The first sovereign debt crisis in the EU

Jon Danielsson, Hermann Oskarsson

The current EZ crisis is not Europe’s first sovereign-debt crisis. This column shows parallels can be drawn from an all-but-forgotten episode, i.e. the 1990 Faroese crisis. Just like Greece, the Faroes got into difficulty because of excess borrowing facilitated by a currency union with an AAA-rated partner undeterred as the sovereign debt spiralled upwards. In the Faroese case, the crisis was eventually resolved when political necessities outweighed the cost of the bailout.

Today is not the first time Europe has suffered a sovereign-debt crisis. Twenty years ago another crisis happened, passing without notice except amongst those affected, i.e. the Faroe Islands. The islands accumulated too much sovereign debt, eventually getting hit by a crisis much larger in magnitude than even the worst in the ongoing European crisis. Little analysis has been published on the crisis, and almost none in English. We mostly rely on Gørtz et al. (1994) and Hansen and Joensen (2008).

The Faroe Islands are a Danish possession, situated between Iceland and Scotland. Even though they are part of Denmark, and use the Danish currency, they are not a member of the EU. The economy of the Faroes is based primarily on fishing. As the neighbouring countries expanded their economic zones to 200 miles, the Faroese fishing fleet lost access to its traditional fishing grounds, and profits plummeted. In response, the government of the Faroes resorted to subsidising its only export sector – fishing – to the tune of 34% of total exports throughout the 1980s.

Background

Before the crises in 1990, government net debt never exceeded 50% of GDP. Private debt, however, had been increasing rapidly, reaching 125% of GDP in 1990. The private borrowing was facilitated by government guarantees, capital subsidies and production guarantees. Some of the loan guarantees were deliberately kept secret from the Faroese Parliament, the Danish government and the public, while bad bookkeeping shielded other support from scrutiny.

The guarantees meant the foreign creditors only worried about the ability of the Faroese government to repay the loans. Creditors implicitly assumed the Faroese sovereign debt was underwritten by the Danish government, with its AAA rating, even though no explicit guarantees were issued. The Danish government did not seem all that concerned and did nothing to disabuse the creditors.

The money was not put to good use; export subsidies directly added to the debt burden and many, if not most, investments turned out to be sour.

In addition to financial intermediation, the local banks actively engaged in interest-rate and tax arbitrage between the Faroe Islands and Denmark, reaping significant profits.

Crisis

Eventually, it all got too much, and as the economy got hit by exogenous shocks due to a slowdown in the global economy and reduced fishing catch, a sovereign-debt crisis ensued. The first affected were the banks, and the Danish financial supervisor, the FSA, became concerned and demanded that the banks shut down their arbitrage schemes and sharply increase loan provisions. This was the final straw for the banks. They defaulted and the Danish government forced the Faroese government to take the banks over at its own expense. This caused the debt-to-GDP ratio to reach 140%, mostly borrowed from the Danish government.

To the chagrin of the Faroese, the Danish deposit insurance fund and foreign banks, like Danske Bank, got off relatively scot-free.

As the domestic banks defaulted, the GDP contracted by 40%, and 15% of the population emigrated.

Post crisis

The crisis soured relations between the Faroese and their colonial masters. The Faroese maintained Denmark had acted with malice in forcing them to assume too much debt in the crisis and imposing too much austerity, a view vindicated by the Danish state-commission report on the crisis in January 1998 and a Parliament decision to ask the government to re-negotiate the settlement terms in favour of the Faroese. The Danes worried about moral hazard and claimed the Faroese had been irresponsible and should not have an open-ended claim on the Danish treasury.

The conflict simmered until March 1998, when the Social Democrats won a majority in the Danish parliament, provided that the Faroese Social Democratic MP supported them. Which he did, securing a settlement of the dispute worth 1.5 billion Danish krone to the Faroese authorities, or 20% of the islands’ GDP.

Recovery

After the crisis, the Faroese economy recovered swiftly, with annual growth at 4% between 1995 and 2010. The Faroese ran a capital-account surplus amounting to 13% of GDP per year for a decade, eliminating the sovereign debt. This was helped by the re-exports of the excess investment goods acquired prior to the crisis, and the sharp fall in imports, not the least because of the widespread emigration.

Parallels

There are many parallels between the Faroese crisis and the ongoing European sovereign-debt crisis, especially Greece. Both countries got into difficulty because of excess borrowing, facilitated by belonging to a currency union with an AAA-rated partner. The creditors implicitly assumed the debt was somehow underwritten, and fiscal misconduct prevented by the rules of the greater community. In neither case, did the senior partner seem all that concerned, even as the sovereign debt spiralled upwards.

In the Faroese case, the crisis in state relations was eventually resolved when political necessities outweighed the cost of the bailout. It did help to have representation in the parliament of the main protagonist.

References

Danish state commision report. 1998. “Den Færøske banksag, Undersøgelseskommissionen vedrørende Den Færøske Banksag 1995-1998.”

Gørtz, E, Magnússon, G and Waagstein, E 1994. “Krisen I den færøske økonomi – herunder bankerne. Baggrund, foranstaltninger og konsekvenser – aktuelt og fremover”. Joint Danish and Faroese government commission report.

Hansen, J A and Joensen, J P (2008). “Føroyar og bankarnir í 100 ár”.