Transcript of a Conference Call on the Completion of the First Review of Iceland’s Stand-By Arrangement with Mark Flanagan, Mission Chief for Iceland, and Franek Rozwadowski, Resident Representative in Iceland
November 2, 2009with Mark Flanagan, Mission Chief for Iceland, and Franek Rozwadowski, Resident Representative in Iceland
Washington, D.C., Thursday, October 29, 2009
MS. GAVIRIA: Hello, everyone. Good morning to those here and good afternoon to those in Iceland. I am Angela Gaviria with the External Relations Department of the IMF. Welcome to this conference call on the completion of the first review of Iceland's Stand-by Arrangement. Mark Flanagan, Mission Chief for Iceland, will have some brief opening remarks to make, and then will be happy to take your questions.
MR. FLANAGAN: Thank you very much, Angela. Good morning and good afternoon to everybody on the line.
As everybody knows, yesterday the IMF's Executive Board approved the first review under Iceland's Stand-By Arrangement. This review was delayed for some time, about six months or so, and there were a couple of reasons for that. There were policy implementation delays. As everyone knows, Iceland went through a period of political turmoil after the financial crisis that culminated in elections in late April. After those elections we managed to get down to the business of the policy requirements for the first review, namely, work toward fiscal consolidation and financial-sector restructuring. Most of that work was completed by early August. However, at that point we didn't yet have financing assurances.
As everybody is aware, the dispute between Iceland, Britain and the Netherlands concerning Icesave complicated efforts by Iceland to secure additional external financing for the program from other participating countries. Once that was resolved and we had adequate financing assurances, we could move ahead. I want to add that these financing assurances are an important issue. Without the external financing in place for the program, we don't necessarily have consistent policies and targets in place. We do need the full package in place before we can move forward.
Let me make a couple of other remarks before we go into the questions.
One is about external debt, which was obviously a lot higher than people expected, and a lot higher that initially understood at the outset of the program. This has become apparent over the course of the review, as we and the central bank have worked very hard to get a better handle on this issue. There are a couple of important reasons for this. One is that, of course, in the immediate wake of the financial crisis, neither we nor the authorities had the full balance sheet of the banking system, nor the breakdown of this into the liabilities of residents and non-residents, and that had to be clarified over time. The other important reason for this is that there were some extremely complex cross-border corporate transactions in the two years leading up to the crisis that weren't properly reported by those undertaking them, and that have now been captured in the data.
But I want to emphasize that while we do see higher debt right now, we also firmly believe that this debt is sustainable. In particular, we have looked at it, we've tested it against a variety of macroeconomic shocks and we believe that it will remain on a robust and sustainable downward path. I also want to point out that for this large level of debt, a big chunk of it is confined to a very narrow corner of the corporate sector. That gives us some assurance that it is a self-contained problem for the corporate sector.
Looking forward, we expect to initiate our discussions for the second review later this year, probably in December. We'll be looking into a number of issues at this point in time, in particular: the implementation of the restructuring framework for private household and corporate debt, articulation of a medium-term public debt management plan, finalization of the budget in line with the medium-term consolidation plan that has been agreed to with social partners, and the first steps toward capital account liberalization.
With that I've concluded my introductory remarks, so let's open the floor for questions.
QUESTIONER: My question is this. Yesterday Icelandic ministers said that the IMF loan would be used to pay off other foreign loans of the state. I wanted to ask if it is allowed or even wise to use an IMF loan to refinance other foreign debt? Has this been done by other recipients of IMF loans?
MR. FLANAGAN: That's a good question. When we provide financing we provide the financing to the central bank and it immediately enters into central bank reserves. The central bank's reserves are fungible. Having more reserves provides the government with a lot of opportunities that it would not otherwise have. It has the opportunity to refinance debt falling due. That can certainly be done. And it has the opportunity to keep it in reserves and try to build greater confidence in the currency. So the short answer to your question is, yes, it can do that and in some circumstances it's probably desirable to do that.
QUESTIONER: I would like to ask about the payment from this tranche. When will it be paid out and is it still depending on the Icesave deal to be formally finalized in the parliament of Iceland?
MR. FLANAGAN: No, there is no remaining condition for the disbursement. The Icelandic authorities have requested it and we expect it to happen this Friday and possibly on Monday. I'm not quite sure: there are some technical issues, but it will be one of those days.
QUESTIONER: But why isn't the Icesave condition still in place as had been said earlier in this process?
