Sigrún Davíðsdóttir's Icelog

One of the problems with the debate in Iceland on capital controls is that so few seem to grasp the essentials. Consequently, politicians and special-interest agents on a mission can get away with saying almost whatever they fancy without being challenged. Once in a while, foreigners dive in, equally ill-informed, thwarting the debate further for Icelanders who, as so many small nations, tend to swallow everything coming from abroad. A case in point is a recent FT article by Gillian Tett with a somewhat misleading description of the Icelandic situation only some weeks after the IMF published a most informative report on Iceland. IMF gives some intriguing hints on two key issues: the Central Bank of Iceland and the legal routes out of the capital controls’ impasse.

Practically all nations forced to save themselves by slamming on capital controls struggle to get rid of them. It is by now an all too familiar problem that the shelter, provided by the controls for solving the original problem calling for controls, tends to turn into a hammock for in-action. Iceland is no exception.

The situation in Iceland however offers further complexities: getting rid of the controls will not prove easy at the best of times – but the overwhelming sense among control-watchers is that there might be wheels within the capital control wheels: first of all, steering the two new banks, Arion and Íslandsbanki, now owned by the failed estates of respectively Kaupthing and Glitnir, into hand-picked, politically-palatable ownership in what could be called “the asset sale of the century” (Icelog on this topic). Secondly, the government is seeking to preferably score a “victory” (à la Argentina) over the foreign creditors by securing funds from them for the state.

Iceland’s attraction for pundits in search of a good case to prove their point

Over the past few years, Iceland has been seductively attractive to economists and pundits looking for a story to prove their points/theories. Writing in July 2010 à propos an article by Paul Krugman on Iceland I pointed out that “when it comes to small countries (or exotic topics) it seems permissible to express opinions without knowing very much – or even anything at all.” – Those in the know and understanding are few and far between.

One myth has been that by letting its banks fail, Iceland’s cost of the collapse was almost negligible (more on this here). The cost partly rose from misguided attempts to save two private banks, possibly because of some domestic interests at stake. In addition, there was the cost of propping up the Icelandic “Sparkassen-system.” Thus, the cost of the collapse and resurrecting the country’s economy is more likely to be one of the highest for every country over the last few decades, ca. 20-25% of GDP.

In a recent article in the FT Gillian Tett joins the company of Krugman and many others on the well-trodden path of misunderstandings regarding the Icelandic collapse, subsequent events and the state of affairs right now. Apart from it being slightly shocking that such an esteemed paper as the FT does not take more care with what it prints the article provides a good opportunity to sum up the essentials on post-collapse Iceland and the capital controls. However, Tett’s general point certainly is valid: there is an essential topic for debate on emergency measures that are used as delaying tactics instead of a necessary shelter to work on solutions.

What happened when the banks collapsed?

Tett writes:

When the three banks collapsed, the government decided to save the domestic parts of the system (and its own taxpayers) by piling pain on to foreign creditors and depositors. So bank bonds held by foreigners were tossed into default and turned into implicit equity claims on the collapsed lenders – and bank deposits that foreign investors held in Icelandic krona were trapped in the country by capital controls.

True, the idea was to save the domestic part. The dilemma was how to dismantle a banking system ca. eight times the GDP of Iceland without drowning the whole economy at the same time. (The Icesave saga is about depositors in Landsbanki’s accounts in the UK and the Netherlands and EU’s passport rules for the financial sector; remarkable there was a mini-rerun of the passport conundrum in the UK following the Cyprus crisis; some aspects of Iceland vs Cyprus here).

Consequently, the operations of the three largest banks were divided into domestic and foreign operations. There were, and still are, persistent rumours that during the hectic days in early October 2008, when the emergency Act was being finalised, the policy really was called “f**k the foreigners.” Hardly shocking: a country staring into the abyss will go to great lengths to save itself, thinking less about others.

As explained in the Financial Services Authority, FME’s, annual report 2009 (there was no annual report in 2008) following the emergency Act (Act 125/2008) passed on October 6 2008 the three largest banks – Kaupthing, Landsbanki and Glitnir – were taken over by the FME and divided into “old” banks (destined to be wound up or liquidated at some point) and “new” banks. Like any estate of a failed private entity these failed banks are controlled on behalf of creditors, now by Winding-up Boards, one for each bank.

The three so-called new banks were turned into fully operating domestic banks. Following a crash settlement in the days after the October 2008 collapse the FME oversaw the finalising of financial instruments, based on valuation of assets transferred, between the old and the new banks. The new banks for Kaupthing, Landsbanki and Glitnir are respectively Arion, Landsbankinn and Íslandsbanki.

Thus there was a clear dividing line – not that “bank bonds held by foreigners were tossed into default.” And as in any failed company the creditors hold claims in the three failed/old banks.

According to the FME assets and liabilities of the new banks the “principal asset classes were loans to customers, on the one hand, which were further subdivided into loans to large corporations, small and medium sized enterprises and retail loans and, on the other hand, other assets. Liabilities consisted almost solely of deposits, which were valued at principal value. Gross loans to customers (that is the outstanding loan balances before any provisions or adjustments) represented over 80% of gross assets in each of the three new banks. Large corporate group loans (with liabilities in excess of ISK 2.5 billion) represented ca. 40%-70% of total gross loans to customers and ca. 55%-85% of corporate loans to customers across the three new banks at the respective carve-out dates.”

The problem that called for capital controls

The original problem, calling for capital controls, was foreign-owned ISK, or “nonresident holdings of liquid krona” as the IMF calls it. At the time these funds were over ISK600bn, but following CBI auctions these funds now amount to ISK322bn (at the end of February 2014) or 18% of GDP; 67% of gross reserves. These funds mostly originated from so called “glacier bonds” – bonds issued in Icelandic króna, ISK, often sold to wealthy individuals, popular in Germany and the Netherlands. At the time, both the government and the CBI chose to ignore the potentially destabilising effect of these, in spite of the effect of similar flows on some Asian countries in the 1980s and the 1990s.

These funds are no longer the greatest threat to Icelandic financial stability. In addition, it seems that at least some part of these funds willingly stays in Iceland because of the (still) high interests there.

But what is now the problem if it is no longer these liquid foreign-owned ISK? Tett talks about the bank bonds held by foreigners being “tossed into default and turned into implicit equity claims on the collapsed lenders – and bank deposits that foreign investors held in Icelandic krona were trapped in the country by capital controls.”

The main obstacles towards lifting the controls are the ISK assets of Glitnir and Kaupthing, in total ISK450bn (end of 2013; further here) and the two Landsbanki bonds of which ISK226bn is still unpaid (more here; more on the numbers and how they are found in CBI’s latest stability report).

The bondholders now hold a claim on the estates, as happens in any other failed company. They were inevitably mostly foreigners since the banks’ fast growth was fuelled by international lenders and not by domestic deposits and domestic bond sales.

It is also worth noting that in total, 5.7% of the claims are owned by Icelanders, or just over ISK100bn, mostly held by the Eignasafn Seðlabanka Íslands, ESÍ (the CBI holding company). These funds could possibly be part of the solution, i.e. used in swaps with foreign creditors. (See here for numbers and facts, in my digest of the latest IMF report and here for my latest overview of numbers and possible solutions).

Why is it important to lift the controls?

“In the past few weeks the government has indicated that it wants to start removing these controls to attract more investment to the energy sector and to create a more “normalised” financial system,” writes Tett.

The story is a lot longer than just a few weeks. The left government, in power from spring 2009 until the elections last spring, did got very far with plans to remove the capital controls – also because it was too weak to tackle the issue towards the end – but some progress was made. The CBI presented a plan in 2011, still the basis as no new plan is in place (here is an Arion bank analysis from December 2011 of that plan; the time frame has since been lifted, meaning that the plan is no longer anchored in time but to certain benchmarks).

During the election campaign the Progressive party, which until early last year seemed destined to be close to a wipe-out in the spring elections, attracted an unexpected following by promising voters debt relief funded by creditors, i.e. funds that would “inevitably” flow to the state as the controls on the two bank estates would be lifted. The numbers mentioned escalated from ISK300bn to as much as ISK800bn mentioned just before the election. However, when the debt relief was presented last November it was not funded by these “inevitable” sources of money but from a bank levy, also on the estates and from people’s own pension savings, a step IMF warns against in its last Iceland report.

It is misleading to say that the scope for lifting the controls is only to attract FDI for the energy sector. And it certainly is not just to normalise the financial sector, but to normalise the whole economy. As the CBI now points out at every opportunity the capital controls do in themselves induce a long-term risk, i.a. here:

Capital controls limit possibilities for cost-efficiency in business and distort the premises for investment decisions. The longer the control regime remains in force, the greater is the risk that investment options will be determined to a growing extent by possibilities of returns within the controls, while at the same time emphasis grows on seeking ways to circumvent the controls. The structure of business and industry could therefore in time develop differently within the control regime than without it. Options decline in number, and output growth and living standards deteriorate.

This spring, numerous individuals and organisations in the business community univocally called for government action towards lifting the capital controls. But no matter the policy it will realistically take some years until the controls are lifted. In addition, Iceland will also have to come up with a credible vision for the króna and the future. There are also those who believe some controls will be needed for years and possibly decades to come.

Correct proportions, correct numbers

According to Tett, Iceland’s “sovereign debt is “just” 84 per cent of gross domestic product, according to the International Monetary Fund. But if you add the remaining liabilities of the banks – which are implicitly owned by the government – the total debt ratio is 221 per cent, and there is little chance of the island repaying it in full.” (Emphasis mine).

According to the IMF’s latest report Iceland’s sovereign debt was 89.9% last year and projected to be 86.4% this year. The three new banks are not “implicitly owned by the government”: the state owns 13% of shares in Arion and 5% in Íslandsbanki with the estates of Kaupthing and Glitnir respectively owning the rest. The government owns 97.9% of Landsbanki with the employees owning the tiny rest.

Further, Tett writes that “any relaxation will force a new debate about that debt mountain, since the $7.4bn of krona held by foreigners in Iceland’s banks will almost certainly flee if controls are removed without any clarity on how creditors who hold Icelandic bank debt will be treated. And a flight of capital could spark a fresh crisis.”

“That debt mountain” seems to refer to the 221%. What the $7.4bn of foreign-owned krona assets refers to is not entirely clear: the foreign-owned ISK in Glitnir and Kaupthing are in total ISK450bn, $3.9bnbn – and the original overhang is ISK322bn, $2.8bn.

Thinking that the controls will be lifted “without any clarity on how creditors who hold Icelandic bank debt will be treated” seems to indicate a fundamental lack of understanding of the problem: this is exactly the main problem now being worked on and no lifting can or will happen until it is solved. As the CBI and the IMF have repeatedly pointed out any steps towards lifting the controls will have to include a plan as to how to deal with foreign-owned ISK in Glitnir and Kaupthing. And not until then can the estates start paying out to the creditors (see here).

“The good news,” according to Tett, “is that the government announced this week that it has appointed external advisers for talks with creditors. But the bad news is that finding any resolution could prove very hard. A group that represents about 70 per cent of bond holders wants its claims to be settled by selling the successors to the collapsed Icelandic banks to new foreign owners.”

True, it is good news that there are foreign advisers (given that their expertise will be used wisely). The bad thing is not, as Tett points out, that it could prove hard to find a solution. The bad thing is, as I have pointed out earlier, if the government does not have any plan to get their advise on – or is not ready to accept their proposals (perhaps because it is focused only on a solution that will move the ownership of Arion and Íslandsbanki to Icelandic owners with the right political pedigree).

Finding a solution is indeed not necessarily very hard (see here). Again, it will not be easy if the government is hell-bent on not just lifting the controls but also securing some special interests at the same time. According to the Act on Financial Undertakings  no. 161/2002 (the “Act on Financial Undertakings”) votes of parties controlling at least 2/3 of share capital or guarantee capital need to accept all major decisions of the estates.

Iceland is not Argentina – or at least not just yet/does not need to be

Tett is not the first to mention Iceland and Argentina in the same sentence as if the two countries shared the same problems: “So there is every likelihood the country will either end up in a protracted court fight, like the one between Argentina and its “holdout” creditors; or that the government keeps playing for time by extending those supposedly “temporary” controls indefinitely.”

Argentina defaulted and has for a long time (in)famously been involved in legal warfare with some of its creditors (my favourite Argentinian commentaries are those by Joseph Cotterill on the FT Alphaville). Iceland has not defaulted and its problems are, so far, contained in the estates of the three failed private banks.

However, if the Icelandic government strides into the field and incurs liabilities by legal measures, which might make the creditors sue the government, i.a. because of breech of property rights, the situation could turn Argentinian. With foreign advisers, no doubt aware of all of this, as well as being concerned about reputational risks, as is indeed both the IMF and the CBI, it seems unlikely (though by no means unthinkable) that the Icelandic government will by accident or recklessness (or both) unwittingly find itself exposed to legal wrangling with the creditors.

I have argued earlier that the government is incidentally already exposed to such a risk. After a change in the capital controls Act last year, the minister of finance has to agree to certain steps regarding the fate of the estates. It is easy to think up several such scenarios resulting from this. I.a. the creditors could take legal action if they at some point feel that by inaction the minister is indeed a hindrance to payouts.

As many other pundits Tett is recounting the Icelandic financial disaster saga to prove general points. “The first is that “emergency” policy measures that distort the financial world tend to become addictive. Second, this addiction is very hard to break when there is an unpleasant debt overhang, be that of the public or semi-public sort.”

With gross debt rising in the world these are indeed important and never too oft repeated lessons to be learnt from the Icelandic collapse saga. The Icelandic reality is not quite what Tett makes out of it but does never the less support the lessons she wants to draw from the Icelandic fall and recovery.

*All the essential information on Iceland, its economy and capital controls are here: the IMF pages on Iceland – and the CBI financial stability reports.

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According to a new IMF report on Iceland recovery in Iceland “is continuing and the growth outlook is positive, but crisis legacies continue to weigh on the economy. The government is undertaking efforts to address them but this entails significant risks.” IMF points out there are two legal avenues being discussed to release the old banks from capital controls, composition agreement that “would provide an agreed roadmap for exit and the other involving bankruptcy proceedings (liquidation) with an uncertain exit from controls.” – This is a clear hint to the Icelandic government, which way is the least risky.

At times, IMF reports are like a recording of the dialogue between staff and the authorities they speak to. In the newly released IMF report on Iceland there are some interesting parts where the staff says one thing and the authorities something else.

The main topics of interests, apart from capital controls, are the Housing Finance Fund, HFF, FME (the financial services authority) and fiscal policies. Also the Fund stresses the importance of a strong and independent Central Bank – especially interesting now that its structure is under review and a new governor will soon be appointed. Prime minister Sigmundur Davíð Gunnlaugsson has time and again strongly criticised governor Már Guðmundsson and CBI staff.

