Sigrún Davíðsdóttir's Icelog

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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