European country).

Basically every one who does not have debt at stake thinks this policy, first launched as an election promise by the Progressive Party before the election in April, is a bad idea (i.a. potentially inflation-fuelling; funds would be better used to pay down sovereign debt, i.e. benefitting the whole population), amongst them the CBI, OECD, and the IMF. As reported earlier on Icelog, Prime Minister Sigmundur Davíð Gunnlaugsson does not take seriously criticism from foreign “acronyms,” meaning the OECD and IMF – but that is another story.

The glacier bonds and the state-guaranteed assets – 2 x ISK400bn

Though the two estates pose the trickiest problem, the two other batches also need to be dealt with. The glacier bondholders may well get some offer inducing them to stay, such as unfavourable exchange rate/levy. Also, as mentioned above, some of these investors may be in no hurry to leave.

The CBI and others have indicated that the real problem of state-guaranteed ISK assets, though ISK400bn in total, is thought to be ISK250bn because there are ca. ISK150bn worth of foreign assets/revenues to offset it.

Part of the solution would be to extend the maturity of the Landsbanki bonds, now the topic of intense negotiations between the Landsbanki estate and the new Landsbanki. Due to Icesave, the Dutch and the UK guarantee deposit schemes are the estate’s largest shareholders. Dutch and British officials have a thing or two to say on this matter and they are not necessarily dripping with milk of human kindness after the EFTA Surveillance Authority and the EU unexpectedly lost the Icesave case at the EFTA Court.

The trickiest ISK400bn batch

It is clear that the funds for the debt relief should not come from just any of the three problem batches but from the one that mainly regards foreign creditors, i.e. the Glitnir and Kaupthing batch. Politicians, mainly from the Progressive Party, hoping for a windfall here, seem to hope that although the ISK400bn assets are not trivial, the foreign creditors might be willing to negotiate a write-down – or some other measure that would result in funds for the government (though these are assets of private companies) – in order for the creditors to get their hands on the foreign assets in these two estates, the equivalent of ISK1500bn, €9,40bn, close to 90% of Icelandic GDP.

These foreign assets are sitting there, ready to be handed over – ca. ISK1000bn, €6.26bn, in cash, the rest in assets. It is clear though that the CBI, which by law needs to agree to the estates’ composition (or whatever happens to them) will not grant any asset payout until the destiny of the ISK assets is decided. No piecemeal service here.

The possible measures and solutions re Kaupthing and Glitnir are now being furiously pondered on and discussed among those who have a skin in this game – meaning the administrators of the two estates, the creditors (or their ad hoc creditor committees and their representatives), the CBI and the government, probably mostly within the ministry of finance.

Bjarni Benediktsson minister of finance and leader of the Independence Party is well positioned to make an enlightened choice since he has all relevant experts at his fingertips. Also, IP is traditionally well connected to the ministerial administration. Gunnlaugsson, who no doubt will want to follow this closely – given the election promises at stake for him and his party, ultimately his credibility – might find himself in a more difficult position in terms of access to the same kind of expertise, if he wants to make his own independent assessment. The PP, out of government from 2007 to 2013, might not have the same access as the IP.

Why postponing a solution may be a costly option

Foreigners, who have had dealings with Icelanders, often mention that it is notoriously difficult to get Icelanders to make up their mind and commit to a final decision. The estates might be one such problem where the government will find it very difficult to make up its mind, not least because the PP, after their rhetoric and promises, have to present a solution that looks like a victory over the foreign creditors, with the funds to show.

These problems have been clear to everyone concerned for a long time and clearly all those involved with the two estates have been problem-crunching for months now. One of my sources pointed out to me that if this problem is not solved relatively quickly, i.a. a solution presented in the coming month (though the fine and final details make take some mulling-over) this might drag out for quite a while because it would suggest a fear to bite the bullet rather than a lack of informed options.

But can’t the government just wait around until it has found the perfect solution for the two estates? Not necessarily because without a solution the capital controls stay in place. And the longer it takes to solve the issues of the two estates the harder it is to solve. Delays of half or whole years might burden Iceland with added costs of the capital controls.

A delay can have two-fold effect on the estates: the assets will change – and claims will most likely be sold to a different category of investors compared to present creditors.

As to the assets, unsold assets give scope for negotiation of value. The more assets sold and turned into cash, the less scope to negotiate on value. The thinking among some in Iceland is that the creditors of Kaupthing and Glitnir could just solve the problem by giving the ISK assets to the state (for example, handing the over the CBI), in order to get at least the ISK1500bn foreign assets. Negotiating a write-down is more or less the rule in this situation but a pure gift sounds more than wishful since all creditors have to maximise their recovery. Amongst them are the CBI and Icelandic pension funds, which might find it difficult to justify this kind of magnanimous action.

