VoxEU Column Financial Markets

Icesave: The big ultimatum

Many expect Iceland’s March referendum on Icesave to produce a “no” vote. Despite the dire consequences, this column argues that Icelanders, faced with the hard end of the “ultimatum game”, are likely to reject the standing offer which they regard as unfair. This column proposes lowering the interest rate on the loans as a compromise that could solve the problem and avoid a referendum.

On 5 January 2010, Iceland‘s president refused to sign a law passed a few days earlier by the Icelandic Parliament. This law would have allowed the Minister of Finance to guarantee loans from the UK and Netherlands to the Icelandic Deposit Guarantee Fund; these governments have already paid out money due to depositors in the so-called Icesave accounts. These loans amount to €4 billion; almost 50% of Iceland’s 2009 GDP – they carry an interest rate of 5.55%.

The law will now go to referendum set to be held on 6 March.

If voters say no – the likely outcome given recent polls – external funding from the IMF and Iceland’s Nordic neighbours will most likely be withheld. The consequence will be a protracted recession in Iceland. Moreover, a default on external sovereign debt is likely in 2012 (given current currency reserves), and this would precipitate a second crisis.

Expected outcome of ultimatum games

Payments on the Icesave debt are most likely to be in the range of 1-2% of GDP and to last from 2016 to 2025. Given these numbers, and Iceland’s weak negotiating position, saying no to the Icesave deal seems irrational, but it should not come as a surprise. In effect, Iceland’s voters are playing the second part of an ultimatum game. An offer is on the table which is perceived to be unfair and – just as is observed frequently in experimental economics laboratories – it is bound to be rejected.

For Vox readers not familiar with the finer details of the Icesave dispute some background is needed. (For an early account of the Icelandic banking crisis and the institutional framework see Jännäri (2009). An in-depth report by a parliamentary investigative committee is to be published in early February.)

  • It is important to note that Landsbanki had assets which will contribute towards paying the Icesave debt.

The latest estimate is that approximately 90% of priority claims, which include claims of deposit guarantee funds, will be covered by these assets. Does this make the worries of Icelandic voters unfounded or irrelevant? Not quite.

  • Accumulated interest during the grace period is not a priority claim.

Already burdened with a mountain of debt, the Government of Iceland negotiated a grace period on the Icesave bill; payments on what then remains of the loans will begin in 2016. Given a 90% recovery of priority claims and an even payout rate to claimants during 2010-2015, the remaining amount would be €1.3 billion, or 12% of estimated 2015 GDP using reasonable assumptions on growth. This amount plus interest would be paid starting in 2016; annual payments are likely to lie in a range of 1-2% of GDP and amount to approximately 1.5% of GDP on average. The debt should be fully paid by 2025.

A loss of 1.5% of annual GDP over almost a decade is substantial and such funds could be put to good use in Iceland’s strained public sector; substantial and painful cuts have already been made across the board, in particular in the education and health sectors, and there is more of the same to come over the next few years.

Nevertheless, given the alternative, the prudent course of action would seem to be to accept the Icesave deal and move on.

The above estimates are, however, subject to uncertainty – and there are risks. Recovery from the Landsbanki estate may be lower and slower and the recession in Iceland may drag on. If things go really badly – only 50% of priority claims recovered and no payments out of Landsbanki until 2015 – then the amount due to the UK and Netherlands in 2016 could be almost as high as the initial debt. In the case of a protracted recession in Iceland the principal could amount to 30-40% of GDP in 2016. This is a highly unlikely outcome, but after the tough lessons of 2008 we have learnt that highly improbable events sometimes occur.

Why the deal is viewed as unfair

It is likely that the small, but positive, probability of a big cost for Iceland, and the one-sided distribution of this risk onto disputing parties, is one of the main reasons why Icelanders perceive the Icesave deal as being unfair. (Another important issue causing discontent is the interest rate – see below.)

Here it should be noted that a guarantee of the Icesave agreement reached with the UK and Netherlands was passed into law in August 2009, albeit with some additional conditions imposed. These conditions were designed to limit the cost for Iceland in a bad scenario such as the one outlined above. Among the most important conditions was a linkage of annual payments in 2016-2024 to nominal GDP growth and a limitation of the guarantee to payments during those years (renegotiation was to take place if the debt was not fully paid).

These limitations were not fully accepted by the UK and Netherlands. Despite a high probability that the Icesave debt would be fully paid up by 2025, they were not willing to accept the time limitation of the guarantee. Hence, the bill had to be taken to Parliament once more. In the last version of the law, narrowly passed in Parliament on December 30 2009, and then refused signature by the president, the time limitation on the guarantee had been removed.

What happens if the vote is “no”

According to recent polls it is highly likely that the new law will be rejected in the referendum. The August 2009 law giving a conditional guarantee then again comes into effect. However, the UK and Netherlands have earlier rejected important conditions in that law. Iceland then faces complete uncertainty. If further external financing is withheld until the Icesave issue is resolved – as was the case during much of 2009 – the economy is likely to stagnate rather than take off with renewed growth in the second half of 2010 as envisaged in recent forecasts. In a worst case, where the matter is not resolved within a year or two, government default is imminent in 2011 or 2012 when a big pile of public external debt comes due.

Prospects for renegotiation

Clearly, Iceland is in a difficult position. It cannot afford to wait very long for a resolution to the Icesave dispute, but its negotiation partners are in no hurry. The potential costs of not reaching an agreement are much bigger for Iceland.

At a higher political level it is not in the best interests of Iceland, Britain or the Netherlands to head into these murky waters. That can still be prevented.

Provided a solution to the Icesave issue can be found which enjoys broad political backing in Iceland and is acceptable to the UK and Netherlands, the law the president denied signature can be invalidated and a referendum avoided. That, however, requires a new agreement with some substantive changes to the existing one. Given broad political support such an agreement could be quickly passed by Parliament – and there would then be no grounds for the president to refuse to confirm such a law. According to recent reports the Government is now attempting to work towards this solution.

Is there a possible compromise?

The demands of the UK and Netherlands that Icesave costs should not fall on their taxpayers is understandable. So, however, is the criticism that the interest rate on the Icesave loans is too high. At 5.55%, which is 1-2% higher than the costs of borrowing of the UK and Netherlands treasuries, it is widely regarded by Icelanders as the most onerous part of the Icesave agreement. To be sure, it is lower than what Iceland could get in international capital markets. But given the circumstances – in particular what must be considered a shared responsibility for allowing the Icesave accounts to get out of hand and legal uncertainty as regards Iceland’s responsibilities in the matter – this is no ordinary loan agreement.

Why not settle on a rate that is equal to the costs of borrowing for the respective treasuries? This would leave risks for Iceland, but the UK and Netherlands would not be seen to profit from Iceland’s troubles. It seems likely that most Icelanders would judge this to be a fair offer. And just like happens with fair offers in the economic laboratory it would most likely be accepted.


Kaarlo Jännäri (2009), “Report on Banking Regulation and Supervision in Iceland: Past, Present and Future”, March.

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