A resurgent topic hitting the headlines lately is one that deals with an often forgotten island in the Atlantic (no, not Atlantis). Iceland has recently achieved something quite extraordinary – its debt (bond) was upgraded to ‘invest’ quality (BBB-). Less than 4 years after the crash, Iceland is back on a firm economic footing. Thanks to a devalued currency (krona) and nationalising its oversized banks, Iceland has been rewarded with more competitive exports, decent projected growth (2.4% in 2012 says the OCED), falling unemployment (projected 6% for 2012), a current account deficit of 3.5% and a government debt: GDP ratio of 100%. The last one would, in normal circumstances, look pretty bad – but when Greece is heading toward 170%, comparisons are your friend. Big whoop? Well, yes! This is a major achievement on two levels.
- One, an economy which experienced a rock hard landing in 2007/8 has surprisingly sprung back very quickly despite facing similar circumstances to the PIIGS (Portugal, Ireland, Italy, Greece and Spain), which remain weighed down by self afflicted (ahem…) austerity.
- Two, Iceland’s success has proved that a very different path to the ‘keep the bondholders happy’ one adopted wholesale by the EU might actually be best. The success of that small island of 330,000 might actually undermine the entire European effort under the terms of those Portuguese, Irish and first Greek (PIG) EU-IMF bailouts.
In terms of cost, the Icelandic IMF programme was a steal. They received, not a PIG style €62.5-€110bn bailout, but effectively a €1.7bn stamp of approval – an IMF engineered ‘Stand-By Arrangement’ (SBA) giving Iceland access to foreign capital. Its worth noting that the IMFs work was finished by August 2011 and they published a glowing report card.
So how did they do it?
What did Iceland do right?
- First. They let their central bank look after its own interests through its independent monetary policy (while the euro -17 are force fed a ‘one size fits all’ version).
- Second, Iceland recapitalised its banks (cost: about 45-50% of GDP) but didn’t assume all the debts and pay every bondholder. The reasoning was straightforward. Prior to the crash, the Icelandic banking system was hugely concentrated. With 23 financial institutions in operation, the 3 main Icelandic banks accounted for 85% of Iceland’s entire banking sector – which might be an understandable level of concentration for an island of 320,000 people. Except for the not unimportant detail that the Icelandic people were not really the main investors. These 3 banks were massively inflated and perilously exposed – accounting for around 880-950% of Iceland’s GDP by the end of 2007. Iceland couldn’t possibly afford to pay back these debts. It might prioritise some bondholders, but most would understandably have to accept severe losses.
- Third, after nationalisation, stringent capital controls were put in place to stop investors pulling their money from these newly state owned debt banks/albatrosses. The opinion at the time was that this would just be a barrier to inward investment – but a distant Atlantic island with 50% of its GDP extracted from fishing industry exports – may not need to be as externally focused as the eurozone needs to be. See here for some useful Ireland-Iceland-Greece comparatives.
A Brief History Lesson
Iceland’s banks were as bad as those profligate EU banks. They spent wildly, injecting cheap credit into profitable small, open economies which were in turn tentatively supported (down along the chain) by bricks and mortar (property owners current and future) – many of whom couldn’t in reality afford a good sized tent, let alone a mortgage on some 5 bedroom home. That same competitive ‘drive to the bottom’ to deregulate Iceland’s financial industry and remove the governments ‘straightjacket’ on commerce was a mirror image of similar initiatives throughout the Western financial system. As we all now know, this turned out to be mostly about credit rather than commerce.
With attractive banks, appearing to grow exponentially due to perceived ‘success’, Iceland appeared like the promised land for investors, and they piled in, inflating a speculation fuelled bubble. When the banking crisis collided with the ridiculously overstretched and unwieldy positions of the main Icelandic banks (Their assets equated to 880-950% of Iceland’s GDP, remember!). For more detail on this, see the OECD study here. Iceland’s entire banking system was rendered immediately insolvent, forcing those banks, like their counterparts across Europe to desperately run cap in hand to the government to keep themselves and, along that usual logic, the ‘system ‘(and entire economy) afloat. So far, this is exactly the same tale as your typical PIIGS.
BUT…
The price of injecting vital capital into the big banks (nationalising them) was more than just their shares. The government refused to pay those who had invested in bank bonds back (bondholders). The Icelandic people were utterly against assuming such a massive debt around their necks, and understandably so. For Iceland’s banks were so indebted (up to 5 times the level of Irish banks for example), the cost would have been astronomical. So, Iceland..
- Burnt the ‘creditor’ bondholders (not popular with nations who now have to pay back these investors – in part or in full – themselves from their own exchequer to prevent domestic turmoil).
- Prioritised secured bondholders for repayment, eventually.
- Protected creditors (bank customers) only
- Devalued its currency to reignite exports and reboot the economy
- Froze capital (via capital controls) to stop existing investors fleeing with their money.