It is worrying that according to the IMF necessary and planned reform at the FME have not been carried out, there is insufficient funding for much needed IT reforms and on the whole the FME suffers from funding cuts. I.a. progress of new industry rules for risk management and asset classification has been slow, which does not bode well for financial stability.

Capital controls and the estates of the failed banks

The foreign-owned ISK, or “nonresident holdings of liquid krona” as the IMF calls it, amounts to 18% of GDP; 67% of gross reserves. These holdings “are slowly being released via the established FX auction mechanism.” It is assumed that consistent with Icelandic 2011 liberalisation strategy this crisis legacy might well be released by the end of 2016.

The easing of controls on the estates of the old banks is a different and more difficult matter.

The three old bank estates control an estimated 44% of GDP in (net) domestic assets, ie ISK assets in addition to 84% of GDP in (net) fx assets, crucially held overseas and owed to foreign or “non-resident” creditors. These assets are closed in by the capital controls.

The IMF estimates that once lifted the estimated fx outflow caused by Icelandic private individuals and corporate entities, also pension funds, might amount to 20-45% of GDP.

The question is how to resolve the issues of the estates, how to release them from the capital controls. Payouts can only happen when the estates are wound up/liquidated. As the IMF points out: “Two broad legal avenues are being discussed, one involving composition agreements that would provide an agreed roadmap for exit and the other involving bankruptcy proceedings (liquidation) with an uncertain exit from controls.”

The reader can be in no doubt as to which route the Fund favours.

In a video interview with the Financial Times finance minister Bjarni Benediktsson said that foreign creditors have already been paid billions of euros. From his words it could be understood that these funds were euros, earned by exporting Icelanders. The footnote to his words is that priority creditors have been paid ca. ISK1000bn, or ca. 55% of Icelandic GDP so far – but this comes from the estates’ own fx funds, mostly held abroad, not from balance of payment, BOP, sensitive funds. – Or as is pointed out in the IMF report: “Significant payments have also been made to priority creditors of the old bank estates from recovered external assets.”

Guiding principle in lifting the controls: transparency

Further to the general principles that should guide the lifting of the capital controls:

Staff encouraged a transparent, comprehensive strategy that addresses all potential outflows. The approach should be consistent with macroeconomic and financial stability, and conditioned on BOP prospects. Staff noted the importance of carefully considering the legal and reputational risks surrounding the strategy for addressing potential BOP pressures now locked in by capital controls, including the resolution of the old bank estates. Staff emphasized the benefits of a cooperative approach that would minimize risks to long-term growth, the prospects of which remain closely tied to economic and financial links with the rest of the world. In this context, staff welcomed the authorities’ recent organizational changes and planned engagement of advisors, which could help facilitate a resolution. Consistent with past advice, staff noted that appropriate use of incentives could help encourage lasting solutions. The authorities generally agreed with these points. They noted the Landsbankinn bond restructuring could be a useful development, but needs to be assessed in the context of a more comprehensive plan. With respect to the old bank estates, they stressed they would move on to other approaches (e.g., bankruptcy proceedings (liquidation)) should a cooperative settlement not materialize.

In short, the Fund favours carrots but the Icelandic government certainly is not going to throw away the stick, i.e. bankruptcy proceedings (although yes, the Fund gives warning words re orderly vs. disorderly exit from controls).

There is mutual understanding that the strategy to lift controls needs to be linked to a credible balance of payment analysis. “Staff welcomed the CBI’s ongoing BOP work and urged that it be the basis for discussion with key stakeholders.” – This is interesting since part of the task of the new foreign advisers apparently is a BOP analysis. As the Fund underlines, the CBI is working on it; the CBI analysis should be the basis for discussion with stakeholders, i.a. the creditors.

Further, here is an interesting insight into how the Fund vs. the Icelandic government perceives the situation: “Staff reiterated that a revised liberalization strategy should be paced to maintain adequate reserve coverage and that supporting debt management—including Eurobond issuances to maintain FX reservees as repurchases to the Fund take place—will be a necessary component. The government expressed concern with the higher debt and interest costs from such issuances. Staff emphasized the precautionary role of reserves and noted that public sector debt levels would not change.”

The risks in lifting the capital controls

The IMF is not trying to minimise the various risks threatening the Icelandic economy – the word “risk” is used 66 times on the 62 pages (where ca. half of the pages is mostly diagrams).

Here the risks regarding lifting the controls is neatly summarised – and some of it is beyond the control of Iceland:

Staff and the authorities agreed that risks are tilted to the downside. A protracted period of slower global growth could dampen exports and foreign direct investment. Surges in global market volatility have so far had only muted direct effects on Iceland but a sharp deterioration in external financing conditions could complicate refinancing of large external payments coming due during 2015–16 and delay the easing of capital controls. Efforts to resolve the old bank estates could result in faster capital account liberalization, boosting confidence and investment and raising long-term growth. However, missteps could result in a more protracted impasse leading to a weaker business climate, lower investment, asset bubbles from locked in liquidity, eroding competitiveness, and weaker growth. Lifting capital controls before the necessary conditions are in place could destabilize the krona, lead to higher inflation and reserve losses, and lower confidence and growth. Even without liberalization steps, deeper depreciation pressures could emerge that could be difficult to counteract.

As to deciding what to do and when clearly implies some “damned if you do and damned if you don’t”:

It was known when capital controls were imposed that the negative effects would grow faster than the benefits as time went by, and the authorities are resolute to take significant steps towards removing the controls in coming months. The steps taken will be conditions-based. However, there is no risk-free liberalization of capital controls, and the microeconomic costs are accumulating. The risks must therefore be weighed against the costs of delay.

By now, many countries have tasted the intoxicating mélange that capital controls are and there is abundant experience of their effect. It is well known that with time, the benefits originally reaped by capital controls dwindle and the negative impact increases. It is never easy to tell when exactly this turning from positive to negative is reached. Considering how loudly Icelandic business leaders are now complaining about the deadening effect of capital controls it is clear that at least for some businesses this point is already reached.

In general, creditors want to negotiate and creditors to the failed Icelandic estates do not seem to be any exemption from the general rule. As I have underlined earlier, there are strong forces in Iceland, with strong interests, pleading for the “disorderly” and “un-cooperative” approach to the estates. With the IMF report the Icelandic government now has some clearly spelled out advice in words such as “orderly” and “cooperative.”

*All emphasis in quotes is my own.

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So far, every move by the Icelandic government towards lifting the capital controls has taken more time than anticipated and yielded less than promised. Now a managing committee to steer a whole crowd of foreign advisers is in the making: again, it was announced a while ago and although the foreign advisers have already had meetings in Iceland the managing committee is still not in place. If this isn’t to be yet another underwhelming exercise the government has to resolve the tension centring on an orderly composition agreement for Glitnir and Kaupthing or a disorderly bankruptcy and “ISK-ation” creating a mountain of foreign-owned ISK – and whether the Landsbanki bonds agreement passes or not. After all the political rhetoric the solution has to look like victory – but even that would not be too difficult.

The foreigners are coming – not the foreign creditors but foreign advisers. After shunning any foreign assistance the government now has it in abundance. According to Rúv, JP Morgan will advise on the financial side, White Oak Advisory London will advise on the legalities and to figure out what needs to be done there is Cleary’s Lee Buchheit, in Iceland of Icesave fame, and Anne O. Krueger IMF’s deputy manager 2001-2006.

Deciding on foreign advisers has clearly been a tortuous step. Already in April, two months ago, the rumour was that the names would be announced “next week.” Having gotten this far is promising. What is less promising is that in order to orchestrate these formidable forces there is to be an Icelandic managing committee, which – as so often – the government seems to be in great difficulty to agree on. The setting up of this committee was announced some weeks ago, then apparently just about to happen, but no, so far no committee although the foreign advisers have already visited Iceland.

The non-existent managing group is unfortunate in itself but even more so because the delay indicates that the government has not yet made up its mind as to how to proceed regarding the lifting of the capital controls. The greatest obstacle is, as explained earlier on Icelog, how to resolve the estates of Glitnir and Kaupthing: the government still seems to dally with the idea of bankruptcy, including converting fx assets into ISK, in effect an “ISK-ation”of the assets.

In addition, the government has sent the Central Bank of Iceland on an uncertain course, apparently because of a disagreement within the government. With reforms in 2009 the independence of the bank was strengthened. The question is if there will now be a U-turn with the appointment of a new governor.

The two party leaders, prime minister Sigmundur Davíð Gunnlaugsson and minister of finance Bjarni Benediktsson, have oscillated between optimism and pessimism as to how hard the task was and the time it would take to take decisive steps towards lifting the controls. It is now over a year since the present coalition led by the Progressive Party with the Independence Party came to power. In terms of action regarding the capital controls that is mostly a lost year.

The all-Icelandic working group, set up in November, presented its results in March but there was little there in terms of realistic scenarios or solutions. Apparently the approach to Glitnir and Kaupthing and composition or not, i.e. “ISK-ation,” split the group.

A solution leading to a market access – or a specific Icelandic solution

The next stages of the winding-up proceedings must safeguard financial stability and ensure that domestic entities have access to foreign credit markets. Finding a comprehensive solution to the estates’ affairs is a prerequisite for lifting of the capital controls.

The above is how the CBI spells out in its latest Financial Stability Report the goals regarding the lifting of the capital controls. There has to be a comprehensive solution – and any solution that doesn’t ensure access to international credit markets is no solution at all.

Market access is an excellent measure. A specific Icelandic solution, which converts fx assets into, for foreign creditors, useless ISK, thus creating new mountains of foreign-owned ISK for which there is not enough fx, does not seems to be a market-opening solution.

An important lesson from the Greek and Argentine default is that the large majority of creditors do indeed want to negotiate a deal. The Icelandic situation is not comparable to Greece and Argentina – Iceland isn’t about to default – but as explained earlier on Icelog the state could incur liabilities if creditors deem the state is blocking payments from the estates or impairing recovery, such as inducing “ISK-ation.”

So far, the government has refused to negotiate with Glitnir and Kaupthing creditors, clinging to its mantra that these are estates of failed private banks. True, but solving the ISK problem of the estates is a key step towards lifting the controls, truly an issue of supreme national importance. By hiring foreign advisers, the government seems indirectly to accept it has to negotiate.

The three problems that need to be solved

It is often heard in Iceland that surely the problems underlying the capital controls are fiendishly complicated. In a way, they are actually not complicated though certainly not risk free. Three things need to fall in place:

*ISK assets of Glitnir and Kaupthing, in total ISK450bn (end of 2013)

*Remnants of the old ISK overhang (“hot” foreign-owned ISK which originally caused the outflows that demanded capital controls), in total ISK322 (at the end of February 2014)

*The two Landsbanki bonds of which ISK226bn is still unpaid

The Kaupthing ISK assets are mostly tied in its ownership of Arion. If Arion could be sold for fx the Kaupthing ISK problem is solved. Glitnir poses more of an ISK problem: selling Íslandsbanki for fx will only solve ca. half of its ISK problem. Here, the classic solutions would be a write-down, extended pay-outs or a combination of both.

The original overhang no longer poses a major problem. Judging from the CBI auctions these offshore-ISK owners do not seem strongly inclined to leave the high interest environment in Iceland for the low interests in Europe and the US. As long as interests remain low in the Western world the international environment is favourable for lifting the controls – but this favourable situation will of course not last forever.

On May 8 an agreement on the Landsbanki bonds was signed. The CBI is now assessing the agreement and the exemption from controls that is part of the agreement. Application for exemptions seems to have been sent in some time after the agreement was reached, which together with vacation time explains that it is taking the CBI some time to conclude on the Landsbanki bonds packet. As far as I understand the government will not make its own assessment but follow the CBI advice on the agreement.

New Landsbanki is state-owned, those who negotiated on behalf of the bank will have kept the ministry of finance informed and the new agreement broadly followed what the CBI had outlined. Yet the minister of finance, who formally needs to accept the agreement, has expressed some doubts.

In an interview with Rúv July 6, Benediktsson said he foresees a sale of Landsbanki. He envisages that the state keeps 40% of Landsbanki with the rest sold off, limiting other shareholders to 10-20% share of the bank. Strangely enough Benediktsson did not mention that according to the bank’s CEO last December the bank would need to extend its debt to the Landsbanki estate – and, as if in a parallel universe, the minister did neither mention this nor the Landsbanki bonds agreement.

Who is really in charge?

During the election campaign last year the Progressive Party repeatedly stated that there would unavoidably be money for the state coffers from the resolution of Glitnir and Kaupthing. These funds should be used for a debt relief for those who were too well off to have profited from earlier debt relief. When the debt relief plan was presented in November it turned out that it was funded with a banking levy, both on living and dead banks.

At the time I took it to imply that after all Benediktsson, known to doubt funding from the resolution of the estates, did after all have the upper hand in the government. That seems less certain now. Reviewing the first year I would now rather conclude that the prime minister clearly has enough political strength to decide whatever he wants to and then lets Benediktsson pick the policies the prime minister does not have strong views on. This is worrying because political clientilismo has long been strongly connected to the Progressive Party.

Whatever the power divide, this government clearly suffers from lack of communication. Time and again the prime minister says one thing and the minister of finance another. Most tellingly, the disharmony is spelled out in lack of action, on lifting the capital controls in general and now, specifically, in appointing a managing committee and deciding on the next steps.

The CBI under siege

Part of the disharmony within the government has been policies regarding the CBI. After much back and forth – if there should be a reform, three governors instead of the one now, if present governor Már Guðmundsson should continue or not – the position of governor was finally announced but without any clarifications on changes or not.

Guðmundsson has now applied, as have nine other candidates. None can really match Guðmundsson’s professional qualifications but there is a lot of speculation that professor Ragnar Árnason is the government’s favourite. Some doubt his qualifications – his expertise is fisheries economics – but the rumour is persistent. Another candidate, and now possibly more likely though he is less mentioned, is professor Friðrik Már Baldursson.

Morgunblaðið, with former prime minister and leader of the Independence Party Davíð Oddsson as its editor, has waged a forceful campaign against Guðmundsson. The story is that after Guðmundsson took office as governor his salary turned out to be less than he had been made to understand it would be. He sued the bank but lost. Morgunblaðið exposed earlier that the CBI had paid his legal bill. The National Audit Office has now investigated the matter and in its report finds no fault with Guðmundsson. Morgunblaðið claims the investigation is untrustworthy because the sister of the director of the National Audit Office is the head of internal audits at the CBI. In Iceland, many feel certain that Oddsson, who was ousted as a CBI governor, will not rest until Guðmundsson has been driven out of office, even though Guðmundsson played no part in ending Oddsson’s CBI career.

Many feel that the selection process has already been undermined by the choice of a selection committee, which has two lawyers and only one economist. One of these two lawyers, Stefán Eiríksson, is at present the head of the Reykjavík police and is applying for a new public position, as the head of a governmental body that oversees transport in Iceland. Central Banking has already published an article about what it calls “a bizarre committee.”

