Hedge Funds’ Fast Money Not Welcome as Iceland Bolsters Defenses

  • Iceland clamps down on carry trade to limit capital inflows
  • Islands higher interest rates won’t disappear overnight

Iceland has gone its own way since its three largest lenders collapsed in 2008 under a mountain of debt almost eight times the size of its economy. The steps included capital controls that locked in hedge funds, mortgage writedowns and throwing bankers in jail.

With the recovery well under way, the island nation -- once a hedge fund paradise -- is continuing on its isolated path. Lawmakers have effectively outlawed the kind of trade that inflated the bubble a decade ago, protecting against a repeat. Surrounded by sub-zero interest rates, Iceland’s benchmark gauge of 5.75 percent, the highest in the developed world, is luring cash from abroad.

That’s unlikely to change any time soon.

“The problem is the ability to have an independent monetary policy and an independent monetary policy means the ability to have a different interest rate than the rest of the world,” central bank Governor Mar Gudmundsson said in an interview in Reykjavik on Monday. “If that’s not possible, then you can’t have an independent monetary policy. And the problem of very significant interest rate differential -- interest rates in Iceland are higher than the rest of the world -- will not disappear overnight."

Both geographically and financially Iceland is a small island in vast, turbulent waters.

Under the law enacted last week, the central bank over the weekend set rules that will force investors in Icelandic bonds to keep 40 percent of their investments in a zero percent account for a year. That will limit the profit to be made from investing in Iceland, where government bonds offer yields of more than 6 percent. Those type of returns are tempting in a world of near zero and even negative key rates.

As evidence, the Icelandic krona has strengthened this year even as the central bank has been selling the currency to build up foreign holdings as it prepares to lift the capital controls that have been in place since 2008.

But the country may have seen nothing yet, according to the governor.

The new rules are a “precautionary” measure to stifle any major flows after the controls are lifted, he said.

“There have been certain inflows in the last few months,” he said. “We thought there was a possibility of much greater inflows going forward, especially if the auction goes well and we take further steps to liberalize the capital account and the economy is booming and interest rates are high.”

Gudmundsson is planning for a June 16 auction to allow creditors -- mostly hedge funds -- holding about $2.4 billion in krona debt sold before the 2008 crisis to exit. These are the remnants of the fast money that flowed into the island that ended in the collapse of its three largest banks. The bank is offering to buy back the so-called Glacier bonds at a discount of 36-50 percent to the current onshore krona exchange rate.

Iceland has also settled with creditors affected by the $85 billion default of its three biggest banks after keeping them locked in for more than seven years.

Regardless of the outcome of the auction, the nation will move ahead with doing away with capital controls for consumers and corporations this year, according to Gudmundsson.

“We’re going to neutralize the rest of the economy from the offshore kronur and then start to liberalize capital flows for domestic residence, irrespective of whether the turnout is high or low,” he said. “So it’s for them to decide. We’re putting a lot of foreign currency on the table."

Before it's here, it's on the Bloomberg Terminal. LEARN MORE