Sigrún Davíðsdóttir's Icelog

Cyprus is struggling with its capital controls, with no fixed abolition date in sight. Iceland has also discovered that the best way forward is to have a plan with benchmarks but no time limit. Here are some facts on the Icelandic controls, what is at stake and for whom. As Cyprus might find out – and Iceland is already experiencing – the longer the controls are in place, the stronger the forces against abolishing them.

Capital controls come in many shapes and sizes and capital controls in Iceland and Cyprus are of different nature, set to solve different problems. In Iceland, the controls were put in place end of November 2008. At the time, more capital was flowing out of Iceland than could ultimately be converted into foreign currency. The problem stemmed from ISK600bn, €3.76bn, owned by foreigners (or entities abroad), hence the name “offshore krona/ISK” – there was no way the Central Bank of Iceland could find enough foreign currency to convert these ISK investments into foreign currency. Like in Asia in the 1980s these investments, in Iceland called “glacier bonds,” were made to profit from high interest rates in Iceland.

With time, new sources of ISK that need to be paid out in foreign currency have piled up, in total creating a problem amounting to about ISK1200bn, €7.52bn, ca. 70% of the GDP of Iceland. The core of the problem is ISK assets, needing to be converted into foreign currency at some point and kept firmly in place for now by the capital controls. With the controls in place there are various restrictions on movement of assets in out and of the country. I.a., every Icelandic citizen in Iceland has to hand over to the CBI whatever they earn in foreign currency.

The situation in Cyprus, part of the Eurozone, is different. The Cypriot capital controls were needed to prevent a run on the banks, i.e. hindering that deposit holders would empty the banks. Consequently, the controls were more invasive and much more felt, with maximum withdrawal etc. The controls have gradually been eased but there is now, as far as I can see, no certainty as to when or exactly what conditions need to be in place to abolish them.

The laws on capital controls in Iceland expired last year but there is now no time limit. The CBI has certain benchmark needed to be reached.

In Icelandic, one way of describing a short-lived blessing is “peeing in one’s shoes” – it is a quick warmer but the effect does not last and ends up as a messy problem. That is exactly what capital controls are: a quick blessing, which in time turns out to be costly and eventually costlier than the benefits. It is well established that the longer capital controls are in place the greater the damage: they tend to create an asset bubble as too many currency units chase too few investment opportunities, they distort the business environment and eventually they are inductive to criminal behaviour and corruption and – as anecdotal evidence now shows in Iceland: capital controls create unjustified privileges.

The ISK1200bn problem held in place by capital controls

In Iceland, the capital controls now hold three more or less equally large batches of ISK seeking to be paid out in foreign currency. The glacier bonds now amount to ca. ISK400bn, €2.51bn. Those who own them may to a certain degree be patient investors, happy to enjoy Icelandic interest rates, still quite a bit higher than in the Eurozone.

The second ISK400bn batch consists of ISK exposures with direct or indirect state guarantees. The largest part, ISK270bn or €1.69bn, are bonds exchanged between the new and the old Landsbanki when the new one was set up. Other exposures here are loans of state owned companies like Landsvirkjun, the energy company.

The third ISK400bn batch consists of ISK assets in the estates of Glitnir and Kaupthing, which need to be paid out in foreign currency. Ca. 90% of these assets are owned by foreigners but Icelandic creditors like the CBI and Icelandic pension funds own ca. 10% of these assets, meaning that 10% would float back into Iceland when/if these assets (and the estates’ foreign assets) are paid out. It also means that whatever happens to these creditors (i.e. whatever measures used to dissolve the estates and pay out creditors), does not only apply to foreigners but also to Icelandic creditors. And 10% is not a trivial figure in proportion to the Icelandic economy.

In order to lift the capital controls it is necessary to solve the problems that keep the controls in place. This means that in Iceland the size of the problem is roughly 70% of GDP. That in itself would be no mean feat – but in addition, the government (or at least the Progressive Party) has declared that this process has to create a windfall of ca. ISK300bn, €1.88bn, which it wants to use for further debt relief for those who are too well off to have benefitted from earlier debt relief (which so far is the most extensive debt-relief in any debt-hit European country).

Basically every one who does not have debt at stake thinks this policy, first launched as an election promise by the Progressive Party before the election in April, is a bad idea (i.a. potentially inflation-fuelling; funds would be better used to pay down sovereign debt, i.e. benefitting the whole population), amongst them the CBI, OECD, and the IMF. As reported earlier on Icelog, Prime Minister Sigmundur Davíð Gunnlaugsson does not take seriously criticism from foreign “acronyms,” meaning the OECD and IMF – but that is another story.

The glacier bonds and the state-guaranteed assets – 2 x ISK400bn

Though the two estates pose the trickiest problem, the two other batches also need to be dealt with. The glacier bondholders may well get some offer inducing them to stay, such as unfavourable exchange rate/levy. Also, as mentioned above, some of these investors may be in no hurry to leave.

The CBI and others have indicated that the real problem of state-guaranteed ISK assets, though ISK400bn in total, is thought to be ISK250bn because there are ca. ISK150bn worth of foreign assets/revenues to offset it.

Part of the solution would be to extend the maturity of the Landsbanki bonds, now the topic of intense negotiations between the Landsbanki estate and the new Landsbanki. Due to Icesave, the Dutch and the UK guarantee deposit schemes are the estate’s largest shareholders. Dutch and British officials have a thing or two to say on this matter and they are not necessarily dripping with milk of human kindness after the EFTA Surveillance Authority and the EU unexpectedly lost the Icesave case at the EFTA Court.

The trickiest ISK400bn batch

It is clear that the funds for the debt relief should not come from just any of the three problem batches but from the one that mainly regards foreign creditors, i.e. the Glitnir and Kaupthing batch. Politicians, mainly from the Progressive Party, hoping for a windfall here, seem to hope that although the ISK400bn assets are not trivial, the foreign creditors might be willing to negotiate a write-down – or some other measure that would result in funds for the government (though these are assets of private companies) – in order for the creditors to get their hands on the foreign assets in these two estates, the equivalent of ISK1500bn, €9,40bn, close to 90% of Icelandic GDP.

These foreign assets are sitting there, ready to be handed over – ca. ISK1000bn, €6.26bn, in cash, the rest in assets. It is clear though that the CBI, which by law needs to agree to the estates’ composition (or whatever happens to them) will not grant any asset payout until the destiny of the ISK assets is decided. No piecemeal service here.

The possible measures and solutions re Kaupthing and Glitnir are now being furiously pondered on and discussed among those who have a skin in this game – meaning the administrators of the two estates, the creditors (or their ad hoc creditor committees and their representatives), the CBI and the government, probably mostly within the ministry of finance.

Bjarni Benediktsson minister of finance and leader of the Independence Party is well positioned to make an enlightened choice since he has all relevant experts at his fingertips. Also, IP is traditionally well connected to the ministerial administration. Gunnlaugsson, who no doubt will want to follow this closely – given the election promises at stake for him and his party, ultimately his credibility – might find himself in a more difficult position in terms of access to the same kind of expertise, if he wants to make his own independent assessment. The PP, out of government from 2007 to 2013, might not have the same access as the IP.

Why postponing a solution may be a costly option

Foreigners, who have had dealings with Icelanders, often mention that it is notoriously difficult to get Icelanders to make up their mind and commit to a final decision. The estates might be one such problem where the government will find it very difficult to make up its mind, not least because the PP, after their rhetoric and promises, have to present a solution that looks like a victory over the foreign creditors, with the funds to show.

These problems have been clear to everyone concerned for a long time and clearly all those involved with the two estates have been problem-crunching for months now. One of my sources pointed out to me that if this problem is not solved relatively quickly, i.a. a solution presented in the coming month (though the fine and final details make take some mulling-over) this might drag out for quite a while because it would suggest a fear to bite the bullet rather than a lack of informed options.

But can’t the government just wait around until it has found the perfect solution for the two estates? Not necessarily because without a solution the capital controls stay in place. And the longer it takes to solve the issues of the two estates the harder it is to solve. Delays of half or whole years might burden Iceland with added costs of the capital controls.

A delay can have two-fold effect on the estates: the assets will change – and claims will most likely be sold to a different category of investors compared to present creditors.

