Sigrún Davíðsdóttir's Icelog

Friday 6 March Central Bank of Iceland changed rules for offshore króna investment in order to prepare for lifting capital controls. Restricting the investment possibilities might seem only to increase the króna pressure, not lessen it but this step is a first step or half a step: further measure for binding these funds or attracting them with good offers will follow. This is a step in the right direction – but only if other measures follow. And so far, there is nothing to indicate that there is any rapprochement in diverging views on how to solve the ISK problems of the estates of the old banks. The problem is that the government seems to be looking for a solution that does not exist – and this is very time-consuming as the Scot looking for a penny where he had not lost it found out

Foreign-owned króna, or offshore króna, was the original problem, which on November 28 2008 called for capital controls. At the time, this overhang amounted to 44% of GDP but has since dwindled down to 15%. The rules regarding investment of offshore ISK have now been changed.

The new amendments to the CBI exemption lists and to the Rules on Foreign Exchange and the Foreign Exchange Act mean that there are now only two option for the offshore ISK to invest in: Treasury bills and one Treasury Bond, RIKB 15 0408. As before, interests earned can still be taken out of the country.

Restrictions might seem counter-productive – but this move is the first one: other investment offers will follow. To Reuters CBI governor Már Guðmundsson said the aim is to reduce the overhang and to induce investors to stay in Iceland when further steps towards liberalisation will be taken. “… it would be very imprudent if we were just to assume that these 15 percent were stable… We will shortly be offering investors alternatives … and these alternatives are such that they will greatly reduce the likelihood of instability when controls are lifted.” Guðmundsson said that further measured will be announced in a “few weeks or very few months.” Minister of finance Bjarni Benediktsson said to Rúv that the work is aimed to finish within the first half of this year.

There have lately been changes in the government’s advisers: now Eiríkur Svavarsson has left. The rumour is that Glenn Kim has not been seen much in Iceland lately. And as before: no official announcement of any changes, neither of Svavarsson leaving or the new member, Ásgeir Helgi Reykfjörð Gylfason, who recently joined the government’s group of advisers.

The focus of these measures is only offshore ISK. Still unsolved are the foreign-owned ISK assets in the estate of the failed bank, admittedly the politically most difficult nut to crack. It seems that instead of using tried and tested measures from other countries with capital controls the government is trying to find a solution that does not exist. Meanwhile, Iceland is trapped in capital controls.

CBI’s new measures – in detail

Those holding RIKB 16 etc are not being forced to give up their holding – but for reinvestment there is nothing on offer except about-to-expire maturity and Treasury bills. The crude choice for the offshore ISK owners is either to use deposits accounts to keep their funds or accept the new double offer of Treasury bills or RIKB 15 0408, which is maturing 8 April. Amongst those who follow things in Iceland the feeling is that the imminent maturity was a significant reason for acting now considering the fact that maturity of a big issuance is in sight.

At the end of January foreign-owned RIKB 15 amounted to ISK18.7bn (might have changed in February since RIKB 15 could be swapped for RIKB 17; now no longer possible). The RIKB 16, maturing 13 October 2016 is a much larger issuance where foreigners owned ISK57.9bn.

The effect of the changes is that offshore ISK holders cannot swap to longer maturity. Longer maturity gives less impetus to leave, creating possible hold-outs and unforeseen behaviour, from the point of view of the CBI. Consequently, whatever the possible offer will be the hold-out problem is less, or so the thought goes. When this future offer comes, whatever it will be, the offshore ISK holders are more likely to participate.

The critical issuance might be the RIKB 19, where the foreign holding is ISK42.9bn – those holding longer maturity are unlikely to make a move since hopefully/most likely the controls will have been lifted by then. Those with shorter maturity might give it a thought to swap into what is now on offer. Those with RIKB 19 are in the tricky situation of having to gauge the likely scenario.

After the RIKB 15 0408 matures now in April offshore ISK holders can only reinvest in Treasury bills. Interestingly, some years ago foreigners were the largest holders of T-bills but there is at present no foreign-owned holding there. This is bound to change. Treasury bills now amount to ISK22.1bn but is expected to rise to ISK30bn at the end of the year. Next Treasury bills’ issuance in on 18 March.

In an interview on Rúv minister of finance Bjarni Benediktsson said that the government was now well on its way to solve the offshore ISK problem and this could be seen as the first steps towards lifting the controls. “These are preparatory actions, which in a short while could result in the offshore ISK problem being behind us.”

Further, Benediktsson said that the investment options was being restricted but nothing was taken away from anyone. The idea is, according to Benediktsson, to eradicate uncertainty and prepare the ground for further action.

Next step: what and when?

There is of course no official answer to the questions above. However, since the guiding idea is to bind funds to hinder instability the offer clearly has to be long maturity bonds – there have long been rumours that the euro bonds might be offered. Remains to be seen.

Apart from what will be offered the question is when. Governor Guðmundsson vaguely talks about few weeks or few months. To Rúv minister of finance Bjarni Benediktsson said the new investment offers were being worked on. “We hope to conclude this part of the matter in the coming months. I would mention the first half of the year in this context. That is what all our work aims at but it would not be responsible to fix exact dates.”

Considering how tortuous the path towards lifting the controls has been so far, in spite of the optimism expressed by Benediktsson and prime minister Sigmundur Davíð Gunnlaugsson when they came to power, it is not advisable to hold one’s breath. However, if the government wants to maintain credibility and trust in these issues, home and abroad, it has to act resolutely and not too sluggishly.

In terms of securing the offshore ISK funds, hindering instability, the measures now are only half a step: these are the restrictions – the offer to go with it, the other half step, is still missing. Until that step has been taken the usefulness of this measure cannot be judged.

Steps so far

Interestingly, Benediktsson talked about the new measures as the “first steps” towards lifting the capital controls. It can be debated which measures have been towards lifting controls but there have definitely been other measures, which merit to be called “steps towards lifting the controls.”

The first plan to lift controls was published in the summer of 2009 in co-operation with the International Monetary Fund as Iceland was then in an IMF programme. The CBI published a new plan in March 2011. The CBI auctions, an important step intended to reduce the offshore IKS, ended now in February.

Another major step was the bonds agreement between Landsbankinn and the LBI, the estate of the old Landsbanki May 5 2014. Although the agreement had been long time in the making Benediktsson, who needed to grant the exemption from capital controls in order to complete the agreement, took until December 4 2014 to grant the exemptions needed. I have earlier pointed out that it seems to have been more the irritation of the UK government, notably (fearsome) Andrea Leadsom, which pushed Benediktsson to take that step rather than any political energy and initiative on the Icelandic side.

The political outlook

There have been certain discernible trends lately in the political debate on the capital controls. Prime minister Gunnlaugsson has lately neither talked about the exact sums, the ISK billions, he claims the state should gain from the estates nor has he talked about vulture funds, as he did earlier. His new reasoning is “fairness:” Iceland suffered from the collapse of the banks, i.e. the banks caused sufferings and now it would be only fair that the banks paid back to the state for the hardship caused.

Apart from this rather narrow retelling of the collapse saga – after all the SIC report gave a somewhat more nuanced picture of a wider failure of public institutions, politicians and banks – Gunnlaugsson has referred to practices abroad, that foreign banks have paid fines to make up for their misdeeds towards society. (In general, the prime minister has become well known in Iceland for his at time rather inaccurate grasp of facts and reality).

Gunnlaugsson has also recently said in an article in Fréttablaðið that the new banks are too big, they got too much assets on too favourable terms, again arguments for the state getting a cut of the estates (an echo of an earlier debate where an old industrialist, Víglundur Þorsteinsson has been making similar claims, see here). On the same day Gunnlaugsson’s article was published, four members of In Defence, the organisation formed to fight the Icesave agreement, wrote an article in Kjarninn.

The four asked if the state is really going to enable foreign investors to run off with the equivalent of a whole year GDP, partly the profit from resurrecting the economy, paid for with the great sacrifice of Icelanders and sky-high loans. Their suggestion is an exit tax of 60%, not the 40% they claim Benediktsson has mentioned (which he has not; on the contrary he has been unwilling to confirm exit tax and much less any percentage). Gunnlaugsson was at the time very close to In Defense, which has neither been seen nor heard for years until now. It is hardly a coincidence that the two articles appeared the same day.

Benediktsson has mentioned the cost to society of the banking collapse but he has never argued for great sums to be gained from the resolution of the estates. In a speech last October he made some general comments on the controls, the topic of an earlier Icelog: Benediktsson want to avoid risk of legal wrangling with creditors and prefers simple and straightforward solutions.

Eiríkur Svavarsson, who now has left the group of the government advisers, was a vocal part of the In Defence group and is said to be close to the prime minister. Svavarsson has not been replaced. There has been no official announcements of this change, nor has there been a formal announcement of the new member, Ásgeir Helgi Reykfjörð Gylfason.

The prime minister has recently expressed his opinion that not too much should be said about the lifting of the controls since that might feed valuable intelligence to creditors. Whether the names of advisers are part of this intelligence, which should be hidden from creditors, is not clear. It does however look strangely lackadaisical that there is so little stringency as to what is announced and what is not.

Lately, members of Parliament have complained about the secrecy regarding lifting the controls, claiming they are kept uninformed. The Ministry of Finance has now published the text of the contract all advisers have to sign, see the text here (in English) with relevant laws on insiders. Interestingly, there is now gardening leave stipulated at the end of the assignment.

Glenn Kim is still in charge of the group, at least in name; some observers close to the process claim he is increasingly distant and not much seen in Iceland lately.

Looking for a solution that cannot be found

In earlier Icelogs I have often referred to an alleged split between the two government leaders as to how to tackle the estates. The two have time and again denied these rumours but the rumours are still alive and kicking. There are also speculations in the Icelandic media that the underlying strive of the government is to be in the position of deciding to whom the banks are sold.

Both government leaders have talked about the need for a holistic solution. Exit tax on all cross border transactions has i.a. been mentioned. The problem here is that this tax would hit all cross border capital, also debt payment of Icelandic entities – and it will not reduce the core problem: the foreign-owned ISK assets in the estates. I have the feeling that this idea has been abandoned: it might in theory bring the much-desired funds to the state (which is actually doing rather well, thank you, and not much wanting, compared to many other European countries) but it is for many reasons unworkable.

As I pointed out to Reuters it seems that these conflicting views prevent the government from acting on capital controls. But it might me more than only conflicting views. After watching one group of advisers after the other working on capital controls I cannot avoid the feeling that the government is looking for a solution that does not exist. A solution that i.a. would bring funds to the state, make it possible for the government to decide who owns the banks and yet be simple and risk-free. Like the drunken Scot looking for his penny under the street lamp because the light is there, though he lost it elsewhere, the government has been using, or squandering time, on a solution nowhere to be found.

This is doubly regrettable because the problems Iceland faces are neither unique nor particularly hard to solve. That is if, instead of looking for a home-grown Icelandic solution, advisers would look for realistic solutions where the gain would be not billions to the state but the trophy of lifting the controls. Instead, while the search for the non-existing solution, Icelandic businesses are slowly being starved of oxygen as always happens in countries with long-time capital controls.

As far as I understand the two government leaders have not reached an understanding as to how to proceed. Their statements on the capital controls and the banks normally point in different directions. The closer to dealing with the estates the more difficult to iron out these divergences and the harder the political cohesion of the government will be tested. As the drunken Scot found out looking for a solution where it demonstrable is nowhere to found is never a promising approach.

 

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Both in Cyprus and Iceland foreign funds flowed into the islands, in the end forcing the government to make use of extreme measures when the tide turned. These measures are normally called ‘capital controls’ which in these two cases hides the fact that the measures used are fundamentally different in all but name. In Iceland, the controls contain the effect of lacking foreign currency, effectively a balance of payment problem – in Cyprus, the controls were a way of defending banks against bank run, i.e. preventing depositors to move funds freely.

It is a sobering thought that two European countries now have capital controls: Iceland and Cyprus; sobering for those who think that in modern times capital controls are only ever used by emerging markets and other immature economies. Cyprus has been a member of the European Union, EU, since 2004 and part of the Eurozone since 2008; since 1994 Iceland has been member of the European Economic Area, EEA, i.e. the inner market of the EU. – The two EEA countries were forced to use measures not much considered in Europe since the Bretton Woods agreement.

Although the concept “capital controls” is generally used for the restrictions in both countries the International Monetary Fund, IMF, is rightly more specific. It talks about “capital controls” in Iceland and “payment restrictions,” i.e. both domestic and external, in Cyprus.

Both countries enjoyed EEA’s four freedoms, i.e. freedom of goods, persons, services and capital. –Article 63 of the Treaty on the Functioning of the European Union prohibits “all restrictions” on the movement of capital between Member States and between Member States and third countries.

