The ABCs Of The Capital Controls: What’s The Plan?

In November 2008, the government instated capital controls to prevent the country’s currency from tanking after the banking collapse. Seven years later, a plan to lift the controls has been announced. As there has been some confusion surrounding the news, here are some key facts on the controls and the plan to lift them.

Iceland introduced capital controls on November 29, seven weeks after the official date of the financial collapse, October 6, 2008. The reason for the controls is the following: in the years leading up to the collapse, foreign investors had taken advantage of the high interest rates being offered in Iceland, buying Icelandic Treasury bills and other sovereign products, nicknamed “Glacier bonds.” When the crisis hit, investors were busy converting their króna assets (ISK) into foreign currency (FX), thereby rapidly draining the country’s none-too large foreign currency reserves. At the time, these holdings amounted to 625 billion ISK, 44% of GDP. When a country does not have enough FX to convert the domestic currency that wants to leave it is called a “balance-of-payment” problem (in case you want to impress your friends with economist-speak, it’s even better if you just say BoP).

Over time, this original overhang of foreign-owned ISK, the funds that called for the capital controls in 2008, has gone from 44% of the country’s GDP to 16% of the GDP. The Central Bank of Iceland (CBI) has reduced these holdings by auctions. Earlier this year, the CBI announced further measures, the last of which were announced in the plan for lifting the capital controls, introduced on June 8.

The controls are on CAPITAL, meaning that capital for investment cannot be moved in or out of the country. This means that Iceland no longer adheres to the four freedoms of European Economic Area (EEA): the freedom on goods, services, people and capital.

However, the controls are NOT on goods and services. Thus, both companies and private individuals can buy foreign goods and services. So while it’s possible to buy vintage Nike trainers on Ebay or the services of a foreign architect to spruce up your 101 flat, it’s not possible to buy shares in Apple or a flat in Mallorca as a second home until the controls are lifted.

With time, another pool of foreign-owned ISK has built up in addition to the original overhang. This addition is ISK in the estates of the three failed banks: Kaupthing, Glitnir and Landsbanki. Since foreign creditors hold approximately 95% of the claims to these three estates, the ISK assets of the estates have now formed this second pool of foreign-owned ISK, now approximately 25% of GDP. These two pools of foreign-owned ISK hold the controls in place.

The classic way to solve this kind of a problem (Iceland certainly is not the first country to face this problem) would be to negotiate with creditors a so-called haircut. This does not mean that the creditors will be forced to have their hair cut at an Icelandic hair salon (although that might help the local economy): in finance-speak “haircut” means “writing down” assets. In the Icelandic context this means that the creditors accept that there is not enough FX in Iceland for them to convert all their ISK and take it out of the country (remember, the BoP problem) so they agree that they cannot get all the ISK assets in the estates. This “haircut” comes as no surprise to the creditors: they had been hoping for it, but also hoping to negotiate the terms. Until now, the Icelandic government has not been willing to discuss the terms with the creditors, claiming it was none of its business how the estates settled with its creditors. Even now that the plan has been announced, the government still claims they did not “negotiate,” but only had “conversations” with the creditors. No matter the wording, the creditors so far seem content with the new plan, that is, the outcome of the non-negotiations.

One reason why it has taken more than two years to come up with a plan is that before the last elections, in 2013, the Progressive Party had promised that when the estates would pay out their creditors it would “unavoidably” bring a windfall of billions—the highest number mentioned was 800 billion ISK, now approximately 40% of Icelandic GDP. Late last year, however, Prime Minister Sigmundur Davíð Gunnlaugsson stopped mentioning this coming windfall. It was not until talk of fleecing the creditors and the great funds “unavoidably” being there up for grabs that the government acted.

