The Icelandic prime minister and the minister of finance jointly announced last Monday that they were getting rid of capital controls (Ministry of Finance 2015). This signalled that Iceland is serious about tackling its economic problems as a country responsible for its currency and its economic destiny.
The capital controls were imposed in the autumn of 2008 following the Icelandic crisis, as discussed here on Vox (Danielsson, 2008). The original intention was a short term, months at best, protection of the currency. Seven years later the capital controls are still in place and increasingly damaging (Arnason and Danielsson 2011).
While Iceland is flush with liquid funds, investors fear real investments because of the controls, preferring the more liquid stock market and real estate.
Three factors kept the controls in place
To understand how the government will now manage and implement its plan for lifting the controls, it is necessary to explore what factors delayed acting:
- The IMF made the capital controls a condition of its assistance package and remained firmly in favour of them.
This view was widely supported by international policy makers and academics, putting pressure on the Icelandic authorities to retain the controls;
- The amount of carry trades locked in; and
- The resolution of the banking system.
Let’s look at the two latter factors in more detail.
Before the crisis, Iceland enjoyed significant hot money inflows, viewed positively by the government at the time, as the currency appreciated along with living standards. At the time of the collapse, the then locked in carry traders’ positions were estimated to be €4.2 billion, or 41% of GDP in 2008, money that was impatient to leave. It was the fear of this money rushing out which prompted the capital controls. Now in June 2015, €2.0 billion of this amount or equivalent to 15% of GDP remains in Iceland, the rest having left the country by various means.
The failure of the three Icelandic banks, taken together, would be the third largest corporate failure in history behind only Lehman Brothers and Washington Mutual, while Iceland’s GDP is only 0.1% of the US’s GDP. The size of the financial system exceeded 10 times of Iceland’s GDP and over 90% of the financial system collapsed following the 2008 crisis.
The main obstacle to lifting the controls has been the resolution of the estates of the failed banks, especially of the Icelandic component. Their size is so large compared to the economy that any uncertainty about the foreign currency amounts eventually transferred to the foreign creditors needs to be eliminated before the controls are lifted.
The obligations of the failed banks are 94% owned by foreign creditors and 6% by domestic creditors. The estates have foreign assets worth €8.9 billion and domestic assets worth €6.1 billion, or 112% of current GDP. The entire foreign assets and some of the domestic assets are denominated in foreign currency.
The resolution has been held up by a dispute between the government and the creditors. The government put €2.0 billion or 15% of GDP into addressing the various costs arising from the failure of the banks, and it is often argued that those costs should be borne by the estates.
The result has been increasingly acrimonious discussions, even if the parties involved prefer the term “consultations”, on what has become known as the stability tax, serving as a haircut on the estates.
The plan to abolish the capital controls
Following a change in government two years ago (Danielsson 2013 VOX) and enabled by the end of the IMF programme, the abolition of the controls became a priority for the authorities. While the on-going “consultations” between the foreign creditors and the government have frustrated this process, the government has maintained that the cost of the capital controls is so high that the private interest of the creditors and their desire to delay settlements should yield to national interest.
The result now is a two level approach, one tackling the carry trades and the other the bank resolution, (Ministry of Finance 2015).
The holders of the remainder of the carry trades, what is known as offshore-kronas, will be offered to participate in an auction held by the Central Bank. The auction used is a version of a product-mix auction, designed by Paul Klemperer, at Oxford University who designed the successful Bank of England liquidity auctions during the 2008 crisis. The auction procedure is intended to minimize any possibility of hold-outs.
There will be four possible options for holders of offshore ISK, all of which involve exiting at a discount from the on-shore exchange rate.
- Participating in the spot FX auction;
- Investing in long term Icelandic krona treasury bonds, with a penalty for selling early;
- Investing in a medium term EUR bond;
- Term-locked non-interest-bearing accounts.
Regardless what the various investors prefer, this will remove the pressure on the currency from the carry trades.
The authorities have proposed a two-pronged solution to the problem of bank resolution as a prelude to lifting the controls. The creditors will have to choose between:
- Stability conditions, which the estates have to fulfil in order to obtain necessary exemptions from the capital controls, with settlement completed before the end of 2015.
The stability conditions are intended to prevent any risk of outflow through balance of payments, which could risk the stability of the Icelandic krona. The stability conditions are expected to raise about €3.0 billion or 22% of GDP for the government;
- Stability tax, a once-off payment of net 31% of total assets.
The revenue from the stability tax is estimated to reach net €4.6 billion or 34% of GDP.
Either option would facilitate lifting the controls. The optimal solution for the Icelandic government would be if the failed banks chose the first option, as creditors could legally challenge the stability tax on the grounds of unfairness should option two be the final outcome.
Under proposed Icelandic law, 60% of creditors are needed for a binding agreement for all creditors, and it is understood that large creditors have already agreed to the stability conditions, with most of the remainder expected to as well.
The eventual impact is estimated to be a reduction in government debt from 74% of GDP to 40-50% of GDP.
Exiting the controls
After a successful auction for the carry traders and resolution of the failed banks, lifting the controls will be relatively straightforward.
The controls will be lifted in stages. By year end, most restrictions on domestic agents will be lifted, including all restrictions on households. Firms will be able to invest abroad, and the pension funds will be able to freely invest abroad, up to a certain size limit.
Iceland’s decision to get rid of its capital controls can only be welcomed. Now is the right time to do so, the controls are seen as very damaging to the economy and are highly unpopular.
The plan for lifting the controls is well thought out and with a high chance of success. The creditors appear to have accepted the stability contribution instead of the stability tax, removing the main obstacle.
The plan protects the domestic economy while being fair to the foreign creditors, who even after paying the stability contribution will have been handsomely compensated for investing in Iceland at the height of the crisis.
The remaining question concerns the choice of the currency arrangement after the controls are lifted. Iceland has a bad experience with the various types of exchange rate and monetary policies. The immediate arrangement is likely to be a managed float, with the Central Bank standing ready to absorb any inflows of hot money.
Arnason, Ragnar and Jon Danielsson, (2011), “Capital controls are exactly wrong for Iceland”, http://www.voxeu.org/article/iceland-and-imf-why-capital-controls-are-en...
Danielsson, Jon (2008), “The first casualty of the crisis: Iceland”, http://www.voxeu.org/article/how-bad-could-crisis-get-lessons-iceland
Danielsson, Jon (2013) “Iceland’s post-Crisis economy: A myth or a miracle?”, http://www.voxeu.org/article/iceland-s-post-crisis-economy-myth-or-miracle
Ministry of Finance (2015), “Comprehensive strategy for capital account liberalization.” http://www.ministryoffinance.is/news/nr/19594