Who will be chosen as the next CBI governor will be an important indication as to whether the government respects the independence of the bank – or not.

No pay-outs to creditors until the resolution route is chosen

There has been much toing and froing from prime minister Gunnlaugsson and finance minister Benediktsson regarding how and when the controls could be lifted. Considering how tortuous every step has been there is little to underpin optimism on a quick solution as to what to do. Yet, there seems to be determined optimisms amongst the creditors and they have shown remarkable cohesion.

The foreign advisers will most likely need some time to delve into the Icelandic situation. But the fundamental thing is for the government to make up its mind as to what needs to be done and what its aim is and yes, who should be on the managing committee. The lack of clarity explains the sluggish moves so far and in spite of advisers, the latest moves are not entirely convincing.

In the Landsbanki estate priority creditors will get the lion share of the estate’s assets and they have already been paid out along the way. But that has now stopped and since last year the CBI has not given the necessary exemptions. The CBI has also closed down the route for Icelanders to buy foreign life insurance and make limited capital payments towards pension: buying insurance was legal but the capital transfer goes against the controls although this has been going on for some years. This hardening attitude can be interpreted in various ways: that the controls are here to stay, that the CBI is showing the government its tough side etc.

Glitnir and Kaupthing now hold ca. ISK1000bn of fx, that could mostly be paid out without a risk to Icelandic financial stability. However, pay-outs are only possible once the estates are resolved. And they cannot be resolved until either a composition agreement is in place or the estates forced into bankruptcy.

The pension funds and the capital controls

Voices in Iceland have complained that creditors will be able to exit before the Icelandic pension funds. Before the collapse, the funds placed 30% of its investments abroad, which means that its Icelandic investments and the Icelandic investment environment is, under all circumstances, crucial to the funds.

Icelandic business leaders have increasingly voiced their frustration and CEOs of both big and small companies have aired the possibility of moving their companies abroad. Fewer investment options in Iceland due to the capital controls would raise the cost of the controls for the pension funds. It can be argued that lifting or easing the controls, thus improving the business environment in Iceland, is more important for the funds even though they have to wait for a while to invest abroad.

With the sluggishness so far, the advisers and the lost times it now seems unlikely that any negotiations with the creditors will start until September, at the earliest. Even more so, if the advisers will be given the task of doing all calculations, balance of payment and everything else, from scratch.

Getting foreign advisers on board has been seen as a necessary prerequisite for negotiations. That may be true – but hiring advisers and consultants is also a tried and tested, and usually an expensive, option when no one has a clue what to do and those in charge cannot make up their minds.

Complicated but not complex solutions

Given the fact that over the last few years the CBI has worked hard on issues related to the estates and capital controls it is frustrating that the government does not dare negotiate with the creditors but chooses to start a time-consuming process with an apparently unclear course and yet another committee with a difficult birth.

This is all the more frustrating because there really are some relatively simple solutions in sight. This is not to say that negotiating would be easy – no doubt the creditors will drive a hard bargain. It would be strange if they would not. But it is clear that the creditors do want to negotiate and find an end to this matter.

Last November, Lord Eatwell presented an independent report at the behest of Glitnir on macroeconomic balances and capital account liberalisation in Iceland where he pointed out balance-of-payment neutral solutions to the foreign-owned ISK. I have heard others air the same opinion. This is just one of many ways that could be explored. Using assets owned by the CBI asset holding company for swaps is another. Und so weiter.

According to the rumour mill in Iceland the creditors do not want to negotiate. Nothing could be more far from the truth. In general, creditors do wish to negotiate and the same counts for creditors to the Icelandic estates. This is, as far as I can see, a way to create a reason for not even attempting to negotiate but go straight down the bankruptcy route. Any solution has to look like a big fat victory for the Icelandic government – and even that would not be too difficult.

Again, having found experienced advisers might seem promising. But if the course of events will be a version of “if you don’t know where you are going you ain’t likely to get there any time soon” the outlook is bleak. Apart from the political disharmony it is no less worrying that there are strong forces pushing for bankruptcy: some Icelanders are apparently hoping to make a lot of money out of the tumult it would lead to and political favours have long been part of Icelandic politics. All of this is worrying for the Icelandic economy and for all those living in Iceland.

*Update July 9 2014: here is the press release, sent out today, regarding the foreign advisers. After announcing a managing committee, as mentioned above, to work on behalf of the Ministry of Finance and Economic Affairs and the so-called “Ministerial Committee on Economic Affairs and the Steering Group on Removal of Capital Controls” it turns out that no formal group will be set up. Instead,  four experts have been engaged to work alongside the foreign advisers: Benedikt Gíslason adviser to Benediktsson; Supreme Court attorney Eiríkur Svavarsson, earlier in the In Defense group, fighting against the Icesave agreement; Freyr Hermannsson head of reserves management at the CBI and Glenn Victor Kim, currently at Moelis & Co and LJ Capital, served previously as senior adviser to the German Finance Agency re the European Financial Stability Facility (EFSF). Kim will lead the work of the four external experts. – According to the press release, the first task of White Oak Advisory and Anne Krueger will be “to set out the macroeconomic conditions considered necessary with regard to maintaining economic stability.” Tomorrow, the report of the IMF mission to Iceland in spring is expected to be published. Both the IMF and the CBI have worked extensively on these issues. Hopefully, the new advisers will not need to start from scratch here.

*Here is an earlier Icelog on the May 8 agreement on the Landsbanki bonds – and here is a blog on the numbers and the main issues regarding the capital controls.

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Last December, Landsbankinn announced it would need to extend its two bonds of December 2009 with maturity 2018. On May 8, Landsbankinn and the LBI, the estate of old Landsbanki, reached an agreement to extend the final maturity from 2018 to 2026. In return, creditors want a pay-out of fx cash funds with the LBI, only possible with an exemption from the Central Bank of Iceland, CBI, with the blessing of the minister of finance. – With a time clause in the new agreement there is now pressure on the government to find the holistic solution to the estates both the CBI and ministers have talked. At stake is saving the state-owned Landsbankinn or the cataclysm of a failed state-owned bank. Judging from the debate in Iceland it seems that there are those who would either favour some turmoil or do not realise the risks involved in some special Icelandic solution.

The nature of the estates of the three biggest Icelandic banks, which all failed in October 2008, is not the same. This is also reflected in the ownership of the three new banks. On one hand there is Landsbanki, on the other Glitnir and Kaupthing.

Due to Icesave, priority-claim holders, i.e. deposit guarantee schemes of the UK and the Netherlands, will get ca. 90% of the Landsbanki estate, LBI. Not until December 2009 was the ownership of Landsbankinn, the new bank, in place: the state brought equity in addition to a loan from LBI, which due to imbalance between domestic and foreign assets, mostly had to be paid in fx.

The state now owns 98% of Landsbankinn with employees holding the rest. Instead, in Glitnir and Kaupthing creditors holding general claims, i.e. myriad of banks and other financial institutions, get the lion share of the estates. After the collapse in October 2008 creditors of these two estates agreed to fund the two new banks, now Íslandsbanki and Arion, taking a stake in them. The state owns 13% of Arion and 5% of Íslandsbanki.

It was clear from early on that Landsbankinn would not be able to meet the bonds’ payment schedule; the bank is not generating enough fx funds. At the time it seemed a solvable problem for another day, certainly the bank would gain market access before crunch time and be able to refinance. Now, with capital controls still in place etc., this is not about to happen meaning there was no other way but to negotiate with LBI.

Negotiations have been ongoing, on and off, for a year, at times in a rather frosty atmosphere. Already a year ago, the rumour was that an agreement would be reached before the end of the year; 2013 passed, no agreement – until now.

Agreement on extending the Landsbankinn bonds

Those two who negotiated were Landsbankinn, the payer of the two bonds and LBI, i.e. its Winding up Board as well as representatives of both the priority and general creditors.

According to the Landsbankinn press release “Interest rates will remain unchanged at 2.9% margin until October 2018. Thereafter, the margin steps up to 3.5% for the 2020 maturity, increasing up to 4.05% for the 2026 maturity. Each of the maturities between 2020 and 2026 will be equivalent to approximately 30 billion ISK.” – This is more or less what the other banks get offered. Improved conditions will help Landsbanki refinance.

The intriguing bit is this part of the press release: “The agreement is conditional upon the Winding up Board of LBI obtaining certain exemptions from the capital controls.”

The story here is that creditors know full well that saving a state-owned bank may be worth something. This “something” is not spelled out in the press release but it refers to the fact that LBI creditors want to make sure they will actually be paid out their assets in LBI. As it is now, they do not: LBI has i.a. not paid out ISK50bn, paid by Landsbankinn on the bond because the CBI has to grant exemptions to currency law and it has not.

In order to secure their interests, the new agreement states that conditions precedent to closing are that the CBI:

– grants existing exemption requests from the capital controls for Partial Payments to creditors,

– grants a permanent exemption to the capital controls for payments received on the Bonds, and

– grants exemption requests for future payments LBI receives on FX assets of LBI or to the extent such exemptions cannot be granted, a confirmation by the Central Bank that it will consider future exemption requests in good faith

In short, the relevant facts regarding the agreement are:

Outstanding part of the bonds is ISK226bn; eight years extension, from 2018 to 2026; tranches will be paid out every two years instead of every year; the bonds can be paid at a faster rate without any penalties; until current final maturity 2018 the interest rates are the same as earlier agreed, i.e. 290 basic points on Euribor/Libor, the 350bp 2020 ending in 406bp 2026; the agreement is made on condition that CBI grants exemptions.

From positive to negative

The first reception of the agreement was largely positive. After all, extended maturity of the Landsbankinn bonds seems broadly in accordance with CBI’s views in its financial stability reports: Landsbankinn has funds to pay the 2014 and 2015 instalments but the main burden on Icelandic balance of payment in 2016 stems from the two Landsbanki bonds. Once they are extended things will brighten up – which is just what has now been done in the new agreement, or rather the head of terms reached.

Major news regarding the estates and other matters close to the CBI has recently often been leaked to Morgunblaðið. The news of the agreement came fresh from Landsbankinn. Since the CBI position on the importance of extending the maturities was known this was reflected in the first news – a problem that needed to be solved and had been seeking a solution for a long time had indeed found a solution. Without taking a stand, Már Guðmundsson governor of the CBI said the bank would now analyse the agreement.

But after the first surprise of an agreement dissident voices were heard. Prime minister Sigmundur Davíð Gunnlaugsson has said that creditors must not be favoured over ordinary people and the new agreement must not be allowed to impair standard of living in Iceland. Other Progressive voices sounded the same warning. As often, minister of finance Bjarni Benediktsson was more cautious and Delphic.

The strongest and much noted criticism came from Heiðar Már Guðjónsson. In an article in Morgunblaðið Guðjónsson wrote that the new agreement smacks of Icesave, meaning it was too onerous for Iceland. He claims the problem is not solved with extending maturities since the interest rates are too high and that foreigners should not get an exemption from the currency laws until a holistic solution is found; in the end the Icelandic people will only pay the price for this.

Guðjónsson, introduced as an economist (he graduated from University of Iceland) in Morgunblaðið, is better known in Iceland as an investor. His family lives in Iceland but he himself is domiciled in Switzerland where he moved from London after working at Novator. Novator is the investment company owned by Björgólfur Thor Björgólfsson who with his father was Landsbanki’s largest shareholder from when they bought the bank in 2003 until the bank failed only five years later.

In 2010 Guðjónsson led a group of investors who wanted to buy the insurance company Sjóvá. He has later claimed that governor Guðmundsson personally intervened to prevent his offer being accepted. On the other side there are rumours that the CBI did not want to accept the offer because it was conditional on using offshore króna. Last year, Guðjónsson published a book about Iceland and the Artic and he has various investments in Iceland.

Interestingly, those who have sought financial power in Iceland have always sought to own/control a bank, an insurance company and a media – preferably all three. This was true in earlier decades and was still true after the privatisation of the banks.

Precedents and the glaring risk on Landsbankinn

For some reason, none of those who have opposed the new agreement mention the glaring risk that Landsbankinn – and its owner, the state – is facing by not being able to pay off the bonds in 2016. Also, the CBI has time and again called for a holistic solution.

The agreement has been said to constitute a dangerous precedent. The fact is that the LBI is still paying out to priority creditors whereas these have already been paid out in Glitnir and Kaupthing – in fx. In total, the priority creditors in the three banks have been paid out close to ISK1000bn (ca ISK700bn to LBI creditors, the rest to creditors of Glitnir and Kaupthing), amounting to more than half of 2013 Icelandic GDP. Obviously without upsetting the Icelandic economy since this has been paid from fx assets in the estates.

In total, LBI priority claims – mostly rising from Icesave – amount to ca. ISK1330bn. With extended maturity this will not have been paid out until towards the end of the extension. General creditors will most likely get ca. ISK200bn – but not until close to 2026.

Consequently, a pay-out from LBI does not set any precedent regarding pay-out to priority creditors since Glitnir and Kaupthing have already paid their priority creditors. Some people worry about the precedent it sets to give exemptions to pay-out in fx. The interesting thing here is again that this has already happened: as mentioned above the equivalent of ISK1000bn in fx has already left the country/or more likely, been paid out of accounts abroad since most of the fx is actually kept abroad.

A new and unexpected time limit for the government

What the government now faces is that the new agreement has a time limit: LBI and Landsbankinn commit to finalise documentation before June 12 and completion within three months from that time. This means that the government has a thing or two on its plate now.

The CBI grants exemptions but the minister of finance has to agree to exemptions of this magnitude. After seemingly having eternity to make up its mind as to how the estates should be wound up it now has… until September 12 (I have heard there might be a month or even three in grace period but according to a copy of the presentation of the head of terms the date is September 12).

At first glance, Landsbankinn and the LBI have no doubt had in mind to extend in line with the CBI balance of payment forecast. It is difficult to see that the agreement might threaten standard of life in Iceland as prime minister Gunnlaugsson has stated. What is however threatening Iceland are the capital controls.

The nature of capital controls is to give shelter from an imminent danger that cannot be solved imminently – in Iceland it was the situation after the collapse when more króna was seeking to be converted into fx than could be serviced without causing the króna to collapse. However, the danger is that with time the controls turn into a cosy shelter substituting the reforms and changes that need to be made to solve the original problem/danger. Exactly when this happens is difficult to estimate. With Iceland now well into the sixth year, business leaders in Iceland are smarting, complaining loudly about the lack of a credible plan to lift the controls without threatening financial stability.

The asset sale of the century

There are interesting times in Iceland. It is clear that two – and possibly three – banks will be for sale in Iceland in the foreseeable future. Ironically, an agreement on the Landsbanki bonds removes the largest obstacle for the state selling the bank, recovering its funds now tied in that bank.

