Cyprus and Iceland: a tale of two capital controls

Both in Cyprus and Iceland foreign funds flowed into the islands, in the end forcing the government to make use of extreme measures when the tide turned. These measures are normally called ‘capital controls’ which in these two cases hides the fact that the measures used are fundamentally different in all but name. In Iceland, the controls contain the effect of lacking foreign currency, effectively a balance of payment problem – in Cyprus, the controls were a way of defending banks against bank run, i.e. preventing depositors to move funds freely.

It is a sobering thought that two European countries now have capital controls: Iceland and Cyprus; sobering for those who think that in modern times capital controls are only ever used by emerging markets and other immature economies. Cyprus has been a member of the European Union, EU, since 2004 and part of the Eurozone since 2008; since 1994 Iceland has been member of the European Economic Area, EEA, i.e. the inner market of the EU. – The two EEA countries were forced to use measures not much considered in Europe since the Bretton Woods agreement.

Although the concept “capital controls” is generally used for the restrictions in both countries the International Monetary Fund, IMF, is rightly more specific. It talks about “capital controls” in Iceland and “payment restrictions,” i.e. both domestic and external, in Cyprus.

Both countries enjoyed EEA’s four freedoms, i.e. freedom of goods, persons, services and capital. –Article 63 of the Treaty on the Functioning of the European Union prohibits “all restrictions” on the movement of capital between Member States and between Member States and third countries.

Both countries attracted foreign funds but different kind of flows. While the going was good the two islands seemed to be thriving on inflows of foreign funds; in Iceland as a straight shot into the economy, in Cyprus by building a financial industry around the inflows. Yet, in the end the islands’ financial collapse showed that neither country had the infrastructure to oversee and regulate a rapidly expanding financial sector.

It can be argued that in spite of the geography both countries were immature emerging markets suffering from the illusion that they were mature economies just because they were part of the EEA. As a consequence, both countries now have capital controls and clipped wings, i.e. with only three of the EEA’s four fundamental freedoms.

The “international finance centre”-tag and foreign funds

Large inflows of foreign funds are a classic threat to financial stability. At the slightest sign of troubles the tide turns and these funds flow out, as experienced by many Asian countries in the 1980s and the 1990s. Capital controls are the classic tool to resume control over the situation. None of this was supposed to happen in Europe – and yet it did.

Although not on the OECD list of tax havens Cyprus has attracted international funds seeking secrecy by inviting companies with no Cypriot operations to register. After the collapse of the Soviet Union money from Russia and Eastern Europe flowed to the island as well as from the Arab world. Even Icelandic tycoons some of whom grew rich in Russia made use of the offshore universe in Cyprus.

The attraction of Cyprus was political stability, infrastructure, a legal system inherited from its time as a British colony and the fact that English is widely spoken in Cyprus. By the time of the collapse in March 2013 the Cypriot banking sector had expanded to be the equivalent of seven times the island’s GDP. This status did also clearly limit the crisis measures: president Nicos Anastasiades was apparently adamant to shelter the reputation of Cyprus as an international finance centre arguably resulting in a worse deal and greater suffering for the islanders themselves (see my article on the Cyprus collapse and bailout here).

Iceland also tested the offshore regime. Under the influence of a growing and partly privatised financial sector the Icelandic Parliament passed legislation in 1999 allowing for foreign companies with no Icelandic operations to be registered in Iceland. Although it could be argued that Iceland enjoyed much the same conditions as Cyprus, i.e. political stability etc. (minus an English legal system), few companies made use of the new legislation and it was abolished some years later.

But Iceland did attract other foreign funds. Around 2000 a few Icelandic companies started their shopping spree abroad. The owners were also large, in some cases the largest, shareholders of the three main banks – Kaupthing, Landsbanki and Glitnir. The banks’ executives saw great opportunities for the banks to grow in conjunction with the expanding empires of their main shareholders and largest clients. By 2003 the financial sector was entirely privatised, another important step towards the expansion of the financial sector.

In addition, the Icelandic banks had offered high interest accounts abroad from autumn 2006, first in the UK, later in the Netherlands and other European countries, even as late as May 2008. Clearly, Icelandic deposits were not enough to feed the growing banks. They found funding on international markets brimming with money. In 2005 the three banks sought foreign financing to the amount of €14bn, slightly above the Icelandic GDP at the time. In seven years up to the collapse the banks grew 20-fold. In the boom times from 2004 the assets of the three banks expanded from 100% of GDP to 923% at the end of 2007.

