Iceland: Goodbye to capital controls? .....not yet, but we are getting closer

• In connection with Iceland’s financial and economic crisis in 2008, strict capital and currency controls were introduced.
  

• While there has been some progress in lifting these controls, progress has been painfully slow and we have not had high hopes that the controls would be lifted quickly. However, recently there has been some progress and we might be moving closer to seeing the controls lifted.
  

• In this paper, we look at the recent news regarding the outlook for a reliberalisation of currency and capital flows in and out of Iceland.

In connection with Iceland’s financial and economic crisis in 2008, strict capital and currency controls were introduced. While there has been some progress in lifting these controls, the progress has been painfully slow and we have not had high hopes that the controls would be lifted quickly. However, recently there has been some progress and we might be moving closer to seeing these controls lifted. Here, we look at the recent news regarding the outlook for a re-liberalisation of currency and capital flows in and out of Iceland.

Back in July, the Icelandic government brought in an expert team to advise the government on lifting the capital controls. Hence, the Ministry of Finance reached an agreement with New York-based law firm Cleary Gottlieb Steen & Hamilton and London-based consultants White Oak Advisory LLP to advise regarding eliminating the controls. Furthermore, Anne Krueger, professor at the John Hopkins University and former deputy managing director at the IMF, has also been brought in as an advisor.

Last week, the Iceland ministry of Finance published a report on the Progress of plans to remove capital controls. The report is the second since the Icelandic parliament Althingi in 2013 enacted a law requiring the government to regularly report on progress on removing the capital controls.

Key conclusions from the ‘progress report’

• The Icelandic central bank Sedlabanki has continued its FX auctions. These auctions have the purpose of reducing the overall stock of Icelandic kronor (ISK) assets held by non-residents (‘offshore ISK’).

• These auctions have been successful in the sense it has been possible to significantly reduce the overall stock of ‘offshore ISK’ to around 16% of GDP today from more than 40% of GDP in 2008. This obviously reduces the potential ‘outflow’ when capital controls are eventually lifted.

• The Icelandic Pension Funds Association continues to argue that there is a need to increase the pension funds’ foreign assets. In the ‘progress report’, there is a warning that this could put significant pressure on the ISK.

• At the end of 2013, the Icelandic pensions fund held foreign assets for around 22% of their net funds for payment of pensions. The Pension Funds Association argued that this number should rationally be increased to 40-50%. A ‘one-off’ increase in the pension funds’ foreign assets to reach such a target would obviously put significant weakening pressure on ISK. It is argued in the report that such depreciation would ‘erode’ any gains from international diversification of the pension funds assets.

• Sedlabanki has requested that ‘speed limits’ on the increase in pension funds' foreign assets should be considered.

• The report concludes that ‘conditions have become more favourable for taking the next steps towards removal of capital controls’ and that Sedlabanki’s ‘regular FX purchases have been successful and were stepped up further in the summer months’. Finally, that ‘a budget surplus in 2014, no further increase in debt and a continuing reduction of Treasury debt relative to GDP in coming years, for instance, in accordance with the 2015 budget bill and the state's Medium- term Fiscal Programme, are important steps towards removal of capital controls’.

More optimistic on capital control liberalisation

Overall, we agree with the main points in the progress report and we find it particularly relevant that the amount of ‘offshore ISK’ has been significantly reduced.

We also agree that the biggest ‘threat’ to the stability of the ISK when capital controls are lifted will be the pension funds’ – justified – desire to increase their holding of foreign assets. However, this is a challenge that cannot be addressed and managed, for example, with the kind of ‘speed limits which Sedlabanki has suggested.

Therefore, we agree that there has been progress and that it has become more likely that within a reasonable period we will see a more substantial re-liberalisation of capital and currency flows in and out of Iceland.

We also note that the fact that the Icelandic government has brought in foreign advisors on the issue of lifting capital controls is a clear signal to the markets that the Icelandic government is serious about moving toward and lifting the capital controls in the hopefully not too distant future.

Whether we will ever see full liberalisation of capital flows, however, is another question. The main political parties in Iceland still seem to fear full liberalisation. Finance Minister Bjarni Benediktsson has, for example, suggested what he called ‘speed bumps’ to prevent a significant outflow over a short period of time and also to limit carry trade. Similar views have been voiced by Sedlabank officials.

The progress on lifting capital control should certainly be welcomed as we continue to believe that the capital controls are seriously hampering investments into Iceland and therefore reducing long-term growth in Iceland.

It should be noted that we maintain our suspension of forecasting on ISK given the present stage of the currency and capital controls.