Iceland’s three main banks – Kaupthing, Landsbanki and Glitnir – collapsed with $85bn of debts in 2008. Creditors have since tried to get their hands on the estimated Ikr2.8tn ($24bn) of assets controlled by the bank’s administrators – and indirectly by the Icelandic government.
Reaching an agreement with these creditors is vital to lifting capital controls, as the government frets that the failed Icelandic banks’ domestic assets, which amount to about IKr957bn, could be sold quickly by foreign creditors and crash the currency again.
Second, in a 180 degree turn from its handling of the East Asian crisis of 1997-1998, the IMF allowed Iceland to impose strict controls on capital movements, inward as well as outward (International Monetary Fund 2010; see also Yeyati 2011). The controls were originally envisaged to be in effect for 2-3 years, meaning that they should by now have been for the most part, if not completely, dismantled. The reality has turned out differently. The Icelandic authorities have recently sought authority to keep the controls in place until 2015.
The foreign economists seem to be poorly informed about the actual form and implementation of the Icelandic capital controls. This, however, does not prevent them from influencing economic policy in Iceland.
The capital controls the foreign economists seem to have in mind are some sort of short-term prevention of hot money flows. The reality is different. The actual controls are much closer to the 1950s style of capital controls, with virtually all currency transactions requiring permission from the Central Bank.
Icelandic firms seeking to invest abroad need rarely-granted permission from the Central Bank. Icelandic citizens need a government authorisation for foreign travel, since a Central Bank licence is needed to get tightly rationed foreign currency for travel. Any individual seeking to emigrate from Iceland is at least partially locked in by the capital controls by virtue of not being able to transfer his or her assets abroad, a restriction on emigration not commonly seen in democracies. This disregard of individuals’ civil rights as a result of the capital controls violates Iceland’s legal commitments under the European four freedoms.
One of the key factors in Iceland’s financial collapse in October 2008 (see my Vox article, Danielsson 2008) was substantial inflows of speculative capital leading to significant currency overvaluation, causing a trade deficit and the accumulation of foreign currency debt.
Immediately following the crisis, the foreign part of the payment system collapsed, and the exchange rate fell by around 25%. Funds held by carry traders amounted to over 40% of GDP, and it was feared that the bulk of those investors, along with some domestic agents, would seek to leave the Icelandic currency, exaggerating the fall in the exchange rate.
There is a curious difference between how foreign and local economists see the wisdom of capital controls in Iceland. In a recent IMF-government of Iceland conference1, two Nobel Prize winners in economics, along with senior IMF representatives, expressed strong support for the capital controls. The Icelandic economists addressing the conference were not as enthusiastic.
What accounts for this difference? The foreign economists seem to be poorly informed about the actual form and implementation of the Icelandic capital controls. This, however, does not prevent them from influencing economic policy in Iceland.
The capital controls the foreign economists seem to have in mind are some sort of short-term prevention of hot money flows. The reality is different. The actual controls are much closer to the 1950s style of capital controls, with virtually all currency transactions requiring permission from the Central Bank.
Icelandic firms seeking to invest abroad need rarely-granted permission from the Central Bank. Icelandic citizens need a government authorisation for foreign travel, since a Central Bank licence is needed to get tightly rationed foreign currency for travel. Any individual seeking to emigrate from Iceland is at least partially locked in by the capital controls by virtue of not being able to transfer his or her assets abroad, a restriction on emigration not commonly seen in democracies. This disregard of individuals’ civil rights as a result of the capital controls violates Iceland’s legal commitments under the European four freedoms.
The motivating problem
One of the key factors in Iceland’s financial collapse in October 2008 (see my Vox article, Danielsson 2008) was substantial inflows of speculative capital leading to significant currency overvaluation, causing a trade deficit and the accumulation of foreign currency debt.
Immediately following the crisis, the foreign part of the payment system collapsed, and the exchange rate fell by around 25%. Funds held by carry traders amounted to over 40% of GDP, and it was feared that the bulk of those investors, along with some domestic agents, would seek to leave the Icelandic currency, exaggerating the fall in the exchange rate.
Under these circumstances, the government had three choices.
•Let the currency markets determine the exchange rate and face the consequences;
•manage exchange rates by imposing special taxes on speculative capital movements; or
•impose capital controls.
Neither the Icelandic policymakers nor the IMF found the first choice palatable.
The Icelandic authorities seem to have been in favour of the second choice but reportedly the IMF, arguing in terms of equal treatment of all foreign currency transactions, demanded strict capital controls. So, at the IMF’s insistence, all-encompassing capital controls applying both to inflows and outflows of currency were introduced.
