The legislature of Iceland has decided that foreign investment is no longer paramount to the development and prosperity of the island country. On May 22 of this year, the Parliament passed a new law concerning government bonds that are coming due. The aim of officials in Iceland is to prevent the domestic economy worth $16.7 billion USD (United States Dollar) from being overwhelmed from the massive inflow of capital.
Although Iceland is a rather small country with just 327,386 inhabitants, it has been able to punch above its weight in the financial markets. This is due to a healthy economy and an investing environment that has become attractive to capitalists.
Foreign holders of Icelandic debt denominated in krona, discovered that the rules for investment had changed after the fact. These investors have the equivalent of $2.3 billion USD worth of sovereign debt, that is subject to the new law concerning foreign capital.
Investors are being asked to either sell their holdings at below the actual market exchange rate this month or being denied full access to the maturing debt later. When the bonds become due in the future, the money received will be sequestered by the government. These funds will be held indefinitely in bank accounts paying low interest rates.
By some estimates this is an actual sovereign default by the government of Iceland. These new capital controls are being imposed, as a way to protect the country from the financial instability that comes with having more foreign investment than the actual size of the economy.
Legislators are attempting to prevent a repeat of the financial disaster, that occurred eight years ago. Before then, banks in Iceland rapidly grew in size, as they offered high interest rates to foreign investors holding money on deposit. The additional borrowing in bond markets, swelled the balance sheets of domestic banks beyond the GDP (Gross Domestic Product) of the country.
In 2008 as bonds became due, depositors unnerved by the international financial crisis decided en masse to withdraw the proceeds from the banks. It soon caused a run on the banks when it was determined that these institutions had become largely insolvent.
As a result, the Icelandic krona plunged in value against the Euro. The large devaluation that took place was devastating to the domestic economy and created turmoil in the markets. In the end, the government was forced to bail out these banks to prevent a total financial collapse. Part of the solution was to impose capital controls.
More recently fund managers were once again buying bonds in Iceland, because the country offers higher interest rates than elsewhere. The growing economy along with the assurance that investors would be paid, created far more foreign investment than expected.
Authorities behind the new legislation, want to prevent a repeat of what occurred in the last decade. The central bank of Iceland has made it clear that these bond holders will need to accept the terms offered by the government, because the country simply does not need the money.
The auction that will be held this month will allow investors to liquidate their holdings that can be exchanged into Euros. Of course they will be expected to take a loss on the sale through the exchange rate. It takes roughly 140 krona to purchase one Euro. The government is insisting that investors will need 210 krona for each Euro bought. As an incentive to the entire group of bondholders, if enough of them agree to sell, the exchange rate will improve to just 190 krona.
The only other alternative for foreign investors, is to hold onto their bonds and allow them to mature on schedule. They would then receive the expected payout from the government. However, these funds would not be available for withdrawal. They would be placed into savings accounts paying just 0.50% interest, until the present capital controls are finally removed.
The unfavorable conversion rate offered by the government it is claimed, is the result of having so much debt coming due at the same time. If these bonds were released simultaneously on the open market, their value is likely to decline rather precipitously. A devaluation these officials explain, could not be avoided.
Foreign investors still feel that they are being penalized, once again. As a group they were unable to repatriate funds from Iceland, with the capital controls that were implemented in 2008. The actions taken then prevented krona from being converted to other world currencies. Overseas bondholders were in essence, trapped in Iceland.
Although necessary at the time, these controls prevented investors from being able to buy and sell their assets at will. It did allow the government time to manage the resulting economic slowdown that arrived with the collapse of the banks, the devaluation of the krona and the upsurge in inflation.
Currency controls have never been completely removed, since the emergency actions taken in 2008. Iceland did remove some of the obstacles over time, to begin the return to financial normalcy as far as currency controls. The largest one was the deal negotiated with creditors of the Icelandic banks in 2015.
A number of major bond holders have already decided, not to participate in the upcoming auction. The six percent interest rate and the appreciation of the krona have allowed many of them to recoup some of the losses in valuation, of their bonds that occurred in the financial tumult of 2008.
These investors feel over time, that Iceland will be forced to lift all capital controls to remain competitive. If in the meantime money from the bonds that mature is kept in low interest accounts, that is better than the alternative of the auction.
However, Iceland will pay a price for the recent actions taken by the government. It is already creating hesitancy among foreign investors, to make further investments in the economy of the country. This will soon be evidenced in a number of industries and sectors across the board, as investors reconsider whether to gamble on future actions of the government of Iceland.