How Effective Were Capital Controls in Iceland?
It is difficult to establish with any certainty the impact of the capital controls on Iceland’s recovery, given the difficulty of determining the coun- terfactual—what would have happened without the controls? Krugman (2015) , for example, attributes the rapid recovery in employment in Iceland, compared with, for example, Ireland, to the fact that the krona did depreciate, whereas Ireland is a member of the Eurozone and could not, therefore, benefit from a depreciation of its currency. However, if we were to consider time-series data for Iceland, we would find that the imposition of capital controls was associated with a depreciation, rather than an appreciation, of the krona, as might have been expected. The problem is the counterfactual that without capital controls, the rate of depreciation would have been catastrophic and the controls prevented this.
Nevertheless, Iceland made a remarkable recovery from its ‘near-death experience’. By 2015, inflation had been tamed, full employment had been restored and public debt had been greatly reduced, with the budget deficit eliminated. The only cloud on the horizon was the large nominal wage increases that were in the pipeline, due to Iceland’s largely collective bargaining system. The current account had moved back into surplus, initially as the result of the collapse of demand, but, consequently, tourism emerged as a significant foreign exchange earner with the depreciation of the krona. Nevertheless, in spite of this rapid recovery, the level of per capita income was below that of the other Nordic countries (Yglesias 2015).
It is interesting to note that the OECD (2015), like the IMF, now also advocates the selective use of capital controls “to address large swings in capital flows unrelated to fundamentals, while respecting international commitments” (p. 11).
We may distinguish two ways of viewing the use of capital controls. The CBI and IMF view is that the controls should be relaxed gradually, after preventing a total collapse of the currency: They would provide a cheap way of financing the budget and the cost would be shared between residents and non-residents, with the larger burden falling on the latter. The financial repression effect of capital controls enabled Iceland to experience a sharp fall in public debt yields from 2008 onwards (Carmona 2014 , p. 490). This is similar to the ‘policy space’ argument of Grabel (2013, 2015). Capital controls enabled some macroeconomic policies to be carried out that might not otherwise have been possible, with the need for, say, very high interest rates, to try to prevent the uncontrollable depreciation of the currency. It is also similar to the ‘buying time’ approach identified by Carmona (2014, p. 496), with the exception that in this case capital controls lasted longer, to a certain extent ossifying ineffective policies that they were meant to be replaced.
The second view was that the controls should have been lifted as soon as possible even at the risk of some dislocation in the financial market. This is because Icelandic companies need access to foreign markets and its influential fishing industry wished no imposition of controls on where it could spend its foreign exchange earnings. Investment may be reduced, not least by the possibility that capital controls may be introduced in the future, thereby generating uncertainty. This view sees Iceland’s future as lying in the European Union and the euro area and its proponents were dismayed when the government abandoned its application for membership. It is shared by most neoclassical economists because of the supposed serious price distortions and the misallocation of resources that exchange controls bring with them. There is also concern that the failure to lift capital controls will increase the disparities in wealth. The CBI holds auctions where owners of foreign currency can buy krona at a good discount, compared with the separate auctions for domestic residents, and then the foreigners can use the krona to buy up Icelandic real estate and other assets.
Much discussion of capital controls focuses on curtailing destabilizing capital inflows, especially if there is speculative or herd behaviour (Ostry et al. 2010). Clearly, with the benefit of hindsight, there should have been some restriction on these flows into Iceland prior to the crisis. However, as they were part of, and indeed the cause of, the rapid growth of the banking sector, no concern was expressed, not least by the understaffed and ill-equipped FME or the CBI. When the crash came, the IMF saw no alternative to capital controls, particularly with regard to outflows. Sigurgeirsdottir and Wade (2015) express concern that the government did not use the breathing space given by capital controls to “strengthen the financial system’s prudential controls and carry through other institutional reforms” (p. 126) with a view to entering the EU. However, the OECD (2015) is more optimistic considering that “the Icelandic authorities are already at—or close to—the international frontier in prudential regulation” (p. 25). Worryingly, Sigurgeirsdottir and Wade (2015) note that there may be a tendency to backsliding with recent greater political interference in the governance of the banking system and a return to rent seeking. Prior to 2009, monetary policy was set by three politically appointed governors who were then replaced by a board of experts. The OECD (2015) bluntly states that “To protect macroeconomic stability the central bank should remain independent from political interference. The monetary policy committee introduced in 2009 should be retained” (p. 23).