The cost of capital controls
Capital controls distort the price of capital leading to deadweight loss – amounting to up to 1% of GDP per year in Iceland. The longer-run consequences of the capital controls are the weakening of the competitive position of Icelandic industries and a distortion of the structure of domestic industries due to the adjustment to long-term false prices of foreign currency and the presence of capital controls. Both distortions involve structural adjustments that will take considerable time and expense to unwind once the capital controls are lifted.
The capital controls erode the trust of both domestic and foreign investors in the Icelandic economy, resulting in a significant risk premium added to loans and investments. Thus, the capital controls do not only undermine the long-term health of the Icelandic economy, in the long run they also undermine their own objective of maintaining the exchange rate.
Finally, the capital controls transfer significant new powers to the government, enabling it to implement industrial policy whilst conferring favours to those favoured by exemptions, leading to rent seeking and associated distortions. Even if the application of the controls were to be totally devoid of political favouritism and political ideology, the possibility of misuse inevitably generates suspicion, undermining trust and cohesion in society.
Why the IMF change of heart?
Why did the IMF in this case abandon its long-standing role in promoting free capital markets? We can only hypothesise, but three alternatives come to mind.
•First, the IMF may not in 2008 have had the economic understanding, knowledge, and speed of reaction to make real-time policy decisions during crises in modern developed economies.
After all, the last time a similarly developed economy requested IMF aid was the UK in 1976. The IMF’s experience in non-democratic less-developed economies may have suggested to it that strict 1950s style capital controls are useful, and the Fund may not have appreciated the adverse general equilibrium consequences in a highly developed economy integrated into the North European economic zone, nor the resulting violations of civil rights.
•Second, the policy adopted for Iceland might represent a genuine policy shift by the IMF.
This certainly is the impression given by the Fund in its write-up of the conference, statements by an IMF Deputy Managing Director in the conference, and the Fund’s enthusiastic embracement of “Unorthodox Policies” (IMF 2011). The Fund may have come to the conclusion that the Washington consensus has failed, and that financial crises are caused by free financial markets, with extensive direct government intervention in markets the answer.
•Third, it is possible that the IMF, following careful consideration, concluded that capital controls were nevertheless the least bad policy response given the specific Icelandic economic and political context.
This would imply that its imposition of the Icelandic capital controls was a one-off event not to be repeated elsewhere.
Conclusion
Iceland was faced with a serious problem of hot money overhang following its crisis in 2008 and it was feared that speculators would head for the exits, causing an uncontrolled collapse in the exchange rate. In our view, this fear was unfounded. Any speculator exiting under those circumstances would have faced significant losses compared with the option of waiting for economic stabilisation and the consequent currency appreciation. After all, the currency approximately reached its long-term equilibrium rate immediately after the collapse.
Thus, in our view, the imposition of capital controls was both unnecessary and unjustified. Without them, the exchange rate might have temporarily fallen even further in a worst case scenario, in which case a surgical intervention in the form of a temporary tax on short capital outflows would have been a sufficient policy response.
Instead, the IMF forced the Icelandic government to impose draconian capital controls of a type last seen in developed economies in the 1950s, causing significant short-term and long-term economic damage. The capital controls were initially touted as a temporary measure, but now three years after the event it looks like they are there to stay, and as the domestic economy adapts to their presence, they will be increasingly costly to abolish. After all, the last time Iceland imposed capital controls in the 1930s, they lasted until 1993.
The capital controls have resulted in an intrusive licensing regime, with government permission required for foreign travel and those emigrating prevented from taking their assets with them. Both are direct violations of the civil rights of Icelandic citizens and Iceland’s international commitments as a democratic European country.
Our hope is that other countries facing a similar situation will have the good fortune of receiving better advice from the IMF.
The main reason given for the imposition of the capital controls in late 2008 was the carry trade (Benediktsdottir et al. 2011). The idea was that, without strict controls, the holders of “glacier bonds” equivalent to about 50% of GDP would rush to unload their holdings, thereby making the Icelandic króna plunge even further, as if the 50% depreciation from peak to trough surrounding the financial crash was not enough.
The balance-sheet effects of significant further depreciation of the króna on households and firms were considered unacceptable. The “glacier bonds”, mostly local currency deposits held in Iceland by foreigners, who, apparently impervious to the enormous exchange rate risk involved as well as to Iceland’s long history of high inflation and economic mismanagement, had borrowed at very low interest in yen or Swiss francs and bought Icelandic króna to be deposited in high-interest accounts plus government bonds in Iceland. These deposits are for the most part still locked up in Iceland. From the authorities’ point of view, the initial justification for controls still remains intact.
