Iceland's Capital Controls and the Resolution of its Problematic Bank Legacy
34 Pages Posted: 5 Jul 2017
Date Written: July 3, 2017
Iceland’s capital controls were imposed in October 2008 in order to prevent massive capital flight and a complete collapse of the exchange rate. The controls were in place for more than eight years, primarily because of the risk of large outflows of domestic holdings of the failed Icelandic banks. As argued in a precursor to this paper (Baldursson and Portes, 2014), significant restructuring of domestic holdings of foreign creditors of the banks was required before the controls could be lifted. Such a restructuring was finally accomplished in January 2016. Broadly in line with the recommendations of Baldursson and Portes (2014), the resolution involved a voluntary – in much the same sense as the Greek debt restructuring was voluntary – restructuring of the banks’ debt, under which most of the Icelandic krona assets of the banks were relinquished to the state or tied up in Iceland. An attempt at resolving so-called ‘offshore kronas’ – the remains of the carry trade into Iceland in the years before the 2008 crisis – failed resulting in a dispute with international investors. We model the strategic interaction between Iceland and creditors on the resolution of the failed banks as well as the interaction between Iceland and investors on the resolution of the offshore krona holdings. The model explains why the bank resolution was successful and why the offshore krona auction was not. Resolution of the old banks will cut Iceland’s public debt, but it will still be substantially higher than before the crisis. The net international investment position of Iceland has, however, turned positive and is stronger than it has been in decades. In March 2017, the capital controls were removed in practice, albeit not by statute. Inflow measures remain.
Keywords: capital controls, cross-border banking, Icelandic banks, resolution of failed banks
JEL Classification: E58, F31, G21
Suggested Citation: Suggested Citation