Crisis Policy response: Analysis of Capital controls in Iceland and Cyprus

Andrew Moloney Bachelor of Arts in Economics and Sociology

Title page Name: Andrew Moloney ID Number: 09004223 Project Title: Crisis Policy response: Analysis of Capital controls in Iceland and Cyprus Internal supervisor: Dr. Stephen Kinsella External examiner: Degree title: Bachelor of Arts in Economics and Sociology Word count: 9403 Date: February 19th 2014

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Abstract
With the crisis of 2007 a memory of a not so distant past, its remnants still exist. The project assesses the fallout of the crisis with reference to post crisis policies; this will be done with particular attention being paid to capital controls set in Iceland and Cyprus. Both countries are known for their large financial sectors which became disproportionate to their economies due to large cross border capital flows. The collapse of the financial sectors saw the introduction of capital controls prohibiting the convertibility and movement of capital from each country. This paper investigates the use of capital controls as a post crisis policy in Iceland and more recently in Cyprus. Although both had relatively different motivations for introducing capital controls, the repercussions of doing so will be widely similar in both countries. It will argue that although the use of capital controls as a short term precaution were warranted, the notion of capital controls as a quick fix is distant and will have repercussions on the macroeconomy. The results of the study show that while governments have good intentions of relieving capital controls quickly it is almost impossible to do. Icelands and Cypruss status as a creditor country has left them at the mercy of debtor nations decisions. Monetary policy decisions in the US (such as quantitative easing) make Iceland and Cyprus less lucrative investment options. This directly affects the decision making capabilities of both countries. The fast removal of capital controls could see the rapid outflow of capital from both countries. On the other hand a lethargic removal of controls will see Iceland and Cyprus become a less prevalent capital destination.

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Table of contents
Chapter 1: Introduction1 1.1 Relating Iceland and Cyprus ......................................................................................................... 2 Chapter 2: Past policy review and historical evidence...3 2.1 History of Capital controls ............................................................................................................. 3 2.2 Joseph Stiglitz on East Asia............................................................................................................ 5 2.2.1 The IMF and the East Asian crisis; Capital controlled cure ............................................... 6 2.2 Lifting capital controls ................................................................................................................... 9 2.3 To come .......................................................................................................................................... 10 Chapter 3: Origins of the Crisis..12 3.1 Increasing Euro area capital flows .............................................................................................. 12 3.2 Current account deficits ............................................................................................................... 13 3.2.1 Cyprus; Current account deficits ......................................................................................... 14 3.2.2 Iceland; The worlds largest balance of payments deficit .................................................. 16 3.3 Controls were set ........................................................................................................................... 19 3.3.1 Types of controls and alternatives ........................................................................................ 20 3.3.2Capital controls; Iceland and Cyprus ................................................................................... 21 3.4 Lifting capital controls ................................................................................................................. 21 3.4.1 Conventional program exits and unconventional program exits ...................................... 22 3.4.2 The extent to which the global affects the local ................................................................... 24 3.5 Summary........................................................................................................................................ 24 Chapter 4: The Economic consequences of post crisis controls in Cyprus26 4.1 Key macroeconomic indicators; GDP growth and Public debt ................................................ 26 4.1.1 Balance of payments problem ............................................................................................... 28 4.1.2 Avoiding the Icelandic stagflation ........................................................................................ 29 4.1.3 Unemployment rates .............................................................................................................. 30 4.1.4 Financial repercussions ......................................................................................................... 30 4.2 Future capital requirements ........................................................................................................ 31 Concluding remarks....33 Bibliography ........................................................................................................................................ 35

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Acknowledgements:
Firstly, I would like to thank my supervisor Stephen Kinsella whose assistance, knowledge and advice have proven invaluable to me throughout my Final Year Project. Secondly, I would like to thank my classmates and friends. The copious amounts of tea that were had were well worth it. Thirdly, I would like to thank my sisters, who have shown boundless support and interest from the start of my college degree. Finally I would also like, in particular, to thank my parents who have shown me the utmost love, patience and support during my time at university. And I hope that one day I can begin to repay the debt I owe.

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Declaration:
I Andrew Moloney, hereby declare that this project is entirely my own work, in my own words, and that all sources used in researching it are fully acknowledged and all quotations properly identified. It has not been submitted, in whole or in part, by me or another person, for the purpose of obtaining any other credit / grade. I understand the ethical implications of my research, and this work meets the requirements of the Faculty of Arts, Humanities and Social Sciences Research Ethics Committee.

Signed: ____________________________ Date: 19/02/14

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Chapter 1: Introduction
The Cypriot economy is a small open economy with 80.5% of Cypriot GDP being made up of the services sector in 2011, 17.1% of GDP was made up of industry and shrinking heavily to 2.4% of GDP was agriculture and farming. (Georgiou 2013) According to Stephanou (2011) the financial sector in Cypress is one of the largest in proportion to the economy, with 896% of Gross domestic product being held in assets in 2010. Domestically owned banks in Cyprus are large in proportion to the Economy and hold 63% of total assets. Being so large in proportion to the economy left Cypriot economy particularly vulnerable to the failures of the banks, both home and abroad. These banks that are too big to fail are known as Systematically Important Financial Institutions (SIFIs). (Stephnou 2011) My Final Year Project will analyse post crisis policy response; with a view to better understanding the effects financial capital controls may have on an economy. From this I will make suggestions on the best policy response for a small open economy such as Cyprus. This will be done with particular attention being paid to Cyprus while drawing from the Icelandic experience thus far. The European commission (EC), the European Central Bank (ECB) and the International Monetary fund (IMF), which are known collectively as the Trioka, agreed on an Economic adjustment programme which has implemented capital controls on Cypriot banks and public. (Stevis 2013) Using empirical data, historical research and an event study approach; I will analyse the effect that capital controls have on the Cypriot economies to the effects they had on Icelandic economies using key macroeconomic indicators.