Landsbanki
Landsbanki was the country’s biggest bank before the crash. As mentioned, the usual story applies as in Europe. Increasingly loose laissez faire banking policy saw banks lend cheaply and recklessly beyond Iceland’s population, expanding their scope of activities beyond a single jurisdiction, complicating their operations. By this action, they created behemoth financial institutions which, like massive octopi, had long tentacles stretch into many markets while the creature itself lay in just one. As a result, the exposure for Landsbanki was much greater as the stability of the banks foundation rested on prevailing conditions in the entire western financial world. With economic conditions deteriorating, the domestic economy suffered badly. In common with Europe and the US, housing collapsed leaving bank books covered in red ink from delinquent subprime mortgages.
As a result, Landsbanki and its Anglo-Dutch internet-based subsidiary Icesave left savers in the UK and the Netherlands with the prospect of losing all their savings. The UK Financial Services Authority (FSA) attempted to transfer Icesave accounts (which held British savers funds) to a UK subsidiary and protect Icesave accounts under the British deposit guarantee scheme. This wasn’t possible even as the banking crisis worsened in late 2007/early 2008. As Landsbanki became increasingly exposed to its hugely overextended position (compacted by Lehmans Brothers collapse in late 2008), the UK and Dutch authorities desperately fought to protect their savers because, put simply, the €9bn Icelandic economy could not possibly absorb the €63.5bn in accumulated debt on Icelandic bank books.
Bondholders, far from being repaid in full, Landsbanki shareholders in general would received a paltry 5% refund, a whopping 95% haircut. So a dilemma arose. If Iceland wasn’t going to stop its banks from collapsing, Icesave would collapse and along with it all those British and Dutch savers would lose their money, with local credit unions, pension funds and more going bankrupt. The only way to avoid this and protect domestic interests was for the UK and the Netherlands to inject money directly into Landsbanki via the Icelandic governments own deposit protection scheme so that the Icelandic authorities could, themselves, pump enough money into the banks to cover minimum EU deposit guarantees on Icesave accounts in their own jurisdictions. British and Dutch Icesaver customers were saved by British and Dutch taxpayers and not the Icelandic government which, as new owner of Landsbanki, was responsible for doing so.
Naturally, there are some who applaud the Icelandic government’s attempts to ‘burn the bondholders.’ After all, why should Icelandic taxpayers have to pay for the reckless behaviour of cowboy banks which just so happen to be based in their jurisdiction? It’s not as simple as that. Some members of the IMF – mainly Nordic countries – only agreed to allow the IMF role in Iceland to protect Icelandic credibility on the condition that Iceland agreed to refund those who refunded Icesave’s customers – the British and Dutch governments (taxpayers).
The Icesave Saga
As Iceland refused/was unable to pony up to repay investors in Icelandic banks (bondholders), a problem arose. These investors aren’t just bigwigs in suits in the City of London and Wall Street. In many cases, these are private pensions funds, credit unions or other local/community organisations which would completely collapse it they lost their investment in full. So, respective governments had no option but to bail them out with their own money – which, at a total depositor loss of €8.2bn is not small change (including €2.75bn paid by Britain and around €750m paid by the Netherlands which they both want back!). The decision for Iceland to ‘repay’ was put by the government in the hands of the Icelandic people and has been defeated 93%-7% (January 2010) and 63%-37% (April 2011) – at varying (generous) interest rates – from 5.5% (2010) to 3.3% (2011) – over long repayment periods (2010: 6 years from 2016 – 2011: 30 years from 2016) with most of the recovered assets of Landsbanki expected to cover most of the principle sum demanded by Icesave creditors (90%).
The issue is therefore one of fairness – why should the British and Dutch authorities fork out for an Icelandic banks problems? Why should the Icelandic people fork out to recapitalise an Icelandic bank whose own actions caused its downfall? Who pays? The Brits and the Dutch have already compensated Icesave savers in their own countries. The British and the Dutch remain very unhappy about this and there remains a European Economic Area case still pending on this issue. If the verdict goes against Iceland, they could end up paying these countries bank and resuming these debts all over again. This is a hugely hot button issue in Iceland, with causalities of the battle so far including the Icelandic PM and the two decade rule of the Independence Party, which lost power in 2009. The unresolved dispute over Icesave could add to the debt burden. Longer-term, doubts lurk about Iceland’s growth potential, with much debate over how to exploit its natural resources.
Bottom Line
Undoubtedly however, Iceland’s success on rationalising its banking sector and returning to short term economic health so rapidly (at least, on the surface) has hinged at least somewhat on imposing losses on unsecured creditor ‘bondholders’, something that is utterly objectionable under conditional EU-IMF bailout programmes in Greece, Ireland and Portugal. Whether those protagonists of such a view like it or not – Iceland’s success undermines the eurozone argument that says refunding the bondholders in full is the best route back to economic prosperity.
piigsty 