The Icelandic crunch: lack of foreign reserve

At the collapse of the Icelandic banks in October 2008 Icelandic króna, ISK, owned by foreigners, mostly through so-called “glacier bonds” and other ISK high interest-rates products amounted to 44% of GDP. These products, popular with investors seeking to make money on high Icelandic interest rates, had been flowing into the country, very much like “hot money” flowing to Asian countries during 1980s and 1990s.

Already in early 2005 foreign analysts spotted funding as the weakness of the Icelandic banks. In. February 2006 Fitch pointed out how dependent on foreign funding the Icelandic banks were. In order to diversify its funding one bank, Landsbanki, turned to British depositors in October 2006 with its later so infamous Icesave accounts. The two other banks followed suit. In addition, the banks were supporting carry trade for international investors making use of high interest rates in Iceland.

Steady stream of bad news from Iceland during much of 2008 caused the króna to depreciate drastically. After the collapse foreigners with funds in Iceland sought to withdraw them. On November 28 2008 the Central Bank of Iceland, CBI, with the blessing of the IMF, put capital controls in place (an overview of events here). IMF’s favourable stance to capital controls was a novelty at the time; not until autumn 2010 did the Fund officially admit that controls could at times solve acute problems as indeed in Iceland.

It was clear that the CBI’s foreign reserves were not large enough to meet the demand for converting ISK into foreign currency. What no one had wanted to face before the collapse was that the CBI could not possibly be a lender of last resort in foreign currency.

The controls were from the beginning on capital, i.e. capital could neither move freely out of the country nor into the country. The controls were not on goods and services, hence companies could buy what they needed and people travel but investment flows were interrupted (further re the controls see here).

The migrating króna problem

The core problem calling for controls was and still is ISK owned by foreigners, i.e. offshore ISK, but the nature of the problem has changed over the years: the original carry trade overhang has dwindled down to 16% of GDP, through CBI auctions where funds seeking to leave were matched with funds seeking to enter. Now, the major problem is foreign-owned ISK assets in the estates of the three banks, i.e. owned by foreign creditors who, without controls, would seek to convert their ISK into foreign currency.*

As outlined in CBI’s latest Financial Stability report, published last September there is a difference between the onshore and the offshore ISK rate: 17% in autumn 2014, about half of what it was a year earlier. These and other factors indicate that the non-resident ISK owners, i.e. those who owned funds in the original overhangs, are most likely patient investors; after all, interest rates in Iceland are higher than in the Eurozone. Although these investors cannot move their funds abroad the interests can be taken out of the country.

The classic problem with capital controls as in Iceland is that the controls – put in place to gain time to solve the problems, which made them necessary – can also with time shelter inaction. With the controls in place the urgency to lift them disappears. Over time, controls invariably create problems as the CBI pointed out in its latest Financial Stability report: The most obvious (cost) is the direct expense involved in enforcing and complying with them. But more onerous are the indirect costs, which can be difficult to measure. The controls affect the decisions made by firms and individuals, including investment decisions. Over time, the controls distort economic activities that adapt to them, ultimately reducing GDP growth. 

The main ISK problem is now nesting in the estates of the three collapsed banks where the problem, as spelled out in the CBI’s last Financial Stability report , is that “…settling the estates will have a negative impact on Iceland’s international investment position in the amount of just under 800, or about 41% of GDP. This is equivalent to the difference in the value of domestic assets that will revert to foreign creditors, on the one hand, and foreign assets that will revert to domestic creditors, on the other. The impact on the balance of payments is somewhat less, at 510, or 26% of GDP.

The balance of payment, BoP, problem could be solved in various ways, i.a. through swaps between Icelandic creditors who are set to get foreign currency assets from the estates, sales of ISK assets for foreign currency and write-down on some of the ISK assets. In addition there are tried and tested remedies such as time-structured exit tax where those who are most keen to leave pay an exit tax, which is then scaled back as the problem shrinks.

The political stalemate

In March 2011, under the Left government in office from early 2009 until spring 2013, the CBI published Capital account liberalisation strategy, still the official strategy. The strategy is first to tackle the offshore króna problem outside the estates, which has been done successfully (judging by the diminishing difference between the on- and offshore ISK rate) through the CBI auctions. That part of the strategy has now come to an end with the last auction held on 10 February.

The next important step towards lifting the controls is finding a solution to the foreign-owned ISK in the bank estates. Their creditors are mostly foreign financial institutions, either the original bondholders or investors who have bought claims on the secondary market.