That said, the creditors may in due time well show some creativity and present a solution that indicates they understand the problems Iceland faces. Remains to be seen.

As time passes, it will be more difficult for creditors to show any kind of creativity because more assets will be sold and converted to cash, leaving only the currency rate to be negotiated.

Thus, it can be argued that time is not on the side of the state. The creditors will not be happy to wait but they can get out of the situation if they want to and they, being professional investors and institutions, have seen all of this before.

Here is what delays might do to the creditor group. For now, the original bondholders in Kaupthing and Glitnir own more or less half the claims, with the other half having been sold off to those who specialise in distressed debt. The division is not quite clear-cut because banks and big creditors often invest with the buyer when they sell off their claims in order to get a cut of the up-side if there is any.

If creditors start to think that the assets will be dealt with “sub specie aeternitatis” they will sell their claims – and the more hopeless it seems the more the write-off and the more virulent the buyers. The vulture kind, prepared to sue everyone to hell in order to get as much out of the claims as possible. – This potential change of creditors will of course not happen over night but yes, over time if creditors start to lose hope and just want to get however little out of what they have.

Consequently, the longer it takes to find a final settlement re Kaupthing and Glitnir the greater the difficulties in finding a solution, bringing on losses for domestic creditors as well. And, worst of all, the capital controls stay in place.

The destructive effect of capital controls and the rise of a new Icelandic nomenklatura

In several reports, i.a. on financial stability, the CBI has in no unclear terms spelled out the cost of capital controls for the Icelandic economy brought on by a potential asset bubble and distorted business behaviour. The CBI deems that these are potential risks, which have not yet happened.

It is notoriously difficult to tell when there is bubble, i.e. when assets are mispriced and asset prices have been rising fast in Iceland, i.a. property prices and shares of listed companies. Both the CBI and financial analysts say that so far, these price increases are in tune with the economy, not a bubble.

The no less worrying effect is, I think, that capital controls are potentially fertile ground for corruption. With time, they create a booming industry seeking to avoid the controls. And with time this industry will do what it can to keep the controls in place.

This is a general course of events in countries with some kind of capital controls. In addition, the capital controls in Iceland are slowly creating its own special kind of a privileged nomenklatura that can buy assets at a cheaper price than other Icelandic mortals.

In order to relieve the pressure of the offshore ISK, the CBI came up the with the idea of offering offshore ISK owners a way of investing this money, given certain terms and conditions, if they bring in foreign currency in addition to the offshore ISK. This seemed like a reasonable way to attract foreign investment to Iceland. The problem is that this has, apparently, not attracted foreign investors but gives Icelandic investors, with foreign assets (which have to be since before the capital controls) and offshore ISK, the possibility of buying assets in Iceland, be it property or financial assets, at a ca. 20% discount to Icelanders who have nothing but their hard-earned not-worth-much ISK.

This new nomenklatura is now pretty clear and known to everyone though it is hardly ever mentioned in the Icelandic debate. I can certainly not remember ever having heard a politician mention this (but here I might be wrong since I don’t follow the Icelandic debate in detail).

Another sneakier way is less well known but indeed existing, I’m told.

It is always presumed that the glacial bondholders are foreigners. That is probably how it was in the beginning of time, i.e. when these investment objects were created and up to the collapse. What I now hear from various sources is that there are Icelanders in this group. No, not necessarily the notorious billionaire “Viking raiders” but wealthy Icelanders, in Iceland, who have bought the bonds after the collapse and now hold them through foreign companies or “nostro” accounts of foreign banks. Out of the total ISK400bn these may not be high sums but, again in Icelandic context, quite a bit of money.

Here is the trick: the law on capital controls allow glacial bondholders to convert the interest rate of glacier bonds into foreign currency and move them abroad. Icelandic glacial bondholders can then take this foreign currency and bring it back to Iceland through the CBI investment offer, to buy Icelandic assets, meaning they get the Icelandic assets at ca. 20% discount, as mentioned above.

It would be very interesting to know who these alleged Icelandic glacial bondholders are. It would throw light on how privileges are meted out in the regime of capital controls and clarify the stance that certain individuals may take in the public debate.

Waiting is not an option – if the cost of capital controls matters

As argued above, there are various reasons why waiting is costly, why waiting compounds the problem of the capital controls and makes the ensuing problems more engrained over time. Needless to say it is extraordinarily difficult to say exactly at what point the cost is greater than the benefits of the controls. Also, assessing the cost of the corruption the capital controls create is particularly hard to evaluate.

The capital controls in Iceland have been in place for the best part of five years – in Cyprus only for five months. Although the controls in the two countries are of different nature, put in place to solve different problems, Iceland can be an interesting example for Cyprus – and possibly, with time, an example of what to avoid.

*Here are some earlier Icelogs on capital controls.

Follow me on Twitter for running updates.