Iceland’s 2001 Króna Float, the Glacier Bond Carry Trade, and 2008–2017 Capital Controls

On March 27, 2001, the Prime Minister of Iceland and the Board of Governors of the Central Bank of Iceland (Seðlabanki Íslands) signed a joint declaration that abolished the Icelandic króna’s currency-basket fluctuation band, floated the currency on foreign exchange markets, and granted the Central Bank operational independence to pursue a 2.5 percent annual inflation target. Designed to modernize monetary policy for a booming North Atlantic economy, the new regime collided within four years with the largest cross-border banking and carry-trade mania per capita in modern financial history. As the Central Bank ratcheted its policy interest rate up to 15.5 percent to cool domestic overheating, global yield hunters flooded into over ISK 500 billion of króna-denominated “Glacier Bonds” (Jöklabréf), while Icelandic households and firms borrowed heavily in low-interest Swiss francs and Japanese yen. When Landsbanki, Glitnir, and Kaupthing collapsed in October 2008 and the offshore króna plunged from roughly 90 to nearly 300 per euro, Iceland and the International Monetary Fund took the unprecedented step of erecting a comprehensive capital control wall that took more than eight years and a June 2016 offshore króna stability auction to dismantle. ^[1]

March 2001: Abandoning the Peg for a 2.5% Inflation Target#

Throughout the 1990s, following Iceland’s entry into the European Economic Area in 1994 and the deregulation of cross-border capital flows by 1995, Seðlabanki Íslands attempted to anchor domestic prices by pegging the króna to a trade-weighted basket of foreign currencies within a gradually widening fluctuation band (reaching plus or minus 9 percent in 2000). By 2000–2001, however, rapid credit expansion following the privatization of Iceland’s commercial banks, a widening current account deficit exceeding 10 percent of gross domestic product, and heavy speculative pressure against the króna depleted the Central Bank’s modest foreign exchange reserves and made the basket band untenable. ^[2]

On March 27, 2001 (confirmed by the new Central Bank Act No. 36/2001 in May), Iceland abandoned the exchange rate peg and adopted a flexible exchange rate paired with formal inflation targeting. Under the joint mandate, the Central Bank was tasked with keeping twelve-month consumer price inflation as close as possible to 2.5 percent, with a symmetric tolerance band of plus or minus 1.5 percentage points (above or below which the Central Bank was required to submit a public report to the government explaining the deviation and its policy response). ^[3]

In a small, ultra-open island economy with a tiny national currency and newly privatized commercial banks (Landsbanki, Kaupthing, and Glitnir, whose combined assets would swell from roughly 100 percent of Iceland’s GDP in 2000 to nearly 900 to 1,000 percent of GDP by 2007), pure interest-rate inflation targeting soon revealed a fatal transmission flaw. Beginning in 2003–2004, mega-investments in aluminum smelters and hydroelectric power plants in eastern Iceland, combined with aggressive 90 percent loan-to-value mortgage lending by the privatized banks, ignited an acute domestic asset and consumption boom. ^[4]

The 2005–2008 Carry-Trade Mania and the Rise of Glacier Bonds (Jöklabréf)#

To bring inflation back toward the 2.5 percent target, the Central Bank of Iceland raised its benchmark collateralized lending rate relentlessly from 5.3 percent in early 2004 to 9.5 percent in 2005, 13.3 percent in 2006, and ultimately 15.5 percent in the spring of 2008. At a time when the Bank of Japan held policy rates near 0.1 to 0.5 percent, the Swiss National Bank lent at 1 to 2.5 percent, and the European Central Bank sat at 2 to 4 percent, Iceland offered the widest sovereign interest-rate differential in the developed world. ^[5]

Rather than cooling the Icelandic economy, the Central Bank’s rate hikes broke the domestic monetary transmission mechanism from both directions:

• Domestic Foreign-Currency Borrowing: To avoid paying 14 to 16 percent nominal rates (or inflation-indexed verðtrygging rates) on króna loans, Icelandic corporations, fishing firms, municipalities, and tens of thousands of ordinary households took out mortgages and car loans linked to Swiss francs and Japanese yen at interest rates of 3 to 5 percent. Because the influx of foreign capital caused the króna to appreciate in 2005 and 2007, foreign-currency borrowers enjoyed shrinking debt service in króna terms—further fueling domestic spending and import demand.
• Offshore Glacier Bonds (Jöklabréf): Simultaneously, international yield-seeking retail investors (such as Belgian dentists and Japanese “Mrs. Watanabe” accounts) and global macro hedge funds sought a vehicle to capture Iceland’s double-digit yields without taking direct credit exposure to Icelandic banks. Beginning in August 2005, AAA-rated supranational institutions and major European banks—such as the European Investment Bank, Rabobank, and Kreditanstalt für Wiederaufbau (KfW)—began issuing Eurobonds denominated in Icelandic krónur on offshore markets, immediately christened “Glacier Bonds” (Jöklabréf).

