Iceland Bankruptcy-to-Rebound Path Ireland Won’t Take

Iceland President Olafur R. Grimsson
Iceland President Olafur R. Grimsson said in an interview, “The difference is that in Iceland we allowed the banks to fail.” Photographer: Chris Ratcliffe/Bloomberg

Iceland is betting its decision two years ago to force bondholders to pay for the banking system’s collapse may help it rebound faster than Ireland.

Iceland’s taxpayers face a smaller debt burden than their Irish counterparts, where the government’s guarantee of the financial system in 2008 backfired this year when the banks came close to insolvency. Iceland’s budget deficit will be 6.3 percent of gross domestic product this year and will vanish by 2012, compared with the 32 percent shortfall in Ireland, the European Commission estimates.

While analysts expect Iceland’s recession to extend into next year, the nation’s exporters are benefiting from a 28 percent drop in the krona against the dollar since September 2008. The decline may help the nation of 320,000 people rebalance its economy faster than Ireland, whose euro membership rules out a currency devaluation. With Iceland’s OMX share index up 17 percent this year, the third-biggest gain in Europe after Denmark and Sweden, Nobel Prize-winning economist Paul Krugman says Iceland may be an example of “bankrupting yourself to recovery.”

“The difference is that in Iceland we allowed the banks to fail,” Iceland President Olafur R. Grimsson said in a Nov. 26 interview with Bloomberg Television’s Mark Barton. “These were private banks and we didn’t pump money into them in order to keep them going; the state did not shoulder the responsibility of the failed private banks.”

‘Burning’ Question

The island’s bank debt remains with the failed lenders, whose creditors have yet to recoup $85 billion. Deciding who should bear the cost of banking failures is becoming a “burning” question in Europe, Grimsson said.

“Senior bondholders in some countries must accept that they may have to take haircuts or participate in restructurings,” said Michael Derks, the London-based chief strategist at FXPro Financial Services Ltd., in an interview. “It just doesn’t add up otherwise; senior bondholders will need to participate. There is no avoiding it.”

Ireland and Iceland boasted growth rates in excess of 5 percent from 2005 to 2007 as they opened their economies to international investment. Both then succumbed to an overheated financial industry that outgrew their economies. Iceland’s recession will be deeper this year than Ireland’s, though the Atlantic island will overtake the euro member in 2012, the Organization for Economic Cooperation and Development said in a report published Nov. 18.

One Letter, Six Months

In 2009, the joke was: What’s the difference between Iceland and Ireland. Answer: One letter and about six months. “Almost two years on, the joke is on the jokers,” Krugman said in a Nov. 24 column published in the New York Times. “At this point, Iceland actually looks a bit better than Ireland.”

Ireland’s 85 billion-euro ($111 billion) rescue package came after weeks of negotiations during which German Chancellor Angela Merkel was forced to water down demands that bondholders bear part of the cost of future bailouts, instead of heaping the full burden on taxpayers.

Irish banks’ senior bonds rose Nov. 29, the day after the country’s rescue was announced, as investors were spared the prospect of sharing losses with taxpayers. Bank of Ireland Plc’s 1.47 billion euros of senior floating-rate notes due September 2011 gained almost 10 percent to 90 cents. Bondholders of Iceland’s Kaupthing Bank hf, by contrast, will get back about 26 cents per euro, according to brokerage H.F. Verdref hf.

‘Heterodoxy Is Working’

While Irish bank bonds rose, the euro fell as much as 1.3 percent against the dollar, its lowest value since Sept. 21. The euro rose today as the European Central Bank delayed its withdrawal of emergency liquidity measures and bought more government bonds. The single currency gained 0.2 percent against the dollar to trade at 1.3161 at 3:54 p.m. in London.

Krugman says Ireland’s “orthodox” response -- pushing through austerity measures and guaranteeing bank liabilities to stay in the euro -- contrasts with Iceland’s “heterodox” solution -- devaluing the currency, restructuring bank debt and putting capital restrictions in place. “Heterodoxy is working a whole lot better than orthodoxy,” according to Krugman.

Iceland’s budget will be in surplus by 2012, compared with Ireland’s deficit of 9.1 percent of GDP, the European Commission estimates. Unemployment in the euro member will stay at 13.6 percent this year and next, compared with a 2011 peak of 8.1 percent in Iceland, OECD data show.

‘Tremendous Burden’

Iceland, which started EU accession talks this year, is experiencing a “durable recovery” that is “forecast to pick up steam” next year, the IMF said in an October report. Iceland’s government says it had no choice but to let the lenders fail. Before their collapse, the banks had debts equal to 10 times Iceland’s $12 billion GDP.

“Trying to rescue a banking system that is too big is a tremendous burden,” Finance Minister Steingrimur Sigfusson said in an interview in Oslo. “There was not a question that we would rescue the banks; they were far too big.”

An Irish bank failure would plunge much of the rest of the euro region into crisis, said Valdimar Armann, an economist at Reykjavik-based asset management company GAMMA. “The banks are too entangled in the European web of banks,” he said.

European banks had $509 billion in claims against Ireland at the end of June, Bank for International Settlements data show. Euro-region governments will assess how far investors should bear potential write-offs on a case-by-case basis starting in 2013, finance ministers said on Nov. 28.

Kaupthing, Landsbanki Islands hf and Glitnir Bank hf failed two years ago after they were unable to secure short-term funding. Kaupthing’s so-called winding-up committee said Nov. 26 that it’s dealing with 28,167 claims filed by creditors across 119 countries totaling $63 billion.


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