But we agree with Sigurgeirsdottir and Wade (2015) when they argue that the Icelandic case has undermined the view that a rapid growth of capital inflows is a sign of a strong economy (typified by the question, why else would investors move their money there?) and any restriction is likely to only produce both microeconomic and macroeconomic distortions. Indeed, now the opposite is the case. Large inflows of short-term foreign capital (as opposed to FDI) can well be the harbinger of a damaging currency crisis.
Nevertheless, there was not unanimity about the appropriateness of introducing capital controls in Iceland. An alternative view is presented by Danielsson and Kristjansdottir (2015) who subscribe to the orthodox objections to capital controls. Capital controls should not have been used. They assert that it leads to a deadweight loss of one percent of GDP per year in Iceland. The imposition of capital controls destroys trust in the Icelandic financial system (although one may legitimately ask whether there was any trust left in 2008) and may lead to a significant risk premium in future years. “Thus capital controls do not only undermine the long-term health of the Icelandic economy, in the long run they also undermine their own objective of maintaining the exchange rate.” They further express the opinion that capital controls give more powers to the government, through exemptions, and so on, that allow rent seeking, a not unreasonable concern given Iceland’s post-war history when there was a great deal of rent seeking prior to the crisis.
Let us consider the static misallocation of resources argument. The one percent of GDP, even if it is correct and it is not clear how they arrive at this figure, has to be set against the possible disastrous consequences of a free-falling currency, as occurred to the Indonesian economy as a result of the collapse of the rupiah in the 1997 Asian crisis. But is there any evidence that capital controls in a world of path dependency, financial crisis and increasing returns to scale actually led to a major misallocation of resources in Iceland? Certainly, there is little evidence that financial liberalization leads to a significant increase in growth.
A number of studies of the effect of financial deregulation and capital liberalization show that generally this improves stock market efficiency in the allocation of capital resources to the most productive sectors of the economy (see the references in Graham et al. 2015). However, it does not necessarily follow that in periods of economic crisis, such as Iceland went through, the imposition of capital controls necessarily reduces stock market efficiency. The counterfactual is that the failure to impose capital controls with the likelihood of economic meltdown may actually considerably worsen the efficiency of the stock market.
Graham et al. (2015) test the weak form of the efficient market hypothesis for the Icelandic stock market over this period. The weak form is that over time the returns to shares will follow a random walk. The conventional wisdom is that, given the usual assumptions, the imposition of cross-border capital controls would make the Icelandic stock exchange less efficient. Hence, the paper looks at the effect of this policy on the efficiency of the Icelandic stock market. As an attempt to test for the counterfactual, they also test the weak-form stock market efficiency hypothesis for Denmark, Finland, Norway and Sweden, using data for the period 1993-2013. They concentrate on the periods January 1993 to December 1994 and October 2008 to December 2013 for Iceland, when there were capital controls in Iceland, and from January 1995 to October 2008, when there was not. Interestingly, the authors find no evidence in Iceland of weak-form efficiency in the period of deregulation, but that, perhaps paradoxically, the period of capital controls actually improved the efficiency of the stock market (the other four Nordic countries showed greater weak-form efficiency over this period).
What are the implications to be drawn? One possibility is the widespread manipulation of the stock prices in the period of deregulation did not improve the efficiency of the stock market, but worsened it. The crash brought an end to the stock market manipulation, especially in the shares of the banks, and consequently, under capital controls, the efficiency of the stock market increased. It may not necessarily be the case that the imposition of capital controls improved stock market efficiency, per se, but their effects were not adverse enough to worsen the situation.
