The real exchange rate of the króna is somewhat below its likely long-term average, although it has risen in the past year. 6  BIS Review 138/2010  As economic recovery gains pace, the outlook for capital account liberalisation improves. Recovery tends to be accompanied by increased inflow of foreign capital in the form of credit or direct investment. Significant inward foreign direct investment could set the stage for removal of the controls. Although suggestions that recovery began late in 2009 or in the first half of 2010 have proven to be a mirage, a number of indicators imply that Iceland has hit bottom or is close to it, and that growth will resume in the latter half of this year. But the pace of the recovery will depend greatly on our success in attracting foreign capital for exportgenerating investment. The main objective of the IMF programme is to build confidence in Iceland’s economy and economic policy. If that confidence existed now, it would be possible to lift the controls today. Considerable discussion has been devoted to the instability of foreign capital that could flee as soon as the controls that hold it in place are reduced or eliminated. Although the magnitude of foreigners’ frozen ISK assets is broadly known, information on non-resident retail owners of ISK assets is largely hidden.
In short, restrictions were placed on movement of capital because confidence in Iceland’s banking system, currency, and Treasury – actually, in Iceland’s entire economy and institutional framework – was in tatters after all of the country’s major banks failed in one of the largest financial collapses in history. It was clear that the collapse of the banking sector would deal the Treasury a heavy blow, although the exact scope of the shock was unknown. It was also clear that the Treasury would require substantial funding to address temporary deficit operations. The collapse cut a wide swath in the foreign exchange reserves, and it proved necessary to use some reserves to stabilise the foreign exchange market while the reconstruction of the banking system was underway and solutions to private sector debt problems were being sought. Without enhanced reserves, refinancing of Treasury foreign debt could have proven elusive or even unavailable in coming years if efforts to restore confidence in the global markets in due time should prove unsuccessful. There were numerous indications that the global financial crisis could be protracted, as has proven to be the case. Thus it was far from assured that the global financial markets would become accessible to Iceland in time to refinance foreign loans maturing in 2011 and 2012. The problem was exacerbated by the large króna positions accumulated by non-residents from 2005 onwards. It could be assumed that these investors would sell and, in some cases, would be forced to sell at distressed prices at the first opportunity.