21 October 2016

Progress of the Plan for Removal of Capital Controls
This report is published by the Minister of Finance and Economic Affairs as provided for inParagraph 2 of the Temporary Provision I in Act No. 87/1992 on Foreign Currency[The Minister shall make public a report on the progress of plans to remove
restrictions on cross-border capital movements and foreign currency trading at sixmonth intervals until such restrictions are finally removed. The report referred to in
the first sentence shall be published for the first time within six months of the entry
into force of this act]Former reports are available at the website of the Ministry of Finance and Economic Affairs.1
Act on the treatment of króna-denominated assets subject to special restrictions
On 23 May 2016, Althingi passed into law a bill of legislation, introduced by the Minister ofFinance and Economic Affairs on the treatment of króna-denominated assets subject tospecial restrictions. The Act is part of the authorities’ capital account liberalisation strategy
that was presented in June 2015. The assets concerned are believed to be more volatile thanother assets and, thus, more likely to seek a quick exit from the domestic economy when thecapital controls are lifted, with an accompanying negative impact on monetary and exchange
rate stability. These króna-denominated assets have been referred to as offshore króna assets,
as they are often held in custody by non-residents and will, thus, not be sold for foreign
currency except in transactions with other non-residents. The exchange rate in suchtransactions is different than that applying to trade in goods and services undertaken byresidents, which takes place in the domestic foreign exchange market, often referred to as theonshore market. These króna-denominated assets, however, are held in custody by credit
institutions and investment firms in Iceland, although generally not in the name of its
beneficial owners.
The principal objective of the Act is to segregate the offshore króna assets in a secure mannerso that it is possible to take the next steps towards lifting the capital controls and reestablishing unrestricted cross-border transactions with krónur. It is important that this will bedone without jeopardising financial stability or monetary and exchange rate stability. The
stock of offshore krónur stood at 319 b.kr. when the Act was passed. These krónur had been
actively traded in the offshore market at an exchange rate well below the exchange rate in thedomestic foreign exchange market. The offshore króna assets are more likely than otherkróna-denominated asset to seek an exit through the foreign exchange market as the capital
account is liberalised, due to the expected foreign exchange gains from those assets. Thisapplies regardless of whether the beneficial owners are domestic or foreign. Furthermore,offshore króna assets are to a less extent subject to a home bias compared to other krónadenominated assets. In recent years, the Central Bank of Iceland has held foreign currency
auctions and engaged in direct transactions so as to facilitate the exit of a part of offshore
króna assets, as defined in the Act on the treatment of króna-denominated assets subject tospecial restrictions, without negative effects on either exchange rate stability in the domestic
foreign exchange market or the Bank’s foreign exchange reserves.
The Act obliges custodians of offshore krónur to segregate those offshore krónur that were1https://www.ministryoffinance.is/news/nr/20084/

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not bought in the Central Bank’s foreign currency auction in June2. According to the Act,
custodians are obliged to transfer offshore krónur to restricted accounts identified with ledger
code 21 in the Icelandic Banks’ Data Centre hf. system, and to transfer electronicallyregistered offshore króna assets in their custody to so-called administrative accounts with theCentral Bank of Iceland. Balances on restricted accounts are subject to a special reserve
requirement. With this arrangement, the risk of circumvention is alleviated and the Central
Bank of Iceland’s supervision is made more effective without requiring substantially
increased supervisory expenses and a better oversight of offshore króna assets is ensured.
Naturally, it is not possible to transfer electronic custody of offshore króna assets that are notelectronically registered, but the Act assumes that all payments deriving from such assets will
be deposited to accounts subject to special restrictions.
According to the legislation, offshore króna holders are allowed to invest in the same
instruments as before according to a special exemption list from the Central Bank, with theaddition of special certificates of deposit issued by the Central Bank. However, the banks
holding the accounts of offshore króna owners are required to buy special certificates ofdeposit from the Bank for an amount equivalent to the total amount of deposits on thoseaccounts, and these instruments will bear an interest rate of 0.5%. The interest rates shall be
reviewed every twelve months by the Central Bank, with reference to the Bank‘s legally
mandated objectives and returns on its assets.
Central Bank foreign currency auction
On 16 June 2016, the Central Bank of Iceland called for offers to sell assets registered in
Icelandic krónur in return for cash payment in foreign currency. On 21 June, the Bank
announced the main results of the auction and offered to purchase, at an exchange rate of 190
kr. per euro, the offshore króna assets not sold in the auction. The Terms of Tender for thesetransactions were announced on 22 June 2016.
A total of 1,715 offers were submitted and 1,688, or 98.4% of the total, were accepted.
Accepted offers amounted to 83 b.kr., of a total of 188 b.kr. submitted in the auction and thepost-auction tender. The Central Bank of Iceland’s foreign exchange reserves were reducedby just over 54 b.kr. as a result.
The auction was part of the comprehensive capital account liberalization strategy of 8 June
2015. The auction on 16 June 2016 was the last in a series of twenty-three auctions thatstarted in June 2011, in which owners of offshore krónur were invited to purchase foreign
currency before the authorities begin lifting capital controls on resident entities; i.e., pension
funds, other legal entities, and individuals.
The auctions helped to facilitate the exit of offshore króna assets without negative effects on
the foreign exchange market, and the outstanding stock of offshore krónur was reduced
markedly. The remaining owners of offshore króna assets in the form of cash or Treasury
bonds and bills are a smaller and more homogenous group, mostly a few hedge funds andfund management companies. The remaining offshore króna assets have been transferred toaccounts subject to special restrictions at credit institutions and on administrative accountswith the Central Bank of Iceland, in accordance with the newly passed legislation. Owners ofoffshore króna assets will continue to have the right to dispose of their assets; they can makewithdrawals, exchange all interest payments in the foreign exchange market, and trade their
2See further discussion below

