Sigrún Davíðsdóttir's Icelog

Understanding constellations in Icelandic politics, not solely the economics, is the key in order to understand what could and might happen in Iceland regarding the capital controls. Although ex-prime minister Davíð Oddsson left office in 2004 he still seems to be the puppet master and king maker in Icelandic politics. Thus, Morgunblaðið, edited by Oddsson can be read like entrails in the olden times. Comparing the recent IMF report and what Morgunblaðið states provides some hints to what might come – and none of it is uplifting in view of general Icelandic interests.

On an Icelandic debate programme earlier this year one of the participants claimed that when it comes to the capital controls Icelanders are fighting to solve a problem of “hundreds of thousands of billions króna.” – None of the other participants corrected this. The Icelandic GDP 2013 was ISK1786bn, €11.5bn, which would make “hundreds of thousands of billions króna” a truly staggering, if not a hopeless problem to solve. Luckily, the problems are not quite that towering though in no way easy to deal with.

For control-watchers, reading Morgunblaðið like entrails, looking for hidden signs, is essential. A point in case is a recent article on Project Irminger.

Davíð Oddsson, its editor, used to run the country and his party, the Independence party in the 1990s, then switched over to run the CBI (needless to say a lawyer ex-prime minister turning governor of a central bank is unthinkable in all Western countries except Iceland) where he oversaw the collapse of the Icelandic economy and the CBI and from where he was ousted by public demonstrations in early 2009. As editor of Morgunblaðið he has overseen a steep fall in subscription but its owners – 50/50 a fishing-industry with Independence party ties and a Skagafjörður co-op traditionally linked to the Progressive party, thus miraculously mirroring the present coalition government – are more than happy to have him in charge, even after a recent gaff of staggering dimensions.*

The Morgunblaðið entrails and other signs could indicate that the lifting of the controls will be used to steer the two new banks – Arion and Íslandsbanki – into Icelandic ownership. And there needs to be something that looks like a victory for the Progressive-lead government. Prime minister Sigmundur Davíð Gunnlaugsson has time and again talked about the “inevitability” of the state profiting from lifting the controls.

While waiting for the next step towards lifting the capital controls appointing a new governor of the CBI will be a significant indication of the direction the government is heading into.

IMF: the orderly and the disorderly legal route

In its latest report on Iceland the IMF is worried about downward-tilted risks, i.a. in lifting or unwinding the capital controls: “A disorderly unwinding of capital controls could weaken the krona, lower reserves, and bring down market confidence and growth.” “An orderly lifting of capital controls, however, would prevent large capital outflows and disruptions to financial markets.” It is thus glaringly obvious what the IMF wants to avoid sternly warning the government of the dangers of actions leading to disruption and disorder. After all, Iceland very much needs continued access to financial markets.

Creditors cannot be paid out until the estates of the old banks are resolved, either by putting them up for bankruptcy or with a composition agreement. Here the IMF is also clear as to what constitutes an orderly route out of capital controls:

Two broad legal avenues are being discussed, one involving composition agreements that would provide an agreed roadmap for exit and the other involving bankruptcy proceedings (liquidation) with an uncertain exit from controls.

And then there is the reputational risk to keep in mind:

“Staff noted the importance of carefully considering the legal and reputational risks surrounding the strategy for addressing potential BOP pressures now locked in by capital controls, including the resolution of the old bank estates.” (My take on the IMF report is here.)

Project Irminger

The above-mentioned article in Morgunblaðið stated that the government kept the IMF thoroughly informed on every step. Consequently, the IMF was now aware of the government’s estimate of the problems and the avenues it believes passable. Further, according to the article, the IMF agrees with the government it is important not to exclude any possibilities; this was necessary in order to create incentives for creditors to bring to the table a solution fitting the Icelandic balance of payment.

Although the article was published weeks after the IMF report on Iceland the report does not figure in the Morgunblaðið article. On the contrary, the article creates the feeling that the IMF was equally in favour of the two legal routes and broadly in favour of what the government had in mind.

As can be seen from the quotes from the IMF report the Fund is indeed not mincing its words as to the best and most viable routes. Knowing from Morgunblaðið that the IMF is well informed there can be no misunderstanding when it i.a. clearly warns against the bankruptcy route that both the prime minister and minister of finance mention as an option every time they discuss publicly the capital controls and the estates.

The Morgunblaðið article states that the government is now working on a project called Project Irminger (named after an ocean stream that brings warm water to the South West coast of Iceland). The Irminger project seems to give no scope for negotiations with the creditors in spite of their attempts in that direction, at least since end of 2012 when both Glitnir and Kaupthing presented a draft of a composition agreement to the CBI.

Instead, possibly in September (unlikely soon, to my mind; every step announced by the government tends to take much longer than planned) according to the article, creditors will be presented with an analysis of Iceland’s economy, balance of payment etc after which they can adopt their composition agreement to this analysis. It does not seem there will be any negotiation but some sort of a “take-it-or-leave-it” analysis (more or less as the government has been saying from its birth last year: the creditors should understand and appropriately adapt to the reality, as defined by the government). The government will wait for no longer than three months or so and if nothing is forthcoming from the creditors the bankruptcy route will be taken, the article states.

The article is not clear about in what order things will be done. The CBI and the IMF have stressed the importance of resolving Glitnir and Kaupthing’s ISK assets and the Landsbanki bonds. The pension funds and other Icelandic investors are also seeking to direct investments abroad. The order of “exiting parties,” i.e. those allowed to take/convert ISK into fx is important. Whatever the order, the IMF has clearly indicated that the “exits” can only happen over some years and it favours letting the creditors out first; an advise that is easily turned into something anti-Icelandic in the Icelandic debate (see here on the interests of the pension funds in lifting the controls).

As so often with Morgunblaðið articles on hot political topics the Irminger-article seems to be a carefully crafted leak, published to warn, threat and mis-inform.

Rumours and sentiments as to what is in the making

Key issue in solving the ISK problem of Glitnir and Kaupthing is the sales of Íslandsbanki and Arion (more here). Some control-watchers claim that the government plans to instigate a disorderly and messy winding-up process for Glitnir and Kaupthing to ensure a fire sale of two new banks enabling a sale to investors close to the government (two banks, one for each party).

