* Iceland too said capital controls would be short-lived
* Icelandic curbs extended indefinitely after five years
* Depreciation helped Iceland recover, not open to Cyprus
By Alistair Scrutton and Robert Robertsson
STOCKHOLM/REYKJAVIK, March 27 For Iceland, there was a sense of deja vu when Cyprus's finance minister said capital controls would probably last "a matter of weeks". Five years after a banking meltdown, the north Atlantic island has just extended its own controls indefinitely.
When Iceland first announced those surprise plans after market hours in November 2008, the Confederation of Icelandic Employers director general rushed to parliament at night to try to persuade bleary-eyed lawmakers to reverse course.
"They were talking about lifting them in three months. I feared they would be permanent," said Vilhjalmur Egilsson. "But politicians had neither the energy nor intellectual capacity to realise that."
He returned home empty-handed. An International Monetary Fund official woke him in the middle of the night with a phone call, worried about Egilsson's opposition to the controls.
"Everyone seemed tired with late night meetings, thrown into a state of confusion," Egilsson said. "No one was thinking straight."
As in Cyprus, an overblown banking sector that was 10 times the size of Iceland's economy was behind the implosion.
The government protected local depositors but allowed the foreign operations of the banks to collapse. Foreign creditors bore the brunt of the pain.
Capital controls may have been a painful necessity to stop the Icelandic crown from collapsing, but a slide in the currency before the curbs were imposed helped the small economy return to growth quicker than many had expected.
Cyprus, by contrast, cannot devalue because it is a member of the euro zone.
Iceland appears at a loss as to how to lift the restrictions without sparking more capital flight by foreign investors. There are worries that this is dampening investment and creating asset bubbles, such as in real estate.
"The capital controls will prove costly and be a deterrent in the long run," said Jon Sigurdsson, CEO of Ossur, the Icelandic-based company that has made prosthetic limbs for the likes of South African "blade runner" Oscar Pistorius.
"The problem is that it is easy to justify to put capital controls on, but it seems more difficult to find a credible plan to take them off," Sigurdsson told Reuters.
Restrictions on capital movements exclude exporters and importers as well as interest payments on foreign debt. They include foreign holdings of deposits and bonds. Icelanders going abroad are allowed to buy a limited amount of foreign currency for things like holidays.
The central bank has estimated foreign holdings of crowns at 400 billion (some $3.2 billion), more than a fifth of Iceland's gross domestic product. Including money owed to claimants of the bankrupt banks, that could rise to 600 billion crowns.
The biggest difference between Cyprus and Iceland is the currency. Reports that Iceland was mulling adopting the Canadian dollar were not idle talk. It reflected a sense that the only way out may be to adopt another currency - most likely the euro.
But there are also similarities. Both are small islands with small populations where banking and tourism have been major earners. And both were forced to move to capital controls for effectively the same reason - to safeguard the financial system.
In 2008, Iceland made it clear the controls would be short term until the currency stabilised.
The IMF said they would be lifted "near term". The government said "as soon as possible". In 2009, the central bank said the capital controls would be lifted within a few months.
That now seems to have been wishful thinking, at best.
"It will take longer. How much longer I don't have a clue," central bank governor Mar Gudmundsson told Reuters in an interview last month.
What may have saved the crown has become a burden for business, and executives say they hamper a nascent recovery.
The IMF had originally forecast annual growth of around 4.5 percent in 2011-2013. The reality is less than half that figure - although still impressive by European standards. Investment is less than 15 percent of GDP, a record low.
Iceland has an educated workforce and firms like its biggest IT company CCP, a maker of popular computer games such as Eve with clients from Asia to the United States, say controls make foreign investment difficult and recruiting a talented workforce hard.
It was a sign of the times when Ossur - a national icon - delisted from the Iceland stock exchange in 2011 to focus on its Copenhagen listing, although the Icelandic stock exchange later relisted the company for legal reasons.
"It is almost impossible to run an international company in a capital control environment. It has affected us in all our business," said Sigurdsson. "Capital controls therefore also substantially limit the interest of investors."
"The dual listing in Copenhagen has strengthened the company's financial foundation for future growth."
The IMF, which broke with its traditional orthodoxy by supporting the controls, has lauded Iceland as an example of recovery for Europe. The government's decision to act quickly, allowing banks to fail, is held up favourably against prevarication and tortuous decision-making in the euro zone.
The government has tried slowly to reduce foreign funds via currency auctions, allowing foreigners to sell crowns for euros at a rate lower than the official exchange rate.
That had reduced foreign crown holdings by 70 billion crowns in the last two years. At that rate it may take at least five years for the overhang of foreign funds to be fully removed.
"Obviously it is hampering growth of investment into Iceland and it is hampering restructuring because investors are reluctant to invest in bonds," said Danske Bank economist Lars Christensen, well known for predicting the Icelandic collapse before 2008.
Gudmundsson says that for controls to be lifted safety, Iceland needs a combination of high foreign reserves and a budget surplus to cope with increased financing costs once foreign funds exit.
It is not all doom and gloom. The reconstruction of the banking sector, now just twice the size of GDP rather than 10 times, has created more well capitalised and profitable lenders.
The cleanup has led to the estates of the old banks, which are in winding-up procedures and seeking to maximise returns for creditors, becoming major owners in two of the new banks.
The new banks - Arion, created from Kaupthing, and Islandsbanki, created from Glitnir - want to reach so-called composition deals with creditors, which could see the old banks' estates having direct control of the new banks. Though owners, the estates currently have little say in running the new banks.
So while there may be an end in sight, it could still be years away. In the meantime frustrations grow.
"We are now in a vicious circle. We need inflows, but while you have capital controls people don't want to invest," said Hafsteinn Gunnar Hauksson, an economist at Arion.