As indicated above there are solutions – after all, Iceland is not the first country to make use of capital controls while struggling with BoP impasse. However, as long as the political unwillingness, or fear, to engage with creditors prevails nothing much will happen.

When the present Icelandic coalition government of Progressive party (centre; old agrarian party) and the Independence party (C) came to power in spring 2013 it promised rapid abolition of the capital controls. So far, the process has been a protracted one with changing advisers, unclear goals and general procrastination. There has at times been an echo of the belligerent Argentinian tone, blaming foreign creditors for the inertia in solving the underlying problems; importantly, the Progressive party has promised huge public gains from the resolution of the estates, which it seems to struggle to fulfil.

In its concluding statement in December 2014 following the Article IV Consultation IMF points out that the path chosen in lifting the controls “will shape Iceland for years to come. The strategy for lifting the controls should: (i) emphasize stability; (ii) remain comprehensive and conditions-based; (iii) be based on credible analysis; and (iv) give emphasis to a cooperative approach, combined with incentives to participate, to help mitigate risks.” The “cooperative approach” refers to some sort of negotiations with creditors, which the government has so far completely ruled out.

It is important to keep in mind that the estates of the banks, by now the major obstacle in lifting the controls, are estates of failed private companies. The banks were not nationalised and the state has no formal control over the estates. However, as long as the ISK problems of the estates are unsolved the winding-up procedure cannot be finished and consequently there can be no payouts to creditors.

The winding-up procedure will either end with bankruptcy proceedings, which majority of creditors are against, or with composition agreement, which the majority seems to favour. Crucially, the minister of finance has to agree to exemptions needed for composition, which means that the government is indirectly if not directly responsible for the fate of the estates.

The political tension regarding the controls is between those who claim that solving problems necessary to lift the controls is the main objective and those who claim that no, this is not enough: the state needs and should get a cut of the estates.

Finance minister Bjarni Benediktsson has strongly indicated that his objective is to lift the controls whereas prime minister Sigmundur Davíð Gunnlaugsson has allegedly been of the latter view. He has recently been supporting his views by stressing the great harm the banks caused Iceland reasoning that pay-back from the banks would be only fair. This simplified saga of the banking collapse is in conflict with the 2010 report of the Special Investigative Committee, SIC, which spelled out the cause of the collapse as regulatory failure, failure of the CBI and political failure in addition to how the banks were funded and managed.

The government has Icelandic and foreign advisers working on these issues. But as long as the government does not make up its mind on what direction to take nothing moves. Meanwhile Iceland is effectively cut from markets, which makes the financing cost high, in addition to other detrimental effects of the capital controls.

The Cypriot crunch: bank run

The run up to the Cypriot banking collapse in March 2013 was a sorry saga of mismanaged banks, mismanaged country and the stubborn denial of the situation ever since Cyprus lost market access in May 2011. But contrary to Iceland, there has been no investigative report into the collapse, which means that in Cyprus hardly any lessons can be drawn yet from the calamities.

Data from the European Central Bank, ECB, shows that deposits were seeping out: in June 2012 they stood at €81.2bn. In January 2013 they were €72.1bn, down by 2%, in February at €70bn, 2.1% month on month and in March €64.3bn. According to the Anastasiades report (written at the behest of president Anastasiades, leaked to NYTimes and published in November 2014) €3.3bn were taken out of Cypriot banks March 8–15, the week up to the bail-in.

This was an altogether different situation from circumstances in Iceland ensuing from the collapsing banks. Cyprus, part of the Eurozone, was not struggling to convert euros to other currency but it was struggling to convince those holding funds in the Cypriot banks not to withdraw them and move them abroad.

As Iceland, Cyprus was trying to maintain a banking system far larger than the domestic economy could possibly support under adverse circumstances. By the end of 2011 there were 41 banks in Cyprus: only six were Cypriot; 16 were from EU countries and tellingly 19 were non-EU banks. It was clear to regulators that the size was a risk but they maintained that both regulation and supervision was conservative enough to counteract the risk, as bravely stated in a report by the Ministry of Finance on the financial sector in Cyprus. – Ironically, Cyprus had to seek help from the troika just a few months after these assertive words were written.

The controls were put in place with the full acceptance of the troika, i.e. the IMF, the EU Commission and the ECB. “The Enforcement of Restrictive Measures on Transactions in case of Emergency Law of 2013” as the capital controls measures were called by the Cyprus Central Bank, CBC, restricted i.a. daily cash withdrawal to €300 daily, no matter if directly or with a card, or its equivalent in foreign currency, per person in each credit institution. Cheques could not be cashed.

