Nov. 2 (Bloomberg) -- Iceland lifted restrictions on new krona investments, moving toward a broader easing of emergency capital controls, after satisfying donors it had made progress on addressing creditor claims stemming from the island’s financial collapse.

The first step, effective yesterday, allows new investors to exchange the proceeds of their holdings for foreign currency, provided the transactions are registered with the financial supervisory authority and the central bank. The second stage, covering capital outflows, may take another year.

“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,” Reykjavik-based Sedlabanki said in an Oct. 31 statement.

The island 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 economy into the deepest decline in the western world since the onset of the credit crisis. The country has since been relying on a $4.6 billion International Monetary Fund-led bailout to stay afloat.

The central bank will also step up efforts to enforce existing controls “with the aim of enhancing consistency and closing loopholes that have been used to circumvent the capital controls,” the bank said.

The country’s restrictions on currency flows have failed to prevent a 12 percent slump in the krona against the euro since the end of March, making it the second-worst performer of the 26 emerging market currencies tracked by Bloomberg in the period.

Claims Resolved

The IMF withheld loan payments until the island resolved creditor claims stemming from its biggest banks, which failed last October after amassing debt more than 10 times the size of the economy. The IMF last week released a $167.5 million tranche, the first transfer since an initial payment last year.

The funds will be used to strengthen central bank reserves as the capital restrictions are scaled back, Economic Affairs Minister Gylfi Magnusson said on Oct. 29.

An additional $625 million was made available to from Denmark, Finland, Norway, Sweden and Poland.

“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.”

‘Impossible to Say’

Reserves stood at 434.7 billion kronur ($3.5 billion) in September, compared with 155 billion kronur two years earlier, when the credit crisis started, central bank data show.

The bank targets removing most of the rest of the controls in a year, Governor Mar Gudmundsson told reporters in Reykjavik on Oct. 31, adding that “it’s impossible to say how many years the capital controls will apply to investments in bonds and derivatives linked to the carry trade.”

The 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.

Gudmundsson said the removal of capital restrictions on new krona investments won’t result in any “major developments” in currency flows, though he added “there is added interest” in investing in the Atlantic island.”

Rating companies including Fitch Ratings had said they were waiting for a resolution of creditor claims and the next review of the IMF before revisiting their ratings on Iceland.

Fitch and Standard & Poor’s both rank Iceland’s long-term foreign-currency debt BBB-, with negative outlooks, one notch above junk. Moody’s rates the sovereign Baa1, three grades above junk.

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

Last Updated: November 2, 2009 00:55 EST