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1.1 Relating Iceland and Cyprus

The main Cypriot and Icelandic banks acted very similarly in the build up to their crashes. The 3 main Icelandic banks Kaupthing, Landsbanki, and Glitner had built up assets that were over 8 times that of the Icelandic GDP. The Lehman brothers collapse in 2008 brought the beginning of the Icelandic financial crisis and Icelandic Korona devaluation (which was already steadily declining in the years leading up to the collapse). (OBrien 2010) The Cypriot economy had been highly exposed to Greek assets which were deemed toxic in 2008 and with the bailout of Greece in 2010 a contagion effect ensued with the Marfin popular bank exposed to 122.07% of Greek tier one capital. (Mink and De Haan 2013) With this heavy exposer to external sources both countries are a good example of a financial crisis in small open economies that stemmed from much larger countries. And it is this exposer to foreign financial crisis that acted as rationale to implement capital controls. After the Economic adjustment programme agreement, which saw even insured deposits of more than 100,000 invested in Cypriot banks taxed, confidence in the Cypriot financial system has taken a huge hit. As well as this lack in confidence and unprecedented capital controls the Cypriot banking sector is undertaking a complete restructuring with the smaller banks having to take part in mergers and closures. (Stevis 2013) The Cypriot economic crash is unique due to the fact that it had only recently joined the Eurozone and immediately posed a threat to the stability of the euro. The use of capital controls has been widely debated in previous years and the freedom of international markets were seen as a blessing and not a burden to the world economy. (Klien 2012) In the early 2000s after the dotcom debacle many emerging market economies and advanced economies began to place capital controls (albeit light) on their banks to help stabilize their economies. With recent events capital controls have once again been implemented to help stabilize capital flows.
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Chapter 2: Past policy reviews and historical evidence

A review of the historical and empirical evidence in capital controls and macroprudential policies is essential to understanding the logic behind why the Trioka have chosen to suggest the implementation of capital controls on Cyprus and Iceland. There is extensive literature both complimenting capital controls and condemning capital controls as a post crisis response tool. It is important to note that I will be referring to several types of capital controls. These include controls on inflows of capital as seen in China during the Asian crisis or controls set on the outflow of capital in the form of taxes, restrictions or rules that prohibit the mass movement of money out of a specified country. The later will be highly relevant when speaking of Cyprus and Iceland. The free movement of capital can have both good and bad implications for an economy. According to Klien (2012) capital flows can lead to more productive capital usage in an economy. Whereas Qureshi, Ostry, Ghosh and Chamon (2011) suggest excessive capital flows into an economy can be a cause for concern as the liberalization of capital flows can lead to heavy exposer to foreign debt in domestically owned banks. Qureshi, Ostry, Ghosh and Chamon (2011) continue to say that it could lead to a harrowing case of moral hazard as the increase capital flows may not be put to productive use and could be invested in toxic or risky assets.

2.1 History of Capital controls

According to the OECD Code of liberalization (2013) capital controls are seen as rules, taxes or fees on financial transactions that are discriminatory to those outside of the country and benefit those residing within the country. Controls on capital mobility were strongly used and
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advised during the Breton-Woods era of 1944 and onward (Goodman and Pauly 1993). Throughout the Bretton-Woods era Europe and Japan went through what can be seen today as a strong developmental stage and aimed to control capital inflows to help stabilize exchange rates. Over the years capital controls on inflows and outflows of capital have been implemented to help reduce exposer to foreign debt. This had worked until the 1970s saw the end of the Bretton-Woods era, with the free movement of capital and goods taking its place. From the 1970s on the higher authorities such as the WTO and IMF took a neoliberal stance as regards the freedom of capital movement. According to Henry (2006) capital account liberalization is based upon a decision by a government to move from a closed economy with no foreign capital inflows, to an economy which opens itself to foreign capital. In fact according to Harvey (2005) freedom of capital movements had become a pre-requisite to entering the IMF. As the liberalization of capital markets goes, this lead to a more interlocked financial system which left countries more open to contagion affects. With liberalized capital accounts in place in near enough every advanced and developing country, the capital scarce developing countries were experiencing an influx of capital from the capital enriched advanced countries. As is the case with all capital investments, these were done with the hope of a high return to capital (Henry 2006) But has this increase in capital been a burden or a blessing on the stability of these Emerging Market Economies and would it further compromise the stability of a developed economy? According to an IMF working paper written by Sun and Saadi Sedik (2012), there is a positive correlation between capital account liberalization, GDP per capita growth and lower inflation. In the views of Rienhart and Montiel (1999) along with many other economists this high volume of capital into emerging market economies nearly lead to the undoing of these countries and severely damaged the credibility of liberalized capital accounts. Countries in
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Latin America were experiencing an increase in short term capital or in the form of portfolios whereas the East Asian economies were experiencing foreign direct investment. With this increase in short term debt Mexico saw their worst crisis since 1982, followed closely by an unprecedented crash in East Asia. (Rienhart and Montiel 1999) The evidence would suggest that although liberalization of capital accounts can lead to higher GDP and lower inflation, it can also lead to financial instability and runs a severe risk of global contagion. The promotion of free flowing capital is essential for macroeconomic growth but the liberalization of capital flows into small economies can have adverse effects unless the correct macroeconomic policies are in place to help protect against a possible sudden stop in capital.

2.2 Joseph Stiglitz on East Asia

A literature review on capital controls is not complete without reference to Joseph Stiglitz. When writing about the East Asian crisis in the late 1990s Stiglitz was the global leader and believer in capital controls. During this crisis Malaysia and China were two countries on the brink of disaster during the crisis; Malaysia had choose not to opt with the IMF style austerity measures and had instead chosen to opt with one of Joseph Stiglitz greatest contributions to modern macroeconomics. (Stiglitz 2002) Rather than impose straight out capital controls, Stiglitz (at the World Bank at the time) suggested to the Malaysian central bank to impose a control on outflows in the form of an exit tax (Stiglitz 2002). The tax wished to deter the removal of capital as it would cost as much to the investor as leaving their capital in local banks. Those that did remove capital incurred taxes which raised income for the financial sectors. To the amazement of the IMF these capital controls worked, and thus the IMF changed their tune to capital controls. As further reading will show the capital controls that were imposed by Malaysia were the exception to the rule, although they showed resemblances to the modern controls they were more effective in restoring Malaysian growth.

