Removal of Iceland's capital controls brings new opportunity — and old risks

The lifting of Iceland's last capital controls opens the way for the island's pension fund community to invest abroad and provides more flexibility and a better trading environment for the country's restructured banking sector.

Economists have, however, warned that while the liberalization of capital flows is a reminder of the immense scale of the country's post-crisis recovery, it also brings with it possible currency volatility and the risk of the economy overheating again as it did prior to 2008.

The announcement by the Central Bank on March 12 was the final step in the removal of controls that had been in place since 2008. The bank had already removed significant restrictions for individuals and companies in October 2016 and in January, with this final leg eliminating controls for pension and investment funds.

"This marks the end of a very long recovery phase after the shock of 2008/9," said Jakob Christensen, chief analyst at Danske Bank. "It is an important benchmark for the country."

The state remains heavily involved in the banks owning a majority share of Landsbankinn hf., the successor to the insolvent Landsbanki. These stakes are expected to go under the hammer in the coming years and capital liberalization is seen as a precursor to these sales given the government is likely to want to encourage foreign investment.

The economists are in agreement that the time is right — if not overdue — to remove the controls even if the memory of the crisis remains somewhat alive. "The worry is you could see the economy exhibit some of the overheating you saw in the run-up to the crisis in 2008. This is the challenge for a small open economy — with an open capital account there is the risk of destabilizing capital inflows," said Christensen.

The ending of capital controls is, perhaps, not surprising in light of Iceland's thriving economy. On the back of a tourist boom, the country reported GDP growth of 11.3% in the fourth quarter of 2016 while the current account was in surplus by 8% for the whole year — up from a trough of about 25% at the depths of the crisis.

The decision has more than just symbolic meaning too. "It's a game changer," said Sölvi Blöndal, a fund manager and the head of economic research at Icelandic asset manager Gamma. "Pension funds and institutional investors can once again move money abroad.

"In the long run, that's very positive for the Icelandic economy," he said.

Iceland's relatively small economy means there are a limited number of opportunities to invest domestically and the central bank has previously pointed to signs of pent-up demand from the sector for overseas investment. This view was echoed in a note published March 15 by Capital Economics that points out that after nine years of being forced to invest at home only, funds will probably be keen to diversify.

"Returns in Iceland are high when compared with the rest of Europe," Stephen Brown, an economist at the research group and the author of the report, explained in an interview. "But pension funds have a large concentration of funds in Icelandic assets and it makes sense to diversify," he said.

Following the announcement, the krona saw its sharpest fall since the financial crisis, tumbling by as much as 3.3% against the euro and 3.6% against the dollar, before retracing some of its losses.

However, with Iceland's key seven-day term deposit rate at 5%, the country is likely to see higher inflows in the medium term, and the central bank has taken serious steps to discourage the flow of hot money. This is mainly through a capital management tool that requires foreign holders of liquid assets to invest in a noninterest-bearing account.

"There may be some turbulence in the currency market," said Blöndal, noting that the tourism boom that will see some 2.6 million people visit the island nation this year will further support the krona.