Tuesday, June 28, 2011

Iceland Shows Default Doesn’t Lead to a Deep Freeze

By Daniel Gross

, On Tuesday June 28, 2011, 2:02 pm EDT

The specter of sovereign default is haunting Greece and much of Europe. Defaulting on financial obligations is one of the worst things a sovereign nation can do. Stiffing domestic and foreign creditors makes you a persona non grata in the international credit markets, threatens the flow of vital capital, and condemns a country to a future of high interest rates and beggary. After all, who in his right mind would lend to an entity that has displayed a willful inability to do the basic blocking and tackling of financial management?

Argentina in 2001 defaulted on its sovereign debt and in 2005 restructured its bonds. "Nongovernment foreign investors — the biggest included pension funds from Italy, Japan and the United States — took haircuts costing them two-thirds of their investments," as The New York Times reports. While the Argentine economy has recovered and grown, as Paul Krugman notes, it is still shut out of international bond markets and pays high interest rates to borrow.

A formal default by a European country such as Greece, Ireland or Portugal wouldn't just threaten bondholders — it would threaten the French, German and Belgian banks that own so much of those countries' sovereign debt. Because the Euro binds together the currency and banking systems of many countries, the establishment — the European Union, the European Central Bank and the International Monetary Fund — has gone to great lengths to forestall default. Governments have been pressed into passing austerity plans, hacking budgets and raising taxes. The ECB is guaranteeing oodles of dodgy debt and providing limitless liquidity and bailout funds — all so that Greece, Ireland and Portugal can remain current on the financial obligations they've assumed on behalf of their citizens (Greece and Portugal) and their banks (Ireland). And to what end? Wary of the potential for an Argentina-style haircut, investors are demanding high interest rates from the bailed-out European countries. Interest rates on Ireland and Portugal's three-year notes top 14 percent, while rates on Greece's three-year notes are an astonishing 27 percent.

But here's the thing: While default would be a disaster for Europe, it wouldn't necessarily be a lengthy tragedy for Greece or Ireland. Rather than being sentenced to a long stay in a debtors' prison, as Argentina was, they might find that they'll simply be put into the penalty box for awhile. Consider the case of their neighbor to the north who recently defaulted in spectacular fashion: Iceland.

Last decade, Iceland's deregulated banks stormed out of the North Atlantic like Vikings, amassing huge deposits and liabilities all over the world — some $85 billion in total. When Iceland's banking industry capsized in the fall of 2008, the government nationalized the banks. It then faced the question of whether its 320,000 citizens should make the banks' global bondholders and depositors whole. The answer was something of a no-brainer. Iceland's banks had assets that amounted to ten times the country's Gross Domestic Product. And so while the country received an IMF-led bailout, it let the bondholders suffer losses. "Bondholders should not rely on the government stepping in and bailing them out," Iceland Central Bank Governor Mar Gudmundsson said last December. "They should do their due diligence." The Icelandic banks had also taken lots of deposits from savers in the U.K. and the Netherlands, who were lured by competitive interest rates. These savers were bailed out by their own governments. But in 2010, the question as to whether Icelanders should reimburse some $5.3 billion to the governments of the U.K. and Netherlands was put to a referendum. And the answer was a resounding "no." In April 2011, even as Iceland was put on notice that failing to step up would inhibit its ability to borrow on international markets, the referendum failed again. As Bloomberg noted: "This will force the government to postpone its plans to enter the international bond markets."

And yet just two months later, Iceland was back in the international borrowing markets for the first time in five years. In early June, Reuters reported, the government sold $1 billion in five-year bonds that yielded just under five percent. "According to the Finance Ministry, the order book was two times oversubscribed, with the majority of the bonds purchased by U.S. and European investors." Given the world's low interest rate environment, that's not so hot. (The U.S. pays just 1.47 percent to borrow for five years.) But Iceland is paying about one-third the interest rate that other crisis-ridden European countries are paying.

That makes sense. It's actually a much better move to lend to people after they've declared bankruptcy and been able to shuck their debts, not while they are trying to stave off collapse. In 2006, I interviewed a subprime mortgage marketing pro who told me that data on personal bankruptcy exits were a great source of leads. After all, these folks were guaranteed to have the irresistible (to him) combination of poor credit ratings and not much in the way of debt. Companies emerging from Chapter 11 can likewise easily find plentiful, cheap capital — they've already stiffed their creditors, sold assets, fired workers and slimmed down to a manageable profile. Iceland had gone through that process.The economy, which shrank sharply in 2009, is growing again — in part because its devalued currency is making exports cheap. Growth, combined with the refusal to assume its bank debts, means Iceland can handle new debt with relative ease.

With this month's bond sale, Iceland has formally been welcomed back into the international financial community — even as it continues to stiff-arm creditors. And there's more to come. Europeans, some of whom are still feuding with the island nation over the deposits issue, are preparing to welcome Iceland into the fold. Yesterday, the Associated Press reported that Iceland "is beginning formal accession talks with the European Union, following several months of preparation by both sides." (Maybe the EU is recruiting Iceland for its bankruptcy expertise?)

So while bond investors are still crying for their losses in Argentina, they're hot for Iceland. And if this is the punishment you get for default — 5 percent interest rate on five-year debt and an invitation to become a member of a formerly prestigious club — maybe default isn't such a bad option for countries struggling to come to grips with a legacy of financial recklessness.

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