Iceland: Capital Control Relaxation Postponed
Iceland’s central bank governor stated on November 3, 2010, that there will be no fundamental changes to the current capital control regime before March 2011. The same day, Iceland’s central bank lowered its interest rates by 75 basis points, causing a drop in bond yields. Yields also fell as capital moved into bonds, given the longer-than-expected restrictions on investing abroad. Based on the central bank’s earlier communication, many investors believed controls would be relaxed shortly after the third IMF review, which took place in late September.
Iceland is currently struggling with the opposite problem to many emerging markets (EMs), which are concerned about massive capital inflows. In contrast to EMs such as Brazil and Thailand that are trying to use controls to slow such inflows, the aim of Iceland’s controls is to prevent outflows and give the economy time to recover and stabilize its exchange rate after its late 2008 banking crisis. Notably, Iceland’s capital controls have been very effective—especially since the controls were tightened in October 2009—and the Icelandic krona (ISK) has since strengthened against both the euro and the U.S. dollar. Earlier this year, the central bank estimated that the ISK could have depreciated to 260-300 against the euro without capital controls, or even further. In fact, however, the ISK’s weakest point against the euro was at just below 190 in late 2008.
Figure 4: Key Policy Rate and ISK/EUR Exchange Rate
Capital controls have allowed the central bank to conduct much looser monetary policy than would have been possible otherwise. With controls in place at least until March 2011, the conditions for continued rate cuts remain in place. Furthermore, the bank now expects weaker growth for both 2010 and 2011 than in its previous forecast in August. Meanwhile, inflation is edging downwards as the ISK gains strength. (See related Critical Issue on Iceland’s capital controls.)
Editor’s Note: This post is excerpted from a much longer analysis available exclusively to RGE Clients: Europe Focus: EZ’s Head and Tailwinds; Acute Portuguese Crisis; Stalling Russian Growth
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