How Iceland was shocked when IMF endorsed capital controls

Arnór Sighvatsson, Deputy Governor of the Central Bank of Iceland gives an interesting speech talking about the topic.

At the eleventh hour, just prior to the collapse of the banking system, it did not remotely occur to me that signing exemptions from rules significantly restricting the rights of residents to trade in foreign currency could become one of my responsibilities. Admittedly, it had been mentioned on several occasions, in meetings with foreign bankers and investors during the weeks and months leading up to the collapse, that they were of the opinion that capital account restrictions were among the conceivable measures that Icelandic authorities could apply in the dire straits into which the Icelandic economy was clearly headed.

When I was asked whether capital controls could be considered, in the difficult situation that had arisen, I naturally replied in the negative, with reference to the international agreements Iceland had signed – any other answer would have been risky.

Even less did it occur to me that the IMF would endorse capital controls as a key factor in an economic strategy for the reconstruction of Iceland’s financial system and economy, as the Fund has often been criticised for encouraging premature removal of capital controls in many countries around the world.

The capital controls are controversial. Other routes were considered but eventually rejected as too risky. The necessity of temporary controls now appears to be generally recognised, and support for them appears to have grown, so much so that this actually gives cause for some concern. There are likely two reasons for this. In the first place, many people appreciate the exchange rate stability they have brought – that is, after their tightening started to have some effect. Second, this change in attitude may indicate that a certain group has benefited to some extent from the controls, which prompts me to conclude that it is desirable to begin lifting them as soon as is practicable, but without jeopardising stability. To find our way out of the capital controls, we must understand the reason they were imposed.

Read the speech why capital controls were implemented in Iceland (because of capital flight and shapr depreciation of Iceland Kronor). Though he adds they need to be lifted as soon as crisis eases.

Since the controls were tightened, they have contributed to greater exchange rate stability than has been seen for a long time, albeit at a lower level than is desirable. This stability has facilitated implementing economic policy. It therefore comes as no surprise to hear the view expressed that the capital controls should be maintained on a more permanent basis. This is not as attractive an option as might appear at first glance, however. In the first place, liquid capital cannot be kept here forcibly for an indefinite period of time. The controls are a violation of various international agreements signed by Iceland. They are tolerated as long as Iceland follows the economic Recovery programme supported by the IMF, and thus indirectly by the member states of the EEA, OECD, and the Fund itself. Soon after this programme concludes, the controls will likely have to disappear; i.e., if the Icelandic government does not wish to renege on international treaties it has ratified.

It has been quite a turnaround on both Iceland’s economic outlook and capital controls. The former’s status reversed from a fashionable economy to a poor performing one and latter came into fashion big time. First IMF, then various emerging economies and recent ADB report also suggests capital controls could be tried. Though they say it should be a temporary measure but still is quite a change.

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