Iceland will honor its obligations - Interview with Gylfi Magnusson, Minister for Business Affairs

However, from the point of view of Icelandic taxpayers the the problem with the Landbanki accounts in the UK and the Netherlands, is bigger. It seems now inevitable that when all accounts have been settled, some part of the Icelandic debts will be paid by the Icelandic government and then, of course, also by the Icelandic taxpayers. Read more:

President Ólafur Ragnar Grímsson said in a German newspaper last week that German Kaupthing customers should understand, that Icelanders lost everything and therefore shouldn’t carry the burden of paying the deposit guarantees.

The government and you contradicted and said that Iceland will fulfill its obligations. But isn’t the president right also? How do you explain to people, that now that they have lost everything they will also have to pay the banks' foreign debts?

I am glad to get the chance to clear up this misunderstanding. First of all, with regard to Kaupthing Edge in Germany I have been told, it seems almost certain that there are sufficient assets within the bank to pay off depositors. There is a much bigger problem from the point of view of the Icelandic taxpayers in the UK and the Netherlands. But those accounts were with Landsbanki, not Kaupthing. It seems now inevitable that when all accounts have been settled, some part of the Icelandic debts will be paid by the Icelandic government and then, of course also, the Icelandic taxpayers.

How is the government going to raise the money for that? Iceland is seriously in debt. So where does the money come from then? The taxpayer?

Well, in a way yes. That’s basically the only revenue that the government has. But you must also look at the economy from a larger perspective. What is really needed is that the Icelandic economy generates enough trade surpluses to pay off the debts. It is vital for everyone involved, the Icelandic government, the Icelandic people and the creditors, that the Icelandic economy gets back on its feet and manages to keep the export industries going in order to to generate the Euros or Pounds or Yen needed to pay off these debts.

... to raise foreign currencies?

Yes. So we must take a dramatic U-turn from the trade deficit of recent years to a trade surplus. In the last few months we have managed to do this and hopefully will continue to be able to do so. There are several factors that are working with us: the fact that the currency has fallen so dramatically, reduces imports and helps strengthen exports. There are of course also factors that may not work in our favour. In particular, the deterioration of global economy will hurt exports everywhere. But there is really no reason to think that Iceland will be significantly worse affected by this than other countries.

Do you think that any Icelandic bank, if re-privatised in the future, will be able to participate in international competition for private clients, to offer money market deposit accounts, etc.?

Well, not like they did before, that is quite clear. They over-extended very dramatically and reached far beyond what was reachable. So, we will not see anything like that. At the moment, our main concern is to get the New Banks fully functional in order to be able to serve the domestic economy. So, basically all their foreign operations have either been seized or are waiting to be sold off. There will be no significant foreign operations of Icelandic banks. We will have a domestic banking system to start with. At some point their finances and reputation may recover, and then they may be able to expand a little bit abroad but that won’t happen in the immediate future.

Are the Icelandic banks doomed to stay in the country just because Iceland is such a small country and the banks shouldn’t exceed the GDP?

You can say that for now they are in this situation. And of course we want to set up a banking system that has solid finances, a solid balance sheet and limit the scope of the new banks’ activities. We have to do everything that it is needed for the domestic business and will not spend resources on expansion abroad. International expansion wouldn’t be feasible anyway given the current banking climate and the seriously damaged reputation of the Icelandic banks abroad. I’m sure that the Icelandic government will set up a regulatory framework to make sure that nothing similar to what happened in the recent past will be repeated. Obviously a number of things went wrong in Iceland. There were some bad decisions made by the bankers and the owners of the banks, but there was also regulatory failure.

In what way?

In many ways. Our regulatory framework put very little limit on how large the banks could become and there were no serious attempts made to try to reduce their growth. There was domestic and foreign criticism before the banks collapsed. But those voices were not listened to at least not by the ones that made decisions

Why not?

