The bond market reacts to measures to relax capital controls
Recently the Icelandic government and the Central Bank have taken decisive and long-awaited steps designed to facilitate the lifting of capital controls. On May 22 Parliament passed into law a bill laying the groundwork for a foreign currency auction for offshore krona owners. Two days later the Central Bank announced such an auction that subsequently took place on June 16. The Central Bank has noted that this was the last FX auction for offshore krona owners before the process of lifting the controls on residents begins.
On June 2 Parliament passed into law another bill which grants the Central Bank the authority to set rules stipulating a reserve requirement for certain new capital inflow, primarily into bonds, bills and bank deposits. This legislation is intended to give the Central Bank tools to reduce the risk of destabilizing short-term capital flows.
On June 4 the Central Bank followed up on the new legislation by setting Rules on Special Reserve Requirements for New Foreign Currency Inflows. According to the rules the reserve ratio on the new inflow in question is set at 40% with a holding period of one year and the interest rate on the reserves set at 0%. The reserve requirement rules provide a strong disincentive to short term investments in bonds, bills and bank deposits motivated by interest rate differentials as the 40% ratio takes a significant bite out of returns in the short run. However, as the investment horizon becomes longer the less is the impact on average yearly returns.
The two laws and the associated Central Bank action were met with a contrasting response in the bond market. Following the offshore krona legislation and the Central Bank’s auction announcement, 5 and 10-year (nominal) yields fell by about 20 basis points in active trading. The positive reaction by market participants may have been caused by expectations that the legislation would facilitate the normalization of capital flows. The modest size of the reaction might be due to the fact that the market had been anticipating an offshore krona auction around this time for a while, although its terms were not previously known. The Central Bank’s Governor said, for instance, in his speech at the Bank’s AGM on March 17 that the intention was to hold the auction in the first half of the year. In the auction that took place on June 16, the Central Bank accepted offers in the amount of ISK 72 billion out of ISK 178 billion offered for sale in the auction. For comparison the amount of offshore krona assets has been estimated at ISK 319 billion. Thus, less than one quarter of offshore krona assets were sold for foreign exchange in the auction. However, following the auction results, the Central Bank offered to purchase offshore krona assets not sold in the auction at the auction exchange rate (ISK 190 per EUR) provided such requests are received by 10am on June 27. The reaction in the bond market to the auction results was limited with yields little affected.
The reserve requirement legislation was not a total surprise either. In fact, the Central Bank’s Governor alluded to it as one option in the aforementioned speech and noted that it could be argued that “policy instruments [that can be applied to curtail carry trade-related capital inflows] should be on the law books by the time the auction of offshore kronur takes place”. The impact of the legislation was, thus, also modest and to largely offset the yield decline in the wake of the enactment of the offshore krona legislation.
On the other hand, the Central Bank’s immediate use of the new policy instrument apparently took the market by surprise and yields shot up by further 40 basis points in heavy trading in the first two trading days after the rules were enacted, making the combined impact on yields of the reserve requirement legislation and the rules 50-55 basis points. The chart below shows 5- and 10-year yield developments (using the implicit yield on Nasdaq Iceland’s 5- and 10-year bond indexes) from May 20 (the last trading day before the offshore krona legislation) through June 22 (the first trading day after the offshore krona auction results were announced).
Interestingly the ISK exchange rate has not been much affected by recent events. It is possible that the Central Bank mostly neutralized any potential impact although this is not known (in May the Central Bank’s share of trading in the Icelandic FX interbank market was 59.3%).
It is worth emphasizing that equity investments, including those in shares listed on Nasdaq Iceland, are generally not subject to the special reserve requirements.
Yields on Nasdaq Iceland’s 5- and 10-year nominal bond indexes
