Central Bank translation service

Thanks to Mike the UK Nordic Analyst (whatever one of those is) over at IceNews for providing this translation of the main points from the speech of Central Bank Governor Svein Harald Øygard last Friday. It made me laugh out load, so I thought I'd share it with my readership (hi Mum!)

He said
“All efforts should be made to avoid further socialisation of private sector debt”

Which means
“If you think that the Central Bank and Government are going to help you Icelanders pay back, reschedule or even write off, your mortgages, indexed car loans or corporate debts … well you can forget it! We’ve got enough on our plate already with depositor guarantee schemes and ISK bonds due.”

He said
“The negotiation processes in the financial sector and the restructuring and recapitalisation of the banks must therefore be pursued according to plan.”

Which means
“Plan!! Plan? We’re just blundering along being told what to do. As for restructuring the banks it looks as if they will need to come to terms with their creditors. Who cares about the division between “new” and “old” banks? Our foreign bondholders certainly don’t. Let’s hope for the best!”

He said
“As part of this, the foreign exchange exposure and indexed loan exposure of the new banks must be addressed.”

Which means
“I have no idea how the banks are going to pay back their debts, especially those that need to be paid back in foreign currencies! But hell, it’s not my problem – it’s the banks!”

He said
“With declining domestic demand, there will be resources available to service the country’s accumulated debt.”

Which means
“All income from our productive output will be used to pay our foreigner creditors. So frankly we’re not going to have anything to spend on ourselves. Domestic demand? Don’t make me laugh! Bread and water if you’re lucky!”

He said
“The Central Bank also reviews selected measures that may allow the most impatient investors locked in by the capital controls to convert their holdings of ISK, in a way that does maintain the currency reserves of the Bank.”

Which means
“Impatient investors? Why are they impatient? Because their bonds have matured and they want their money back – NOW! If we did pay them it would wipe out our currency reserves. Does anyone have any ideas?”

He said
“Negotiations for bilateral loans, other negotiation processes, and the IMF review should be completed shortly.”

Which means
”The IMF et al are holding back the latest tranche. We need money. We’re descending into poverty. HELP!”

How much is a króna worth?

A couple of days ago, I commented on Sjálfstæðisflokkurinn's crackpot idea to unilaterally adopt the euro as Iceland's currency. Nobody has pointed out the flaw in my argument, so I will come clean and admit it myself! Iceland can't adopt the euro on its own, at least not yet and not at the current exchange rate.

Today's Central Bank of Iceland selling rate is 168.09 krónur per euro, down 12% since 1 February. On the other hand, if you look at Yahoo! Finance, they quote a rate of 290.66 krónur per euro… The European Central Bank hasn't quoted a ISK exchange rate since 3 December, when it was 290 krónur to the euro. How much is a króna really worth?

Entire textbooks have been written about exchange rate theory: fortunately, we only need to consider a very simple definition here. You'll just have to trust me that we would reach the same results through more complicated theory, but we can just consider that a currency is worth what people are willing to pay for it. This leads to two important conclusions, neither of which you are likely to hear from the mouths of Icelandic politicians.

Firstly, in reality, the króna is worth less than 168 to the euro. It must be, because 168 to the euro is the rate it "trades" at within Iceland, where there are strict controls on selling krónur. If the currency controls didn't exist, more people would want to sell krónur – that's only logical, otherwise there'd be no need for the controls! If more people are selling krónur, it's exchange rate will go down. Hence the CBI exchange rate is artificially high.

Secondly, the króna must be worth more than 290 to the euro. To see why, we need to look at where this exchange rate comes from. Imagine you are a foreign investor who bought a million krónur's worth of Icelandic government bonds when times were good (you would have paid about €11,000 for them). As things stand at the moment, you can't get any of your money out of Iceland. because of the currency controls. You have two choices: either you can be patient and wait for the currency controls to be lifted, or you can sell the bonds onto someone who's more patient than you are. If you sell the bonds, you have to agree a price for them, which is equivalent to setting an exchange rate for the Icelandic króna. The 290 krónur to the euro rate means that people outside of Iceland are selling a million krónur's of glacier bonds for about €3500 (once you've factored out interest payments, etc). Now the people who are buying these glacier bonds don't know when they're going to be able to get their money out of Iceland, so they apply a risk premium: they want to make a profit from their patience, so they buy krónur at an artificially low exchange rate.

In other words, we don't know how much a króna is worth and we won't know until the glacier bond problem is sorted out. We can say that the króna is not worthless. Jokes like "What's the capital of Iceland?"—"About twenty euros and a couple of dried cod." are exactly that: just jokes. The offshore exchange rate, as quoted by the ECB, reached a high of 200 krónur to the euro last November: that's about as good a guess as you're going to get for the real exchange rate, but it's only a guess.

