The Icelandic government adopted a revised strategy for gradual liberalisation of capital controls in a cabinet meeting yesterday. The strategy was developed by the Central Bank of Iceland in cooperation with the Ministry of Economic Affairs, Ministry of Finance and the Financial Supervisory Authority. Furthermore, consultations were carried out with the International Monetary Fund and advice sought from an external expert with experience in managing and lifting capital controls.
The strategy is in two main phases. The first phase focuses on releasing so-called offshore krona, which are largely held by foreign residents in bank deposits and government securities. These offshore krona are estimated at over ISK 400-500 bn. or around 25% of Iceland‘s annual GDP. Their existence has undermined confidence and distorted prices in key financial markets. It is for this reason that the first phase aims at substantially reducing offshore krona holdings. When sufficient progress has been made to this end, and other conditions have been met, the second phase, focusing on onshore krona can begin.
The strategy does not include a timeline. The pace of its execution will depend on the evolution of relevant economic conditions and on the outcome of previous steps in liberalization. The overall approach aims to minimize possible negative effects on currency stability, bank liquidity and the bond market. Numerous small steps will therefore be taken as conditions permit.
In the first stage, offshore krona will be addressed through series of currency auctions. Initially, the Central Bank of Iceland will auction foreign currency to owners of offshore krona. These offshore krona will then be offered in auctions to owners of foreign currency who will be required to invest them either in long-term government bonds or in Icelandic enterprises for a set period of time. Current owners of legally obtained offshore krona will also be able to channel them into investments in Icelandic enterprises, subject to similar requirements. Those who wish to invest in domestic enterprises will be allowed to match their foreign currency investment with an equal amount of offshore krona. In time, holders of offshore krona who have neither sold them in the auctions nor invested them in Icelandic enterprises will be allowed to either swap their offshore krona into a long-term foreign currency government bond or pay an exit levy.
The second phase of the strategy will be carried out after adequate progress has been made in reducing offshore krona holdings, the offshore exchange rate has converged sufficiently with the onshore rate and other economic preconditions have been met. Iceland’s future monetary policy framework will also have to be in place. The decision on the beginning and implementation of the second phase will be made by the government in cooperation with the Central Bank of Iceland.
Normalisation of Icelandic capital markets remains a priority for the authorities. To secure the liberalisation of the capital controls without threatening financial stability, the Minister of Economic Affairs will propose to the Icelandic parliament, Althingi, an extension of the temporary provision authorising capital controls until year-end 2015. However, the government may lift the controls at an earlier date if conditions permit.