Both countries attracted foreign funds but different kind of flows. While the going was good the two islands seemed to be thriving on inflows of foreign funds; in Iceland as a straight shot into the economy, in Cyprus by building a financial industry around the inflows. Yet, in the end the islands’ financial collapse showed that neither country had the infrastructure to oversee and regulate a rapidly expanding financial sector.

It can be argued that in spite of the geography both countries were immature emerging markets suffering from the illusion that they were mature economies just because they were part of the EEA. As a consequence, both countries now have capital controls and clipped wings, i.e. with only three of the EEA’s four fundamental freedoms.

The “international finance centre”-tag and foreign funds

Large inflows of foreign funds are a classic threat to financial stability. At the slightest sign of troubles the tide turns and these funds flow out, as experienced by many Asian countries in the 1980s and the 1990s. Capital controls are the classic tool to resume control over the situation. None of this was supposed to happen in Europe – and yet it did.

Although not on the OECD list of tax havens Cyprus has attracted international funds seeking secrecy by inviting companies with no Cypriot operations to register. After the collapse of the Soviet Union money from Russia and Eastern Europe flowed to the island as well as from the Arab world. Even Icelandic tycoons some of whom grew rich in Russia made use of the offshore universe in Cyprus.

The attraction of Cyprus was political stability, infrastructure, a legal system inherited from its time as a British colony and the fact that English is widely spoken in Cyprus. By the time of the collapse in March 2013 the Cypriot banking sector had expanded to be the equivalent of seven times the island’s GDP. This status did also clearly limit the crisis measures: president Nicos Anastasiades was apparently adamant to shelter the reputation of Cyprus as an international finance centre arguably resulting in a worse deal and greater suffering for the islanders themselves (see my article on the Cyprus collapse and bailout here).

Iceland also tested the offshore regime. Under the influence of a growing and partly privatised financial sector the Icelandic Parliament passed legislation in 1999 allowing for foreign companies with no Icelandic operations to be registered in Iceland. Although it could be argued that Iceland enjoyed much the same conditions as Cyprus, i.e. political stability etc. (minus an English legal system), few companies made use of the new legislation and it was abolished some years later.

But Iceland did attract other foreign funds. Around 2000 a few Icelandic companies started their shopping spree abroad. The owners were also large, in some cases the largest, shareholders of the three main banks – Kaupthing, Landsbanki and Glitnir. The banks’ executives saw great opportunities for the banks to grow in conjunction with the expanding empires of their main shareholders and largest clients. By 2003 the financial sector was entirely privatised, another important step towards the expansion of the financial sector.

In addition, the Icelandic banks had offered high interest accounts abroad from autumn 2006, first in the UK, later in the Netherlands and other European countries, even as late as May 2008. Clearly, Icelandic deposits were not enough to feed the growing banks. They found funding on international markets brimming with money. In 2005 the three banks sought foreign financing to the amount of €14bn, slightly above the Icelandic GDP at the time. In seven years up to the collapse the banks grew 20-fold. In the boom times from 2004 the assets of the three banks expanded from 100% of GDP to 923% at the end of 2007.

The Icelandic crunch: lack of foreign reserve

At the collapse of the Icelandic banks in October 2008 Icelandic króna, ISK, owned by foreigners, mostly through so-called “glacier bonds” and other ISK high interest-rates products amounted to 44% of GDP. These products, popular with investors seeking to make money on high Icelandic interest rates, had been flowing into the country, very much like “hot money” flowing to Asian countries during 1980s and 1990s.

Already in early 2005 foreign analysts spotted funding as the weakness of the Icelandic banks. In. February 2006 Fitch pointed out how dependent on foreign funding the Icelandic banks were. In order to diversify its funding one bank, Landsbanki, turned to British depositors in October 2006 with its later so infamous Icesave accounts. The two other banks followed suit. In addition, the banks were supporting carry trade for international investors making use of high interest rates in Iceland.

Steady stream of bad news from Iceland during much of 2008 caused the króna to depreciate drastically. After the collapse foreigners with funds in Iceland sought to withdraw them. On November 28 2008 the Central Bank of Iceland, CBI, with the blessing of the IMF, put capital controls in place (an overview of events here). IMF’s favourable stance to capital controls was a novelty at the time; not until autumn 2010 did the Fund officially admit that controls could at times solve acute problems as indeed in Iceland.

It was clear that the CBI’s foreign reserves were not large enough to meet the demand for converting ISK into foreign currency. What no one had wanted to face before the collapse was that the CBI could not possibly be a lender of last resort in foreign currency.

The controls were from the beginning on capital, i.e. capital could neither move freely out of the country nor into the country. The controls were not on goods and services, hence companies could buy what they needed and people travel but investment flows were interrupted (further re the controls see here).

The migrating króna problem

The core problem calling for controls was and still is ISK owned by foreigners, i.e. offshore ISK, but the nature of the problem has changed over the years: the original carry trade overhang has dwindled down to 16% of GDP, through CBI auctions where funds seeking to leave were matched with funds seeking to enter. Now, the major problem is foreign-owned ISK assets in the estates of the three banks, i.e. owned by foreign creditors who, without controls, would seek to convert their ISK into foreign currency.*

As outlined in CBI’s latest Financial Stability report, published last September there is a difference between the onshore and the offshore ISK rate: 17% in autumn 2014, about half of what it was a year earlier. These and other factors indicate that the non-resident ISK owners, i.e. those who owned funds in the original overhangs, are most likely patient investors; after all, interest rates in Iceland are higher than in the Eurozone. Although these investors cannot move their funds abroad the interests can be taken out of the country.

The classic problem with capital controls as in Iceland is that the controls – put in place to gain time to solve the problems, which made them necessary – can also with time shelter inaction. With the controls in place the urgency to lift them disappears. Over time, controls invariably create problems as the CBI pointed out in its latest Financial Stability report: The most obvious (cost) is the direct expense involved in enforcing and complying with them. But more onerous are the indirect costs, which can be difficult to measure. The controls affect the decisions made by firms and individuals, including investment decisions. Over time, the controls distort economic activities that adapt to them, ultimately reducing GDP growth. 

The main ISK problem is now nesting in the estates of the three collapsed banks where the problem, as spelled out in the CBI’s last Financial Stability report , is that “…settling the estates will have a negative impact on Iceland’s international investment position in the amount of just under 800 b.kr., or about 41% of GDP. This is equivalent to the difference in the value of domestic assets that will revert to foreign creditors, on the one hand, and foreign assets that will revert to domestic creditors, on the other. The impact on the balance of payments is somewhat less, at 510 b.kr., or 26% of GDP.

The balance of payment, BoP, problem could be solved in various ways, i.a. through swaps between Icelandic creditors who are set to get foreign currency assets from the estates, sales of ISK assets for foreign currency and write-down on some of the ISK assets. In addition there are tried and tested remedies such as time-structured exit tax where those who are most keen to leave pay an exit tax, which is then scaled back as the problem shrinks.

The political stalemate

In March 2011, under the Left government in office from early 2009 until spring 2013, the CBI published Capital account liberalisation strategy, still the official strategy. The strategy is first to tackle the offshore króna problem outside the estates, which has been done successfully (judging by the diminishing difference between the on- and offshore ISK rate) through the CBI auctions. That part of the strategy has now come to an end with the last auction held on 10 February.

The next important step towards lifting the controls is finding a solution to the foreign-owned ISK in the bank estates. Their creditors are mostly foreign financial institutions, either the original bondholders or investors who have bought claims on the secondary market.

As indicated above there are solutions – after all, Iceland is not the first country to make use of capital controls while struggling with BoP impasse. However, as long as the political unwillingness, or fear, to engage with creditors prevails nothing much will happen.

When the present Icelandic coalition government of Progressive party (centre; old agrarian party) and the Independence party (C) came to power in spring 2013 it promised rapid abolition of the capital controls. So far, the process has been a protracted one with changing advisers, unclear goals and general procrastination. There has at times been an echo of the belligerent Argentinian tone, blaming foreign creditors for the inertia in solving the underlying problems; importantly, the Progressive party has promised huge public gains from the resolution of the estates, which it seems to struggle to fulfil.

In its concluding statement in December 2014 following the Article IV Consultation IMF points out that the path chosen in lifting the controls “will shape Iceland for years to come. The strategy for lifting the controls should: (i) emphasize stability; (ii) remain comprehensive and conditions-based; (iii) be based on credible analysis; and (iv) give emphasis to a cooperative approach, combined with incentives to participate, to help mitigate risks.” The “cooperative approach” refers to some sort of negotiations with creditors, which the government has so far completely ruled out.

It is important to keep in mind that the estates of the banks, by now the major obstacle in lifting the controls, are estates of failed private companies. The banks were not nationalised and the state has no formal control over the estates. However, as long as the ISK problems of the estates are unsolved the winding-up procedure cannot be finished and consequently there can be no payouts to creditors.

The winding-up procedure will either end with bankruptcy proceedings, which majority of creditors are against, or with composition agreement, which the majority seems to favour. Crucially, the minister of finance has to agree to exemptions needed for composition, which means that the government is indirectly if not directly responsible for the fate of the estates.

The political tension regarding the controls is between those who claim that solving problems necessary to lift the controls is the main objective and those who claim that no, this is not enough: the state needs and should get a cut of the estates.

Finance minister Bjarni Benediktsson has strongly indicated that his objective is to lift the controls whereas prime minister Sigmundur Davíð Gunnlaugsson has allegedly been of the latter view. He has recently been supporting his views by stressing the great harm the banks caused Iceland reasoning that pay-back from the banks would be only fair. This simplified saga of the banking collapse is in conflict with the 2010 report of the Special Investigative Committee, SIC, which spelled out the cause of the collapse as regulatory failure, failure of the CBI and political failure in addition to how the banks were funded and managed.

The government has Icelandic and foreign advisers working on these issues. But as long as the government does not make up its mind on what direction to take nothing moves. Meanwhile Iceland is effectively cut from markets, which makes the financing cost high, in addition to other detrimental effects of the capital controls.

The Cypriot crunch: bank run

The run up to the Cypriot banking collapse in March 2013 was a sorry saga of mismanaged banks, mismanaged country and the stubborn denial of the situation ever since Cyprus lost market access in May 2011. But contrary to Iceland, there has been no investigative report into the collapse, which means that in Cyprus hardly any lessons can be drawn yet from the calamities.

Data from the European Central Bank, ECB, shows that deposits were seeping out: in June 2012 they stood at €81.2bn. In January 2013 they were €72.1bn, down by 2%, in February at €70bn, 2.1% month on month and in March €64.3bn. According to the Anastasiades report (written at the behest of president Anastasiades, leaked to NYTimes and published in November 2014) €3.3bn were taken out of Cypriot banks March 8–15, the week up to the bail-in.

This was an altogether different situation from circumstances in Iceland ensuing from the collapsing banks. Cyprus, part of the Eurozone, was not struggling to convert euros to other currency but it was struggling to convince those holding funds in the Cypriot banks not to withdraw them and move them abroad.

As Iceland, Cyprus was trying to maintain a banking system far larger than the domestic economy could possibly support under adverse circumstances. By the end of 2011 there were 41 banks in Cyprus: only six were Cypriot; 16 were from EU countries and tellingly 19 were non-EU banks. It was clear to regulators that the size was a risk but they maintained that both regulation and supervision was conservative enough to counteract the risk, as bravely stated in a report by the Ministry of Finance on the financial sector in Cyprus. – Ironically, Cyprus had to seek help from the troika just a few months after these assertive words were written.

The controls were put in place with the full acceptance of the troika, i.e. the IMF, the EU Commission and the ECB. “The Enforcement of Restrictive Measures on Transactions in case of Emergency Law of 2013” as the capital controls measures were called by the Cyprus Central Bank, CBC, restricted i.a. daily cash withdrawal to €300 daily, no matter if directly or with a card, or its equivalent in foreign currency, per person in each credit institution. Cheques could not be cashed.

Trade transactions were restricted to €5,000 per day; payments above this sum, up to €200,000 were subject to the approval of a Committee established within the CBC to deal with issues related to the controls. For payments above €200,000 the Committee would take into account the liquidity buffer situation of the credit institution. Salaries could be paid out based on supporting documents. Those travelling abroad could only take the equivalent of €1,000 with them.

The roadmap for abolishing them came in August 2013, again with the full blessing of the troika. There was no time frame, only that the measures would be “in place for as long as it is strictly necessary.” They would be removed gradually and with prudence, always with a view on financial stability. First the restrictive measures on transaction within Cyprus would be abolished and only subsequently could the restrictions on cross-border transactions be lifted.

The controls have since gradually been eased and by May 2014 all domestic restrictions were indeed fully eliminated. On 5 December 2014 i.a. the limit for travel abroad was sat at €6,000, from previous €3,000 and business activity not subject to approval was sat at €2m. With the last change, on 13 February, those travelling abroad can now take €10,000 with them. Transfers of funds abroad were increased from the December limit of €10,000 to €50,000. The island’s pension funds are still subject to capital controls.