Capital controls have a tendency to overstay their welcome. Deprived by law of the possibility to take their funds abroad, foreign carry-traders and local investors – pension funds, for example – are grounded at home where they find it best to buy government bonds, thereby facilitating the government’s financing of its budget deficit and thus also reducing the pressure on the government to rein in the deficit. Another hidden benefit of extended controls from the authorities’ point of view is the increased demand for real estate from local investors with nowhere else to go because their entry into the local housing market helps reverse the drop in real estate prices during and after the crash. Through these channels, and others, capital controls tend to become self-preserving.
This is not all. The extent to which Icelandic exporters fail to bring home their foreign exchange earnings because of their limited confidence in the króna is not well known, or at least not publicly acknowledged. To the extent that exporters do not bring home all their foreign earnings, they help keep the currency weak. The exchange rate of the króna in terms of euros is still about the same as it was immediately after the crash in October 2008. The 50% nominal depreciation of the króna vis-à-vis the euro since before the crash shows as yet no signs of partial reversal as occurred, for example, in Indonesia and Thailand after the East Asia crisis in 1997-1998. Indonesia and Thailand, famously, unlike Malaysia, did not impose capital controls. The IMF would not let them. Clearly, however, the depreciation of the króna has greatly reduced imports and bolstered the value of exports, lifting them from the equivalent of one-third of GDP since long before the crash to 56% in 2010. This is a good sign.
Although much of the carry trade stock had already left by the time of the crisis, the controls locked in remaining carry trade funds amounting to 40% of GDP. Half of these funds still remain in Iceland and would on their own make it difficult to lift the capital controls. But this is only part of the story. The domestic assets of the failed Icelandic banks also represent a huge obstacle to lifting the controls. These assets must be substantially restructured (Baldursson and Portes 2013b).
The old banks and the offshore krona overhang
When the three large Icelandic banks – Landsbanki, Glitnir and Kaupthing – collapsed in October 2008, deposits and deposit insurance were given priority over other claims on the banks. Domestic loans and deposits were transferred into new banks. Bondholders were left with claims to assets remaining in the old, failed banks, second in line after deposits and deposit insurance.
The margin of assets over liabilities at each new bank became a claim of the old bank on the new. In the case of Kaupthing and Glitnir, this claim eventually became a majority equity share of the old bank. In the case of Landsbanki – familiar to many from the Icesave story (Baldursson and Portes 2013a) – most of the claim took the form of a bond, now held by the old bank, and to be redeemed in 2015-18. The Icelandic state supplied most of the new equity for New Landsbanki and now owns it fully, but it took only a minority share in New Glitnir (now Islandsbanki) and New Kaupthing (now Arion Bank).
The old banks still formally exist as companies in bankruptcy process with total remaining assets of €16.4 billion (Table 1). For comparison, projected 2013 GDP is €11.15 billion (same conversion rate as in Table 1). Foreign creditors hold 95% of claims on the banks. Foreign assets are €10.6 billion, or 65% of the old banks’ total assets. They could be distributed to creditors without pressure on the exchange rate.
Table 1. Failed banks’ assets (End 2012. Amounts in € billions. Icelandic kronas converted to euros at 160 ISK/€)
portes table 12 nov
Source: Central Bank of Iceland, Financial Stability Report (2013).
Approximately €5 billion has already been paid out to creditors – most of this by the old Landsbanki to deposit insurance funds in the UK and the Netherlands. Creditors of the banks have been pushing for progress in bankruptcy proceedings, so that further payments can be made, but the Central Bank of Iceland (CBI) is blocking this.
If the CBI would comply with these wishes, not only the banks’ foreign assets would be freed up, but also Icelandic krona denominated assets amounting to 23% of GDP, which would be added to the 19% of krona assets held by non-residents. The net foreign exchange requirement due to domestic FX assets corresponds to the Landsbanki bond, which amounts to 16% of GDP. With the ‘old’ carry trade overhang, the total foreign exchange required would thus rise to 58% of GDP.
International capital markets are still closed to Iceland, except for the sovereign; the underlying current account surplus (3% of GDP p.a.) is too small for Iceland to be able to finance outflows of this magnitude out of current income. Allowing the winding-up to proceed without intervention and no capital controls is impossible.
The CBI has signalled that a substantial reduction in the Icelandic krona holdings of Glitnir and Kaupthing, and a restructuring of the Landsbanki bond, are necessary conditions for lifting the capital controls (Gudmundsson 2013). Indeed, if these two conditions were met, then the offshore krona overhang could be manageable.
