Whether because of the enthusiasm of its football commentators or interest in its EEA arrangement as a model for post-Brexit UK, Iceland has been in the news frequently recently. Its economy has been growing fairly rapidly in recent years, up around 30 per cent from its 2009 trough, though still more than 20 per cent below its 2007 peak in US dollar terms. This period of more rapid growth has led to consideration of normalisation of some of Iceland’s restrictive capital controls.
At the peak of financial market exuberance in the mid-2000s, Iceland was a major linkage in international financial flows, with its relatively high interest rates at the time providing opportunities for a “carry trade”, whereby investors borrowed money in other countries, such as Japan, at low interest rates and then invested those funds in Iceland to get higher returns. At the same time, Icelanders themselves had taken out lower interest rate loans in other currencies.
When the music stopped, with Iceland’s banks (14 times the size of the economy) failing and the economy crashing (GDP fell nearly 40 per cent in dollar terms by 2009), the government attempted to limit the speed at which capital fled the economy by imposing capital controls, stopping investors from taking money out of the country and even requiring holidaymakers to take their airline tickets to the bank to obtain foreign currency.
With growth returning, the restrictions on ordinary families have been largely removed and there has been some modest easing of restrictions on investors. But a number of important restrictions continue, and there is a lobby within Iceland to make some form of capital controls permanent so that the country cannot again face the danger of large inflows and outflows destabilising its economy.
One notable form of restriction concerns government bonds. Foreign investors who had originally bought government bonds on the basis of being able to trade them in secondary markets are being asked to swap them for bonds that they must hold until they mature.
This may sound relatively innocent at first, but if investors cannot sell bonds to obtain cash if they need it, they will have to hold other cash idle or hold more lower-yielding high-liquidity assets than they might want to. They will also miss out on the opportunity to sell bonds at a good moment in the market (i.e. when the price is high). These losses come at a cost, meaning Iceland must offer higher interest rates on its bonds than would otherwise be required, which in turn means that Iceland’s government has to pay higher debt interest and Icelandic firms find it more expensive to raise funds for investment. What looks in the short run like a measure that keeps money in the country over the longer term proves costly.
This is part of a more general lesson for smaller economies which has replayed in the Gulf and the Far East in recent years as well as in Iceland. Openness to global capital investment provides huge opportunities for small economies that can attract funds. Every now and then, things will go wrong and funds will leave. But that only returns the economy to the position it would have been in if it had never attracted the funds in the first place. It is perverse for economies to prevent investment for fear that they might one day have to live without that investment. Surely it’s better to have the funds for a while and make the most of them while they are there than to never have them at all!
Economies around the world reacted to the 2007-09 financial crisis in more or less counter-productive ways. But now that it is growing again, Iceland should be seeking to normalise back to a functioning open market economy – as indeed we should in the UK and across the rest of Europe, albeit in the ways most relevant to us.