Recent runs on short-term bank liabilities and the fiscal crisis in the euro area are a clear example of this. No one wants to be the last one to withdraw his deposits from a tottering bank, sell bonds issued by a country heading for insolvency, or rid himself of the currency of a country facing an imminent balance of payments crisis and potentially unsustainable debt burden, even though it may only be unsustainable provided that other investors think it is. The capital controls stopped a run on Iceland’s currency. In a sense, they also undermined confidence for the long term – that is, investors’ confidence that Iceland’s economy and public sector finances could achieve balance and sustainability in the absence of controls, knowing that the fragile balance created by the controls is based on coercing many investors to hold króna assets. Ultimately, confidence can be established only under conditions of free trade, not through coerced transactions. Fortunately, however, investors’ view on the Icelandic economy is diverse. Some understand quite well that behind the cloud of dust swirling in the wake of Iceland’s financial collapse is a country fraught with opportunity. When the dust has settled, Iceland’s net international investment position may turn out to be lower than it has been in decades, and in spite of sizeable gross debt, the Treasury’s net debt position indicates that it will be possible to reduce gross debt rapidly, if the programme of fiscal consolidation set forth is followed strictly.
In addition, a number of investment projects are extremely foreign exchange-intensive because of imports. The króna could depreciate as a result, with heavy outflows of foreign currency, even if there were ample opportunities for investment. This is the problem the liberalisation strategy is attempting to solve. Emphasis is placed on protecting the foreign exchange reserves by converting short-term claims against domestic entities to long-term investments to the extent possible. The Central Bank acts as an intermediary, and the auction format ensures that only a small portion of the foreign exchange reserves are in play at any given time. The auction format also ensures that transfers of banking system liquidity will not be large enough to jeopardise the system’s stability. The foreign exchange reserves are protected as well by the requirement that investors bring foreign currency into the country and exchange it for krónur in the domestic market. This will offset the foreign exchange outflows that often accompany new investment. Another important aim of the strategy is to ensure short-term Treasury financing. Even though significant progress has been made in controlling the fiscal deficit after the crash and halting the accumulation of unsustainable debt, it is important not to underestimate the current dependency of Treasury financing on the capital controls. More than half – and, in some instances, as much as ¾ – of the stock of short-term Treasury bonds is held by nonresidents.