Sigrún Davíðsdóttir's Icelog

In the months leading up to the June 2015 plan on moving the three banking estates out of capital controls minister of finance Bjarni Benediktsson was adamant about avoiding legal risk. Indeed, that plan was only announced once the creditors had agreed to a haircut on the estates’ króna assets. The new Act on the offshore króna raises some legal issues as two of the four funds holding the lion share of these assets have pointed out in a letter to Alþingi. Intriguingly and contrary to last year, Benediktsson and the Central Bank of Iceland now seem to be intensely relaxed about legal risk though this time, contrary to last year, it really is the state that is the counterparty.

There has been little debate in Iceland regarding the offshore ISK and measures to lift controls on its owners. Certainly, the numbers are fundamentally different from when these offshore ISK, i.e. owned by foreigners (individuals or entities registered abroad; can in theory be Icelandic and are in some cases) caused the introduction of capital controls in November 2008. At the time these assets amounted to 44% of Icelandic GDP; now they amount to 14% of GDP or ISK319bn.

The largest part of the offshore ISK is owned by a few large institutional investors, two of them being Autonomy Capital and Eaton Vance. The underlying assets are Icelandic sovereign bonds and T-bills, meaning that the counterparty here is the Icelandic state.

As with creditors last year there have been meetings between the large offshore ISK owners and Icelandic representatives of the ministry of finance and the CBI. Contrary to last year, when nothing was done until it had been negotiated with the creditors of the estates, no agreement was reached before the new Act was passed in parliament this weekend.

Officials met with representatives of offshore ISK holders yesterday in New York to inform them of the new measures.

The state sure will pay its debt or… maybe not

Last year, creditors to the estates agreed to roughly a 75% haircut on the estates’ ISK assets. This outcome came as no surprise but had been more or less foreseen for the last several years, based on the Icelandic current account: this is what Iceland could manage without upsetting financial stability.

Hawkes among Icelandic officials have been adamant that offshore ISK owners should endure a similar fate. That however goes against the rule that a state pays its debt in full. At a hearing in the parliament’s economy and trade committee a CBI official underlined this fact: the sovereign will pay its debt.

This is clearly what the funds owning the offshore ISK have literally been banking on: the state is its counterparty and a state pays its debt.

Two options: ISK220 for a euro or deposit at negative rate

The new Act (English translation of the Bill) stipulates that offshore ISK holders can participate in an auction where the reference exchange rate will be ISK220 for the euro, more than a third higher than the present onshore rate of ISK140.

There was a meeting in New York yesterday, where the measures were explained. Clearly, a higher participation in the auction would lead to a better price (creating a version of “prisoner’s dilemma”…) but the funds might also calculate that they were better off heading to court.

If an auction doesn’t tempt them the assets will be turned into a “Central Bank of Iceland certificates of deposit: Debt instruments issued by the Central Bank of Iceland to deposit money banks that hold offshore króna assets in accounts subject to special restrictions.” This debt instrument has no maturity, interest rates are set at 0.5% but will be reviewed annually. Needless to say, 0.5% in Iceland is negative interest rates, well below inflation.

Effectively, the offer is either a haircut of more than a third of the assets or a lock-in at negative interest rates for unspecified time.

If the haircut was meant as a carrot compared to the lock-in stick, offshore ISK owners might well keep in mind the CBI official’s words that the sovereign was of course going to pay its debt in full – and simply head for the courts.

Property rights and human rights

Over the weekend, Eaton Vance and Autonomy sent a clarification of their stance to parliament (here, in Icelandic). The funds protest the Bill defines all offshore ISK as being “potentially more volatile than other króna-denominated assets, as the latter are subject to a home bias.” This does not at all apply to the funds, they claim since they have already shown a preference to being long-term investors in Iceland, i.e. they are willing to buy Icelandic bonds and T-bills.

In addition, they point out that considering growth and good state of the Icelandic economy, the present offer can’t be justified by hardship, as emergency measures following the banking collapse in October 2008.

Furthermore, the funds see their position as being strong since a partial payment would amount to a credit event, thus putting the state into default, with all the unpleasant consequences involved – a potentially expensive experience for Iceland, both the state, public institutions and companies.

There is a “Provisions of the Constitution and the European Human Rights Convention” in the Bill, stating that the “recommendations in the bill of legislation have been drafted with the aim of maintaining compliance with the Constitution and the European Human Rights Convention, particularly as regards protection of ownership rights and prohibition of discrimination.” – The funds clearly disagree and consider these provisions to be inadequate.

A legal risk but so what…

One view heard from one of those involved on the Icelandic side is that the measures are clearly close to the margin of the possible and postulate a clear legal risk. However, there was no need for Icelandic authorities to pay any special attention to problems the offshore ISK holders might identify, according to this source. Yes, the offshore ISK owners could now decide to challenge the Act but perhaps they had already had enough of wrangling with Icelandic authorities and might just be ready to call it a day. And anyway, an Icelandic court is unlikely to rule against the parliament, states the source.

That is certainly one way of seeing the situation. What I find difficult to explain is why the minister of finance and other officials were so adamant last year about avoiding all possible legal risks, by beforehand securing the creditors’ support to the plan to lift controls for the estates – but are now apparently intensely relaxed about possible legal risks and the pretty obvious invitation to a legal challenge.

All the more surprising since the creditors to the estates had known for a long time that they would only get part of their ISK assets whereas the offshore ISK owners are certainly counting on the state paying back and in full.

Could the Act be only a stick (as was the “stability tax” last year), are talks still going on? That’s one version and an Act of law can certainly be changed. That said, I still find the Act looking surprisingly like a final act if the intention is to explore further avenues with offshore ISK holders.

Reputation risk and “those in the cage”

At a public meeting on the offshore ISK in 2013, some of those present argued that the solution to the Icelandic current account problem was just to cage in the foreign-owned assets so capital controls could be lifted on the domestic part of the economy. Present at the meeting was CBI governor Már Guðmundsson who pointed that when new investors would then arrive in Iceland they would see the cage and ask who was in it. “The investors who invested in Iceland last time around.”

This doesn’t seem to be the most alluring introduction to Iceland but that is none the less what seems about to happen: offshore ISK holders are being offered a cage, unless they prefer fleecing.

Icelandic officials will clearly have Icelandic interests at heart. Last year, it seemed that these interests were best safeguarded by negotiating an outcome with creditors so as to secure a full harmony in the outcome and execution. With the offshore ISK the same officials seem to act in the certain belief that the state can dictate an outcome it wishes, with no need to pay any special attention to those who lent money to the state and who are also willing to continue lending. It will take some time before it’s clear if this is a sound judgement and what the possible reputation risk will be.

Update: here is further information from Ministry of finance on the new Act.

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