Arnór Sighvatsson: Shedding the shackles of capital controls Speech by Mr Arnór Sighvatsson, Deputy Governor of the Central Bank of Iceland, at the breakfast meeting of Icelandic Securities Ltd, Reykjavík, 7 October 2010. *  *  *  Restrictions on movement of capital to and from Iceland are in contravention of Iceland’s international obligations, including the European Economic Area Agreement. Such controls distort economic incentives, lead to lost business opportunities, discourage foreign investment, are costly and inconvenient for the public and private sector alike, and are a breeding ground for illegal activity aimed at circumvention. There is also the risk that a capital controls regime will be progressively more difficult to enforce over time. Moreover, there is good reason to believe that, in the long run, Iceland’s pension system would benefit from diversifying risk by investing abroad. Indeed, this has become abundantly clear in the current financial crisis. In sum, there are a host of reasons not to impose capital controls, and to lift them as soon as possible if they do exist. In spite of these arguments to the contrary, capital controls were imposed after the Icelandic financial system collapsed, and removing them has taken longer than originally anticipated. It is useful to review the reasons for imposing the controls, as those reasons are the key to understanding what conditions must be met before the controls can be lifted. Why capital controls?
Had this happened, the króna would probably have plunged in the meantime and not recovered before prices and wages had adjusted. But the problem was not restricted to non-residents. Residents, including Iceland’s pension funds, allocate substantial funds that must be invested on a continuous basis. With the economy paralysed and the Treasury’s ability to fund a large deficit over the next few years uncertain, domestic institutional investors also became reluctant to invest in domestic assets. Under these conditions, central government financing would have been extremely challenging, which would have undermined exchange rate stability still further. The third reason for the capital controls was the shaky balance sheets of the newly established financial institutions and the other financial firms that survived the onslaught, however briefly. Their balance sheets were fraught with uncertainty and potentially unstable. BIS Review 138/2010  1  A considerable share of their deposits could prove unstable as well. The balance sheets of households and businesses were likewise in a state of disarray. In the absence of exchange rate stability, it would be extremely difficult to restructure the finances of Iceland’s households, corporations, and banks. Prerequisites for capital account liberalisation The foregoing discussion should make it clear that the capital controls will not be lifted in full until confidence has been restored to the extent that their removal will not cause prolonged instability.