Well... (pause)... that is probably a long story, but I think that there were several factors involved. One was that on the surface everything looked extremely rosy. The banks were growing rapidly, generating huge profits. They were hiring people left and right on very high salaries. The stock market was booming. The real estate market was booming. And anybody, who pointed out that maybe we didn´t have the necessary financial support and that we were running too fast, was ignored. The banks were relying to an ever-increasing degree on a horrendous amount of borrowing, both for funding and also to keep asset prices high. There was a real danger, that if there was some disruption in the flow of foreign capital, we could have a very rapid negative spiral where the asset prices could fall and the krona could depreciate. Which is unfortunately what happened. Many people, including me in my previous job, very seriously pointed out this possibility, not just as a theoretical possibility, but as an actual threat.

Don’t you think that the banks would have had the obligation towards the Icelandic customers to advise them not to take loans in foreign currencies, which is – given the devaluation of the Krona - the reason why most Icelanders can’t pay their loans back now?

I’m certain that they should have done that. They have obviously advertised risky behavior and risky products, assets and loans. And it’s quite clear, that when a banker tells a customer, who has no foreign currency earnings, to make a huge bet on the Icelandic krona by taking a foreign loan, the current exchange rate fluctuations can make the customer bankrupt overnight. One more reason why people were taking all these foreign loans was that interest rates in Iceland were very high. This was a policy mistake by the Icelandic Central Bank. It should have used all different kinds of means, rather than just increasing interest rates to reach its economic goals.

After Landsbanki’s seizure Gordon Brown froze all assets of Icelandic banks in the U.K. using anti-terror-legislation. Subsequently Kaupthing had to be put into receivership, the official explanation being that Kaupthing was in technical default of its foreign loan relations after a run on the bank. Do you think that Gordon Brown precipitated the fall of Kaupthing?

This is of course one of the issues between Iceland and the UK. The UK government claims that these actions were justifiable; the Icelandic government sees it differently. I don’t really want to state how much damage the action of the British authorities against Singer & Friedlander, the British Kaupthing subsidiary, actually did. But Iceland was in dire straits, obviously trying desperately to keep a part of its banking system afloat. And the actions taken by the British government certainly didn’t help.

How highly is Iceland in debt now?

(sigh) This is a very complicated story. The government will take on sizable debts as part of the IMF programme and the settlement of the Icesave deposits and also some domestic debts due to the refinancing of the Icelandic banking sector. Then there are some other liabilities, for example due to the fact that we will have a very sizable budget deficit this year and next year as well. So Iceland’s government debt will rise dramatically, going from being one of the least indebted countries in the world to one of the most indebted ones in Western Europe, at least temporarily.

That said; the gross debt - I’m reluctant to give you a precise estimate because of too many uncertainties involved – will be somewhere around one year’s GDP. That means that the situation here is somewhat worse than the situation in Belgium or Italy before the worldwide financial crisis. But a considerable part of that is temporary.

If we look at the IMF loan for getting assets there is little reason to think that we will use up all of the assets. So when things get calm again, we can repay the loan by returning the assets. There will be costs due to interest rates, but we should be able to significantly reduce the government’s debt when things stabilize and when we don’t need these huge currency reserves that the IMF programme has in its plan.

But how is Iceland supposed to pay all these debts considering the depression, companies going bankrupt, consumption decreasing and interests piling?

It’s certainly going to be tough. I don’t want to say a year or two, because it will most likely take somewhat longer than that, but the immediate future looks pretty grim because of all those factors that you mentioned and with government tax receipts falling at the same time. Demands towards the government are also rising, for example unemployment benefits are increasing.

The financial crisis has devastating effects on financial assets, but we have to keep in mind that it doesn’t destroy real assets. They are all there. We have more or less all the human capital. We certainly hope that we will not face too much of a brain drain abroad, although there will be some. But even then we will still have a very well educated and hard-working, flexible labor force.