As for the investment-savings nexus, a work by Raza et al . (2015) studies the Feldstein and Horioka (1980) hypothesis for Iceland. This is that with restricted capital mobility, there should be a close correlation between savings and gross domestic investment. The converse is that with free capital mobility and investors seeking to invest in those countries, which have the highest returns, the correlations should be nonexistent, or at least very weak. They found that the correlation between saving and investment is higher during the first period of capital restrictions (1960-1994) and becomes lower when the free capital mobility regime is included in the sample, as is to be expected. However, the introduction of controls in response to the global financial crisis did not increase the correlation between savings and investment. The cause is that the deep recession curtailed both the rate of investment and the savings ratio, but the latter recovered much more quickly. Raza et al. (2015) conclude: “The implications of the results we obtain for policy makers are clear: real interest rates matter for small open economies, and closely monitoring the rate of growth of both saving and investment is vital. Institutional and structural changes can have far-reach effects on the development of all economies, but for small open economies, capital controls in particular can alter their potential growth rates, both positively and negatively, in both the medium and long run” (p. 14).
To summarize: Iceland constitutes a case of unorthodox policies, the most interesting of which has been the imposition of capital controls that not only was greeted with approval by such economists as Krugman and Stiglitz, but also defined “a dramatic precedent” (Grabel 2013, p. 19). It is seen as a remarkable change of view from IMF’s orthodox longstanding defense of unfettered international financial markets. Iceland is the first developed country where the IMF recommended the introduction of capital controls. What happened in Iceland matters as it induced a rethink of the economic orthodoxy that disapproves the limits on crossborder capital flows (Sigurgeirsdottir and Wade 2015). Krugman (2011) expressed the view at a conference that “Iceland’s heterodoxy gives us a test of economic doctrine”. In fact, the conventional wisdom before the global financial crisis was that free movement of capital allows financial markets to allocate the resources efficiently and they are capable of correctly valuing financial risks. Huge increases in capital inflows are also seen as evidence of strong fundamentals and that the less state intervention, the better. The case of Iceland shows that all these are not necessarily true. It constitutes a good example of how financial markets cannot always accurately assess the risks and how huge speculative capital inflows may well ruin an entire economic system (Sigurgeirsdottir and Wade 2015; Carmona 2014).
The Icelandic case is the culmination of a move to the acceptance of capital controls, at least in the short term, in response to a severe financial crisis and as part of a package of other policy measures. This compares with the earlier neoliberal period when capital controls had no role to play. As we have seen, the recovery in Iceland in terms of employment and the reduction of unemployment has been faster than in, for example, Ireland that went down the more traditional austerity route.
However, the imposition of capital controls in Iceland should not be seen as a panacea. Given the length of time that they have been in place, the OECD (2015, p. 53) sees evidence that they are now leading to distortions. The krona has been trading at a discount in the offshore markets compared with the CBI official domestic rate. Capital controls exempt new foreign investment, but FDI is modest compared with the pre-2008 period. This is partly due, according to the OECD (op. cit.), to uncertainties and the possible costs of gaining permission for the investment. Icelandic businesses see the controls as the single most important factor impeding their economic performance, particularly with respect to start-up firms that had previously benefitted from foreign capital and expertise. The OECD (op. cit.) also points to the fact that Icelandic pension funds are unable to diversify their portfolios (and risk) using foreign assets to a prudent extent. At the moment foreign assets holdings comprise 22 per cent of the portfolio, compared with a target of between 40 and 50 percent set by the domestic pension funds (the maximum share in 2006 was about 30 percent).
Nevertheless, there is no denying that there has not been a change in the IMF’s ’institutional view’ about the efficacy of capital controls. However, this does not mean that there has been a return to the Keynes- Dexter position on capital controls.