Derivatives traders targeted in Iceland currency experiment

Balancing act...

Iceland is tempering its goal of lifting capital controls as the new government says it will probably keep some restrictions to stop currency speculation.

“It’s possible that Icelanders will, in the same way as other countries are contemplating, impose limits on derivative trades with the currency,” Finance Minister Bjarni Benediktsson said in an interview. The nation may also “place a limit on Icelandic banks gathering foreign exchange in foreign branches. This can be considered as some kind of restriction on capital flows, but we can also view this as a normal part of managing the currency.”

Benediktsson, who together with Prime Minister Sigmundur Gunnlaugsson has pledged to target a swift removal of capital controls since before April 27 elections, is redefining the goal as the euro zone tries to plot an exit from its controls in Cyprus. The path Iceland chooses -- and the restrictions the island ends up leaving in place -- promises to serve as a guideline for nations learning that such regimes are easier to put in place than they are to escape.

The balancing act of when to exit currency controls is one that has prompted a review at the International Monetary Fund. The Washington-based lender warns that keeping such limits in place too long can distort markets, while efforts to prevent speculation risk hitting the wrong group.

‘Hot Money’

“You may have the best intentions to target the ‘hot money’ flows but you may target a broader class of flow and therefore you may have some collateral damage,” Jonathan Ostry, deputy director of the IMF’s research department, said in an interview. “So the intentions may be right but the practical difficulties should not be underestimated.”

Iceland has in the past shown it’s ready to take extreme measures with investors. Bondholders in the nation’s biggest banks were forced to accept an $85 billion default, dwarfing Iceland’s $14 billion gross domestic product, when the island’s financial industry imploded in 2008.

Offshore creditors representing about $8 billion have been trapped by the capital controls since Iceland tried to seal off its markets more than four years ago.

Iceland is now asking creditors in the failed banks to forgive about $3.6 billion in krona-denominated claims to help take pressure off the currency once controls are phased out. Without forcing losses on to bondholders, Iceland can’t return to a currency regime that is guided by market forces, Gunnlaugsson said.

Making Mistakes

“It’s in the interest of both parties -- Icelanders and the foreign creditors -- that we reach an outcome which enables us to lift controls,” he said in an interview. “One assumes that it can be completed quickly.”

The desire to maintain some form of protection can backfire, according to Nobel Economics laureate Edmund Phelps.

“One of the risks is that since it may be a bit unsettling to take them off, there may be a tendency, even for a good government, to hang on to them for too long,” Phelps said in an interview. “The market may make some mistakes in that interim period by making some decision on the basis of prices that are not going to hold.

According to the IMF, keeping currency controls in place too long can contort markets. Iceland has already struggled to contain a capital influx into its housing bonds, the island’s most liquid market and one of the few places offshore investors can place their kronur without breaching restrictions.

‘‘The economy, the industries and the nation can’t wait much longer for solutions,” Fridrik Jonsson, an economist at the World Bank in Washington, said on his blog today. “Traditional methods haven’t been sufficient, as the situation isn’t traditional. It’s time for untraditional and radical” methods to be used in Iceland, he said.

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