But there are major obstacles.
•The claims in question are on private parties – not the government or the CBI – so the Icelandic authorities are not in the position of a debtor negotiating for a restructuring with its creditors.
•The banks are in formal bankruptcy proceedings under Icelandic law, which in ordinary circumstances would be left to the winding-up boards and the creditors.
Strategic positions
At present, the CBI does have considerable legal powers to influence the resolution of the failed banks– provisions of the Foreign Exchange Act allow it to block payments out of the banks’ estates, indefinitely. As soon as payments in foreign currency out of the estates are allowed to go forward, however, the CBI will lose whatever power it had to influence the resolution process. It is, therefore, not surprising that the CBI has blocked further payments to creditors.
It is difficult for Icelandic authorities to take the initiative in this situation. The role of the authorities is first, and foremost, to look out for legitimate Icelandic interests– both safeguarding financial stability and the solvency of Iceland, and lifting the capital controls. But Iceland must in some sense be neutral vis-à-vis the banks’ creditors, and avoid being seen to apply coercive force.
Creditors of the old banks can, however, voluntarily suggest solutions to the current stalemate. (We use ‘voluntary’ here much in the same sense as the recent restructuring of Greek government bonds was voluntary, see Gulati et al. 2013.) Such a solution can be implemented in various ways. At Glitnir and Kaupthing a large haircut on Icelandic krona assets of the failed banks is necessary. Foreign assets constitute 70-80% of the book value of assets (Table 1). Hence, a 75% haircut, say, on krona holdings (the remaining 20-30% of assets), combined with full payout of foreign assets, would reduce payments to 80-85% of assets, implying an overall haircut of 15-20% of assets.
This might be an acceptable compromise for the majority of creditors at these banks. Many are distressed debt funds – colloquially often called vulture funds – which purchased their claims at heavily discounted prices and would make a handsome profit, multiplying their investment several times over, even with a substantial haircut on Icelandic assets.
As for Landsbanki, as soon as New Landsbanki would reach an agreement with its ancestor on restructuring the problematic bond, the CBI might allow payments to priority claimants to proceed. A restructuring involving an extension of maturity by twelve years, and a lowering of the interest rate, has been requested (Morgunbladid 2013). Landsbanki, however, constitutes a very different strategic case from that of Glitnir and Kaupthing for three main reasons.
•First, a contract (the bond) is already in place.
•Second, the main creditors of Landsbanki are the British and Dutch authorities.
•Third, the Icelandic state is the sole owner of New Landsbanki.
Should the UK and Dutch authorities refuse to restructure, and if the CBI refuses to grant the required foreign exchange, then New Landsbanki will be in default. Apart from wider-ranging concerns – financial stability, the credit rating of the sovereign, etc. – the Icelandic authorities will not want to see this happen to a bank fully owned by the state.
Possibly complicating matters, a new two-party coalition government has directly linked possible government revenues created by the winding-up of the old banks (e.g., through an exit tax) to the financing of debt relief for Icelandic households. Indeed, debt relief on price-indexed housing mortgage loans was the most prominent election promise of the new Prime Minister’s party. It is not clear how this will affect the outcome.
•On the one hand, this connection has put the CBI under pressure to achieve a large reduction in Icelandic krona holdings.
•On the other hand, the government is under pressure from a part of the electorate to live up to its promise as soon as possible.
That indicates impatience in achieving resolution, which weakens the position of the Icelandic authorities. There is also a risk that the Icelandic authorities would be seen to be motivated by the desire to profit in an illegitimate way from the winding-up of the old banks, rather than by the legitimate concerns mentioned earlier.
Policies on lifting the capital controls
Iceland faces a difficult, but not insurmountable, problem in resolving its failed banks and lifting capital controls. The stakes are high. It is important for the country’s future economic prosperity ultimately to lift the capital controls. This must, however, be done without endangering financial stability and national solvency. Even if the controls are damaging, the gains from lifting them are likely to be much lower than the costs associated with a currency crisis following a premature liberalisation of capital outflows (Gourinchas and Jeanne 2006, Coeurdacier et al. 2013, Obstfeld 2009, Rey 2013). Although Forbes and Klein (2013) find in a large sample that “new controls on capital outflows appear to have particularly negative effects, as they generate sharp and significant decreases in GDP growth”, it is hard to see such effects in the Icelandic recovery from the crisis, and easy to imagine the hugely disruptive consequences of lifting the controls without solutions to the problems we have described. So, patience is of the utmost importance on the Icelandic side.
