Development Studies Association 2012 Annual Conference London, November 2012 Capital controls in Iceland. Does anybody know what is going to happen? Pablo.

Development Studies Association2012 Annual Conference

London, November 2012

Capital controls in Iceland. Does anybody know what is

going to happen?

Pablo Aguirre

[email protected] Instituto Complutense de Estudios Internacionales

Structure

• Why is this case interesting?

• Context and capital controls description

• Determinants

• Effects

• Costs

• Challenging liberalization

• Final remarks

Capital controls in Iceland: why is it interesting?

• Economic theory: opened question

• Empirical analysis: opened question

• Capital controls: policy tool currently used, debate ongoing

• Iceland: good study case

Context

• Imposed on 10-October-2008

• IMF Stand-By Agreement– Legitimates capital controls: “needed tool”– Main goal: avoid further ISK depreciation

• Outflows– Residents: not allowed to purchase foreign currency to perform

any financial operation– Non residents: not allowed to take investments out

• Inflows: free but…

• Current account transactions: no restrictions

Context

• Liberalization strategy ongoing– Main goal: safeguard financial stability (= avoid capital flight)– Problem: non-resident investors with short term assets worth 25% GDP– Proceeding slowly so far

• Financial sector rescued (partially) and reestructured– Cost = 43% GDP– Main bank: 81% public.

• Progressive fiscal reform

• Main pillars of welfare state maintained

• Forecast: incipient economic recovering

Determinants: why capital controls?

• Different starting points from literature do they fit to Iceland?

• Government’s “fears” (depreciation) (Magud and Reinhardt, 2006) YES

• Curative or preventive controls (Edwards,1999) CURATIVE

• To gain monetary policy independence (Krugman,1998; Grabel,2003) YES

• To “buy time”: dealy unavoidable and needed changes on economy, thus

maintaining inefficiencies (Edwards,1999;Battilossi,2005) NO

Effects: what we see

1. Uncertainty: would recovery vanish without capital controls?

2. Exchange rate stabilization

3. Off-shore ISK market

4. Lower interest rates

5. Cheaper public debt (capital controls+other factors)

6. Overall effect: sustaining economic recovery

Exchange rate (ISK/EUR)

80

100

120

140

160

180

200

220

240

260

280

300

320

340

360

Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11

Offshore Onshore

Source: Central Bank of Iceland. Economic Indicators

Central Bank interest rates

0.00

5.00

10.00

15.00

20.00

25.00

Overnight loan discount rates

Current account

Loan against collateral (nominal rate)

Source: Central Bank of Iceland. Interest Rates

General government gross debt

0.0

20.0

40.0

60.0

80.0

100.0

120.0

00 01 02 03 04 05 06 07 08 09 10 11

Source: Central Bank of Iceland. Economic Indicators

Treasury debt. Yields on primary market

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

2008 2009 2010 2011 2012

3 months 1 year 10-11 years

Source: Government Debt Management

Primary market: yields ↓

Secondary market: yields ↓

Capital controls

Market makers close to Government

Investors not allowed toinvest abroad

Domestic scenario: few alternatives to public debt

Bank’s partial nationalization

How does public debt market work?

Effects (5): cheaper public debt on literature

• Huge attention (but Iceland is not the typical example in this regard)

• Often related to financial repression (Giovannini and De Melo, 1993; Roubini and Sala-i-Martín, 1995)

• Empirical analysis: financial repression implies (Alesina et al., 1993; Reinhardt and Rogoff, 2009):

– Public debt cost ↓– Public debt stock ↑

Effects (6): capital controls and economic recovery

• Iceland: capital controls sustaining financial delicate equilibrium during incipient recovery

• This effect is not captured by analizing individual macro variables

Viable banks

Households deleveraging

Public accountssustainabilityEc. Recovery

Cheap public debt

Capital controls

(other)

Iceland’s “trilemma”

Costs

• Benefits not available limited inflows, poor risk management, sub-optimal saving allocation, unsensible policies mantained– Maybe: there are some costs (on the medium-long term)– Sure: other costs (short-medium term) have been avoided

thanks to capital controls– Tradeoff ??

• Damages: – Opportunity costs, evasion efforts (Forbes, 2006): more important

as long as capital controls turn out ineffective (it’s not the case)– Corruption: always possible. Important ??

Liberalization challenges economic recovery

• Potential damages– Capital flight– Debt sustainability– Economic recovery: “trilemma” equilibrium at risk

• Resistances: if the institutions are captured by capital control bureaucracy (Dooley, 1995) Uncertain

• Government’s will– Explicit will to remove controls– Incentives not to do it– Tricky issue: uncertain scenarios, no guarantee of success.

When is the right moment to remove controls?

