Sigrún Davíðsdóttir's Icelog

Minister of finance Bjarni Benediktsson discourses boldly on decisive and imminent steps towards lifting the capital controls. Prime minister Sigmundur Davíð Gunnlaugsson now rarely mentions the topic and then only in the most general terms. The next important event is the October 24 deadline* for the Landsbanki bonds agreement. The government faces strikes, the final vote on the 2015 budget is still to come and the “Correction” – writing-down of loans – is moving slower than planned. Worst of all for a government: the two leaders seem light-years apart on key issues. The question is if the two of them really can forge a coherent policy on the capital controls (as well as some other issues).

Russia watchers have Kremlinology. The equivalent in Iceland could be Arnarhvoll-ology (admittedly a word that will not flow easily off a foreign tongue): the art of observing and making qualified guesses of what is really going on in Icelandic politics.

Arnarhvoll is the imposing 1930 building, which now houses the ministry of finance, built at the time when most buildings in Iceland were corrugated-iron sheds or turf-roofed cottages. With an eye on modern Iceland – new(ish) cars, big houses and Harpan – it is easy to forget the giant steps this once so, literally, dirt-poor country took into affluence and modernity. Now Arnarhvoll nests by the Supreme Court house, the Central Bank and the National Theatre, not far from Harpan.

Below is an attempt to practice some Arnarhvoll-ology to gauge where the government stands regarding the capital controls, most of all the pressing issues of the Landsbankinn bonds agreement and of how to resolve the estates of Kaupthing and Glitnir.

Benediktsson’s knowns and unknowns

Minister of finance Bjarni Benediktsson gave a speech last week at a symposium in memory of an Icelandic economist, Jónas Haralz. In his speech, (here, only in Icelandic) Benediktsson reminded the audience of the last time capital controls were put in place in Iceland: stayed for 60 years. With new controls in 2008 Haralz said that compared to earlier Iceland was now much more connected to the outer world in addition to the support of the IMF; Haralz was sure the controls would not be allowed to fester for 60 years this time.

Although Benediktsson’s speech was fairly general it did, to my mind, include soms paragraphs, which under the lenses of Arnarhvoll-ology might give some hints on his thoughts: no, the creditors are no this main worries but, as far as I can see, his coalition partner.

As before Benediktsson said any solutions had to be financially feasible, socially fair and politically doable. It was also important to be aware of the risks implied, he said, aware that circumstances can change quickly in spite of the present positive outlook. Solutions should not be based on too much optimism regarding the coming years. In addition, circumstances abroad could change – a timely reminder for Iceland, he said, to pay off its debt (but no, he did not mention why then ISK80bn of public money should be used for the “Correction” and not to paying off sovereign debt).

Benediktsson said that since last year much work had been carried out to analyse the problems and develop solutions. Then this declaration (which sounds equally un-Icelandic as it sounds un-English in my translation; emphasis mine): “I make the demand that during this year important questions will be answered so that next steps can be taken. They (the questions) will i.a. touch on if it is realistic to solve the issues of the estates without a direct intervention by authorities.”

Benediktsson emphasised the importance of a holistic solution, taking care to respect national interest “as well as respecting law, international commitment and ensure equal treatment.” The balance-of-payments needs to reflect reality (never easy in Iceland at the best of times), also to prevent another economic down-turn. Then again, a very interesting sentence: “Actions that take less time, are simple and minimise legal risk will be favoured over more complicated ones; each action needs to be in accordance with the general solution.”

Benediktsson said the government was willing to listen to all constructive ideas, no matter where they came from, also regarding exemptions, as long as they improved the economy. But all decisions would be taken with the general interest of the nation at heart, not single interest groups – interestingly, a comment that could as easily be directed at some Icelanders as well as the creditors.

But there were also words clearly meant for the creditors: “If those seeking exemptions from capital controls do not put forward realistic ideas to meet these points of view as well as others still being worked on, things will be put in order of priority according to the needs of the real economy.” – This means that creditors must take into account issues the government has already presented as well as those not yet presented, the knowns and the unknowns; never an easy proposition.

Anyway, both Kaupthing and Glitnir have tried: Kaupthing has had no answer; Glitnir has had an answer after which it amended its composition draft. There are simply far too many possibilities and variables for this silly game to continue. The government cannot claim the estates are none of its business when it is the final arbiter in the process of the estates’ resolution.