As to the assets, unsold assets give scope for negotiation of value. The more assets sold and turned into cash, the less scope to negotiate on value. The thinking among some in Iceland is that the creditors of Kaupthing and Glitnir could just solve the problem by giving the ISK assets to the state (for example, handing the over the CBI), in order to get at least the ISK1500bn foreign assets. Negotiating a write-down is more or less the rule in this situation but a pure gift sounds more than wishful since all creditors have to maximise their recovery. Amongst them are the CBI and Icelandic pension funds, which might find it difficult to justify this kind of magnanimous action.

That said, the creditors may in due time well show some creativity and present a solution that indicates they understand the problems Iceland faces. Remains to be seen.

As time passes, it will be more difficult for creditors to show any kind of creativity because more assets will be sold and converted to cash, leaving only the currency rate to be negotiated.

Thus, it can be argued that time is not on the side of the state. The creditors will not be happy to wait but they can get out of the situation if they want to and they, being professional investors and institutions, have seen all of this before.

Here is what delays might do to the creditor group. For now, the original bondholders in Kaupthing and Glitnir own more or less half the claims, with the other half having been sold off to those who specialise in distressed debt. The division is not quite clear-cut because banks and big creditors often invest with the buyer when they sell off their claims in order to get a cut of the up-side if there is any.

If creditors start to think that the assets will be dealt with “sub specie aeternitatis” they will sell their claims – and the more hopeless it seems the more the write-off and the more virulent the buyers. The vulture kind, prepared to sue everyone to hell in order to get as much out of the claims as possible. – This potential change of creditors will of course not happen over night but yes, over time if creditors start to lose hope and just want to get however little out of what they have.

Consequently, the longer it takes to find a final settlement re Kaupthing and Glitnir the greater the difficulties in finding a solution, bringing on losses for domestic creditors as well. And, worst of all, the capital controls stay in place.

The destructive effect of capital controls and the rise of a new Icelandic nomenklatura

In several reports, i.a. on financial stability, the CBI has in no unclear terms spelled out the cost of capital controls for the Icelandic economy brought on by a potential asset bubble and distorted business behaviour. The CBI deems that these are potential risks, which have not yet happened.

It is notoriously difficult to tell when there is bubble, i.e. when assets are mispriced and asset prices have been rising fast in Iceland, i.a. property prices and shares of listed companies. Both the CBI and financial analysts say that so far, these price increases are in tune with the economy, not a bubble.

The no less worrying effect is, I think, that capital controls are potentially fertile ground for corruption. With time, they create a booming industry seeking to avoid the controls. And with time this industry will do what it can to keep the controls in place.

This is a general course of events in countries with some kind of capital controls. In addition, the capital controls in Iceland are slowly creating its own special kind of a privileged nomenklatura that can buy assets at a cheaper price than other Icelandic mortals.

In order to relieve the pressure of the offshore ISK, the CBI came up the with the idea of offering offshore ISK owners a way of investing this money, given certain terms and conditions, if they bring in foreign currency in addition to the offshore ISK. This seemed like a reasonable way to attract foreign investment to Iceland. The problem is that this has, apparently, not attracted foreign investors but gives Icelandic investors, with foreign assets (which have to be since before the capital controls) and offshore ISK, the possibility of buying assets in Iceland, be it property or financial assets, at a ca. 20% discount to Icelanders who have nothing but their hard-earned not-worth-much ISK.

This new nomenklatura is now pretty clear and known to everyone though it is hardly ever mentioned in the Icelandic debate. I can certainly not remember ever having heard a politician mention this (but here I might be wrong since I don’t follow the Icelandic debate in detail).

Another sneakier way is less well known but indeed existing, I’m told.

It is always presumed that the glacial bondholders are foreigners. That is probably how it was in the beginning of time, i.e. when these investment objects were created and up to the collapse. What I now hear from various sources is that there are Icelanders in this group. No, not necessarily the notorious billionaire “Viking raiders” but wealthy Icelanders, in Iceland, who have bought the bonds after the collapse and now hold them through foreign companies or “nostro” accounts of foreign banks. Out of the total ISK400bn these may not be high sums but, again in Icelandic context, quite a bit of money.

Here is the trick: the law on capital controls allow glacial bondholders to convert the interest rate of glacier bonds into foreign currency and move them abroad. Icelandic glacial bondholders can then take this foreign currency and bring it back to Iceland through the CBI investment offer, to buy Icelandic assets, meaning they get the Icelandic assets at ca. 20% discount, as mentioned above.

It would be very interesting to know who these alleged Icelandic glacial bondholders are. It would throw light on how privileges are meted out in the regime of capital controls and clarify the stance that certain individuals may take in the public debate.

Waiting is not an option – if the cost of capital controls matters

As argued above, there are various reasons why waiting is costly, why waiting compounds the problem of the capital controls and makes the ensuing problems more engrained over time. Needless to say it is extraordinarily difficult to say exactly at what point the cost is greater than the benefits of the controls. Also, assessing the cost of the corruption the capital controls create is particularly hard to evaluate.

The capital controls in Iceland have been in place for the best part of five years – in Cyprus only for five months. Although the controls in the two countries are of different nature, put in place to solve different problems, Iceland can be an interesting example for Cyprus – and possibly, with time, an example of what to avoid.

*Here are some earlier Icelogs on capital controls.

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In historical perspective, the left victory in 2009 was truly surprising but the great loss of the left now is much less surprising. Iceland has, since 1944, been a conservative stronghold. The recent results do not necessarily demonstrate any nostalgia but rather the political norm in Iceland. What the left, especially the Alliance (social democrats), lost now was the opportunity to break the norm

The left and its Freudian death wish

Compared to the situation in Ireland, not to mention Greece, the left coalition of the Left Green led by the Alliance, social democrats, did a tremendous job of turning recession to growth – albeit a paltry 1.6%, not much to shout about where 6% and more seemed the law of nature some years ago. And it is no less a tremendous success to get from 10% unemployment down to below 5% at the beginning of the year (end of March 6.8%).

Although Iceland is now in its third year of growth, the Government treated its success as the merest nothing. It sure did not make a song and dance about it. The two parties in power, both ministers and MPs, have been their own worst enemy, belittling its success – a prime example of what Sigmund Freud meant by “death wish.” Either, they did not realise what a feat they carried through or they did not have the political confidence to believe in what they did.

There is though a bit more to this inability to profit from success. Being a left Government they seemed to conclude that with the emphasis on private debt and the unavoidable hit so many families took due to indexed loans and forex loans (both these loan types are a whole saga in itself) they could not really step out and tell the voters, who did not sense a turnaround, that things were actually not that bad, compared to other countries. And the measures taken by the left Government only seemed to increase the discontent.

The Government could not – or did not dare to – tell voters that measures to write-down private debt were actually working. In June last year, the Central Bank of Iceland published a detailed paper, Households’ position in the financial crisis in Iceland, showing that the debt crisis stemmed from imprudent lending in 2007-2008, i.e. before the crisis hit but was alleviated by measures taken by the Government.

Again, the Government made little of this and other research and allowed the opposition to monopolise the debt debate.

There is no doubt more to the left

Compared to the UK Labour party that turned its fortune around after the election in 1997 by turning into an electable party and not just a lightening rod for an antry electorate, the Icelandic social democrats squandered their four years in Government. There is no doubt more to the left loss and others might explain it differently – but whatever the explanation the loss is spectacular and the largest in the history of Iceland: a loss of 27%.

The Progressives and Pascal’s Wager

The Progressive Party, which had for a long time been promising a 20% general write-down of all household debt, went fishing on the wide ocean of discontent. Now, not only promising the 20% – though never writing it down as an election manifesto but only referring to it now and then – it outdid itself by promising to miraculously squeeze ISK300bn (€195m) out of the creditors to Glitnir and Kaupthing and distribute it to indebted households, in no time at all.

No matter if political opponents showed that this would profit non-struggling households with high debt and not those who according the CBI Working Paper were struggling to make ends meet, voters embraced the idea very much like Pascal’s Wager: maybe the Progressives cannot deliver but then they are no worse an option than others; if they per chance could it’s better to vote them in.

End of January, when the EFTA Court ruled in favour of Iceland in the Icesave dispute, the Progressives could say that yes, they had been right on Icesave and so they would be on this. No one mentioned that in autumn 2008 their leader Sigmundur Davíð Gunnlaugsson said he would single-handedly solve the crisis by securing a Norwegian loan. He travelled to Norway but failed to deliver the loan.

