By Marc Jones
LONDON (Reuters) - Iceland's finance minister struck a defiant tone on Wednesday after the main foreign investors locked up by the country's post-2008 capital controls rejected a bid by Icelandic authorities to resolve the issue.
On Tuesday, Iceland's central bank was offered just 75 billion crowns of a possible 178 billion crowns at its last currency auction before it is expected to start lifting the controls for Icelandic residents in August.
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The result meant a large number of the big "offshore crown" foreign bond holders rejected the 190-crown-per-euro offer and will now see their money effectively frozen, albeit with a token interest payment of 0.5 percent.
For the handful of funds, the offer would have effectively cut the value of their bonds by roughly a third from what they originally paid for them, before the crisis.
"We would have liked to have seen less of the overhang follow us into the future, but the law made it clear we were also ready if part of the overhang would not come forward," finance minister Bjarni Benediktsson told Reuters on Wednesday.
"What we have in our hands at the moment is the fact that this auction has happened and the law provides that those who did not participate, they will go on the blocked accounts."
Iceland imposed the controls during the country's 2008 financial crisis. They prevented investors holding Icelandic assets from selling them and taking the money out of Iceland, which would have further weakened the then tottering economy.
Iceland hopes to fully remove the controls, but a clean exit depends on those few large investment funds agreeing to its terms.
The result of the auction came as little surprise for those who have followed the negotiations over the last year.
The central bank's FX offer would have effectively meant a 30 to 38 percent loss for the funds such as Loomis Sayles & Co, a unit of Natixis; Eaton Vance, Autonomy Capital and Discovery Capital Management.
At the same time, the government holds a strong hand. The economy is expected grow more than 4 percent this year and its interest rates of 5.75 percent are a strong draw for the developed world's yield-starved investors.
At a Euromoney bond conference where Benediktsson was speaking, one investor asked him why the central bank hadn't made a more attractive FX offer or the opportunity to switch into other bonds.
"Because we don't need to," he said. "Our main priority has to be to protect the economy of Iceland ... We are not forcing anyone to accept that."
The other difficulty Iceland has is the flow of foreign capital attracted by its high interest rates. Its central bank has just brought in measures, in the form of zero-interest reserve requirements, to try to stem the flow. That rate could fall even lower, Benediktsson said.
"Negative (rate on reserves), yes definitely. Under the law the central bank can decide on negative interest rates," he said, although that is not likely to happen "in the coming weeks or months."
(Reporting by Marc Jones, editing by Larry King)