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2.2.1 The IMF and the East Asian crisis; Capital controlled cure
Although it is be denied tooth and nail and is widely debated in global economics that the East Asian crash in the late 90s can be accredited to poor policies and even poorer management of capital movements. The IMF as well as the US treasury played a pivotal part in creating and exacerbating the crisis with poor policies and hefty restrictions. (Stiglitz 2002) In the following paragraphs I will discuss the East Asian crisis; in discussing this I wish to explain the difficulties associated with complete capital account liberalization, the use of capital controls in crisis prevention and most importantly I will explore the advantages of using controls on outflows of capital with reference to Malaysia. I will do this with the intentions of relating Malaysia to the Cypriot and Icelandic situations. The East Asian crisis wasnt just one mistake which lead to the near undoing of many countries, it was a culmination of several mislead governments that had the pressures of the IMF and US treasury baring down on how they should run their capital account. Stiglitz in his book, globalization and its discontents (2002), looks closely at the IMF and capital account liberalization and the price that the East Asian countries are still paying. The IMF maintained the argument that capital account liberalization lead to financial stability and that without liberating capital accounts you were economically inefficient (Stiglitz 2002). In a paper by Paul Krugman (2000), it was found that capital inflows in Thailand had hit an alltime high of 10.1% of GDP which was well over the average across the whole region of 6.7% of GDP. This flow of capital was unheard of in these countries. It left Thailand with copious amounts of capital it couldnt handle and couldnt use efficiently, while making it a debtor country in the global economy. In a more recent study by Eichengreen, Gullapalli and Panizza (2009), they studied the effect of capital account liberalization on individual sectors. They did this by analysing and

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comparing growth within sectors that were dependent on foreign investment to sectors that were dependent on domestic investment. They found that the free movement of capital lead to strong sector growth and thus higher public growth. Furthermore Eichengreen, Gullapalli and Panizza (2009) found that countries that protected against possible shocks were much better off than countries then didnt open their capital accounts at all. To add to this point, while studying the effects of capital controls on the resilience of countries to financial sector shock, Ostry, Ghosh, Chamon and Qureshi (2011) found that countries with controls on capital accounts, prudential foreign exchange measurements and reserve requirements on financial sector capital helped buffer against financial crisis. According to Stiglitz (2002) the first mistake was made when the IMF demanded such a quick delivery of capital account liberalization without analysing and accounting for the possible negative effects it may have for the region. But most of all, when disaster struck the IMF imposed policies on the East Asian economies which promoted further recession. Stiglitz (2002) suggests that when an economy that is small and open economy enters a recession the best response is with quick expansionary fiscal or monetary policies. Doing this may help improve demand in an economy and thus improve domestic consumption while maintaining both public and private tax revenues (Stiglitz 2002). This can be seen in the US as President Obama continues to promote expansionary fiscal policies by increasing Government spending (Forbes 2013).Unfortunately the policies that were pursued were the opposite and rather than stimulating the economy, they helped choke it even further. Mid-crisis policies are essential to macroeconomics as they set the tone for the economy to grind out growth in treacherous economic conditions. It is these policies that determine whether or not a speedy recovery or a possible double-dip recession ensues. According to Friedman (2012), when speaking of the sovereign debt crisis, suggests that expansionary fiscal and monetary polies are needed in order for a speedy recovery and to avoid turning a
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sovereign debt crisis into a household debt crisis (much like we see in Ireland at the moment). Yet although Stiglitz suggested stimulating the economy, the policies implemented by the IMF were austere and extreme; these policies included demanding a balanced budget as well as a ludicrous demand for a trade surplus through either increased exports, which was never going to happen due to trading partners being weak or decreased imports by reducing the incomes through extreme austerity (which is what happened). (Stiglitz 2002) These policies sent many of the East Asian economies into a heavy recession from which they found it difficult to recover from. Yet as stated earlier in the chapter, Malaysia was one of the few countries in East Asia to not fully open their capital account to foreign investment during the late 90s. Although they didnt come out of the crisis completely unscathed, they experienced positive growth rapidly.
Figure 2.1

Figure 2.1 shows the annual GDP growth percentage for Malaysia over a 30 year period which was seen as the most prosperous period of growth in Malaysian history. Malaysia experienced 30 years of nearly all positive growth until the East Asian crisis which was due

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to a mass contagion effect. In 1998 Malaysian officials opted to take the stance of stimulation rather than strangulation of the economy. Rather than increasing the interest rate, the Malaysian officials decreased the interest rate in order to boost the economy rather than strangle indigenous businesses (Stiglitz 2002). This policy was implemented alongside controls on the removal of capital from the country for the short term coupled with the return of all offshore Ringgit (Stiglitz 2002). These policies were implemented in 1998 and within just one year of implementing a different policy to that of the IMF, the Malaysian economy was well on its way to recovery and avoided household debt crisis by enforcing high Austerity measures. Since the success story of Malaysia the IMF have (somewhat) changed their tune when it comes to policies implemented post financial crisis. As seen in Cyprus which is a small extremely open economy, rather than imposing the Austerity that was associated with the IMF during the East Asian crisis we can see different measures been taken as short term capital controls have been taken on as a member of a stabilizing toolkit. Although these measures may have been taken on board for Cyprus, it is very important to note it was a troika suggested strategy and that the IMF didnt have entire choice as regard policy implications.

2.2 Lifting capital controls

Goodman and Pauly (1993) note that in recent years it has been rare that governments fall back on capital controls. On the occasion they do, there is an emphasis placed on how temporary they are. The history of the effectiveness of controls have been hard to find as effectiveness is measured in many ways cross border. Yet one thing is clear with capital controls, they are hard to remove.

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Capital controls were best associated with developing countries that wished to protect themselves from becoming a debtor country to the rest of the world. The removal of capital controls by Mexican officials was decision that would haunt officials. According to Edwards (2000) in the case of Mexico the large increase in capital flows when controls were lifted could lead to an exchange rate appreciation. Empirical evidence shows that Mexico among other countries experienced a large increase in capital flows from 1977-1991 (Edwards 2000). Prior to the increase in capital flows Mexico was part of a closed Latin America. In the years of the late 1980s, flows into Latin America equalled roughly 8bn US dollars a year. (Calvo, Liederman and Rienhart 1993) In 1990 and 1991 Latin America received $24 billion and $40 billion respectively, 45% of this going to Mexico. (Calvo, Liederman and Rienhart 1993) The main concern is that when controls on capital flows were lifted, the Mexican economy saw a large inflow and outflow of capital. This poses a severe threat to the stability of the Icelandic and Cypriot economies as a removal of controls could result in an increased outflow of capital. This will be discussed in greater detail later in the paper.