As in Iceland, abolishing, for unspecified time, one of the EEA’s freedoms was to be in place only for a short time. Until late 2014 it seemed as if the Cypriot capital controls might be entirely abolished by the end of that year. That did not happen. The last bit remaining is the politically tough one.

The task for Cyprus: overcoming the political hurdles

With the domestic restrictions abolished the IMF Staff report in October 2014 for the Article IV Consultation pointed out that the “external-payment restrictions” in Cyprus have to be relaxed in a gradual and transparent way. “…owing to the short deposit-maturity structure, significant foreign deposits (close to 40 percent of the total), large reliance of BoC (Bank of Cyprus) on ELA (Emergency Liquidity Assistance), and the lack of other market funding, external restrictions remain in place. While restrictions do not apply to fresh foreign inflows into Cyprus, they limit outflows, hampering trade credit and affecting overall confidence.” If the external restrictions remain in place they can damage investors’ confidence and consequently foreign direct investment, FDI.

As in Iceland, the main Cypriot problems stem from political tensions, which “could have adverse implications for confidence and the recovery,” according to the IMF. The key obstacle in Cyprus is lack of progress in addressing non-performing loans, NPL, staggeringly high in Cyprus at 37.9% of total gross loans in 2014. Debt-restructuring framework, including i.a. a foreclosure legislation and insolvency regime is still a lingering political problem. Further, banks need to restructure and build capital buffers, critical to lift the remaining restrictions.

Visiting Cyprus in early December I was told that the work on the NPLs was about to be finished and a new insolvency framework would be in place by the end of the year. It is still not in place, a sign that the politial tensions have not eased. In spite of all that has been done Cypriots have lost trust in their banking system: almost two years after the collapse it is estimated that the islanders keep up to 6% of GDP at home, under their proverbial mattresses or wherever people stash cash.

The political test for Cyprus and Iceland

Both islands face a political challenge lifting capital controls.

In 2012 the CBI published a report on Prudential Rules Following Capital Controls, thus outlining what is needed once the capital controls have been lifted. This is greatly facilitated by the fact outstanding work of the SIC. Consequently, life and prudence after the controls are lifted has been staked out.

Iceland is however struggling to throw off shackles of nepotism, even more so under the present government than for quite a while: personal connections seem to matter more not less than before. Lifting the controls will test the times, if they are new times with accountability, transparency and fairness or the old times of nepotism, opacity and special favours.

Cyprus stands harrowingly high on the Eurobarometer corruption index and it suffers from lack of stringent analysis of what happened, making it difficult to draw any lessons, i.e. on how regulation needs to be improved, failures at the CBC etc. Cyprus authorities have some way to go in order to win trust with the islanders. The fact that no public inquiry has been held into the collapse, no investigation, no report written adds fuel to the already low trust. I have earlier written that Cyprus with high unemployment and contracting economy bitterly needs hope.

Both Cyprus and Iceland will have to show that they understand what happened and how it can be prevented from happening again. The exit from capital controls for both these islands will depend on political decisions, which will shape their next decades.

*I have blogged extensively on Icelog on the capital controls in Iceland. Here is the latest one, on the politics. Here is one from end of last year, on i.a. the various possible solutions. I have at times blogged on Icelog on Cyprus or compared Iceland and Cyprus. Here is a collection of blogs on Cyprus, i.a. two on the topic of Cyprus, Iceland and capital controls. – This post is being cross posted on A Fistful of Euros.

 

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Why do the inhabitants of an EU country prefer to keep cash amounting to ca. 6% of GDP hidden at home? Badly burnt after the banking collapse in March 2013 Cypriots neither trust their government nor banks to keep their money safe. After following from afar the events in Cyprus I recently visited the island. Many Cypriots feel that the banking collapse is now only history and no point thinking about it. But that is far from the truth: as long as neither Cypriots nor the other EU countries know the whole Cypriot saga it can neither provide lessons nor a warning; and the mistrust lingers on. In addition to a public investigation of what really happened and why, write-downs of household debt and a functioning insolvency framework Cypriots desperately need one thing: hope for the future.

Crisis-stories are a plenty in Cyprus and the islanders are more than willing to tell them. During the traumatic days in March 2013 when the banks were closed for ten long days people called the Central Bank of Cyprus, CBC, crying. “The bail-in wasn’t fair because it hit depending on with which bank you were banking,” one Cypriot said. “And look at what it’s done to us, all the empty space in the centre,” said the owner of a small business. “One of my clients,” said a man working in finance, “had a loan of €5m and €7m in deposits. Next day, he still had a loan of €5m but only €100,000 in deposits.” The client, of course, banked with Laiki Bank, also known as Cyprus Popular Bank and Marfin Popular Bank. Then there was the man on the beach in Paphos, selling boat trips. He now owns 500,000 shares in Bank of Cyprus worth quite a bit less than the €500,000 on his account until his funds, together with all other deposits above €100,000, were converted into shares.

In March 2013 Cyprus stared into the abyss of financial collapse. In order to qualify for a €10bn Troika loan, the absolute maximum the Troika – i.e. the European Union, EU, the European Central Bank, ECB and the International Monetary Fund, IMF – was willing to lend, Cyprus had to raise €5.8bn. After the Eurogroup threw out its first rescue plan, which included a levy on guaranteed deposits, i.e. less than €100.000, the Cypriot government grabbed deposits above €100,000 in Laiki to merge it with Bank of Cyprus where non-guaranteed deposits were turned into shares. This bail-in came as a surprise but had indeed been worked on since summer of 2012 by a small group of Cypriot officials.

From the Cypriot point of view it seems unfair that whereas Cyprus had to find own funds other hard-hit European countries – Ireland, Greece, Portugal and Spain – got Troika loans to bail out banks. The overwhelming feeling in Cyprus is that the island’s 1.1m inhabitants and an economy contributing 0.2% of the euro zone economic output was too small and insignificant to matter to the Troika. Abroad lingers the suspicion that Russian money in Cyprus were unpalatable to the Troika.

However, the reason for the misery seems more complicated and closer to home: the government of Demetris Christofias was adamant not to enter a Troika programme; a noble aim in itself but the government’s manoeuvres to avoid it seem less noble. CBC officials fed incomplete if not misleading information to the ECB. Fragments of this story have emerged only recently, not from the two attempted public enquiries but from a secret report done at the behest of president Nicos Anastasiades, later leaked to the New York Times.

“People want answers,” one Cypriot said but so far, there are few answers but plenty of questions, the most pressing being why there is no wish for  a proper investigation on the events leading to the drama in March 2013. The Special Investigative Committee, SIC, set up in Iceland after the Icelandic collapse in 2008 would be an ideal inspiration.

The story of the Cypriot collapse has many intriguing aspects. One of them is the sale of Greek branches of Cypriot banks, i.a. Bank of Cyprus’ Greek operations; another is the purchase of Greek sovereign bonds (mainly from German banks, which had a high exposure on Greece) by Cypriot banks, possibly seeking high-risk high yield investment to cover earlier disastrous lending.

Below, two further aspects are scrutinised: why the bail-in happened and why the Troika accepted, though only for some hours, a crisis levy on guaranteed deposits.

The rumours before the collapse and the hope that this time, it would be different

As in Iceland, the Cypriot banking sector was far too large – seven times the island’s GDP – for Cyprus to support it on its own. Its destabilising core was Laiki Bank,. The bank had for a long time offered higher interest rates than other banks; only ever attractive to risk-takers and naïve investors who do not recognise it as a warning sign. In the summer of 2012 the Cypriot government attempted to solve the Laiki problem by nationalising the bank.

With Ireland, Portugal, Greece and Spain struggling there had been little focus on tiny Cyprus but its problems were evident to anyone who bothered to look. After the nationalisation of Laiki there were talks with the Troika in late summer and autumn 2012 as to what should be done. No one, least of all the Cypriots, expected any drama. My Cypriot contacts kept telling me that the talks would no doubt end quietly in a negotiated bail-out of some sort. After all, Cyprus was a small economy, the Troika had by now some practice in dealing with failing banks threatening an entire economy; and there was also a growing awareness that private debt should not be shifted on to the state. Compared to the on-going Greek drama his would go well, I heard.

There were however rumours that this time it would indeed be different. In January 2013 Landon Thomas wrote in the New York Times of “Questions of Whether Depositors Should Shoulder the Bill:” officials in Brussels and Berlin were said to be working on “a controversial plan that could require depositors in Cypriot banks to accept losses on their savings. Russians, holding about one-fifth of bank deposits in Cyprus, would take a big hit.” Truly a radical departure from bailouts in Portugal and Ireland and a haircut, albeit only after an earlier bailout, in Greece – so far, bank deposits had been held sacrosanct.

Considering the delicate situation CBC governor Panicos Demetriades gave a rather remarkable interview to Wall Street Journal on March 5 2013 where he rejected the idea of haircut on depositors. Instead, he aired the idea of a “special solidarity levy” on interest income, which could give the state an annual income of as much as €150m – a risible sum compared to what was needed – but hoped that privatisation would gather €4.5bn. Alex Apostalides lecturer at the European University Cyprus has recently written about an encounter with Demetriades on the fateful 15 March 2013: when asked, Demetriades said that any haircut on deposits would be a catastrophe for the banking sector.

At the beginning of 2013 all the Cypriot political energy was in the presidential election campaign. But some were more aware than others that something might happen; there are still rumours of people who emptied their bank accounts just before the bail-in. ECB data shows that deposits were seeping out. In June 2012 they stood at €81.2bn. In January 2013 they were €72.1bn, down by 2%, in February at €70bn, 2.1% month on month and in March €64.3bn. According to the Anastasiades report €3.3bn were taken out of Cypriot banks March 8–15, the week up to the bail-in.

Capital controls, i.e. limits on amounts taken out from deposits or moved between deposits, were part of the package in March 2013. Yet, money did allegedly seep or even flow from certain deposits in spite of the controls. In Cyprus stories are told of private jets clouding the skies over Nicosia on and after 18 March, carrying neck-less black-clad men accompanying their angry-looking masters to the banks; all returned smiling with bursting hold-alls. List with names of people said to have taken out money in spite of the controls circulated in the media. – All of this is part of the still unwritten report of what really happened.

What seemed like good idea at the time: ‘un-guaranteeing’ the €100,000 deposit guarantee

On Friday March 15 2013 the Eurogroup met in Brussels at 5pm after markets closed. In the wee hours of March 16 the Group published a statement and its representatives held a press conference. The statement itself was short but not sweet, at least not for the Cypriots who had hoped and believed that their island would be assisted like other troubled euro-countries.

The press release stated (emphasis mine in all quotes):

The Eurogroup further welcomes the Cypriot authorities’ commitment to take further measures mobilising internal resources, in order to limit the size of the financial assistance linked to the adjustment programme. These measures include the introduction of an upfront one-off stability levy applicable to resident and non-resident depositors. Further measures concern the increase of the withholding tax on capital income, a restructuring and recapitalisation of banks, an increase of the statutory corporate income tax rate and a bail-in of junior bondholders. The Eurogroup looks forward to an agreement between Cyprus and the Russian Federation on a financial contribution.

The Russian loan never materialised any more than a Russian loan promised to the governor of the Central Bank of Iceland, CBI as the Icelandic banks collapsed in October 2008. (Cyprus’ relationship with Russia was long-standing Iceland was not known to have any particular relationship with Russia, which meant that this promise seemed very much out of the blue.) However, just as the Christofias government was against a Troika programme the governor of the CBI and a few others were equally against seeking assistance, in Iceland’s case from the IMF.

Interestingly, neither the March 16 press release nor the statement specified what ‘an upfront one-off stability levy’ implied. Those who gave the 4AM press meeting seemed  ill at ease and unwilling to spell out the action. Christine Lagarde director of the IMF only talked of “burden sharing.”

According to Reuters, citing an unnamed source, Cyprus “agreed a one-off levy of 9.9 percent to apply to deposits in Cypriot banks above 100,000 euros and of 6.7 percent for deposits below 100,000 euros…”

With this fundamental diversion from earlier policies the Eurogroup agreed that an EU country could touch deposits below the guaranteed €100,000. In other words: depositors in EU now knew that in a financial crisis their guaranteed deposits were no longer untouchable.

Whether a momentary mental black-out or a wish to try something unorthodox this solution evaporated over the weekend. The statement released following a Eurogroup phone conference on Monday March 18 carried a very different message:

The Eurogroup continues to be of the view that small depositors should be treated differently from large depositors and reaffirms the importance of fully guaranteeing deposits below EUR 100.000. The Cypriot authorities will introduce more progressivity in the one-off levy compared to what was agreed on 16 March, provided that it continues yielding the targeted reduction of the financing envelope and, hence, not impact the overall amount of financial assistance up to EUR 10bn.

Given the fact that the Eurogroup had less than 48 hours earlier agreed to a levy on guaranteed funds the words “continues” and “reaffirms” do not quite rhyme with the earlier statement.