And last but not least some edifying words for those working on lifting the capital controls: “For those responsible for moving these issues forward it is at last important to realise that it will not be possible to calculate all potential outcomes, eliminate all risk and foresee investor behaviour far into the future. What is needed, after the necessary preparation, is simply to make a decision.”

Benediktsson’s message according to Arnarhvoll-ology

From all directions it echoes that Benediktsson and Gunnlaugsson are light-years apart on the key issues of the capital controls. Each side appointed people in the all-Icelandic advisory group at work last winter – in the end it allegedly only came up with a mish-mash of various and to some degree conflicting ideas. In the group now at work each side also appointed its representatives, which means, I am told, that there is not much momentum to solve the underlying and fundamental disagreement on composition vs bankruptcy re Kaupthing and Glitnir. Glenn Kim, the foreign advisor in charge of this group is apparently not much seen in Iceland these days (though yes, with modern means of communication presence is not all).

Reading Benediktsson’s speech with this in mind, it is difficult to avoid the feeling the Benediktsson really is talking to his opponents in the government and not so much to creditors. He is telling his opponents that rather than embarking on the risky road of bankruptcy, simple foreseeable routes are preferable. Or, as the IMF put it: composition is an orderly legal route, bankruptcy a disorderly route.

Benediktsson prefers the simple to the complicated and he also prefers solutions that take less time than long time. And Benediktsson is also well aware of reputational risk: my friends (if he still uses that word for his coalition members), lets keep in mind the rule of law, international law and equal treatment for all, both Icelanders and foreigners. An all-encompassing certainty can never be achieved in this world: those who have the painful role of deciding must in the end… eh, make up their minds.

The Progressive Party has over the years been good at securing good deals for chosen party members. The feeling is that some would like to steer Íslandsbanki and Arion, now owned respectively by Glitnir and Kaupthing, into Icelandic hands. If so, this goal could influence their thinking on the issues at stake in lifting the control.

As tried and tested Kremlinologists know the interpretation is only as good as the political understanding it is based on. But no matter what: it is politics and not economy that decides on the vital issues regarding the lifting of the controls.

The best of times

In its recent Financial Stability Report the CBI came out with its so far most clear warning on the “steadily increasing” cost of the capital controls and their detrimental effect on the economy (emphasis as in the FS report):

There are numerous costs associated with the capital controls. The most obvious is the direct expense involved in enforcing and complying with them. But more onerous are the indirect costs, which can be difficult to measure. The controls affect the decisions made by firms and individuals, including investment decisions. Over time, the controls distort economic activities that adapt to them, ultimately reducing GDP growth. The direct costs associated with liberalisation centre primarily on the possible lack of confidence in liberalisation and the associated risk of disorderly capital outflows, which would weaken the króna, stimulate inflation, and result in higher interest rates.

If liberalisation is not carried out successfully, these costs will make themselves felt quickly. On the other hand, liberalisation will lead to increased efficiency over time, as decisions will be made without consideration of the capital controls. Measures aimed at making it easier for some parties in the economy to tolerate the controls reduces the incentive to lift them, with the associated expense for the general public. 

The FS Report is equally clear on the present favourable economic conditions:

At present, economic conditions are favourable for large steps in liberalisation. The economic outlook is better in Iceland than in its main trading partner countries, interest rates abroad are at a historical low, Iceland’s interest rate differential with its main trading partners is positive, GDP growth is stronger in Iceland than in most trading partner countries, domestic inflation is close to target, Iceland has an established trade surplus, the fiscal budget is estimated to be in surplus next year, the spread between the official Central Bank exchange rate and the offshore exchange rate has narrowed significantly in recent months, and the Treasury has demonstrated repeatedly that it has access to foreign credit markets. Therefore, it appears that current economic conditions are conducive to successful liberalisation of the capital controls. It is important to remember, however, that these conditions could change for the worse later on.

The main problems relating to liberalisation have been identified as the stock of offshore krónur owned by non-residents, Iceland’s balance of payments, and the settlement of the failed banks’ estates. The narrowing of the spread between the Central Bank’s official exchange rate and the offshore rate, increased access to foreign credit markets, deleveraging of foreign loans, and the persistent trade surplus diminish the effects of the first of these two risks. The remaining problem, the settlement of the failed banks’ estates, is the largest factor complicating the liberalisation process. 

