31 July 2009

Capital account liberalisation strategy approved

The Icelandic Government has approved a strategy for removal of capital account restrictions, which was prepared by the Central Bank of Iceland in consultation with the Ministry of Business Affairs and the International Monetary Fund. In order to avoid economic instability when the controls are lifted, their removal is carefully sequenced, with each phase dependent upon the fulfilment of specific conditions. Once certain requirements have been met, the implementation of the strategy will begin with the removal of restrictions on those capital movements that are unlikely to cause instability. Other restrictions will not be lifted until this stage of the strategy has been completed successfully. On Wednesday, August 5, 2009, the Central Bank will present the phases of the strategy in further detail.

After the collapse of the banks, there was a substantial risk that the exchange rate of the króna would be under heavy pressure upon resumption of foreign exchange market activity. Therefore, with the amendment to the Foreign Exchange Act in late November and the adoption of the Central Bank of Iceland’s Rules on Foreign Exchange, restrictions were placed on foreign exchange transactions related to certain classes of capital movements. The Government's economic programme, presented to the International Monetary Fund in November, states that one of the Central Bank's most critical tasks in the medium term is to guarantee the stability of the Icelandic króna and to lay the groundwork for its appreciation.

Although the capital controls were necessary to promote the stability of the króna, it is clear that they have various negative side effects. Hence it has been the aim from the outset to lift the capital controls as soon as possible. The formulation of a capital account liberalisation strategy is therefore an important element of the economic recovery programme. Furthermore, the Stability Pact signed by the Government and the social partners provides for such a liberalisation strategy.

In order to remove the capital controls in a gradual, sequenced manner without inducing instability, it is necessary to reduce uncertainty about and create sufficient confidence in the economic programme. Many important steps have been taken in this direction in the recent term. These should make it possible to begin lifting the controls in the next few months. The Government's long-term fiscal consolidation programme entails increased restraint in public sector finances, which should, over time, eliminate uncertainty about the sustainability of public sector debt. Monetary policy has been cautious, and inflation has subsided. The Government and the social partners have concluded the previously mentioned Stability Pact. Important steps have been taken towards the establishment of a strong, well-administered, and appropriately supervised financial system that will be able to sustain volatility upon the removal of the controls. Furthermore, it appears as though, within a few months, the foreign exchange reserves will have been strengthened sufficiently to withstand potential temporary foreign exchange market instability. The capital account restrictions will not be lifted until these preconditions have been met, but the liberalisation strategy assumes that this will have been achieved by November 1, 2009.

As is noted above, the capital controls will be lifted in stages. Restrictions on foreign currency inflows for new investment will be removed first. It will be permitted to move the new capital out of Iceland once again, provided that the new investment has been registered with the Central Bank of Iceland. It is expected that this first stage of liberalisation will have limited or positive impact on the foreign exchange reserves. Upon fulfilment of given conditions, and assuming that the first stage of the strategy is successful, the next phase of the strategy – the removal of restrictions on capital outflows – will be enacted. That phase will be divided into smaller steps that will be described further in the presentation at the Central Bank on August 5.

No. 24/2009

July 31, 2009