The Progressives made no mistake in their election campaign. Being large on promises and silent on solutions served them well. A remarkable success given the fact that only a year ago it seemed the party would silently evaporate. Historically a rural party, always greatly aided by the imbalance between urban and rural votes (in some cases one rural vote equals three in Reykjavík) the party was doing so badly in Reykjavík that Gunnlaugsson, fearing he would not get elected in his constituency, Reykjavík, moved North to take the top seat there.

The Progressive turn-around is a much more remarkable feat than the Independence Party again returning to being the largest party – because that is what the Independence Party has almost always been.

And the next Government – a strong two-party coalition or weaker political patchwork?

It is now up to President Ólafur Ragnar Grímsson to choose who first gets the mandate to forming a Government. The procedure follows no rules but the tradition is that the President talks to leaders of all parties presented in the Icelandic Parliament, Alþingi. The President then gives the mandate to the leader he deems most likely to form a Government, based on what he has learnt from the party leaders.

The only two-party option now is a coalition of the two largest parties. Sunday, both leaders spoke favourably in that direction, the IP leader Bjarni Benediktsson perhaps more than Gunnlaugsson. A two-party coalition has very much been taken as given in Iceland for the last few days, also because these two parties have been together in Government for 26 years, out of 69 years since 1944.

However, the promises of the Progressives might render the party toxic to other parties since no one outside of the party can see how this extensive deb-relief can be brought about. Given the promised speed of delivery, the Progressives could lose popularity quicker than Francois Hollande if the party gets to lead the Government and so would its fellow-coalition party.

Furthermore, the other parties have pointed out that if all this money were available, pumping it into the economy would be hellishly unwise. Much better using it to pay off public debt. – On other issues, the two parties seem natural allies, such as job creation, energy, and belief in market solutions, lower taxes and anti-EU stance. Together, the two parties strengthen each other’s tendency to isolationistic views.

It is pretty clear that Grímsson will ask either of the two – Gunnlaugsson or IP’s leader Bjarni Benediktsson – to form a Government. Both parties have 19 seats in Alþingi though the Independence Party got more votes. Grímsson could turn to Gunnlaugsson because his party is the real winner in terms of the leap the party has taken – or he could turn to Benediktsson as the leader of the largest party.

Most Icelanders feel that Grímsson not only wants to act as a midwife, assisting a new Government into the world, but has great desire to play a political role in forming it. However, the President is bound by the political realities – the party leaders will have to live with the Government formed, not the President.

The general sense is that Benediktsson, whose fiercest enemies are found among the old guard in his own party, will not get any political peace unless he secures the Prime Minister post. Gunnlaugsson, being a younger leader of a unified party, is seen as less needy in this respect. And playing the second violin in Government might free the Progressives from the apparently hopeless task of delivering the debt-relief.

There are however all sorts of theoretical possibilities in the present situation.

A Progressive-Left Government has often been mentioned in the last few weeks. Often though it has been as a warning to Independence Party voters not to vote for the Progressives as many of them seemed inclined to do and did.

With six parties, there certainly are many possibilities of a political patchwork Government. But after a weak left Government of warring factions, a two-party coalition of parties that have a long history of being together in Government and which in most respects are politically close to each, so as not to say intimate with each other, does seem the most likely option. Unless it does not work out.

– – –

Some facts: there are 63 seats in Alþingi, hence 32 is the lowest number of seats to secure majority. The two large parties have 19 seats each, the social democrats have 9, Left Green 7 – and the two new parties, Bright Future and the Pirates get respectively 6 and 3. (The final results, with all parties, in Icelandic.)

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The coming elections in Iceland are characterised by greater voter volatility than previously seen. Fifteen parties – up from five in the present Parliament – are courting the voters. In spite of turning the economy from recession to growth in record time the coalition Government has lost trust. Voters, sticking to the two parties that have been the mainstay of Icelandic politics for decades, seem to long for the past.

The Government and its unrewarded and squandered success

In spite of extensive write-down of private debt, orchestrated by the present Government of social democrats, Samfylkingin, the “Alliance, and Vinstri grænir, “Left Green,” private debt is the main election issue in Iceland. Framsóknarflokkurinn, the “Progressive Party,” has earlier promised to write down all private debt by 20% but is now talking of distributing ISK200-300bn (€) to those with debt, no matter if they can repay their debt or not, meaning the party will help indebted wealthy individual. The party claims it will extract this money, not clear how, from the estates of the two failed banks, Kaupthing and Glitnir.

Judging from the debate and the enormous loss of favour suffered by the two coalition parties it could be thought that the present Government had ignored the problems rising from the surge of private debt after the collapse of the three big Icelandic banks in October 2008. But that is not the case at all. More has been done in Iceland than in any other European country in crisis. Debt has been written down – mortgages cannot be higher than 110% of the value of the property and morgages are consequently written down to that level. Bankruptcy laws have been amended, meaning that bankruptcy period is now two years (only recently have the Irish taken steps to chang their bankruptcy law).

Compared to the situation in other debt-ridden countries, i.a. Ireland, where private debt is high and no public policies have been introduced to assist indebted individuals, the enormous discontent in Iceland is a mystery. Part of the explanation is surely that Icelanders compare their lifestyle to 2007 – not to the situation in other European countries in crisis.

The present Government has been eminently bad at taking credit for the turn-around in the economy. In the summer of 2011, as recession had turned to growth, minister of finance and then leader of the Left Green Steingrímur J. Sigfússon was interviewed on Rúv. When so many of his European colleagues would have announced a growth of 2% with fanfare, Sigfússon lamented the growth was “only” 2% (it ended in 2.9% that year, 2011).

This week, when asked about the poor performance in opinion polls newly elected leader of the social democrats, Árni Páll Árnason said the party’s fate was similar to the fate of other parties in government in European crisis-struck countries, i.e. the voters punish governments for the crisis. For some reason, Árnason did not mention that there is this not so trivial difference: in Iceland, the Government has actually turned the economy around.

Fifteen parties – up from five

The “Four-Party,” Fjórflokkurinn, is the nickname often used for the four old parties: the conservative Independence Party, traditionally the largest party, the progressives, the social democrats and the Left Green. This name underlines the latent sense of many voters that there is “the same arse” (excuse my language, this is an old Icelandic expression) under all of them, meaning there is no real difference between them and that they really look only after their own interests, not the interest of the voters.

In addition to the “Four-Party” there have often been one or two new parties in the run. In addition to the “Four-Party” in Parliament there is now the “Movement,” Hreyfingin, a protest party that ran for the first time in the elections in March 2009 but which has now split.

Following the success of the “Best Party,” Besti flokkurinn, in Reykjavík in the local election in 2010, the “Four-Party” has had good reasons to worry if some unexpected surprise, in the shape of a new party, would spring up in parliamentary election and steal votes. For a while, it seemed as if “Bright Future,” Björt framtíð, a centre-liberal pro-EU party, would be the only new party.

It now turns out there are eleven new parties. Out of the fifteen parties running, eleven are running in all six constituencies. The only one of the new parties, apart from Bright Future that might get more than five per cent of votes is the Pirate Party, led by Birgitta Jónsdóttir who started her political career in the “Movement.” She became an international celebrity for her role in Wikileaks earlier but is now a well-known activist on media freedom and the Internet.

According to the latest poll, the Progressives top the list with 32.64%, Independence Party 22.88%, the social democrats 10.39%, Bright Future 9.49%, the Pirate Party 8.99% and Left Green 6.69%.

The historic loss of the Independence Party 

It is still too early to say if the Independence Party will indeed fare as badly as forecasted by the polls. After a consistent 30% or more in the polls for the last few years their luck turned following their party conference earlier this year. Their leader, Bjarni Benediktsson, was re-elected with a convincing majority but failed to rouse the spirit outside the party faithful and has been unable to connect to latent conservatives voters.

Behind the scenes the old guard has been plotting ferociously against him, meaning the Davíð Oddsson and the die-hard followers of this former leader, prime minister and Governor of the Central Bank, now editor of the once (not any more) largest and most powerful newspaper, Morgunblaðið. In spite of the party’s lacklustre performance Morgunblaðið’s editor has not used his sharp pen to rouse conservative voters. And in spite of the surge of the Progressives, quite obviously stealing votes from the conservatives, Morgunblaðið has been most sweet towards the Progressives.

Oddsson fought Icesave tooth and nail and, from his point of view, Benediktsson committed the cardinal sin of taking the opposite view: after the last attempt to negotiate with the Brits and the Dutch, Benediktsson supported the agreement, which then failed in a referendum, in spite of gathering a large majority in the Parliament. Oddsson – and the Progressives who were on his side – felt hugely victorious when the EFTA Court ruled in favour of Iceland on Icesave. Hence, the mild Morgunblaðið tone towards the Progressive Party.

