All this is done to preserve the foreign exchange reserves of Iceland, reserves that are almost completely borrowed from the IMF, Scandinavian countries and others. However, there is a great shortage of FX in the country as is rather blatant by the existence of the capital controls.
Andri Gudmundsson, CEO of H.F. Verdbref ("H.F. Securities"), said that the problem was that Icelanders spent too much on imported goods. This is quite fantastically right! And the lack of FX will end up with the krona falling in value. But how are we managing to spend so much on imported goods? Where is the spending power, in ISK, coming from in the first place?
The source of that spending power has traditionally been the banking system. When the banks extend loans they create the borrowed money out of thin air. The extra money in the economy is then spent on goods, including imported goods of all kinds (investment and consumer goods). When we've borrowed a lot and spent the lot on imported goods we realise we're in FX problems. The krona then falls in value when the market sobers up. The fall in the value of the krona defers people from spending their money on imports and helps exports to gain foothold.
The story is always the same in Iceland: the krona has never fallen in value unless there is expansion of bank loans in the years before. Using the data from Statistics Iceland, that's rather blatant.
Four distinctive periods are very obvious in the economic history of Iceland when it comes to expansion of bank loans and the subsequent fall in the value of the krona.
After the bank-loan expansion that fuelled and funded the bubble that collapsed in 2008 the external balance of the macroeconomy was in ruins; we had more than 20% current account deficit in 2006 after massive imports of all kinds of consumer and investment goods. Then the krona finally collapsed.
The krona-collapse in 2008 was not enough. It's somewhat like the exchange rate collapse in 1950; ten years and some bank-loan expansion later we had another and more severe devaluation. There is still too much of kronas in the economy in comparison to the FX reserves, which is of course why we have the capital controls in the first place. And despite all the devaluation of the krona, we are still running the current account deficit in the negative territory. One reason for that is the fact that the banks are lending out money again, now in the form of unindexed mortgages. And all that money is fresh off the banks' conveyor belt.
The plan and the aim is to abolish the capital controls in 2015. That plan will fail at the pace of the recent progress. We need to get serious.