The banks remained closed on the following Monday, March 18 2013 as the Cypriot government under president Nicos Anastasiades, only in power since March 1, struggled to get a grip on failing banks – and to find another solution when the original idea lost its sparkle.

In a rare display of tense irritation the ECB issued a statement on March 21 saying that the ECB governing council had “decided to maintain the current level of Emergency Liquidity Assistance (ELA) until Monday, 25 March 2013. Thereafter, Emergency Liquidity Assistance (ELA) could only be considered if an EU/IMF programme is in place that would ensure the solvency of the concerned banks. – As far as is known, this is the only time the ECB has ever issued a statement acknowledging the end of ELA.

The Cypriot banks remained closed for whole ten days, until March 28. When they opened again there were capital controls in place to prevent a run on the banks – and depositors in Laiki and Bank of Cyprus had been singled out to carry the cost.

In hindsight, it is profoundly interesting that the Eurogroup, ECB and the IMF did indeed agree to a levy on guaranteed deposit. Allegedly, the Germans were not happy but agree they did. In the end, things did change in the coming days. Further, a general levy was voted down in the Cypriot parliament. The Cyprus collapse did not happen over a few days in March but over almost two years, from May 2011 when the island lost access to markets. The course of events cannot just be explained by panic.

Indeed the bail-in was no panic solution but had been in the making for more than half a year; only the Cypriots did not know it.

A pact with the offshore devil

Since slamming a levy on guaranteed deposits truly was a novel idea the short struggle to ram this measure through merits attention, also because it can be argued that it was indeed a much fairer financing of the crisis solution than the one used.

According to much of the media coverage the idea of a levy on guaranteed deposits came from the Cypriot government. However, sources close to these events have indicated to me that the EU commission, attempting to merge various and to some degree conflicting points of view, originally suggested a levy on guaranteed as well as non-guaranteed deposits. The preposition was that Cyprus had to fund a big part of the rescue package, banks have heaps of money on deposits – and a small percentage levy is a relatively painless way for a state to spread the burden in a crisis.

The various parties to the talks were advocating various solutions. IMF advocated the full resolution of the two banks, Laiki and Bank of Cyprus and did not seem to be opposed to a bail-out. The Anastasiades government was looking for a traditional bail-out programme apparently unaware that the Christofias government had worked on a bail-in (more on that below). The Commission was looking for a middle way where wealth tax could perhaps fill a gap if needed but sensed that a bailout was out of the question.

The country needed to raise €5.8bn in order for the Troika to lend the €10bn needed. It was a matter of arithmetic how to juggle the percentage so as to land on the right sums; it proved a struggle as Reuters recounted on 18 March. President Anastasiades and his team refused to go above 10% on the uninsured deposits and settled for 9.9%. These deposits amounted to €38bn, insured deposits were €30bn which meant that €2bn had to be taken off the latter if the government held onto 10% being the pain threshold; ergo, the percentage had to be respectively 6.75% and 9.9%.

Non-Cypriot officials wanted the percentage on the guaranteed deposits to be lower, even considerable lower. Already at the meeting the feeling was the Anastasiades was sheltering the island’s offshore status, ignoring the interest of ordinary Cypriots.

The political reaction in Cyprus drew the attention from the fact that after sleeping on it the Eurogroup woke up realising that the levy would ‘un-guarantee’ the guaranteed €100,000. The original plan must have come with some convincing reasoning (from the EU Commission, right?); otherwise, it would not have gone through. For sure, it worked like magic – but struck by daylight the carriage was again a pumpkin.

“The guaranteed deposits turned out to be EU’s sacred cow,” one source said. In a certain sense, for every country crisis is utterly unique, not in the general mechanism, but in the outward detail. If Cyprus had indeed accepted a levy on guaranteed deposits the EU would have been in a difficult position: it would have had to argue that Cyprus was an utterly unique case.

In order to reach the necessary sum of €5.8bn 15% levy on the uninsured deposits would have done the trick. But on an island, which lives – and has lived well – from its off-shore status and the foreign funds it attracts the government baulked at taxing the non-guaranteed deposits too heavily so as not to drive these funds elsewhere. That was the cost of the Cypriot pact with the offshore devil.

Laiki: the core of the Cyprus problem

In the euro-crisis context the bail-in was a remarkable solution but as can be seen from the Anastasiades report it was, quite remarkably, not a new idea. It had been in the making for some time, at least from autumn 2012, and was closely connected to the core problem: Laiki. The report traces the drafting of a new bank resolution framework, which rested on using deposits in an insolvent bank in a bail-in.

The desperate state of the Cypriot economy was exposed when Cyprus lost market access in May 2011, much due to Laiki Bank owned and managed by Andreas Vgenopoulos. Laiki was diligently issuing bullet loans to Vgenopoulos’ companies. Bullet loans are familiar to those who have studied the operations of the Icelandic banks where they were issued to large shareholders and other favoured clients. The Icelandic bullet loans to these clients were either constantly rolled over or refinanced, rarely paid back. The bullet loan magic on a balance sheet is i.a. that in spite of not being paid back they are not non-performing.

One insistent question for Cypriots is why the CBC and other Cypriot authorities allowed Laiki to operate as it did and for so long. By summer 2012 the Cypriot authorities had run out of excuses and justifications for continued assistance to Laiki, to the ECB and others. Instead of investigating Laiki’s operations, the bank was nationalised, hook line and sinker and no questions asked.

It is a pertinent question when the CBC realised that Laiki was a dead bank. There were leaks in Cypriot and Greek media in autumn and winter 2012 on the severe state of Laiki, allegedly known to the CBC. Even sending staff to be questioned by a prosecutor CBC focused on investigating the leaks, not the issues they raised.

Nationalising Laiki increased the state’s liabilities; the EU and the IMF were uneasy, as expressed at a Eurogroup meeting 12 September 2012 in Cyprus. Laiki was in a sorry state and it was dragging down another weak bank, Bank of Cyprus. The government continued its delay-tactic, thereby taking the entire banking sector hostage.

The Troika held a meeting 9 November 2012 in Cyprus but could not reach an agreement with Cyprus. By now, Cyprus was, quite literally, living on borrowed money, straight from the ECB: on 15 November 2012 ECB’s Emergency Liquidity Assistance, ELA, to Cypriot banks, i.e. Laiki, amounted to €11.9bn, around 65% of GDP.

The Troika’s patience was evaporating fast: when president Demetris Christofias visited Brussels 22 November he was informed the ECB would stop the ELA immediately. The following day finance minister Vassos Shiarly said the government had now agreed to the terms of the “Memorandum of Understanding on Specific Economic Policy Conditionality.”

The birth of a brutal and unfair solution

The November 2012 MoU was full of good intentions. But the direction taken was not new. During the Troika meeting in Cyprus in June 2012 those present had agreed that the core of the Cypriot problem was an over-extended financial sector, which the feeble island economy could not support. Consequently, an alternative way to recapitalisation had to be found but the question was how.

In a 2 July 2012 letter ECB stated, referring to its opinion on legal support for Laiki, that the best way was to use a fully-fledged bank resolution tool, as outlined in Directive proposal, COM (2012) 280 final adopted in June 2012, for bank resolution where the cost was not being borne by tax payers, adopted in June 2012 and later developed into a Bank Recovery and Resolution Directive.

Hence, amongst those working on the coming Cyprus banking rescue operation it was already clear by the summer of 2012 that Cyprus could not expect anything like the other troubled euro countries. The assessment circulating, i.a. from Fitch, was that Cyprus needed €10bn in financial aid, 60% of GDP.

The three key objectives of the MoU were “to restore the soundness of the Cypriot banking sector by thoroughly restructuring, resolving and downsizing financial institutions, strengthening of supervision, addressing expected capital shortfall and improving liquidity management; to continue the on-going process of fiscal consolidation in order to correct the excessive general government deficit” by reducing current primary expenditure, maintaining fiscal consolidation i.a. by increasing the efficiency of public spending, enhancing tax collection and improve the functioning of the public sector; structural reforms to support competitiveness.

As the MoU shows Cyprus was not stingy with its promises, i.a. : “With the goal of minimising the cost to tax payers, bank shareholders and junior debt holders will take losses before state-aid measures are granted. Before any state recapitalisation is granted, the Central Bank of Cyprus will require a conversion of any outstanding junior debt instruments into equity for the purpose of protecting the public interest in financial stability, including by implementing voluntary or, if necessary, mandatory subordinated liability exercises (SLE)… the necessary legislation will be introduced no later than [January 2013]. The Central Bank of Cyprus together with the EC, the ECB and the IMF will monitor any operation converting junior debt instruments into equity.”

The innocent-looking clause in the November 2012 MoU, which the Cypriot government was arm-twisted into accepting, was a further foreboding of the bail-in to come: The authorities will introduce legislation establishing a comprehensive framework for the recovery and resolution of credit institutions, drawing inter alia on the relevant proposal of the European Union.

The Anastasiades secret report concludes that it was clear from summer 2012 that the legal tools being forged would prevent a bail-out, forcing Cyprus to rescue its financial system with own resources, i.e. a bail-in:

“However, the perception which prevailed was that neither the government nor the CBC adequately understood this context. Moreover, no one admitted to know or have heard about the bail-in before the Eurogroup of 15 March 2013. The fact that the government, the state and its institutions acted as if they could not comprehend what was going on in order to disguise their inadequacy… ultimately proved to be a very effective policy to avoid taking responsibility. The reality is that as early as 6 November 2012, the CBC Governor, Panicos Demetriades, informed the ECB President, Mario Draghi that the resolution law was almost done, three whole weeks before the MoU of 25 November. …

From the moment the two major banks would pass into the hands of the Resolution Authority, the CBC should have to act within the given legislative framework and to provide solutions which would not bear any burden to the taxpayer. The law in itself was prohibiting the bail out and was legalizing the bail-in.“

The law, legalising a bail-in, was supposed to be passed in January 2013 but the Cypriot government and the CBC continued the delay game. After being reassured that short-term financing need was covered, the Eurogroup finally accepted to wait; it seemed clear that the final agreement on a programme would have to wait until after the election in February.

When the Anastasiades government came into power March 1 2013 neither the out-going government nor the CBC presented it with the draft for the resolution law. Accordingly, the new government seems to have intended to negotiate a bail-out as in previous Eurozone crisis countries. The old powers and the CBC kept quiet, making it look as if the bail-in was all the work/fault of the new government – or that is at least how the story is told in the Anastasiades report. The Resolution of Credit and Other Institutions Law of 2013 was published 22 March 2013 as part of the crisis measures.

The Anastasiades report shows that though panicky the decisions taken over the fateful days in mid March were no last-minute solutions. The Christofias government had been planning a bail-in, i.e. a self-financed salvation or refinancing of the banking system – and it was vehemently against entering a Troika programme.

The “punishment for the Russian connection” theory and other speculations

In hindsight – always a great vantage point – a one-off levy on deposits, even a tiny sliver on guaranteed deposits, would have been a lot less painful to Cypriots in this time of great crisis. But the political reaction in Cyprus was such that the government stepped back and abandoned any general levy. “The measures chosen did not punish risk-takers but made some people poorer completely by chance,” one source said.

“The solution was to treat deposit holders as investors,” as one Cypriot put it. Indeed, but only deposit holders in two banks took the hit for everyone else; a much more brutal and arguably a less fair measure than a levy.

In the weeks following the Cypriot bail-in there were speculation that the anomalous outcome had been dictated by a lack of trust in Cyprus for allowing Russian funds to flow so freely through the country’s banking system. It is alleged that 20% of Cypriot deposits are Russian; considering the long-standing connections between Russia and Cyprus this does not seem shockingly much.

In addition there are rumours, strenuously denied by Cypriot authorities, that the island’s financial system had been facilitating money laundering. According to persistent rumour the German authorities had commissioned a secret report that showed as much. However, nothing concrete did ever materialise and certainly no German report.

Cypriot officials were very much aware of these rumours and visited some European capitals in January 2013, i.a. Den Haag, to rebut the rumours and explain measures taken in Cyprus against money laundering.

The IMF viewed Cyprus as a unique case because of the size of its banking sector. Germany was in no mood for a bail-out. “Cyprus had irritated the Troika so much,” one source said. The ECB press release on ELA 21 March 2013 proves the point. Christofias had publicly spoken badly of the IMF; his attempts to get loans from China and Russia were not successful.

Essentially, a bail-in had been in the making for a while and seems to be what Christofias and his government had in mind. “It was clear that Cyprus would indeed be different,” on source said. “The obstacles were mostly political.”

Why the Christofias government did aim at a bail-in can only be clarified in a Cypriot SIC report. Perhaps the government saw that as a good way to keep the Laiki story buried, a continuation of the fact that Laiki had been nationalised but neither restructured nor scrutinised. And/or Christofias the communist was content to nationalise it to prove a political point. Fundamental question on the March 2013 events can only be answered in a thorough report. Sadly, it seems that very few Cypriots believe that such a tell-all report is possible on their little island.