Also on EU Oddsson and the Progressive see eye to eye, both being firmly against. Benediktsson used to be seen as pro-EU but has turned on that issue following the collapse and, probably more importantly, as he has had to fight the Oddsson wing of the party.

Oddsson was ousted from the post of Governor of the Central Bank in early 2009. When a report on the collapse and necessary lessons from it was presented at a party conference in 2009 Oddsson held an unannounced speech and not only shredded the report but taunted those who had written it. Many feel that by preventing a much-needed discussion of the past Oddsson caused great harm to the party. This incident still looms in the discussion now and throws a shadow, shaped like Oddsson, on the party.

When a poll was published last week, showing that half of those now in favour of the Progressives, would vote for the conservatives if Hanna Birna Kristjánsdóttir, vice-chairman of the Independence Party, would led it, Benediktsson said he needed to consider his position. This was widely taken as a hint he was stepping down but he quit the idea of quitting and showed a tougher and more resolute side than earlier. Rumours said that supporters of Kristjánsdóttir had paid for the poll and this is now seen to have been greatly damaging to her. Again, this is seen as a plot to de-throne Benediktsson, stemming from the old guard.

Morgunblaðið’s owners have always been companies and individuals closely linked to the Independence Party. Interestingly, this is no longer so. Among the owners there are now companies with strong links to the Progressives, one of them being Kaupfélag Skagfirðinga, a remnant of the once so powerful co-op movement in Iceland, always part of the Progressive’s sphere in Icelandic politics. The CEO of KS is Þórólfur Gíslason, one of the country’s most powerful men though not at all a well-known name in Iceland.

Morgunblaðið, formerly a conservative stronghold, has at present strong ties to the two parties – the Independence Party and the Progressives – which together have ruled Iceland in total for 26 years since 1944.* The editor of Morgunblaðið once led a coalition government of the two parties for nine years, from 1995 to 2004. Morgunblaðið seems to have been doing its best to shape the ground for such a coalition. Bar unexpected events, it is difficult to what could exclude a coalition government led by the Progressives, together with the Independence Party.

The leaders of the two biggest parties– and the return to the past

Sigmundur Davíð Gunnlaugsson leader of the Progressive Party is born into the party. His father, Gunnlaugur Sigmundsson, was also briefly an MP for the party. Sigmundsson was on the board of a public IT company, Kögun, which he later bought when it was privatised and became a wealthy man. Recently, Teitur Atlason, a blogger living in Norway, accused Sigmundsson of corruption in connection to Kögun. Sigmundsson sued the blogger for libel but lost. Atlason’s allegations were not new and had been published in Icelandic media more than ten years ago. Sigmundsson claims they are wholly unfounded and he has never been charged in relation to Kögun. Anna Pálsdóttir, Gunnlaugson’s wife, is independently wealthy, being the daughter of Páll Samúelsson who in 2005 sold Toyota Iceland.

Also Bjarni Benediktsson is born into his party, the Independence Party. For the most part of the last century his family has been both wealthy and powerful. As so many in his family Benediktsson is a lawyer. His father and uncle were in business with Milestone, a now failed holding company, owned by Karl Wernersson. Milestone was a big shareholder in Íslandsbanki (later named Glitnir) and the insurance company Sjóvá. Benediktsson is seen by many as being tainted by investigations into the affairs of Milestone, which is being investigated by Office of the Special Prosecutor.

It is interesting that less than five years after the collapse, two parties and two leaders seen to be closely connected to politics and businesses before the collapse are now doing immensely well in the polls – and might very well be the powers to be in Icelandic politics, thus connecting the past to the present. Possibly because this past, i.e. the 1990s, is seen as a time of prosperity and stability.

The voters seem to seek confidence in the two parties, which have been the political backbone in Icelandic politics and more than any other parties shaped Iceland in the decade before the boom, which led to the collapse that turned everything upside down in Iceland almost five years ago.

*The 26 years refers to years when both parties have been in two together in Government. In 1958-1959 and 1979-1980 the social democrats were in Government and then from 2009 to 2013 the social democrats and the Left Green. Out of the 69 years since the foundation of the Icelandic republic, the Independence Party or the Progressives or both have been in Government for 63 years. See here for a Wikipedia list (in Icelandic) of Icelandic Cabinets. The social democrats have been through many metamorphosis. Their fate, as well as the fate of left parties, has been to split at regular intervals.

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The idea of an doing” an Icesave,” of an “Icesave solution,” for Cyprus pops up again and again. But can Cyprus do an Icesave? The short answer is “no.” If doing an Icesave means Cyprus avoiding to reimburse foreign/Russian depositors Icesave provides no example to follow.

Icesave was a foreign operation. When the Icelandic banks failed, it was decided to keep alive the banks’ Icelandic operations, letting those abroad fail. It also meant that all deposits in Iceland were moved into new banks, the rest was wound up. The governments in the UK and the Netherlands reimbursed the Icesave depositors.

An “Icesave solution” indicates a division between domestic and foreign accounts. That is of no great use to Cyprus because the major part of the deposits in Cyprus are in Cyprus and that is also where the largest part of their operations are.

Contrary to the Cypriot situation, the largest part of the operations of the three Icelandic banks were abroad, not in Iceland. Kaupthing, the largest bank, had ca 80% of its operations abroad. The two others, Landsbanki and Glitnir, were heading in the same direction.

In Cyprus, the main operations of the banks are in Cyprus. Ergo, a division like the Icesave – or more exactly, in domestic and foreign operations – does not provide a Cypriot solution. EU Directives do not allow for differentiating between foreign and domestic depositors within the same country. Consequently, Cyprus can not decide to insure deposits owned by Cypriots and Cypriot entities and not others. Completely forbidden.

The only way to differentiate between deposits in Cyprus – for levy or any other action – is to differentiate between insured and non-insured deposits, i.e. between deposits under €100.000 and over €100.000. An Icesave “trick” does not help in Cyprus.

*Here is an earlier blog on the EFTA Court ruling re Icesave.

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As Icelog has pointed out earlier, there are many similarities between Iceland and Cyprus. One of them is Icesave.

If Laiki Bank, a badly hit Cypriot bank, folds it will leave some depositors in the UK under a Cypriot Deposit Guarantee Scheme because Laiki, apparently, has branches in the UK, not subsidiaries. As Landsbanki’s Icesave accounts, set up as a branch, showed so clearly these depositors will have to seek to Cyprus for their deposit guarantees. If Laiki operations in the UK had been in a subsidiary it would fall under the UK DGS.

Ever since Icesave the UK Financial Services Authorities have had their eye on branches. But they seem to have reacted somewhat slowly – Icesave collapsed over four years ago, in October 2008. Yet another failure on part of the FSA.

The lesson from Iceland is that if Laiki folds it is very important that insured deposits are moved into a new entity (for which funds are needed) and the rest left to a resolution company. (In Iceland, all deposits were insured, no minimum).

What Iceland did – which has proved very beneficial to uninsured deposits (which were the deposits abroad) – is that in the Emergency Bill (passed into law just as everything was collapsing October 6 2008) deposits were made a priority claims in bankruptcy. This meant that uninsured depositors get paid first, i.e. have hope of getting something back.

This was relevant not in Iceland but in the Icesave branches in the UK and the Netherlands because these deposits were then given priority and will actually get fully reimbursed. But alas, one’s gain is another’s loss – it means that other creditors to Landsbanki’s foreign operations aren’t getting very much.

What happened in Icesave was that the UK and the Dutch did reimburse depositors (to avoid unrest) but then wanted this money back from Iceland. Iceland resisted – and now in January the EFTA Court ruled that because it was a major systemic failure Iceland did not need to reimburse the two governments. (This is a hotly disputed outcome, the European Court of Justice might see it differently).

In a situation like in Iceland and Cyprus, someone will feel the pain. In Iceland, ordinary deposit holders lost 30-40% of their ISK deposits, measured in euro. Exiting the euro is no solution for Cyprus. With banks kept alive since January by the ECB’s Emergency Liquidity Assistance, the Cypriot catastrophe has been on the horizon for a while. It is a pity that it was not better prepared when the crash finally came.