Final remarks1. Capital controls in Iceland: very particular case

2. Difficult issue to address• Still evolving• Literature: focused on countries not similar to Iceland

3. Have capital controls been useful?• Intrinsic value: policy space gained (Krugman, 1998; Grabel, 2003)• Diagnosis? SO FAR, quite useful in making feasible current

promising scenario• Costs? Sure (how important?), but…what about alternatives costs?

(Grabel, 2003)

4. Uncertainties• Costs of financial crash delayed but not avoided?• Huge uncertainty, but…is there any certainty at all? (look at the EURO

area)• At least, capital controls have contributed to a better present scenario

“The future evaluation of the “Icelandic model” will depend in part on the success of this process”

Már Guðmundsson Governor of Iceland’s Central Bank

“Lifting the restrictions on capital outflows is one of the most complex tasks facing the Icelandic authorities at present”

Thank you

References• Aizenman, Joshua y Pablo E. Guidotti (1990). Capital controls, collection costs, and domestic public debt. NBER

Working Paper Series. Working Paper nº 3443. National Bureau of Economic Research. Cambridge. Massachusets.

• Aizenman, Joshua and Brian Pinto (2011b). “Managing Financial Integration and Capital Mobility: Policy Lessons from the Past Two Decades”. World Bank Policy Research Working Paper 5786.

• Alesina, Alberto, Vitorio Grilli y Gian Maria Milesi-Ferretti (1993). The political economy of capital controls. NBER Working Paper Series. Working Paper nº 4353. National Bureau of Economic Research. Cambridge. Massachusets.

• Battilossi, Stefano (2003). Capital mobility and financial repression in Italy, 1960-1990: a public finance perspective. Woeking Paper 03-06. Economic History and Institutions Series 02. Febrero de 2003. Universidad Carlos III de Madrid. Getafe.

• Dooley, Michael P. (1995). A surveyof academic literature on conrols over international capital transactions. NBER Working Paper Series. Working Paper nº 5352. National Bureau of Economic Research. Cambridge. Massachusets.

• Edwards, Sebastian (1999). “How effective are capital controls?” Journal of economic perspectives, Volume 13, nº 14 – Otoño 1999 – 65-84.

• Forbes, Kristin J. (2006). Capital Controls. Submission for Palgrave’s Dictionary of Economics, 2nd edition.

• Giovannini, Alberto y Martha de Melo (1993). “Government revenues from financial repression”. American Economic Review, 83, n. 4, 953-63.

• Grabel, Ilene (2003). “Averting Crisis? Assessing Measures to Manage Financial Integration in Emerging Economies”. Cambridge Journal of Economics 27 (3):317-336.

References

• Guðmundsson, Már (2012). Reflections on the “Icelandic model” for crisis mangement and recovery. Már Guðmundsson, Governor of the Central Bank of Iceland. Speech at an Adam Smith Seminar named: 2012 and Beyond. World Economic Prospects, in Paris on 7 March 2012. The Central Bank of Iceland. Reykjavik.

• Guðmundsson, Már (2012b). Speech delivered at the 51st Annual General Meeting of the Central Bank of Iceland, 29 March 2012. Már Guðmundsson, Governor of the Central Bank of Iceland. The Central Bank of Iceland. Reykjavik.

• Henry, Peter Blair (2007) “Capital Account Liberalization: Theory, Evidence, and Speculation,” Journal of Economic Literature 45: 887-935.

• Kose, M. Ayhan, Eswar Prasad, Kenneth Rogoff and Shang-Jin Wei (2006). Financial Globalization: A Reappraisal. National Bureau of Economic Research. Working Paper n. 12484. Cambridge, Massachusetts.

• Krugman, Paul (1998). “Saving Asia: it’s time to get radical”. Fortune. September 7, p.74-80.

• Magud, Nicolas y Carmen M. Reinhardt (2006). Capital controls: an evaluation. National Bureau of Economic Research. Working Paper n. 11973. Cambridge, Massachusetts.

• Obstfeld, Maurice, Alan M. Taylor (2004). Global capital markets : integration, crisis, and growth. Cambridge University Press. Cambridge

• Prasad, Eswar, Kenneth Rogoff, Shang-Jin Wei y M. Ayhan Kose (2003). Effects of financial globalization on developing countries: some empirical evidence. International Monetary Fund.

• Reinhart, Carmen y Kenneth S. Rogoff (2009), This time is different: eigth centuries of financial folly, Princeton University Press, Princeton, N. J.

References

• Rodrik, Dani (1998). Who needs capital account convertibility? Contribution to a symposium edited by Peter Kenen, to be published as part of a Princeton Essay in International Finance.

• Roubini, Nuriel y Xavier Sala-i-Martín (1995), “A growth model of inflation, tax evasion and financial repression”, Journal of Monetary Economics, 35: 275-301.