Countries will initially be reluctant to default on their sovereign debt
(although there have been plenty of examples in the past). But things are
different in cases where there is scope for a state to question its
responsibility to repay. That was the case with the debts of Dubai World, which
the city-state claimed were not government-backed (Abu Dhabi, Dubai’s fellow
emirate, eventually agreed to help out). And it is also the case with Iceland.
The dispute dates back to the expansion of Icelandic banks such as Landsbanki
into the European savings market. Under brand names like Icesave, these banks
offered online accounts with high interest rates that were often the best
available in the market. Avaricious savers known as “rate tarts” shifted their
money into such accounts with the help of comparison websites.
Landsbanki’s products were not covered by the domestic deposit-insurance
schemes of the target countries. Under a passport system covering the European
Economic Area (a broader, watered-down version of the European Union),
investors were supposedly covered by the Icelandic deposit-insurance scheme.
The problem was that the banks took on liabilities that far outgrew Iceland’s
GDP. When Landsbanki collapsed, the insurance scheme was inadequate to cover
its debts. That prompted a row between governments over who was responsible for
clearing up the mess. The British and Dutch governments have compensated their
domestic depositors in Icesave for their losses, and are claiming the money
back from the Icelandic government. The legal position is far from clear. Do
such insurance schemes actually carry a state guarantee? Yet the British and
Dutch governments have some powerful weapons on their side, such as the ability
to block Iceland’s accession to the EU.
There is a recognised concept in international finance of “onerous debt”, which
says that a population should not be responsible for debts run up by murderous
or kleptocratic dictators. But it is hard to make that case for Iceland, a
democracy that benefited from open markets in other countries to indulge in an
acquisition spree. During the banking boom Reykjavik resembled a gold-rush
town.
(...)
A more subtle way of getting rid of at least part of your foreign debt is to
allow your currency to depreciate. This option is only available to the likes
of America and Britain, which have been allowed to borrow in their domestic
currencies and seem already to be exploiting this fact.
Creditors used to be alive to these dangers and insisted on international
agreements that required countries to safeguard the value of their currencies.
But this is mainly a world of floating exchange rates. Combine these with
democracy and countries have a licence to abuse foreign creditors. They have
always had the motive to do so. The credit crunch has given them the
opportunity.