The same views are widely heard throughout the Icelandic business community, most recently expressed in an article (only in Icelandic) by Þorsteinn Víglundsson managing director of SA, the employers’ organisation.

One way of managing life under controls would be to give more exemptions to domestic entities. Were that route to be used increasingly it undoubtedly means that the government is planning for the controls to be in place for a long time – no good sign.

Landsbanki bonds agreement

According to rumours the Landsbanki bond agreement is yet another battleground between the two coalition leaders. Benediktsson has been in favour of agreeing to it. It seems the prime minister sees the agreement as giving too much to the creditors. (See here for further details regarding the agreement).

Some prudent voices claim the agreement sets precedence for the general creditors. Others claim that the main importance is to abolish the uncertainty Landsbankinn with no agreement poses. The CBI points clearly out the risks for Landsbankinn and Iceland as a whole unless the bonds’ maturities are extended:

Other things being equal, if the Landsbankinn bonds are not extended, domestic demand would have to contract and the currency would have to depreciate in order for the domestic economy to generate enough additional foreign currency to service the debt. Analysis using the Central Bank’s macroeconomic model indicates that, in comparison with a scenario providing for the lengthening of the bonds, the exchange rate would have to decline temporarily by up to 8%, private consumption would contract by up to 2%. Inflation would rise and, according to the model, Central Bank interest rates would have to be kept higher in the near future in order to bring it back to target. In order to prevent this, the State or the Central Bank would have to provide Landsbankinn with long-term foreign-denominated funding, with the associated implications for the Treasury debt position and the Bank’s foreign exchange reserves.

If the bonds are lengthened and external conditions remain unchanged, it is likely that the trade surplus will suffice to cover resident entities’ unfunded debt service burden in foreign credit markets in coming years…

Landsbanki estate, the LBI, has not been able to pay out to priority creditors for over a year now, see its financial statement here. With time and no explanations from the authorities it will make the UK government increasingly frustrated as well as other priority claimants. Again, does not bode well for Landsbankinn. Also, it prepares a case for creditors that the Icelandic authorities are withholding their funds.

The worst of times – in sight

In addition to the good times in Iceland there are positive circumstances abroad. As Benediktsson pointed out in his speech nothing lasts forever. In Iceland, an ominous winter is ahead.

Coalition MPs disagree wildly over tax – Benediktsson proposes to put VAT on food up from 7% to 12% and offsetting this by lowering VAT on i.a. kitchen appliances. This is a thorny issue for the Progressive Party. Sigmundsson himself wrote some years back on the unfairness of putting up VAT on food, an opinion widely shared by his fellow MPs. The question is if Gunnlaugsson will side with his fellow party members or with Benediktsson and the Independence Party when the budget coms up for a final vote in Althing: a truly impossible choice unless Benediktsson helps him out, which in turn hurts Benediktsson and cements his reputation as a ditherer.

Because of this the budget might not go down smoothly in Althingi. In addition, the “Correction” is still not in people’s pockets and so far unclear when it will happen.

Physicians got the right to strike some thirty years ago but have never gone on strike so far. That might be about to change: the Icelandic Medical Association now threatens a strike on October 27. Other strikes could follow in the coming winter.

The times for lifting the capital controls may be as good as they get. Objectively, Benediktsson has excellent reasons to be optimistic about decisive steps in sight. There are solutions in sight, tickling the finger-tips. But as long the underlying discord and clear-cut disagreement is unresolved the good economic circumstances do not help. The truly frustrating thing is that because of the work carried out by the Icelandic authorities those who, like Benediktsson, favour a quick and simple solution really do see various ways to reach the goals set forth by Benediktsson. Above, nothing is said about the unknowns related to possible creditor action against Icelandic authorities – hopefully an unknown Benediktsson is working on understanding and then explain possible risk to those who take a different view on how to proceed, also the fact that no action on behalf of the Icelandic authorities is not entirely risk-free either.

If the underlying disagreement remains unsolved  and if strikes and budget battles are on the horizon the best of times could easily become the worst of times… and drain the government of the political energy needed for taking the decisive steps the minister of finance is demanding. Sad for Iceland but hopefully it will not take 60 years as last time.

*Updated version. – The original version gave the LBI deadline as Oct. 26; sorry, it is indeed October 24 as stated in an earlier Icelog.

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