This shift represented not a change in policy but a response to changed circumstances. 4  BIS Review 138/2010  One of the prerequisites for lifting the capital controls without causing exchange rate instability is a sufficiently strong external balance – preferably a surplus. That prerequisite has already been met to the extent that the Central Bank has initiated regular foreign exchange purchases in the market. Excluding the estates of the failed banks, there is a sizeable trade surplus. When winding-up proceedings conclude, there will be a net debt to non-residents; however, it will probably not be large enough to eliminate the underlying surplus. The fundamental problem lies not with the current account balance but with capital movements. Residents’ payments on foreign loans will probably exceed inflows of new borrowed funds or other investments as long as Iceland’s access to foreign credit markets is  BIS Review 138/2010  5  constrained and economic recovery is delayed. However, Landsvirkjun’s recent bond issue indicates that foreign credit markets are not entirely closed, although few firms are in a position to obtain foreign credit and the terms are far from favourable. It would arguably be wise to commence capital account liberalisation while the real exchange rate is relatively low. With a relatively low real exchange rate, owners of ISK assets en masse are less likely to view the removal of capital controls as a selling opportunity, and it is more likely that foreign investors will view it as an opportunity to acquire krónur from those wishing to sell.

While the capital controls are being removed, the risk-adjusted interest rate differential between Iceland and its trading partners must be sufficient to make ISK assets attractive relative to foreign currency alternatives. On the other hand, there are strong arguments for a considerable reduction in interest rates, provided that the capital controls keep the króna stable. Whether the interest rate at any given time is appropriate depends in part on the timing of the phased capital account liberalisation. Both the market and the Monetary Policy Committee face uncertainty about when, and in what stages, it will be possible to lift the controls. In line with transparent monetary policy implementation, the Monetary Policy Committee has explained how this uncertainty affects its decisions. To that end, the Committee has given an account of various factors that affect the prospects of continuing the phased capital account liberalisation that began in November 2009. Uncertainty about key Supreme Court decisions and the third IMF review increased the likelihood that the next stage of liberalisation could be delayed quite a while. The bond market appeared to interpret this delay to be more fundamental in nature than the Monetary Policy Committee intended to convey in its statement, thus contributing to the decline in yields that had begun somewhat earlier. The uncertainty had abated by the time the Monetary Policy Committee met in September, and the Committee explained this in its statement. Furthermore, the Committee implied that it would inevitably consider this point in its next interest rate decisions.