MR. FLANAGAN: Let me clarify. The Fund has never had a formal condition on Icesave completion. Never. It has never been part of our formal conditions for the program, and that's a matter of record. How Icesave affected the timing of the review was indirect and related to the broader financing for the program. Because other creditors of Iceland made it a condition, we had to wait until they were satisfied, essentially that their conditions were being satisfied, and at that point, for the program as a whole, we had sufficient financing assurances. It was not directly related to Icesave, it was indirectly related. At this point all are happy that there has been sufficient progress on the Icesave issue so that we have these financing assurances.
QUESTIONER: So that means that the other creditors now are happy with the situation in the Icesave issue?
MR. FLANAGAN: That's right.
QUESTIONER: I was wondering if you could maybe expand on what you meant yesterday about Iceland possibly turning the corner next year, the middle of 2010. Where do you see the growth coming from? Is that you expect more confidence in the system? The other question I have is also on the creditors. You talk about the creditors needed to be dealt with fairly and equitably. Are there suggestions that you've made on this? How do you see that proceeding to ensure that this is not another Argentina?
MR. FLANAGAN: Two good questions. Let me answer the first one first. Where will growth come from in 2010? We do expect quarter-on-quarter growth to reappear toward the middle of 2010, maybe the second quarter, maybe the third quarter. Growth for 2010 as a whole may be negative because of base effects, but the economy will have effectively turned around by the middle of the year.
Where is this growth going to come from? Several sources. One is through the external sector. At the moment Iceland has experienced a very substantial real currency depreciation, some 40 percent since the beginning of the crisis, and the krona is well below levels at which the export sector is very competitive. We understand that times are good in the export sector right now in Iceland, so that's certainly one source of growth. A second source of growth is the private sector. As I have mentioned in the past, we have managed to undertake the bank restructuring in a way that sees write-downs up front on their books of loans, and we and the government are trying to translate that into fairly rapid restructuring of debts for viable borrowers. We think this will help support private-sector balance sheets and the private sector’s ability to consume and invest. Thirdly, we do expect some foreign direct investment next year. Talks are underway concerning beginning work on a new aluminum smelter. As you know, one of Iceland's biggest comparative advantages is energy-intensive industries. We talk to these investors and we expect work to begin next year.
On the fair and equitable treatment of creditors, first of all, let me clarify this: the program has always been clear that treatment of creditors had to be fair and equitable in line with applicable law, and that the government had to avoid further socializing losses from the private sector. The latter is for obvious reasons, as the debt is very high in Iceland. These are two equally important imperatives guiding the work on banking sector restructuring. What does fair and equitable treatment in line with applicable law mean? Iceland faces certain treaties with the European Union that governs how it can handle the situation. It also has elements of domestic law, for instance bankruptcy law, that apply in this case, and these help determine, for instance, the order of creditors in recovery during the liquidation of banks. This is what we're looking for, that the law be adhered to as the process of windup goes forward.
QUESTIONER: On rescheduling the disbursements, can you give us an idea of how you see those disbursements now being rephased?
MR. FLANAGAN: Basically, if you look at the original program, the disbursements are at all the same dates, except that we've added two at the end. We've added one in early 2011 and one in May 2011, and that's essentially what's happened. They're all the same size, about US$167 million at current exchange rates.
QUESTIONER: In the agreement with the Icelandic government that was signed on November 2008 you said that the external debt of 240 percent of GDP would clearly be unsustainable. The debt is much higher than you anticipated at first, but you consider it to be sustainable. I'm just going to ask a simple question. How is Iceland going to pay back these high debts, because sustainability means that we can pay the interest payments? What about the capital itself? Our business minister says we're going to use export revenues. So I would like to hear from you what is the plan of repaying back the capital itself of these high debts?
MR. FLANAGAN: These are good questions. First of all, yes, in the original program there were some comments that could have been interpreted as implying that 240 percent of GDP was unsustainable. Two things: any statements we made at the time of the original program applied to the policy framework that was being proposed in the original program. We and the government, after observing the increase in external debt, made some changes to the policy framework to make sure that robust sustainability would be maintained. On top of that we found some additional debt, but as I said at the outset, this is confined to a very specific corner of the corporate sector and we happen to think that it's pretty self-contained in that corner, that it's really a problem for the company or companies involved, and that it won't translate into a problem for Iceland as a whole.
How will Iceland pay down this debt? First of all, I want to make note of the fact that many large advanced globally integrated economies have external debt ratios that are well above 100 percent of GDP. Iceland is not alone up there. Many are over 200 percent. So it sounds like a high number, but in an international perspective it actually is not too far off what is pretty normal.