But now it is here and something needs to be done. Iceland managed to do a few things right – helped by the fact that the there were foreign creditors that could be forced to take the greatest loss, ca 5-6 times the Icelandic GDP –  painful though it was. It seems that the Cypriot shock might be greater, no clear cut group of foreign creditors who can be forced to swallow losses. Still, for  Cyprus a quick stab might be better than the lingering pain the Greeks have lived with for far too long.

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Fitch Ratings have upgraded Iceland’s status – it is now BBB instead of BBB-. The upgrade, as a similar move by Moody’s recently, partly stems from the EFTA Court’s Icesave ruling, which has removed uncertainty of possible state liabilities. Fitch underlines the improved economic situation, not least the debt status of the sovereign, all moving in a positive direction and gives Iceland a slightly higher rating than Moody’s and S&P.

The capital controls are the great unknowns. But first, a few words on the situation in Iceland here and now, relevant to the capital controls.

In the wake of the collapse of the Italian political system, following the corruption investigations in the early 1990s, old powers in the new centre around Silvio Berlusconi found ways of conquering the political vacuum. The collapse of the Icelandic banks set the scene for similar movements, not only for power but for assets as well. Shortly after the collapse of the banks a person with a great insight into Icelandic society said to me that we would, in the coming years, see a fierce battle for assets and power in Iceland.

This battle is now taking place, centered around the ownership of the holding companies which control the two banks, Islandsbanki and Arion. The owners of these two holding companies are foreign creditors, ca half and half original creditors and funds that have bought claims. The crux of the matter is if the two holding companies will go through an orderly composition and a sale of asset at the best possible time or if the companies will be brought into bankruptcy, forcing them to sell off assets in a relatively short time, assumedly at a knock-down price.

Mar Gudmundsson governor of the Central Bank of Iceland has expressed that the best solution would be to sell one of these banks for foreigners who brought in fresh foreign currency. The delicacy of the situation is partly that whichever bank is sold first will, in a sense, knock down the price of the remaining one, especially if there are only Icelandic buyers interested.

The latest is that a fund owned by Icelandic pension funds, in conjunction with major shareholders of MP Bank, are negotiating a purchase of Islandsbanki. The group is led by Skuli Mogensen, who after leaving a bankrupt IT company OZ ca ten years ago, made his fortune in Canada, and like in a novel, returned to his homeland a rich investor, keen on building his fortunes there again. In MP Bank he has allied himself with two investors, who have previous Icelandic ties – David Rowland and Joe Lewis.

However, the “ruler” in deciding the turn of events re selling the two banks is the CBI. The bank will have the last word on agreements re the composition, which have to be weighed against the pressure on the Icelandic krona due to lack of foreign currency in Iceland. The CBI is well aware of the problems and yet, some forces in Iceland are trying to undermine its authority by insisting on political control and the role of the Parliament in deciding the fate of the two holding companies.

Before the privatisation of the Icelandic banks they were run like political fiefdoms. Following the privatisation, fully in place by 2003, the banks were still run as fiefdoms, this time with the largest shareholders as the bank ruling class. The publication of the SIC report drew a concise, insightful and bleak image of these convoluted alliances and power structures.

One way of understanding the ongoing struggle in Iceland re ownership of the two major banks is to see it as the attempt of those who used to rule, before 2008, to reclaim their position. Others might say that this sounds like fiction – but lets wait and see. The outcome of the elections will be a decisive factor in constructing the future of Iceland.

Now, back to Fitch. Below is the Fitch press release, emphasis is mine.

Fitch Ratings has upgraded Iceland’s Long-term foreign currency Issuer Default Rating (IDR) to ‘BBB’ from ‘BBB-‘ and affirmed its Long-term local currency IDR at ‘BBB+’. The agency has affirmed the Short-term foreign currency IDR at ‘F3’ and upgraded the Country Ceiling to ‘BBB’ from ‘BBB-‘. The Outlooks on the Long-term IDRs are Stable.

KEY RATING DRIVERS The upgrade reflects the impressive progress Iceland continues to make in recovering from the financial crisis of 2008-09. The economy has continued to grow, notwithstanding developments in the eurozone; fiscal consolidation has remained on track and public debt/GDP has started to fall; financial sector restructuring and deleveraging are well-advanced; and the resolution of Icesave in January has removed a material contingent liability for public finances and brought normalisation with external creditors a step closer.

The Icelandic economy has displayed the ability to adjust and recover at a time when many countries with close links to Europe have stumbled in the face of adverse developments in the eurozone. The economy grew by a little over 2% in 2012, notwithstanding continued progress with deleveraging economy-wide. Macroeconomic imbalances have corrected and inflation and unemployment have continued to fall. Iceland has continued to make progress with fiscal consolidation following its successful completion of a three-year IMF-supported rescue programme in August 2011. Fitch estimates that the general government realised a primary surplus of 2.8% of GDP in 2012, its first since 2007, and a headline deficit of 2.6% of GDP. Our forecasts suggest that with primary surpluses set to rise to 4.5% of GDP by 2015, general government balance should be in sight by 2016.

In contrast to near rating peers Ireland (‘BBB+’) and Spain (‘BBB’), Iceland’s general government debt/GDP peaked at 101% of GDP in 2011 and now appears to be set on a downward trajectory, falling to an estimated 96% of GDP in 2012. Fitch’s base case sees debt/GDP falling to 69% by 2021. Net public debt at 65% of GDP in 2012 is markedly lower than gross debt due to large government deposits. This also contrasts with Ireland (109% of GDP) and Spain (81% of GDP).

Renewed access to international capital markets has allowed Iceland to prepay 55% of its liabilities to the IMF and the Nordic countries.

Risks of contingent liabilities migrating from the banking sector to the sovereign’s balance sheet have receded significantly following the favourable legal judgement on Icesave in January 2013 that could have added up to 19% of GDP to public debt in a worst case scenario. Meanwhile, progress in domestic debt restructuring has been reflected by continued falls in commercial banks’ non-performing loans from a peak of 18% in 2010 to 9% by end-2012. Nonetheless, banks remain vulnerable to the lifting of capital controls, while the financial position of the sovereign-owned Housing Finance Fund (HFF) is steadily deteriorating and will need to be addressed over the medium term.

Little progress has been made with lifting capital controls and EUR2.3bn of non-resident ISK holdings remain ‘locked in’. However, Fitch estimates that the legal framework for lifting capital controls will be extended beyond the previously envisaged expiry at end-2013, thereby reducing the risk of a disorderly unwinding of the controls. Fitch acknowledges that Iceland’s exit from capital controls will be a lengthy process, given the underlying risks to macroeconomic stability, fiscal financing and the newly restructured commercial banks’ deposit base. However, the longer capital controls remain in place, the greater the risk that they will slow recovery and potentially lead to asset price bubbles in other areas of the economy.

Iceland’s rating is underpinned by high income per capita levels and by measures of governance, human development and ease of doing business which are more akin to ‘AAA’-rated countries. Rich natural resources, a young population and robust pension assets further support the rating.

RATING SENSITIVITIES The main factors that could lead to a negative rating action are: – Significant fiscal easing that resulted in government debt resuming an upward trend, or adverse shocks that implied higher government borrowing and debt than projected – Crystallization of sizeable contingent liabilities arising from the banking sector. In this regard, the HFF represents the main source of risk.

– A disorderly unwinding of capital controls leading to significant capital outflows a sharp depreciation of the ISK and a resurgence of inflation. The main factors that could lead to a positive rating action: – Greater clarity about the evolution capital controls and, in particular the mechanism for releasing offshore krona.

– Enduring monetary and exchange rate stability.

– Further signs of banking sector stabilisation accompanied by continued progress of private sector domestic debt restructuring.

– Continued reduction in public andexternal debt ratios.

KEY ASSUMPTIONS In its debt sensitivity analysis, Fitch assumes a trend real GDP growth rate of 2.5%, GDP deflator of 3.5%, an average primary budget surplus of 3.2% of GDP, nominal effective interest rate of 6% and an annual depreciation of 2% (to capture potential exchange rate pressures resulting from the lifting of capital controls) over 2012-21. Moreover a recapitalization of HFF equivalent to 0.7% of GDP is assumed in 2013. Under these assumptions, public debt/GDP declines from its current level to 69% of GDP in 2021. The debt path is sensitive to growth shocks. Under a growth stress scenario (0.2% potential growth), public debt would remain on a downward trajectory but it would stabilise at a markedly higher level (90% of GDP) by 2019. While Iceland’s debt dynamics appears to be resistant to an interest-rate stress scenario, a sharp deterioration in the exchange rate (possibly associated with a disorderly unwinding of capital controls) would have a more adverse effect.