2.3 To come
It is clear that from the East Asian crisis we can learn quite a bit in term of economic policy during a downturn. The success of capital controls in Malaysia was simply the exception to the rule. Edwards (2000) found that capital controls for the most part resulted in prolonged economic recovery. In contrast the typical IMF austerity measures attempt to promote recovery while attempting to prevent moral hazard. Capital controls in a small open economy have been proven to be difficult to lift after implementation. In the next sections of the paper I will discuss capital mobility and controls with relevance to the Cypriot and Icelandic economies. In this I will be analysing the origins of crises and why capital controls were implemented. I will discuss the possible problems of exiting capital
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controls and why policy makers cannot rely on them being a short-term fix. From this I will make predictions on the future of the Cypriot economy with reference to the Icelandic economy.

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Chapter 3; Origins of the Crisis

According to Truman (2013) since the 70s economists have formed a means of understanding the origins of crises. The origins of crises have been classified into 4 groups; Currency crises or speculation crises, current account crisis which is triggered by a sudden stop in inflows of capital, a public sector debt crisis and finally a systemic banking crisis. Truman (2013) notes that these are not seen as single occurrences that take place, these often overlap and combine to exacerbate the situation. This was true for the European crisis, rather than seeing each problem as individual it is important to note that one problem may have been the causality of another.

3.1 Increasing Euro area capital flows

Unlike a single currency economy like Iceland, capital flows in a monetary union creates a new kind of problem. Lane (2013) when writing a European commission paper on capital flows in a monetary union outlines the special circumstances that require exceptional consideration. A single currency economy such as Iceland has just one nation with a single current account deficit or surplus to acknowledge (in this case a deficit). Whereas in a monetary union there are many countries that have either a creditor or debtor status; according to Lane (2013) notes that each country will have distinct adjustments to different types of shock. Moreover Lane (2013) notes that wage and price rigidities within a monetary union make it increasingly difficult for a governing central bank to find equilibrium within a monetary union. Exchange rate behaviour may have differing results in differing economies; an appreciation will lead to a decrease in exports which leads to a profit decrease in companies, as the profit decreases it leads to an adjustment by wage setters and flexible price setters. In
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this situation depreciation would incur to help increase imports, yet in a monetary union any single country does not have control over exchange rates and so cannot use monetary policy to adjust to the situation like the US have with quantitative easing methods. With capital flows in a monetary union having a direct impact on exchange rates, capital flows become more important as the ability to use monetary policy to adjust is impeded. According to Lane (2013) increasing capital flows in the Euro area was highly evident after monetary integration. After the 2000-2001 crash capital flows tripled between 2002 and 2007. (Lane 2013) The large increases of capital flows into Eurozone economies were increasing the foreign assets and liabilities in balance sheets. This in turn will lead to large current account deficits.

3.2 Current account deficits

A current account is one of the best indicators of the economic health and standing of a country. The current account usually shows which countries are creditors or debtors in the world. According to Ghosh and Ramakrishnan (2012) of the IMF, when a country runs a constant current account deficit it is becoming more indebted to foreign nations. Although getting more than youre giving is a good way of stimulating an economy it can be argued that unless financial institutes are allocating the capital efficiently, when the foreign debt needs to be paid back it leads to complications. Ghosh and Ramakrishnan (2012) also argue that a current account deficit is more commonly related to a young developing country experiencing large annual growth. The main aspect of the current account is the international trade of goods (exports and imports), when there is a trade deficit it is up to the financial account to balance the payments. The liberalization of capital mobility has made the world much more susceptible to contagion during economic crisis due to this financial instability which emerged from large current account deficits.
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Having a current account deficit may go unnoticed as long as capital continues to flow. According to Truman (2013) many economists and the IMF noted that a country that ran a current account deficit could not experience a sudden stop of capital flows. This was due to the fact that flows were in a common currency and as long as the common currency as a whole ran a surplus a sudden stop would not ensue. The IMF and many economists were wrong as we now know the answer is yes. The metaphor of a car can be used; the car may seem fine, if untreated for oil and petrol, it will run out of both, this means that the driver is left with a lemon due to not taking the precautions needed to prevent the breakdown. Truman notes that after the crisis began capital flows unwound which left countries vulnerable to shock as target 2 balances cushioned the crisis. Account deficits can be seen in both Cyprus and Iceland, other factors such as currency crises and banking crises added to the damage.

3.2.1 Cyprus; Current account deficits

The Cypriot economy had the characteristics of a young developing country which had recently just opened its doors to complete freedom of trade. Cyprus is the largest Island in the Mediterranean; this means that Cyprus is a direct link to the Middle-East, North Africa and Europe. Cypruss leading export partners are Greece, the UK and Lebanon while imports rely heavily on Israel, the UK and Greece (cyprusprofile 2013). In fact 19% of all Cypriot imports were from Greece in 2012 which amounted to $1,423,595,412, while exports to Greece amounted to $700,008,185 which was 18% of all Cypriot exports (The observatory of economic complexity 2012). It is this close tie and high exports to Greece that may have contributed to Cypruss vulnerability to external shock. Cyprus was a country that in the years leading up to the crisis lead a consistent current account deficit. According to the central bank of Cyprus Annual economic indicators (2013), GDP in terms of millions of s was 13,402.0, 14,432.5 and 15,829.7 in the years

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2005, 2006 and 2007, relative to the GDP of Cyprus is the current account balance as a percentage of GDP. In 2005, 2006 and 2007 the balances as a % of GDP were -5.9, -7.0 and 11.8 respectively. These current account deficits were phenomenally and consistently high which lead to a large emphasis on the Cypriot financial sector. This pressure that was placed upon the small financial sector in Cyprus was too much for them to handle, this lead to the eventual implosion of the Cypriot banking system. Figure 3.1 is a time series data taken from Eurostat (2013); this shows the consistently negative balance of payments in the Cypriot economy in comparison to other small open economies.
Figure 3.1

Source: Eurostat graph builder 2013

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Cyprus and Greece were so close that they shared relatively similar current account deficits. Ireland. Ireland were another country that had to enter a Trioka bailout programme had a relatively low current account deficit but still had a large current account deficit in terms of economy size. The Creditor/Debtor status can be seen clearly when the current account of Cyprus is compared to Luxembourg. After the 2007 crash, the situation worsened for Cyprus as Greece (one of Cypruss main trade partners) fell victim to a debt moratorium but more importantly to the corruptness of the Greek government who revised their already high fiscal deficit of 6.0% (which is above 3.0% allowed by the EU) to 12.7% which would be further revised to 15.4%. (Gibson, hall and Tavlos 2012) Many economists have seen this current and financial account deficit as highly unsustainable with a current account deficit accrediting creditor country status to the holder.

