Beware of Icelanders Bearing Smiles

In the rarefied world of global finance, Iceland is where local pols and central bankers trample on the interests of bondholders like a herd of marauding reindeer. At least that’s the perspective of foreign bondholders and distressed asset hedge funds hoping to recoup their investments in three Icelandic lenders—Landsbanki Islands, Glitnir Bank, and Kaupthing Bank—that defaulted on $85 billion in debts in 2008.

In a parliamentary election on April 27, the Independence Party—which was in power during the meltdown—and the Progressive Party together won just over 50 percent of the vote. Both ran on an anti-austerity platform of lower taxes and home mortgage relief, to be funded in part by forcing overseas creditors to accept losses on the $3.8 billion in krona-denominated assets they’re owed by three failed lenders. Also in play is $8 billion in deposits and loans owed to overseas creditors that have been trapped in Iceland, thanks to capital controls imposed in 2008.

Iceland’s politicians won praise from American economists including Paul Krugman and Joseph Stiglitz for refusing to bail out Iceland’s banks, whose balance sheets had ballooned to 10 times the size of the island’s economy. Unlike many other nations, Iceland did not use taxpayer money to protect bank bondholders and creditors. The strategy worked: Iceland is no longer a ward of the International Monetary Fund, which together with Finland, Sweden, Norway, and Denmark spent $4.6 billion to bail out the country. Its economy is expected to grow 2.1 percent this year, according to the Central Bank of Iceland. The unemployment rate has fallen to 5.3 percent from a peak of 9.3 percent.

Even so, the new regime faces a dilemma: Play too rough with foreign creditors and the country runs the risk of becoming a financial pariah.

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