The cure for a currency default – in Iceland and beyond

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Article Highlights

  • In a world where international capital floods into and out of national markets, currency-exchange defaults will become more prevalent than government bond defaults.

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  • The tools developed to facilitate the restructuring of sovereign debts over the past decade can be easily adapted to resolve unpayable currency exchange obligations.

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  • With a well-structured collective-action mechanism, Iceland—and any country in similar circumstances—can cleanly solve a balance-of-payments problem that gnaws at its economy and isolates it from global investors.

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In a world where international capital floods into and out of national markets, currency-exchange defaults will become more prevalent than government bond defaults. Faced with a demand for foreign currency it couldn't meet in October 2008, Iceland defaulted on its promise to investors to convert their kronur into dollars and euros and froze their holdings inside the economy.

Iceland's government had a tiger by the tail. Lift the restrictions and $7 billion of liberated foreign investor funds would wipe out the nation's $4 billion of international reserves and precipitate a balance-of-payments crisis. Make an offer that would satisfy all foreign speculators and the government would be bankrupt.

After six long years of financial isolation, Iceland's leaders have decided to open discussions with foreign creditors who have been locked up behind "temporary" capital controls. Iceland has found that it was easier to close the gate than to pry it open. Still, there is a way out—and it is important for policy makers to know it because currency crises will become more frequent.

The tools developed to facilitate the restructuring of sovereign debts over the past decade can be easily adapted to resolve unpayable currency exchange obligations. If executed properly, the overhang of foreign holdings of kronur can be eliminated and full convertibility of the frozen krona can be restored—all without recourse to the Icelandic taxpayer.

Collective-action clauses are now a standard element of sovereign bonds used for debt restructuring. Under these clauses, if a predetermined supermajority of bondholders accepts a restructuring offer, it is binding for the remaining creditors. The clauses stop a small minority of investors from extorting a preferential value for its claims by blocking a solution desired by the debtor and most of its creditors.

In 2012 as a part of Greece's $270 billion debt restructuring, collective-action clauses were introduced retroactively into the government's domestic bonds by the Greek parliament. The mechanism achieved 100% success in restructuring Greece's domestic debt.

A structure for the collective action of foreign holders of krona assets can be created by the Icelandic Parliament. For instance, under a new law, if a 66.7% majority of foreign investors accepts a government offer for their krona assets, all remaining foreign holders would be locked in on the same terms.

With the collective-action mechanism in place, Iceland would offer to exchange the krona assets of foreign investors for euro cash and euro-denominated government bonds. The euro-exchange prices will be set at discounts to the official exchange rate to ensure a sustainable balance of payments after controls are lifted and a manageable government debt repayment schedule is in place.

With the exchange completed, the excess supply of kronur is extinguished and the currency can be allowed to trade freely without fear of calamity.

No debt will be transferred from the private sector to the taxpayer. The government simply sells euro cash and euro-denominated government bonds at premium prices to foreign investors for these investors' kronur and krona-denominated government bonds. Iceland will honor its debts in full by accepting its bonds at face value on the same terms as cash.

The government's total debt will fall significantly after the exchange. Its euro-denominated debt will rise. But its krona-denominated debt will fall by a greater amount. If investors exchange 800 billion kronur ($7 billion) of assets and the euro exchange discount is 33%, Iceland's debt will drop by 265 billion kronur or 15% of GDP.

The actual loss for investors is much smaller than the exchange discount because of the high returns earned on krona assets. Krona interest rates have exceeded euro rates by an average 6% per annum over the 2008-14 freeze. This differential creates a relative cumulative krona gain of 40%. An investor holding krona assets over the entire period will have a 7% profit in euros even after the 33% exchange-rate loss.

In a crisis, fleeing foreign investors have to sell both their domestic bonds and the rubles, pesos, rand or rupees received from the sale. But the central bank often doesn't have enough dollars to convert all the currency offered and so imposes controls to save the exchange rate from collapse. When pressed, countries from Venezuela and Argentina to Malaysia, Thailand and Russia have all restricted outflows of funds.

But exchange controls are a broken government promise to allow the free conversion of a nation's money into foreign currency. It is little different from the broken promise when a government defaults on its debt. Both must be resolved to bring back foreign capital and economic growth.

With a well-structured collective-action mechanism, Iceland—and any country in similar circumstances—can cleanly solve a balance-of-payments problem that gnaws at its economy and isolates it from global investors. Either that, or it can continue to pursue timid measures that postpone its revival.

Mr. Lerrick is a scholar at the American Enterprise Institute who has advised European officials on debt and currency issues.

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Adam
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