What Will Lifting Capital Controls Mean For Iceland’s Recovery?

If Icelanders wants to buy currency, say US dollars, they can only purchase $2,800 USD, and they must prove to their bank that they are travelling to another country. Icelanders have been operating under this reality for the last four years, when capital controls were put in place to protect the value of Iceland’s currency.
With the removal of those capital controls set to take place 2013, Icelanders may soon have an easier time buying foreign currency. At the same time, there is much concern over how this will affect Iceland’s economic recovery.
UH OH, THE GLACIER BONDS
To refresh your memory, capital controls were established in late 2008 after the króna plunged as much as 80% against the euro. The controls blocked an estimated $8 billion in assets from leaving the economy.
The main reason given for establishing capital controls at that time was that without strict controls, there was a risk that the owners of ‘Jöklabréf’ (“glacier bonds”), equivalent to 50% of GDP, would rush to unload their holdings thereby making the Icelandic króna plunge even further than the 50% depreciation from the króna’s peak to bottom.
“Glacier bonds were issued for $300 billion ISK,” says Dr. Sigríður Benediktsdóttir, director of the financial stability department at the Central Bank of Iceland. “To put it simply, there’s a John Smith in Canada holding a bond in ISK, payable in ISK, as it has a higher interest rate than his local bond market. The crisis hit in 2008 and to pay out that bond and simultaneously all of them within a few days, it would have resulted in a steep devaluation of the currency, which wouldn’t have been very good. This is the reason we had to resort to capital controls and this is the overhang we’re working with now.”
To reduce the future risk of a currency collapse, the Central Bank of Iceland has submitted proposals for relaxing capital controls in stages, in an effort to remove the controls as soon as possible without risking economic stability.
“The main thing we’re trying to do is prevent what happened before the financial collapse,” Sigríður says. “Many things that we’re proposing have been in effect in other countries.”
Why should you care? This is an essential step in Iceland’s financial recovery.
CUTTING OFF LIFE SUPPORT
In a 2011 Central Bank report, it was stated that before the capital controls would be lifted for Icelandic residents, it would be necessary to adopt rules designed to protect the financial system against the risk that could accompany unrestricted capital flows, including liquidity risk in the financial institutions’ balance sheets. Iceland would also have to address the risk entailed in foreign currency lending to residents without income in the borrowed currencies.
The time has come for proposals.
“The first rule deals with liquidity issues,” Sigríður says. “Before the collapse we would only look at short-term inflows and outflows and we didn’t care if the outflows were in foreign currency. That was a problem.”
The proposed rules “should limit foreign exchange risk in the financial system, as well as limiting foreign currency liquidity risk; furthermore, they will, in combination, limit the banks’ potential for excessive growth.”
Another proposal in the Central Bank’s report concerns limiting deposits from abroad. “The issue, deposits from abroad, came to half of our GDP,” Sigríður says. “The regulator couldn’t stop the deposits. It’s the way that governance is. It takes time. We want to limit it, but the aim of this is to not to punish foreign deposit holders. In fact, what we’re trying to achieve is to discourage foreigners from putting deposits in our banks.”
Sigríður is optimistic about lifting the restriction: “Some are bullish, and I tend to be,” she says. “To the extent that the economy has 2–3% growth, we have about 5% unemployment, and strong exporting and tourism, I think lifting capital controls will be positive.”
When will the Central Bank’s changes be enacted? The timeline for the proposals is complicated. “This is a political decision,” she says. “As of now, the rules for capital controls expire at the end of 2013, but we also have elections in April next year and their outcome may affect the liberalisation process.”
WILL THE KRÓNA MAKE IT?
Meanwhile, others are less optimistic, and talk of adopting an alternative currency continues.
Þórólfur Matthíasson, an economics professor at the University of Iceland, told the New York Times in July: “The capital controls are worse and worse for companies, but the fear is that if we lift them, the value of the króna will collapse.” Þórólfur says the solution would be for Iceland to join a larger, more stable currency, such as the euro.
A Central Bank report on Iceland’s currency and exchange rate published on September 17, noted that there could be positive outcomes if the euro is adopted including increased international trade.
Still, it’s not so straightforward. Már Guðmundsson, governor of the Central Bank, said at a press conference, “The unilateral adoption of another currency would have significant risks associated with them.” He went on to say that joining the Eurozone would depend on the debt crisis in Europe, which is in its third year.