Carry Trade Blocked by Iceland in Bid to Avoid Crisis Replay

Iceland erected new defenses to block fast money from chasing western Europe’s highest interest rates as the nation prepares to dismantle the last remnants of capital controls that have existed since 2008.

Over the weekend, the small north Atlantic island set requirements for new offshore investors forcing them to keep 40 percent in reserve accounts in Iceland for at least one year, according to rules issued by the central bank. The measure mainly targets bonds and deposits. The law passed by parliament allows for a reserve ratio as high as 75 percent and a five-year holding period.

"Investors who were considering financial transactions in and out of the country -- aimed at these kinds of financial instruments -- and were planning on stopping over for a short period of time with large sums of money, will be impacted by the rules,” said Finance Minister Bjarni Benediktsson in an interview in Reykjavik on Sunday.

The economy is now growing at a healthy clip more than 7 1/2 years after its economic and financial collapse, with money once again flowing in. A capital influx driven by carry trades -- in which investors borrow cash at low interest rates and invest in assets with high rates --contributed to the overheating that played a major part in Iceland’s financial collapse in 2008.

This year, the krona has strengthened 1.1 percent against the euro, despite central bank sales of the currency to build up foreign reserves before capital controls are removed. The krona gained 0.2 percent to 139.85 per euro as of 2:48 p.m. local time.

The new rules will form part of Iceland’s toolbox designed to ensure financial stability through the final stage of its exit from capital controls, Benediktsson said. “There are limitations to how much tools of this kind can assist us in achieving that, but we do expect that this will have an impact," he said.

Iceland’s central bank last week kept its main interest rate at 5.75 percent. It raised rates three times last year to cool inflation at a time when other central banks have driven policy below zero and added stimulus through bond purchases.

While the government is trying to make it harder for offshore money to get in, it’s also preparing to let other investors out. The central bank will on June 16 conduct an auction to allow creditors holding about $2.4 billion in krona debt sold before the 2008 crisis to exit. The central bank is offering to buy back so-called Glacier bonds at a discount of 36-50 percent compared with the current onshore krona exchange rate.

Iceland has already settled with creditors affected by the $85 billion default of its three biggest banks. The government has said it will unwind restrictions for consumers and corporations before the end of the year.

To contact the reporter on this story: Omar R. Valdimarsson in Reykjavik at valdimarsson@bloomberg.net. To contact the editors responsible for this story: Jonas Bergman at jbergman@bloomberg.net, Tasneem Hanfi Brögger