The financial engineering behind a Glacier Bond linked the offshore carry trader directly to the balance sheets of Iceland’s three commercial banks. When an AAA-rated European institution issued a one- or two-year Jöklabréf paying an 11 to 13 percent króna coupon, the issuer had no business need for Icelandic currency. It immediately entered into a cross-currency interest-rate swap with Kaupthing, Landsbanki, or Glitnir (or bought króna certificates of deposit from them), handing the króna proceeds to the Icelandic bank in exchange for euros or dollars. Between August 2005 and early 2008, gross issuance of Jöklabréf exceeded ISK 500 billion, with outstanding balances peaking at over ISK 400 billion—equivalent to roughly 30 to 35 percent of Iceland’s entire annual gross domestic product. ^[6]

As Economist Brad Setser and financial stability analysts observed as early as the February 2006 “mini-crisis” (when a Fitch ratings outlook downgrade sent the króna tumbling 20 percent as early carry traders bolted), Iceland had become the ultimate carry-trade trap: high policy rates attracted hot money that artificially propped up the króna, encouraged unhedged household foreign-currency borrowing, and funded an unsustainable current account deficit exceeding 16 to 24 percent of GDP. ^[7]

October 2008: The Króna Crash and the IMF Capital Control Wall#

When Lehman Brothers collapsed in September 2008 and global wholesale interbank markets froze, Glitnir, Landsbanki, and Kaupthing toppled into receivership within a single week in early October 2008 under the Emergency Act (Act No. 125/2008). As foreign hedge funds and maturing Glacier Bond holders rushed to dump their króna positions for euros and dollars, the Icelandic foreign exchange market seized up completely. ^[8]

From an pre-crisis level near 70 to 90 ISK per euro in 2007, the onshore exchange rate depreciated past 150 to 190 ISK per euro, while thin, panicked offshore quotes in London and Frankfurt traded between 250 and 340 ISK per euro—a collapse of more than 70 percent. Had the remaining ISK 400 to 600 billion in non-resident króna deposits, Treasury notes, and maturing Jöklabréf been allowed to exit freely through the spot foreign exchange market, the króna would have entered a freefall that would have bankrupted almost every Icelandic household and business carrying foreign-currency or inflation-indexed debt.

In October and November 2008, as part of a $2.1 billion Stand-By Arrangement with the International Monetary Fund—representing the first time since the 1970s that the IMF endorsed strict capital account restrictions in an advanced economy—the Central Bank of Iceland and Althingi enacted the Foreign Exchange Act (Act No. 134/2008, amending Act No. 87/1992). While current-account payments for imports and exports remained open, all cross-border capital outflows by both residents and non-residents were strictly prohibited. Foreign investors holding maturing Glacier Bonds and Icelandic Treasury securities could collect their principal and interest in krónur, but those funds were locked onshore inside Iceland—creating a vast pool of trapped “offshore króna” (aflandskrónur) alongside the claims of foreign creditors on the estates of the three failed banks.

The 2015–2017 Unwinding: Stability Contributions, the June 2016 Auction, and Removal#

Originally envisioned as a temporary two-year shield, Iceland’s capital controls remained in place for more than eight years because lifting them prematurely risked unleashing a balance-of-payments crisis from two overhangs: roughly ISK 800–900 billion in domestic assets held by the winding-up estates of Landsbanki, Glitnir, and Kaupthing, and over ISK 300 billion in liquid offshore króna assets descended from the 2005–2008 Glacier Bond carry trade.

In June 2015, the Icelandic Ministry of Finance and Economic Affairs and the Central Bank unveiled a comprehensive three-pronged liberalization strategy supported by the IMF:

• Failed Bank Estates (2015): Under legislation enacted in 2015, the estates of Glitnir, Kaupthing, and Landsbanki were given a choice between paying a 39 percent exit “stability tax” or concluding voluntary “stability contributions” (whereby the estates surrendered hundreds of billions of krónur in domestic assets, including full ownership of Íslandsbanki, and extended the maturity of domestic bank bonds) in exchange for exemptions to distribute foreign-currency recoveries to international creditors.
• The June 2016 Offshore Króna Auction and Act No. 37/2016: To neutralize the remaining ~ISK 319 billion in liquid offshore króna holdings, Althingi passed Act No. 37/2016 on May 23, 2016, requiring unexchanged offshore krónur to be segregated into special low-interest reserve accounts at the Central Bank. On June 16, 2016, Seðlabanki Íslands conducted a final single-price foreign currency auction, purchasing roughly ISK 72–83 billion of offshore krónur at a discounted rate of 190 ISK per euro (compared to an onshore rate near 140 ISK per euro), followed by further purchases that cut the offshore overhang to under ISK 190 billion by year-end 2016.
• The March 2017 Final Settlement and Lifting of Controls: Bolstered by a booming tourism sector that pushed Central Bank foreign exchange reserves to an all-time high of roughly ISK 800 billion, the Central Bank struck a deal in March 2017 with the largest remaining offshore institutional bondholders to buy approximately ISK 90 billion of restricted offshore króna assets at 137.5 ISK per euro. On March 12, 2017—taking effect on Tuesday, March 14, 2017—the Government of Iceland formally lifted capital controls on households, corporations, and pension funds, closing the sixteen-year monetary cycle that began with the March 2001 float.

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