Bill Totten's Weblog

Sunday, January 10, 2010

Iceland can refuse debt servitude

by Michael Hudson

Plus a Financial Times editorial

Financial Times (January 06 2010)

Olafur Ragnar Grimsson, Iceland's president, has created uproar with his decision to block legislation that would have repaid 3.9 billion Euros ($5.6 billion) lost by British and Dutch savers in a failed Icelandic bank, triggering a referendum that the government is expected to lose. The initial response by credit rating agencies was to downgrade Icelandic bonds, as if Iceland were repudiating its debts, Argentina-style. But opponents of the bill have no intention of reneging on their legal obligations.

At issue is what the relevant European law says should be done - and, more to the point, what should have been done on October 6 2008, when Gordon Brown closed down the UK operations of Icesave, an online subsidiary of Landesbanki, Iceland's second-biggest bank. Icelandic authorities were given no voice in how to resolve matters. Did the British prime minister let Iceland off the hook by jumping the gun in reimbursing depositors as though they were covered by UK insurance rather than following European Union procedures?

Under normal conditions Iceland, a prospective EU member that had signed up to European deposit insurance rules, would have availed itself of the right to settle with depositors in an orderly manner. Article 10 of EU Directive 94/19/EC gave Iceland's Depositors' and Investors' Guarantee Fund (TIF) nine months to settle matters after the failure of a financial institution. Privately funded by domestic banks (unlike Britain's public Financial Services Agency), the TIF collected just one per cent of deposit liabilities as a risk premium.

The EU law did not anticipate a systemic failure and made no provision for the government to be liable beyond its insurance agency. But guidelines agreed by the Ecofin meeting of European Union finance ministers on November 14 2008 were clear: "These negotiating discussions shall be conducted in a compatible and co-ordinated manner and account will be taken of the difficult and unprecedented circumstances in which Iceland finds itself and the urgent necessity of deciding on measures which will enable Iceland to restore its financial and economic system".

So the broader issue concerns Iceland's ability to pay 250 per cent of its current gross domestic product - nearly $20,000 for each Icelandic citizen - to settle its Landsbanki mismanagement. The International Monetary Fund did not think this was a realistic option when its team calculated in November 2008 that: "A further depreciation of the exchange rate of thirty per cent would cause a further precipitous rise in the debt ratio (to 240 per cent of GDP in 2009) and would clearly be unsustainable".

Opponents of the Icesave agreement explain that they want to appeal to the EU rules regarding bank bail-outs and the Ecofin understanding that any agreement would preserve Iceland's economic viability. That is why Iceland's parliament, the Althing, asked last autumn for an impartial court to adjudicate the issue. Britain and the Netherlands turned down the request. They have been willing to negotiate over the timing of payments by Iceland - with interest mounting - but not the overall amount.

Iceland's government was willing to give in as the price necessary to obtain EU membership, but recent polls show that seventy per cent of voters have lost interest in joining. This is the same proportion estimated to oppose approving the Althing's agreement to give Britain and the Netherlands what they are demanding.

Icelandic voters are worried about how they reasonably can be expected to pay enough in taxes to cover the huge debt. The problem is that foreign debt is not paid out of GDP. It is paid out of balance-of-payments receipts from net exports, from the sale of assets to foreigners and from new borrowing. The market for cod is limited, and many of Iceland's quota licences already have been pledged to bankers for loans, whose debt service absorbs much of the export revenue. Interest charges also absorb most of the revenue from its aluminium exports and its geothermal and hydroelectric resources, leaving little taxable revenue behind.

There is also a dagger hanging over the heads of Iceland's homeowners: mortgages and other debts are indexed to the consumer price index. For an import-dependent country such as Iceland this, in effect, means the foreign exchange rate. Attempts to pay more foreign currency than the nation can generate in export earnings will cause the currency to depreciate and raise monthly mortgage bills. Many will lose their homes. Many already are. There is a moratorium on foreclosures, but it expires in February.

A pragmatic economic principle is at work in such conditions. Debts that cannot be paid, will not be (unless one pays back Peter by borrowing from Paul). At stake, therefore, is how much can be paid without wrecking Iceland's economy. How many Icelanders must lose their homes as carrying charges soar on mortgages indexed to the exchange rate? Emigration is accelerating, and many foreign workers already have left. How many more must depart? And if the post-Soviet experience of a steep and sudden drop in living standards is relevant, by how many years must Icelandic lifespans shorten?


The writer is professor of economics at the University of Missouri

Copyright The Financial Times Limited 2010. Print a single copy of this article for personal use. Contact us if you wish to print more to distribute to others.

"FT" and "Financial Times" are trademarks of the Financial Times.

(c) Copyright The Financial Times Ltd 2010.


Do not put Iceland in a debtors' prison

Financial Times Editorial

Financial Times (January 06 2010)

Olafur Ragnar Grimsson, Iceland's president, this week rejected a law settling his country's dispute with the UK and the Netherlands over the sorry Icesave affair. In truth he had little choice: a quarter of this fiercely independent electorate signed a petition against it, a show of defiance no leader can ignore.

The law will now go to a referendum, likely to vote it down. This may teach Dutch and British leaders the limits of what can be achieved with duress, but too late to do anyone much good.

Landsbanki offered the Icesave accounts under European "passporting" rules, which let banks open branches abroad if they satisfy the home country's regulators and take part in its deposit guarantee scheme. But as its October 2008 collapse showed, Landsbanki was exposed far beyond what Iceland's deposit guarantee fund could pay.

In June, the UK and the Netherlands agreed a fifteen-year loan to the guarantee fund to reimburse their Icesave depositors, but demanded an Icelandic government guarantee for the loan, which would leave taxpayers on the hook for more than one-third of Iceland's yearly output. (The amount actually paid would be less, depending on what can be recovered from Landsbanki assets). Icelandic legislators passed it only after limiting the guarantee to a share of economic growth over the life of the loan. When British and Dutch authorities balked at the guarantee possibly expiring with the debt still unpaid, changes were passed that were acceptable to the creditors - but not to Mr Grimsson or to most Icelanders.

It is hard to fathom the need to make an example of Iceland. For the creditors, the loans are trivial: they sum to 3.9 billion Euros, one-hundredth of what the UK alone will borrow this year and next. Neighbourly generosity would cost Amsterdam and London next to nothing.

They are also not innocent victims. British and Dutch banks benefited greatly from the rules. Had they failed on the same scale, it is delusional to think their governments would take on hundreds of billions in debt to rescue foreign savers, and odious to force a weak neighbour to do the equivalent.

From the start, Iceland has been under the gun. Loans from Poland, Nordic neighbours and the IMF depend on successful IMF reviews that in turn hinge on an Icesave solution. A lifeline-grasping application for EU membership is hostage to British and Dutch goodwill.

Landsbanki showed that Europe must reform its rules to achieve stronger common standards. This will not be done by putting Iceland in a debtors' prison.

Copyright The Financial Times Limited 2010. Print a single copy of this article for personal use. Contact us if you wish to print more to distribute to others.

"FT" and "Financial Times" are trademarks of the Financial Times.

(c) Copyright The Financial Times Ltd 2010.

Bill Totten


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