The reserves were above the minimum aimed at during the prelude to capital account liberalisation. Relative to GDP, Iceland’s reserves are currently at their largest since the end of World War II. There is no doubt that we have already benefited greatly from these relatively large reserves. They have enabled us to lift the capital controls without taking excessive risk with economic and financial stability. The reserves play a key role in Iceland’s recent credit rating upgrades, as can be seen in the press releases from the rating agencies. The upgrades will lead to an improvement in the borrowing terms offered to the Treasury, the banks, and large companies in foreign credit markets. And last but not least, large reserves provide a buffer against shocks in the future. They greatly increase the probability that if the króna depreciates because the equilibrium exchange rate has fallen and the positive output gap has closed, it will not pose a threat to stability. Many countries have undergone such an adjustment, and a sudden collapse of the currency such as that occurring in Iceland during the financial crisis is the exception rather than the rule. The benefits deriving from the reserves are therefore significant. The problem, however, is that the benefits are distributed widely, while the Central Bank bears the costs alone. Last year the Bank recorded an operating loss of 35 b.kr. This was due to an exchange rate loss of nearly 90 b.kr. on the reserves, owing to the appreciation of the króna during the year.
In addition, the policy interest rate was lowered by 0.75 percentage points last year, the króna has appreciated by over 16%, the Central Bank has bought more than 350 b.kr. worth of foreign currency, the foreign exchange reserves have grown by over a third in foreign currency terms, and capital controls have been almost completely lifted in three large steps. These are substantial changes in a single year – changes that will presumably take their place in economic history. What lies behind these developments? How could the domestic economy grow by more than 7% in 2016 without overheating and unleashing inflation? Five major factors are presumably of considerable significance whose mechanism it is important to understand in order to assess what comes next and formulate appropriate economic policy responses. First of all, the supply side of the economy is more flexible than before, owing to increased economic integration with the rest of the world. The EEA Agreement plays a large role here, but so do other trade related agreements and 1  general market-driven developments in the global economy. Because of this, when demand pressures start to develop, it is easier than before to mitigate them: by importing labour and other production factors, by using foreign inputs in domestic production chains to a greater degree, or by moving a portion of operations out of the country. Last year, for instance, net migration among foreign nationals was closing in on the previous peak from 2006.