No appetite for investigations

The Anastasiades report bears the telling title: Laiki Popular Bank – How a bank’s mismanagement toppled an economy. Laiki was not the only problem in the Cypriot economy but it was the crystallisation of many problems. Some advisers had recommended action on Laiki already when Cyprus lost market access in May 2011 but to no avail. As one source said: “It was a grave mistake not to take Laiki over earlier.”

The Anastasiades report was not intended for publications. It was not the first investigation into the Cypriot banking mess. There was an earlier planned investigation, which as the Anastasiades report stated, “didn’t happen.”

In August 2012 the CBC assigned Alvarez & Marsal, a management and restructuring consultancy, to examine why Laiki and Bank of Cyprus had requested state support, which they got, in total €1.8 bn. The following four points were to be investigated:

1. Bank of Cyprus’ losses from investing in Greek bonds
2. The purchase of shares of the Romanian bank Banca Transilvania
3. The acquisition by the Bank of Cyprus of the Russian bank Uniastrum
4. The merger of Marfin Laiki with Egnatia and in specific the conversion of Egnatia from a subsidiary of Marfin Laiki to a Cypriot bank

In October 2013 this assignment was in the news, not for the firm’s findings but for its fees: on top of €4.5m it turned out that CBC governor Panicos Demetriades had, without the CBC knowledge, agreed to a further fee of €11m. Nothing has been heard of the report and regrettably the four items above remain unexplained.

As the Anastasiades report states: Now we know why: An investigation into the reasons why the Cyprus Popular Bank requested state support of €1.8 bln, would reveal the disastrous decision taken by the Christofias government to nationalize the Cyprus Popular Bank and this was achieved in collaboration with both CBC Governors, initially Orphanides and later on Demetriades.

The Anastasiades report comes to its own conclusions:

The Cyprus Popular Bank, was insolvent before the haircut of the Greek bonds. After the haircut, the Bank had little chance to survive. The only realistic option for a successful recapitalization was through the EFSF. However, it was impossible to receive funding from the EFSF without entering a programme. Christofias’ government followed a policy of avoiding the programme at all costs. By refusing the programme, Christofias’ government led the entire banking sector into captivity.

What the Anastasiades report spells out quite clearly is how Cypriot authorities, from autumn 2011, led by the various ministers of finance and governors of the CBC kept convincing the ECB that all was well and fine with Laiki. When it was no longer possible to dress the bank up as a solvent company the bank was nationalised. In March 2013 it was no longer possible to plaster over the cracks, the bank was restructured and merged with Bank of Cyprus – at the cost of €5.8bn from deposits in the two banks.

According to the New York Times, Benoît Coeuré executive board member of the ECB was also instrumental in coming up with a collateral plan when there were seemingly no collateral left to support further ELA for Laiki. Cypriot authorities, led by the CBC, conspired to thwart suspicious ECB. This whole exercise left the Cypriot state with €10bn of ELA debt, apparently the cost of trying to save a failed bank.

After the events in March 2013 president Anastasiades set up an investigative committee to examine possible civil, criminal and political liabilities regarding the development in the Cypriot economy and financial sector. The six members were all elderly judges with long careers.

Their report was handed over to the cabinet end of September 2013. It has not been made public. The documents leaked by the New York Times indicate that there is plenty of material that the commission did not make use of. Since this report has not been published it is impossible to say how thorough it is but the general feeling is that the 280 pages did not reveal anything much. The attempts to investigate the events leading up to March 2013 and the aftermath have so far been futile exercises.

Based on available material it seems logical to conclude that the bail-in was part of the Christofias government plan to avoid a Troika programme and possibly the scrutiny that might follow. If the latter was the case all fears have been groundless: regrettably, the Troika has never pushed for an investigation to clarify events.

The fact that Cypriot authorities did everything to hide and deny the dire situation from May 2011 had hardly mellowed the Troika in March 2013 when action could no longer be postponed. But it does not explain the attempt to put a levy on insured deposits.

Being a gateway to offshore structures may not have helped Cyprus. That said, EU and IMF officials are hardly squeamish in these matters: Luxembourg and Malta offer similar environment not to mention the tax structures provided by Ireland and the Netherlands.

What Cyprus needs

The ECB is trying to strengthen trust in the European banking sector. In general, an important step towards creating confidence “is to recognize loans that are bad and write them off, ” according to William White, former economic adviser to the Bank for International Settlements. Non-performing loans have been a major problem in the Cypriot financial sector. I heard in December that with a new insolvency or foreclosure framework this would be resolved.

I therefore find it both surprising and worrying that according to Eurogroup remarks 16 February 2015 the foreclosure framework has still not been finalised but is much needed in order to enable banks to clean their balance sheet and start lending again. This is now the main hurdle in the recovery program for Cyprus.

Household debt is a problem – Cyprus could do with some general measures similar to the Icelandic “110% way” where mortgages were written down to 110% of the estimated value of the property to pull households out of the doldrums of negative equity.

“Confidence in the Cypriot banking sector has not been restored,” one source pointed out. That can i.a. be seen from the fact that many prefer to keep cash at home; as much as 6% of GDP could be under pillows and mattresses.

As so often in countries plagued by corruption everyone is aware of it but it is rarely mentioned except when it surfaces in news. But is indeed a huge problem as can be seen from EU Anti-Corruption Report 2013: 78 % of Cypriot Eurobarometer respondents claim corruption is widespread, EU average is 76 %; 92 % say that bribery and good connections is the easiest way to access certain public services, EU average is 73 %. Among Cypriot business people 64% say corruption is a problem compared EU average of 43 %. And most seriously, 85 % of entrepreneurs think that favouritism and corruption hamper business competition in Cyprus when EU average is 73 %.

Cypriots need to know exactly what happened and when – and so does Europe, if any lessons are to be drawn from the crisis. But most of all, Cyprus needs hope. Parents need to believe there is future for their children on the island. Young people have to see a reason for staying after their education or returning there after studying abroad. A country marred by untold stories, unexplained action and corruption is simply not a good country for growth and optimism – the necessary prerequisite for hope.

*My oral sources are all from Cyprus. In agreement with them they are not identified by position since Cyprus is a small country. – This blog is cross-posted on A Fistful of Euros.

 

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A journalist at Morgunblaðið, Hörður Ægisson, has a remarkable access to mole/moles within the CBI and/or the civil service who provide him most lavishly with one leak after the other. Ægisson has earlier touched upon Project Slack, apparently the code name for the plan being hatched on the capital controls. Today, he not only mentions the plan by name but seems to copy and paste parts of it: interesting information on exit tax etc. with most interesting ramifications. The leak might be good news for creditors as it gives them the time to figure out a line of defense. But whether it will be used is another matter: it does not seem in line with the minister of finance vision of a simple route steering well away from legal risks.

One of the key concepts mentioned again and again to justify exit tax – i.e. the omnibus one on the whole of Iceland – is equality: exit tax should be equal for everyone, both foreign creditors and Icelandic businesses. This never sounded plausible; after all, those who want the state to make money out of lifting the controls aim at getting that money from the estates and foreign creditors, not from just everyone in Iceland. The leak in Morgunblaðið clarifies this strife for “equality.”

Morgunblaðið writes (p. 16 of print copy; my translation; emphasis in bold and additions in brackets are mine):

In other words, the (exit) tax is a declaration on behalf of Icelandic authorities that cross-border payments, for example due to possible exemptions for the estates (of the failed banks) accompanying a composition agreement, would be treated as is the case with other Icelandic entities. There would be no difference if the payment was in ISK or foreign currency. … Further, the aim is to find ways for domestic entities, both pension funds and businesses, to bring funds out of the country without having to pay the exit tax planned to be introduced as part of the plan of lifting capital controls.

So much for the declared intention of equality. This is a plan where there are foreign creditors on one hand, domestic entities on the other and some are more equal than others. I.e. first there is a general rule for everyone and then exemptions for some, who all happen to be Icelandic.

This does of course not come as any surprise. It has long been clear that a) the Progressive Party wants to channel funds, not only ISK but also FX, from the estates to the Treasury; b) if this channeling were an easy path to follow it would have been done as soon as the government came to power. – The path towards the funds has to be done under the sign of equality but in order for these measures only to hit the foreign creditors some special paths are needed. It is never easy to formulate “equality” that effectively is discriminatory; which explains why it is taking so long. And even more difficult since Bjarni Benediktsson minister of finance defined the route he wants to take: simple and avoiding legal risks.

Further, Morgunblaðið writes: “The estates’ foreign assets will not be treated separately, as creditors had planned, since they only own claims in ISK in Icelandic estates.”

It remains to be seen if this somewhat narrow definition matters or not. Following a Supreme Court ruling on November 10 (an unofficial English translation here) creditors can now ask for a payout in FX, even to the degree that the estates are free to buy FX to provide for a payout.

As to levying the exit tax (or “exit levy” – Morgunblaðið uses the term “levy,” as in the 2011 capital control plan, not “tax” as has been used lately) Morgunblaðið writes: “The exit levy will however cover offshore ISK owned by foreign entities (which is odd to mention because the definition of offshore ISK is “foreign-owned ISK” – does this indicate that there is no levy on offshore ISK owned by Icelandic entities through foreign bank accounts? Or is this just a manner of writing?) after they have been forced to convert their ISK, with a haircut, into FX bonds with maturity of more than 30 years. According to Morgunblaðið’s sources the proposal is to issue these bonds with fixed interest rates below 3%. It is likely that the sovereign would have to pay close to 50% higher interest rates by issuing comparable bonds in international markets.”

Here it is of interest to note that these (foreign) offshore ISK owners would be subjected to haircut twice: first when they would be forced (how? By law?) to convert their ISK into FX bonds – and then when they take the bonds abroad.

Interestingly, long maturity is normally imposed to keep funds inside a country, i.e. to prevent it from leaving, when capital controls are lifted. This double-fencing in does, at first sight, not quite seem to add up.

Also, this only seems to fit offshore ISK holders in the original overhang, not the foreign-owned ISK in the estates but that might be my misunderstanding.

The worrying, or out-right scary, news for Icelanders is however that this plan seems built on the belief that with this plan Icelandic sovereign bonds will stay near to a junk/below-investment-grade level if the authors of this mighty plan calculate that 3% is a way for Iceland to get cheap interest rates. That is definitely bad news for Iceland and for Icelandic businesses, which to a great degree are dependent on the sovereign rating. After all, lifting the controls is meant to provide market access for Iceland and Icelandic businesses, not to keep them stuck under a new name in capital-control environment for another 30 years.

As Bjarni Benediktsson put it so well in a speech in October foreign investors tend to mistrust countries that need capital controls to survive.

The original overhang offshore ISK owners (now amounting to ISK307bn; 16% of GDP) are in for some changes if Morgunblaðið is in possession of the real plan: “Investment provisions of offshore ISK owners, who now hold ISK130bn in deposits and ISK170bn in sovereign bonds, will be tightened so they will have a choice either to participate in such a sovereign bond exchange or hold their ISK on non-interest bearing accounts in the CBI without any investment provisions. Offshore ISK owners who have invested in sovereign bonds will be forced into a bond exchange when their bonds mature. Foreign entities own ca. ISK80bn in state securities maturing in 2015 and 2016. The (exchange) bond, issued by the sovereign, is tradable but if investors wish to sell their bonds they will have to pay a 35% exit levy.”

It would be most interesting to know if Project Slack has already been blessed and signed by the foreign advisers or if this is “home-knitted,” to use an Icelandic idiom, i.e. if it is put together by Icelandic experts fulfilling the wish of the powers that are. My understanding is that the foreign advisers are indeed familiar with this project. The leak might hone their understanding of the political territory they are operating in.

In an interview with Viðskiptablaðið CBI governor Már Guðmundsson throws some cold water on speculation regarding an exit tax. In a most becoming governor-like Delphic utterance he points out that such a tax was already part of the 2011 plan but it is untimely to speculate what role it might play or how high it might be used. – Keeping in mind the original 2011 exit tax, targeted at foreign-owned ISK against the all-encompassing exit tax now discussed it is indeed appropriate to mention its role and eventual usage as something that needs to be pondered on.

Whoever named the project must be complemented for his (must be a “he” – no women working on this project) sense of irony given the myriad of connotations it can have: the slack legal framework, the slow-moving project etc.

Perhaps creditors know all of this already and have themselves acquired copies of Project Slack, just like Morgunblaðið. But if not, Morgunblaðið has done the creditors a huge big favour providing their lawyers with stuff with which to prepare for the eventualities listed above. Unless of course the slack project in the end neither fits the CBI, IMF, EU and Benediktsson’s sense of practicality and enforceability, not to mention irony.