As to possible actions the ideas flying around are i.a. legal measures to isolate the estates from the economy so pension funds and other Icelandic entities can convert ISK to fx, i.a. for investing abroad, i.e. would exit from the controls before the estates. Again, such measures would not be a solution, only another hammock.

There are also tentative ideas that Eignasafn Seðlabanka Íslands, ESÍ (the CBI holding company) and some pension funds could form a joint venture to buy out the new banks. The fear is that none of this is thought through or creditors’ reactions taken into account; in short that these and other rumoured measure will not at all be the orderly route the IMF recommends.

The feeling all along has been that the aim of the government has been to get hold of the banks – to secure Icelandic ownership in Icelandic interest or in Icelandic special interests, depending whom to believe. Iceland is apparently the only country in Western Europe where no foreign banks operate and where domestic investors own all banks (apart from the accidental ownership of Arion and Íslandsbanki and foreign investors in MP Bank).

It is difficult to argue why it would be the end of Icelandic businesses if Glitnir and Kaupthing were sold to foreign investors, paying in fx – thus solving the estates’ ISK problems. Foreign ownership might possibly end banking the Icelandic way that played a big role in bringing down the Icelandic financial system but those who profited from that system might certainly want to reinstate it.

Glitnir and Kaupthing – but what about selling new Landsbankinn? Incidentally, that bank is owned by the Icelandic state but the bank cannot be sold until the problems of the Landsbanki bonds is solved. There is now an agreement in place and although it seems to be close to what the CBI had advised (and after all, it can hardly have been done against the wishes of the bank’s owner, the state) the government seems unwilling to take the steps needed to ensure the agreement. Intriguingly, new bank is at the mercy of its bondholder, the Landsbanki estate where the creditors from the two other estates wield power.

The frustrating thing is that possible solutions, in the general interest of Iceland and not narrow interests, are not that difficult to map out – complicated but not complex. There are even some Icelandic civil servants who would like to negotiate with the creditors, believing that beneficial solutions could be found relatively easily and fast: it is after all in the interests of not only creditors but also Icelanders to lift the controls though Icelandic politicians tend to speak as if Iceland can wait but the creditors are in a hurry.

Interestingly, civil servants have mostly been kept away from the plans of the present government, which instead makes use of a few trusted lieutenants. The government keeps appointing Icelandic “individual experts/advisers” as it calls them in press releases though then calling them a “group” when their role is discussed. It is not clear why this systematic mis-presentation of their roles but one reason might be that formal working groups are expected to be made up of men and women whereas the two capital controls “groups” have been all-male.

The importance of a(n independent) central bank

Lastly there is the importance of CBI in what ever will happen in Iceland, soonest regarding the Landsbanki bonds agreement.

In general, IMF is adamant about the importance of independent central banks. For good reasons, the IMF has been worried about the CBI and states in its last report on Iceland: “Maintaining a financially sound, independent, and accountable central bank is important for policy credibility and anchoring inflation expectations, which in turn supports stability and growth.”

It is most likely only a matter of days until the name of the next governor will be announced. As I have written earlier the feeling is that professor Ragnar Árnason is the government’s favourite for the position though the third leading candidate, professor Friðrik Már Baldursson might be a possible compromise. It would be a stretch to see CBI’s independence strengthened with Árnason who most recently has i.a. been the government’s representative on the CBI board and the chairman of an advisory council for the minister of finance, in addition to earlier services to the Independence party for more than a decade.

In addition to the present governor Már Guðmundsson the selection committee , which was called “bizarre” in a recent article in Central Banking, deems that both Árnason and professor Friðrik Már Baldursson are equally fit to serve as a governor. To put the three side by side as equally fit is quite remarkable, to say the very least, considering Guðmundsson’s experience and standing.

The governor of the CBI will be a key person when it comes to lifting the capital controls – and in the asset sale of the century, the sales of Arion and Íslandsbanki. Hardly anything re the capital controls and the estates can be decided on without assistance of the CBI, most notably the governor of the CBI.

If Már Guðmundsson will not be reappointed as a governor it sets in jeopardy any orderly route towards lifting the capital controls. Ousting Guðmundsson might well indicate that there are interesting times ahead in Iceland but not necessarily the best of times for financial stability and the interests of Iceland as a whole.

*The Oddsson/Morgunblaðið gaff: recently, Morgunblaðið published, in quotation marks, what it claimed was part of an email written by the Althingi Ombudsman Tryggvi Gunnarsson who was on the Special Investigative Commission. The email was published July 12 in a weekly column, called “Letter from Reykjavík,” traditionally unsigned but known to be written by the editor, now Davíð Oddsson. Morgunblaðið claimed Gunnarsson had sent the mail to many news outlets in January late at night, a claim Icelanders take as a hint that the email-writer was drunk. In the email Gunnarsson sided with the Brits (highly dubious in the view of Morgunblaðið) in using the so-called terrorism legislation to freeze Icelandic assets in the UK. Further, Gunnarsson spoke badly of the president of Iceland, who Morgunblaðið holds in high esteem after he hindered an agreement in the Icesave dispute. On the day Morgunblaðið published the Tryggvason email the paper published a correction on its website, stating that the email was a forgery only to admit later in the day, with apologies to the Ombudsman, that the letter was indeed written by a certain Tryggvi Gunnarsson, namesake of the Ombudsman and not the Ombudsman. The namesake is apparently known among Icelandic media people as a prolific email writer whose opinions are never reported; his email is a Hotmail address. There was absolutely nothing in the email to indicate that the Ombudsman had written it. The second, and no less interesting part of the “Tryggvason email” story is that the editor’s atrocious mistake has had no consequence for the editor who continues in his job, unchallenged as before. The gaff was like a stone thrown into a lake producing no rings on the surface; an airy phenomenon. – Journalist Egill Helgason notes on his blog that Oddsson is driven by such hatred that in attacking his enemies scrutiny of sources is easily forgotten. – The last thing to draw attention to Oddsson’s view of the world is that Morgunblaðið’s Letter from Reykjavík July 26 talks about “Barack Hussein Obama II,” characterizing him as “indeed a mulatto,” a word that is generally no longer used in Icelandic and has the same connotations as in English.

