Iceland's Rationale for Stiffing Bondholders Melts Away

One of the world's fastest-growing economies can easily pay its creditors, but chooses not to.

Time to pay up.

Photographer: Leon Neal/AFP/Getty Images

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 can’t meet their obligations. Recent examples include Greece, Jamaica and Ecuador. But 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), 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 OECD on the country’s prospects begins this way: “Economic growth is strong with continued expansion in tourism, robust private consumption and favourable 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 $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 that gave bondholders a choice: either sell their bonds to the government at a special “offshore” exchange rate of 190 krona 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. The currency appreciated 16 percent last year. Foreign-exchange reserves have quadrupled in the last two years.

A report by an Iceland securities firm, Fossar, says that foreign-exchange reserves are now double the IMF's guidance for providing safety to 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 last fall, Mar Gudmundsson, governor of the Central Bank of Iceland, 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 wouldn’t 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 U.S. and European companies -- so the logic apparently goes -- Iceland can apply different rules to them.

But 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 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 European Union. 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 Securities and Exchange Commission.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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