3.2.2 Iceland; The worlds largest balance of payments deficit

Iceland was a typical example of a country thriving during the economic boom that was taking place prior to the 2007 downturn. Much like Cyprus, Iceland is on the periphery of Europe and is home to an abundance of natural resources such as geothermal energy and hydroelectric energy. (Gildea 2013) According to the Observatory of Economic complexity in (2012) Icelands main trading Partners were the Netherlands with over 26% of all exports bound for Dutch soil, in recent years Iceland have been running a trade surplus in order to try and stimulate the economy with Exports reaching over 5 billion US dollars and imports only reaching 3.6 billion US dollars. In the years leading up to the crisis Iceland was another country with debtor status as it had what was the largest current account deficit in the world peaking at 24% of GDP. (Gildea 2013) As stated earlier in the chapter this leads to immense pressure on the financial sector to try and balance the payments of the country. Noted in the introduction of the paper, the 3
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Icelandic banks held assets that were 8 times more than Icelandic GDP. This made the 3 main banks so large that the Icelandic central bank wouldnt be able to bail them out if needs be. Iceland experienced what is known as a common currency crisis which contributed heavily to the current account deficit that they held in the years leading up to the crisis. OBrien (2010) noted that the Icelandic Krona was declining since 2008 and then nose-dived after the collapse of Lehmann brothers. The Icelandic banks attempted to draw the money from their overseas subsidiaries in the UK, however when this failed they found themselves starved of money and forced in the direction of bankruptcy. According to Lane (2008) the problem with Iceland began at the beginning of the millennium with the Icelandic central bank taking up a monetary policy such as inflation targeting. By doing this the Icelandic central bank increased interest rates in order to promote a stable level of inflation. In 2006 the inflation rate for Iceland was averaging 6.8% with the interest rates of the Icelandic central bank increasing from 6.06% to 13.03% from July 2004 to December 20th 2006. (Inflation.eu statistics 2014) (Icelandic central bank 2014) With interest rates rising the populace and Icelandic firms began borrowing in different currencies. Baldursson and Portes (2014) note that in 2008 the difference in interest rates between the Icelandic Krona and low yielding currencies such as the Swiss Franc and Japanese Yen was roughly 10%. This gave carry traders the opportunity to make large profits investing in Iceland. According to Lane (2008) this gave the Icelandic locals the illusion of wealth. The illusion of wealth lead to economic growth and further increases in inflation rates which saw a death spiral begin as this induced the Icelandic central bank to increase interest rates again. This inevitably created a bubble which saw high domestic interest rates and currency appreciation and capital flows. (Lane 2008) But when the depreciation of the Icelandic Krona began when investors began to recall the money they had in Iceland.

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Comparing these figures and policy methods to Icelands Nordic counterparts Sweden, a country that emerged from the financial crisis relatively unscathed, shows that Sweden had an interest rate of 3.5% average for February 2004 to 3.5% in December 2004. The interest rate remained stable and consistent throughout the typical bubble years. Swedish inflation remained stable and steady while experiencing economic growth, an inflation rate of .24% in 2004 increased to 1.64% in 2006. (Sveriges Riksbank 2014) The monetary policy pursued by the Icelandic central bank was ideal on paper, in practice however it created large problems for the Icelandic economy.
Figure 3.2 Icelandic and Cypriot BOP's

Figure 3.2 shows Icelandic and Cypriot balance of payments as a percentage of their GDP. Cyprus ran what was a relatively large deficit in comparison to their GDP whereas Iceland ran what was a death wish with their balance of payments and placed sever pressure on the

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Financial system, this left their government particularly vulnerable to the instability of the financial sector. After the crash of 2008 both countries balances reached what were their highest imbalances yet. This can be largely due to the fact that exports in both countries reduced severely due to the economic downturn in 2007. Both countries have since begun to balance payments under the IMF programmes.

3.3 Controls were set

Capital controls were put in place by the Troika, but with what logic behind them? The Cypriot banking system was in disarray after the crash. For the first time since Northern Rock in the UK, economists and policy makers were afraid of a bank run. This would have further crippled the financial system within Cyprus, as said above 2 of the biggest banks held the vast majority of assets in Cyprus. According to a report published by Freshfields Bruckhaus Deringer (2013) the main logic behind the implementation of capital controls was that it would allow Cypriot banks to restructure themselves following a long period of closure. This would prevent this bank run and lead to the beginning of financial stability; but at what cost? According to Kalotay (2013) the capital controls that were set on Cyprus will be detrimental to Cypruss position as a financial centre in Europe. This comes as terrible news for Russian investors that have more than 100,000 euro deposited in one of the top 2 banks in Cyprus. This haircut was aimed to raise 5.8 billion on top of the 10 billion requested by the Cypriots. According to a German memo sent in November (Rose and Tugwell 2013), it was estimated that Russian assets in Cypriot banks had accumulated to roughly 26 billion euro. The bank restructuring and hitting these high end bondholders with a deposit tax has left confidence in Cypriot banks in ruin.

