Lifting of Capital Controls in Iceland – What Will Happen?
Capital controls were enforced in Iceland under extreme economic distress in the wake of the financial collapse in October 2008. The right time to lift the controls has been under debate for some time, however with economic conditions dramatically improving over the past years and projections indicating further improvements, time has finally come to open the doors. The ground has been prepared – but how will the market be affected? First, let us look at the facts.
1) Economic indicators look good. Just over 4% economic growth is forecast this year and around 3% in 2017 and 2018. The outlook is better than in most developed countries. Iceland‘s external position is more favorable than it has been for half a century. At the end of last year, the net external position was negative by 14% of GDP, a better position than the average in the OECD countries and further improvements are on the horizon. The Central Bank‘s scheduled auction of offshore ISK is expected to have a positive impact as well. Furthermore, it is estimated that the cumulative surplus of foreign trade over the next three years will amount to 9% of GDP. Thus it is possible that the net external position will be positive within a few years.
2) Resilient and flexible economy. Recent years‘ strong economic growth combined with a positive outlook point towards a flexible and adaptable future. The economy‘s adaptability has without doubt affected investment decisions of all investors looking towards Iceland, foreign or domestic. Unquestionably, external conditions have also been favorable. Falling commodity prices and low foreign inflation have so far kept inflation under control, despite rising domestic wages. Iceland has been trendy among tourists, not least because of the attention received in the wake of the Eyjafjallajökull volcanic activity. In recent years, annual export revenues of the tourism industry have increased surprisingly fast in a very short time. Robust tourism companies have been established and existing ones have been substantially strengthened. Looking at the labor market as a whole, the number of employees is now nearly 30 thousands greater than four years ago, a 17% increase.
3) A growing confidence in the Icelandic economy. In recent years a growing confidence in the Icelandic economy has materialized through factors such as rising credit ratings. Furthermore, the credit ratings of the commercial banks have been raised, their debts‘ interest premia have fallen, and they have increased financing from abroad. There has been a considerable influx of foreign capital into the bond market since the government‘s announcement of lifting of capital controls as well as the creditors‘ declaration in June 2015. Thus, non-resident holdings of Treasury bonds and bills increased by 66 billion ISK from end of May, thereof 12 billion ISK during the first two months of this year.
Conditions for lifting the capital controls are thus favorable. But what will happen when they are removed?
1) A turning point for growth companies. They will increasingly be able to finance themselves domestically for overseas growth. The limited possibilities of these companies to obtain capital from domestic investors for growth abroad under capital controls has hurt the companies themselves, investors and the economy in general. Without constraints on capital movement we can expect more growth companies to enter the stock market in the near future, including small innovative companies. As a consequence, the stock market should be able to support the economy more effectively by increasing productivity and creating jobs and thereby raise the standard of living.
2) More diverse investment alternatives on the market. The public has increasingly found its way onto the market, particularly through mutual funds. It is likely that with a diverse spectrum of businesses on the market, individual investors will become more active.
3) Increased participation of foreign investors in the stock market. Currently holdings by foreign investors in listed Icelandic companies are about 18% of the total market capitalization. The lifting of capital controls could facilitate access to capital for Icelandic businesses as well as support efficient price formation in the stock market.
4) The pension funds will have more diverse investment alternatives. The pension funds will be able to increase their foreign investments, which is a healthy option for them to have in terms of more diverse investment opportunities and risk mitigation. However, given the economic outlook and local investment opportunities it is likely that the Icelandic market will still play a large role in their portfolios. There are concerns that free in- and outflow of capital could cause market disruptions, however these risks can be mitigated with sound economic policy and prudential rules for the financial system as well as more specific measures, such as the Central Bank‘s intervention and emergency brakes on capital inflow in the form of reserve requirements or taxes.
To summarize, the removal of capital controls will undoubtedly contribute to a more robust market, diversification by businesses and investors, a more active dialogue and efficient price formation on the market. It will open up a new channel for capitalization through the stock market, which in turn will be beneficial for growth companies and the economy at large.