The sale of two – Arion and Íslandsbanki – or even three banks will clearly be the largest asset sale in the history of Iceland. There might be foreign buyers and that is what the Winding up Boards of Kaupthing and Íslandsbanki are actively looking into, helped by creditors. Selling one or two of the banks would resolve the problem of converting the ISK assets of the Glitnir and Kaupthing into fx.

Some say that foreigners should not own any Icelandic banks, which in the light of the experience of home-run and –owned banks is a remarkably forgiving opinion.  And yes, there might also be Icelandic buyers.

There are the pension funds, which might very well be tempted/lured into (depending on the point of view) to buy a bank or two with their foreign assets. Interestingly, most major Icelandic investors, who got rich by being actively involved with the three banks in the five to eight years up to the collapse and who still have the urge to invest in Iceland, are all living abroad.

The political choice: negotiations or turmoil

The government has to make up its mind as to how to deal with the estates. It will now feel emboldened by having paved the way to debt relief – the two necessary Bills have been passed in Althing and the website for applications is up and running. The coming local elections in Iceland May 31 will most likely be bad news for the government though the successful introduction of the debt relief might pull some votes for the Progressive party in the election’s final spurt.

The debt relief, though carried out by the Ministry of finance, is the Progressive’s big project. Its realisation will greatly strengthen the party’s credibility in the eyes of the voters. It will also strengthen the party in government, which again might strengthen the party’s view on the estates. Its former views on money accruing to the state from the estates have not been heard much lately. It is however clear that some of the government’s local advisers are of the same view though it is safe to say that if this were an easy route it would already have been taken.

Anyone bringing fx to Iceland in order to buy assets now gets ca. 20% discount, compared to those with investors holding króna in Iceland. The rumours in Iceland are that if the government chooses some unconventional way in resolving the problems related to the bank estates, releasing legal action and other unforeseen consequences, the resulting turmoil might drive down prices in Iceland. Turmoil might benefit those intending to buy assets in Iceland but it will certainly not benefit the average Icelander who would yet again see the economy in jeopardy.

The CBI has preached the importance of keeping an eye on financial stability. The IMF still keeps an eye on Iceland and certainly has all the expertise needed to deal with the situation. Lately, some international advisors, specialised in sovereign debt issues have been visiting Iceland. If the government hires such advisors it might make it more likely that the route of negotiations will be chosen. By following the example of how other countries have escaped capital controls and how big financial estates are dealt with, the CBI goal of financial stability and market access might be within reach. Or as the CBI writes in its last financial stability report:

The next stages of the winding-up proceedings must safeguard financial stability and ensure that domestic entities have access to foreign credit markets. Finding a comprehensive solution to the estates’ affairs is a prerequisite for lifting of the capital controls.

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In recent weeks Icelandic business leaders have voiced concern on the isolation of Icelandic businesses behind capital controls and by breaking off EU access negotiation. In order to lift the controls – or rather, start the process towards that goal – it is necessary to negotiate the payment schedule of the Landsbanki bond and the ISK assets of Glitnir and Kaupthing. Possible solutions are in sight but it is ultimately a political question and not about economics. So far, it is unclear if the government is seeking to lift the controls or if it also seeking to fatten the state coffers. Another – and in the long run possibly a more serious problem – is a short-term plan with no perspective on the future. As the CBI points out in its latest Financial Stability Report the solution has to be holistic, safeguard financial stability and pave the way for Icelandic public and private entities to international credit markets.

The word among those involved in the winding-up of the estates of Glitnir and Kaupthing is that these are by no means difficult cases but the weirdest process they have been involved in. The “weirdness” stems from the fact that although the minister of finance has the last word on the winding-up of the two estates, there is no one to negotiate with. One of those involved complained that they keep coming to Iceland, for meetings and presentation, but there is no one with a mandate to make any decisions.

The process has been rambling, with a committee that then was not really a committee and had no chairman. The prevailing assumption in Iceland seems to be that Iceland has all the good cards on its hand and can afford to wait as long as it pleases, “to make the creditors sweat” as some have been whispering. But that may be a slight misconception.

What should focus the mind of the government is first of all the growing and vocal irritation within the Icelandic business community on lack of credible plan to lift the controls. Also, 2016 is a crunch year when the new Landsbanki cannot pay (not for lack of liquidity but of foreign currency). Uncertainty on repayment is particularly unfortunate since the new bank is owned by the state. The third issue are legal risks. The fourth issue, somewhat hypothetical in terms of time but absolutely real in terms of effect, is the relative cohesion of the creditors, contrary to what it could later.

The process

The process of abolishing the capital controls has been rambling. Under the previous government the Central Bank was working on the payment-of-balance analysis and prognosis and published a report, only in Icelandic,* in March last year as well as reports on abolition plans. In early 2013 an ad hoc working group with members from the Icelandic government, EU Commission, the European Central Bank and the IMF was set up to work on an interim report. However, when the present government announced it was putting EU accession talks on hold the EU Commission notified the government it would withdraw from the group, which then met its demise.

During the election campaign last year the Progressive party announced time and again that “unavoidably” the state would make money on the winding up the banks’ estate and these funds should be used for debt relief. When announced in November it came as a surprise that the debt relief was to be funded with a banking tax, also on the estates, not from money from the winding-up process. Much less has been heard of this fountain of funds, the winding up process, lately.

The new government announced it would appoint a “capital controls abolition director,” due to be appointed soon after the government took over. However, this position was never filled. End of November the government set up an “advisory group” with the task of making proposals on steps and overall plan of abolishing the capital controls. It was unclear if this was a committee or not (said by adversaries not to be a committee because a committee would be bound by law on gender equality) and it was too informal to have a chairman.

However, in a recent report on the abolition progress (after an Althing resolution last year a report on the abolition progress is published twice a year) Sigurbjörn Þorkelsson, a banker in London, is said to be its chairman. Other members were Eiríkur Svavarsson, Jón Helgi Egilsson, Jón Birgir Jónsson, Ragnar Árnason and Reimar Pétursson. Benedikt Árnason and Benedikt Gíslason, both from the Ministry of finance, assisted the group.

Its proposals have not been made public and the group seems to have come up with a smorgasbord of proposals but no overall plan, as far as is known. Also, there are rumours of differing opinions within the group. Recently, Benedikt Gíslason gave a presentation at Independence party’s head quarters but the scanty reporting did not indicate any firm view on the process and the immediate future. According to the rumour mill the members have been giving power-point presentation at various meetings; always the same slides but the interpretation varies according to who presents the slides.

This group has now been disbanded. It now seems it will be substituted with a new group. Also, it is rumours that international advisers of all types have been visiting the ministry of finance strutting their feathers. So far no names have been confirmed nor is it clear what the mandate will be.

The numbers

The capital controls stem from the fact that Iceland does not generate enough foreign currency, fx, to meet demand on converting ISK into fx. There are three main hurdles: pre-2008 foreign-owned ISK, mostly so-called “glacier bonds,” ISK327bn, €2.1bn – ISK assets in the estates of LBI (the Landsbanki estate), Glitnir and Kaupthing – and liabilities by Icelandic entities, such as Landsvirkjun and the state itself, in fx, directly and indirectly state-guaranteed. In a way, it makes sense to group the Landsbanki bond in this last group since new Landsbanki, shouldering these liabilities, is state-owned.

The combined assets of the three estates amount to ISK2,552bn, or 143% of Icelandic GDP. The ISK assets of the estates in Glitnir are ISK302, €1.94bn, in Kaupthing ISK148bn, €950m and in LBI ISK47bn, €300m, in total ISK497, €3.19bn. The largest part of the Glitnir and Kaupthing ISK assets are the new banks, respectively Íslandsbanki, valued at ISK132bn, €850m and Arion at ISK116bn, €750m (on latest numbers and stats see the CBI latest Financial Stability Report)

Contrary to the creditors of the three estates the foreign-owned ISK, the glacier bond-holders, are not an organised group. Some have estimated that a third, perhaps as much as half of them are indeed Icelanders. Whether this group will leave rapidly or not is difficult to say but there are indications that at least part of this money is happy to stay in the high-interest Icelandic economy.

The liabilities of indirectly/directly state-guaranteed liabilities are manageable, according to the CBI, for next year, partly because fx has been put aside against rainy days. The problem becomes insurmountable in 2016-2018 unless the new Landsbanki refinances/extends, in total ISK177bn, €1.14bn for these three years.

Composition or bankruptcy?

The major question, facing the government is whether to find a solution for winding up of the estates of Glitnir and Kaupthing, i.e. composition as creditors want – or opt for filing a petition for bankruptcy straight away. Bankruptcy gives less leeway to manage assets whereas composition gives creditors much better control over the assets, which might in the long run improve their recovery. Needless to say, the creditors favour composition.

For some reason, those who speak for the bankruptcy route, have added to it the so-called “ISK-isation” of all the assets, meaning that the fx assets, mostly held abroad, must be converted into ISK, paid out and then those foreigners with bucket-loads of króna would have to negotiate an exit, participate in auctions etc. I fail to see how this route could solve anything at all or be in the interest of Icelanders. To my mind, it is chaos and risk and no solution at all. In addition to lawsuits and other legal devilry it makes the process unpredictable, possibly prolonging unnecessarily the capital controls.

Both prime minister Sigmundur Davíð Gunnlaugsson and minister of finance Bjarni Benediktsson have repeatedly hinted at this possibility. Benediktsson has argued that the winding-up process is taking unduly long though not mentioning that both Glitnir and Kaupthing put forth a draft for a composition bill in late 2012. So far, Kaupthing has received no answer. Glitnir has been answered after which they put forth another draft, as yet without an answer.

The ministers have no doubt mentioned bankruptcy to scare the creditors who perceive they will lose a lot through bankruptcy with assets unavoidably going on fire sale with the usual consequences. However, that is only money, so to speak and losses for some financial institutions. The losses for Iceland is, from my point of view, much more serious: longer time under capital controls with ensuing direct and indirect cost, uncertainty and what could be seen from abroad as increased political risk, rising from instigating a process fraught with unforeseen consequences.

The legal risks

Most of the debate in Iceland regarding the capital controls and the two estates has focused on the evident balance-of-payment problem and the need to find a solution that does not put the country’s financial stability in jeopardy. The legal risks are hardly ever mentioned.

Some of those I have spoken to, advocating the bankruptcy route, claim there is no inherent legal risk in it. As a proof they refer to an ECJ ruling regarding a case against LBI in France in which Icelandic bankruptcy laws and the procedures was found to comply with EU regulations. However, this case only shows that so far Icelandic laws are in compliance. With a different route or deviation from this course the situation might be different.

So far, none of the fx assets have been paid out to creditors – it can only happen after priority claims have been paid out, as in Glitnir and Kaupthing (LBI will only finish that earliest in 2018) and either bankruptcy or composition chosen. Paying the fx would not harm Icelandic financial stability. One reason for postponing decision is rumoured to be that preventing the fx payout makes the creditors more amenable to leaving a large chunk of ISK assets to the government. From the legal point of view this might be questionable, to say the very least. By preventing payment the state can easily risk legal action.

Frustrated creditors could use Icelandic law to seek their rights. The notorious cases of creditors vs Argentina demonstrate the ample recourse creditors have internationally to seek justice. In addition to direct legal risks there is the risk that legal wrangling tends to take a long time, possibly adding years to capital controls in Iceland – again, a costly delay for Iceland.

Legal risks are well known from similar cases in other countries and it is a well-trodden path for creditors. If the creditors feel forced to take that route the consequences might be unpleasant for Icelanders and come as a surprise. However, in an international perspective there will most likely be few novelties.

The political risk

One risk assessment regarding countries is political risk. If the government keeps dithering, postponing a solution, the political risk increases. The priority claim-holders to LBI, the British and the Dutch government, no doubt have an eye on the political risk in weighing up possible actions.

For some reason media reports in Iceland on the Landsbanki bond ignore the fact that behind Landsbanki is its owner, the state. One source said to me that the state would not do whatever it takes to save the new bank. – Needless to say, letting Landsbanki fail would create quite some turmoil, to say the very least.

The Progressive party, the winner of the last elections, is now much weakened. Both the party and its leader muster little popularity and trust according to polls. A weakened party will either try to be more reasonable and responsible, in order to get re-elected. Or it can go all-out on demagogy and populism, knowing it will only get one term in power anyway so there is nothing to lose. It is still too early to tell what route the progressives will choose. So far, the prime minister has been very absent in the Althing debate, causing much speculation as to what makes him stay away.

Partly due to the prime minister’s absence Bjarni Benediktsson leader of the Independence party has at times appeared as both the minister of finance, as he is, and an acting prime minister. Within his party there is brewing discontent that the party has gone out on a limb to make the Progressives’ promises of debt relief come true. The two Althing bills needed to carry out the debt relief plan have not yet been through Althing and it is still unclear when it will happen. Icelanders have been promised that they can apply for the relief from mid-May.

The EU issue – to break off negotiation, as the Progressives insist on – has turned into a poisonous topic for the Independence party. Its leaders point at polls showing that its voters are in favour but the fact is that many of the more EU-friendly voters have already left the party. The party has now a much smaller following than ever in the past when it hovered around 40% while now hovering around and well under 30%. A new conservative EU-friendly party is still in the making but not yet born.

The feeling is that the cause of inaction regarding the estates of Glitnir and Kaupthing is due to differing views within the government. As long as the course is unclear political tension and the ensuing risk of inaction is in sight.

Ultimately, as pointed out on Icelog earlier, the controls will be decided in a political wrangling. Understanding that politics is a key issue here.

Possible solutions

The worst problem for Iceland is the Landsbanki bond since the liabilities are on Iceland, indirectly a sovereign problem since the new Landsbanki is state-owned. Theoretically, the solution is simple: extending the payment schedule, with adjusted interest rates. Although simple in theory, it is clearly not that simple in reality. Here, contrary to what seems to be generally understood in Iceland, the creditors have the upper hand. Nothing is really clear until the solution here is clear.

In addition, it is clear to everyone, including the creditors, that Iceland does not create enough fx to pay out, in the near future, ISK assets held by foreigners. With focus on the estates of Glitnir and Kaupthing the question is what to do about it.

There are of course the usual. One is extending payment etc but that is not very satisfactory for various reasons, i.a. risk rising from unforeseen circumstances etc. Haircut is another way. The CBI has been in favour of 75%; Arion bank analysts recently mentioned 55% as the necessary number.

However, the CBI has lately been advocating solving the problem within the framework of the estates, i.a. using domestic held fx, asset swaps etc. – 5.7% of the claims are owned by Icelanders, in total just over ISK100bn, mostly held by the Eignasafn Seðlabankans (the CBI asset-holding company).

The creditors have pointed out that selling the two banks, Arion and Íslandsbanki, to foreigners/for fx might be the solution. As pointed out in the 2014 report on capital controls: “Sale of the holdings for foreign currency to non- residents who intend to hold these assets for a longer term would avoid such negative effects, although there might be pressure over a longer period when the banks paid dividends to their foreign owners.” – However, also regarding dividend there are possible solutions.

