It feels like Groundhog Day. Iceland’s Minister of Finance has for the third time brought a new agreement on how to resolve the Icesave dispute between Iceland on the one hand, and the UK and the Netherlands on the other, before the Parliament of Iceland (Reuters 2010).
Remember foreign branches of Landsbanki, one of Iceland’s failed banks, collected retail deposits into internet savings accounts in the UK and the Netherlands marketed under the “Icesave” brand. When Landsbanki collapsed in October 2008 the authorities in these countries paid out deposit insurance to depositors in Landsbanki branches – including the minimum insured amount as defined in the European deposit insurance directive to be paid by the Icelandic deposit insurance fund. That portion amounted to €4 billion at current exchange rates, or 40% of Iceland’s 2010 GDP, whereof the €0.1 billion contained in the Icelandic deposit insurance fund, could only cover a small fraction. The various agreements on Icesave all specify how, and on what terms, the UK and Netherlands are to reclaim their €4 billion.
The second version (I shall not discuss the first version!) of the Icesave agreement was ratified by Iceland’s Parliament in late December 2009, but vetoed by the President on 5 January 2010 and sent to a referendum held in March 2010.
Icelanders and many others regarded the agreement as deeply unfair for several reasons. For example it was seen as unfair:
- that Icelandic taxpayers should have to pay the debts of a failed private bank, and
- that they should pay the full costs of a manifest failure in EU deposit insurance regulation
- there are legal uncertainties as to the responsibility of the state of Iceland for backing up Iceland’s deposit insurance fund, and
- the interest rate in the agreement included a substantial mark-up on costs of financing of the UK and Netherlands treasuries.
The interest rate is an all important variable for Iceland. In all likelihood the estate of Landsbanki will cover most or even all of the principal of the payments, but, inter alia for legal reasons, not interest accruing on the Icesave bill until payments are made out of the estate.
Hence, the most likely scenario is that Icelandic taxpayers will only have to pay the interest on the mentioned amount, from a negotiated issue date until the estate reimburses all three deposit insurance schemes, i.e. those of the UK, the Netherlands, and Iceland.
In a Vox column written shortly after the President’s veto on January 2010 (Baldursson 2010), I likened the situation to an “ultimatum game”. Despite the real possibility of dire consequences I predicted that Icelanders, faced with the hard end of such a game, were likely to reject the standing offer which they regarded as unfair; this they resoundingly did.
I also proposed lowering the interest rate as a compromise that could solve the problem and avoid a referendum. Crucially, the new Icesave agreement does exactly this. The interest rate is now calculated as an average of the UK and Dutch treasuries’ costs of financing, thus these two countries can no longer be seen to be profiting from a much small negotiating partner’s troubles as was the case before. In addition, there are several other important improvements – from Iceland’s perspective – regarding legal issues.
The new agreement is a substantial improvement on the last version. In expected present value terms (using Ministry of Finance assumptions) the costs to Iceland are lowered from about 10% of GDP (€1 billion) to roughly 4% (€0.4 billion). The difference between costs in the two agreements would be increased should recovery of priority claims from the Landsbanki estate be lower than assumed, so the downside risk to Iceland is reduced. Markets, however, place a positive probability on more than full recovery of priority claims. The bonds of Landsbanki, which are subordinate claims, currently trade at about 10 cents to the dollar.
The cost of a delayed resolution in the dispute is uncertain. A year ago it seemed likely – based on earlier experience – that, as long as the Icesave issue remained unresolved, external funding from the IMF and Iceland’s Nordic neighbours would be withheld. Given a prolonged delay in further foreign financing, a default on external sovereign debt was imminent by the end of 2011. Uncertain access to foreign reserves also prevented any relaxing of capital controls. As it turned out this outcome, which would have been extremely costly for Iceland, was avoided, and in fact Iceland’s creditworthiness has been on the rise of late according to credit default swap spreads; the country now enjoys a better standing on this measure than Spain, not to speak of Ireland or Greece. A critical factor in avoiding a renewed financial crisis was the failure of the UK and Netherlands to make good on their prior threat of blocking further financing from the IMF.
There have, however, been adverse effects due to the non-resolution of the Icesave dispute. The hovering uncertainty which resulted has certainly been a turn-off for foreign investment and financing. In particular it has been a hindrance to foreign financing of major investment projects in the power sector; pending projects are large in the Icelandic context, even on a macroeconomic scale, and would have triggered renewed growth.1 There are dynamic effects of delays to investment and reduced growth so the cumulative cost in terms of lost income may be large – potentially larger than the gain due to the new Icesave agreement.2 But other government policies (or lack thereof) have also contributed to delayed growth and investment and it is difficult to disentangle their adverse effects from those of Icesave.
So it is unclear whether it was in Iceland’s economic interests to reject the earlier Icesave agreement; the costs may well outweigh the benefits.3 That is, of course, a moot point now – what matters is the present situation and the current agreement.
It can be argued that it must be rational for Iceland to ratify this agreement; relations with its neighbours will be bettered, capital markets will open up, and foreign investment and growth will resume earlier. And it will be easier to remove the odious capital controls in place since October 2008. However, due to the relaxed external financing situation following the last successful IMF review, costs to Iceland of delaying resolution of this dispute have been lowered; default no longer looms on the near horizon.
Hence, even if it seems prudent for Iceland to ratify the current agreement and move on, there is not the same urgency to resolving the dispute as a year ago. Some claim that it is best to play an all-or-nothing strategy where the dispute is taken to court. There are clear and substantial risks related to that strategy due to discrimination between Icelandic and foreign depositors in the so-called emergency legislation of October 2008, but after the last version of the agreement was refused without major and readily visible consequences it is tempting to discount such risks.
Finally, those who are against EU membership have used the Icesave dispute successfully to turn public opinion against the EU, and will surely continue doing so; even with the interest rate issue out of the way it is still possible to argue that it is unfair in principle that the public is made to pay for the losses of a private bank. British and Dutch taxpayers could of course argue that it is no fairer that they pay the bill.
We have come out of the laboratory and into the real world with all its complexities. This is not a one-shot ultimatum game, but a repeated real-life game with high stakes, and the rules are made up as we go along.
Fridrik M Baldursson (2010), “Icesave: the big ultimatum”, VoxEU.org, 29 January.
Ugo Panizza, Federico Sturzenegger, and Jeromin Zettelmeyer (2009), “The economics and law of sovereign debt and default”, Journal of Economic Literature, 47(3):651–698.
Reuters (2010), “Iceland finance minister presents new Icesave bill to parliament”, 16 December.
1 It is natural that it takes time for international capital markets to open up to Iceland after the 2008 crisis. More than two years after a crisis, however, it would be normal to see at least a beginning recovery in private capital flows (see e.g. Panizza et al. 2009). Perhaps more tellingly, public organisations, such as the European Investment Bank, and the Nordic Investment Bank, which might be expected to be the leaders in resuming lending to publicly owned Icelandic enterprises such as power companies, have denied or delayed financing to viable investment projects in the power sector in Iceland.
2 Johanna Sigurdardottir, Prime Minister of Iceland, said in a recent speech that essentially the same agreement was on the table prior to the referendum of March 2010. Had that offer been accepted most of the costs of delay would have been avoided. For political reasons it was, however, too late by then to close a deal and avoid the referendum.
3 That would almost certainly hold were the outcome adjusted for ex ante risk. Apparently it takes more than a financial crisis to teach us to do that with accounting surplus.