Abstract
This paper provides an assessment of the economic conditions, outlook, and crises in Iceland. There is a mounting sense that capital controls hurt growth prospects, repressing local financial markets, scaring foreign investors, and impeding savings diversification, and that it is time for them to go. Recent settlements with the bank estates are a huge step forward, improving already favorable macroeconomic conditions. At 4 percent in 2015 and gaining pace, real GDP expansion is among the fastest growing in Europe, opening up a positive output gap. However, the biggest risk for Iceland is overheating. Large wage awards on top of already hot economic readings speak to Iceland's boom-bust history.
This supplement updates the staff report (SM/16/126) and appraisal.
On June 2, 2016, the Althing legislated to permit the imposition of a reserve requirement on selected capital inflows. Amendments to the Foreign Exchange Act vest such authority in the Central Bank of Iceland (CBI). Selected flows may be subject to a reserve ratio of up to 75 percent, with the resulting reserve amount to be deposited, for a holding period up to five years, in a deposit institution in Iceland. The deposit institution, in turn, shall deposit such amount in a reserve account at the CBI.
On June 4, the CBI issued rules activating the tool, which was announced as a capital flow management measure (CFM). The reserve base, as further detailed, comprises foreign currency debt flows entering Iceland after June 4, most of which come through the New Investment Route introduced in late 2009 (these inflows are issued with “yellow tickets” exempting them from capital controls). The special reserve ratio is set at 40 percent, the holding period at 12 months, and the interest rate on the reserve accounts at the CBI at nil. FDI, investments in listed and unlisted equities and in real estate, and flows restricted under the capital control regime are unaffected.
The stated purpose of the action is to curb incentives for a new carry trade. By taxing inflows, in effect, the authorities seek to temper them and influence their composition, thereby reducing risks to macroeconomic and financial stability. Iceland has telegraphed that, while it remains committed to lifting capital controls, it shall do so on its terms—its priority is not foreign investment in a shrinking stock of public debt, but rather steps to let out bottled up domestic savings, consistent with the current account surplus. Seeing no sign of overlap between yellow ticket and FDI investors, the authorities assess the impact on TFP enhancing inflows to be limited.
On timing, the authorities point to bitter past experience and argue an ounce of prevention is better than a pound of cure. Characterizing recent inflows as significant, they apprehend also that legacy offshore króna investments that exited via the CBI’s auction could return using the yellow ticket route, replacing an immobilized overhang with a dynamic and potentially flighty one, complicating the liberalization of capital controls on residents. The auction has thus been one factor driving their timing.
The authorities have also been candid that there is a monetary policy dimension. The recent capital inflows have hurt transmission to long-term rates. The CBI Governor has argued for tools aimed at giving monetary policy more room for maneuver, informing that work was underway to ready measures to temper inflows that, inter alia, interfere significantly with the domestic interest rate channel of monetary policy transmission.
Staff also considers the reserve requirement a CFM as defined in the Fund’s Institutional View. Staff had noted circumstances could arise where CFMs form part of an efficient policy response in Iceland, and had pointed the authorities to the Institutional View. The guidance therein emphasizes the central role of macroeconomic policies in managing the risks associated with inflow surges, yet notes CFMs can be useful in certain circumstances. Such measures, if used, should be transparent, targeted, temporary, and nondiscriminatory and should not substitute for warranted macroeconomic adjustment.
With the Institutional View envisaging the use of CFMs in the context of inflow surges, staff sees no compelling reason for having activated the tool now. Although the policy objectives are clearly communicated, fundamentally, there is no inflow surge at present. Recent inflows have been modest and centered on the Treasury bond market. With credit growth subdued and with no obvious signs of credit fueled asset price pressures, serious financial stability risks are not currently in evidence. In the absence of an inflow surge, it is difficult to form a definitive assessment of the room to adjust macroeconomic policies, not least because the macroeconomic outlook may change with inflows. While it is clear that inflationary pressures argue against any lowering of the policy rate at the current juncture, there may be some room for further appreciation of the króna given an external position that is broadly consistent with fundamentals, and for further reserve accumulation in tandem with the planned liberalization of outflow controls on residents. Staff also notes that the tool, with its long holding period, looks to be a permanent part of the toolkit, and advises greater clarity on the exit strategy.
Capital Flows: Then and Now
Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A003
Sources: Bloomberg; Central Bank of Iceland; and IMF staff calculations.Separately, the latest national account and price data are consistent with staff’s baseline projections. Real GDP expanded by 4.2 percent y/y in Q1, with domestic demand surging 8.3 percent y/y, led by private consumption (up 7.1 percent) and fixed investment (up 24.5 percent). CPI inflation was 1.7 percent in May, with inflation excluding housing coming in at 0.3 percent.