Similarly, a scenario with no fiscal consolidation (primary deficit of 0.3% of GDP in the medium-term) would reverse the debt downward path: debt would reach 100% of GDP in 2015 and would remain above that level for 2015-21.

Fitch assumes that contingent liabilities arising from the banking sector (mainly through HFF) will be limited. Under a scenario where contingent liabilities arise due to the recapitalisation of HFF and they account for 4% of GDP each year from 2014 to 2016, public debt would still remain on a downward trajectory. However, it would reach 81% of GDP by 2021 (versus 69% under the baseline).

Fitch assumes that capital controls will ultimately be unwound in an orderly manner.

Fitch assumes that the eurozone remains intact and that there is no materialisation of severe tail risks to global financial stability.

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From 1998-2000 I lived in Denmark and followed how things evolved both there and in the Nordic neighbouring countries. Outside, these countries seemed an oasis of tranquillity, peace and harmony though that feeling was less prominent inside. Of course, there were a lot of problems to be discussed and solved at a closer look – and it is that closer look that colours the public debate.

In the summer of 1992 I spent some weeks on an Italian beach immersed in hectic, loud and lively Italian family life. One of these summer days, the Sicilian judge Paolo Borsellino was assassinated, only a few months after the assassination of his colleague Giovanni Falcone. These were tense and tragic times and the uncertainty and power vacuum following spectacular corruption cases, the rise of “mani pulite” and the collapse of the Italian “partitocrazia” was palpable. There were even rumours that the army was thinking of asserting itself. Returning home to Copenhagen I opened the door. The Swedish newspaper “Svenska Dagbladet” was on the doormat. The main headline was “Bad ventilation in public places” – surely, this can only make headlines when all problems have been solved.

Moving to the UK in 2000, I looked back at these countries with certain nostalgia – compared to most, almost all, other countries the Nordic countries just seemed to have solved all problems. I nodded approvingly at the recent Economist’s front page coverage of the Nordic countries as a supermodel, excluding Iceland, embodied by a Viking. I was also glad to see the use of the term “Nordic” – a native English speaker once told me this term was not English. Well, it has now turned English though in the Nordic countries themselves the term includes the five countries – Denmark, Finland, Iceland, Norway and Sweden.

There is a good case for not including Iceland among the Nordic supermodels – the social structure is different, so is the value system. In the four other countries, social democrats have been the political architects. In Iceland it has been the conservative, the Independence Party. And so on.

Yes, there is much to be learnt from the four Nordic countries, in particular the natural inclination to egalitarianism and taking it for granted that society is made up of men and women and should be accommodating to both – an attitude woefully lacking ia in the UK. Research after research shows that such societies thrive and grow and it is not prohibitively extravagant to expect these fundamentals to be in place. Which of course doesn’t abolish political dispute but that is what democracy is for – to discuss these issues in a more or less civilised way and reach a workable conclusion and compromise.

My own country made the front page of the FT February 5, also with a Viking, this time a statue holding the Icelandic flag, embodying “The Icelanders’ angst; Saga of a society in rehab. Analysis.” The feeling is more chatty Hello than stern FT; the analysis done not with graphs and statistics but with mini portraits of seven Icelanders, all well known in Iceland. The point is to show that in spite of good economic numbers – such as unemployment falling from a peak of 9.2% to 5.7% (or 5.6% according to Iceland Statistics) and a growth of ca 2% – Icelanders are still “struggling, some are angry and some are keen to move on.”

Right, there is the whole gamut of feelings, as in most countries but angst? No, I don’t think angst is the prevailing mood among Icelanders and even much less now than a week ago when the EFTA Court ruled on Icesave. “Not enough done” has however been a common theme in the political debate. The government has been spectacularly bad at taking credit for the recovery that has, in spite of problems, taken place, giving the opposition plenty of space to spread its own version of too little, too late, wrong and bad.

Recently, I was on the Pat Kenny show on Irish Rte, explaining the Icelandic 110% way, the extensive write-downs of mortgages, one of the measures to get things moving again. Kenny asked if this meant that had he a mortgage of €400 and the value of his property was only €200 would he then get his mortgage written down to €220. Yes, exactly. There was a few seconds’ stunned silence. This would be seen as quite something to do, universally and over the line in Ireland or in any other country. In Iceland, people shrug their shoulders; yes, it’s good – but it’s not enough. Not for everyone.

Right, it’s not the panacea solution for everyone but it is quite helpful to many. The same goes for changes in bankruptcy law, to shorten the time of bankruptcy to two years and some other measures. Daniel Gros, CEPS, thinks that small countries like Latvia and Iceland do not have much to teach bigger countries re austerity. He might have a point in general but some of the measures taken in Iceland could prove of use to others, ia Ireland and Spain.

Icelanders are notoriously good at spending. The Icelandic term is “eyðslukló” – “spending claw” – and the Icelandic spending claw is now at it again. Going abroad, buying this and that, thereby showing some optimism. The spending claw is certainly not showing any sign of angst, not even now, in mid winter. According to Gallup Iceland “National Pulse” (Þjóðarpúlsinn) the mental state of the nation is slightly down from summer – as normally happens during this naturally dark time of the year – but it peaked higher in July last year than the previous year and is now also slightly higher than same time last year. Consumption of smaller goods was ISK5bn over Christmas a year ago, this time ISK7.1bn. And so on.

Plenty of things Icelandic in the international media recently. “Have you seen the front page of the International Herald Tribune,” an Icelander asked me in Brussel last Friday. “It’s the most beautiful IHT front page I have ever seen.” Right, the Esja – the majestic mountain cuddled up under white clouds on the other side of the bay from Reykjavik – was naturally well at ease on the front page and so was Olafur Hauksson, the special prosecutor and poster boy of bankers and financiers’ investigations in Iceland. The headline, “Iceland, Fervent Prosecutor of Bankers, Sees Meager Returns.”

I am not sure what the “meagre returns” mean here. The Office of the Special Prosecutor, headed by Hauksson, was set up in early 2009 with no staff and nothing. Now, three men are in prison related to financial dealing before the collapse. Some high-placed managers and large shareholders have been charged but these cases are still being processed by the Courts. HSBC has admitted to money laundering going back to the early 2000s. No one has been charged. It is only recently that bankers involved in Libor rigging, also going back number of years here in the UK are being investigated – it seemed at first there would only be fines. The investigations in Iceland are going far slower than most would like – but the bankers and other major players in the financial boom in Iceland are actually being investigated. That is more than can be said for most countries.

Is it necessary to make criminal investigations into what went on during the bubble years in Europe? Some say not, that one should look forward and not backward. I can’t see that one excludes the other. Human beings are not one-track beings and society can put efforts into both. Moreover, I think that the palpable anger in countries like Greece, Spain and Ireland – though expressed in different ways – also stems from the fact that little has been done to throw light on, investigate – and prosecute where appropriate. In addition, there is the immensely illuminating report of the Special Investigative Commission, set up at the behest of the Icelandic parliament, whose report was published in April 2012. No country has recently done comparable investigation.

It is perhaps the dark, cynical and prodding mind of editors that come through in the headlines mentioned above – there is often discrepancy between articles and headlines – but when their behaviour is scrutinised Icelanders do not seem to be particularly angst-ridden. Though the OSP investigations are taking time they take less time than some of the major SFO investigations. The judgements in OSP cases so far indicate that at least in a certain type of cases, of which there will no doubt be more, sentencing is likely, in some cases severe sentencing. The OSP might certainly experience some setbacks; charges might be thrown out, those charged found not guilty but at least Icelanders can’t say that nothing is being done in bringing bankers and financiers to justice. Too big to fail, to important to jail doesn’t quite hold in Iceland.

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What is the reaction to the EFTA Court’s Icesave ruling in Iceland and abroad? In Iceland, there is no gleeful victory, in Brussels people worry about the effect on perception and depositors’ protection and in the UK and the Netherlands politicians sense that there is no obvious way to recuperate their respective cost of paying Icesave depositors

I keep being asked if Icelanders are celebrating after the unexpected Icesave ruling of the EFTA Court. The answer is: no, not really. There is no victorious glee, as far as I can sense, but a huge relief. A friend who sat at a café in Reykjavik the morning after the judgement mentioned palpable relief but said people were also talking about the irresponsible behaviour of Landsbanki and the other banks.

