Iceland Seen Threatened by Capital Flight from Its Own Citizens

By Omar R. Valdimarsson | February 28, 2014

Its own citizens may follow if the government doesn’t show it can lift capital controls in place since 2008 without triggering a currency sell-off, according to Iceland’s biggest insurance firm.

If people lack confidence, they will take their money elsewhere as soon as the controls are lifted,” Sigrun Ragna Olafsdottir, chief executive officer of insurer Vatryggingafelag Islands hf, said in an interview in Reykjavik. “And here I’m referring to Icelanders, not just foreigners. This presents a much greater threat to the Icelandic economy than if foreigners decide to leave.”

Iceland has yet to test the staying power of its economic recovery. Capital controls, imposed at the end of 2008 after the island’s three biggest banks defaulted on $85 billion, have so far stopped offshore investors selling $7.2 billion in assets, equivalent to half the nation’s gross domestic product.

Hedge funds, including Davidson Kempner Capital Management LLC and Taconic Capital Advisors LP, bought claims on the banks’ assets at prices well below face value. Five years later they’re still waiting to cash in. Efforts to speak with the government, communicated by the winding up committees of the failed banks, have fallen on deaf ears.

Default Insurance

Prime Minister Sigmundur D. Gunnlaugsson said last month he won’t negotiate with speculators and underlined his commitment to removing capital controls in a way that underscores financial stability.

“It’s in everyone’s interest to create a situation which would allow for the lifting of controls,” Gunnlaugsson said in January.

There are signs investors are growing wary. Since hitting a low in June, the cost of insuring against losses on Iceland’s debt using credit-default swaps has risen about 50 percent to 190 basis points, according to data compiled by Bloomberg.

Though Iceland has managed to reduce its public debt to 82 percent of gross domestic product, the island still has net external debt equivalent to 436 percent of GDP, central bank statistics show.

Iceland may need help from the other Nordic governments to help it through a transition out of capital controls, according to Lars Christensen, chief emerging markets analyst at Danske Bank A/S in Copenhagen.

Nordic Support

“The best way would be to try to negotiate some kind of a standby agreement with the other Nordic central banks to try to provide some support for the krona in a period,” he said by phone. “But that can be quite challenging.”

Iceland said back in 2008 the capital controls would be a temporary measure to protect its markets during the darkest hours of the crisis. The International Monetary Fund, which has praised the island’s crisis management program, says removing currency restrictions is key to restoring economic health.

The main concern for Icelanders now is whether they’ll be lifted without jolting markets and disrupting a recovery. The economy will expand 2.7 percent this year, according to the Organization for Economic Cooperation and Development. That’s better than the average for the OECD-area as a whole, which will grow 2.3 percent, the Paris-based group estimates.

Shielded by capital controls, companies like Vatryggingafelag have grown without needing to fend off the vagaries of market swings. Since the insurer went public last April, its stock has gained 15 percent. Yet the flipside is that companies can’t draw on foreign investors, limiting growth.

“We’ve been waiting for the investment environment to improve with more investment opportunities,” said Olafsdottir. “That seems to be picking up although the capital controls have a severe impact on that.”

–Editors: Tasneem Brogger, Jonas Bergman

 

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