Sigrún Davíðsdóttir's Icelog

The Minister of Finance Bjarni Benediktsson has just released his twice-a-year report on progress in removing capital controls. The tone is as if prime minister Sigmundur Davíð Gunnlaugsson did not exist. Another event, distantly related to the capital controls, is a draft Bill by two academics on the future organisation of the Central Bank of Iceland, CBI. The draft is hardly bringing out the champagne bottles since the academics propose that governor Már Guðmundsson, whom the government has been trying to remove ever since it came to power, should remain in office but with diminished power and two deputies. The backdrop to these events if the drastic fall in the government’s popularity, this time hitting the Independence party, buoying the Pirates.

Last year, the government held the CBI in uncertainty for half a year while trying – and then failing – to substitute Már Guðmundsson as the bank’s governor. At the end of that ungraceful saga (see earlier Icelog) he was reappointed but given to understand that the bank’s organisation model would be revised, even before the end of 2014, which might mean his days in office were numbered.

So far nothing has happened until recently that the two academic asked to revise the CBI Act, handed in their proposal. It is safe to conclude that it will not create much happiness, neither in the Ministry of Finance nor in the Prime Minister’s office.

This last week also saw the minister of finance present his spring report on the capital controls. Apart from general remarks on how to lift the controls in an environment suffering from balance of payment problems it is more worrying that the report seems to include some misleading or even factually wrong statements. I am not aware of this happening before, which leads me to believe that there was less input in the report from the CBI, compared to earlier, and more input from those working on lifting the controls. Again, not a good sign.

If the government is going to make a move in either of these two cases, it has to make up its mind soon because the deadline for new Parliamentary proposals, new law or amendments is the end of this week as Alþingi goes on summer recess at the end of May. There is however a legal provision for presenting Bills later requiring an agreement with the opposition. The latest opinion polls also raise the question if the government’s diminishing popularity will push the government to come up with some measures to win voters over. Another test is the fact that strikes and labour market unrest is foreseeable, most agreements will run out now in spring; particularly dark forebodings in these matters.

A sluggish reaction to CBI proposals

The two academics, Friðrik Már Baldursson professor at the University of Reykjavík and Þráinn Eggertsson from the University of Iceland, sent in their proposals on 6 March. Not until 20 March, following news based on the leaked proposals, did the Ministry of Finance publish the proposals. The academics have as yet only filled part of their remit, there is more to come but these proposals cover the most sensitive part, i.e. how to change the organisational structure of the bank. Benediktsson now has to make up his mind as to what changes he intends to make.

The proposals underline that the power given to the governor of the CBI far exceeds power wielded by central bank governors in the neighbouring countries. The two academics propose a board of three governors similar to the structure at the Bank of England where there is one governor and two deputy governors, each heading a special field within the bank.

In addition, the academics propose that Guðmundsson remains in office. If, follwong the ungraceful process last year, the government was planning to remove the present governor from office on the basis of these proposals they certainly do not provide the government with the ammunition for such action.

In Iceland, it is widely thought that the two party leaders want to revert back to the bad old days of continuous political pressure on the CBI with politically appointed governors. The sentiment in the air is that in addition to a governor with the proper professional qualification the government would like to see two more governor by his side, one anointed by the Independence party, the other by the Progressive party.

If the two government leaders find some solution here remains to be seen, also if Guðmundsson will be part of the solution or not. If things move as they mostly have done under this government, i.e. slowly, indecisively and inconclusively, not much will happen re the CBI any time soon. In addition, blatant political interference is much harder in the present day and age than some decades ago. The International Monetary Fund, IMF, has used every report on Iceland since the crisis to emphasis the importance of an independent central Bank.

Capital controls: two possible solutions

The new report by Benediktsson on the capital controls concludes that there are indeed only two possible options in dealing with balance of payment problems akin to those Iceland is now faced with: either by “(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.”

This is quite correctly a description of classis solutions in countries with similar problems Iceland is dealing with. But this description seems completely unrelated to the political situation in Iceland where politicians, with the exception of Benediktsson, have lately been falling over themselves in outdoing each other in exit tax on the estates in their entirety, ISK assets as well as foreign assets.

The prime minister has earlier talked about the inevitability of the state accruing funds from the estates and “vulture funds” gaining distastefully on Iceland. Lately he has presented it as a principle of fairness that the estate leave funds to the state for the harm the banks caused Iceland.

There is nothing of this tone in the report.

There are however statements in the report, which are either inaccurate or misleading.

The report states: “The estates’ largest ISK assets are holdings in the new banks, in addition to which they own considerable amounts of cash. Distributions by these domestic undertakings to resident creditors will not affect the balance of payments, but distributions to foreign creditors will impact the balance of payments when the distributed assets exit Iceland.” – The fact is that if domestic creditors repatriate their foreign currency distribution this has a positive impact on the balance of payment whereas the impact is negative if foreign creditors move their ISK assets abroad. This will hardly be categoric: not all FX owned by domestic creditors will be left abroad and not all foreign-owned ISK will leave.

Re “possible outflows by domestic parties” the report points out that it is difficult to assess what these outflows could amount to. It quotes the latest IMF report, which guesses that this could be as much as 25% of GDP or ca. ISK500bn; however, IMF underlines that this development very much depends on stability and trust in Iceland, as well as the currency rate. – What this analysis in the new report lacks is to underline how Icelandic action or non-action influences these eventualities.

The same counts for the effect of trust on foreign investment in Iceland. Foreign investment will not leave a trustworthy environment. No country is in the position to pay out all foreign investment at any given time. To set that as a benchmark makes little sense.

The report points out that Iceland faces balance of payment problem, consisting of three part: “the offshore ISK problem, difficulties arising from distributions by financial undertakings in winding-up proceedings and potential capital outflows from other parties, including residents.”

However, this last part, potential outflows from other parties, including residents, differs from the balance of payment problem, as defined by the CBI. In the Financial Stability Report 1 last year the problem is said to consist of three parts: “First of all, the debt service burden on foreign debt… 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.”

For some reason, the new report magnifies the problem and minimises the effect of what the authorities can do to stabilise the situation by inspiring trust.

Political outlook: panic politics or power to the Pirates!

New poll caused a political earthquake last week: it showed the Pirate Party with a following of 29.1%, equivalent to 19 MPs. The party now has three MPs, got 5% in the last election. The Progressive party got 11.6%, the social democrats make a slight gain from previous poll, with 16.3% and Bright Future and Left Green with 9% each. The biggest loser is the Independence Party, falling from 28% in last poll to 23.4%. – This does not seem a freak outcome, the upswing for the Pirates, over 20%, was seen in an earlier poll from a different polling company.

To Rúv, prime minister Gunnlaugsson said that this outcome certainly was surprising but a sudden gain by one party had been happening frequently in the past years and decades. “This is perhaps first and foremost a message that people are now impatient to see the results of what the politicians are working on. However, these results are now starting to be visible however they are measured.”

This result is singularly bad for the two coalition parties. Part of the explanation is no doubt its action to break off accession negotiations with the EU, which cause great and general anger in Iceland where there is not majority for membership but strong majority for bringing the negotiations to an end. Also, the Pirates have been measured and professional in debates, ignoring special-interest groups. The rest of opposition has been fairly lame.

In addition to crashing popularity, the government now has gone through half its mandate period. It is clear that the debt relief, orchestrated by the Progressive party but brought to fruition by Minister of Finance Benediktsson has not helped. Nor has changing direction on the EU negotiations helped. The question is if this crash in popularity will cause the government to turn to panic politics, if it will possibly attempt some drastic measures to gain popularity.

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