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One of the problems with the debate in Iceland on capital controls is that so few seem to grasp the essentials. Consequently, politicians and special-interest agents on a mission can get away with saying almost whatever they fancy without being challenged. Once in a while, foreigners dive in, equally ill-informed, thwarting the debate further for Icelanders who, as so many small nations, tend to swallow everything coming from abroad. A case in point is a recent FT article by Gillian Tett with a somewhat misleading description of the Icelandic situation only some weeks after the IMF published a most informative report on Iceland. IMF gives some intriguing hints on two key issues: the Central Bank of Iceland and the legal routes out of the capital controls’ impasse.

Practically all nations forced to save themselves by slamming on capital controls struggle to get rid of them. It is by now an all too familiar problem that the shelter, provided by the controls for solving the original problem calling for controls, tends to turn into a hammock for in-action. Iceland is no exception.

The situation in Iceland however offers further complexities: getting rid of the controls will not prove easy at the best of times – but the overwhelming sense among control-watchers is that there might be wheels within the capital control wheels: first of all, steering the two new banks, Arion and Íslandsbanki, now owned by the failed estates of respectively Kaupthing and Glitnir, into hand-picked, politically-palatable ownership in what could be called “the asset sale of the century” (Icelog on this topic). Secondly, the government is seeking to preferably score a “victory” (à la Argentina) over the foreign creditors by securing funds from them for the state.

Iceland’s attraction for pundits in search of a good case to prove their point

Over the past few years, Iceland has been seductively attractive to economists and pundits looking for a story to prove their points/theories. Writing in July 2010 à propos an article by Paul Krugman on Iceland I pointed out that “when it comes to small countries (or exotic topics) it seems permissible to express opinions without knowing very much – or even anything at all.” – Those in the know and understanding are few and far between.

One myth has been that by letting its banks fail, Iceland’s cost of the collapse was almost negligible (more on this here). The cost partly rose from misguided attempts to save two private banks, possibly because of some domestic interests at stake. In addition, there was the cost of propping up the Icelandic “Sparkassen-system.” Thus, the cost of the collapse and resurrecting the country’s economy is more likely to be one of the highest for every country over the last few decades, ca. 20-25% of GDP.

In a recent article in the FT Gillian Tett joins the company of Krugman and many others on the well-trodden path of misunderstandings regarding the Icelandic collapse, subsequent events and the state of affairs right now. Apart from it being slightly shocking that such an esteemed paper as the FT does not take more care with what it prints the article provides a good opportunity to sum up the essentials on post-collapse Iceland and the capital controls. However, Tett’s general point certainly is valid: there is an essential topic for debate on emergency measures that are used as delaying tactics instead of a necessary shelter to work on solutions.

What happened when the banks collapsed?

Tett writes:

When the three banks collapsed, the government decided to save the domestic parts of the system (and its own taxpayers) by piling pain on to foreign creditors and depositors. So bank bonds held by foreigners were tossed into default and turned into implicit equity claims on the collapsed lenders – and bank deposits that foreign investors held in Icelandic krona were trapped in the country by capital controls.

True, the idea was to save the domestic part. The dilemma was how to dismantle a banking system ca. eight times the GDP of Iceland without drowning the whole economy at the same time. (The Icesave saga is about depositors in Landsbanki’s accounts in the UK and the Netherlands and EU’s passport rules for the financial sector; remarkable there was a mini-rerun of the passport conundrum in the UK following the Cyprus crisis; some aspects of Iceland vs Cyprus here).

Consequently, the operations of the three largest banks were divided into domestic and foreign operations. There were, and still are, persistent rumours that during the hectic days in early October 2008, when the emergency Act was being finalised, the policy really was called “f**k the foreigners.” Hardly shocking: a country staring into the abyss will go to great lengths to save itself, thinking less about others.

As explained in the Financial Services Authority, FME’s, annual report 2009 (there was no annual report in 2008) following the emergency Act (Act 125/2008) passed on October 6 2008 the three largest banks – Kaupthing, Landsbanki and Glitnir – were taken over by the FME and divided into “old” banks (destined to be wound up or liquidated at some point) and “new” banks. Like any estate of a failed private entity these failed banks are controlled on behalf of creditors, now by Winding-up Boards, one for each bank.

The three so-called new banks were turned into fully operating domestic banks. Following a crash settlement in the days after the October 2008 collapse the FME oversaw the finalising of financial instruments, based on valuation of assets transferred, between the old and the new banks. The new banks for Kaupthing, Landsbanki and Glitnir are respectively Arion, Landsbankinn and Íslandsbanki.

Thus there was a clear dividing line – not that “bank bonds held by foreigners were tossed into default.” And as in any failed company the creditors hold claims in the three failed/old banks.

According to the FME assets and liabilities of the new banks the “principal asset classes were loans to customers, on the one hand, which were further subdivided into loans to large corporations, small and medium sized enterprises and retail loans and, on the other hand, other assets. Liabilities consisted almost solely of deposits, which were valued at principal value. Gross loans to customers (that is the outstanding loan balances before any provisions or adjustments) represented over 80% of gross assets in each of the three new banks. Large corporate group loans (with liabilities in excess of ISK 2.5 billion) represented ca. 40%-70% of total gross loans to customers and ca. 55%-85% of corporate loans to customers across the three new banks at the respective carve-out dates.”

The problem that called for capital controls

The original problem, calling for capital controls, was foreign-owned ISK, or “nonresident holdings of liquid krona” as the IMF calls it. At the time these funds were over ISK600bn, but following CBI auctions these funds now amount to ISK322bn (at the end of February 2014) or 18% of GDP; 67% of gross reserves. These funds mostly originated from so called “glacier bonds” – bonds issued in Icelandic króna, ISK, often sold to wealthy individuals, popular in Germany and the Netherlands. At the time, both the government and the CBI chose to ignore the potentially destabilising effect of these, in spite of the effect of similar flows on some Asian countries in the 1980s and the 1990s.

These funds are no longer the greatest threat to Icelandic financial stability. In addition, it seems that at least some part of these funds willingly stays in Iceland because of the (still) high interests there.

But what is now the problem if it is no longer these liquid foreign-owned ISK? Tett talks about the bank bonds held by foreigners being “tossed into default and turned into implicit equity claims on the collapsed lenders – and bank deposits that foreign investors held in Icelandic krona were trapped in the country by capital controls.”