As it is, everyone is losing out on inaction. Creditors lose around ISK100bn, €640m, a year because of lost interest. Icelandic businesses and ultimately the country are losing, as always happens when capital controls stay longer than necessary Icelandic businesses and ultimately the country are losing both money and opportunities.

Analysts at Arion Bank have done some calculations, pointing out that the only real problem is the Landsbanki bond. Here is their interesting overview.

The risky silence on long-term perspectives

The latest CBI financial stability report states: “The next stages of the winding-up proceed- ings must safeguards financial stability and ensures access of domestic entities to foreign credit markets. Finding a comprehensive solution to the estates’ affairs is a prerequisite for lifting of the capital controls.”

In addition to a missing comprehensive view and a holistic solution is missing a vision of the future after lifting the controls is nowhere in sight. How will Iceland cope on its own after the controls have been lifted? Can Iceland survive with no controls, will controls on inflows or outflows be needed, should the króna be pegged or not, another currency found? And is the EEA agreement enough for Iceland in the long run?

In September 2012, the CBI produced an extensive and informative report, Iceland’s currency and exchange rate policy options (only small part of it in English), inducing realism in an often lofty so as not to say wholly misleading debate, on the currency options. Instead of instigating a debate it more or less ended all debate without any ensuing policy.

As far as is known the government is not working on any comprehensive analysis of future options. Some say that politician are avoiding to discuss these wider issues and the government, or rather the Progressives, is hell-bent only on finding some clever way of fleecing foreigners. Yet, if there is only that policy once they are fleeced, what next?

The solution to lifting the capital controls needs to be coherent and comprehensive – but to back it up there also needs to be a clear plan for the future after the capital controls. That is what politics should be about. The EU debate shows that there is an ongoing battle for the soul of Iceland going on – whether to dare to engage with the outer world or to withdraw and isolate, letting the forces that have ruled Iceland for the last decades rule on.

*Sorry, this is of course wrong. Here is the report in English.

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Those who understood the Eurozone correctly were those who understood that politics mattered more than economics. It might very well be the same in Iceland: in order to understand the course of events regarding capital controls, foreign-owned ISK assets and the estates of the failed banks, politics might weigh more than the economics. And as in Europe the political weight might bode messy course.

To continue with the Eurozone analogy: the (at first hidden, later more overt) agenda of all action taken by the EU was to prevent any bank in the Eurozone failing. It was deemed to be bad for the reputation of the young currency area and in the Realpolitik it counted that the strong German and French governments were adamant in sheltering their own banks from unwise lending to the debt-ridden periphery. Both these agendas were politically driven and those who understood the political dominance over sound economic thinking got their predictions right: no euro-exit, good public money thrown in to reward bad lending.

In Iceland, there might also be an agenda, other than just abolishing the capital controls without jeopardising financial stability: the Progressive Party and its leader, prime minister Sigmundur Davíð Gunnlaugsson has time and again, since the election campaign early last year and after it came to power, stated that there will unavoidably be money for the state coffers when the bank estates will be dealt with in order to abolish the controls (see more on facts and figures in an earlier Icelog).

The Independence Party, led by minister of finance Bjarni Benediktsson, has appeared to be less focused on abolition as a way to enrich Iceland. Recently though he has faintly echoed Gunnlaugsson’s view that doing it quickly, via bankruptcy rather than the more long-term composition the creditors are keen on, might be a sensible way. It is not clear though if he really believes it or is just putting pressure on the creditors.

It seems increasingly clear that the abolition of the capital controls, which needs an action plan on dealing with the foreign-owned ISK assets of the estates, might well be more dependant on political solutions than purely finding a way to secure financial stability. Both parties will want as much of the credit for a plan to abolish the controls – but the Progressive party seems also keen to create a situation where it will be seen as having won over the foreign creditors. The Progressive narrative is that it secured an Icelandic victory in the Icesave case (though the Icesave problems are alive and kicking in the unsolved Landsbanki bonds) – and now it is going to secure a victory over other foreigners, the creditors.

The necessary solutions will be conjured up in the tense political sphere between the two parties.

What, when and how?

There is probably no one in Iceland who is as yet able to answer the question what exactly is needed to resolve issues preventing the abolition of the capital controls, when action will be taken and how it will all be brought about.

Because of the Progressive’s earlier promises the government’s agenda might not be only to abolish the controls and to secure financial stability but to make sure the state profits from it. Compared to other countries fighting to abolish controls, such as Cyprus, this is a novel situation and makes it a whole lot more difficult.

How much does the government want from the process of abolition? It clearly wants at least ISK120bn since that is what it is claiming in tax from the estates of Landsbanki, Glitnir and Kaupthing, albeit over the next four years. But judging from sources close to the government it seems that a whole lot more is desired – probably all the ISK assets of the two estates (Landsbanki is in a different place due to its creditors and the bonds between old and new Landsbanki) and a slice, let’s say 10-15% of the fx assets.

If this really is the goal then this is the “what” needed to solve the controls conundrum, from the point of view of the government.

When action will be taken is unclear. On a Rúv TV talk show (in Icelandic) February 9 Benediktsson once again said that the abolition could start this year, it would not happen over night but over some years and it all depended on if there could be some harmonisation of expectations. Recently he also said it might be seen as unfair to Icelanders that the creditors were the first ones to get out with their money.

There is now a working group at work on behalf of the government on issues related to the capital controls. It first seemed it would finish its taks in February but now March or April seems more realistic. The group consists of both bankers and lawyers (led by much respected banker, Sigurbjörn Þorkelsson living in London). The group is not expected to come up with one solution but various scenarios. If their indirect remit is to show that the only viable way out of the controls is that the creditors hand over both all ISK assets and a slice of the fx then that will surely be part of their solution.

Then there is the CBI working on current account forecast, which ideally should underpin a payment forecast – how much fx will there be for paying out creditors in the coming years? The next CBI Monetary Bulletin will be out now on February 12, clearly an important event. The last CBI currency auction was deemed to have gone well for the bank and the bank has been unexpectedly active in the currency market (see here a short overview from Íslandsbanki).

It will be interesting to see if the CBI stats appeal to the government and the working group or if they will seek other ways to underpin their own plan, whenever it emerges.

The goal will determinate the road to the goal. The thing to look for is if it will be a neat solution, nested within present rules and regulations or will it be an all-Icelandic messy solution, depending on special legislation.

Difficult decisions in tense political climate

Icelandic political pundits have noticed, from early on in the life of the coalition that the two party leaders rarely are in tandem on important issues. The first great big test of the government was the execution of the Progressives’ promise on extensive debt relief. That promise was defused by the Independence Party, which cut it down from vaguely promised ISK300bn to ISK80bn – and instead of funds coming from the resolution of the estates it will be financed by banking tax, albeit partly from the estates.

However, the promise could be said to have been kept. Thus the Progressives strengthened their reputation as a party to be trusted and the leadership of the Independence Party could feel quietly satisfied that it had delivered the promise in a way it deemed viable.

The second test was another Progressive promise, abolishing indexed loans. A committee delivered a split report – majority came up with several solutions to change loans but in no way supporting the Progressive view it should be chucked out fast; a minority report suggested the loans should and could be abolished right away. (The Icelandic debate on indexed loans is truly weird from a foreign point of view: the problem rather seems the chronic inflation rather than the loans per se but that is not reflected in the debate.) Again the Progressives could say this promise was now all on track though what exactly is the track is not clear whereas the Independence Party said little other than there was now material to study.

The outcome so far is that the Progressives have kept their promises. Although it has been done with cutting off a toe here and a heal there to make it all fit the party seems to have managed to stay its course. The Independence leadership can be quietly content that it has indeed managed to steer the toe- and heel-cutting to suit its own policies. So far so good for Benediktsson.

Some Independence supporters are feeling uneasy that the party has staked its own existence on carrying out Progressive promises that were far from the Independence line. The point of view of the Independence leadership might well be that the promises better be gotten out of the way as soon as possible in order to avoid distraction in focusing on other matters. Such as the capital controls.

In spite of smooth executions so far there seems to be quite some tension between the two parties, also regarding the capital controls. No matter the rhetoric the course so far it has been decided by the Independence party. This might indicate that Benediktsson really decides on the important issues regarding the economy. But the future is not always like the past.

Both coalition parties need to get the most out of their time in government. The Independence party because it is used to be in government; a leader who does not again firmly position the party for another term is politically dead. The Progressives need to turn their tide tangibly in order to escape what seemed to be their imminent future up until the Icesave ruling: that they would keep on hovering around 12% of votes.

Young politicians in an atmosphere of former times

The Left government put effort into breaking out of the old political mould i.a. by nominating people on merit more than for party allegiance. It seemed for a while that this was an answer to the call of the time. However, although the two coalition leaders are young their attitude seems to hark back to the olden times.

The biggest test when it comes to nominating people for leading positions is the governorship of the CBI; it expires in autumn. The position needs to be advertised six months in advance, i.e. by February 20. One rumour was that it would look bad to do it at the last moment so had nothing been done by end of January it was a sign that Már Guðmundsson would be reappointed.

Now the rumour mill is in overdrive. The Progressives are said to be hell-bent on getting rid of Guðmundsson. Allegedly they cannot forgive him for wanting to negotiate on Icesave and in addition the party would like to be able to influence the bank’s position on major matters, such as the capital controls. So much for the independence of the central bank.

However, the problem for the Progressives is that Guðmundsson is widely respected, not only in Iceland but even more importantly abroad. He has the high standing and trust that a governor of a central bank needs in order to be taken seriously and in order for a country to be taken seriously in terms of monetary policy. It seems highly unlikely, if not impossible, that the Progressives can come up with anyone anywhere near Guðmundsson’s format.

The Independence leadership has been said to be more bent towards keeping Guðmundsson, also in order to encourage trust and stability. One version has it that the government might keep Guðmundsson but make some other changes, i.a. add a vice-governor, favourable to the Progressives or change the present one, Arnór Sighvatsson, also well respected.

The new magazine Kjarninn wrote last week that the Progressives wanted to appoint a banker at MP bank, Sigurður Hannesson, for the CBI job. Hannesson is head of private wealth management and has, to say the very least, a CV that differs radically from the CV of central bankers in the neighbouring countries. But he is very close to Gunnlaugsson.

Kjarning also wrote that Benediktsson was in charge of this appointment and his idea was to appoint Ólöf Nordal, a lawyer who has just left parliament to follow her husband to Switzerland. Kjarninn pointed out that her credentials were that she practically grew up in the CBI where her father was a governor. It is not clear from the context if Kjarninn was serious about her merits but yes, yet an altogether different CV from central bankers in the Western world.

Should Guðmundsson not get reappointed the whole capital control conundrum will get postponed… until late this year. Should Guðmundsson get ousted for someone of much more inferior professional standing it bodes a return to the Icelandic past of clientilismo and political patronage. And that bodes ill for everything – also the abolition of capital controls – and everyone in Iceland, except of course those with the right connections.

The paradox of political (non-)intervention

It is not altogether a uniquely Icelandic situation that the government refuses to negotiate with creditors claiming it has nothing to do with winding up of failed private banks. This is often the case with semi-sovereign debt situations. However, the situation in Iceland is tricky because with the approval of all MPs parliament voted last year that the government should indeed be part of the estate equation.

This was what happened when parliament approved a change of the currency law stipulating that the CBI can only give exemption to the law, above certain sums (which firmly includes the estates) with the blessing of the minister of finance, after he has presented it to the parliament (which does not need to approve it but well, a minister is unlikely to go against the parliament on this issue.)

Therefore, there is this paradox that the government – or the minister in charge – denies to negotiate an agreement that cannot pass through the CBI without his political blessing.

This situation greatly frustrates creditors. They feel they are trying to do everything right, talking to the CBI, trying to figure out what write down is needed (obviously, from their point of view as small as possible) by studying the current account, studying what assets can be used to negotiate on (such as assets owned by the CBI holding company, ESÍ etc), stretching out payments and in general trying to figure out all variables that can be used in negotiations.

But so far, this is just a monologue – there is no one who wants to sit down on the other side of the table. And yet the government clearly indicates it does want certain things from the creditors – it is just not going to tell them what it wants and no, not negotiate with them. The creditors have to figure it out themselves and reach a conclusion that satisfies the government.

This is seemingly an impossible way to go about things. And it is even more impossible if the government wants not only to find a solution that safeguards financial stability and takes into account the current account balance over the coming years but, in addition, wants to secure money for the treasury.

But one day the government will, in some way, make its position clear. Until then, when, how and what are only things to be guessed. And as we know from the Eurozone crisis: figuring out the economics is easy – guessing the politics is a lot more difficult.

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So far, there is no solution in sight in matters that need to be solved in order to abolish capital controls in Iceland. The government blames creditor of the estates of Glitnir and Kaupthing but unresolved dispute in Landsbanki matters as well though hardly ever mentioned. The government seems to play a waiting game, perhaps to make creditors more forthcoming. Ministers maintain the government cannot interfere in a process of private companies and yet they seem to be contemplating interfering via laws, which would directly expose the government to being sued by creditors. The creditors mostly remain silent but might have more cards up their sleeves than the government seems to believe.

“It seems they’ve (creditors) been waiting to see whether the government would somehow step into the process. But this is not a project for the government. The only role of the government here is to assess whether they come up with a solution which allows for the lifting of the controls,” prime minister Sigmundur Davíð Gunnlaugsson recently said to Bloomberg. He has also stated that “I’m unaware of them having found any solution” which would allow the banks to complete creditor settlements. In September Gunnlaugsson said the controls could be lifted “in foreseeable future” if the creditors were “willing to assist us.”

And here is the creditors’ view, as expressed by Steinunn Guðbjartsdóttir head of Glitnir’s winding-up board: “It’s definitely not Glitnir that’s delaying the process when it comes to completing creditor settlements. Our proposals have simply not been answered, making it impossible for us to move forward.”*

In problem keeping the capital controls in place is the fact that foreigners own more ISK assets than can possibly be converted into foreign currency in the foreseeable future – a problem contained by the capital controls. Hence, the problem of foreign-owned ISK has to be resolved before the controls can be abolished. It will not happen over night, will no doubt take some years to abolish them in stages. However, it will be a decisive step when the ISK assets of the old banks – Kaupthing, Glitnir and Landsbanki – have been resolved

Who is waiting for whom – and what is everyone waiting for? How should these seemingly conflicting statements be interpreted? Here is an attempt at interpretation, as well as sizing up the problem and the possible solutions.

1 By late 2012 both Glitnir and Kaupthing had presented their drafts for composition of the two estates. The Central Bank, CBI, which needs to accept a composition agreement due to the capital controls, rebutted the Glitnir draft but has not replied to a new draft from Glitnir sent a new in November. Kaupthing has had no answer.

2 The CBI can only give its permission if the minister of finance, Bjarni Benediktsson, accepts the proposal, after presenting it to the parliament economy and trade committee.

