It is a sobering thought that two European countries now have capital controls: Iceland and Cyprus; sobering for those who think that in modern times capital controls are only ever used by emerging markets and other immature economies. Cyprus has been a member of the European Union, EU, since 2004 and part of the Eurozone since 2008; since 1994 Iceland has been member of the European Economic Area, EEA, i.e. the inner market of the EU. – The two EEA countries were forced to use measures not much considered in Europe since the Bretton Woods agreement.
Although the concept “capital controls” is generally used for the restrictions in both countries the International Monetary Fund, IMF, is rightly more specific. It talks about “capital controls” in Iceland and “payment restrictions,” i.e. both domestic and external, in Cyprus.
Both countries enjoyed EEA’s four freedoms, i.e. freedom of goods, persons, services and capital. –Article 63 of the Treaty on the Functioning of the European Union prohibits “all restrictions” on the movement of capital between Member States and between Member States and third countries.
Both countries attracted foreign funds but different kind of flows. While the going was good the two islands seemed to be thriving on inflows of foreign funds; in Iceland as a straight shot into the economy, in Cyprus by building a financial industry around the inflows. Yet, in the end the islands’ financial collapse showed that neither country had the infrastructure to oversee and regulate a rapidly expanding financial sector.
It can be argued that in spite of the geography both countries were immature emerging markets suffering from the illusion that they were mature economies just because they were part of the EEA. As a consequence, both countries now have capital controls and clipped wings, i.e. with only three of the EEA’s four fundamental freedoms.
The “international finance centre”-tag and foreign funds
Large inflows of foreign funds are a classic threat to financial stability. At the slightest sign of troubles the tide turns and these funds flow out, as experienced by many Asian countries in the 1980s and the 1990s. Capital controls are the classic tool to resume control over the situation. None of this was supposed to happen in Europe – and yet it did.
Although not on the OECD list of tax havens Cyprus has attracted international funds seeking secrecy by inviting companies with no Cypriot operations to register. After the collapse of the Soviet Union money from Russia and Eastern Europe flowed to the island as well as from the Arab world. Even Icelandic tycoons some of whom grew rich in Russia made use of the offshore universe in Cyprus.
The attraction of Cyprus was political stability, infrastructure, a legal system inherited from its time as a British colony and the fact that English is widely spoken in Cyprus. By the time of the collapse in March 2013 the Cypriot banking sector had expanded to be the equivalent of seven times the island’s GDP. This status did also clearly limit the crisis measures: president Nicos Anastasiades was apparently adamant to shelter the reputation of Cyprus as an international finance centre arguably resulting in a worse deal and greater suffering for the islanders themselves (see my article on the Cyprus collapse and bailout here).
Iceland also tested the offshore regime. Under the influence of a growing and partly privatised financial sector the Icelandic Parliament passed legislation in 1999 allowing for foreign companies with no Icelandic operations to be registered in Iceland. Although it could be argued that Iceland enjoyed much the same conditions as Cyprus, i.e. political stability etc. (minus an English legal system), few companies made use of the new legislation and it was abolished some years later.
But Iceland did attract other foreign funds. Around 2000 a few Icelandic companies started their shopping spree abroad. The owners were also large, in some cases the largest, shareholders of the three main banks – Kaupthing, Landsbanki and Glitnir. The banks’ executives saw great opportunities for the banks to grow in conjunction with the expanding empires of their main shareholders and largest clients. By 2003 the financial sector was entirely privatised, another important step towards the expansion of the financial sector.
In addition, the Icelandic banks had offered high interest accounts abroad from autumn 2006, first in the UK, later in the Netherlands and other European countries, even as late as May 2008. Clearly, Icelandic deposits were not enough to feed the growing banks. They found funding on international markets brimming with money. In 2005 the three banks sought foreign financing to the amount of €14bn, slightly above the Icelandic GDP at the time. In seven years up to the collapse the banks grew 20-fold. In the boom times from 2004 the assets of the three banks expanded from 100% of GDP to 923% at the end of 2007.
*Continue reading at A Fistful of Euros.