The measured mood can be seen here where Prime Minister Johanna Sigurdardottir (the second lady from the right) took a few dance steps while waiting on Monday to go on air after the EFTA Court judgement on Monday – very small steps, no big swings.

It will be interesting to see how and if the EFTA Court judgement will influence the electoral campaign in Iceland where election is expected latest in April. After the leaders of the Progressive Party declared they would propose a vote of no confidence against the Government they then changed their mind. After all, the voters will have a say very soon.

It seems that Facebook – a much used tool in Icelandic public debate – was overflowing with unflattering comments about politicians who were in favour of earlier Icesave agreements. However, many do recognise that the judgement was truly unexpected. At the time, negotiating an agreement to end the dispute and eradicate the accompanying uncertainty seemed like the sensible thing to do at the time.

Membership of the European will be an election topic. At first, I thought the judgement would be a weapon for the eurosceptics – after all, it had paid to go against the received wisdom of negotiating. Now I am less sure. It can also be reasoned that the EFTA Court – part of the European Economic Area pillar – did save Iceland from the British and the Dutch claims. The Dutch and the British opted to use the European Economic Area, EEA, Treaty and EFTA Surveillance Authority to challenge the Icelandic position of not paying. At the end of that path lay victory for Iceland. – Suffice it to say that the judgement is not a clear-cut weapon for any one party.

The view from Berlaymont

It is no exaggeration to say that people at Berlaymont and elsewhere in EU institutions are gobsmacked and shaken by the EFTA Court ruling. So is indeed everyone else who has read the ruling. To have it black on white – albeit from the EFTA Court and not the European Court of Justice (but there should be homogeneity between the two) – that the Directive on deposit guarantee schemes does not protect depositor in a major collapse shook the ground under the whole European banking system though depositors may not have noticed it. At least not yet.

An excellent legal reading of the judgement on European Law Blog summarises the judgement regarding the Directive by saying it “might be called a lifejacket, but it doesn’t mean it’s built for emergencies.

The ruling is based on the deposit Directive as it was in 2008 – it has been changed since – but it has, as far as I can see, not been changed in such a way as to make it unequivocal that the state is the final guarantor. If the idea with the changes in 2009 was to make states guarantee deposits a short sentence saying that they did, could have been inserted. That was not done. Understandably so, because it raises moral hazards as is pointed out in the ruling.

The Directive was designed to give depositors the feeling the state did indeed guarantee the DGS and make investors think that no, of course the state doesn’t do that. This was always an impossible task, it just went unobserved – until the EFTA Court judgment on Icesave. – It is, I believe, still not clear from the Directive that the state guarantees a result.

According to the statement by Stefaan de Rynck, Michael Barnier’s spokesman, the Commission will study the judgement but so far, it has not changed an iota in the Commission’s understanding of the Directive: “The Commission maintains its interpretation of the current Deposit Guarantee Scheme (DGS) in the EU.  The deposit guarantee schemes in the 27 Member States also apply in the event of a systemic crisis, and Member States are responsible to ensure that national deposit guarantee schemes effectively pay the compensation guaranteed by EU law within the whole single market.” – I have also heard that not everyone in the Commission is unhappy with the judgement. Some think this clarification was useful because the Directive was flawed as it was and the changes have not repaired the flaws.

No doubt, the ruling will be read back and forth over the coming weeks. But one thing could be taken as a lesson, not from the ruling but from action taken in Iceland in October 2008: make deposits priority claims in case of a bank collapse. This has indeed put the foreign Landsbanki depositors in a better place than would have been in a comparable situation with any other bank.

Another point Iceland emphasised is that a state facing a situation like the Icelandic one, will do whatever it takes to save its own interests – and it will not necessarily use a deposit guarantee scheme. Iceland moved domestic deposits to a new bank. The British Government moved Kaupthing Edge deposits to the Dutch ING (which interestingly went bust shortly after).

I can see that deposits need to be protected – but I have some aversion to DGS as I find the moral hazard too great. On this topic the Court quotes an article by Joseph Stiglitz – a first time the Court quotes anything but another judgement in its own ruling (see paragraph 167).

There are some concerns within the EU Commission that the European Court of Justice might have ruled differently on the Directive, ie that the EFTA Court’s ruling was more narrow than its rulings hitherto, leaving a sense of divergence between the EFTA and EU pillar of the single market. After all, there should be homogeneity between or within the two pillars. However this feeling will develop DGS and especially the joint one now being discussed are not a matter for courts to decide but, as Michael Waibel points out in his summary of the judgement, “a matter for the parliaments to decide.”

The Court concludes that the Directive does not apply to systemic failure like in Iceland. But that does not mean depositors are unprotected as seen from the examples of above. And the very best deposit guarantee is to regulate and supervise banks so they simply don’t fail. In any case, as paragraph 161 in the EFTA judgement reminds the reader, a state will not only use one tool to save a bank but all tools needed: “They may benefit from other provisions of EEA law regarding financial services, as well as the activities of supervisors, central banks, and governments.”

What will the Dutch and the Brits do?

The feeling is that the Dutch are most unwilling to forget the Icesave dispute, the British less so. Therefore, the Dutch are no doubt seeking and searching for ways to recuperate the costs accrued by paying out Icesave depositors. The deposits themselves will come – and are coming – from the Landsbanki estate. Not the cost.

As far as I can sense there is no willingness in the corridors of Berlaymont to support Dutch Icesave grievances. The Berlaymontians are worried but neither for the Dutch nor the British but for the EU financial system, EU consumers and depositors.

There are all sorts of rumours as to what the Dutch are mulling over. It is even being mentioned they are looking at the nuclear option – of leaving the EEA. (Normally, the EEA countries are said to be Iceland, Norway and Liechtenstein but since the EU is part to the EEA treaty so are the EU member states.) As the Grexit debate clarified there are no provisions for leaving the EU. With the EEA it is different. If the Dutch left it would put the EEA – already a bit of an eyesore in the EU landscape for some – it would put that construction in jeopardy. The question how much political goodwill the Dutch would reap from an action that does look more like a tantrum of a spoiled kid than a carefully planned policy. The EU does not much need yet another event to challenge its equilibrium.

At the beginning of the Icesave dispute the Dutch and the British had two options to pursue their goal of recuperating costs. There was the EEA/ESA route, eventually chosen and, since the two states were of the opinion that Iceland had promised to pay but later retracted an earlier promise, there was the option to sue Iceland for contractual breach.

For the British there was no single contract but what they consider a string of broken promises. For the Dutch, in addition to a similar string, there is a Memorandum from October 11 2008, signed by the then Dutch Ambassador and two Icelandic civil servants – the director of the Icelandic deposit guarantee fund, TIF and the permanent secretary of the Ministry of Finance.

In to the Memorandum the Dutch Government declared it would lend Iceland what amounted to EUR20.887 (the European minimum guarantee of EUR20.000 with added currency cost) – there was no total amount mentioned – against 6.7% interest (quite hefty at the time of low interest rates). This money would then be put at the disposal of the Dutch Central Bank and used to pay out the Icesave depositors.

That Iceland never paid according to the agreement can be explained by the fact that the loan was never issued. Further, these civil servants signed on behalf of their Governments but no further governmental contract or agreement was made. However, the Dutch might still try to use this – as far as I can see rather feeble ground – to sue Iceland for contractual breach. The Dutch may claim they have some further documentation but I find it difficult to believe there are still unknown documents related to Icesave (though I would not exclude it).

Icesave – the end?

Is the January 28 EFTA Court judgment the end of the Icesave saga? As far as I can see it is the end to the dispute between the three countries – Iceland, Britain and the Netherlands. It also seems the EU has come to the same conclusion.

However, the effect of the judgement on the Directive will rumble on for a while with EU’s legal heads and other studying it closely. The EU Commission must figure out how to respond. It won’t be easy to reach the same opaque equilibrium as previously now that the EFTA Court has spoken. A drastic rethinking on DGS, also in terms of a pan-European scheme in a planned banking union, would be desirable. But that is perhaps hoping for too much.

Addita: In response to an FT Editorial on Icesave here is a letter of mine to the FT, published January 31:

A misleading version of Iceland’s recovery

Sir, After all the excellent FT reporting on Icesave it is astounding that your editorial should have turned the history of Iceland’s recovery into a heroic saga of a small island challenging the big powers and the bankers of this world.

This is a highly misleading version of the recovery saga. Correct, it didn’t bail out the three banks but smaller financial institutions were bailed out, to the exorbitant cost of 20-25 per cent of gross domestic product.