Last week, Finance Minister Steingrímur J. Sigfússon predicted that "it is possible that there will be news about the arrangements of the glacier bonds at the annual meeting of the Central Bank of Iceland" last Friday. I've heard more reassuring politicians… Governor Svein Harald Øygard did indeed speak of the problem: apparently "the Central Bank also reviews selected measures that may allow the most impatient investors locked in by the capital controls to convert their holdings of ISK, in a way that does maintain the currency reserves of the Bank."

Hints of these "selected measures" came out over the weekend. Apparently Norðurál is looking at financing the new aluminium smelter at Helguvík with "glacier bonds". In effect, they propose to exchange ISK-denominated securities for Norðurál bonds denominated in US dollars. An interesting proposal, but the devil is in the details. What will be the exchange rate proposed to holders of glacier bonds? Will it even be made public? Or will this just be another deal between friends of the type which has made Icelandic business infamous over the last few months? In any case, the Helguvík smelter will cost 80–90 billion krónur, less than a fifth of the total value of the glacier bonds: at best, the Norðurál solution will only be a partial one.

A better bet would be to set up currency auctions to allow holders of glacier bonds to liquidate their króna capital. If, at the moment, the Central Bank of Iceland can only afford to pay back, say, €500 million euros to glacier bond holders, it should organise an auction. Investors could offer their bonds to the Central Bank at a given exchange rate and, once the pot of euros is used up, the CBI stops buying. The sellers (ie, bond holders) determine the exchange rate at which they wish to bid, and those who bid the most krónur for each euro get their bonds bought off them. Auctions could be organised every few months until the problem is resolved. That way, the Central Bank gets the benefit of the current offshore speculation on the króna and overseas investors get to put a cash price on their impatience. Don't expect this idea to become reality though – it would require too many people to face up to difficult realities as to the true value of Iceland's currency.

The £200 million question

Like a mosquito on a summer's night, one question keeps buzzing back into the collective consciousness just as we try to think of something else. Did the UK authorities offer to take Landsbanki under British jurisdiction in return for the Central Bank of Iceland granting one last liquidity loan (of GBP 200 million, all the same, hardly small change even in the City of London)? If so, the refusal of the CBI would weigh heavily on its responsibility for the meltdown of Iceland's banking system. Or is this just a delusion (for not to say an outright lie) of Björgólfur Thor Björgólfsson, one of the former owners of Landsbanki? After all, as I pointed out on Wikipedia back in October, the whole thing sounds more like "I know a few guys in London who'll solve all our problems, but they need 200 million GBP to do it…" rather than a serious business proposition worthy of backing with large quantities of public money. Both the British and Icelandic authorities have denied the existence of any agreement, although neither set of clowns enjoys much confidence in either country these days.

One thing everyone admits is that there were talks between British and Icelandic officials in Reykjavík over the weekend of 4–5 October 2008 concerning the position of Icelandic banks operating in the UK. These talks led to a formal letter from the Icelandic government to its British counterpart on Sunday 5 October, explaining Iceland's position regarding deposit insurance. Apart from formalities, the letter reads:

If needed the Icelandic Government will support the Depositors' and Investors' Guarantee Fund in raising the necessary funds, so that the Fund would be able to meet the minimum compensation limits in the event of a failure of Landsbanki and its UK branch.

There's no mention here of the UK Financial Services Compensation Scheme taking over responsibility for Icesave deposits: indeed the letter assumes that Iceland's Tryggingarsjóður would retain responsibility for insuring the first tranche of deposits (the first €20,887 of each account, in practice more than half the total amount insured).

On the other hand, both governments were aware of the need for liquidity in Landsbanki's London branch, responsible for the Icesave accounts. It is mentioned in the now-famous telephone conversation between British Chancellor of the Exchequer Alistair Darling and Icelandic Minister of Finance Árni M. Mathiessen on Tuesday 7 October, after Landsbanki had been intervened in Iceland but before its UK assets were frozen:

AD: What I… I take it therefore that the promise Landsbanki gave to us that it was going to get £200 million of liquidity back into it has gone as well.

ÁMM: Yes, they didn’t get that liquidity.