That said, we do think repayment is going to come in part through discrete adjustments. How? To give you one example, asset recovery in the failed old banks will help. That is, as we have asset recovery going forward, a lot of that will be used to pay the Icesave external debt obligation. In fact, right now we think most of the Icesave obligation will be covered by asset recovery and that amounts to some 40 to 50 percent of GDP.
We also recognize that Icelandic corporations have a lot of external assets, and we expect some restructuring of their balance sheets going forward, probably voluntary restructurings in most cases, where they elect to reduce external assets in favor of having less external debt as well. Thus in general the level of assets provide some assurance. I hope that helps answer your questions. They're good questions.
QUESTIONER: I heard you say that we are not alone up there with this high external debt, but we are in kind of a special situation. We have our small currency, which is one of the smallest currencies in the world. It's not easy, especially under the current circumstances, to trade our currency without it depreciating more. I'm asking: how are we going to get the foreign currency to pay back these loans? We need export revenues to gain the foreign currency to pay it back because I would think that if we trade our kronas for the foreign currency, there is going to be more pressure on the krona to maybe depreciate more, especially if we're going to remove capital controls and lower the central bank's interest rates.
QUESTIONER: You're right that the pressure of debt service does affect the balance of payments and that's one reason why the krona has dropped to around 180 to the euro at the moment. At that level, Iceland's external sector is going to do very well. There will be a lot of export revenues over time.
You're right that the pressure of the overhang of nonresident liabilities in Iceland represents an issue for the balance of payments and could lead to some currency volatility, but I would remind everybody that the principal objective of this program from the start has been to contain the volatility of the currency, to preserve stability. We've done that through appropriate monetary policy measures and we have carefully, in cooperation with the government, designed a capital control liberalization strategy that is meant to preserve the stability of the currency and avoid destabilizing movements. So we're reasonably assured that the bottom will not fall out of the currency and that Iceland will be able to earn the foreign currency revenues to repay its debt. Let me note on that last point that two years ago the current account deficit in Iceland was coming off a couple of years of over 20 percent of GDP deficits. That has completely unwound. On a cash basis at the moment, we're probably near balance, possibly in surplus. So there has been a big turnaround in the current account and that is what is going to provide the foreign exchange revenues going forward.
QUESTIONER: What's your view on Iceland possibly going into the European Union?
MR. FLANAGAN: Maybe I will offer that one to Franek to answer.
MR. ROZWADOWSKI: Yes. At present I would say that our view on Iceland going into the European Union is neutral in the sense that the decision whether to go in or not is a sovereign decision. As you know, it is a very controversial decision in the sense that the Icelandic people are very divided on this question. From our point of view, that's a decision for Iceland to make and we will be ready to adapt our discussion and our policy advice to whatever the choice of the Icelandic people is.
QUESTIONER: I would like to follow-up on my previous question. Did you name another country that has used its IMF loan to refinance other foreign debt?
MR. FLANAGAN: As I said, money is fungible. There is no earmarked account in the central bank with IMF funds. There are reserves. I can't point specifically to IMF funds in a central bank account. I can point to many countries that have essentially intervened when they have received extra IMF resources to support the currency in the face of debt service outflows. Even in our program projections going forward, many people have mentioned that Iceland is borrowing and that this is all going into reserves. It's not true. In fact, if you look at our program projections going forward, and we hope to release the staff report very soon, you'll see that Iceland's reserves are changing much less than the amount of loans being taken on and that is because we anticipate over time that the government will use some of these reserves to smooth temporary outflows of capital.
Funds are fungible, the money that we loan is fungible up to at least the targets for reserves in the program. Beyond that, it's the government's choice about how to use it to refinance or to add to reserves. We discuss this with them all the time and there are circumstances in which it's probably desirable for them to smooth volatility in the currency.
QUESTIONER: Both Iceland and Hungary are in stand-by arrangements with the IMF and both the Icelandic krona and the Hungarian forint went through a steep fall last year. If we compare the two we've seen the forint's value go steadily upward while interest rates there have been going steadily down from 11.5 to 7 percent. Here in Iceland we've had currency restrictions and a constant 12 percent interest rate, but the krona has not been gaining strength. Why the difference in approach with regard to interest rates? Are the currency restrictions here holding back the krona and preventing the central bank from lowering interest rates? Or can you explain this?
