After three months of stalemate, Iceland formed a new coalition government this week. Part of the three-party deal was a parliamentary vote on whether to hold a referendum on joining the European Union, but will the EU welcome a country that is gaining a reputation for reneging on its debts?
Nations with poor economies and bad governance often get into financial trouble and cannot meet their obligations. Recent examples include Greece, Jamaica and Ecuador. However, Iceland may be unique in the annuals of borrowing — a country that can easily pay its creditors but simply chooses not to.
With a population of 332,000 (less than half the size of Indianapolis, Indiana), Iceland became a haven for European investors during the early years of the new millennium, and the country’s banks soon lost their bearings. The global recession hit hard, and the Icelandic stock market quickly lost 80 percent of its value, nearly half the country’s businesses went bankrupt and 97 percent of the banks collapsed.
But Iceland recovered. It now has one of the fastest-growing economies in the world, with loads of foreign reserves, an unemployment rate of 3.1 percent, inflation of just 1.7 percent and a huge budget surplus and trade surplus.
A recent report by the Organisation for Economic Co-operation and Development (OECD) on the country’s prospects begins this way: “Economic growth is strong with continued expansion in tourism, robust private consumption and favorable terms of trade. Steep wage gains, employment expansion and large investments are fueling domestic demand.”
Last year, Iceland, with the advice of Cleary Gottlieb Steen & Hamilton, the same law firm that helped Argentina stiff its creditors for more than a decade, concocted a rationale for declining to repay US$2.3 billion in government bonds owned by foreigners, mainly Americans. It was the strangest default in financial history. The excuse was that if the debt were honored at the regular Icelandic exchange rate, then the krona, the local currency in which the bonds were denominated, would suffer a severe decline, damaging the recovering economy.
As a result, Iceland’s legislature passed a law in May last year that gave bondholders a choice: either sell their bonds to the government at a special “offshore” exchange rate of 190 kronor to the euro, a haircut of about two-fifths, or keep the assets in Iceland in a savings account paying less than 1 percent interest. The bondholders chose not to sell. Their repeated attempts to settle were ignored.
Meanwhile, Iceland has been thriving and, as a result, the krona has been strengthening. Icelandic securities firm Fossar Markets reported that the currency appreciated 16 percent last year. Foreign-exchange reserves have quadrupled in the last two years.
“The reserves,” a Fossar report says, “are double the IMF’s guidance on how big the foreign-exchange reserves should be” to provide adequate safety for the financial system. Iceland built this cushion even though it has been lifting capital controls for households and domestic businesses.
When the controls were eased in fall last year, Central Bank of Iceland Governor Mar Gudmundsson approved, saying, “The economy is stable; we have a trade surplus; we have a good credit rating; the state treasury has access to foreign loan markets, as do the banks to an increasing extent.” Mar added that the goal had been “to prepare sufficiently so that an unplanned capital flight would not be likely once the controls were lifted. I think everyone agrees that the likelihood of that happening is negligible.”
If the likelihood is negligible, then one wonders why Iceland insists on trapping foreign bondholders in a kind of Roach Motel, unless the reason is the most obvious one: greed triumphing over moral and legal responsibility. The bondholders include the hedge funds Autonomy Capital and Discovery Capital and the public mutual funds of Loomis Sayles. Since these are US and European companies — so the logic apparently goes — Iceland can apply different rules to them.
However, Iceland’s twisted rationale has now been revealed for the subterfuge it always was. The country has easily enough reserves to allow all the foreign bondholders to exit by trading in their bonds at the onshore exchange rate of about 120 kronor to the euro — and still meet the reserve-adequacy recommendation of the IMF.
Right now, foreign reserves provide Iceland’s financial system with an enormous shock absorber, but a strengthening krona will ultimately harm the country’s exporters.
The logical move is now to pay off the bonds — to benefit Iceland’s economy, to maintain the nation’s culture of probity and to improve its chances to get into the EU. The EU has already had enough bad experiences with defaulting countries to add another.
James K. Glassman recently completed a three-year term as a member of the Investor Advisory Committee of the US Securities and Exchange Commission.
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