In the cases of Glitnir and Kaupthing, a satisfactory outcome can probably be implemented by agreements with creditors and winding-up boards that involve foreign currency payment out of the failed banks’ estates, combined with an exit tax on Icelandic krona assets. Alternatively, there could be an exchange of assets in which long-dated low-interest bonds, denominated in foreign currency, would be exchanged for Icelandic krona assets.
As for the Landsbanki bond, one can only hope that even if the Icelandic, British, and Dutch authorities were at loggerheads over the Icesave issue, there is willingness to find a solution that does not compromise financial stability or sovereign solvency in Iceland. This requires goodwill at the highest political level.
The design of policy on lifting the capital controls requires consideration of other risks. These include the likelihood of domestic outflows, as well as fiscal and financial stability implications of rising yields on assets. Fiscal risks can be reduced by using possible proceeds from an exit tax to lower public debt.
It is tempting to compare Iceland to Cyprus, which has also imposed capital controls after the failure of large cross-border banks. There is, however, a key difference between these two countries– Cyprus’s membership of the Eurozone. The case of Iceland is certainly instructive, but with its failed large banks that are still unresolved, and still pose a threat to financial stability within the very small Icelandic currency area, it is unique.
Nordic dilemma over how much to include the populist parties
Richard Milne, Nordic Correspondent
Should the main parties let the right-wing Finns be part of the next government after the election?
Populist parties have shaken the political elite across Europe. But as groups such as the Finns, France’s National Front or the UK Independence Party grow in popularity, establishment parties face a dilemma, summed up by a former senior Finnish minister.
“The question is: is it better to embrace them or ignore them completely? Which is the better way to kill them off?” he asks.
It is a question that all four big Nordic countries have answered, in different ways and with varying degrees of success, which are instructive for other European countries.
The question comes up again on Sunday with Finland’s elections. The Finns (having dropped the “True” from their name) have established themselves as one of the four big parties fighting to be part of the next government.
But in recent polls they have lost close to a quarter of their support compared with the 2011 elections, pulling in about 15 per cent instead of 19 per cent. Turmoil in Greece may still help the party in these elections as it did last time. Other parties, however, are taking a tough line on Greece too, limiting the Finns’ appeal.
So should a new government try to bring the Finns into a coalition or keep them outside? Timo Soini, the Finns’ leader, has tamed down his party’s wilder fringes and is open about his ambition to join the next government.
Much will depend on the final election result, with three of the four largest parties likely to have to form a coalition. But Juha Sipilä, frontrunner to be the next prime minister, says he would be happy to have them in government. Alex Stubb, the current prime minister, adds that the Finns are much better than their reputation abroad. Still, plenty in Mr Sipilä’s Centre party would like to see the Finns excluded.
That would emulate Sweden. All the mainstream parties there have ostracised the populist, anti-immigration Sweden Democrats.
But after they came third in September’s elections with 13 per cent there are increasing doubts as to whether exclusion is the right strategy. Several of the smaller centre-right opposition parties have debated whether to end the broad consensus on immigration and introduce some restrictions, albeit much less severe than the Sweden Democrats propose.
Much of the revulsion over the Sweden Democrats stems from its roots in the neo-Nazi movement. Karl-Petter Thorwaldsson, a Swedish labour leader, points out that populist parties in Norway and Denmark had their background in the anti-tax movement, making them “more fun”.
That is one reason why in Norway governing parties have embraced the populist Progress party, which was born in the 1970s to press for lower taxes. It has been in government for the past two years in tandem with the Conservatives.
But in recent months Progress has received some of its worst poll results in two decades, pulling in only about 10 per cent, as its voters seem disappointed with its achievements in government. “It’s always a challenge governing a country. We have seen ups and downs,” says the party leader and finance minister, Siv Jensen.
Norway is thus Exhibit A for taming a populist party by bringing them into government. But head further south to Denmark and the results become less clear.
The Danish People’s Party may never have been in government, but they were a support party for the previous centre-right administration over eight years, gaining influence over policies in return for parliamentary help.
The anti-immigration party has since grown stronger, topping polls in June’s European parliament elections and causing the establishment parties to toughen their rhetoric on immigration. Largely embraced by the system, the party still appears to be flourishing.
It therefore seems little wonder that Anders Borg, Sweden’s well-regarded former finance minister, sums up the Nordic predicament on dealing with populists by saying: “The problem is we don’t have a good answer.”
Still, many Norwegians and Danes would argue some answers are worse than others. Ignoring a populist party, as in Sweden, is unlikely to make it go away, and risks alienating a large part of the electorate. Bringing such a party into the mainstream might not kill it off, but it can bring extra scrutiny of their policies.