Trade transactions were restricted to €5,000 per day; payments above this sum, up to €200,000 were subject to the approval of a Committee established within the CBC to deal with issues related to the controls. For payments above €200,000 the Committee would take into account the liquidity buffer situation of the credit institution. Salaries could be paid out based on supporting documents. Those travelling abroad could only take the equivalent of €1,000 with them.

The roadmap for abolishing them came in August 2013, again with the full blessing of the troika. There was no time frame, only that the measures would be “in place for as long as it is strictly necessary.” They would be removed gradually and with prudence, always with a view on financial stability. First the restrictive measures on transaction within Cyprus would be abolished and only subsequently could the restrictions on cross-border transactions be lifted.

The controls have since gradually been eased and by May 2014 all domestic restrictions were indeed fully eliminated. On 5 December 2014 i.a. the limit for travel abroad was sat at €6,000, from previous €3,000 and business activity not subject to approval was sat at €2m. With the last change, on 13 February, those travelling abroad can now take €10,000 with them. Transfers of funds abroad were increased from the December limit of €10,000 to €50,000. The island’s pension funds are still subject to capital controls.

As in Iceland, abolishing, for unspecified time, one of the EEA’s freedoms was to be in place only for a short time. Until late 2014 it seemed as if the Cypriot capital controls might be entirely abolished by the end of that year. That did not happen. The last bit remaining is the politically tough one.

The task for Cyprus: overcoming the political hurdles

With the domestic restrictions abolished the IMF Staff report in October 2014 for the Article IV Consultation pointed out that the “external-payment restrictions” in Cyprus have to be relaxed in a gradual and transparent way. “…owing to the short deposit-maturity structure, significant foreign deposits (close to 40 percent of the total), large reliance of BoC (Bank of Cyprus) on ELA (Emergency Liquidity Assistance), and the lack of other market funding, external restrictions remain in place. While restrictions do not apply to fresh foreign inflows into Cyprus, they limit outflows, hampering trade credit and affecting overall confidence.” If the external restrictions remain in place they can damage investors’ confidence and consequently foreign direct investment, FDI.

As in Iceland, the main Cypriot problems stem from political tensions, which “could have adverse implications for confidence and the recovery,” according to the IMF. The key obstacle in Cyprus is lack of progress in addressing non-performing loans, NPL, staggeringly high in Cyprus at 37.9% of total gross loans in 2014. Debt-restructuring framework, including i.a. a foreclosure legislation and insolvency regime is still a lingering political problem. Further, banks need to restructure and build capital buffers, critical to lift the remaining restrictions.

Visiting Cyprus in early December I was told that the work on the NPLs was about to be finished and a new insolvency framework would be in place by the end of the year. It is still not in place, a sign that the politial tensions have not eased. In spite of all that has been done Cypriots have lost trust in their banking system: almost two years after the collapse it is estimated that the islanders keep up to 6% of GDP at home, under their proverbial mattresses or wherever people stash cash.

The political test for Cyprus and Iceland

Both islands face a political challenge lifting capital controls.

In 2012 the CBI published a report on Prudential Rules Following Capital Controls, thus outlining what is needed once the capital controls have been lifted. This is greatly facilitated by the fact outstanding work of the SIC. Consequently, life and prudence after the controls are lifted has been staked out.

Iceland is however struggling to throw off shackles of nepotism, even more so under the present government than for quite a while: personal connections seem to matter more not less than before. Lifting the controls will test the times, if they are new times with accountability, transparency and fairness or the old times of nepotism, opacity and special favours.

Cyprus stands harrowingly high on the Eurobarometer corruption index and it suffers from lack of stringent analysis of what happened, making it difficult to draw any lessons, i.e. on how regulation needs to be improved, failures at the CBC etc. Cyprus authorities have some way to go in order to win trust with the islanders. The fact that no public inquiry has been held into the collapse, no investigation, no report written adds fuel to the already low trust. I have earlier written that Cyprus with high unemployment and contracting economy bitterly needs hope.

Both Cyprus and Iceland will have to show that they understand what happened and how it can be prevented from happening again. The exit from capital controls for both these islands will depend on political decisions, which will shape their next decades.

*I have blogged extensively on Icelog on the capital controls in Iceland. Here is the latest one, on the politics. Here is one from end of last year, on i.a. the various possible solutions. I have at times blogged on Icelog on Cyprus or compared Iceland and Cyprus. Here is a collection of blogs on Cyprus, i.a. two on the topic of Cyprus, Iceland and capital controls. – This blog is cross posted on Icelog.

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