Responding to Capital Flows in a Very Small Economy

Speculative capital inflows raised the exchange rate and stock prices in Iceland in the prelude to the financial turmoil that gripped the country in 2008. Speculators profited from the interest differential as well as the continued appreciation of the currency from 2004 to 2008 and the rise of stock prices. The inflow was not sustainable because domestic debt was increasing at an unsustainable pace, faster than the rate of interest. Investors attempted to leave the krona when international capital markets became unstable in 2008 and the foreign risk premium rose. The sudden stop of the inflows left most domestic businesses in technical default as well as many households, the banks collapsed and the currency lost half its value. Capital controls were imposed to stem the outflow. Now seven years later, capital controls are being relaxed and the inflow of speculative capital has started again. The paper describes the macroprudential regulations that have been passed in recent years and the possible ways the authorities could reduce the inflows or change their nature from short-term to long-term investment. The issue whether a very small economy can have a floating exchange rate and a free flow of capital is discussed.