Last weekend the voters of Iceland said no to honouring claims made against their nation by the British and Dutch governments. These claims originate from the failure of “IceSave” saving accounts. Many depositors in these accounts were based in the UK and Holland. In the wake of the funding crisis the UK and Dutch governments covered the losses of their respective citizens.
The Icelandics are faced with a dilemma. Do they choose the cheap short-term option of walking away from their debt, or the expensive short-term option of paying up? If they choose the latter, then Iceland will probably garner greater support in terms of future potential borrowing, and a higher possibility of joining the EU club.
It is likely that the next stage of the IceSave process will be in court, and this shows the dilemma of lending to a state as opposed to a corporation. Even if the court rules against Iceland, how will the UK and Dutch governments recover their money? Default risk is lower in sovereign credits than corporates, but recovery is often at the whim of the electorate, and rightly so. Most sovereign states have the benefit of democratic constitutions. When lending to a corporation it is the probability of default and recovery potential that investors have to focus on. When lending to a sovereign it is the willingness and ability of the citizens to repay debt that investors have to focus on.
The claim from the UK and the Dutch is a result of them bowing to their own electorate who had invested with Icelandic institutions, and they were given their money back in full, despite the deposit protection scheme being well publicised. In this case, we have the bizarre situation where a company operating outside its national boundaries has defaulted, the voting members of the sovereign state they operate in get bailed out, and the claim is passed onto another state, whose electorate (not surprisingly) do not wish to pay.
The Icelandic voters have decided they did not want to bail out the UK and Dutch governments, who had bailed out their own voters. Given the structure of the Eurozone banking system, one currency, hugely mobile capital, and a multitude of democracies, Iceland could well be a test case of what happens next (see previous blog on Iceland here). Financial integration without political integration may plain and simply will not work.