The main obstacles towards lifting the controls are the ISK assets of Glitnir and Kaupthing, in total ISK450bn (end of 2013; further here) and the two Landsbanki bonds of which ISK226bn is still unpaid (more here; more on the numbers and how they are found in CBI’s latest stability report).

The bondholders now hold a claim on the estates, as happens in any other failed company. They were inevitably mostly foreigners since the banks’ fast growth was fuelled by international lenders and not by domestic deposits and domestic bond sales.

It is also worth noting that in total, 5.7% of the claims are owned by Icelanders, or just over ISK100bn, mostly held by the Eignasafn Seðlabanka Íslands, ESÍ (the CBI holding company). These funds could possibly be part of the solution, i.e. used in swaps with foreign creditors. (See here for numbers and facts, in my digest of the latest IMF report and here for my latest overview of numbers and possible solutions).

Why is it important to lift the controls?

“In the past few weeks the government has indicated that it wants to start removing these controls to attract more investment to the energy sector and to create a more “normalised” financial system,” writes Tett.

The story is a lot longer than just a few weeks. The left government, in power from spring 2009 until the elections last spring, did got very far with plans to remove the capital controls – also because it was too weak to tackle the issue towards the end – but some progress was made. The CBI presented a plan in 2011, still the basis as no new plan is in place (here is an Arion bank analysis from December 2011 of that plan; the time frame has since been lifted, meaning that the plan is no longer anchored in time but to certain benchmarks).

During the election campaign the Progressive party, which until early last year seemed destined to be close to a wipe-out in the spring elections, attracted an unexpected following by promising voters debt relief funded by creditors, i.e. funds that would “inevitably” flow to the state as the controls on the two bank estates would be lifted. The numbers mentioned escalated from ISK300bn to as much as ISK800bn mentioned just before the election. However, when the debt relief was presented last November it was not funded by these “inevitable” sources of money but from a bank levy, also on the estates and from people’s own pension savings, a step IMF warns against in its last Iceland report.

It is misleading to say that the scope for lifting the controls is only to attract FDI for the energy sector. And it certainly is not just to normalise the financial sector, but to normalise the whole economy. As the CBI now points out at every opportunity the capital controls do in themselves induce a long-term risk, i.a. here:

Capital controls limit possibilities for cost-efficiency in business and distort the premises for investment decisions. The longer the control regime remains in force, the greater is the risk that investment options will be determined to a growing extent by possibilities of returns within the controls, while at the same time emphasis grows on seeking ways to circumvent the controls. The structure of business and industry could therefore in time develop differently within the control regime than without it. Options decline in number, and output growth and living standards deteriorate.

This spring, numerous individuals and organisations in the business community univocally called for government action towards lifting the capital controls. But no matter the policy it will realistically take some years until the controls are lifted. In addition, Iceland will also have to come up with a credible vision for the króna and the future. There are also those who believe some controls will be needed for years and possibly decades to come.

Correct proportions, correct numbers

According to Tett, Iceland’s “sovereign debt is “just” 84 per cent of gross domestic product, according to the International Monetary Fund. But if you add the remaining liabilities of the banks – which are implicitly owned by the government – the total debt ratio is 221 per cent, and there is little chance of the island repaying it in full.” (Emphasis mine).

According to the IMF’s latest report Iceland’s sovereign debt was 89.9% last year and projected to be 86.4% this year. The three new banks are not “implicitly owned by the government”: the state owns 13% of shares in Arion and 5% in Íslandsbanki with the estates of Kaupthing and Glitnir respectively owning the rest. The government owns 97.9% of Landsbanki with the employees owning the tiny rest.

Further, Tett writes that “any relaxation will force a new debate about that debt mountain, since the $7.4bn of krona held by foreigners in Iceland’s banks will almost certainly flee if controls are removed without any clarity on how creditors who hold Icelandic bank debt will be treated. And a flight of capital could spark a fresh crisis.”

“That debt mountain” seems to refer to the 221%. What the $7.4bn of foreign-owned krona assets refers to is not entirely clear: the foreign-owned ISK in Glitnir and Kaupthing are in total ISK450bn, $3.9bnbn – and the original overhang is ISK322bn, $2.8bn.

Thinking that the controls will be lifted “without any clarity on how creditors who hold Icelandic bank debt will be treated” seems to indicate a fundamental lack of understanding of the problem: this is exactly the main problem now being worked on and no lifting can or will happen until it is solved. As the CBI and the IMF have repeatedly pointed out any steps towards lifting the controls will have to include a plan as to how to deal with foreign-owned ISK in Glitnir and Kaupthing. And not until then can the estates start paying out to the creditors (see here).

“The good news,” according to Tett, “is that the government announced this week that it has appointed external advisers for talks with creditors. But the bad news is that finding any resolution could prove very hard. A group that represents about 70 per cent of bond holders wants its claims to be settled by selling the successors to the collapsed Icelandic banks to new foreign owners.”

True, it is good news that there are foreign advisers (given that their expertise will be used wisely). The bad thing is not, as Tett points out, that it could prove hard to find a solution. The bad thing is, as I have pointed out earlier, if the government does not have any plan to get their advise on – or is not ready to accept their proposals (perhaps because it is focused only on a solution that will move the ownership of Arion and Íslandsbanki to Icelandic owners with the right political pedigree).

Finding a solution is indeed not necessarily very hard (see here). Again, it will not be easy if the government is hell-bent on not just lifting the controls but also securing some special interests at the same time. According to the Act on Financial Undertakings  no. 161/2002 (the “Act on Financial Undertakings”) votes of parties controlling at least 2/3 of share capital or guarantee capital need to accept all major decisions of the estates.

Iceland is not Argentina – or at least not just yet/does not need to be

Tett is not the first to mention Iceland and Argentina in the same sentence as if the two countries shared the same problems: “So there is every likelihood the country will either end up in a protracted court fight, like the one between Argentina and its “holdout” creditors; or that the government keeps playing for time by extending those supposedly “temporary” controls indefinitely.”

Argentina defaulted and has for a long time (in)famously been involved in legal warfare with some of its creditors (my favourite Argentinian commentaries are those by Joseph Cotterill on the FT Alphaville). Iceland has not defaulted and its problems are, so far, contained in the estates of the three failed private banks.

