Sigrún Davíðsdóttir's Icelog

While the Icelandic government is planning to play clever and give offshore króna holders, i.e. sovereign bondholders, a haircut – apparently because the Icelandic economy isn’t strong enough – Kaupthing, the largest owner of Arion bank , and that bank are assessing how to make use of the strong Icelandic economy with regards to Kaupthing’s shares in Arion. An intriguing case of “mixed messages”… now that another step is being taken to further ease the capital controls, in place since November 2008.

In the past few days, two articles have appeared – an op ed in Wall Street Journal and a guest blog on FT Alphaville – spelling out that Iceland is about to opt for a sovereign default, quite voluntarily and apparently with open eyes.

Iceland, of course, doesn’t quite see it that way, as I explained recently at some length. That said, I have been utterly baffled why Iceland, having taken such care last year to avoid all legal risk by negotiating with the creditors of the three fallen banks, is now reverting to the tactic, which at the time of the collapsing banks in October 2008 was half (but not quite) jestingly called “xxck the foreigners.”

Last year, some foreign pundits were comparing Iceland’s situation with Argentina, a wholly misplaced comparison since the government was no partner to the composition of the estates of the banks though the government had to take on the role of a facilitator in solving problems related to the foreign-owned, i.e. offshore ISK assets of the estates.

The outcome was around 75% haircut of the Icelandic assets. So successful was this step towards easing  capital controls that foreign inflows into sovereign bonds started at once, now amounting to around 5% of GDP – nothing compared to the 44% of GDP in November 2008 when the capital controls were put in place, under the auspice of the International Monetary Fund.

This time the government IS the other party since the offshore ISK assets are sovereign securities, which led James Glassman in the WSJ and then Arturo Porzecanski* in FT Alphaville to compare Iceland to Argentina: Iceland was about to turn into a very chilly version of Argentina.

Actually, after years of legal wrangling Argentina has of course finally settled with creditors, advised by the law firm Cleary Gottlieb, also advising Iceland (though somewhat ominously Cleary was the adviser not only in solving the Argentinian problem but also during the dark years); Argentina is now happily borrowing again. Financial firms have a notoriously short memory, after all they can’t afford to hold grudges. But the legal wrangling all over the world did blight the lives of Argentinians for around 15 years and no need to minimise how unpleasant and costly it all was.

The Icelandic situation right now is that tomorrow, on June 16, the Central Bank of Iceland will hold an auction for OS ISK holders (all info here). After setting the terms in such a way that a hair cut was all but inevitable for those participating in the auction and negative interest rates for those who didn’t the terms were changed this week – last minute wisdom… or panic, depending on the reader:

The amendments to the Terms of Auction removes ambiguity about whether, in spite of the auction results, the Bank can decide on a more favourable auction price than is specified in the table. As before, all owners of offshore krónur will receive the same price for their krónur, as the auction has a single-price format, which applies irrespective of whether the price accepted is lower than is specified in the table. It is appropriate to reiterate that as before, the Central Bank reserves the right to accept some or all of the offers submitted, or to reject all of them (emphasis mine).

Effectively, the CBI can now choose to accept the best offer… or well, come up with a better one.

Two questions: why this sudden and very late change and why was such care taken last year to negotiate whereas now it’s a take it or leave it offer?

As to the sudden change I don’t know but given the fact that a high participation is needed to solve the issue – or otherwise the OS ISK will be locked up in a really cold dungeon, i.e. at negative interest rates with no maturity in sight but only some vague words of a revision when suitable – it can be surmised that the CBI sensed that the large OS ISK holders were not going to participate: they have indicated as much. Although the auction is set for June 16 this isn’t the kind of auction where bidders walk in from the street and wave their hands; the bids will have been placed earlier due to time-consuming procedures.

On the different approach last year v now I had already made some guesses in my last blog: whetted appetite for collecting more for the state coffers, following last year’s windfall from the estates’ ISK assets; political need for a victory before the planned election in October (no date set yet); the certainty that OS ISK owners can’t rely on Icelandic courts to rule in their favour against the sovereign; using the harsh terms as a stick to beat the ISK holders (but when?) – I don’t find any of these very plausible, partly because I don’t see any of these reasons as a winning strategy.

One lesson from the Argentina very very long struggle is that international creditors rely on a many-pronged strategy, i.a. legal actions not only in the home country of the bond issuer but in many jurisdictions. I refuse to believe that Icelandic courts would side with the sovereign against the law but ultimately that’s not a deciding point since legal action will, most likely, be taken in many jurisdictions. And it’s not up to Iceland to define if a certain action is a default event or not.

The fact that two non-journalistic articles have already been published in international finance media indicates interest in certain quarters and a preparation, meaning that the large OS ISK holders, quite unsurprisingly, already have their plan A B and C mapped.

Considering the strong Icelandic economy Iceland has in general a weak case for forcing a haircut on holders of Icelandic sovereign bonds. The government can certainly hold its course but testing its limits to such a degree that it loses control of the situation – as it would i.a. if legal action were taken against it – shows at best lack of realism and worst a staggering stupidity.

That brings me to the same question as earlier: after the care taken last year to avoid time consuming action and legal risk why is the government and the CBI now opting for a course that involves all the things religiously avoided last year?

*In his blog Porzecanski is dismayed that the CBI and the government have recently passed a Bill to temper inflows. This action does however not come as any surprise. Already in its 2012 outline of prudence rules following the lifting of capital controls the CBI spelled out various measures which would be used in the future to secure financial stability. Considering the fact that the inflows in the years up to 2008 ultimately caused Iceland to opt for the capital controls, now being eased, this prudence is highly sensible, in my opinion. Yes, interest rates could be lowered in order to temper the appetite of international investors but that’s another thought for another day. In short, I definitely don’t share Porzecanski’s view though I can see his point. There is an Icelandic saying that a burnt child stays away from the fire – and that is, I’m sorry to say, an apt description of the mood in Iceland re foreign inflows.

Updated: Minister of Finance Bjarni Benediktsson has now responded in the Wall Street Journal, claiming that Iceland shares little with Argentina except that creditors have bought distressed debt at knock-down prices. – However, in the end it only matters who holds the debt, not how it was acquired. Also, Benediktsson does not mention that after legal wrangling, at great cost also legal cost, over 15 difficult years Argentina did indeed negotiate with creditors.

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