Sigrún Davíðsdóttir's Icelog

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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