Now that the plan is in place, and with the largest creditors agreeing to it, there are voices in Iceland asking why Iceland could negotiate so effortlessly when Greece and Argentina are locked in furious disputes with their creditors. The short answer is that the Icelandic capital controls are a BoP problem, NOT a sovereign debt problem, as in Argentina and Greece. The Icelandic state does not owe the creditors money: it just has to find a way for the creditors to take their money out of the country without depleting Iceland of all its currency. The Icelandic capital controls are not comparable to the capital controls in Cyprus, which were put in place to keep money in the Cypriot banks and prevent them from collapsing as funds flowed out due to wild uncertainty.

Some 500 billion ISK of the 2,200 billion ISK in the three estates are in ISK, the rest in FX. Now, why have the creditors not been paid out the FX? The answer is that nothing can be paid out of estates to general creditors until the estates either go into composition or bankruptcy. The winding-up boards of Glitnir and Kaupthing applied for a composition in 2012 and 2013, but little to nothing came out of that, as the government was unsure of how to proceed. Because payouts would have followed a composition, the government could not agree to a composition until it was clear what would happen to the ISK paid to creditors.

An outline of the new plan to lift capital controls

First, some media trivia: since the government came to power it has been promising a final plan to lift the controls. Every now and then, what they seemed to be working on ended up in the Icelandic media, always through the same journalist, Hörður Ægisson, with Morgunblaðið, until earlier this year when he moved over to DV, as new owners, who are close to the Progressive party hierarchy, took over that paper. Then the leaks moved to DV, via Hörður. In March, the Ministry of Finance announced that everyone working on the capital controls had to sign a non-disclosure agreement threatening fines, if not fire and brimstone, to everyone who abused their insight. Then, the Friday before the plan was announced, Hörður more or less spilled the plan on the pages of DV. In spite of the measures taken to prevent leaks, nothing has been heard of any action to clarify the leak.

The government has defined the problem keeping the controls in place as amounting to 1,200 billion ISK, approximately 60% of Icelandic GDP, divided thusly: the old overhang is 300 billion ISK; the problem in the estates of the three failed bank is 400 billion ISK, i.e. debt that Icelandic entities (mostly because they have FX income) repay in FX; and lastly is 500 billion ISK, which is purely ISK assets, the largest being Glitnir’s holding in Íslandsbanki and Kaupthing’s holding in Arion.

It can be argued that the 400 billion ISK is not part of the problem at all since these liabilities, paid in FX anyway, do not need to be converted. But the government, perhaps rather maximising than minimising the problems looking for resolution, sees these 400 billion ISK as part of the problem.

The plan rests on one assumption: in order to limit the outflow of FX, the foreign-owned ISK needs to be reined in before the controls are lifted. The old overhang will be dealt with in autumn: more CBI auction and offer of long-term bonds, all simple and clear.

This then leaves the 900 billion ISK (according to the government; others say 500 billion ISK, see above). In order to prevent these sums from wrecking the economy the government has told creditors that any solution needs to meet what it calls “stability conditions.” These conditions are “non-negotiable,” according to the government plan, but what exactly this means in krónur, i.e. how short the “haircut” needs to be, is not stated.

There are now two ways to meet these “stability conditions”: the first option is that the winding-up boards, which run the failed estates, negotiate a composition (which means that the estates are in essence run like a company, with assets sold off over time, to maximise return for the creditors, who are then paid out when the funds are in cash; there is already plenty of cash in both estates) before the end of the year and agree to pay voluntarily a so-called “stability contribution” to satisfy the “stability conditions.” Again, this contribution, paid to the state over two to three years, is not a fixed sum but depends on the value of assets and other variables over the next two or three years. According to Minister of Finance Bjarni Benediktsson this could be as much as 500 billion ISK; calculations I have seen range between 300 billion ISK to 420 billion ISK. The reason for this difference is simply that the there is an optimistic estimate and a less optimistic one as to how the underlying variables will develop over the time the contribution is to be paid.

