Már Guðmundsson: Currency and exchange rate regime options Introduction by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, to a report issued by the Central Bank of Iceland on Iceland’s currency and exchange rate policy options, Reykjavík, 7 September 2012. * 1.1  *  *  Introduction  In the near future, Icelanders must make important decisions concerning the framework for the currency and monetary policy, the structure of the financial system, and the degree of integration with the world economy. These decisions must be taken in view of what can be learnt from the financial crisis and from previous monetary policy implementation in Iceland. Iceland has applied for membership of the European Union (EU) and, if membership materialises, it will define a clear path for most of these issues. If Iceland does not join the EU, the choices will be different. In both instances, Iceland must lift the capital controls that are currently in place. According to EU rules, this must be accomplished before accession. The experience of recent decades shows, however, that completely free movement of capital comes with significant risk. To reduce that risk, it is necessary to develop a regulatory framework that prepares the Icelandic financial system for the volatility that can accompany free movement of capital. That regulatory framework may entail some restrictions on Iceland’s financial integration with other countries, particularly as regards domestic financial institutions’ freedom to conduct international business. The scope of such restrictions will depend, however, on which currency option Iceland chooses.
But the fluctuations need not be larger than many other and larger countries appear able to tolerate. Finally, it is appropriate to emphasise that independent monetary policy under a flexible exchange rate regime can take many forms, including different types of price stability target and taking into consideration the role of money and credit in policy formation. It can therefore change from one period to another without necessitating major decisions concerning the currency as such. 1.7  Capital controls and exchange rate regime options  Lifting the capital controls is one of the most important yet most complex challenges facing Iceland at present. The controls have proven an important means of achieving stability in the wake of the financial crisis. Because of this, they were approved by signatories of the EEA Agreement even though they are contrary to the spirit of the Agreement. In the long run, however, it is critical that they be abolished. There are at least two main reasons for this. First, the costs associated with the capital controls grow over time and will ultimately exceed the benefits. Second, they are in contravention of Iceland’s international obligations. For the long term, it will be impossible to retain universal restrictions on capital outflows and remain in the EEA. Iceland must therefore make a genuine attempt to lift the controls. It may prove complicated and time-consuming, but there is no other option. This gives rise to the question of how capital account liberalisation is related to the choice of currency and exchange rate policy.