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3.3.1 Types of controls and alternatives

Although controls were set in both countries, the problems were of a different nature. According to Davsdttir (2013) Cyprus was a special exception that caused significant problems for the Cypriot economy. With talks of an imminent run on the banks, the government took invasive measures to try and avoid a run. According to Knight (2013) of BBC news the details of how much access the public had to their accounts in initial stages of the controls that were set in Cyprus were frustratingly absent. The initial stages in the Cypriot banking crisis say a flurry of bank holidays been announced. In a 1999 review Christopher J. Neely noted the potential purposes of capital controls; Neely noted that controls on outflows can come for various reasons. As noted above a crisis may entail many reasons, for this reason it is important to note that controls have been set for a number of reasons. Neely (1999) notes that a balance of payments crisis can be solved by contractionary monetary policy, this would mean that the central bank would sell domestic bonds. Selling domestic bonds in theory would lower domestic money supply and raise domestic interest rates. According to Alesina, Grilli and Milesi-Feretti (1993) Monetary policy only has a short-term impact on output; expansionary monetary policy results in an increase in output and imports, this also induces an immediate loss of federal reserves. This would only exacerbate the situation for Iceland as a speculative attack on federal reserves led to a currency crisis. Alesina, Grilli and Milesi-Feretti (1993) also note that in various studies lightly implemented capital controls can be used to prevent attacks on federal reserves due to speculation, although in the long run reserves would depreciate through the current account. In order to save foreign reserves the Icelandic central bank and government had no choice but to implement full capital controls on outflows.

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The implementation of full capital controls was imminent. Fratzsher (2012) undertakes a study to test the motivation behind capital controls. Facing a currency crisis initially it was imperative that Iceland protected international reserves from being removed from the country. Having decided to undertake inflation-targeting, Iceland became financially open. When inflation rates still rose as well as exchange rates, the volume of capital flows into Iceland increased, as did the volatility of these flows.

3.3.2Capital controls; Iceland and Cyprus

The controls implemented were unprecedented and according to Knight (2013) they fly in the faces of European treaties that is built on the premise of free flowing capital between European countries. Weaver and Stothard (2013) note the details of the controls stating that depositors could not withdraw more than 300 a day, transfers of more than 5000 needed permission from the Central bank of Cyprus and there would be a limit of 3000 in bank notes for overseas trips. In explaining the controls that were set in Iceland, Danielsson and Arnason (2011) take an extreme yet realistic view of the controls set describing them as draconian and a violation of human rights. Citizens of Iceland could not transfer assets abroad and thus indirectly abolishing emigration. (Danielsson and Arnason 2011) Families looking to take a holiday would have to request permission from the government, as the Iceland central bank had to ration foreign reserves and finally firms seeking to invest abroad to request permission from the Icelandic central bank.

3.4 Lifting capital controls

According to Baldursson and Portes (2014) the capital controls that were set in each country were seen as a short term means of stabilizing their economy. Cypriot and Icelandic officials

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will be hoping to remove their controversial capital controls sooner rather than later. Many economists have noted that implementing capital controls is much easier than removing them. In this section a comparison between exiting a typical bailout strategy and a capital control policy will be drawn. This will be done with the comparison of Ireland (that on 14th of December 2013 officially exited the IMF bailout) to Cyprus and Iceland that have yet to fully remove capital controls. All three economies have had similar trade policies and a relatively equal balance of payments deficit. I will also note how removing capital controls will be harder as there is a constant fear of capital being removed from the banks.

3.4.1 Conventional program exits and unconventional program exits

With the IMFs history of implementing conventional bailout packages, it was no surprise that they would implement austerity upon the next troubled economy. Ireland recently exited an 85bn bailout that the troika implemented on them. Although they have exited the bailout this does not mean that they have the money paid back. Ireland will be paying back the bailout loan until the year 2042. Upon exiting the bailout the Irish government rejected a 10bn emergency credit line. The exit from the bailout was seen as clean as Ireland we dubbed the poster child of the EU. After 3 years of austerity under the watchful eye of the Trioka, it is now entirely in the hands of the Irish government. Iceland has been a country that has suffered considerable pain in exiting the capital controls. As stated above capital controls that are set in a country are set as short term measure to help stabilize an economy. (Baldursson and Portes 2014) According to Danielsson (2013) this was the second time that Iceland has implemented capital controls (with the first being in the 1930s). Past experience with capital controls has been similar; countries that implement capital controls are seen as a liability, in the short run investors wish to remove their money from that country. (Danielsson 2013) This desire will continue unless optimism is renewed in

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that particular economy. Even if capital controls are seen as a short term measure the threat of capital outflows remain as long as confidence in the economy is low. Baldursson and Portes (2014) note that if capital controls are removed from Icelandic banks the flow of capital would mean that the CBI would have to convert Kronas worth over 60% of their GDP to a foreign currency. Cyprus is not in a better situation than Iceland; being in the Eurozone the possibility of having an attack is relatively small. Santa and ODonnell of Reuters (2013) wrote that Cypriot finance minister Harris Georgiades is planning a gradual yet steady lifting of capital controls. According to Suoninen (2014) since May 2012 Cyprus banks have seen deposits drop by 30% but Harris Georgiades claims that this is part of the financial restructuring taking place in Cyprus. In order for Cyprus to hope for a removal of controls the economic forecast for Cyprus must improve. In the autumn (2013) forecast by the European commission Cyprus will see negative growth in 2013 by at least 8%, inflation is forecast to reduce to 1% from 3.1%. As well as this Cyprus is predicted to see an increase in public debt in the coming years, rising from 86.6% in 2012 to 127.4% in 2015. With this prediction the threat of capital flowing outward if capital controls are eliminated. As seen with Iceland, the desire to remove capital from a country in political and financial turmoil will continue unless confidence is restored. Danielsson (2013) notes that it is imperative that Cyprus and Iceland remove capital controls as soon as possible as it may lead to a situation where the economy adjusts to the controls. Both economies have another underlying problem that may create further difficulty when removing capital controls; removing controls will not only enable foreign investors to remove capital but it will enable domestic investors to remove their capital from domestic banks. By doing so domestic investors will look to diversify their capital more.

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3.4.2 The extent to which the global affects the local

The issues that these economies have faced as regards removing capital controls are also due to external issues. As these are small open economies that are interlinked with other economies, the decisions and ideas of larger creditor countries has a large effect on the policies of Iceland and Cyprus. The United States Federal reserve has undertaken monetary easing strategies such as Quantitative easing. These strategies have been viewed as unconventional, according to Subramanian and Weatherstone (2014) note in a recent paper that all decisions made by the fed to take part in QE will have a direct effect on investment, capital flows and trade internationally. The threat of tapering made by the Fed gives the possibility of high interest rates in the US. According to Subramanian and Weatherspoon (2014) the tapering of the Quantitative Easing poses a threat to economically unfit nations, namely the threat of outflows of capital. With this in mind, the removal of capital controls by both Iceland and Cyprus indefinitely would see capital flow freely out of their countries. Having introduced capital controls in order to protect a run on banks and foreign reserves. Policy makers in Cyprus and Iceland have to be vigilant of the moves made by the US and other creditor nations. The case for a quick removal of capital controls is abolished as it could lead to capital flowing into countries like the US.