If a composition agreement is not reached before the end of the year, the estates go into bankruptcy. This is not the desired course of events from the point of view of creditors, mainly because bankruptcy implies a limited time to sell assets, which again will most likely mean lower prices and less recovery. Also—and most importantly—a bankrupt estate will incur a tax of 39%, or 850 billion ISK, reduced by certain deductions to 680 ISK (or, more likely, to 620 billion ISK), payable by April 15 next year. Here, bankruptcy and the “stability tax” is the stick because this is not what the creditors want, whereas a “stability contribution” and composition is the carrot the creditors are aiming for.

“Over decades, many foreigners have complained that the old Roman saying “Pacta sunt servanda” (“an agreement stands”) has never reached Iceland, that Icelanders only feel that an agreement stands as long as they do not think of a new one.”

Now, you might ask why the government agrees to “only” 300 billion ISK to 420 billion ISK or thereabouts if it could possibly get 700 billion ISK or even more. The reason is that there are all sorts of legal uncertainties connected to the bankruptcy tax: creditors might challenge it in court and even though the government might win (not necessarily likely, but who knows), this will cause delays, no controls lifted and Iceland stays in limbo. Another gain for Iceland from a successful implementation of the plan: rating agencies, who decide the cost of borrowing for countries and companies, will pay attention. If they are unhappy with how Iceland treats creditors, both the Icelandic state and Icelandic companies get punished with high borrowing costs, not an ideal situation.

The sensible people advising the government and most of those working on capital controls issues in the CBI and the Ministry of Finance support dangling the “carrot.” With the plan agreed to, this is the likely way. The only thing that could scupper the plan is “panic politics”—politics that arise when politicians are in panic about losing power. The next election is in 2017, and already next year politicians will be planning for it. Over decades, many foreigners have complained that the old Roman saying “Pacta sunt servanda” (“an agreement stands”) has never reached Iceland, that Icelanders only feel that an agreement stands as long as they do not think of a new one. So there are some caveats as to what could happen—though for the time being, composition and stability contribution are the likely outcome.

So when will those yearning for a flat in the sun or foreign shares or pension funds with billions to invest get out of the controls? Although the rhetoric when the plan was presented was that this was all done with the interests of the “real economy” at heart, i.e. Icelanders, businesses and pension funds, there was no date for lifting the controls for them. That plan will come in autumn or next winter, according to sources close to the government. This will take some years to carry out.

How can Iceland allow creditors who will make zillions on their claims to walk away with their huge profits? Well, before profits, there have been huge losses, but not necessarily for the same creditors. There are essentially two types of creditors. One type is the foreign banks that originally lent the Icelandic banks and who have lost what amounts to five or six GDPs. The three estates now own assets worth approximately 2200 billion ISK, approximately 110% of Icelandic GDP. No need to weep over their losses, as some of those original lenders still hold onto their claims, hoping they will get something in the end; they can now hope for around 10% of what they lent Landsbanki, 20% of what they lent to Kaupthing and approximately 30% of what they lent to Glitnir. The second type is those creditors who have bought claims (to begin with from the original lenders, type one; later also from each other) on the so-called “secondary market,” after the banks had failed. Bankruptcy assets are called “distressed assets,” and make up a small but lucrative part of the financial sector. It is a myth that those who bought the claims after the collapse all did so at two cents to the dollar and stand to make thirty or forty. There was very little trade to begin with and the price soon rose but yes, some of those who bought on the secondary market will make a lot and that is the way it goes. It is however important to keep in mind that their profit comes from the estates of failed banks, not from the Icelandic state and Icelandic taxpayers.

If Iceland treats the creditors harshly, it may scare away foreign investors, sorely needed at the moment. Although that being said, the finance market tends to forget quickly. Shortly after the last election, in a discussion about capital controls at an open meeting in Reykjavík, one businessman advocated for the harsh treatment: the estates should just be boxed in and the controls lifted on everyone and everything Icelandic— people, companies and pension funds. Már Guðmundsson, the governor of the CBI, was present and in his calm and measured central banker tone, he said that this was certainly possible. Then, in a few years time, foreign investors will come to Iceland, see the cage, and ask who is in it. “Well, those are the foreign investors who were here last time…”