In short, restrictions were placed on movement of capital because confidence in Iceland’s banking system, currency, and Treasury – actually, in Iceland’s entire economy and institutional framework – was in tatters after all of the country’s major banks failed in one of the largest financial collapses in history. It was clear that the collapse of the banking sector would deal the Treasury a heavy blow, although the exact scope of the shock was unknown. It was also clear that the Treasury would require substantial funding to address temporary deficit operations. The collapse cut a wide swath in the foreign exchange reserves, and it proved necessary to use some reserves to stabilise the foreign exchange market while the reconstruction of the banking system was underway and solutions to private sector debt problems were being sought. Without enhanced reserves, refinancing of Treasury foreign debt could have proven elusive or even unavailable in coming years if efforts to restore confidence in the global markets in due time should prove unsuccessful. There were numerous indications that the global financial crisis could be protracted, as has proven to be the case. Thus it was far from assured that the global financial markets would become accessible to Iceland in time to refinance foreign loans maturing in 2011 and 2012. The problem was exacerbated by the large króna positions accumulated by non-residents from 2005 onwards. It could be assumed that these investors would sell and, in some cases, would be forced to sell at distressed prices at the first opportunity.

Let us consider the prerequisites for capital account liberalisation and Iceland’s position on the path towards fulfilling them: The IMF Stand-by Arrangement has ensured sufficient foreign exchange reserves to roll over Treasury debt in coming years and address potential outflows associated with the first stages of liberalisation. When the loan facilities have been drawn in full, Iceland will probably be in a better position than many European countries in terms of refinancing risk. This will place the Icelandic Government in a comfortable position when it seeks foreign market funding once again. A central government budget aimed at ensuring a primary surplus in 2011 has now been drafted and, according to the medium-term fiscal programme, the Treasury will record an overall surplus in 2013. According to these estimates, public sector debt will peak in 2010. Fiscal consolidation is the cornerstone of the policy aimed at reviving Iceland’s creditworthiness and creating the conditions necessary for capital account liberalisation and sustainable exchange rate stability. Thus it is vital to adhere to these objectives. 2  BIS Review 138/2010  The financial system is now in a better position than it was only a few months ago to withstand the volatility of short-term capital flows that could accompany the removal of capital controls. The most recent Supreme Court judgment eliminated a large source of risk that had made it extremely difficult to estimate the banks’ liquidity. According to the Icelandic authorities’ Letter of Intent, the Financial Supervisory Authority will review the banks’ planned responses to the judgment by 15 November.