3 When Gunnlaugsson claims he is unaware of any solution he is of course aware of the drafts ­– but his words need to be understood in the right context: he doesn’t recognise the solutions put forth by the estates as acceptable.

4 By saying that controls can be lifted when creditors “are willing to assist us” the prime minister seems to mean that when creditors have accepted what the government wants them to accept the government will accept their proposal.

5 The government has clearly indicated that it cannot enter into negotiations with creditors of private companies so how this “assisting” by the creditors should come about is not clear. Nor is it clear how the creditor should be informed as to what exactly is needed to solve issues now blocking a CBI agreement to composition.

6 There are those who warn that by engaging with the creditors the government might make itself liable to being sued, thus creating an unforeseen risk. At the same time, the government seems to be contemplating a legal intervention, which would clearly make it an actor in the game.

7 Further, it is not possible to prevent risk by not engaging since creditors could – and most likely will – at some point lose patience and seek ways to litigate abroad. The worst scenario would be a version of the Argentinian situation where every sum in foreign currency that Iceland pays to fulfil foreign obligation will be litigated.

Below are some points of importance in order to understand the issues at stake.

Two ways to resolve the Glitnir and Kaupthing estates: negotiate – or not

In principle, there are two ways to solve the dilemma of the two estates, i.e. how to proceed with the winding up and eventually pay out what is due to the creditors:

A) Agreement with the creditors, based on composition.

B) Bankruptcy proceedings, meaning i.a. that assets have to be sold within a fairly short time span with less creditor control than with the abovementioned route.

By presenting drafts for composition for both Kaupthing and Glitnir the creditors of these two banks (to a large extent the same creditors, ca. half are institutional bondholders owning bonds of the two banks before the collapse and then hedge funds and others dealing in distressed assets who bought the bonds after the collapse). Composition means that the estates are run as holding companies, owned by creditors, who by selling assets when circumstances are favourable recover over time what there is to recover from the estates.

Recovery from bankruptcy proceedings will most likely be less, which is one reason why the creditors oppose it. Also it means they have less control over the course of events.

Under normal circumstances a government doesn’t engage with bankrupt private companies. In Iceland, the capital controls and laws passed last spring, just before the dissolution of parliament up to the election, changed all of that. At stake are first and foremost the ISK assets of Glitnir and Kaupthing – and the majority is tied up in the new banks, Íslandsbanki and Arion, respectively owned by the estates.

The amount of ISK assets of the two estates totals ISK417bn but differs greatly. Kaupthing’s ISK assets are ISK141bn, whereof Arion’s valuation amounts to ISK116bn. Glitnir owns a good deal more of ISK or ISK276bn, whereof Íslandsbanki is valued at ISK132. Kaupthing owns 87% of Arion; Glitnir owns 95% of Íslandsbanki. The rest of both banks is owned by the Icelandic state.

If the two banks could be sold for foreign currency the Kaupthing ISK problem would be more or less solved. Glitnir has a tougher task. The creditors seem to have some faith in this being possible; others find that hard to believe but it will ultimately all depend on the price.

Who will buy Iceland or rather, the two banks Íslandsbanki and Arion?

Those who buy these two banks will wield great power in the Icelandic business community and in Iceland in general. First, when the idea was floated in the late 1990s that Landsbanki would be privatised the intention of the Davíð Oddsson government (conservative) was spread ownership.

That policy evaporated when the bank was sold to father and son Björgólfur Guðmundsson and Björgólfur Thor Björgólfsson. Eventually, the three big banks – Landsbanki, Kaupthing and Íslandsbanki (later named Glitnir; the new bank has reverted to the old name) were owned and dominated by large shareholders who incidentally were not only the respective bank’s largest shareholders but their largest borrower. No wonder that ownership of the two banks, now for sale, awakes disturbing thoughts.

Who will buy the banks? Foreign investors with no previous ties to Iceland, Icelanders with money abroad, clients (Icelandic or foreign) who got mountains of loans on favourable terms from the Icelandic banks before the collapse? Or the Icelandic pension funds? There is no lack of guesses.

One thing that will clearly affect the price is how the estates will be resolved. With bankruptcy the assets would have to be sold quickly, most likely knocking the price down should two banks be sold simultaneously in Lilliputian Iceland. Conspiracy theorists might feel that if the government eventually acts in a way that lowers the price of the banks – and some investors with intriguing ties to the past banks or with the government parties (or both) – it will be no coincidence.

The official “abolition manager” that never was – and the working group without a chairman

In August, it was announced that “next week” the prime minister would appoint “an abolition manager” to oversee the process of abolishing the capital controls. But nothing happened. According to rumours the two party leaders could not agree on who should be appointed. And no one was ever appointed.

In November, a working group of four was mentioned but by the beginning of the New Year it had grown to six. There is to be no chairman (too difficult to decide on?) but a former banker, Sigurbjörn Þorkelsson is in charge though without the title. He was thought to be the one favoured by Benediktsson as an “abolition manger.” The others are two engineers, Jón Birgir Jónsson (a banker in London) and Jón Helgi Egilsson, lawyers Eiríkur Svavarsson and Reimar Pétursson as well as Ragnar Árnasson professor of economics. This group is now said to be working fast and furiously on mapping out various scenarios for the government.

In principle, no one knows what the government’s policy is in the matters of the two estates; the two party leaders have not specified how they would like to see the bank estates dissolved. Benediktsson has however said that bankruptcy law do not stipulate that composition can be negotiated forever, hinting at some change in the bankruptcy law and possibly that he would prefer rout B).

His comment could also be understood to indicate that the government was prepared to or preparing to intervene in the bankruptcy process with a bill aimed at the estates. That will be a tricky undertaking because, like in most Western countries, assets of estates are protected by laws on property rights. Creditors will obviously challenge anything that smacks of infringement on such rights.

A legal intervention – or any government intervention – will be a u-turn from the government’s present stance on declared and staunch non-engagement. It might well open up a Pandora’s box of possible legal action against the government, not only in Iceland but also abroad.

Neither A) nor B): the “krona-path”

In addition to A) and B) there is another path, which is often mentioned in the debate in Iceland but apparently not always well understood.

According to Icelandic bankruptcy law, the value of a failed company is calculated in ISK, which means that whatever fx it owns is converted into ISK, as well as all claims. This does not mean that that the assets themselves are converted; the conversion is for auditing purposes only.

The assets of the three banks are as follows (in ISK)

ISK                             Fx                                Domestic fx assets

Glitnir             276bn                        614bn                        35bn

Kaupthing      141bn                        570bn                        62bn

Landsbanki     51bn                         405bn                        385bn

There are those who argue – and both Gunnlaugsson and Benediktsson have touched upon this – that the estates should be considered as pure ISK assets meaning that they should also pay creditors only in ISK. This would then create an almighty ISK overhang the moment this was paid out, increasing the already far too big a reserve of ISK owned by foreigners (which after all is what the capital controls are reining in).

How could the creation of a humungous overhang, in addition to the already insurmountably large one, be a solution? Because this would be a way for the state to get a slice of the fx assets, which should then be converted back into fx, but at a much less favourable rate; another possible execution is some sort of exit levy.

A recent ruling of the Icelandic Supreme Court has been mentioned as an argument for the “krona-path”: on September 24 2013 the Court ruled in a case (in Icelandic) linked to the Landsbanki estate. The thrust of the case was that when Landsbanki paid preferred creditors, on December 2 2011 and May 24 2012, the bank used the currency rate on April 22 2009, the day the bank entered into bankruptcy proceedings.** The creditors challenged Landsbanki’s decision, lost in Reykjavík District Court but won in the Supreme Court. Consequently, it is now clear that the currency rate on the day of payment counts.

Those who adhere to the “krona-route” have interpreted this court decision to mean that an estate should pay out in ISK – whereas the decision, according to many lawyers, only says that an estate can pay out in ISK but, most importantly, does not need to. One Icelandic lawyer (not working for creditors) mentioned to me that converting fx assets into ISK in order to pay the creditors could well be seen as expropriation, again exposing the government to being sued by creditors. Since most of the fx assets are outside of Iceland, creditors claiming to be an offer for expropriation could sue the Icelandic state abroad, most likely in London.

Another cause for legal action on behalf of the creditors against the government might be if at some point they feel that by inaction the government is preventing them from accessing their undisputed assets: the fx assets. After all, the fx assets are the property of failed private companies, unrelated to the government as repeatedly emphasised by the government.

The action taken in autumn 2008 with the “Emergency Act” and capital controls was taken under exceptional circumstances. Although the lack of foreign currency poses problems there is no emergency, comparable to October 2008, to justify any exceptional measures. On the contrary, there is time to negotiate terms and conditions.

What the capital controls contain

Ultimately, the government seems to favour not so much a route as a goal: a goal that brings as much to the public coffers as possible.

During the election campaign last spring prime minister Gunnlaugsson repeatedly claimed it was “unavoidable” that in dissolving the estates money would be due for the Icelandic state. As with so many other things, he never specified how exactly this should/would happen but seemed to indicate the “krona-route”: that converting fx assets should/would/needed to be converted into ISK thereby securing great wealth to the state coffers.

An aside here is that most Icelandic economists heartily agree that channelling mountains of ISK into the economy would be an almighty economic disaster. Ideally, any such windfall should be taken aside, if not actually burned. But for some reason, this argument is hardly ever uttered aloud in Iceland.

Before guessing how much is enough for the government, let us revise on how much ISK assets the capital controls contain. As mentioned above, the ISK assets of Glitnir and Kaupthing amount to ISK417 bn. The “glacier bonds” – essentially invested in carry trades in the years before the collapse – now amount to ISK340bn. Since this is money owned by a diverse group there is no one to negotiate with.

Further, these assets might partly be “patient” money, not waiting to run out of Iceland where interest rates are still attractive. There is also intriguing evidence that ca. half of the “glacier bonds” is owned by… Icelanders who bought it at a knock-down price after the collapse (which might be why this is not much talked about any longer as a problem, all the focus being on the “vulture” hedge funds” as they are often referred to in the Icelandic public debate). The last batch of foreign-owned ISK is the Landsbanki bond, debt of new Landsbanki to the old Landsbanki, now ISK247bn.

In total, the ISK assets contained by the capital controls are close to ISK1000bn. However, dividend in the new banks, which is not paid out, piles up so the problem is not diminishing but increasing. And then there are the classic collateral damages of controls such as less investment and corruption.

How much is enough – and the narrative to support it

Then there is the question: how much is enough for the government? How much, measured in krona, is the value of the “willingness to assist,” from the point of view of the government? Ultimately, it depends on how the government views the estates: as a problem to solve – or a rich fishing ground.

Consequently, there are two possible answers:

1 Enough to run a sustainable economy where a balance of payment will ultimately decide the course of payment of ISK assets. This is a calculation the CBI is working on. Leaving aside the “glacier bonds,” the problem is the Glitnir and Kaupthing assets as well as the Landsbanki bond, in total ISK665bn. This is not an insurmountable sum, the creditors know they will not get the whole amount, are willing to negotiate (if they can find anyone to talk to) and there are state-owned assets (in the CBI holding company, ESI), which could be part of the solution. – If this procedure is followed there is however nothing for the government to lay its hands on because ultimately this is not a process, where the government is involved except to secure financial stability as spelled out by the CBI.

2 Considering how prime minister Gunnlaugsson has spoken – and indeed promised Icelanders – he and his party clearly do indeed see the estates as a fishing ground, ready to be exploited. Finance minister Benediktsson has never uttered anything in this direction and there are indications, i.a. from the appointment of an abolition director that the two party leaders do not see eye to eye in this matter. It is by now a well-established pattern in the political debate that the prime minister says X and then a few days later the finance minister says Y on the same matter. From sources close to the two coalition parties, I hear that the ultimate goal should be all of the ISK assets of the two estates and a slice of the fx assets – otherwise, the financial stability of Iceland is threatened. I am not claiming this is what the two party leaders have in mind, only that this is consistently heard from sources close to the two leaders. – The path would probably be some version of the “krona-path” and a legal intervention.

Both ministers have consistently said that the new banking levy, also on the estates (quite unorthodox to tax debt; will most likely be challenged by the estates; another saga for another day) is only natural because of the cost the banking collapse caused the Icelandic society (though how the new banks, founded after the collapse, could have caused harm is a bit of a mystery). This narrative might also well be used to argue for a “catch” from the estates (though again, this spreading of the original sin could be debated).

The tax, calculated to cost the three estates ISK120bn over four years, is an interesting sum because it indicates to the creditors that this is at least the sum wanted by the government. This sum could then be the starting point in a negotiation though, if the rumours I keep hearing, this would be very far from what the government has in mind.

The fact that Iceland won the case that the EFTA Surveillance Authority, ESA, brought against Iceland because of Icesave, emboldened the leadership of the Progressive Party. The fact that Icesave was not resolved with the British and the Dutch had two drastic consequences: it moved the ownership of Landsbanki over to the state meaning that the state, at least indirectly, guarantees a bank – and in addition burdens the state through the Landbanki bond. This is not part of the “Iceland won Icesave-saga,” as commonly told in Iceland.

In the Icelandic debate on the estates and the creditors it can at times sound as if it is decidedly un-Icelandic not to seek a “windfall” from the creditors. To be on the side of the rule of law in this matter does not seem enough. No doubt, the tone will become harsher at the hour of decision.

Contrary to natural catastrophes such as earthquakes and eruptions, the catastrophes stemming from wrong political decisions unfold over a long time. The consequences will be felt long after the term of this government comes to an end.

* Glitnir Winding-up Board has today made an unexpected move: it has hired MP Bank’s Corporate Finance Division as a financial advisor in finalising a composition agreement, to “independently review and evaluate solutions to that end.” Especially ALMC (former Straumur Bank, already through composition, now operationg under a new name, ALMC), which seemed to be sure it was going to act as Glitnir’s advisor. The intriguing part of this assignment is that a close friend and advisor to prime minister Gunnlaugsson, Sigurður Hannesson is head of private banking at MP and the CEO of MP, Sigurður Atli Jónsson, is the prime minister’s brother in law. Whether this intimacy will simplify Glitnir’s task in guessing what is enough to negotiate composition remains to be seen.

**The legal procedures are described here, p. 6, for Kaupthing; the same counts for Landsbanki and Glitnir.

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Thinking back to five years ago, Iceland was forced to take the right decisions, not saving the big banks. But that was perhaps the easy decision: after all, the major part of creditors in these banks were foreigners. Later on, frantic attempts were made to save the very Icelandic banks, i.e. Saga Capital, VBS and some saving societies. Now, the idea is to tax estates where foreigners are ca. 90% of creditors whereas other failed financial companies are not taxed. “Fuck the foreigners” was a policy after the collapse – and it still seems to be the only policy five years after the collapse.

Last week, in the policy speech by prime minister Sigmundur Davíð Gunnlaugsson Icelanders were told that Iceland is a country almost too good to be true. However, for basic principles Iceland is less good. One of the basic principles is that property rights are inviolable. Some wonder if such principles still count in Iceland.