What Iceland has, however, done wisely is to write down debt, both of companies and private individuals, as well as easing its bankruptcy law, thereby avoiding a zombie economy. This part, not the Icesave saga, is “the victory for law and economic sense”. That is what debt-ridden countries could learn from the Icelandic recovery.

In general, not only in Iceland, voters tend to vote for the future by evaluating what the various political programmes means for them instead of focusing on the past. Voters can punish politicians for their policy but I rather doubt they will punish the parties for their stance on Icesave – I would guess their perspective is broader.

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Alors, on Monday January 28 the EFTA Court will rule in the Icesave case, which ESA applied to put to the court.

The thrust of the case is:

Having studied some EFTA Court judgments where ESA is the applicant it is fair to conclude that it is not promising to be on the receiving end of an ESA action: ESA almost never loses a case as ESA is clearly most careful in choosing and preparing its action. But ESA will not win its case on statistics – and it is notoriously difficult to gauge a judgement.

I have not met a single informed person, unrelated to the Icelandic case, who thinks that Iceland is likely to win but there is not much debate on the issue in Iceland right now. The heat is out of the Icesave issue in Iceland.

One Icelander has however aired his strong view, president Olafur Ragnar Grimsson. He used an interview with Sky in Davos today to send icy regards to former Prime Minister Gordon Brown (whom Grimsson might run into in the Davos corridors of power) and his Government at the time for putting Iceland on a list of countries harbouring terrorism when Landsbanki assets were frozen following the collapse of the Icelandic banks.

Correct, this was a harsh action, caused Iceland and Icelandic companies serious problems and it is difficult to see it was necessary – but it doesn’t only show Brown’s panic at a time when some British banks were teetering on the brink of collapse. It also shows an extreme frustration within the British Government and Whitehall, built up over more than half a year, by lack of reaction from the Icelandic banks to demands by the FSA and by lack of understanding – so as not to say misleading information – from the Icelandic Government. Grimsson did not mention this rather unflattering part of the Icesave Saga. The UK authorities took action – albeit brutal and harsh – and saved Icelandic authorities from themselves closing down the banks.

The presentation made by the Icelandic Government during 2008, until the banks collapsed in early October, is spelled out here (see paragraph 26-30)in the ESA application to the EFTA Court. This is one of ESA’s arguments for its case.

But even if the Court rules in favour of ESA Monday will not mark an end to the Icesave saga. The Court will only rule on a yes/no to alleged failures by the Icelandic Government to comply with EU directives and the EEA Agreement. It will not order Iceland to anything. However, the judgement will no doubt be used by the British and Dutch Government to knock on the door of the Icelandic Ministry of Finance to remind Icelanders that well, Iceland still hasn’t paid what these two countries think they are owed.

Iceland’s refusal to pay the Icesave debt has, misleadingly been presented as a popular uprising against bailing out banks. The debt to the two Governments arose as they bailed out depositors in Icesave – not banks, bankers or bondholders. Deposit holders who may well argue that they kept their money in Icesave because they heard Icelandic politicians, for example in this Channel 4 report, as well as bankers, tell them that their money was save and Iceland had a deposit guarantee scheme, just like the UK and the Netherlands.

At the hour of extreme national anxiety the Icelandic Government made the understandable decision to secure domestic deposit holders. But that hour has long passed and the UK and the Netherlands think it is high time to get their money back.

*See earlier Iceogs on Icesave here. Here is the ESA page with all relevant information re the ESA Icesave case.

Updated: According to Sky Grimsson said the judgement will only be advisory, and that “it will not lead to any financial obligations or transactions of any sort”. – As far as I know, an EFTA Court judgement is all but advisory. It is the final say in our earthly realm of reality – there is no other court that can rule on a breach of EU directive/EEA Agreement or not, for an EEA country.

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Before the end of January the EFTA Court might have ruled on Icesave. The largest battle for assets ever to take place in Iceland (since the 13th century) – ultimately for the power over Arion bank and Islandsbanki – will be, by far, the biggest issue in Iceland. At the core of it are the negotiations on composition for the holding companies of Kaupthing and Glitnir, the owners of the two respective banks. The capital controls are one variable in this equation. In addition, the Office of the Special Prosecutor will continue to churn out charges during 2013.

1) It now seems likely that the EFTA Court will rule on Icesave in or around the third week of January. As Icelog has explained earlier, there really are two questions that the Court is ruling on: Did Iceland breach the Directive 94/19/EC of the European Parliament and of the Council of 30 May 1994 on deposit-guarantee schemes – Has Iceland ‘breached the prohibition on discrimination on grounds of nationality under Article 4 EEA?’

Considering the fact that deposit guarantee schemes are a contagious topic in the EU right now, with a pan-European scheme being planned as part of the European Banking Union in the making (but the Directive has been changed since autumn 2008), it seems plausible that the EFTA Court justices will rule on this issue as narrowly as possible, so as not to plant on the EU the definite understanding of this directive. But then, justices don’t always do the plausible. In any case, it is less the Directive and more the discrimination that could rattle Icelandic stoicism.

The EFTA Court is not ruling on the dispute with the UK and the Netherlands regarding the cost these two countries think they have born by paying out the Icesave deposit holders in the two respective countries (UK in full, the Dutch Government up to €100.000). If the ruling – on one or both matters (more serious financial consequences if the discrimination goes against Iceland, see the link above) – shows that Iceland was in breach, the two countries will no doubt come knocking to recover their cost. Then the Icesave dispute might start all over again, another round of negotiations – or, the three countries would agree to hold on to the last agreement.

So much for Icesave – one way or another it might be resolved this year. Otherwise, there is the 6th Icesave Christmas in sight for next year.

2) Although Icesave did take up much space in Iceland in the last few years the agreements regarding the composition of Glitnir and Kaupthing do not only revolve around assets and money but around power in the Icelandic financial sector. There is a huge suspicion against foreign ownership of the banks and this fear is being played on by those who favour a bankruptcy of the two estates and a fire sale of the two banks.

Those who whip up this fear of foreign ownership seem to ignore that nothing will happen regarding the composition except with the blessing of the Icelandic Central Bank. This is not an issue that is about to wreck the Icelandic economy. It is an issue under control, albeit without a solution so far. The CBI will focus on the stability of the Icelandic economy. The solutions sought aim at resolving a few matters at once, together with the composition: the capital controls, the overhand of foreign currency (stemming from the carry trade going on up to the collapse of the banks in October 2008) – and, as the CBI sees it, preferably selling one or both banks to foreigners, in order to have at least one bank sold for foreign currency. In addition, there is the Landsbanki bond – debt rising from the constitution of the new Landsbanki, owed to the Landsbanki estate: it has a 6 year maturity but that now seems an unreasonably short time.

This is, in short, the bundle of problems that needs to be resolved in one go – or at least all these issues need to be solved and settled considering the interaction between them. Not a trivial project – on which there is now an ad hoc working group pondering, with experts from the ECB, IMF and the EU as well as Icelandic civil servants.

3) The original plan of the Office of the Special Prosecutor was that all charges regarding the collapse of the banks should be brought by 2014. Exactly how many the cases will be is not yet clear. The Icelandic Financial Services Authority, FME, has passed on ca 80 cases the OSP, just to given an idea of numbers but the OSP makes an independent assessment of cases.

On December 28 the Icelandic County Court ruled in a case brought against the Glitnir managers, ex-CEO Larus Welding and Gudmundur Hjaltason former head of Glitnir’s corporate finance. The charges related to a complicated loan structure ultimately benefitting Milestone, one of the large Icelandic holding companies, owned by Karl Wernersson and his siblings. The OSP reckoned the loans caused Glitnir a loss of €50m and had asked for a 5 1/2 year and 5 year prison sentence. Instead, the Count Court sentenced both men to nine months in prison, six of which are suspended for two years. Legal bills are divided between the two men and the state. – The State Prosecutor is likely to appeal. The Milestone ruling is the first ruling concerning the big banks and leading bankers.

So far, managers from Kaupthing and Glitnir have been charged by the OSP, as well as major shareholder in the two banks, respectively Olafur Olafsson and Jon Asgeir Johannesson, but no one from Landsbanki has (yet?) been charged.

Updated:

It’s worth adding that the Icelandic economy is growing – not like during the pre-2008 boom years but at around 2%. Here is the latest IMF report on Iceland, with an overview of the Icelandic economy.

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