However, if the Icelandic government strides into the field and incurs liabilities by legal measures, which might make the creditors sue the government, i.a. because of breech of property rights, the situation could turn Argentinian. With foreign advisers, no doubt aware of all of this, as well as being concerned about reputational risks, as is indeed both the IMF and the CBI, it seems unlikely (though by no means unthinkable) that the Icelandic government will by accident or recklessness (or both) unwittingly find itself exposed to legal wrangling with the creditors.

I have argued earlier that the government is incidentally already exposed to such a risk. After a change in the capital controls Act last year, the minister of finance has to agree to certain steps regarding the fate of the estates. It is easy to think up several such scenarios resulting from this. I.a. the creditors could take legal action if they at some point feel that by inaction the minister is indeed a hindrance to payouts.

As many other pundits Tett is recounting the Icelandic financial disaster saga to prove general points. “The first is that “emergency” policy measures that distort the financial world tend to become addictive. Second, this addiction is very hard to break when there is an unpleasant debt overhang, be that of the public or semi-public sort.”

With gross debt rising in the world these are indeed important and never too oft repeated lessons to be learnt from the Icelandic collapse saga. The Icelandic reality is not quite what Tett makes out of it but does never the less support the lessons she wants to draw from the Icelandic fall and recovery.

*All the essential information on Iceland, its economy and capital controls are here: the IMF pages on Iceland – and the CBI financial stability reports.

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By overturning an earlier court decision an appeal court in Luxembourg now seeks to establish an investigation into “money laundering, fraud and criminal conspiracy.” Benjamin Bodig, lawyer for the Landsbanki victim group, says it “opens the door to discover the truth and could lead to its victims being recognised as aggrieved customers” according to an article in Wort.

In October it will be six years since Landsbanki collapsed. The Luxembourg clients, mostly elderly foreign pensioners owning property in Spain and France, who had taken out equity release loans from Landsbanki have now for years sought to have investigated how Landsbanki handled these loans and the investment that were part of the loans and also the actions of the liquidator, Mme Hamilius.

Special prosecutor in Iceland has already charged Landsbanki managers for market manipulation and breach of fiduciary duty. These charges are still being dealt with by Icelandic courts. In France there is now an investigation into the Landsbanki practices as well. From what I have seen regarding Landsbanki operations in Luxembourg there is good reason to investigate the bank’s operation, both before and after the collapse.

The actions against Landsbanki in France and Luxembourg would not have happened if it were not for the heroic attempts by the Landsbanki victim group to have these operations investigated. Their attempts in Luxembourg were met by remarkable lack of interest on behalf of the authorities, the height of which was when Robert Biever Procureur Général d’Etat, state prosecutor, sided openly with the liquidator, echoing her view that the Landsbanki Luxembourg clients raising concerns just did not want to repay their loans, as mentioned in an earlier Icelog.

As I have written earlier this “case has shown that when it comes to unified European financial  sector it only works for banks, facilitating cross-border operations. For clients and consumer protection this sector has as many holes as a Swiss cheese. A food for thought: if cross-border operations only work for banks and not for clients they should not be allowed.”

Here are some earlier Icelogs on the remarkable story of this case that authorities in Luxembourg have ignored for so long.

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According to a new IMF report on Iceland recovery in Iceland “is continuing and the growth outlook is positive, but crisis legacies continue to weigh on the economy. The government is undertaking efforts to address them but this entails significant risks.” IMF points out there are two legal avenues being discussed to release the old banks from capital controls, composition agreement that “would provide an agreed roadmap for exit and the other involving bankruptcy proceedings (liquidation) with an uncertain exit from controls.” – This is a clear hint to the Icelandic government, which way is the least risky.

At times, IMF reports are like a recording of the dialogue between staff and the authorities they speak to. In the newly released IMF report on Iceland there are some interesting parts where the staff says one thing and the authorities something else.

The main topics of interests, apart from capital controls, are the Housing Finance Fund, HFF, FME (the financial services authority) and fiscal policies. Also the Fund stresses the importance of a strong and independent Central Bank – especially interesting now that its structure is under review and a new governor will soon be appointed. Prime minister Sigmundur Davíð Gunnlaugsson has time and again strongly criticised governor Már Guðmundsson and CBI staff.

It is worrying that according to the IMF necessary and planned reform at the FME have not been carried out, there is insufficient funding for much needed IT reforms and on the whole the FME suffers from funding cuts. I.a. progress of new industry rules for risk management and asset classification has been slow, which does not bode well for financial stability.

Capital controls and the estates of the failed banks

The foreign-owned ISK, or “nonresident holdings of liquid krona” as the IMF calls it, amounts to 18% of GDP; 67% of gross reserves. These holdings “are slowly being released via the established FX auction mechanism.” It is assumed that consistent with Icelandic 2011 liberalisation strategy this crisis legacy might well be released by the end of 2016.

The easing of controls on the estates of the old banks is a different and more difficult matter.

The three old bank estates control an estimated 44% of GDP in (net) domestic assets, ie ISK assets in addition to 84% of GDP in (net) fx assets, crucially held overseas and owed to foreign or “non-resident” creditors. These assets are closed in by the capital controls.

The IMF estimates that once lifted the estimated fx outflow caused by Icelandic private individuals and corporate entities, also pension funds, might amount to 20-45% of GDP.

The question is how to resolve the issues of the estates, how to release them from the capital controls. Payouts can only happen when the estates are wound up/liquidated. As the IMF points out: “Two broad legal avenues are being discussed, one involving composition agreements that would provide an agreed roadmap for exit and the other involving bankruptcy proceedings (liquidation) with an uncertain exit from controls.”

The reader can be in no doubt as to which route the Fund favours.

In a video interview with the Financial Times finance minister Bjarni Benediktsson said that foreign creditors have already been paid billions of euros. From his words it could be understood that these funds were euros, earned by exporting Icelanders. The footnote to his words is that priority creditors have been paid ca. ISK1000bn, or ca. 55% of Icelandic GDP so far – but this comes from the estates’ own fx funds, mostly held abroad, not from balance of payment, BOP, sensitive funds. – Or as is pointed out in the IMF report: “Significant payments have also been made to priority creditors of the old bank estates from recovered external assets.”

