arnor sighvatsson : capital controls, fiscal policy and economic recovery address by mr arnor sighvatsson, deputy governor of the central bank of iceland, at a morning meeting of the iceland chamber of commerce, reykjavik, 24 march 2010. * * * ladies and gentlemen, at the eleventh hour, just prior to the collapse of the banking system, it did not remotely occur to me that signing exemptions from rules significantly restricting the rights of residents to trade in foreign currency could become one of my responsibilities. admittedly, it had been mentioned on several occasions, in meetings with foreign bankers and investors during the weeks and months leading up to the collapse, that they were of the opinion that capital account restrictions were among the conceivable measures that icelandic authorities could apply in the dire straits into which the icelandic economy was clearly headed. when i was asked whether capital controls could be considered, in the difficult situation that had arisen, i naturally replied in the negative, with reference to the international agreements iceland had signed – any other answer would have been risky. even less did it occur to me that the imf would endorse capital controls as a key factor in an economic strategy for the reconstruction of iceland ’ s financial system and economy, as the fund has often been criticised for encouraging premature removal of capital controls in many countries around the world. the capital controls are controversial. other routes were considered but eventually rejected as too risky. the necessity of temporary controls now appears to be generally recognised, and support for them appears to have grown, so much so that this actually gives cause for some concern. there are likely two reasons for this. in the first place, many people appreciate the exchange rate stability they have brought – that is, after their tightening started to have some effect. second, this change in attitude may indicate that a certain group has benefited to some extent from the controls, which prompts me to conclude that it is desirable to begin lifting them as soon as is practicable, but without jeopardising stability. to find our way out of the capital controls, we must understand the reason they were imposed. to start with, we can recall a few basic facts. it is true of both banks and currencies that their stability is based on confidence. if confidence evaporates, banks fail and currencies plunge, often far below the levels justified by fundamentals. confidence in a country ’ s currency and confidence its main financial institutions are closely connected, because the banking

system links domestic and foreign financial markets. it is the lifeline of any currency. if that lifeline is cut, the consequences are catastrophic. in simple terms, this is what happened when the icelandic banking system collapsed. there was a real danger that a vicious circle, as capital fled isk - denominated assets, could have amplified major difficulties faced by highly indebted households and businesses. when an entire country ’ s financial system collapses, as was the case here, it can take a long time to make it fully operational once more. as a result, it could take some time, given the global financial crisis, for foreign credit markets to re - open, as turned out to be the case. in view of the fact that considerable refinancing of treasury debt was scheduled for 2011 and 2012, there was clearly limited scope to use the central bank ’ s foreign reserves to mitigate exchange rate fluctuations without risking the treasury ’ s ability to refinance or pay off the loans maturing in these years. for whatever reason, when it came down to it, the imf was not prepared to extend loans to facilitate in the reconstruction of the icelandic economy unless it could be guaranteed that funds provided would not be sucked down a whirlpool of capital fleeing the country. the capital controls provided the authorities with leeway to restructure the financial system, get a grip on treasury finances, and deal with the problems of debt - ridden households and businesses. all of this is a prerequisite for regaining the trust of international credit markets in the icelandic economy and in the ability of the treasury to meet its obligations. since the controls were tightened, they have contributed to greater exchange rate stability than has been seen for a long time, albeit at a lower level than is desirable. this stability has facilitated implementing economic policy. it therefore comes as no surprise to hear the view expressed that the capital controls should be maintained on a more permanent basis. this is not as attractive an option as might appear at first glance, however. in the first place, liquid capital cannot be kept here forcibly for an indefinite period of time. the controls are a violation of various international agreements signed by iceland. they are tolerated as long as iceland follows the economic recovery programme supported by the imf, and thus indirectly by the member states of the eea, oecd, and the fund itself. soon after this programme concludes, the controls will likely have to disappear ; i. e., if the