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The depressing thing is that resolving the capital controls in Iceland might not be that tricky: there are some really sound ideas on lifting the capital controls and there is no lack of literature/IMF papers on similar situations in other countries. The problem is a political one: politicians have on one hand promised too much, on the other fear the responsibility of fateful decisions. Dallying around has already caused a costly delay for Iceland. But two significant steps have been taken recently: the Landsbankinn bonds agreement is finally in place and the Central Bank has announced its final foreign currency auction on February 10.

Finally, creditors – or rather the Winding-up Boards of the three failed banks and some of their advisers – got to meet the government’s so-called advisory group. An IMF-group, in Iceland now, was not at the meeting according to sources but had meetings with i.a. representatives of the creditors following the meeting yesterday. This is a meeting that will sprout many meetings but nothing more concrete for the time being.

The meeting was called for by the foreign advisers to hear the view of Winding-up Boards and creditors. With no plan presented it seems a bit of an exercise in trying to be seen doing something but as Lee Buchheit said to Rúv last night the foreign advisers thought it was time to hear from the Winding-up Boards before presenting their proposals. – And when could a plan be expected? Early next year, according to Buchheit. In the light of the past that seems an optimistic bid.

With the Landsbankinn bonds agreement in place Benediktsson has shown long-awaited determination though the press release curiously has six statements about what is not being done. Further, it is of great interest to see that the CBI auctions are now being brought to an end with a final auction on February 10. It is reasonable to think it will then take a couple of months to finalise plans, which means that in early spring some plan for dealing with the estates and easing capital controls might reasonably be expected; perhaps in the Icelandic tradition of giving summer presents on the first day of summer, celebrated annually on the third day of April.

However, an exercise in cleverness that does not resolve quickly and effectively the ISK assets, the core of the capital controls, will not be a happy solution for Iceland: most Icelandic business leaders agree that Iceland needs a speedy lifting of the capital controls, of course always with an eye on financial stability.

No conclusion – it wasn’t that kind of a meeting

Ever since Glitnir and Kaupthing presented their draft for a composition agreement to the CBI in 2012 creditors have been waiting to meet someone with authority to negotiate a deal. With foreign advisers at hand they had hoped the government would feel confident enough but so far it has not happen. Although nothing was decided today it was at least a day where it was acknowledged that the WuBs and creditors are a party to lifting the controls.

“No, it wasn’t that kind of a meeting,” Jóhannes Rúnar Jóhannesson from Kaupthing’s Winding-up Board said to Rúv when asked if an official plan of lifting capital controls had been presented. Steinunn Guðbjartsdóttir, Glitnir, said the meeting had been a positive step in the right direction. “I think we have to be optimistic. At least this has started and judging from what Icelandic authorities indicate they seem to be optimistic and steadfast in putting an end to this and start working towards lifting the capital controls,” Guðbjartsdóttir said.

Kaupthing’s main message, according to Jóhannesson, was that composition would be the best way forward for Kaupthing’s creditors but also for the Icelandic state, given that such an agreement would be final and abolish both uncertainty and risk. Being based on an agreement composition would be binding for all creditors. Jóhannesson also said that Kaupthing’s message to Icelandic authorities was that the WuB could offer to conclude Kaupthing’s resolution without challenging financial stability in Iceland. – This last thing is very much what the WuBs have been offering: a balance-of-payment, BoP, neutral resolution.

The possible measures

This was a meeting for the WuBs to make their voices heard and they had all worked hard to prepare for it. The WuBs were asked to explain how their proposals would support the aim of the government to secure financial stability. As mentioned above: the WuBs have all been working towards a balance-of-payment neutral resolution, which they aim at concluding through composition.

An exit tax is still being discussed.* The debate in Iceland has been un-nuanced: there is a huge difference if an exit tax is levied on the offshore ISK assets – as was part of the 2011 CBI plan for lifting the controls; same as i.a. Malaysia did with good results at the end of the 1990s, a classic solution in this situation – or on all funds (of course above a certain amount) leaving the country. Would this cover transactions/payouts between the WuBs’ foreign accounts to the creditors’ foreign accounts? No doubt, those who are constructing this plan would be of that opinion because it is first and foremost foreign funds prime minister Sigmundur Davíð Gunnlaugsson and those who agree with him are keen on securing.

Árni Páll Árnason leader of the social democrats who met with the advisers on Monday as part of the Alþingi Economic and trade committee on Monday pointed out after that meeting that the prime minister’s plan to catch funds from lifting the controls had always rung hollow. As far as he could see the aim of the plan-in-the-making was nothing like the prime minister had not only promised but claimed it was unavoidable that the state would accrue money out of the process of lifting the controls.

The goal here is a tax that would be non-discriminatory, not a trivial thing and yet create money flows to the Icelandic treasury. From the point of view of creditors such a tax is akin to an expropriation (especially if not based in national necessity as was the Emergency Act in 2008) and will no doubt be challenged.

The tax levied on the estates this year to fund the latest write-downs, the “Correction,” will as well be challenged. Then there is also another tax, ,,asset-handling tax” (“fjársýsluskattur”), hardly ever mentioned in the debate in Iceland but also greatly upsetting from the point of view of creditors. This tax is, according to them, levied on funds that arise only in the accounts, due to the effect on the asset status when i.a. claims that have been filed twice are corrected and other such measures, i.e. with no tangible funds.

Converting ISK assets into bond with long maturity – 30 years have been mentioned – is one classic solution to prevent funds from leaving the country. Creditors could then sell these bonds or keep them, meaning that for them ISK assets were tradeable. This seems to be part of the plan now in the making.

Solutions tailored to the ISK problem

The problem is that these are all general measures. It would be quicker and more to the point to simply negotiate with Glitnir and Kaupthing regarding their ISK assets, which after all is the core of the problem. The old ISK overhang, now ISK 307bn or just under 16% of GDP.

As the CBI pointed out in its latest Financial Stability report: A solution must be found for the estates’ ISK assets. This is the problem keeping the controls in place – and this is the problem that should be solved.

According to the CBI “settling the estates will have a negative impact on Iceland’s international investment position in the amount of just under 800 b.kr., or about 41% of GDP … The impact on the balance of payments is somewhat less, at 510 b.kr., or 26% of GDP, because a portion of the estates’ foreign-denominated domestic assets are backed directly or indirectly by foreign assets. Residents with foreign-denominated debts to the estates own substantial foreign assets that could be sold upon settlement. Furthermore, the estates’ foreign-denominated sight deposits are backed by foreign liquid assets, according to the Central Bank’s liquidity rules. The impact of the estates’ settlement on the balance of payments is virtually the same as their ISK assets. All of the above amounts will decline by 110 b.kr., or 6% of GDP, with the payment of bank taxes. (Emphasis is mine.)

In addition “Glitnir and LBI have now converted about 70% of the estates’ original asset portfolios to liquid funds, and Kaupthing has converted roughly 60%.”

The sentence in bold outlines how this part of the foreign-denominated debt could be resolved. The book value of the estates’ holdings in Arion Bank and Íslandsbanki accounts for ca. 77% of their domestic ISK-fixed assets. Roughly the whole of Kaupthing’s ISK problem is its holding in Arion. Glitnir has ca. ISK100bn in addition to its holding in Íslandsbanki. There are persistent rumours that Glitnir is close to finding foreign buyers to Íslandsbanki. Another way would simply be to list one or both banks abroad as well as in Iceland – the Norwegian stock exchange has been mentioned as an option.

Agreeing with the CBI the ISK problem needs to be solved. The easiest way to tackle it is by simply negotiating with creditors of the two estates. Swaps with the CBI’s ESÍ and other technical solutions could be used. But as long as the government is captured by its thoughts of making money out of the estates simple solutions are in the danger of being pushed aside for more complex and riskier plans.

Another reason for staying away from negotiations is the government’s fear of getting exposed to legal risk arising from an involvement. But that risk is, to my mind, already there as any exemption granted by the CBI needs the blessing of the minister of finance.

The economic environment: from inflation to deflation

In November Statistics Iceland forecast growth of 2.7% this year. Three weeks later it published new data showing a growth of 0.5% over the first nine months of the year with recession of 0.2% during the third quarter. All of this is way off the 3% widely forecasted at the beginning of the year. Inflation is now at 1%, historically low. As expected, the CBI lowered its rates today: the seven-day collateral lending was lowered from 5.75% to 5.25% (its press release throws some light on the economic situation of weaker growth than previously forecasted).

After living (rather too happily, it seems) with inflation (or the “ghost of inflation” as it is often called in Iceland, perhaps indicating that it is not taken very seriously: a ghost sounds less ominous, more ethereal, than the real thing) Iceland now seems headed for deflation though still too incredible to contemplate. Interestingly, this does not seem to register much. Strangely, compared to other countries, DEFLATION has not been printed in big letters or caused furious and worried debate. Oil price has fallen by 40% over a short time and such swings in commodity can very well aid deflation. People might have been waiting to see what the “Correction,” the debt write-down, would bring – these are the explanations economists have been coming up with.

A deflationary environment is of course a wholly different thing than a growing economy and would pose some real challenges in lifting the capital controls. After all, the conditions for lifting have been most favourable, both in Iceland and abroad.

Iceland’s economy, being a small one, often shows great big swings for little reasons. However, the deflationary tendency is a novelty. It remains to be seen if this is a trend or just a bleep.

An IMF-group was in Iceland yesterday to follow things though not present at the meeting. Both the IMF and the EU are monitoring the situation and a solution without their blessing is unthinkable.

What can unhappy creditors do?

The short answer is: plenty. Still too early to speculate, and hopefully there will not be much reason to, but the hedge funds and other claimants would not have been doing their job if they did not have plan A-Z at hand. Law suits abroad is a common route, plenty of scope there for speculation.

Or something as simple as to short Icelandic sovereign bonds.

Again, remains to be seen. A topic for another day but all of this is clearly been worked on by those whose job it is to steward claims in the estates of the three banks.

The government’s foreign advisers live and breath this environment and there will be nothing there they have not encountered before in other parts of the world. The advisers will be aware of the reputational risks for Iceland (and for themselves).

It is – of course – all about politics but not only in Iceland

There are now three things that indicate the growing political strength of Bjarni Benediktsson. The Landsbankinn bonds agreement went through, as did the ISK400bn payment to the priority creditors. This is allegedly what Benediktsson wanted to do all along, unsuccessfully until recently.

This might indicate an upper hand over the prime minister who was allegedly vehemently opposed to the deal though there was no plan in sight as to how to then save Landsbankinn from default in the foreseeable future.

But it was not only Benediktsson’s growing strength that helped finalise the agreement. According to various sources the Icelandic government sensed great pressure from abroad, first and foremost from the British government, eager to recuperate its Icesave expense but also from the European Union. “Quite severe pressure,” one source said. US officials were putting a lot of pressure on the government earlier this year but do not seem to have shown much interest lately.

If this foreign pressure has been a decisive factor the Landsbankinn move might be more due to the pressure than Benediktsson’s strength. The sticks and carrots were not needed for the LBI, the old bank, but for the government, which allegedly got more sticks than carrots from abroad to accept the agreement.

But there is also another movement: the CBI is resuming its currency auctions, which have been stalled for the last many months. There have been various explanation as to why but whatever the reason was the auctions have now been revived – definitely an important step. Being the final auction it will complete this stage of the plan from 2011.

After the whole sorry affair of getting rid of Hanna Birna Kristjánsdóttir minister of interior Benediktsson appointed a new one, Ólöf Nordal. She is not an MP and was a most unexpected choice. gave Benediktsson the possibility to show the capacity to finding an unexpected solution. It however did take him over a week, though Kristjánsdóttir’s resignation certainly did not surprise. It has generally been taken as a sign of Benediktsson’s strength but others think that in the long run this affair will weaken Benediktsson because it shows he has no faith in his Parliamentary group. He might discover at his peril that few bear grudges like belittled MPs.

Rather tomorrow than today

“Morgen Morgen nur nicht heute, sagen alle faule Leute, (tomorrow and not today, say lazy people)” is a German saying. In the case of Iceland it is not so much about being lazy as being fearful in front of the task of taking decisions that will set the course for Iceland in the coming years; and a political disharmony within the government.

There is an on-going action towards lifting the capital controls. Important steps have been taken but they have been taken rather on the back-foot than with a forward surge and energy. The difficult issues are still unsolved: to lift the controls with the lifting itself as the reward – or lifting by trying to get hold of foreign assets of the estates; two different routes demanding different approaches.

With the long preparation, dealing with the ISK assets is the most direct and shortest route towards lifting the controls. The creditors have a full understanding of the situation, also the political situation. Though they will evidently fight fiercely for every króna in the estates there is no doubt also a sense of reality among them what is likely to be within reach, also because a BoP neutral solution is needed as far as possible. If the Icelandic government could muster the courage, aided by their foreign advisers, to take an aim at the core problem it is perfectly achievable to lift the capital controls in the foreseeable future. Again, this is a problem of politics, not economics – and that does not make it any easier to tackle.