Part of the budget proposals, put forth last week, is that estates of the failed banks should be taxed. Taxing debt is a novel thing, remains to be seen how that idea fares. The proposal is vague as to how and what is being taxed. The proposal mentions the estates of Kaupthing, Glitnir and Landsbanki. The justification is that these three banks caused a lot of damage to Iceland – another novelty: tax is based on the principle of damage and the perceived good and evil.

There are however other failed financial institutions that did indeed cause a lot of harm and cost: Saga Capital and VBS, to mention just two, in addition to SpKef, Byr and others: the government did indeed try to save the two first ones and lost a lot of money on the attempt.

The intention seems clear enough. It would indeed be much more clear-cut if the definition was plainly to tax “estates where major part of creditors are foreign.”

Now on the fifth anniversary of the bank collapse politicians have been reminding Icelanders of the harm foreigners have caused Icelanders, i.a. the British actions five years ago against Kaupthing and Landsbanki. Less has ben said of what went on in the years before these few fateful days. And no mention is made of the fact that Icelanders, contrary to most other crisis-struck countries do actually know what happened and why: there is the SIC report that gives a clear and concise account of what happened.

The prime ministers is untiring in telling Icelanders what a great nation Iceland is. It is interesting to keep in mind the political rhetoric in Argentina. In any free country, i.e. a country, which is not locked up inside capital controls, citizens can vote with their currency, in the sense that if they do not like the policy they can go abroad. In Iceland – and in Argentina – that is not possible.

Both in Argentina and Iceland politicians constantly remind their countrymen of the unfair foreigners. In Argentina, this has been going on for almost 13 years. In Iceland, it is just beginning.

Qui vivra verra – but so far, Iceland seems to be emulating Argentina in trying to be a country that writes its own rules, forcing these rules on its citizens because they cannot go anywhere else and acting as if the outer world does not matter. Argentina, after almost 13 years, is waking up to the fact that this may not be that easy. Iceland still has years to find out if isolation matters. As one economist puts it, capital controls strangle the economy.

The weather has been glorious these days of the fifth collapse anniversary, as seen on the photo, taken on the outskirt of Reykjavík (for those who know Reykjavík it was taken out on the tip of Seltjarnarnes last night), truly if feels as a view of forever. In truth, the view here seems to be the view into populism, the only fast-growing thing within Iceland of capital controls.

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There is yet no clear plan in sight as to how to deal with the estates of the failed banks and, eventually, lifting the capital controls in Iceland. However, the fact that the government has declared it intends to use a given “wind-fall” from the estates indicates that there is a certain wish(ful thinking). The question is how this “wish” will materialise – and most of all, if the creditors will stage some counteraction, either as a group or single creditors, to seek to claim their foreign assets in foreign courts.

“I hope to see you and your money! in Iceland,” said prime minister Sigmundur Davíð Gunnlaugsson at the end of his speech at “Iceland Investment Forum” in London September 19. His words were met with laughter, more nervous than merry. Many of those present are creditors to the Icelandic banks, possibly not eager to invest more in Iceland until the fate of their last investment is clear.

In his speech the prime minister sought to stress that Iceland was keen to receive foreign investors in Iceland. “My government understands that vibrant business and industry is the basis of growth and welfare. We, therefore, welcome investments in Iceland and are willing to create an environment that is conducive to your needs as investors.”

Interestingly, last Saturday the prime minister said on Rúv that Iceland was not necessarily in need of foreign investments. Although foreign investment might in some cases bring the added value of knowledge, it was essentially a foreign loan; foreign investors just intended to get more out of their investments than they put into it. – An interesting insight into the PM’s business acumen.

In his London speech the prime minister did air his so oft repeated statements of the “leeway” in the estates of the fallen banks:

This brings me to my fourth point, namely the necessary settlement of debts of failed financial undertakings and assets of insolvent estates. My government intends to take advantage of the leeway, which inevitably will develop in tandem with the settlement of the insolvent estates, to address the needs of borrowers and persons who placed their savings in their homes. I have described this as a win-win situation as these settlements will allow us to lift the capital controls to the benefit of the creditors and borrowers alike.

The intriguing question for creditors is what this means for their recovery.

Spending time in Iceland recently I sought to gather impressions on a possible plan regarding the estates. My feeling is that this win-win situation will mostly apply to the government. For the creditors it might be more lose-lose in terms of their Icelandic assets though everyone with interests in Iceland will eventually win-win by having the capital controls lifted.

No doubt the creditors are aware of this – and might be contemplating their next move. In total, the claims against the three estates run to ISK7836, €47.6bn. The three estates hold ISK2750bn, €16.7bn. The difference is what the creditors have already lost.

So far, the estates’ foreign assets amount to ISK1793 bn, €11bn (Central Banki of Iceland, CBI Financial Stability 1, 2013, chapter viii). Of this sum, 57% is liquid funds. Although these are foreign assets, to a large extent held abroad and do not threaten the financial stability of Iceland, the CBI has not allowed them to be paid out, thus securing that Icelandic authorities keep an upper hand in the wrangle over the estates.

The Icelandic upper hand could however quickly turn limp if the foreign creditors, either as a group or single creditors, would choose to test their luck abroad. The fact that the government has only yesterday levied tax on the estates, could possibly instigate legal action, in this case from the estates themselves.

Below, I will try to go through issues related to the capital controls as things stand now. The topics of interest are the Landsbanki bonds, a recent Supreme Court ruling in Iceland regarding old Landsbanki, LBI, guesses as to what the government might be contemplating and what the creditors might be contemplating.

The reality behind the Landsbanki bonds

The three failed banks – Kaupthing, Glitnir and Landsbanki – were, each of them, split in two parts. Not bad and good bank, as might have been logical, but into an domestic operating bank, overtaking domestic, i.e. Icelandic, deposits and other domestic assets and liabilities and then an estate holding foreign deposits and other foreign assets and liabilities. Thus there are the three estates – LBI, Glitnir and Kaupthing – and respectively the new operating banks, Landsbankinn, Íslandsbanki and Arion Bank. The two latter are owned by the estates, i.e. the largest assets of the tow old banks are the two new banks whereas the state owns Landsbankinn.

Because of Icesave – the Landsbanki internet accounts set up in the UK and the Netherlands 2006 and 2008 – the main creditors of LBI are the deposit guarantee schemes of these two countries, both with priority claims. To some degree there is an overlap between the general creditors of the three banks. Around half of the creditors are the original bondholders; the rest has bought claims on the secondary market.

Due to uncertainties regarding Landsbanki assets, the new bank, Landsbankinn, eventually issued two bonds to LBI, to be paid in 2014-2018, mostly in foreign currency. It has been clear for a while that the scheduled repayments are too steep for the economy, i.e. LBI does not holds enough foreign currency to cover the repayment and there is not enough left on the current account for it to buy from the CBI.

The payment schedule is: 2014 ISK17bn, €100m, then ISK60-74bn, €360-450m, the next three years, having then paid the bonds in full 2018. It is disputed how much is needed. The numbers flying around have ranged from ISK50bn, €300m to 200bn, €1.21bn. This does not mean the new bank doesn’t have the funds to pay. It does, but not in foreign currency.

Under normal circumstances, a bank never pays up all its debt in full but refinances. As things are now, that is not a realistic option for any Icelandic financial firm – Icelandic financial companies do not have access to sustainable funding. That could change but for the time being the option is not there.

The Landsbanki bonds, its stakeholders and a step towards abolishing capital controls

After some wrangling between Landsbankinn and LBI, echoing in the Icelandic press this summer, the two entities have now entered into negotiations “on possible adjustments” to earlier settlement regarding the bonds (press release here).

The outcome will be interesting for several reasons: it will remove a certain threat, explained above, to Landsbankinn and its owner, the Icelandic state; it will indicate positions of those negotiating the bonds – and it is a first big step, regarding the estates, towards abolishing the capital controls. The numbers at stake here are considerable: the expected recovery of LBI is now ISK1531bn, €9.29bn with priority claims at ISK1325, €8.04bn. This leaves ISK206bn, €1.25bn, for general claims.

The management of Landsbankinn seems to have felt that LBI was not being very forthcoming in negotiating. On the LBI side the priority creditors, essentially the Dutch and the British governments, certainly have a lot to say on this issue.

The Dutch and the British governments stand to recover their Icesave compensations, i.e. minimum compensation of €20.000 for each depositor. They have already recovered 53.9% of what they expect to get, paid out in three instalments. However, it makes quite some difference to them if they recover everything by 2018 or have to wait considerably longer.

From what I understand there is still some pent-up Icesave irritation among the Dutch and the British negotiators. But the general creditors have also been vocal on rescheduling. Although they stand to get “only” ISK206bn, this is money as well. But since general claims are not paid out until priority claims have been paid out in full, any extension of the Landsbanki bonds will mean that their waiting is prolonged.

The CBI views the rescheduling as the first firm step towards abolition of the capital controls. Many of the general creditors are also creditors to the two other banks, making the Landsbanki bond negotiation interesting in terms of issues that need to be settled re the two other estates. The Landsbanki negotiations can thus be seen as a dress rehearsal for the full performances to come.

Landsbanki bonds – possible solutions

It is clear to everyone involved that the Landsbanki bonds need to be extended. The prospect of the Icelandic economy will be debated, in terms of what could possibly be set aside of foreign currency towards bond payments but also to what extent Landsbankinn could possibly refinance its debt. All of these issues will be mulled over by those negotiating the rescheduling, in addition the more specific terms and conditions of the bonds themselves.

In Iceland, it has officially be mentioned that the rescheduling needs to be “a few years” but that seems far too optimistic. Ten or 15 years seems a more reasonable number. As it is now, the interest rates are low, which means that interest rates will no doubt be negotiated.

Landsbankinn and its owner, the state, are obviously unwilling to see the bank fail. With the bonds being a sizeable chunk of the LBI assets, its creditors are no doubt adamant to secure that the bonds get paid – if not on time then in the foreseeable future.

It is however very difficult to imagine that LBI will agree to any extension unless the creditors get something substantial in return. The intriguing question is what this “substantial” could be. An obvious bit would be a substantial up-front payment. Steinþór Pálsson CEO of Landsbankinn has already mentioned (in Icelandic) a sum of ISK70bn, €420m.

Another – and a truly interesting “substantial” – would be for the LBI to get a permission from the CBI (which has to agree to all payments) to pay out all the foreign assets of the LBI. The reason this is so interesting is that so far, none of the estates have paid out any of the foreign assets, although they, as pointed out above, to not threaten financial stability in Iceland.

At a meeting in London September 26 possible solutions were introduced. It is a pure guess as to what exactly has been offered to the LBI but it is difficult to imagine that the creditors will not try to use their bargaining position to get their foreign assets paid out.

And it is also clear, that the prime minister and Bjarni Benediktsson minister of finance, representing Landsbankinn’s owner, will need to accept whatever solution is negotiated. It must be equally likely that only a solution that the owner accepts a priori will be seriously discussed.

The two tales of a Supreme Court judgment re LBI

September 24, the Icelandic Supreme Court ruled in a case (553/2013) brought by creditors of LBI, both priory and general claimants and the Icelandic state against the LBI. The case centred on how partial payments in foreign currency should be calculated, i.e. what ISK exchange rate should be used. The LBI had used the exchange rate on April 22 2009, the date when the winding-up proceeding commenced. The Reykjavík District Court had originally ruled in favour of LBI but the Supreme Court reversed that ruling.

This case has been interpreted in two distinctly different ways in Iceland, basically spinning two different tales.

The first one is a low-key tale: this ruling brings no fundamental changes. It points out, what was already known, that once the winding-up proceedings starts the assets in an estate holding foreign assets are converted into ISK, for accounting purposes. An estate can – but does not need to – pay out in foreign currency. The exchange rate for payment in foreign currency should be the rate on the day of the payment. This is how several lawyers have interpreted the ruling in the Icelandic media.

The other interpretation is a more sensational tale, so far mostly heard from politicians, i.a. the minister of finance: this ruling is a fundamental confirmation that the estates are in ISK and should only pay out in ISK.

It is interesting that both creditors and the Icelandic state supported the conclusion of the Supreme Court. The motive behind the state’s view is a remnant from the Icesave case where it held the view that the exchange rate on payment day should be used, hoping in due course to gain from ISK appreciation, as a set-off against the interest rates.

Is paying out the estates in ISK the way out of the ISK dilemma?

As mentioned above, the three estates hold ISK2750bn, €16.7bn, of which 2/3, ISK1800bn, €11bn is in foreign assets and 1/3 is ISK assets. This 1/3 is part of the problem that the capital controls keep at bay: there is not, and will not be in the foreseeable future, enough foreign currency to convert these (and some others) ISK assets, owned by foreigners. This problem is further crystallised by the fact that 5% of the claims are domestic, 95% foreign whereas 33% of the assets are domestic, 67% foreign (Central Banki of Iceland, CBI Financial Stability 1, 2013, chapter viii).

Listening to politicians following the Supreme Court judgment, it sounds as if paying out all of the assets of the estates in ISK, the total ISK2750bn, would be the solution to the ISK problem. A priori, as seen from the numbers above, paying all out in ISK can hardly be a solution to anything but only make a huge problem utterly humungous.

Unless, of course, something else is done as well, such as offering the creditors, now holding nothing but ISK, a certain exchange rate in order to exchange their Hvannadalshnjúkur (the highest summit in Iceland) of ISK into foreign currency, with the government then having found its frequently mentioned “leeway” there. More on that below.

As an Icelandic lawyer (not working for the creditors) said recently: “If Iceland wants to remain on good terms with the outer world the estates will be allowed to pay out their foreign assets in the foreign currency they own,” meaning that the ISK problem needs to be solved separately.

Glitnir, Kaupthing and composition

Glitnir and Kaupthing have both applied for an exemption from the capital controls, under the Foreign Exchange Act No. 87/1992 in order to proceed with composition. In this respect, composition means that the estates will be run as holding companies, working on recovering and realising assets on behalf of creditors and eventually paying out the funds recovered.

From the point of view of creditors this process is preferable to bankruptcy proceedings because a bankrupt estate needs to sell off assets in a shorter time. One of the comments heard in Iceland after the LBI ruling was that bankruptcy would allow for all assets to be paid out in ISK. This is however wrong. There is no difference as to payment between composition or bankruptcy.

Both Glitnir and Kaupthing sent an application for composition to the CBI before end of last year. CBI has not answered but following a query this summer from Glitnir, the CBI has now answered Glitnir in a letter September 23. The bank emphasises that analysis of the situation of the Glitnir estate is on-going, both within the bank and the estate.