We have infrastructure and real assets, including the natural resources. There is nothing that says that - once we have gone through this painful financial reorganization - we can’t pick up speed and use these real assets to generate goods and services, including exports.

And we must also keep in mind that the government is getting a lot of assets as well. For example, it now owns the banks and even if they won’t be sold - which is of course a political question whether you want to privatize the banking system again - these should become healthy companies that provide revenues to the government. So, the government’s net debt should fall below one year’s GDP and end up similar to many Western European countries, maybe 50-60% of the GDP, even if we don’t paint a very rosy picture.

History tells us of course that a lot of countries have gone through financial crises – this one of course is fairly severe by international historical standards - but there is no insurmountable problem.

Do you think that other countries might soon face the danger of bankruptcy like Iceland in the course of the worldwide economic crisis, like Greece, Portugal, Ireland?

I certainly hope not. And what is strikingly different in these countries is the fact that they don’t have a small floating currency like we have and they have the backup of EU Central Bank and maybe even some fiscal backup from their fellow governments within the EU. All of that makes it less likely that these countries will have a financial sector that collapses as spectacularly as the Icelandic one.

On the other hand, our currency, being very weak now, will probably help us faster than other countries that are stuck with the Euro. Because the Euro is so strong now that it doesn’t help exports. So our currency contributed to the downfall and the big problems that we have now with foreign debts. But then again we are probably better situated to recover through exports than countries with a strong currency.

When he resigned, Björgvin Sigurdsson, your predecessor said that he regretted not having pushed Iceland more towards EU-membership. Do you think EU-membership would have prevented or reduced the consequences of the worldwide crisis for Iceland?

It would not have prevented a crisis but it would have made the dynamics different, especially when it comes to debts and the loans and the crushing exchange rates. But I doubt that Iceland as a EU-member with the Euro would have escaped the financial crisis, if nothing else had changed.

Should Iceland join the EU now?

This is a very controversial question. Many people are in favor of many aspects of EU-membership, in particular of adopting the Euro. And most economists claim that having its own floating currency without any ties to another currency, is really not a viable option for Iceland in the long-run. But the main stumbling block on Iceland’s way to EU-membership is domestic opposition to adopting the EU fishery policy.

Are you personally in favor of EU-membership?

I am in favor of finding out what it would entail. We should start negotiating with the full intention of entering but of course not deciding to enter until we know what the framework would look like for Iceland’s entry into the EU. Icelandic negotiators would presumably call for some sort of exemption or special treatment with regard to the fishing industry. After completing the negotiations, it would be possible for the Icelandic people to take an informed decision on whether to join or not. But a deal, where we lose all sovereignty over the fishing rights would never be politically viable in Iceland.

Iceland already enjoys almost all other benefits of EU-membership through the EEA agreement. We already have labor mobility, freedom of investment, free-trade and all the economic aspects of being a EU-member so it really boils down to the fishing rights. EU-membership won’t happen in the immediate future, no matter how we rush it.

But I think that a reasonable plan of entering and – when we have entered – then starting moving towards adopting the Euro would be very helpful to bringing financial stability to Iceland. It would maybe not restore full trust in the Icelandic financial system, but it would contribute significantly to building trust in the financial system both in Iceland and in the international community.

Iceland would have to meet the economic requirements also to join the EU?

It would be one of our challenges, that we brought Icelandic interest and inflation rates down to the Euro-zone average within a few years, which is one of the pre-requisites for adopting the Euro. But having a plan that would bring us on that path would be immensely helpful for getting a calmer economic environment in Iceland.

Last question: David Odsson refused to resign when the current Prime Minister asked the Board of Directors of the Icelandic Central Bank to resign. Will he have to go?

This matter is before the Parliament at the moment. There is a bill for discussion in the Parliament, which will change the legislation regarding the Central Bank. I think it’s most likely that the bill will be passed and then we get not just a new bank government but also new monetary policy board.

Gylfi Magnusson, Minister for Business Affairs

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