FX market reacts strongly to removal of capital controls

As of noon today, the ISK exchange rate has fallen by 2.9% against the euro and the US dollar and 3.4% against the pound sterling. The drop is due largely to the Government’s announcement yesterday that the restrictions in the Foreign Exchange Act imposing controls on households’ and businesses’ foreign exchange market transactions, foreign investments, hedging activities, and borrowing and lending activities are to be lifted in full. Furthermore, resident entities will no longer be required to repatriate foreign currency. 

Prudential rules remain 

Prudential rules governing carry trade and restrictions on derivatives contracts involving the Icelandic króna will remain in effect following the abolition of the capital controls, owing to the speculative nature of the transactions and the risk that an overhang of offshore ISK will develop. The capital flow management measure (CFM) designed to control inflows will remain in place. Rules on the CFM have been amended to accord with the amended Foreign Exchange Act; however, no changes have been made to special reserve requirements or special reserve ratios. As before, non-residents wishing to invest in domestic bonds or deposits must deposit the equivalent of 40% of the amount invested to a non-interest-bearing account for a holding period of 12 months. 

Agreement reached with offshore ISK owners

An agreement has been reached with owners of offshore ISK , whereby they will sell approximately ISK 90bn to the Central Bank (CBI) at ISK 137.5 per euro. The transactions will reduce the bank’s foreign exchange reserves by EUR 655m, to a net balance of EUR 4.9bn. Other owners of offshore ISK (representing about ISK 100bn) are invited to conclude agreements with the CBI at the same exchange rate within the next two weeks. The treatment of the ISK assets remaining in closed accounts with the CBI after that time will be examined in the coming term.

According to the Ministry of Finance website, at least one owner with a large offshore ISK position has been hesitant to make an agreement at the price others have accepted. It is hoped that a large proportion of other offshore ISK holders will accept the CBI’s offer. The CBI is expected to capitalise a gain of approximately ISK 18bn on these transactions, and potentially quite a bit more if other investors’ respond positively to its offer. 

Task force on monetary policy framework review

Finally, the Government announced today that it had appointed a three-member task force whose role is to find the monetary and currency regime that it deems most conducive in the long run to economic and financial stability, with consideration given to GDP growth, inflation, interest rates, exchange rates, and employment levels. The review will include an assessment of the current monetary policy framework and an analysis of the reforms that could be made so as to retain the main characteristics of the inflation-targeting regime, as well as an analysis of other monetary policy options such as various types of exchange rate targeting; for instance, a conventional peg or a currency board. The aim is that the task force will submit its findings by the end of this year. 

Positive move but a source of short-term uncertainty

The final step now being taken to lift the capital controls centres on restrictions that have not made a major impact on households, businesses, or pension funds in the recent past. It is unlikely that the removal of these controls will result in a significant increase in FX outflows as time passes. It could create uncertainty, however, and exacerbate short-term exchange rate volatility, as early responses from the FX market indicate. That said, we expect the CBI to use its reserves to prevent excessive volatility, as it emphasised at the time of its last interest rate decision.

The step now being taken to remove controls and shrink the stock of offshore ISK is positive for the Icelandic economy in the long run, though, and is a move towards re-establishing normal foreign exchange trading. Over time, it should strengthen the economy, improve Iceland’s sovereign credit ratings, and shore up the króna.

The Government announced the measures yesterday as part of a plan to prevent excessive appreciation of the ISK. Clearly, the Government is concerned that the strong króna may be starting to harm export sectors, and it wishes at least to slow the pace of the appreciation. Further measures aimed at achieving that objective are said to be in the pipeline. Although the authorities did not specify what measures those might be, the Minister of Finance has mentioned that the next steps could be announced later this month. 

Testing ground for monetary policy credibility

The CBI’s Monetary Policy Committee (MPC) is meeting today and tomorrow to discuss its next interest rate decision, to be announced Wednesday. In our forecast, published last Friday, we said that we expect the Committee to hold the CBI’s interest rates unchanged. In our view, today’s ISK depreciation and the near-term exchange rate uncertainty created by the above-described liberalisation measures will provide additional grounds for those MPC members who prefer to keep rates unchanged, in keeping with the Committee's repeated reminders hitherto that steps towards liberalisation give cause for caution in rate-setting.

On the other hand, the Minister of Finance said yesterday that he would like to see the CBI lower its interest rates. Clearly, then, there is political pressure to lower rates. But the now three-year-long episode of inflation at or below target has enhanced the credibility of monetary policy, which depends in no small part on the MPC’s independence in its decision-making. That credibility is never as important as at times like these, when uncertainty about exchange rate developments (a major determinant of inflation) is on the rise.

We believe the MPC will pass the test and decide to keep rates unchanged on Wednesday. We expect that it will prefer to wait and see what impact these most recent steps in the liberalisation process have on near-term exchange rate developments—and, by extension, on the inflation outlook.