3.5 Summary
The origins of the Icelandic and Cypriot crises were not solely due to one specific reason; in fact it was the culmination of the different types of crises occurring in tandem. The current account deficits of each country were unsustainable, this lead to the solidification of the debtor status of each country. As stated above, receiving more that youre giving is good until youre no longer receiving and expected to give back. The heavy currency crisis incurred in
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Iceland questioned the monetary policies pursued by the Central Bank of Iceland. The controls that were set in the face of the crisis have been widely regarded as draconian and as a violation of human rights. The East Asian experience and the western experience have been different in terms of results of controls that have been set. The removal of such controls has proven to be even more difficult that initially envisaged; this can be accredited to many reasons such as the constant fear of both domestic and foreign capital being moved overseas by investors hoping to cut their losses.

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Chapter 4: The Economic consequences of post crisis controls in Cyprus

In this chapter the key macroeconomic variables which contribute to growth will be assessed during the years each country has implemented capital controls. I will assess the potential damage that implementing capital controls can have on key macroeconomic indicators as well as the Cypriot financial sector. Reference will be made to the sovereign debt of Cyprus and the stability of the financial sector which makes up for the vast majority of the Cypriot services sector. Evidence will be taken from Icelands struggle with capital controls in place as light will be shed on the situation in Cyprus.

4.1 Key macroeconomic indicators; GDP growth and Public debt

Holding to Edwards (1999) finding that those who have implemented post crisis capital controls have found the recovery period much more difficult. Of course as noted above there are outliers such as Malaysia, but the vast majority have not seen any improvement. Since the implementation of capital controls on outflows Iceland have not seen a much improved GDP growth, growth in 2007-2008 declined rapidly as expected from 6.0% growth to 1.2% (Eurostat 2013). This was greeted with steep decline in GDP growth from 1.2% to -6.6% in 2009 (Eurostat 2013). This decline in GDP saw large increase in public debt as Icelands debt continues to grow half a decade after the controls were implemented. Public debt in Iceland grew from 70.4 to 96.4 as a percentage of GDP (Eurostat 2013). Controls on outflows and the gradual restructuring of the Icelandic financial system have seen the steady increase in debt to GDP ratio. The prognosis for Cyprus is similar as year on year GDP growth declines there is a gradual increase in public debt. Cypriot GDP growth has been fluctuating since 2009, but since capital controls in were introduced in 2013 projected GDP growth is bleak as the

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economy is expected to contract by 87% this year and 3.4% in 2014 (Cyprus profile 2013). Figure 4.1 shows the GDP growth as a percentage of GDP for Cyprus, Iceland and Ireland.
Figure 4.1

Source: Eurostat (2013)

Ireland is the only country in figure 4.1 not to have implemented post crisis capital controls. This figure shows the extent to which GDP growth in Iceland, Ireland and Cyprus is similar. Cyprus are set to decline even further while the outlook for Iceland and Cyprus is much more promising. Ireland is experiencing a large public debt crisis and implemented austerity as a crisis policy response method. Ireland has a government debt to GDP ratio of 117.4% in 2012 with projects of an incline to its peak of 120% set for 2013 (Eurostat 2013).

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After this Ireland will be expected to reduce the debt to GDP ratio steadily, but will find it paying off the public debt until at least 2040. The trends in this graph are similar showing that growth may be similar too. With Cypriot GDP set to contract, the policy makers of Cyprus will find it increasingly difficult to remove capital controls. A quick removal of capital controls could result in a quick flight of capital out of the country. Ireland and the austerity that was faced will have an easier time than Cyprus when trying to reduce the public debt problem.

4.1.1 Balance of payments problem

The short term goal for Cyprus was to prevent a run on the banks in 2013; this was a clearly a pipe dream, as previously noted, the balance of payments deficit that Cyprus encountered became a main contributor to the Cypriots problems. With Cyprus attempting to restructure their financial system the pressure that was placed on the financial sector in the years leading up to the crisis cannot be redone. Iceland has had a current account deficit before and since the implementation of capital controls. Since the 2007 crisis and the need for the stability of the balance of payments Iceland have steadily reduced the current account deficit which peaked at 27.7% of GDP in 2008 and has declined since to a predicted number of 4.7% in 2012 (Eurostat 2013). Cyprus has not had a current account surplus for over 10 years, it is key that Cyprus adopt a mercantilist mentality of trade and try and boost exports. With the financial downturn in Cyprus, imports will automatically reduce due to the decrease in consumption. Decreased consumption is a key reason for GDP growth becoming negative. Cyprus will find it difficult to reduce this deficit in the coming years as GDP continues to decline in comparison to previous years.

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4.1.2 Avoiding the Icelandic stagflation

As noted, Iceland is currently experiencing negative growth in their economy. With this negative growth has come large year on year inflation. Although during positive economic growth it is essential that prices rise to ensure that real wages rise as actual prices exceed expected prices. Increases in real wages lead to increased consumption and increased imports. If a nation is to experience negative growth and high levels of inflation or sometimes hyperinflation it will have adverse effects. As the output drops, but inflation occurs, companies will no longer be able to afford to pay wages, thus leading to increased unemployment. During a financial restructuring the credit line that would otherwise be available at will to businesses is lost and thus more closures ensue. Iceland since 2008 have experienced hyperinflation in 2008 and 2009 with 12.8% and 16.3% respectively with steadily increasing year on year inflation rates between 2010 and 2012. (Eurostat 2013) Inflation in Cyprus has been somewhat maintained, a steady inflation rate of roughly 2% in the years leading to the crisis has continued into the post crisis era rarely fluctuating. As Cyprus is part of a monetary Union it has made recovery via monetary policy easier. The ECB have maintained a low benchmark interest rate which has declined since the 2007 crisis. With this inflation rates have been maintained due to increased lending capabilities. With Eurozone inflation remaining hopelessly low at .7% in 2013 there has been calls for a decrease in the ECB interest rates (Irish independent 2014). If rates were cut this could lead to increased inflation in Cyprus which is not what the country needs at the moment. Capital controls in Cyprus have in the short run allowed banks to stay open, but in the long run, when capital controls are lifted the banks will need repayment on loans and mortgages. If mortgages are not repaid the fear of another bank recapitalization could unfold. Recapitalization of the Cypriot banks could mean an added haircut for the uninsured deposits above. A Death Spiral could ensue with haircuts ensuring that those with over 100,000 in
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Cypriot banks will look to relocate immediately following the removal of capital controls. This resurfaces the theory that capital controls (although intended to be a short term means of bank protection) could end up becoming a permanent fixture of the Cypriot financial sector.