*To clarify: in the 2011 capital control plan the exit tax, called “exit levy,” was presented as last-step in the plan to lift the controls: “Finally, the remaining owners of offshore krónur will be offered the chance to sell their ISK deposits for foreign exchange, subject to an exit levy, or to swap króna‐denominated Treasury bonds for eurobonds issued by the Treasury. It is difficult to state when this phase will be concluded; this will be determined by the interplay of internal and external factors.” – As has been emphasized above and earlier on Icelog: what is now being discussed is a very different beast: exit tax on all funds (above a certain amount, no doubt a matter of severe discussion among the advisers) leaving the island, creditors, pension funds and all and sundry. The offshore ISK exit tax targets the core problem, the omnibus exit tax does not: offshore ISK owners, within the estates and those from the old overhang (now ca. 16% of GDP) could well wait, which means that there is nothing to ensure the offshore ISK problem will be solved. – For this reason I find it difficult to imagine that the IMF and the EU would accept the omnibus version of the exit tax though nothing is ever certain in this world.

Update: among the questions WuBs were asked about was why they preferred composition to bankruptcy proceedings – and also their opinion on inserting some sort of a sunset clause into the process (retroactive law?)

Further: I was asked what I thought the exit tax would be. It seems impossible to answer this question in a rational way. First: the estates aim at a BoP neutral solution – as Lord Eatwell suggested in his advice to Glitnir. Kaupthing is talking about the same. Second: what is the tax being used for? To raise money for the state? Then it is impossible to calculate the tax unless knowing how much the government is seeking to raise. Or, tax to solve the problem of the ISK? As far as I can see an omnibus exit tax does not solve the ISK problem, see above. – That said, the number must consistently mentioned is 45% but again, will it be a transparent tax/levy, i.e. with a clear aim/timeframe, as successfully used in Malaysia; or a non-transparent one with no clear aim/timeframe.

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The Winding-up boards of the banks have been waiting to be called to a meeting with the committee overseeing the lifting of the capital controls – and now an invitation has landed on their tables for a meeting next Tuesday. Remains to be seen what the message is.

In the meantime, there is the extension of the Landsbanki bond agreement and a payment of ISK400bn to priority claimants in Landsbanki, announced yesterday, all explained here. The agreement has been changed from what it was originally but at least decisions have been taken and the Brits have had some happy tidings.

The question is if something more will follow, hen’s or horse’s steps.

Bjarni Benediktsson has heaped time pressure on himself (allegedly trying to push the PM to good deeds) by continuously referring to a plan in spe by the end of the year. With domestic politics in mind, he might feel that Icelanders need some taken care of, i.e. some control easing for domestic entities rather than foreign creditors. Without solving the problem of the offshore ISK any domestic move can be little but some window-dressing.

So far, the fundamental rift between the two government leaders hasn’t been fixed – that the PM hopes to gain funds out of lifting controls while Benediktsson is, I believe, “just” trying to lift the controls. As long as they don’t look in the same direction it is difficult to believe in the big steps necessary to lift the controls.

It certainly is a victory for Benediktsson that he has finally – after months (depends if one counts from May or later) been able to do what he apparently wanted all along: extend the Landsbanki bonds (albeit by changing the agreement but not in a materially different way). Better late than never. Incidentally, this happened on a day where he appointed a new minister of interior, Ólöf Nordal, thereby making a popular choice for everyone except his parliamentary group, which in the long time might turn problematic. The group will certainly not feel they owe him any favour.

In November a year ago when Benediktsson managed to drastically tame the PM’s wishes re the “Correction” as the plan was first presented, I thought this signaled that Benediktsson was gaining the upper hand in the relationship with his coalition party. I was dismally wrong that time; no drastic steps followed. Now that Benediktsson has taken steps re Landsbanki, after all this time, doesn’t necessarily mean he is gaining the upper hand.

The last paragraph in the press release from the Ministry of Finance is interesting:

The settlement of priority claims marks a major step forward in the winding-up proceedings of the failed banks and will assist the Government in implementing a comprehensive capital account liberalisation strategy. 

So is there now the long-awaited strategy? Not sure yet, more needs to be seen.

Another interesting new move – Heiðar Már Guðjónsson has now demanded at Reykjavík District Court that Glitnir be put into bankruptcy proceedings; another interesting twist.

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If minister of finance Bjarni Benediktsson sticks to his well-publicised intension of moving towards lifting the capital controls before the end of the year a plan must be imminent; some of the foreign advisers have been visiting. One strategy being examined is exit tax on both ISK and FX. Such an exit tax will not solve the offshore króna problem and might prolong the capital controls under a different name. A new judgement by the Icelandic Supreme Court may well have effected the certainty of those pleading for the “ISK-isation” of the failed banks’ estates. Central to the coming plan is whether the government is content with lifting the controls – or if it wants to gain funds for the state coffers as well. As before, the politics count more than the economics.

As soon as they were in office both prime minister Sigmundur Davíð Gunnlaugsson and minister of finance Bjarni Benediktsson said they would work towards quickly lifting the capital controls. In office since early summer 2013 the two leaders do not have much concrete to show for their oft-repeated words.

To those close to the process the reason for the sluggish pace is clear: the two ministers have diametrically opposing ideas. Gunnlaugsson has not been saying much recently on the controls but has earlier championed the idea of enriching the state with money from the foreign creditors he invariably calls “vulture funds.” Benediktsson’s speech in October indicated a willingness to avoid legal uncertainties.

An exit tax is a classic solution to capital controls as Malaysia demonstrated in the 1990s. It is also part of the three-step liberalisation strategy set out in 2011 and in its original form intended for offshore ISK. Now however the feeling is that the Icelandic government is planning an exit tax on all funds leaving the island, ISK or FX. And the percentage? Anything less than 30-35% is hardly credible given that the difference between the ISK on- and offshore rate is now 17%; as much as 50% has also been mentioned. Whether this strategy would be based on a transparent plan is not clear.

The rumour in the Icelandic echo chamber is that a plan, some plan, might be presented by the end of November and the exit tax will be a part of that plan. What else it might contain is not yet clear.

Exit tax – in theory not a new idea

As mentioned in the most recent IMF report on Iceland the 2011 capital controls liberalisation strategy included FX auctions, as the CBI has been doing and then further two steps, Eurobond swap and exit tax, not yet implemented.

This exit tax is in line with measures taken in other countries with capital controls: in order to temper outflows, which the controls were put in place to contain, there is a tax. The transparent way is to announce at the outset both the percentage and a schedule for lowering it. If things go well the easing can be accelerated as turned out to be the case in Malaysia: the plan was implemented in less time than foreseen at the beginning. Those holding the problematic currency can then choose if they want a tax haircut or if they wait; other capital movements are not affected.

However, the rumour is that the Icelandic government is planning an entirely different version of the classic exit tax, i.e. a tax on all movement of capital out of the country, whether offshore ISK or FX. This prolongs the controls in all but name. In theory everyone is equally (badly) off, which solves the problem the government is actually very worried about: equality between creditors and others.

In particular the government does not want to be seen as aiding greedy foreign creditors to exit while Icelandic individuals and entities are still locked inside controls. Unfortunately this is partly a misconceived argument – Iceland as a whole stands to gain quite immensely by lifting the controls. This should be the focus of the government, not the possible gain of the creditors. Whether the lifting happens some months later is of a much lesser importance than Iceland getting out of controls. The Icelandic gain of lifting the controls is escaping the controls.

Interestingly, this timing problem could indeed be solved in a fairly simple way: if a composition agreement for Glitnir and Kaupthing is reached it will take at least 4-6 months to work out the details. With an agreement in place this time could be used to open up exit avenues for Icelanders.

Acting so as not to act

An exit tax on all flows seems to be a (not so?) clever way of avoiding a decision on the, for the government, thorny issue of composition or bankruptcy proceedings for the estates of Glitnir and Kaupthing (and for Landsbanki further into the future). The message to the creditors is then that they can decide whatever they want – composition or bankruptcy, no problem, make your own choice. Beyond the estates there is the exit tax.

An exit tax on all outflows does not necessarily solve the offshore ISK problem – the underlying cause for the capital controls – and it does not solve the problem of that particular part of the foreign-owned ISK in Glitnir and Kaupthing: Íslandsbanki and Arion.

The recent judgment by the Supreme Court in the case of Kaupthing v Aresbank SA (in Icelandic; here an unofficial English translation) did not come as a surprise for those who had interpreted Icelandic state and creditors v Landsbanki Supreme Court judgement from September 2013 along the lines now clarified. For those working for the “ISK-isation” of the estates this judgment is no happy tidings. Not only can the estates pay out in FX if they or creditors so wish: the estates can go out into the market and buy FX in order to pay out; quite a feisty judgment as judgements come.

Will the government act at all?

The government is no doubt working on a plan but will it actually have the courage to act? Interestingly, some hardened political observers in Iceland do believe that in spite of all the rhetoric the government will actually not be able to make the necessary decisions. They think the government will simply limp through its four years continuously finding some reasons for in-action on the controls.

Rationally, I have to say I find it difficult to believe this could be the case not least with Benediktsson’s oft repeated intention to act before the end of the year. On the other hand this government has shown some spectacular abilities for inaction or leaving things open (appointing a new CBI governor; a debt relief yes but very different from the original intentions; Landsbanki bonds agreement etc.). With this in mind it is easy to believe that the difficult issues regarding the controls will prove to difficult to solve.

Most strikingly, the government – or, to be more precise, the minister of finance and the prime minister – has not been able to act so far on the Landsbanki bonds agreement and the ISK226bn, €1.45bn, remaining for Landsbanki to pay LBI. If agreed on it will most likely be with some further restrictions for general creditors than in present agreement (though they will not get paid until the estate either goes into bankruptcy proceedings or there is a composition agreement; i.e. the agreement sets on precedence since priority creditors have been paid out in Glitnir and Kaupthing). The next deadline (the fifth) is Monday 17 November.

Regarding Landsbanki the delicate act is how to treat the main priority claimant, the UK deposit guarantee scheme. Economic Secretary to the Treasury Andrea Leadsom allegedly did not mince her words when talking to Benediktsson on his visit to London in autumn. He thought he was coming for a collegial meeting over drinks but instead got an almighty dressing down from the fearsome Leadsom. There are even rumours that the Secretary was waiving a legal writ already penned. All of this is rumours rumours and nothing more.

Political tremors

I have earlier pointed out that so far the prime minister has had an upper hand since he apparently stopped Benediktsson from agreeing to the Landsbanki bonds agreement. Now that Gunnlaugsson’s grand promise on debt relief is being carried out, to no great happiness of many Independence Party MPs, Benediktsson needs to strengthen his grip on lifting the controls his way if he wants to maintain his political credibility. The question whispered is “When will Benediktsson man up?”

Coalition certainly is built on compromises but since the controls are part of Benediktsson’s portfolio anything that smacks of the Progressives steering the controls policy will make Benediktsson look weak, very weak indeed. If he is forced on a path fundamentally different from the one he has outlined it will seriously harm his political credibility.

Interestingly, the political focus is firmly kept on the losses the creditors suffer from the waiting game as if none of this mattered for the interests of Icelanders themselves. The legal risks are hardly ever mentioned nor the fact that threatened Landsbankinn is indeed the state’s largest single asset, amounting to 12% of the state’s assets. Benediktsson talks about starting to sell shares in Landsbankinn next year and yet never mentions the connection between the bonds agreement and the possibility of a sale. This rather skewed picture is rarely challenged also because very few people, also politicians, have any firm understanding of the underlying facts.

A political wrestle is also taking place over the 2015 Budget. Benediktsson wants to increase VAT on food from 7% to 12%, a principal change towards simplification from Benediktsson’s point of view and therefore of fundamental importance for his strategy. Progressive Party MPs are against. The intriguing question is if the prime minister will side with his finance minister or his party. Again, any change here reflecting badly on Benediktsson’s political strength will undermine him. (Those who think ex-prime minister Davíð Oddsson still is a political force to reckon with will notice that Oddsson, in Morgunblaðið, has come out against the VAT increase yet again siding with the Progressive party and not with the leader of his own party.) Benediktsson can take some comfort in the fact that the Progressives have plunged in opinion polls whereas his own party is strengthened.

Cyprus implemented capital controls last year. Aimed at hindering outflows from banks the Cyprus controls are intrinsically different from the Icelandic ones. As in Iceland the controls were meant to be in place only for a few months. Cyprus is now far into lifting the controls, has indeed already eased them quite a bit contrary to Iceland where they have gradually been tightened. Cyprus might possibly have lifted them altogether by the end of the year.

Six years into controls Iceland seems far from lifting them – though this year the Christmas crackers might contain unexpected surprises. It remains to be seen who will then have a crackin’ good time.

