Reykjavik - Iceland's recovery from economic collapse is much weaker than the government proclaims, and a major debt write-down will be needed before crippling currency controls can be lifted, the country's likely next leaders told Reuters on Tuesday.
Two centre-right opposition parties are expected to form a new government after elections on Saturday, aiming to negotiate a deal with creditors who hold about $21.4bn worth of assets in Icelandic banks that failed in 2008.
Sigmundur Gunnlaugsson, chairperson of the Progressive Party which leads in the opinion polls, said creditors such as hedge funds that bought up Icelandic bank assets cheaply after the crisis would have to agree to the writing off of much of that debt.
Only after such a deal could Iceland start lifting the capital controls that prevent foreign creditors from getting their money out of the country, said Gunnlaugsson, who is tipped to become the next prime minister.
"Hedge funds bought into this situation and knew very well they would have to negotiate their way out; they bought into capital controls," said the 38-year-old Gunnlaugsson.
"It's also been clear that such negotiations will have to end with some of this [debt] being left behind so they could take the rest and let us lift capital controls," he said in an interview at the Althing, Iceland's parliament.
Slow economic growth
Iceland's collapse was spectacular. Its three banks, having grown to 10 times the country's GDP, failed in quick succession, leaving British and Dutch savers billions of euros out of pocket.
Their combined bankruptcy was second only to Lehman Brothers, the US investment bank which also failed in 2008.
The recovery also seemed quick thanks to the capital controls that stabilised the currency after a massive fall, debt write offs to households, and an IMF bailout that helped the tiny Nordic nation of just 320 000 to keep its investment grade credit rating.
However, Bjarni Benediktsson, the chairperson of the Independence Party that is likely join a coalition government under Gunnlaugsson, cast doubt on this success story.
"Sure, on paper it always looked good but the reality is very different," he told Reuters in a separate interview. "The rebound has been much weaker than the government claims and people felt very little of it," said Benediktsson, a 43-year-old former professional soccer player and keen trout fisherman.
Economic growth slowed to 1.8% in 2012 from 2.6% in 2011 and Arion Bank, one of the Iceland's biggest, forecasts it will slow to 1.5% this year.
This weakness has devastated the ruling centre-left coalition in the polls, virtually ensuring that the two centre-right parties, which ruled alone or together for almost 30 years until the collapse, will return to power.
Gunnlaugsson's Progressive Party has around 28% support while the Independence Party, its natural centre-right ally, is closing the gap with 24%. The ruling Social Democrats, whose Prime Minister Johanna Sigurdardottir is retiring, are a distant third with 12%.
Under the capital controls, businesses must seek central bank permission to buy foreign currency. This has deterred foreign investors because repatriating profits is almost impossible under the current regime.
Any debt negotiation will be a delicate manoeuvre; it has to be voluntary because anything that appears like confiscation will lead to more capital flight. But it also has to be done relatively quickly to get much-needed investment flowing again.
"If talks progress too slowly then Iceland will need to start the process by other means, for example through the tax system," Gunnlaugsson said, adding that a tax on money leaving the country or a levy on market transactions were possibilities.
"Clearly the country cannot be locked in capital controls for years to come," Gunnlaugsson said, stressing that his preference was for a deal about write-down’s.
The two leaders were reluctant to discuss what they considered an appropriate level of write-down on the banks' assets. But Gunnlaugsson pointed to discussions among the business elite which centre on 75% while Benediktsson said this figure was "not far from being realistic".
"The lifting of capital controls needs to happen in the next government's term and I would like to see it happen in a period of 12-18 months," Benediktsson said.
Debt relief to households was also necessary as 40% of them are still struggling to make ends meet and over 10% are in arrears on their mortgages - most of which are linked to inflation and therefore constantly growing.
Household debt peaked at around 130% of GDP in 2009 and is still over 100% as the index-linked mortgages have been rising due to rapid inflation, even though the state has granted some debt relief.
Inflation hit 5.2% in 2012 but slowed to an annual 3.9% in March after the central bank raised interest rates to stop the crown from sliding.
The Progressive Party would like to use funds gained from the debt write off to relieve households and abolish indexation while the Independence Party would be more keen on tax relief to households.