This time it’s different, prime minister says as Iceland booms

February 17, 2017 GMT

Iceland may be booming again, but there are still nearly $2 billion worth of offshore krona assets threatening to lay to waste more than seven years of painstaking cleanup work, its new prime minister said.

The country is preparing the final steps to do away with the last of the capital controls imposed in 2008, but still has to contend with an overhang of offshore kronur, a big chunk of which is held by Eaton Vance Corp. and Autonomy Capital LP and is now the subject of a legal battle.

“It can’t be underestimated that this has to be dealt with in a very careful manner,” Prime Minister Bjarni Benediktsson said in an interview in Reykjavik. “This is still around 8 percent of GDP, which is an enormous figure. And it means that we have to take every single step carefully.”

Iceland was practically bust less than a decade ago, with the carry trade contributing to a speculative bubble that led to the demise of its three largest banks. Its rebound has been nothing short of spectacular: The economy is expanding at an annual pace of just over 10 percent, wage growth is also in double digits and unemployment has plunged to about 3 percent.

Five weeks after assuming office, Benediktsson says the new government is “very much following the script” when it comes to removing the last remnants of the controls. A foreign exchange auction was held last year and “definite steps toward lifting controls” were taken at the end of 2016, the prime minister said.

Offshore hostage

The premier, who acted as finance minister in the previous administration, says he’s been “surprised” at the limited amount of outflows that have occurred since the country started easing controls last year.

Although the Icelandic currency rose a massive 16 percent against the euro during 2016, climbing for a fourth year, “the domestic market still seems to believe that the krona can continue gaining in strength,” Benediktsson said.

It’s easy to imagine how that might suddenly change.

The central bank has already warned of signs of overheating. After raising rates throughout 2015, Sedlabanki was forced to go into reverse in the second half of last year as looser capital controls and a tourist boom boosted inflows of capital, pushing the krona up and inflation down below the central bank’s 2.5 percent target. In the event, the bank decided to hold rates at 5 percent at its Feb. 8 meeting. But with political risks gathering on the global horizon, a cut can’t be discounted when it next meets, on March 15.

Booms and busts

Iceland’s history is one of booms and busts. But the leader of the ruling Independence Party insists this time it’s “totally different.”

“What’s different today from, say, 10 years ago, is that we have a totally different situation regarding the balance of payments,” he said. “Services are attracting inflows and the tourism sector is a new pillar under our economy. We still need to keep a close eye on developments, but the fundamentals are so much stronger now than they were before.”

Benediktsson’s center-right government has set up a group to explore ways of stabilizing the currency. It will also take a close look at the central bank’s mandate, part of a coalition deal between the Independence Party and its two junior allies, the Reform Party and Bright Future.

While pegging the currency to the euro may be on the cards, full euro membership is unlikely to happen under Benediktsson’s watch.

“Monetary unions such as the euro zone have been in the firing line over the past few years,” he said. “We need to look at the environment and ask ourselves, what can we learn from what has happened? Who, of the nations that we like to compare ourselves with, is using the formula that might serve us best?”

The answer probably won’t be found in Brussels or Frankfurt.