*I have often gone through the underlying economic problems of the controls; also well explained in the CBI Stability Reports over the years. The last one, published in autumn, clearly underlines the cost and damaging of the controls. – The government’s basic information, in English, on the debt relief is here. (Correction: in the first published text it said the government had been in power since early 2014; that should of course be early 2013 as it now says.)

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Minister of finance Bjarni Benediktsson discourses boldly on decisive and imminent steps towards lifting the capital controls. Prime minister Sigmundur Davíð Gunnlaugsson now rarely mentions the topic and then only in the most general terms. The next important event is the October 24 deadline* for the Landsbanki bonds agreement. The government faces strikes, the final vote on the 2015 budget is still to come and the “Correction” – writing-down of loans – is moving slower than planned. Worst of all for a government: the two leaders seem light-years apart on key issues. The question is if the two of them really can forge a coherent policy on the capital controls (as well as some other issues).

Russia watchers have Kremlinology. The equivalent in Iceland could be Arnarhvoll-ology (admittedly a word that will not flow easily off a foreign tongue): the art of observing and making qualified guesses of what is really going on in Icelandic politics.

Arnarhvoll is the imposing 1930 building, which now houses the ministry of finance, built at the time when most buildings in Iceland were corrugated-iron sheds or turf-roofed cottages. With an eye on modern Iceland – new(ish) cars, big houses and Harpan – it is easy to forget the giant steps this once so, literally, dirt-poor country took into affluence and modernity. Now Arnarhvoll nests by the Supreme Court house, the Central Bank and the National Theatre, not far from Harpan.

Below is an attempt to practice some Arnarhvoll-ology to gauge where the government stands regarding the capital controls, most of all the pressing issues of the Landsbankinn bonds agreement and of how to resolve the estates of Kaupthing and Glitnir.

Benediktsson’s knowns and unknowns

Minister of finance Bjarni Benediktsson gave a speech last week at a symposium in memory of an Icelandic economist, Jónas Haralz. In his speech, (here, only in Icelandic) Benediktsson reminded the audience of the last time capital controls were put in place in Iceland: stayed for 60 years. With new controls in 2008 Haralz said that compared to earlier Iceland was now much more connected to the outer world in addition to the support of the IMF; Haralz was sure the controls would not be allowed to fester for 60 years this time.

Although Benediktsson’s speech was fairly general it did, to my mind, include soms paragraphs, which under the lenses of Arnarhvoll-ology might give some hints on his thoughts: no, the creditors are no this main worries but, as far as I can see, his coalition partner.

As before Benediktsson said any solutions had to be financially feasible, socially fair and politically doable. It was also important to be aware of the risks implied, he said, aware that circumstances can change quickly in spite of the present positive outlook. Solutions should not be based on too much optimism regarding the coming years. In addition, circumstances abroad could change – a timely reminder for Iceland, he said, to pay off its debt (but no, he did not mention why then ISK80bn of public money should be used for the “Correction” and not to paying off sovereign debt).

Benediktsson said that since last year much work had been carried out to analyse the problems and develop solutions. Then this declaration (which sounds equally un-Icelandic as it sounds un-English in my translation; emphasis mine): “I make the demand that during this year important questions will be answered so that next steps can be taken. They (the questions) will i.a. touch on if it is realistic to solve the issues of the estates without a direct intervention by authorities.”

Benediktsson emphasised the importance of a holistic solution, taking care to respect national interest “as well as respecting law, international commitment and ensure equal treatment.” The balance-of-payments needs to reflect reality (never easy in Iceland at the best of times), also to prevent another economic down-turn. Then again, a very interesting sentence: “Actions that take less time, are simple and minimise legal risk will be favoured over more complicated ones; each action needs to be in accordance with the general solution.”

Benediktsson said the government was willing to listen to all constructive ideas, no matter where they came from, also regarding exemptions, as long as they improved the economy. But all decisions would be taken with the general interest of the nation at heart, not single interest groups – interestingly, a comment that could as easily be directed at some Icelanders as well as the creditors.

But there were also words clearly meant for the creditors: “If those seeking exemptions from capital controls do not put forward realistic ideas to meet these points of view as well as others still being worked on, things will be put in order of priority according to the needs of the real economy.” – This means that creditors must take into account issues the government has already presented as well as those not yet presented, the knowns and the unknowns; never an easy proposition.

Anyway, both Kaupthing and Glitnir have tried: Kaupthing has had no answer; Glitnir has had an answer after which it amended its composition draft. There are simply far too many possibilities and variables for this silly game to continue. The government cannot claim the estates are none of its business when it is the final arbiter in the process of the estates’ resolution.

And last but not least some edifying words for those working on lifting the capital controls: “For those responsible for moving these issues forward it is at last important to realise that it will not be possible to calculate all potential outcomes, eliminate all risk and foresee investor behaviour far into the future. What is needed, after the necessary preparation, is simply to make a decision.”

Benediktsson’s message according to Arnarhvoll-ology

From all directions it echoes that Benediktsson and Gunnlaugsson are light-years apart on the key issues of the capital controls. Each side appointed people in the all-Icelandic advisory group at work last winter – in the end it allegedly only came up with a mish-mash of various and to some degree conflicting ideas. In the group now at work each side also appointed its representatives, which means, I am told, that there is not much momentum to solve the underlying and fundamental disagreement on composition vs bankruptcy re Kaupthing and Glitnir. Glenn Kim, the foreign advisor in charge of this group is apparently not much seen in Iceland these days (though yes, with modern means of communication presence is not all).

Reading Benediktsson’s speech with this in mind, it is difficult to avoid the feeling the Benediktsson really is talking to his opponents in the government and not so much to creditors. He is telling his opponents that rather than embarking on the risky road of bankruptcy, simple foreseeable routes are preferable. Or, as the IMF put it: composition is an orderly legal route, bankruptcy a disorderly route.

Benediktsson prefers the simple to the complicated and he also prefers solutions that take less time than long time. And Benediktsson is also well aware of reputational risk: my friends (if he still uses that word for his coalition members), lets keep in mind the rule of law, international law and equal treatment for all, both Icelanders and foreigners. An all-encompassing certainty can never be achieved in this world: those who have the painful role of deciding must in the end… eh, make up their minds.

The Progressive Party has over the years been good at securing good deals for chosen party members. The feeling is that some would like to steer Íslandsbanki and Arion, now owned respectively by Glitnir and Kaupthing, into Icelandic hands. If so, this goal could influence their thinking on the issues at stake in lifting the control.

As tried and tested Kremlinologists know the interpretation is only as good as the political understanding it is based on. But no matter what: it is politics and not economy that decides on the vital issues regarding the lifting of the controls.

The best of times

In its recent Financial Stability Report the CBI came out with its so far most clear warning on the “steadily increasing” cost of the capital controls and their detrimental effect on the economy (emphasis as in the FS report):

There are numerous costs associated with the capital controls. The most obvious is the direct expense involved in enforcing and complying with them. But more onerous are the indirect costs, which can be difficult to measure. The controls affect the decisions made by firms and individuals, including investment decisions. Over time, the controls distort economic activities that adapt to them, ultimately reducing GDP growth. The direct costs associated with liberalisation centre primarily on the possible lack of confidence in liberalisation and the associated risk of disorderly capital outflows, which would weaken the króna, stimulate inflation, and result in higher interest rates.

If liberalisation is not carried out successfully, these costs will make themselves felt quickly. On the other hand, liberalisation will lead to increased efficiency over time, as decisions will be made without consideration of the capital controls. Measures aimed at making it easier for some parties in the economy to tolerate the controls reduces the incentive to lift them, with the associated expense for the general public. 

The FS Report is equally clear on the present favourable economic conditions:

At present, economic conditions are favourable for large steps in liberalisation. The economic outlook is better in Iceland than in its main trading partner countries, interest rates abroad are at a historical low, Iceland’s interest rate differential with its main trading partners is positive, GDP growth is stronger in Iceland than in most trading partner countries, domestic inflation is close to target, Iceland has an established trade surplus, the fiscal budget is estimated to be in surplus next year, the spread between the official Central Bank exchange rate and the offshore exchange rate has narrowed significantly in recent months, and the Treasury has demonstrated repeatedly that it has access to foreign credit markets. Therefore, it appears that current economic conditions are conducive to successful liberalisation of the capital controls. It is important to remember, however, that these conditions could change for the worse later on.

The main problems relating to liberalisation have been identified as the stock of offshore krónur owned by non-residents, Iceland’s balance of payments, and the settlement of the failed banks’ estates. The narrowing of the spread between the Central Bank’s official exchange rate and the offshore rate, increased access to foreign credit markets, deleveraging of foreign loans, and the persistent trade surplus diminish the effects of the first of these two risks. The remaining problem, the settlement of the failed banks’ estates, is the largest factor complicating the liberalisation process. 

The same views are widely heard throughout the Icelandic business community, most recently expressed in an article (only in Icelandic) by Þorsteinn Víglundsson managing director of SA, the employers’ organisation.

One way of managing life under controls would be to give more exemptions to domestic entities. Were that route to be used increasingly it undoubtedly means that the government is planning for the controls to be in place for a long time – no good sign.

Landsbanki bonds agreement

According to rumours the Landsbanki bond agreement is yet another battleground between the two coalition leaders. Benediktsson has been in favour of agreeing to it. It seems the prime minister sees the agreement as giving too much to the creditors. (See here for further details regarding the agreement).

Some prudent voices claim the agreement sets precedence for the general creditors. Others claim that the main importance is to abolish the uncertainty Landsbankinn with no agreement poses. The CBI points clearly out the risks for Landsbankinn and Iceland as a whole unless the bonds’ maturities are extended:

Other things being equal, if the Landsbankinn bonds are not extended, domestic demand would have to contract and the currency would have to depreciate in order for the domestic economy to generate enough additional foreign currency to service the debt. Analysis using the Central Bank’s macroeconomic model indicates that, in comparison with a scenario providing for the lengthening of the bonds, the exchange rate would have to decline temporarily by up to 8%, private consumption would contract by up to 2%. Inflation would rise and, according to the model, Central Bank interest rates would have to be kept higher in the near future in order to bring it back to target. In order to prevent this, the State or the Central Bank would have to provide Landsbankinn with long-term foreign-denominated funding, with the associated implications for the Treasury debt position and the Bank’s foreign exchange reserves.

If the bonds are lengthened and external conditions remain unchanged, it is likely that the trade surplus will suffice to cover resident entities’ unfunded debt service burden in foreign credit markets in coming years…

Landsbanki estate, the LBI, has not been able to pay out to priority creditors for over a year now, see its financial statement here. With time and no explanations from the authorities it will make the UK government increasingly frustrated as well as other priority claimants. Again, does not bode well for Landsbankinn. Also, it prepares a case for creditors that the Icelandic authorities are withholding their funds.

The worst of times – in sight

In addition to the good times in Iceland there are positive circumstances abroad. As Benediktsson pointed out in his speech nothing lasts forever. In Iceland, an ominous winter is ahead.

Coalition MPs disagree wildly over tax – Benediktsson proposes to put VAT on food up from 7% to 12% and offsetting this by lowering VAT on i.a. kitchen appliances. This is a thorny issue for the Progressive Party. Sigmundsson himself wrote some years back on the unfairness of putting up VAT on food, an opinion widely shared by his fellow MPs. The question is if Gunnlaugsson will side with his fellow party members or with Benediktsson and the Independence Party when the budget coms up for a final vote in Althing: a truly impossible choice unless Benediktsson helps him out, which in turn hurts Benediktsson and cements his reputation as a ditherer.

Because of this the budget might not go down smoothly in Althingi. In addition, the “Correction” is still not in people’s pockets and so far unclear when it will happen.

Physicians got the right to strike some thirty years ago but have never gone on strike so far. That might be about to change: the Icelandic Medical Association now threatens a strike on October 27. Other strikes could follow in the coming winter.

The times for lifting the capital controls may be as good as they get. Objectively, Benediktsson has excellent reasons to be optimistic about decisive steps in sight. There are solutions in sight, tickling the finger-tips. But as long the underlying discord and clear-cut disagreement is unresolved the good economic circumstances do not help. The truly frustrating thing is that because of the work carried out by the Icelandic authorities those who, like Benediktsson, favour a quick and simple solution really do see various ways to reach the goals set forth by Benediktsson. Above, nothing is said about the unknowns related to possible creditor action against Icelandic authorities – hopefully an unknown Benediktsson is working on understanding and then explain possible risk to those who take a different view on how to proceed, also the fact that no action on behalf of the Icelandic authorities is not entirely risk-free either.

If the underlying disagreement remains unsolved  and if strikes and budget battles are on the horizon the best of times could easily become the worst of times… and drain the government of the political energy needed for taking the decisive steps the minister of finance is demanding. Sad for Iceland but hopefully it will not take 60 years as last time.

*Updated version. – The original version gave the LBI deadline as Oct. 26; sorry, it is indeed October 24 as stated in an earlier Icelog.

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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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