Sigrún Davíðsdóttir's Icelog

“Iceland’s selective default?” was the topic of a seminar in New York this week, organised by EMTA, the association of emerging markets investors. The measures taken by the Icelandic government and the Central Bank to reduce the offshore króna have placed the question mark in the question. Sadly, that question mark was not erased at the meeting but that doesn’t seem to worry the Icelandic government.

The concept selective default has been waved around recently in connection with the measures taken by the Icelandic government: at the strategic time, just before – what is or was to be – the last offshore króna auction, two foreign experts waved the “selective default” banner in Wall Street Journal and FT Alphaville (see my latest on this).

The two writers were present at the EMTA event in New York, James Glassman as the moderator, with Arturo Porzecanski on the panel together with Magnús Árni Skúlason, an Icelandic economist advising some of the funds holding the offshore króna and Lee Buchheit from Cleary, Gottlieb, advising the Icelandic government.*

Very much contrary to how the estates of the failed banks were dealt with last year (as I have repeatedly pointed out) – when nothing was finalised until the creditors had agreed to the measures – the Icelandic government, advised by Cleary, is engaging with offshore króna holders, to use an Icelandic expression, “with two ram’s horns,” meaning belligerently. Or as Buchheit said: let them litigate.

It is indeed a real possibility that the largest funds will litigate their way through this mess. The question is what that would entail for Iceland in terms of inter alia long-lasting and costly litigation, negative effect on credit ratings and possible delays in lifting capital controls, the goal of the whole exercise. In addition, several interesting points came up in the debate: the banks’ estate v offshore króna; recent restrictions on inflows; discrimination based on nationality – and was the recent auction really the last one?

Litigation: a real threat?

Icelandic authorities have deemed the auction successful because of good participation although CBI governor was more cautious. True, there were plenty of bids – but small ones. The large offshore króna holders didn’t participate or their offers weren’t accepted. Ergo, the bulk of the offshore króna is still inside capital controls. There is now litigation in the air, the largest offshore króna holders, all large international funds, have taken the first steps in that direction. The question is what the effect on Iceland and the Icelandic economy will be.

Buchheit said he wanted to puncture what the articles by Glasman and Porzecanski stated. He dismissed that the offshore króna holders had any claim on the Icelandic sovereign. Waving a dollar note, he stated that owning this note didn’t make him a creditor to the US; equally, owning a króna didn’t make the offshore króna holders a creditor to the Icelandic sovereign. – However, the large offshore króna holders aren’t waving króna bills but Treasury securities; around 2/3 of the offshore ISK319bn are Treasury securities which makes the situation slightly more convoluted.

Dismissing any comparison with Argentina, Buchheit did however neither directly counter the argument that the underlying assets are indeed Treasury securities nor give any tangible argument against the Argentina comparison except claiming it was not true. The funds could try litigating but neither Britain nor the Netherlands had found great sympathy for their cause, he said.

This must refer to the Icesave dispute, ruled on by the EFTA Court in January 2013 (link to the Judgement and my digest of the main points.) From the point of view of Iceland this seems a worryingly feeble argument since that dispute was, as far as I can see, fundamentally different from the issues at stake re the offshore króna (see below). Also, the argument that the offshore króna holders had bought their assets with a haircut inside capital controls seems beside the point; the point is that an owner of these securities can demand a payment on time and in full.

The testing point will be if courts – in Iceland and possibly elsewhere – will side with offshore króna holders or not. After all, Argentina decided to negotiate with those holding Argentinian sovereign bonds after a costly dispute lasting 15 years where Cleary Gottlieb was their main adviser (but not Buchheit until at the recent and final negotiations).

Cooperation last year, none this year

It now seems that the Icelandic strategy is to fix the offshore króna overhang with this last auction with remaining funds placed on locked low-interest accounts with the CBI, as the Treasury securities reach maturity, thus ignoring the possible legal risk. The next steps will then be towards lifting controls on the domestic economy, most importantly the pension funds. Only later will the locked accounts be revisited.

Magnús Árni Skúlason stressed that the funds he advised had come up with many proposals as to how to solve the issue. He pointed out that due to the very strong and booming Icelandic economy and sizeable foreign currency reserves it was difficult to argue for a haircut on grounds of a weak economy.

As I’ve repeatedly pointed out I find the difference in approach last year with the creditors of the failed banks and now with the offshore króna holders perplexing. In the latest IMF Article IV Consultation with Iceland, concluded on June 20, the IMF compares its 2014 recommendations with Authorities’ responses. On capital controls the IMF recommended in 2014 that the “updated liberalization strategy should be comprehensive, conditions based, and with an emphasis on a cooperative approach with appropriate incentives.”

As to the Authorities’ response the “updated liberalization strategy released in June 2015 takes a staged approach. The bank estates were resolved first, in a cooperative manner, which minimized legal and reputational risks and won credit rating upgrades. The authorities are now working to release offshore króna investments via an auction. Residents will be addressed thereafter (emphasis mine).

