Oct. 31 (Bloomberg) -- Iceland will begin lifting capital controls from tomorrow, freeing new investors from restrictions imposed after the collapse of the island’s banking system and the plunge in value of its currency, the central bank said.

The decision means foreign-currency inflows linked to new investments will be exempt from the controls, the bank said in a statement in Reykjavik today.

“Investors are authorized, without restrictions, to convert into foreign currency the sales proceeds from assets in which they invest after Nov.1,” the bank said in the statement. “Previously, non-residents were fully authorized to transfer foreign currency deriving from interest and dividends on investments in Iceland.”

The central bank imposed the restrictions at the end of last year after the failure of its largest banks prompted a sell-off of the krona and plunged the island’s economy into a recession, forcing the government to seek a $4.6 billion International Monetary Fund-led bailout. Even after controls were introduced, the central bank raised the key rate to a record 18 percent, before lowering it to 12 percent in June.

“The capital controls imposed on Nov. 28, 2008, were considered necessary in order to stabilize the economy in the wake of the financial crisis that struck Iceland in October 2008,” the bank’s statement said. “The conditions necessary for the initial stage in removing the controls, in accordance with the capital account liberalization strategy presented by the Bank on August 5, 2009, have now developed.”

The second stage of the lifting of controls will target foreign-exchange outflows.

Next Phase

“The next phase of capital account liberalization - the removal of restrictions on capital outflows - will be determined by the success of this phase and the progress made under the macroeconomic program,” according to the statement.

Today’s decision comes two days after Iceland completed a review of its economic program with the IMF. Upon completing the review the IMF disbursed $167.5 million to Iceland, and an additional $625 million were made available to the north Atlantic island from Denmark, Finland, Norway, Sweden and Poland. The funds will be used to strengthen Iceland’s reserves as the capital restrictions are scaled back, Economic Affairs Minister Gylfi Magnusson said on Oct. 29.

“It was clear we needed it to strengthen our reserves, prior to abolishing the capital controls,” said Magnusson. “Without the funds, abolishing the restrictions would have taken longer.”

Opportunities

The central bank’s main challenge is to “find opportunities to bring down interest rates with domestic economic circumstances in mind without putting pressure on the exchange rate of the krona and at the same time start the process of removing capital controls,” said central bank Governor Mar Gudmundsson on Aug. 25.

All restrictions on capital flows will be dropped in two to three years, the then interim Governor Svein Harald Oygard told reporters in August.

Iceland’s economy will contract 9.1 percent in 2009 as household spending falls 19.7 percent and investment slumps 48.4 percent, the central bank said on Aug. 13.

To contact the reporter on this story: Omar R. Valdimarsson in Reykjavik valdimarsson@bloomberg.net.

Last Updated: October 31, 2009 06:16 EDT