plan and the financial market restructuring plan. according to the programme, the most important task of monetary policy is to promote exchange rate stability. one reason for this is the currency crisis that accompanied the financial crisis, pushing the exchange rate far below levels previously thought possible, let alone desirable. this currency collapse fuelled inflation, of course, and amplified the debt crisis faced by households and businesses. two factors played leading roles in that development. the first is the relatively large share of foreign - denominated loans – an average of 20 % for households and 70 % for businesses. the latter factor is an unusually strong exchange rate pass - through effect, which stems from the magnitude of the exchange rate drop and the lack of confidence that the krona would recover in the near future. as a result, the principal of indexed loans – which constitute about 70 % of household debt and 10 % of business debt – was written up. as is often the case in severe financial crises that are at the same time country crises, there was a genuine risk of a multi - faceted spiral of currency collapse, inflation, debt crisis, and economic contraction. it was critical to stave off such a vicious cycle, and therefore of vital importance to stabilise the exchange rate. but this was problematic because of the large amount of capital that had accumulated in iceland through carry trading during the economic upswing. current estimates indicate that some 500 b. kr. remain in the icelandic economy. there was the risk that this money would try to escape through a collapsed foreign exchange market, with unimaginable consequences for the exchange rate. thus it was quite possible that astronomical interest rates would have been required if exchange rate stability were to be achieved through interest rate policy alone. in view of this, it was decided to impose broad - based capital account restrictions and thereby create the scope for less restrictive monetary policy than would otherwise have been feasible. as is usually the case, there were probably other options available at the time. but because i prefer to focus on the current situation and the road ahead, i would prefer not to spend time rehashing the past and ruminating about hypothetical options. such speculation cannot change the past. generally speaking, however, it seems to me that other options would have entailed significantly higher interest rates – initially, at least – and more risk to the exchange rate. but that doesn ’ t change the fact that, although the capital controls provided a certain temporary shelter, they also entail significant cost

mar guðmundsson : preserving the credit of the sovereign through a financial sector meltdown – the case of iceland speech by mr mar guðmundsson, governor of the central bank of iceland, at the international monetary seminar 2013 “ sovereign risk, bank risk and central banking ”, organised by the bank of france, paris, 8 july 2013. * * * i would like to thank banque de france for inviting me to speak at this interesting seminar. this session is on resolving sovereign debt crises and the relative roles of the public and private sectors in that process. my comments will obviously be based on my own country ’ s experience during the financial crisis, which is a case of a sovereign debt crisis being avoided in spite of the meltdown of a large part of the financial sector and the country ’ s deepest recession since the interwar period. that result was achieved by relatively good fiscal position prior to the crisis, by a refusal – based on need rather than stubbornness – to rescue private cross - border banks with public money, and by on - going medium - term fiscal consolidation that was an important part of the economic programme developed in cooperation with the imf. the bottom line is that all sovereign obligations have been honoured ; the sovereign has maintained investment - grade credit ratings and market access. in order to distinguish between the parts of this story that provide lessons that are applicable to the rest of the world and those that do not, we need to get some of the facts straight, because to this day there are still several misconceptions floating around about what was done in iceland during the crisis. the collapse of iceland ’ s three cross - border banks in early october 2008 was the most noticeable event in the unfolding of the financial crisis. the combined balance sheet of these banks was 10 times iceland ’ s gdp ( see figure 1 ), and their combined bankruptcy, measured in terms of balance sheets, ranks second in size in the international history of corporate failures, only after lehman brothers. and this happened in a country that ranks among the smallest in the world! we are still dealing with the complications that this entails, as can be seen in our overblown and unbalanced iip and the controls on capital outflows. figure 1 source : central bank of iceland. bis central bankers ’ speeches before the collapse, the banking system had expanded very rapidly, growing in just five years from a combined balance sheet of less than 2 times gdp at the end of 2003 ( see figure