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assets in the offshore market.
Capital flow management measures
On 2 June 2016, Althingi passed into law a bill of legislation introduced by the Minister ofFinance and Economic Affairs on a capital flow management measure to alleviate potentialnegative impacts of capital inflows. The Act allows the Central Bank to set rules on necessary
capital flow management measures in order to temper inflows of foreign currency and toaffect the composition of such inflows. Two days after the bill was approved, the Central
Bank published the Rules on Special Reserve Requirements for New Foreign Currency
Inflows, which are intended to to reduce the risk that could accompany excessive capital
inflows under the current regulatory framework for foreign exchange, support other aspectsof domestic economic policy, and contribute to macroeconomic and financial stability.
The Central Bank’s capital flow management tool is based on the application of special
reserve requirements for new inflows of foreign currency and is structured so as to reduce therisk potentially accompanying strong capital inflows by directly affecting the incentives forcarry trades. The tool is therefore intended, among other things, to support effective monetary
policy transmission. Furthermore, the structure is intended to ensure that the measure isflexible, effective, and efficient in implementation so as to make it possible to respondquickly to changed circumstances.
The Rules contain provisions on the implementation of special reserve requirements for new
foreign currency inflows, including the special reserve base, holding period, special reserve
ratio, settlement currency, and interest rates on deposit institutions’ capital flow accounts
with the Central Bank of Iceland. The special reserve base is defined as new inflows offoreign currency in connection with specified types of capital, particularly to include newinvestment in electronically registered bonds and bills, and deposits bearing at least 3%
interest rates. In addition, new inflows related to loans taken for investment in such
instruments can create the special reserve base. The Foreign Exchange Act states that theholding period may range up to five years and that the special reserve ratio may range up to75%; however, the Rules currently set the holding period at one year and the special reserve
ratio at 40%. The Rules also set the interest rate on capital flow accounts with the Central
Bank of Iceland at 0% and specify the Icelandic króna as the settlement currency.
Capital account liberalisation on resident entities
On 11 October 2016, Althingi passed a bill, introduced by the Minister of Finance andEconomic Affairs, amending Act No. 87/1992, on Foreign Exchange. The Act is part of theauthorities' capital account liberalisation strategy, introduced on 8 June 2015. With it,
important steps are taken to lift the capital controls in full. The bill was prepared inaccordance with general recommendations from the International Monetary Fund (IMF), witheconomic stability and the public interest as guiding principles.
With the Act, consideration is given to easing controls on resident and non-resident
individuals and legal entities, in two steps; first upon passage of the bill and second by theturn of next year. The conditions for liberalisation of the controls are in many respects
optimal, and large individual risk factors, such as the settlement of the failed banks’ estates or
the offshore króna problem, no longer pose a threat. In spite of favourable conditions, it isimportant that the capital controls be lifted in structured phases where caution is observed,
particularly as regards potential strain on the liquidity position of the financial system and thebalance of payments.

