Risks from cross-border funds
by Arnór Sighvatsson
In the years leading up to the 2008 financial crisis, carry trade-related capital inflows complicated monetary policy and contributed to the accumulation of systemic risk in many small, open and financially integrated countries.
Iceland’s experience shows the challenge posed by volatile capital flows. Before the crisis, inflows amounted to about a third of Iceland’s GDP, which put massive pressure on the króna once the crisis struck.
Problematic rate differentials
Many countries face similar problems. When interest rates on key international currencies are low, some economies may experience demand shocks and find themselves in a relatively strong cyclical position. They then have to keep interest rates higher. The rate differential can attract excessive and potentially volatile capital inflows. This may disrupt the transmission of monetary policy and contribute to systemic risk.
At present, interest rates on key currencies are even lower than before the financial crisis. Fund managers are searching for yield, preferably without taking too much counterparty risk. But the stock of suitable assets is relatively small. If only a fraction of the funds under portfolio managers’ control are allocated to higher yielding economies, the bond and foreign exchange markets of these countries could be swamped. This would push their exchange rates up and their domestic interest rates down at a time when higher rates are needed to contain demand. This will also expose those countries to sudden capital flow reversals.
Managing growing exposure to flows
Iceland is a good example. The economy has experienced rapid export-driven growth, with GDP expanding by 7.2% in 2016. Its public and private debt ratios have fallen quickly, its credit ratings have risen and the current account is in surplus. The international investment position has turned from minus to positive territory.
Given the economy’s strength, the short-term interest rate has been significantly higher than among major trading partners, making Iceland attractive to investors.
However, there is a problem: Iceland’s bond market is tiny compared with the global demand for secure high-yield assets. Its domestic bond and foreign exchange markets are much less liquid than those in most advanced countries. Bond yields will therefore be driven down quickly as foreign investors dive in, and the króna will rise in the interbank market of the three domestic banks.
In June 2016, fearing the impact of growing exposure to volatile capital flows, the Icelandic authorities activated a special reserve requirement on capital inflows into high-yielding domestic bonds and deposits. At the same time, the authorities held an auction of offshore krónur, facilitating a rapid move towards the removal of most remaining capital account restrictions. These had been in force since 2008. Prior to the introduction of the SRR, inflows into the domestic bond market were already severely distorting the transmission of monetary policy through the interest rate channel. This shifted policy transmission increasingly towards the more unpredictable exchange rate channel.
Tool for beneficial composition
The SRR is intended to temper and affect the composition of capital flows to Iceland. Its aim is to reduce systemic risk and support other aspects of domestic economic policy, including monetary policy, thereby contributing to macroeconomic and financial stability. The activation of the SRR was partly a preventive macroprudential measure and partly aimed at mitigating the macroeconomic risk that had already surfaced. After it was introduced, normal monetary policy transmission through the interest rate channel was quickly restored.
Before the introduction of the SRR, over 70% of inflows were invested in Treasury bonds. Subsequently, investors have focused on equity, including foreign direct investment. Thus the SRR achieved its objective of discouraging carry trade-related inflows that bring no long-term benefits for the Icelandic economy, increase systemic risk and carry substantial costs in terms of large reserves. At the same time, it preserved and even encouraged (by containing the over-appreciation of the króna) long-term capital inflows that are likely to be beneficial, by enhancing productivity and improving the risk-sharing properties of the economy.
When the SRR is eventually scaled back, the Central Bank of Iceland intends to keep it in its toolkit as a measure that can be activated to safeguard stability. Capital flows can have significant benefits but also pose risks. Maintaining the balance is crucial.
Arnór Sighvatsson is Deputy Governor of the Central Bank of Iceland.