Lifting Capital Controls: The Effect of a Potential Rebalancing of Residents’ Investment Portfolios 1
This Selected Issues Paper analyses the impact of a potential rebalancing of Icelandic residents’ investment portfolios as capital controls are lifted. The paper applies optimal portfolio theory to calculate the potential rebalancing towards foreign assets, and then makes an estimate of the cumulative impact on the balance of payments and international reserves. The paper draws conclusions for the authorities’ capitalaccountliberalizationstrategy
This paper discusses the recommendations of the Sixth Post-program Monitoring Discussions with Iceland. Iceland recently updated its capital account liberalization strategy. The strategy takes a staged approach, starting with steps to address the balance-of-payments overhang of the old bank estates—prioritizing a cooperative approach with incentives—in a manner consistent with maintaining stability. Growth is accelerating in 2015 and is expected to reach 4.1 percent, backed by significant investment, wage- and debt relief-fueled consumption, and booming tourism. The general government is projected to record a surplus of 0.8 percent of GDP in 2015, helped by large one-offs. Small deficits are also expected over 2016–20.
On June 24, 2015 the Executive Board of the International Monetary Fund (IMF) concluded the Sixth Post-Program Monitoring (PPM) Discussion with Iceland. 1
Iceland’s economy is facing two major challenges. The first is implementation of its new capitalaccountliberalizationstrategy, aiming for full reintegration with global financial markets. The second challenge is navigating significant wage increases that look likely to disrupt Iceland’s otherwise strong and stable economic position.
Iceland recently updated its capitalaccountliberalizationstrategy
This supplement provides information that has become available since the issuance of the staff report . The information does not alter the thrust of the staff appraisal in the Sixth PPM staff report.
Iceland announced its updated capitalaccountliberalizationstrategy . Details are still emerging, but the updated strategy is broadly in line with staff expectations. The strategy takes a staged approach.
The first stage targets a reduction in the balance of payments (BOP) overhang—nonresident net claims on domestic assets—of the old bank estates
accrued interest payments on intra-company debt held by a large multinational, but estimated and projected data do not.
2/ Baseline projections no longer incorporate the 2011 capitalaccountliberalizationstrategy. Instead, projections assume a gradual release of overhang while maintaining minimum reserve adequacy.
3/ Reflects debt service payments on Fund repurchases and Nordic loans repay.
4/ Excludes the income receipts and expenditures of DMBs in winding up proceedings, and accrued interest payments on intra-company debt held by a large
This Selected Issues paper analyses the impact of a potential rebalancing of Icelandic residents’ investment portfolios as capital controls are lifted. It applies optimal portfolio theory to calculate the potential rebalancing toward foreign assets, and then makes an estimate of the cumulative impact on the balance of payments and international reserves. Conclusions for the authorities’ capital account liberalization strategy are drawn. This paper also measures the potential budgetary savings from improving the efficiency of public spending in health and education in Iceland. A Data Envelopment Analysis is used to estimate an efficiency frontier by comparing across Organization for Economic Cooperation and Development countries the transformation rates of public spending into valuable social outcomes.
KEY ISSUES Iceland’s otherwise strong and stable economic position looks likely to be disrupted by significant wage hikes. Collective wage bargaining looks headed for economy-wide cumulative 3½-year nominal wage growth of 20–25 percent, along with fiscal measures costing ½ percent of GDP annually to help break an impasse between social partners. With a closed output gap and modest productivity gains, this would propel inflation well above the Central Bank of Iceland’s (CBI) 2.5 percent target, generate budget pressures, erode competitiveness, and slow capital account liberalization. A decisive policy response will be needed. Excess demand pressures will likely boost economic growth this year. Monetary policy tightening will be needed to bring inflation back down to target. Fiscal policy should be adjusted to reduce demand pressures, while staying on track to achieve debt reduction objectives. Fiscal adjustment plans will need to become more specific. The tighter policies are expected to pull inflation gradually toward the target and slow real GDP growth in 2016 and beyond. Iceland looks ready to finalize its updated capital account liberalization strategy. Considerable effort has been made to better understand the challenges, risks, and range of options for addressing Iceland’s still-significant balance of payments (BOP) overhang, estimated at 65–70 percent of GDP. The authorities look ready to proceed with an updated comprehensive, conditions-based liberalization strategy, while maintaining stability and giving emphasis to a cooperative approach with incentives. However, the pace of implementation, particularly for the real sector, may be slowed by macroeconomic volatility and erosion in competitiveness from large wage hikes. Efforts to strengthen core policy frameworks are broadly on track. Approval of an ambitious budget framework law (Organic Budget Law, or “OBL”) is expected soon. Important draft laws to bring financial sector safety nets in line with European Economic Area (EEA) standards and to strengthen the macroprudential policy framework are expected to be passed later this year. Critical efforts to strengthen financial supervision are continuing. Work to refine the monetary policy framework and the role of macroprudential policies is underway. A review of central bank legislation will continue later this year and should aim for an outcome consistent with maintaining independence and accountability. Final agreement on run-off of the loss-making Housing Financing Fund (HFF) and a successor strategy remains elusive.