Guiding principle in lifting the controls: transparency

Further to the general principles that should guide the lifting of the capital controls:

Staff encouraged a transparent, comprehensive strategy that addresses all potential outflows. The approach should be consistent with macroeconomic and financial stability, and conditioned on BOP prospects. Staff noted the importance of carefully considering the legal and reputational risks surrounding the strategy for addressing potential BOP pressures now locked in by capital controls, including the resolution of the old bank estates. Staff emphasized the benefits of a cooperative approach that would minimize risks to long-term growth, the prospects of which remain closely tied to economic and financial links with the rest of the world. In this context, staff welcomed the authorities’ recent organizational changes and planned engagement of advisors, which could help facilitate a resolution. Consistent with past advice, staff noted that appropriate use of incentives could help encourage lasting solutions. The authorities generally agreed with these points. They noted the Landsbankinn bond restructuring could be a useful development, but needs to be assessed in the context of a more comprehensive plan. With respect to the old bank estates, they stressed they would move on to other approaches (e.g., bankruptcy proceedings (liquidation)) should a cooperative settlement not materialize.

In short, the Fund favours carrots but the Icelandic government certainly is not going to throw away the stick, i.e. bankruptcy proceedings (although yes, the Fund gives warning words re orderly vs. disorderly exit from controls).

There is mutual understanding that the strategy to lift controls needs to be linked to a credible balance of payment analysis. “Staff welcomed the CBI’s ongoing BOP work and urged that it be the basis for discussion with key stakeholders.” – This is interesting since part of the task of the new foreign advisers apparently is a BOP analysis. As the Fund underlines, the CBI is working on it; the CBI analysis should be the basis for discussion with stakeholders, i.a. the creditors.

Further, here is an interesting insight into how the Fund vs. the Icelandic government perceives the situation: “Staff reiterated that a revised liberalization strategy should be paced to maintain adequate reserve coverage and that supporting debt management—including Eurobond issuances to maintain FX reservees as repurchases to the Fund take place—will be a necessary component. The government expressed concern with the higher debt and interest costs from such issuances. Staff emphasized the precautionary role of reserves and noted that public sector debt levels would not change.”

The risks in lifting the capital controls

The IMF is not trying to minimise the various risks threatening the Icelandic economy – the word “risk” is used 66 times on the 62 pages (where ca. half of the pages is mostly diagrams).

Here the risks regarding lifting the controls is neatly summarised – and some of it is beyond the control of Iceland:

Staff and the authorities agreed that risks are tilted to the downside. A protracted period of slower global growth could dampen exports and foreign direct investment. Surges in global market volatility have so far had only muted direct effects on Iceland but a sharp deterioration in external financing conditions could complicate refinancing of large external payments coming due during 2015–16 and delay the easing of capital controls. Efforts to resolve the old bank estates could result in faster capital account liberalization, boosting confidence and investment and raising long-term growth. However, missteps could result in a more protracted impasse leading to a weaker business climate, lower investment, asset bubbles from locked in liquidity, eroding competitiveness, and weaker growth. Lifting capital controls before the necessary conditions are in place could destabilize the krona, lead to higher inflation and reserve losses, and lower confidence and growth. Even without liberalization steps, deeper depreciation pressures could emerge that could be difficult to counteract.

As to deciding what to do and when clearly implies some “damned if you do and damned if you don’t”:

It was known when capital controls were imposed that the negative effects would grow faster than the benefits as time went by, and the authorities are resolute to take significant steps towards removing the controls in coming months. The steps taken will be conditions-based. However, there is no risk-free liberalization of capital controls, and the microeconomic costs are accumulating. The risks must therefore be weighed against the costs of delay.

By now, many countries have tasted the intoxicating mélange that capital controls are and there is abundant experience of their effect. It is well known that with time, the benefits originally reaped by capital controls dwindle and the negative impact increases. It is never easy to tell when exactly this turning from positive to negative is reached. Considering how loudly Icelandic business leaders are now complaining about the deadening effect of capital controls it is clear that at least for some businesses this point is already reached.

In general, creditors want to negotiate and creditors to the failed Icelandic estates do not seem to be any exemption from the general rule. As I have underlined earlier, there are strong forces in Iceland, with strong interests, pleading for the “disorderly” and “un-cooperative” approach to the estates. With the IMF report the Icelandic government now has some clearly spelled out advice in words such as “orderly” and “cooperative.”

*All emphasis in quotes is my own.

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So far, every move by the Icelandic government towards lifting the capital controls has taken more time than anticipated and yielded less than promised. Now a managing committee to steer a whole crowd of foreign advisers is in the making: again, it was announced a while ago and although the foreign advisers have already had meetings in Iceland the managing committee is still not in place. If this isn’t to be yet another underwhelming exercise the government has to resolve the tension centring on an orderly composition agreement for Glitnir and Kaupthing or a disorderly bankruptcy and “ISK-ation” creating a mountain of foreign-owned ISK – and whether the Landsbanki bonds agreement passes or not. After all the political rhetoric the solution has to look like victory – but even that would not be too difficult.

The foreigners are coming – not the foreign creditors but foreign advisers. After shunning any foreign assistance the government now has it in abundance. According to Rúv, JP Morgan will advise on the financial side, White Oak Advisory London will advise on the legalities and to figure out what needs to be done there is Cleary’s Lee Buchheit, in Iceland of Icesave fame, and Anne O. Krueger IMF’s deputy manager 2001-2006.

Deciding on foreign advisers has clearly been a tortuous step. Already in April, two months ago, the rumour was that the names would be announced “next week.” Having gotten this far is promising. What is less promising is that in order to orchestrate these formidable forces there is to be an Icelandic managing committee, which – as so often – the government seems to be in great difficulty to agree on. The setting up of this committee was announced some weeks ago, then apparently just about to happen, but no, so far no committee although the foreign advisers have already visited Iceland.

The non-existent managing group is unfortunate in itself but even more so because the delay indicates that the government has not yet made up its mind as to how to proceed regarding the lifting of the capital controls. The greatest obstacle is, as explained earlier on Icelog, how to resolve the estates of Glitnir and Kaupthing: the government still seems to dally with the idea of bankruptcy, including converting fx assets into ISK, in effect an “ISK-ation”of the assets.

