The Icelandic government announced today it it lifting its capital controls. Private investors, pension funds and the government need to prioritise investing abroad to lower the chance of another crash.
The Icelandic authorities in November 2008 imposed capital controls because they were in a panic over how to react to the crisis. The IMF was an enthusiastic supporter, its representative at the time arguing that it was one half of a belts and suspenders policy, the other being interest rates of 21%.
It was a mistake at the time to impose the controls, in my words in 2011, Capital controls are exactly wrong for Iceland.
We thought the time had come to lift them in early summer 2015, as I argued then, Why Iceland can now remove capital controls but as it turned out, it took longer to settle with the pre-crisis carry traders and the post-crisis creditors of the failed banks than expected.
The government has now finally reached a settlement and the creditors will be able to exchange their Icelandic krona at 20% above last Friday’s exchange rate.
About time. The exchange rate has appreciated rapidly and the economy is overheating. Economic growth was 7.2% last year, mostly thanks to tourism. (If there was a Noble prize to be had for marketing, the person that managed to sell the Icelandic winter to tourists deserves it.)
While the Icelanders are enjoying the benefits of the rapid economic growth, their investment opportunities have been quite limited because of the capital controls. Investments have flown into domestic equities and real estate, fuelling a bubble.
What is needed is for the pension funds and other domestic investors to diversify abroad. Not only will that alleviate the pressure on the krona, the overheating economy, and the real estate and equity bubble, it will also be a are useful hedge when the cycle turns.
Furthermore, the government should set up a sovereign wealth fund invested abroad. This would soak up some of the inflows of foreign currency and its domestic surpluses. Finally, the central bank should then lower interest rates and do non-sterilized interventions in the currency markets. See here for more details
“There is a general sense that we are at the top of the boom cycle. There is an expectation that at some point the cycle will turn. The question is whether the government can make the most of the current upside to prepare for the downturn,” FT, Iceland to lift capital controls in return to financial markets
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