4.1.3 Unemployment rates

Unemployment rates are one of the key indicators of local wealth; Iceland due to sound monetary policy has been successful in keeping unemployment rates down. Cyprus on the other hand has experienced the continuous incline of their unemployment rates. Since 2008 Cyprus has incurred an increase of unemployment by 12%, reaching record lows of 3.7% in 2008 to record highs of 16% in 2013 with this figure expected to rise. (Eurostat 2013) Capital controls in Cyprus and Iceland will have a major influence on the unemployment rates of these countries. As the controls prohibit the large transfer of capital cross border this will in effect render the movement of human capital improbable as the transfer of assets cross border is prohibited. This will lead to an increase in unemployment rates and a further decline in political stability as a weakened nation grows weary of indecisive governance. Ireland has shown increased unemployment rates, reaching a peak of 14.7% in 2012, and declining in 2013 to 13.1%. (Eurostat 2013) This is a hazy figure as the unemployment rate would have been higher had the large emigration from Ireland had not taken place. However this can be seen as a negative thing, as the economy begins to increase the need for skilled young workers will increase. With the brain drain occurring many of the young skilled workers may not return from their extended holidays.

4.1.4 Financial repercussions

The financial outlook for Cyprus is bleak, as part of the bail-in requires the downsizing of the financial sector in Cyprus. The services sector in Cyprus accounts for 80% of the economies GDP prior to the crisis. The downsizing of the financial sector will see the financial sector in
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the Cypriot economy shrink and thus the GDP growth of Cyprus decrease further. This will be exacerbated by the haircuts that have taken place in the bail-in. With uninsured deposits having to bear the brunt of the bail-in due to political reasons confidence in the Cypriot banks will be at an all-time low. Holding to this, the Cypriot financial sector will no longer feature as a financial region in Europe. For Cyprus it is imperative that the Cypriot government

look for an alternative sector that can possibly take over from a severely damaged financial sector. Taking the events in Iceland as a template for what could happen in Cyprus; examining the output of the financial and insurance industries as a percentage of GDP it is clear that Icelandic banks have gone through a severe downsizing. In the years leading up to the crisis industry output data in Iceland shows that the financial and insurance industry accounts for 9.4% of GDP in both 2005 and 2006. Since the crash, the implementation of capital controls and the downsizing of the financial sector had dropped by almost 4%. (Statistics Iceland 2013) Having reached 9.1% in 2008 the financial sector output plummeted to 5.4% of GDP and has failed to regain momentum since reaching only 5.8% of GDP in 2012. (Statistics Iceland 2013) One wouldnt be optimistic for the Cypriot financial system as a large downsizing of the financial sector is imminent. Capital controls in place may further damage the reputation of many Cypriot banks and force more closures and mergers.

4.2 Future capital requirements

Future banking policies must be aimed at the preventative as oppose to recovery policies. One of the tools that can be the use of contingent capital with dual triggers; as a firm enters bankruptcy it is due their liabilities outweighing their assets. In order to avoid bankruptcy public funds may be used to absorb losses taken by depositors (Flannery 2009). Contingent Capital certificates fuel banks with equity as capital ratios begin to decline. (Flannery 2009)

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It is important to note that these instruments do not provide the bank with more funds; they turn debt into common tradable stock that could bolster defences against bankruptcy. If capital ratios in the banking system fall below a certain level this triggers the initial contingent capital to convert debt to tradable stock. (Flannery 2009) If ratios continue to decline it will lead to the second triggering event; as these convert more debt to tradable stock the shareholders of the firm will experience a rapid decline in stock prices. However, if the sale of the stock occurs it will provide more equity for the bank. These Contingent capital credits prevent the tax payer or the bondholders of a bank from taking the majority of the damage from the bankruptcy of the firm.

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Concluding remarks
The Cypriot financial system is currently undergoing a severe downsizing, the implementation of capital controls on the banking system has left it battered and bruised. From this paper we have sought to understand important aspects of the implementation of capital controls, the reasons for doing so and finally the consequences of doing so. Firstly, it was a series of unfortunate events that lead to controls being placed. The origins of a crisis were an accumulation of many occurrences from a balance of payments deficit to a currency crisis. With the high holding depositors of the Cypriot banks being of Russian decent there were political reasons for incurring haircuts. These haircuts left the domestic depositors scared and frantic; hoping to cut loses a near catastrophic run on the banks would have ensued if it were not for the controls in place. Secondly, as noted by Edwards (2000) the implementation of capital controls as a short term means of relief is not realistic as many barriers to removing the controls remain. Due to the increasingly interlinked financial systems, events in the US could have substantial influence on the movement of capital in debtor nations. If controls are removed too soon there could be an outflow of capital, which would have only prolonged the situation that the troika were trying to avoid. Noting this, the failure to remove capital controls at the correct moment could result in capital controls becoming a constant feature of a financial sector. This can leave investors disillusioned by the financial sector. Thirdly, Cyprus will have to endure many years of hardship before there are any signs of recovery. A mercantilist approach to trade may have to be implemented to try and improve the balance of payments which will be hurt by the controls on capital flows. Capital controls have an indirect and direct effect on key macroeconomic variables such as GDP growth and unemployment. Finally, the Cypriot policy financial sector will be downsized, it is imperative that the Cypriot government introduce correct measures to ensure that adequate capital is stored in banks. The key to aiding future bail-outs or bail-ins are preventative measures that require more robust capital ratios for 33 | P a g e

banks. Both Cyprus and Iceland have to remain patient in removing controls, the use of capital controls was justified on a political level, but the use of capital controls will have repercussions further into the decade and beyond.

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