Iceland’s Carry Trade Trauma Shapes New Currency Regime Limits

Iceland is about to exit its capital controls, but it probably will never go back to a full, free-floating currency, Finance Minister Bjarni Benediktsson says.

Bjarni Benediktsson on Aug. 24,

Photographer: Arnaldur Haldorsson/Bloomberg

One of the key lessons of the 2008 financial meltdown was never again to create an environment in which offshore investors can take advantage of the island’s higher interest rates just to turn a quick profit. Anyone who wants to invest in the island needs to have a longer-term interest in its economic future, he said in an interview in Reykjavik on Wednesday.

The currency inflows that Iceland is seeing at the moment “are challenging,” said Benediktsson, who’s head of the Independence Party and faces an election in October. “The krona has gained considerably over the last two years.”

As Iceland navigates the final stages of its exit from eight-year-old capital controls, it’s already adjusting policy to ensure its currency and financial markets don’t take a hit. The central bank on Wednesday cut its benchmark interest rate for the first time since late 2014. But even after shaving 50 basis point off its benchmark, Iceland still boasts western Europe’s highest policy rate, at 5.25 percent.

The “challenge” now is to find a “good balance for the krona in an open market,” Benediktsson said. “When I talk about stability, I’m talking about treading a path towards releasing capital controls and at the same time maintaining lower interest rates, sustaining low inflation, high employment numbers, and Iceland’s overall competitiveness.”

That means the investors won’t again see the completely free flows that whipsawed Iceland’s krona during its 2008 crisis, he said.

“We won’t have capital controls of the kind that we’ve had since 2008," said Benediktsson. "Macro-prudential tools are neither capital nor currency controls. But I don’t believe that we will have the same fully, freely floating krona. That wouldn’t be prudent.”

The curbs that Iceland will impose to protect its currency will mostly be in the form of macro-prudential measures, according to Benediktsson.

The government in June imposed new rules designed to limit the inflow of fast cash, setting requirements for new offshore investors that included keeping 40 percent in reserve accounts in the island for at least one year. The requirement targets bonds and deposits.

“These are tools that I foresee that we’ll have to rely on,” he said. “If you do all of those things, you don’t have to worry as much about the currency being more freely traded than under the controls that we’ve had. At the end of the day we do want the currency to reflect what’s happening in the economy.”

Whether he’ll have to worry as finance minister after the Oct. 29 election is up to the voters. Benediktsson and his coalition partner, the Progressive Party, are backed by only 36.1 percent of the voters, challenged by the upstart Pirate Party at 25.3 percent, a Gallup poll showed last month. The Independence Party was the biggest at 26.2 percent.

For more on the Iceland election see here.

“I think most Icelanders agree today that the regained stability that we’ve enjoyed throughout this election period is of great value for everyone, and maintaining stability is what matters going forward,” he said.

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