MR. FLANAGAN: First of all, obviously different countries have different circumstances. I'm not going to comment on Hungary. But I will say this much. The scale of the challenge in Iceland is very large. Iceland was caught with a lot of non-resident exposures in domestic debt markets and this has created a big overhang for the authorities to deal with. There are essentially two ways you can handle this if you're not going to allow a massive overshooting depreciation of the currency, and as I've said in my earlier answers, we don't consider a massive overshooting of the currency to be desirable. There are two ways you can handle this: You can apply very steep and sharp increases in interest rates, and I'm not talking about the 12 to 18 we did. I'm talking about probably 20 to 40 or 50. That's the sort of approach you would need if you just purely relied on interest rates to stabilize the currency. Or you can bring in capital controls and try to use those to stabilize the currency. What I'm getting at is that I think you've got it backwards. The capital controls have actually allowed Iceland to have much lower interest rates than would otherwise have been the case. I think it would be useful for you to go back and look at the experience of other crisis cases in the late 1990s where we saw huge spikes of interest rates where capital controls were not applied, as I mentioned, to 40 to 50 percent.
In sum what the capital controls have done is that, given the scale of the problem, they've given the government room to manage it without a very restrictive and aggressive interest rate policy. So I don't think that the capital controls are at all holding up interest rate reductions. I think they've actually allowed a much lower level of interest rates than otherwise would have been the case in Iceland.
QUESTIONER: If the Icesave case didn’t go through parliament, would the IMF do anything? Would it conflict with the review?
MR. FLANAGAN: The review is done. This review is done so there is no more relation to that.
QUESTIONER: And the next one?
MR. FLANAGAN: As I've said, Icesave has never been a formal condition in the IMF program and it is not a formal condition now either. What we require at every review is that the mix of policies, macroeconomic targets and external financing be consistent. Otherwise we can't bring a program to our Executive Board. If it doesn't add up, we just can't simply put in front of our Board. It would not be accepted. We'll have to assess at the time of the next review, given the policies and the macroeconomic targets, whether we also have adequate financing assurances. And that's a broader issue than just Icesave. Would non-passage of Icesave affect financing assurances? I don't know how things will play out. I'm not willing to speculate about that.
QUESTIONER: Does the IMF anticipate that the first review will not prevent Iceland's credit rating from being downgraded?
MR. FLANAGAN: We certainly hope that the first review will help with that. Of course, credit rating agencies make their own decisions. What I can say is that we think the package of policies and financing in place is going to put a floor under Iceland's crisis and allow a recovery sooner than otherwise would be the case. We would like to think that rating agencies will recognize that as well, but they make their own decisions in these areas.
QUESTIONER: I would like to ask you both about the debt burden of households in Iceland. Are you worried that there are going to be a lot of bankruptcies, that households are going to go bankrupt more and more during this wintertime? People are worried and this is what concerns them the most, the extremely high debt burden of households here.
MR. FLANAGAN: Yes, we and the government both have our eye on this problem. We are aware that there is a heavy debt burden and we're aware of the form of the debt burden, namely the exposures to inflation and foreign currency. I think that's one reason why the government has put in place a framework for restructuring household debts, which as you know was passed last Friday. I mentioned at the outset in my introductory remarks that during the second review one of the focuses will be on implementation of the framework for corporate and household debt restructuring. We do think that this is important. We do not want to see a string of bankruptcies in households. But let me add too that it's not just households. Households are employed by corporations, so we also have our eye on corporate debt restructuring. We don't want layoffs or unemployment to increase any further beyond what we expect at the moment. So we also have our eye on corporate debt restructuring with the aim to indirectly insulate the household sector as well through this channel.
QUESTIONER: According the central bank's plan, capital control liberalization should start on November 1. Are you optimistic this can take place so soon, and to what extent can capital controls be liberalized?
MR. FLANAGAN: I think the conditions are in place to begin a cautious liberalization of controls. The first step has always been identified as liberalizing capital inflows and that, if anything, will have a positive impact on Iceland's balance of payments. The issue has always been if Iceland's financial sector would be ready to absorb the additional volatility that would be implied through liberalization. That issue along with the balance-of-payment constraints is why the strategy is cautious in the first place. But we do think that financial-sector progress is at a stage right now, given the recapitalization that's occurring, given the work that's been done to operationally restructure, given the enhanced oversight of the system, that it can handle this cautious first step of liberalizing inflows.
MS. GAVIRIA: Thank you all for participating.