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Just over 54 b.kr. were allocated in the foreign currency auction, which was held in mid-June.
Following the auction, the reserve adequacy ratio is approximately 158%, according to theInternational Monetary Fund’s (IMF) reserve adequacy metrics (RAM) criteria. The Fundconsiders it desirable that Iceland’s RAM threshold be at least 150% in the prelude toliberalisation of capital controls on residents, and the Central Bank agrees with thisassessment. The reserves are roughly 34 b.kr. above the threshold.
The first phase of the Act
Upon the Act coming into effect on 21 October 2016 outward foreign direct investment (FDI)
became unrestricted but subject to confirmation by the Central Bank, in part because it caninvolve very large sums of money. Furthermore, investment in financial instruments issued inforeign currency, other monetary claims in foreign currency, and prepayment and fullpayment (retirement) of foreign-denominated loans became permissible up to a ceiling of 30
m.kr., which will be increased in stages. The authorisation is subject to certain conditions
concerning beneficial ownership and financing of the transaction; moreover, it is initiallyrequired that the investment must be held with a domestic custodian. The purpose of this is toenable the Central Bank to oversee and supervise properly the transactions covered by theprovision so that, among other things, it can take informed decisions on raising the ceiling in
the provision when conditions allow.
Individuals are now allowed to purchase one real estate per calendar year, subject to priorconfirmation by the Central Bank of Iceland. Until now, individuals’ authorisations forforeign exchange transactions in connection with real estate purchases abroad have been
restricted to purchases made due to a change of residence, and they have been subject to aceiling of 100 m.kr.
The requirement that residents repatriate foreign currency has been scaled down so as toreduce the inconvenience to individuals and firms in connection with foreign investment.
Now, the repatriation requirement does not extend to capital relating to loans taken abroad byindividuals for the purchase of real estate or transport equipment abroad, or to capital relating
to loans taken for other foreign investment.
With the Act, the Central Bank‘s authorisations to gather information has been expanded inorder to monitor the development of systemic risk in the economy on the basis of the Act on
the Central Bank of Iceland. Finally, various special restrictions are lifted and various special
authorisations under the Act are expanded.
The second phase of the Act
The second phase of the law on capital account liberalisation will be implemented on 1
January 2017; cf. the new Temporary Provision in Article 14 of the aforementioned Act
amending the Act on Foreign Currency. At that time, the ceiling on investment in financial
instruments issued in foreign currency, other monetary claims in foreign currency, andprepayment and full payment (retirement) of foreign-denominated loans will be raised to 100
m.kr. and transfers of deposits will be permissible, subject to the same ceiling, the domestic
custodianship requirement for foreign securities investments will be revoked, and foreign
currency purchases in cash will only be limited by the aforementioned ceiling. This will
enable residents and non-residents to transfer deposits and securities to and from Iceland, totrade in securities abroad, and purchase or withdraw foreign currency in cash within theceiling.

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It is important that capital account liberalisation be structured so as to prevent undue strain on
financial institutions‘ liquidity and on the balance of payments. Ceilings on deposit transfers
and foreign investment must take account of the probable strain on the balance of payments
and an analysis of the potential impact on financial institutions‘ liquidity. Deposit transfers
entail funding losses for domestic financial institutions and will force them either to tap liquid
assets or find other funding sources. As a result, it is advisable to raise the ceilings in stages.
Upgraded credit rating with stable outlook
On 1 September 2016, Moody‘s Investors Service upgraded Iceland‘s sovereign rating to A3
from Baa2. The rating outlook is stable. One reason for the upgrade was the progress of theplan for lifting the capital controls. In a news release following the publication of theupgrade, Moody‘s stated that Iceland‘s rating trajectory has lagged the improvement of someof its core fundamentals since the financial crisis, because of the residual risks posed toeconomic and financial stability by the complex process of removing the capital controls. The
upgrade now, however, reflects Moody‘s expectation that the phasing out of capital controls
will proceed smoothly to completion, without disrupting economic and financial stability.
Pension funds‘ authorisation for foreign investment
The Central Bank of Iceland has granted pension funds and other domestic custodians ofthird-pillar pension savings an exemption from the Foreign Exchange Act, no. 87/1992,
thereby permitting them to invest in financial instruments issued in foreign currency. From
mid-2015 through the end of 2016, pension funds have been authorised to engage in foreign
investment for a total of 95 b.kr.
The grounds for exemptions to pension funds and other domestic custodians of third-pillar
pension savings are related to macroeconomic benefits associated with allowing the pension
funds to diversify their portfolios and reduce their pent-up investment need before controls on
residents are lifted. This, in turn, reduces the risk of monetary and exchange rate instability
upon full liberalisation of the controls.
Full liberalisation of the capital account
Both full liberalisation and its timing depend on several things; for instance, asset portfolios
must have adjusted to a desirable composition of domestic versus foreign assets, outflow
pressures must be manageable, and the authorities must be given the scope to develop
appropriate prudential tools. Furthermore, the size of the foreign exchange reserves at any
given time is important, as are developments in the current account balance and the external
position of the economy.
The authorities’ capital account liberalisation strategy is in line with recommendations fromthe IMF on an integrated three-stage approach to capital account liberalisation. Morespecifically, the Fund broadly recommends that restrictions on capital inflows for inward FDI
be lifted first, followed by restrictions on outflow for outward FDI, other long-term capital
movement and a portion of short-term capital movement. Other controls should be lifted last.
The Fund also recommends that the authorities’ supervision and oversight of external trade
and the financial market be strengthened as these stages are implemented, including withincreased and more effective information acquisition.
According to plan Icelandic authorities will, early next year, reassess the conditions forraising the 100 m.kr. ceiling on investment in financial instruments issued in foreign

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currency, other monetary claims in foreign currency, and prepayment and full payment(retirement) of foreign-denominated loans, transfer of deposits and foreign currency
purchases in cash, as well as continuing the preparation for full capital account liberalisation.