Amendments to the Icelandic capital controls legislation 

The Parliament of Iceland has approved two amendments to the capital controls regime in an attempt to halt increasing circumvention through the bond market and possible negative effects of large capital flows originating from the winding-up process of the failed Icelandic banks.

It is of the utmost importance that the controls that are kept in place hold. If the controls are not managed, the risk of circumvention grows.

Substantial and rising circumvention reduces the Central Bank's ability to carry out the capital controls liberalisation strategy approved by the cabinet in March 2011 – thus prolonging the existence of the controls with costs for the whole economy but large financial gains for those able to circumvent the controls. With a more stable capital controls regime now in place, some amendments towards easing the controls will be proposed by the Minister of Economic Affairs in the coming weeks.

The bond market

• Before these amendments, an investor could change amortization and the indexation share of a CPI indexed annuity bond into foreign currency and transfer out of the economy – even though a principle payment on a non-CPI indexed bond could not be exchange into foreign currency. 
• These CPI indexed annuity bonds were not seen as a major problem in the beginning. As time passes, however, the share of the annuity payment rises in the total repayment of the bond.
• Foreign investors had increasingly seen these bonds as a way to circumvent the controls, leading them to double their holdings in shorter-term CPI indexed annuity bonds issued by the state-owned Housing Financing Fund (HFF) in the past year. Increased demand for these bonds pushed down their yields and caused a sharp break in the yield curve.
• To put this problem into perspective, total payments excluded from the controls (before this legislation) related to the most problematic bond issued by the HFF would have amounted to ISK 42 bn from March 2011 until the bond matures in September 2014. This compares with a total turnover in the króna FX market of ISK 77 bn in 2011 (excluding trades by the Central Bank of Iceland).  
• There has also been growing evidence that market participants have been preparing to issue such CPI indexed annuity bonds for the sole purpose of circumventing the controls.

The winding-up boards

• Until now, the winding-up boards of the failed Icelandic banks have to a large extent been exempted from the controls. In effect, these exemptions will continue in force subject to control of the Central Bank.
• As the winding-up process progresses, the estates collect a large sum of ISK that will be paid to the bank's former foreign creditors. The way in which the winding-up boards dispose of these ISK assets – e.g. the currency which they are sold for – can affect the balance of payments and the ISK exchange rate.
• The net ISK assets expected to be paid out to the foreign creditors is estimated at around 32% of GDP.
• In light of these large amounts, the pay-outs from the estates could have a serious detrimental effect on Iceland's balance of payments if not managed in a suitable manner over time.