Minister of finance Bjarni Benediktsson has earlier emphasised the same as the IMF above, as did Buchheit at the EMTA meeting, that creditors have not challenged the measures last year in lifting capital controls on the banks’ estates. Due to the “cooperative manner” last year there were no legal challenges, which again raises the question why it’s suddenly not important to avoid the legal and reputational risk. So far, no clear answer.

Misconceptions on Icelandic “vindictiveness”

In his FT Alphaville guest blog Arturo Porzecanski criticised the Icelandic government for its measures on offshore króna, pointing out that the measures would place Iceland in selective default. He also strongly criticised recent law authorising the CBI to impose measures to discourage foreign inflows into Iceland.

Porzecanski embellished his points further at the EMTA meeting. According to him, the Icelandic government is, in his words, being “vindictive;” as if investors were responsible for the 2008 crisis, the government now wanted to “bleed investors” as it had tried last year with what he called a “departure tax” on creditors of the failed bank. However, he didn’t mention that the outcome an agreement with creditors (see my blog). To him this all smelled of punitive coercive action, just as in Greece and Argentina.

The tone in Iceland towards foreign investors has at times been harsh, mainly because of the politics at play, but Porzecanski’s description is to my mind out of proportions. After all, a 2010 report by an Icelandic Special Investigative Commission on the 2008 banking collapse, firmly and squarely placing the responsibility with Icelandic authorities, the CBI and politicians. And Icelandic bankers have been sentenced to imprisonment for criminal actions before the collapse of the banks.

The measures to temper inflows have long been expected: already in 2012 the CBI published a report on Prudential Rules Following Capital Controls, outlining what is needed to preserve financial stability once the capital controls have been lifted. Quoting IMF research one of the measures announced is restricting inflows, as indeed many countries have done over the past decades.

Porzecanski claims this is just done because the inflows were seen as a problem earlier, saying there is no justification for this measure. Well, he is right that the inflows were seen as a problem earlier, indeed the capital controls were put in place with the blessing of the IMF because of inflows, now the offshore króna overhang. As Porzecanski should be aware of and as emphasized in the 2012 report, IMF research underpins these measures, as do many economists. From the publication of the 2012 report it was clear that in due course these fairly traditional restrictions would be made use of.

Discriminating between foreigners and Icelanders?

A question from the audience at the EMTA event, on potential discrimination between Icelanders and foreigners, raised some interesting issues. The point was that Icelanders holding a króna would get a full króna whereas the offshore króna measures subjected foreign króna holders to getting only say 70 aurar (100 aurar = 1 króna). Buchheit’s point was that there was no discrimination involved. – Yet, the question still raises an interesting aspect.

The Emergency Law, passed on 6 October 2008 did differentiate between deposits held by individuals and entities domiciled in Iceland and abroad (which has partly shaped the definition of the offshore króna). This division was in fact a version of splitting the banks into a bad and good bank since roughly the foreign loans were put into the estates and Icelandic deposits into the new, living banks (it was slightly more complicated but this is the rough outline). – The Emergency Law has been contested in Icelandic courts and found to be in accordance with the constitution and Iceland’s international obligations.– These were extreme measures in extreme time taken by a sovereign defending its vital interests.

Eventual discrimination came up also in the Icesave case as the EFTA Surveillance Authority claimed in the EFTA Court, focusing on the use of the Icelandic Deposit Guarantee Fund, TIF. The question of discrimination was deflected in the Judgement due to the course of events in Iceland: the deposits had indeed been moved from the failed banks to the new banks but not reimbursed by the Icelandic TIF. Consequently, the Icelandic TIF didn’t need to reimburse foreign depositors, i.e. there was on discriminations involved and no breach of the relevant Directive. – Maybe it’s my lack of legal intricacies but I don’t quite see the relevance of the EFTA Court Icesave Ruling for the offshore króna problematic (as above, link to the Judgement and my digest of the main points.)

Is this really the last auction – and more confusion

In his introductory remarks Buchheit mentioned offhandedly that there are FX auctions all the time and this latest one was just another auction, in a series of 22 offshore króna auctions. Porzecanski asked if this meant this latest really was just another auction, would there be auctions following this announced last one but got no answer.

Porzecanski also pointed out that this last auction was indeed not a proper auction, more like bringing work of art to an auction house which then would set the price, i.e. no bidder on the other side.

During the question and answer session Skúlason mentioned that one concern of his was that part of the underlying assets was indeed Treasury bonds. Buchheit agreed there were some bonds, which would be paid in full and on time as Iceland had a stainless record in terms of fulfilling its sovereign obligations: it has never defaulted. – This statement seems to conflict with earlier statements – unless there is some tricky teleological interpretation behind the advice to the Icelandic government.

Last year, my main worry regarding the estates of the failed banks was if the government was ever going to have the political strength to agree on the necessary measures (mainly the haircut of the estates’ króna assets) and secondly that these measures would steer clear of legal risks. This year, the worry is that for some inexplicable reasons the cooperative method isn’t in vogue, in Iceland, possibly leading to legal risks and reputational damage so astutely avoided last year. Maybe I’m missing something but the discussions at the EMTA meeting didn’t inspire much confidence: “let them litigate” sounded decidedly belligerent compared to the cooperative approach last year.

*I had been invited to join the panel but ended up only listening via phone from London.

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