The end of a saga: Iceland lifts capital controls

At last, the country marks a symbolic recovery from its financial meltdown

 

IT WAS one of the worst-hit casualties of the financial crisis 0f 2007-08, but Iceland this week took steps that symbolised its recovery. The last remaining controls on capital outflows were lifted, allowing pension and investment funds to invest their money abroad. And the central bank struck another deal with offshore holders of frozen krona-denominated assets—buying more of them back at a discount.

The country’s crisis experience was a cautionary tale of an over-exuberant financial sector. Three of its banks, with assets worth 14 times GDP, keeled over within a week; the krona fell by 70% on a trade-weighted basis in a year; Iceland was the first rich country since Britain in 1976 to need an IMF rescue.

To stem capital outflows and further falls in the krona, the government in 2008 slapped restrictions on money leaving the country. The measures also froze offshore holdings of krona-denominated assets, which at the time amounted to 40% of GDP. Even the IMF, usually in favour of more orthodox free-market policies, supported the move. The country nonetheless experienced a severe recession, with GDP falling by more than 10% that year.

Eight years on, things look rosier. The IMF loan was repaid early, in 2015. GDP rose by 7.2% in 2016, boosted by an explosion in tourism: visitor numbers are expected to exceed 2m this year, seven times the population. As the economy has recovered, capital restrictions have been eased. It is hoped the latest liberalisation will cool the economy a little, says Jon Danielsson of the London School of Economics. By stopping investment abroad, capital controls may have inflated domestic asset prices; house prices have climbed by around 16% in a year. Outflows should also reduce pressure on the krona, which rose by 16% against the euro in 2016, but has fallen by 3.5% since the announcement.

Iceland’s problem is that its economic cycle is out of sync with other rich countries, says Fridrik Mar Baldursson of Reykjavik University. Before the crisis investors sought to profit from the gap between high Icelandic interest rates and lower rates elsewhere, by borrowing abroad to invest in Iceland. With the krona interest rate now at 5%, that “carry trade” has resurfaced. The central bank is hamstrung: if it lowers rates to deter foreign money, it risks stoking up the domestic economy further.

So though controls on capital outflows were lifted this week, those on inflows were tightened. They try to dim the attraction of investing in Iceland by making investors keep 40% of their money in non-interest-bearing accounts for at least a year. Determined speculators, Mr Danielsson fears, will always find a way in. But the measure is at least a step towards avoiding a rerun of the 2008 saga.

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