In addition, the government has sent the Central Bank of Iceland on an uncertain course, apparently because of a disagreement within the government. With reforms in 2009 the independence of the bank was strengthened. The question is if there will now be a U-turn with the appointment of a new governor.

The two party leaders, prime minister Sigmundur Davíð Gunnlaugsson and minister of finance Bjarni Benediktsson, have oscillated between optimism and pessimism as to how hard the task was and the time it would take to take decisive steps towards lifting the controls. It is now over a year since the present coalition led by the Progressive Party with the Independence Party came to power. In terms of action regarding the capital controls that is mostly a lost year.

The all-Icelandic working group, set up in November, presented its results in March but there was little there in terms of realistic scenarios or solutions. Apparently the approach to Glitnir and Kaupthing and composition or not, i.e. “ISK-ation,” split the group.

A solution leading to a market access – or a specific Icelandic solution

The next stages of the winding-up proceedings must safeguard financial stability and ensure that domestic entities have access to foreign credit markets. Finding a comprehensive solution to the estates’ affairs is a prerequisite for lifting of the capital controls.

The above is how the CBI spells out in its latest Financial Stability Report the goals regarding the lifting of the capital controls. There has to be a comprehensive solution – and any solution that doesn’t ensure access to international credit markets is no solution at all.

Market access is an excellent measure. A specific Icelandic solution, which converts fx assets into, for foreign creditors, useless ISK, thus creating new mountains of foreign-owned ISK for which there is not enough fx, does not seems to be a market-opening solution.

An important lesson from the Greek and Argentine default is that the large majority of creditors do indeed want to negotiate a deal. The Icelandic situation is not comparable to Greece and Argentina – Iceland isn’t about to default – but as explained earlier on Icelog the state could incur liabilities if creditors deem the state is blocking payments from the estates or impairing recovery, such as inducing “ISK-ation.”

So far, the government has refused to negotiate with Glitnir and Kaupthing creditors, clinging to its mantra that these are estates of failed private banks. True, but solving the ISK problem of the estates is a key step towards lifting the controls, truly an issue of supreme national importance. By hiring foreign advisers, the government seems indirectly to accept it has to negotiate.

The three problems that need to be solved

It is often heard in Iceland that surely the problems underlying the capital controls are fiendishly complicated. In a way, they are actually not complicated though certainly not risk free. Three things need to fall in place:

*ISK assets of Glitnir and Kaupthing, in total ISK450bn (end of 2013)

*Remnants of the old ISK overhang (“hot” foreign-owned ISK which originally caused the outflows that demanded capital controls), in total ISK322 (at the end of February 2014)

*The two Landsbanki bonds of which ISK226bn is still unpaid

The Kaupthing ISK assets are mostly tied in its ownership of Arion. If Arion could be sold for fx the Kaupthing ISK problem is solved. Glitnir poses more of an ISK problem: selling Íslandsbanki for fx will only solve ca. half of its ISK problem. Here, the classic solutions would be a write-down, extended pay-outs or a combination of both.

The original overhang no longer poses a major problem. Judging from the CBI auctions these offshore-ISK owners do not seem strongly inclined to leave the high interest environment in Iceland for the low interests in Europe and the US. As long as interests remain low in the Western world the international environment is favourable for lifting the controls – but this favourable situation will of course not last forever.

On May 8 an agreement on the Landsbanki bonds was signed. The CBI is now assessing the agreement and the exemption from controls that is part of the agreement. Application for exemptions seems to have been sent in some time after the agreement was reached, which together with vacation time explains that it is taking the CBI some time to conclude on the Landsbanki bonds packet. As far as I understand the government will not make its own assessment but follow the CBI advice on the agreement.

New Landsbanki is state-owned, those who negotiated on behalf of the bank will have kept the ministry of finance informed and the new agreement broadly followed what the CBI had outlined. Yet the minister of finance, who formally needs to accept the agreement, has expressed some doubts.

In an interview with Rúv July 6, Benediktsson said he foresees a sale of Landsbanki. He envisages that the state keeps 40% of Landsbanki with the rest sold off, limiting other shareholders to 10-20% share of the bank. Strangely enough Benediktsson did not mention that according to the bank’s CEO last December the bank would need to extend its debt to the Landsbanki estate – and, as if in a parallel universe, the minister did neither mention this nor the Landsbanki bonds agreement.

Who is really in charge?

During the election campaign last year the Progressive Party repeatedly stated that there would unavoidably be money for the state coffers from the resolution of Glitnir and Kaupthing. These funds should be used for a debt relief for those who were too well off to have profited from earlier debt relief. When the debt relief plan was presented in November it turned out that it was funded with a banking levy, both on living and dead banks.

At the time I took it to imply that after all Benediktsson, known to doubt funding from the resolution of the estates, did after all have the upper hand in the government. That seems less certain now. Reviewing the first year I would now rather conclude that the prime minister clearly has enough political strength to decide whatever he wants to and then lets Benediktsson pick the policies the prime minister does not have strong views on. This is worrying because political clientilismo has long been strongly connected to the Progressive Party.

Whatever the power divide, this government clearly suffers from lack of communication. Time and again the prime minister says one thing and the minister of finance another. Most tellingly, the disharmony is spelled out in lack of action, on lifting the capital controls in general and now, specifically, in appointing a managing committee and deciding on the next steps.

The CBI under siege

Part of the disharmony within the government has been policies regarding the CBI. After much back and forth – if there should be a reform, three governors instead of the one now, if present governor Már Guðmundsson should continue or not – the position of governor was finally announced but without any clarifications on changes or not.

Guðmundsson has now applied, as have nine other candidates. None can really match Guðmundsson’s professional qualifications but there is a lot of speculation that professor Ragnar Árnason is the government’s favourite. Some doubt his qualifications – his expertise is fisheries economics – but the rumour is persistent. Another candidate, and now possibly more likely though he is less mentioned, is professor Friðrik Már Baldursson.

