. that will be determined in part by the results of the preparatory work currently underway. foreign owners of frozen short - term assets are not the only parties that must be considered when the capital controls are lifted. domestic institutional investors – particularly the pension funds – will play an important role in bringing about sustainable stability. as of the end of july, iceland ’ s pension funds owned over 500 b. kr., or 3. 3 billion euros, in foreign assets, but their liabilities are entirely in icelandic kronur, and their ability to hedge against foreign exchange risk is limited. as such, given the historically low real exchange rate, it is reasonable to expect that there might be an opportunity to reduce their exchange rate risk. some pension fund executives, however, have stressed that the dearth of domestic investment opportunities with an acceptable risk - return balance makes a shift to domestic assets problematic. the icelandic economy is still fettered by a debt crisis, and for a while government - guaranteed bond yields fell below levels that many pension funds considered acceptable. but domestic investment opportunities will grow in number as corporate debt problems are solved. it may also be the case that the pension funds ’ required yield for the lowest - risk domestic bonds is simply too high. although the actuarial assessment of their position is based on a given yield, it appears unrealistic to demand this yield on assets with the lowest - risk with respect to the pension funds ’ liabilities. the capital controls – and more particularly, it seems, some parties ’ expectations that they will remain in effect for a very long period of time – have played a role in generating relatively low yields. the bond market instability that may be associated with market expectations about when capital account liberalisation will begin highlights the role of the capital controls in price formation. domestic investors are in the same position as foreign investors in that awareness of impatient investors with frozen isk assets erodes their confidence in the krona. it is important to open up an exit route for the most impatient among the impatient investors and create a framework within which the others can divert their liquid krona assets into longterm investment. conclusion is it possible to lift the capital controls without causing significant exchange rate instability? yes, it is – if sufficient confidence has been built. at present, confidence is not present to a sufficient degree to support large steps in this direction. on the other hand, it is perfectly appropriate to begin preparatory work. the icelandic authorities have made excellent progress in building confidence,

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. 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. the remaining risk is due primarily to foreign banks ’ krona deposits and the old banks ’ deposits. however, before the controls on these deposits can be lifted in full, it is necessary to channel as much of this capital as possible into long - term investments and structure the winding - up of the old banks so as not to jeopardise exchange rate stability. although conditions in the global financial markets are still difficult, they are better overall than they were a year ago, not to mention two years ago. but the fiscal problems faced by greece, ireland, portugal, and spain have contributed to investor flight to the relative safety of low - yielding markets. the icelandic government is faced with the intricate task of demonstrating that iceland is a better target for investment than other indebted european countries. the progress made under the imf programme is gradually laying the foundation for enhanced confidence, but the programme will only be successful if we adhere to its objectives. funds lying in wait in the shelter of low - yielding markets will eventually seek more bountiful shores. when the flight to safety begins to subside and investors begin to seek out better returns, the icelandic authorities must be ready to direct their attention to iceland. the existence of capital controls and their proposed removal represents a problem for both the monetary policy committee and those who trade in the bond market. 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 krona 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