This exchange is from near the end of the conversation, but it is notable that AD refers to "the promise Landsbanki gave to us", not to any agreement between the two governments (despite the talks of the previous weekend). The promise to which AD presumably refers was leaked to the Icelandic press last month, just after Björgólfur Thor had repeated his claims on the influential Kastljós television programme (see Alda's blog about the emission). It takes the form of an email from Landsbanki to the UK Financial Services Authority, sent in the early hours of the morning of Monday 6 October, and reads:

I have been informed by my CEOs that a transfer of the amount of GBP 200 million in favour of Landsbanki London branch is required tomorrow morning to meet potential further Icesave outflows and the amount of GBP 53 million in favour of Heritable bank by end of tomorrow. We have been working on arrangements, including a repo transaction with the Central Bank and have submitted to them our pool of assets for those purposes. We understand that the Central Bank will deal with this tomorrow. As soon as the repo transaction has been completed we will transfer the required funds as discussed. I trust this meets the requirements discussed earlier tonight with you and Mr. Hector Sants.

Before I enter into the textual analysis of the email, let's take another look at the sums involved. Two hundred million pounds is a lot of money in anyone's terms – Icelanders might like to think of it as 40 billion krónur (at the exchange rates of the time), while Brits should consider it as £600 from each and every Icelander. Yet it is small change compared to the (then potential) liabilities of Landsbanki failing. Landsbanki had £6.26 billion in sterling deposits from customers at the end of June 2008, according to its interim financial statement, of which most was presumably from the United Kingdom. Not all of those deposits were covered by EEA deposit insurance schemes: initial estimates spoke of £4 billion in insured deposits in the UK, although more recent estimates I've seen put the figure slightly lower.

Björgólfur Thor is alleging that the UK authorities were willing to take on the deposit insurance liabilities of Landsbanki's London branch for a "price" of 5% of the total risk. That's a lot more than the 1% that Tryggingarsjóður (the Icelandic deposit insurance scheme) requires, but it would be a remarkably generous offer for a bank in the middle of a run on its deposits and which could not obtain the necessary liquidity from the private markets or its own central bank. A bank, in short, which was already in the middle of failing (or are we supposed to believe that high-level weekend meetings between British and Icelandic officials are normal, run-of-the-mill events?)

The email leaked to the Icelandic media (in this case, visir.is) makes no mention of Landsbanki's London branch becoming a full member of the UK Financial Services Compensation Scheme. In fact, it was quite specific: the £200 million was "to meet potential further Icesave outflows". That the London branch needed liquidity is not really in question: even once the Icesave liabilities had been set aside, it still needed a loan of £100 million from the Bank of England (formally guaranteed by HM Treasury) to restart its UK operations.

The leaked email gives us another clue to the nature of the discussions in referring to a separate £53 million needed by Heritable Bank. Had Landsbanki wanted to place its UK Icesave liabilities under British jurisdiction, it could have transferred them (with sufficient assets to cover them) to its wholly owned Scottish subsidiary, Heritable Bank. Such a move would have required the approval of the UK authorities, but would have been much simpler than setting up a new subsidiary. However, and unlike Kaupthing, Landsbanki chose to keep its UK retail deposits within a structure governed by Icelandic law. Why we can only imagine, but the decision has turned out very expensive for Icelandic taxpayers. I could mention the relative rates of capital gains tax – 18% in the UK, 10% in Iceland – but I doubt this is the whole reason.

To conclude, Björgólfur Thor's allegations have to be dismissed on the evidence available, without wanting to suggest that he doesn't believe them himself. History is full of deluded people who think they can dig themselves out of financial holes with one last try at the same game, from King Midas onwards.

Nevertheless, had Landsbanki wanted its Icesave deposits guaranteed by the UK compensation scheme, there were many ways they could have done it, and much earlier than the weekend that those very deposits were dragging the whole bank under. But Landsbanki wanted to stay with the Tryggingarsjóður, and hit out strongly this time last year at suggestions that other EEA schemes might not be as rapid at repaying depositors than the UK FSCS: this was a "falsehood", and the mere suggestion was a violation of EEA law, in Landsbanki's eyes. With the benefit of hindsight, the Icelandic scheme proved not only slow but incapable of paying out, and the attitude of Landsbanki has proved remarkably damaging to Iceland.

***UPDATE (Wednesday 22 April)***
I should have credited freelance journalist Friðrik Þór Guðmundsson (blog in Icelandic here), who went to the trouble of demanding detailed responses from the UK authorities (HM Treasury and the Financial Services Authority) under the UK Freedom of Information Act 2000. He has been kind enough to forward one of the responses to me, which basically confirms that the UK FSA regarded the £200 million as a regulatory issue (the FSA is not obliged to go any further under the FoIA). In other words, this money was connected with Landsbanki's current status in the UK, not with any possible change of status.