Iceland is a Nordic free-market democracy with glacier-covered volcanoes and hyperactive geysers. If you’re into mind-bendingly complex song lyrics, there’s Björk and Sigur Rós. In the rarefied world of global finance, Iceland is also where local pols and central bankers trample on the interests of bondholders like a herd of marauding reindeer. At least that’s the perspective of foreign bondholders and distressed asset hedge funds hoping to recoup their investments in three Icelandic lenders—Landsbanki Islands, Glitnir Bank, and Kaupthing Bank—that defaulted on $85 billion in debts in 2008.
In a parliamentary election on April 27, the Independence Party—which was in power during the meltdown—and the Progressive Party together won just over 50 percent of the vote. Both ran on an anti-austerity platform of lower taxes and home mortgage relief, to be funded in part by forcing overseas creditors to accept losses on the $3.8 billion in krona-denominated assets they’re owed by three failed lenders. Also in play is $8 billion in deposits and loans owed to overseas creditors that have been trapped in Iceland, thanks to capital controls imposed in 2008.
Talks are under way in Reykjavik to form the new government. Sigmundur David Gunnlaugsson, chairman of the Progressive Party, has called for steep reductions on the amount owed to more than 100 creditors, including Royal Bank of Scotland (RBS), Deutsche Bank (DB), Goldman Sachs (GS), and distressed asset investor Davidson Kempner Capital Management, a New York hedge fund. The new government aims to “write down the kronur claims of creditors of the failed banks, which everybody knows have to be written off,” Independence Party Chairman Bjarni Benediktsson said in a mid-March interview. Either Gunnlaugsson or Benediktsson is expected to be named prime minister, and new debt negotiations may begin this summer.
Iceland’s politicians won praise from American economists including Paul Krugman and Joseph Stiglitz for refusing to bail out Iceland’s banks, whose balance sheets had ballooned to 10 times the size of the island’s economy. Unlike many other nations, Iceland did not use taxpayer money to protect bank bondholders and creditors. The strategy worked: Iceland is no longer a ward of the International Monetary Fund, which together with Finland, Sweden, Norway, and Denmark spent $4.6 billion to bail out the country. Its economy is expected to grow 2.1 percent this year, according to the Central Bank of Iceland. The unemployment rate has fallen to 5.3 percent from a peak of 9.3 percent.
Even so, the new regime faces a dilemma: Play too rough with foreign creditors and the country runs the risk of becoming a financial pariah. “Iceland will be locking itself out of the international debt markets and reducing the country’s chances of raising investments,” says Lars Christensen, chief emerging markets economist at Danske Bank (DNSKY).
Beating up creditors may not be a smart legal strategy. “If the government forces the creditors to negotiate on its terms, it can be tantamount to a de facto expropriation, which can afford the creditors the right to damages,” says Hróbjartur Jónatansson, a bankruptcy attorney in Reykjavik. Leaving capital controls in place indefinitely could be viewed by a court as an illegal asset seizure, he says.
Iceland is paying a price for its stance. The krona has fallen 40 percent against the euro since 2008. That’s raised import prices and resulted in an annual inflation rate of 3.3 percent as of April. Families, already hit hard by a housing market bust, are carrying heavy debt loads. There are also about $11.3 billion in consumer loans in the nation with repayment terms linked to changes in consumer prices.
Both victorious parties support lifting capital controls, but Iceland’s trade balance and foreign exchange reserves are too small to pay the bank creditors all at once without cratering the currency, the government says. The government will need to demonstrate that it really can’t afford to pay back creditors without more lenient terms in future debt talks, according to two people close to the creditors who declined to be identified ahead of the negotiations. They add that since the crash, foreign creditors haven’t seen a dime. Repayment would have to take place “over a long period of time,” says Gylfi Magnússon, an economist at the University of Iceland.
Big banks and hedge funds aren’t the only creditors hoping to get paid back. Landsbanki Islands has repaid only $5.7 billion to the Netherlands and Britain to compensate depositors who lost more than $11 billion five years ago in a high-interest online savings product called Icesave. The Iceland government has said the bank will pay the full amount, but hasn’t said when.