Hedge Funds Facing Exit Choice as Iceland Brings `Pot of Money'

  • Bank to solve issue from standpoint of Iceland, its people
  • Central Bank working on measures to cool carry trade

After years of playing hard ball with hedge funds and other creditors, Iceland’s central bank chief is feeling a bit more generous.

The authorities are designing the final step in freeing the last of the investors trapped behind country’s seven-year-old capital control regime. And for the first time Iceland is putting its foreign exchange reserves on the table, but the exit door is still anticipated to be narrow.

The auction will be “bidding for a pot of foreign exchange, on the one hand, or taking a long position, on the other,” Governor Mar Gudmundsson said in an interview Friday in Reykjavik. “And if everybody wants to leave, and everybody bids for the pot, then, of course, the exchange rate in the auction will be low.”

The auction, which is being set up to free about 291 billion kronur ($2.2 billion) held by investors in old so-called glacier bonds, is the last hurdle to vault before the country can also start loosening controls for households and corporations. Iceland imposed restrictions on the krona in 2008 after its largest banks collapsed under an $85 billion mountain of debt.

Iceland’s premier, Sigmundur Gunnlaugsson, in an interview last week, said the investors should prepare themselves to accept a “reasonable price” to exit the controls. While the central bank is “graciously” putting its own balance sheet to work, the governor also said that the investors can hardly expect current on-shore exchange rates.

“You could say it’s a haircut relative to leaving through the onshore foreign exchange market,” he said. “That’s not on offer for them now and never will be.”

In the end, Iceland its tackling the issue from “the standpoint of solving the problem for Iceland and for the population,” he said. “So we’re able to lift capital controls and normalize our relations financially with the rest of the world.”

And the world has been warming up to Iceland again. In fact, the country is once again seeing increasing inflow from investors seeking to profit from its higher interest rates. To cool inflation, Gudmundsson has raised the benchmark interest rate three times since last June, hitting 5.75 percent, even as rates hover near zero or lower in much of the rest of western Europe.

The krona rose 0.3 percent to 141.12 per euro as of 2:33 p.m. local time. It has risen almost 8 percent over the past 12 months.

New Measures

The bank is now working on rules to get a better handle on the fast money, which was partly to blame for the collapse in 2008. These measures could include reserve requirements or a tax and may be designed so that they can be switched on and off, according to the governor.

The carry trade “is not a financial stability issue at the moment,” he said. “It’s mostly to do with the transmission of monetary policy where the induced carry trades are forcing the transmission mechanism toward the exchange rate channel.”

The emergence of the carry trade has strengthened the krona and pushed down long-term interest rates, at the same time as the bank is seeking to raise rates to cool inflation.

Iceland has seen a “very significant increase” in terms of trade and is “importing deflation from the rest of the world,” Gudmundsson said. This means that the economy’s ability to handle wage increases has increased, he said.

“We’ve said ourselves that these developments have meant that we didn’t have to go as fast up and possibly not as high as was envisaged, say, last spring,” he said.

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