Morgunblaðið, with former prime minister and leader of the Independence Party Davíð Oddsson as its editor, has waged a forceful campaign against Guðmundsson. The story is that after Guðmundsson took office as governor his salary turned out to be less than he had been made to understand it would be. He sued the bank but lost. Morgunblaðið exposed earlier that the CBI had paid his legal bill. The National Audit Office has now investigated the matter and in its report finds no fault with Guðmundsson. Morgunblaðið claims the investigation is untrustworthy because the sister of the director of the National Audit Office is the head of internal audits at the CBI. In Iceland, many feel certain that Oddsson, who was ousted as a CBI governor, will not rest until Guðmundsson has been driven out of office, even though Guðmundsson played no part in ending Oddsson’s CBI career.

Many feel that the selection process has already been undermined by the choice of a selection committee, which has two lawyers and only one economist. One of these two lawyers, Stefán Eiríksson, is at present the head of the Reykjavík police and is applying for a new public position, as the head of a governmental body that oversees transport in Iceland. Central Banking has already published an article about what it calls “a bizarre committee.”

Who will be chosen as the next CBI governor will be an important indication as to whether the government respects the independence of the bank – or not.

No pay-outs to creditors until the resolution route is chosen

There has been much toing and froing from prime minister Gunnlaugsson and finance minister Benediktsson regarding how and when the controls could be lifted. Considering how tortuous every step has been there is little to underpin optimism on a quick solution as to what to do. Yet, there seems to be determined optimisms amongst the creditors and they have shown remarkable cohesion.

The foreign advisers will most likely need some time to delve into the Icelandic situation. But the fundamental thing is for the government to make up its mind as to what needs to be done and what its aim is and yes, who should be on the managing committee. The lack of clarity explains the sluggish moves so far and in spite of advisers, the latest moves are not entirely convincing.

In the Landsbanki estate priority creditors will get the lion share of the estate’s assets and they have already been paid out along the way. But that has now stopped and since last year the CBI has not given the necessary exemptions. The CBI has also closed down the route for Icelanders to buy foreign life insurance and make limited capital payments towards pension: buying insurance was legal but the capital transfer goes against the controls although this has been going on for some years. This hardening attitude can be interpreted in various ways: that the controls are here to stay, that the CBI is showing the government its tough side etc.

Glitnir and Kaupthing now hold ca. ISK1000bn of fx, that could mostly be paid out without a risk to Icelandic financial stability. However, pay-outs are only possible once the estates are resolved. And they cannot be resolved until either a composition agreement is in place or the estates forced into bankruptcy.

The pension funds and the capital controls

Voices in Iceland have complained that creditors will be able to exit before the Icelandic pension funds. Before the collapse, the funds placed 30% of its investments abroad, which means that its Icelandic investments and the Icelandic investment environment is, under all circumstances, crucial to the funds.

Icelandic business leaders have increasingly voiced their frustration and CEOs of both big and small companies have aired the possibility of moving their companies abroad. Fewer investment options in Iceland due to the capital controls would raise the cost of the controls for the pension funds. It can be argued that lifting or easing the controls, thus improving the business environment in Iceland, is more important for the funds even though they have to wait for a while to invest abroad.

With the sluggishness so far, the advisers and the lost times it now seems unlikely that any negotiations with the creditors will start until September, at the earliest. Even more so, if the advisers will be given the task of doing all calculations, balance of payment and everything else, from scratch.

Getting foreign advisers on board has been seen as a necessary prerequisite for negotiations. That may be true – but hiring advisers and consultants is also a tried and tested, and usually an expensive, option when no one has a clue what to do and those in charge cannot make up their minds.

Complicated but not complex solutions

Given the fact that over the last few years the CBI has worked hard on issues related to the estates and capital controls it is frustrating that the government does not dare negotiate with the creditors but chooses to start a time-consuming process with an apparently unclear course and yet another committee with a difficult birth.

This is all the more frustrating because there really are some relatively simple solutions in sight. This is not to say that negotiating would be easy – no doubt the creditors will drive a hard bargain. It would be strange if they would not. But it is clear that the creditors do want to negotiate and find an end to this matter.

Last November, Lord Eatwell presented an independent report at the behest of Glitnir on macroeconomic balances and capital account liberalisation in Iceland where he pointed out balance-of-payment neutral solutions to the foreign-owned ISK. I have heard others air the same opinion. This is just one of many ways that could be explored. Using assets owned by the CBI asset holding company for swaps is another. Und so weiter.

According to the rumour mill in Iceland the creditors do not want to negotiate. Nothing could be more far from the truth. In general, creditors do wish to negotiate and the same counts for creditors to the Icelandic estates. This is, as far as I can see, a way to create a reason for not even attempting to negotiate but go straight down the bankruptcy route. Any solution has to look like a big fat victory for the Icelandic government – and even that would not be too difficult.

Again, having found experienced advisers might seem promising. But if the course of events will be a version of “if you don’t know where you are going you ain’t likely to get there any time soon” the outlook is bleak. Apart from the political disharmony it is no less worrying that there are strong forces pushing for bankruptcy: some Icelanders are apparently hoping to make a lot of money out of the tumult it would lead to and political favours have long been part of Icelandic politics. All of this is worrying for the Icelandic economy and for all those living in Iceland.

*Update July 9 2014: here is the press release, sent out today, regarding the foreign advisers. After announcing a managing committee, as mentioned above, to work on behalf of the Ministry of Finance and Economic Affairs and the so-called “Ministerial Committee on Economic Affairs and the Steering Group on Removal of Capital Controls” it turns out that no formal group will be set up. Instead,  four experts have been engaged to work alongside the foreign advisers: Benedikt Gíslason adviser to Benediktsson; Supreme Court attorney Eiríkur Svavarsson, earlier in the In Defense group, fighting against the Icesave agreement; Freyr Hermannsson head of reserves management at the CBI and Glenn Victor Kim, currently at Moelis & Co and LJ Capital, served previously as senior adviser to the German Finance Agency re the European Financial Stability Facility (EFSF). Kim will lead the work of the four external experts. – According to the press release, the first task of White Oak Advisory and Anne Krueger will be “to set out the macroeconomic conditions considered necessary with regard to maintaining economic stability.” Tomorrow, the report of the IMF mission to Iceland in spring is expected to be published. Both the IMF and the CBI have worked extensively on these issues. Hopefully, the new advisers will not need to start from scratch here.

*Here is an earlier Icelog on the May 8 agreement on the Landsbanki bonds – and here is a blog on the numbers and the main issues regarding the capital controls.

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