February 1, 2016 / 11:17 AM / 3 years ago

Iceland central bank preparing new weapons to fight capital rush

LONDON (Reuters) - Iceland is drawing up plans to tax foreigners who buy its bonds or to remove certain interest privileges to keep from being overwhelmed by a flood of money drawn by the highest interest rates in western Europe.

Mar Gudmundsson, Governor of the Bank of Iceland, arrives at the Jackson Hole Economic Policy Symposium in Jackson Hole, Wyoming August 22, 2014. REUTERS/David Stubbs

The country is about to start the tricky process of removing the capital controls that have been in place since what the central bank governor, Mar Gudmundsson, calls “the third biggest bankruptcy in the history of mankind”.

With its economy recovering and interest rates at 5.75 percent compared with virtually zero in the rest of Europe, concern is growing about a destabilizing rush of cash coming in.

“The conditions are good for lifting capital controls - they have never been better,” Gudmundsson said in an interview with Reuters. “A current account surplus, high level of reserves, a fiscal surplus and, hopefully, inflation that is still not too high.”

He expects the first stage of that process to come in the next few months, which is to remove restrictions on foreigners’ ‘offshore crown’ funds, which are worth around 14 percent of Iceland’s annual economic output.

Once that it is done, the bank has said, it will use some of its foreign exchange reserves to prevent any bad reaction, before taking the more uncertain step of lifting controls for the wider population.

“Possibly in the Autumn or hopefully at least before the end of the year” controls on domestic residents can be lifted, Gudmundsson said.

With interest rates higher in Iceland than in virtually every other developed economy in the world, Gudmundsson said, it was unlikely locals would be rushing to take their money out of their bank accounts. It was more likely foreign investors will put more in.

Foreign cash flowing into the country’s banks was one reason Iceland got into so much trouble in the first place. It has introduced a raft of measures to prevent those kind of problems. But now has a different one: so many people are buying its government bonds that interest rate increases are losing their effect. As a result, it is drawing up some counter measures.

“We are working on designing certain tools that hopefully we do not need to use often but are there on the shelf if capital inflows into the bond market are making it very difficult for us to run our own monetary policy,” Gudmundsson said.

“Theoretically we can do it through a tax, so instead of having an interest rate of say 6 percent, you are getting an interest rate of 3 or 4 percent in effective terms.

“You can do the same with non-renumerated reserves. So when you come in, part of what you are coming in with is put in reserves and then you get it back when you leave, but you are losing interest in the mean time,” he added.

OUT OF A PLANE WITHOUT A PARACHUTE

The central bank’s next meeting will be held in a couple of weeks. It left rates unchanged last month. Falling oil prices since the start of the year are helping counteract inflation pressure coming from rising domestic wages.

“We paused in December and now monetary policy will be governed by incoming data. But it is not as obvious where we are,” Gudmundsson said.

“We have had very strong wage growth, far in excess of what is compatible with the inflation target in the long run. But this has not resulted in inflation above the target because we are importing deflation from the rest of the world.”

The other issue confronting Iceland is the euro zone’s new banking union, which it says leaves countries with their own currencies at a disadvantage. It also might clash with Brussels over the use of macro prudential rules to combat issues such excessive capital inflows.

“If we needed to introduce prudential rules to make it possible for us to run our own independent monetary policy and ensure financial stability, and those rules were deemed to be in contravention of EU rules, then we would have to say OK, we have a problem here.

“If someone told me to take the risk to jump out of an aeroplane without a parachute, I would say, no thanks, I would like to have a parachute.”

Editing by Larry King

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