Although a detailed analysis is not yet complete, it is clear that the Central Bank of Iceland cannot give a positive answer to the Glitnir winding-up committee’s exemption request without a solution concerning the assets that, other things being equal, will have a negative effect on Iceland’s balance of payments when they are disbursed to creditors, 93.8% of whom are non-residents, as is stated in Central Bank of Iceland Special Publication no. 9. Reference is made here to the classification of creditors, to Glitnir hf.’s króna assets (including shares in Íslandsbanki), and foreign-denominated claims against domestic parties. In order for the Central Bank to be able to grant an exemption for the above-mentioned composition agreement, there must be a solution concerning these assets, so that Iceland’s balance of payments and planned capital account liberalisation provide scope for disbursement to foreign creditors. It is important to emphasise that this is not a matter for negotiation. Either this condition is fulfilled, or it is not. Glitnir’s exemption request does not fulfil this condition at present.

In view of the foregoing, the Central Bank considers that there are no premises for setting up a process of the type proposed in the winding- up committee’s letter, and certainly not one subject to binding time limits. It is the role of the Glitnir hf. winding-up committee, in connection with its exemption request, to create the conditions that allow for the approval of an application for a composition agreement. As before, the Central Bank of Iceland is prepared to assess whether it is likely that specified options fulfil the above-mentioned conditions. If the Glitnir hf. winding-up committee has developed ideas of this type, as is asserted in its letter, the Bank is ready and willing to discuss them.

This letter indicates that the estate – and this would assumedly apply to Kaupthing as well – will need to come up with a solution on the ISK assets. The CBI is not going to negotiate though it seems to indicate willingness to engage in assessing if conditions are met or not.

Creative taxing: taxing estates of financial companies

The first action taken by the new coalition government, in power since May, regarding the estates of the fallen banks is a tax on the estates of failed financial companies, announced October 1 in the budget proposal for 2014. Bank tax will be increased from 0.041% to 0.145%, levied on all licensed financial companies, operating or in winding-up proceedings.

At first sight, this might seem to indicate all financial companies in winding-up proceedings, i.e. the three estates but also other failed financial companies such as Saga Capital, VBS, Icebank and some saving societies. However, according to the FME (Icelandic FSA) website over licensed financial companies there is only one such licensed company, now in winding-up proceedings, LBI. The other failed financial companies have all lost their licensed status and are mere holding companies.

The idea was hardly to tax only LBI but as the proposal stands, the tax apparently only hits LBI. If the tax should cover the other estates the proposal, as far as can be seen, needs to be rewritten or clarified along the lines of “companies, which were once licenced/licensed before/after anno XXX as financial companies…”

Taxing estates is, I’m told, normally not done and has, to my knowledge, never been the practice in Iceland, anymore than in other countries. Lawyers have mentioned that a tax on failed companies could be seen as an expropriation. The ministry of finance has definitely shown remarkable creativity here.*

What the government wants – all of the ISK assets and/or even more?

It is safe to conclude that the Progressive Party was voted to power on the basis of its election promises of finding a “leeway” in the estates of the collapsed banks in order to provide what the prime minister has called the most extensive debt-relief in the world. He has been unwilling to mention any numbers but one persistent number is ISK300bn, €1.8bn.

The debt-relief has been widely criticised, i.a. because of inflationary effects, by economists. It also goes against promises of the Independence Party of a sustainable fiscal policy and paying down public debt.

The government and some businessmen have been pointing out lately that it is wrong to portray the problem of capital controls as touching solely creditors locked in with their assets in Iceland. All Icelanders are locked in. Consequently, drastic moves are needed to abolish the controls.

It now seems that one of the solutions possibly contemplated by the government is to “take over” all the ISK assets and possibly some of the foreign assets – though how this would be possible is still unclear. The motive for this drastic move is that the Icelandic current account will not, for the many coming years, allow for any foreign currency to be used to convert ISK assets of foreign creditors.

Those who propose this “take over” seem to feel that the “ISK-isation” of the estates, i.e. regarding all the assets as ISK assets and paying them out in ISK, is an essential move. Writing the assets down via the exchange into foreign currency would then be one possible way of achieving this “take over.”

Although – as far as I can see – creating quite a number of problems, this would however solve two fundamental problems for the coalition government: it would provide the Progressive Party with the ISK300bn, or whatever it will decide is needed for the debt relief – and it will placate those within the Independence Party who think that “estate-windfall” should benefit Icelanders in paying down public debt.

From the numbers above, it is possible to guess at the numbers involved: all the ISK debt is about 1/3 of the estates, ISK950bn, €5.76bn, meaning there would be something like ISK650, €3.94bn, out of this process, a third of Icelandic GDP, to pay down public debt. Given that the Icelandic public debt to GDP is forecasted to be just below 100% of GDP this year, this sum would reduce the debt by a third.

Will the government proceed with these ideas? Time will tell. Relevant ministries and the CBI all have legal opinions at hand, underlining Icelandic law on property right, the importance of keeping all actions within Icelandic law etc. But if the wishful thinking becomes so strong, fuelled by little sympathy for foreign creditors, one never knows. All solutions can be made pretty in an excel document – but to turn them into something that withstands legal challenges and doesn’t just solve the problem like warming one’s toes by peeing in the shoe is quite another matter.

What the creditors could do

Five years from the collapse in Iceland, the capital controls are still in place and the foreign creditors have not yet received any of their assets, apart from the priority creditors to Landsbanki. The priority claimants to Kaupthing and Glitnir have already been paid out, respectively ISK130, €790m and ISK54bn, €330m.

Faced with the possibility that their assets will now be gnawed into by tax, it is seems likely that the estates will take a legal action to challenge the new taxation.

It has taken some years to clarify various legal issues. From the point of view of the foreign creditors, the cash part of the foreign assets – ISK1029bn, €6.24bn, of the ISK1793bn, €10.88bn or 57% – is just waiting there to be paid out.

However, that is not happening as long as the fate of the ISK assets has not been settled. And after a change in the foreign currency law in March 2012, the CBI has to agree to, give exemption to, all payments of the estates.

The bondholders and other creditors may eventually lose patients and sell their claims. In Iceland, much is made of the huge profits made by creditors. That is somewhat misleading. The bondholders have already incurred huge losses though large institutions have no doubt sought shelter behind CDS. Depending on when the buyers in the secondary bought some of them will profit handsomely.

Invariably when creditors lose hope and patience claims get sold and the buyers are those who specialise in difficult assets. These creditors use the courts as much as they can. From small creditors in the Icelandic banks I have heard that there is no lack of suitors from this pack.

It is difficult to avoid the thought that at some point the creditors might lose patience – either as a group or single creditors – and seek legal action against the Icelandic state. That would then most likely start with proceedings where the foreign assets are, to get the assets frozen, after which the creditors would try to prove that they have been waiting needlessly long and nothing is being done to solve the issues.

The Icelandic government has, until earlier this year, not been party to the fate of the estates. With a change in the foreign currency law (nr. 87/1992), the minister of finance and minister of banking have to agree to CBI exemption regarding companies with a larger balance sheet than ISK400bn, €2.42bn, which includes the estates.

This might prove to be a double-edged sword in the sense that the government now risks to be sued because of the estates of the collapsed banks.

The creditors are much vilified in the Icelandic debate, seen as vultures and predators and no politician mentions them without these words. It is ironic that now on the fifth anniversary of the collapse there are again foreigners to blame, thus clouding the fact that the creditors are there as a result of actions taken by a group of ca. thirty Icelanders.

There is much at stake for the creditors, as there is for everyone who stands to gain from the abolition of the capital controls. But those who can gain most from a successful abolition – and consequently stand to lose most from mishaps and delays – are Icelanders themselves. Hopefully, all those involved will recognise this and have the good sense to seek constructive solutions. As an economist said recently: “Capital controls are a slow death.”

*At a closer look, the three estates – of Kaupthing, Landsbanki and Glitnir – are named in the budget proposal (the budget proposal, in Icelandic). As mentioned above, there are other estates of failed financial companies in Iceland but apart from size, the real difference between these other estates and the three big estates is that in the small ones most of the creditors are Icelandic whereas the creditors to the three big ones are 93% foreign entities. – The text seems ambiguous and will most likely be clarified at some later stage.

These are all complicated issues. I hope I haven’t made mistakes, will correct them if found. However, I hope Icelog readers do check the sources if needed.

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Again and again prime minister Sigmundur Davíð Gunnlaugsson has been asked about his exact plans for the abolition of the capital controls. But so far, it is entirely unclear how the government plans to proceed on debt relief, the estates of Glitnir and Kaupthing, the issues concerning Landsbanki and ultimately the abolition of the capital controls. There are by now some indications that the two coalition parties find it difficult to advance on these issues because the two parties disagree much more fundamentally than has appeared hitherto.

During the election campaign Sigmundur Davíð Gunnlaugsson leader of the Progressive Party and now prime minister said there was scope to get a considerable sum of money out of the estates of Glitnir and Kaupthing. These funds were to be used for a “correction fund” to finance debt relief for those whose loans had gone up but who had not profited from the extensive debt relief, the so-called 110% way (explained here), put in place by the previous government.

The voters seemed untroubled by the fact that the Progressive Party never clarified in detail how exactly this considerable sum could be extracted from the estates, which after all are the estates of two failed private banks. The fact that the government needs to agreed to terms of the composition of these two banks – due to the foreign-owned ISK assets (not enough foreign currency to exchange the ISK assets) – has been presented by the Progressive Party as a way to create this, in Progressive-speak, “scope” to gain funds.

In the coalition agreement the following (in my translation) is stated:

As indexed debt increased and asset prices fell, i.a. because of the effect of the collapse of financial firms and because of their appetite for risk leading up to the collapse, it is right to use the scope – which will most likely be created parallel to the winding down of the estates (of the collapsed banks) – to assist borrowers and those who put their savings towards their homes, just like the Emergency Law (passed on October 6 2008) secured that the assets of the estates were put to use to defend financial assets and to resurrect domestic banking. The Government keeps open the possibility to set up a special correction fund to reach it goals.

This was neither elegant nor clear (the clunky prose reflects the Icelandic original). Then came the opening speech of the prime minister as Althing gathered in early summer but the speech threw no light on how this “scope” would be created.

Last week, the prime minister was interviewed on Rúv’s morning programme where the two journalists asked the prime minister if he could clarify what people could expect in terms of debt-relief, the funding of the “correction fund” and how the estates would be treated. The prime minister said he now was much more optimistic than earlier, the “scope” was much greater than he had expected but unfortunately he did not share with listeners what his exact plans are. He did say that he had by now talked about these issues so often that it should be clear what he had in mind but as the journalists pointed out it is still not clear because it has never be clarified.

Yesterday, Althing gathered again after the summer recess. In his speech (in Icelandic) there was one sentence on the capital controls (my translation):

New plan on the abolition of the capital controls is forthcoming. A special consideration will be given to minimising the possible negative influence of the winding-up of the collapsed banks and to strengthening the framework of the financial system, which is one of the prerequisites of a successful abolition of the controls.

Tonight, the prime minister was interviewed on Rúv and yet again he was asked about the by now usual topics: the “correction fund,” the capital controls and what people could be expect in terms of debt relief. Again, no clarity, no detail but the prime minister said one rather remarkable thing: if people wanted to understand better what to expect they could calculate it from the coalition agreement. – Having read the agreement back and forth, I can’t possibly find anything in the agreement that gives any clear indication as to what people can expect. (I have sent an email to the prime minister’s spokesman asking what part of the agreement the prime minister is referring to and how that part can be used in the way the prime minister indicates.)

Clear what the creditors want – unclear what the government wants

During the election campaign earlier this year Bjarni Benediktsson leader of the Independence Party and now minister of finance repeatedly said that abolishing the capital controls was easy and would not take long. That might be true if there were a plan in place to abolish them. That plan does not seem to exist – or at least, nothing credible has been heard of it.

The Central Bank of Iceland has clearly done extensive work in terms of clarifying the macro economic aspects of the economy. The estates of Glitnir and Kaupthing, as well as the creditors have also done extensive analysis of the financial situation of the estates.

The prime minister has indicated that he is now waiting for the creditors to make a move. However, he seems to ignore that the creditors have already made a move: both Glitnir and Kaupthing have presented a detailed draft of composition to the CBI – but so far no answer. It is abundantly clear to the CBI what the creditors want. The only unclear thing is what exactly the government wants to do and how it wants to proceed.

Keep Icelandic banks Icelandic

The CBI has indicated that if one of the two new banks – Íslandsbanki and Arion, owned respectively by Glitnir and Kaupthing – could be sold to foreign investors the sale, in foreign currency, would facilitate solving the problem of the foreign-owned ISK assets. There is already news that Hong Kong investors have shown interest in buying Íslandsbanki and other offers might surface.

Without intending to launch some conspiracy theories it is safe to assume that parts of the political establishment and parts of the Icelandic business community want to keep ownership of the Íslandsbanki and Glitnir on Icelandic hands. If the government listens to these voices, as it well might do, it is highly likely that part of its equation is not only how to create the “scope” for finding the money for the “correction fund” but also how to keep the two banks in Icelandic ownership.

This angle of the whole controls conundrum does not make it any easier to solve and it adds yet another political non-financial hurdle to the process.

Landsbanki – a special case

Landsbanki is owned by the Icelandic state because the two major creditors of old Landsbanki – the Dutch and the UK government (harking back to the old Icesave saga) – were not willing to assist in setting up the new bank, in the same way the creditors of Glitnir and Kaupthing agreed to when Íslandsbanki and Arion came into being. Therefor the state had to step in to capitalise the new bank.

There is now the problem that new Landsbanki owes the old one ca ISK270bn, €1.67bn, in two bonds, due in foreign currency by the end of 2018. The first step towards resolving the capital controls is to find a solution to the Landsbanki bonds, i.a. extending maturity of the two bonds, changing interest rates etc. The new bank has mentioned it needs a “few years” – 15-20 years seems a more realistic solution but nothing near this number has been mentioned officially.

Is there really a majority for the Progressive’s debt relief?

As explained in an earlier Icelog, many have criticised the debt relief ideas but that does not deter the prime minister from advocating this with great fervour. However, there is also strong criticism from some members of the Independence Party parliamentary group. The last few days I have heard musings that there really might not be a majority in parliament for the kind of debt relief the Progressive Party has been advocating. At least one IP parliamentarian, Vilhjálmur Bjarnason, has aired his views openly, saying he could not support the kind of debt relief the Progressives have in mind.

In addition, there seems to be disharmony at the core of the coalition government as to how to proceed regarding the capital controls. Some weeks ago it was announced that the government was just about to appoint “abolition coordinator” who would oversee the process towards abolishing the capital controls. Two names were mentioned as the most likely ones, one from each party. So far, nothing has been done because it seems the two parties cannot agree on whom to choose.

So far, there is a complete lack of clarity as to how the government will go about solving the problems that have to be solved in order to abolish the capital controls. The feeling is that since the government does not know where it is going it is not likely to get there any time soon.

*Here is an earlier Icelog explaining the financial aspects of the capital controls.

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