## _wp13242

## Source details

**Canonical URL:** [_wp13242](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13242.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13242.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13242.pdf.json)

---

### Risk weights, Basel II, and mortgage lending
- With the introduction of Basel II principles, in 2008, the risk weights on mortgage lending were decreased to 60 percent and after a two-year transition period harmonized with the EU directive to 35 percent.

### Policy measures taken in the Baltic countries and Iceland during credit booms
- Latvia
  - Authorities increased reserve requirements, significantly broadened the reserve base and increased official interest rates when first signs of overheating appeared in 2004.
  - IMF advice: enhance supervision and prudential measures.
  - Anti-Inflation Plan measures:
    - obligation for banks to require borrowers’ to provide a statement of legal income;
    - a minimum down payment of 10 percent.
  - The minimum down payment requirement was abolished by the authorities in June 2008.
- Lithuania
  - Gradual improvements to financial regulation and supervision to tackle excessive credit growth.
  - Implemented IMF recommendations:
    - enhancing monitoring of borrowers’ credit quality;
    - limiting the inclusion of current-year profits in capital;
    - introducing stricter risk weights for commercial real estate.
  - 2006 IMF staff flagged “aggressive lending practices” and encouraged forward-looking supervisory analysis and additional supervisory measures.
  - 2007 IMF staff suggested identifying and raising bank-specific capital requirements.
  - 2008 recommendation: further increase capital buffers and closer cooperation with banks, parent banks and home authorities.
  - Implementation did not substantially counteract fiscal incentives such as residential mortgage subsidies and the absence of a property tax.
- Estonia
  - Authorities regarded prudential measures as more effective with joint efforts and support from home-country authorities.
  - Effectiveness of LTV or LTI restrictions considered unclear prior to the crisis.
  - Most macroprudential measures applied only to local banks and subsidiaries and left branches untouched, potentially harming the level playing field.
- Iceland
  - Prior to the crisis, few measures other than tighter monetary policy were introduced; CFMs were not recommended by the IMF and were not introduced.
  - Authorities argued measures dealing with free capital flows must be directed at financial regulation.
  - Suggested measures that could have limited credit expansion:
    - higher capital and reserve requirements for banks;
    - limitation of FX-denominated loans to households and non-financial corporates;
    - stricter regulation on currency and maturity mismatches in banks’ balance sheets;
    - stricter liquidity requirements.

### Macroeprudential tools and capital flow management measures (CFMs) — assessments and estimates
- Estonia
  - Authorities judged the impact of alternatives to higher risk weights and reserve requirements to be negligible because large parent banks could overcome them easily.
- Latvia
  - Authorities considered a restriction on maximum LTV as the most powerful tool to curb speculative real-estate activity; introduced at a very late stage.
  - An earlier introduction of a comprehensive credit register would have prevented the build-up of speculative private debt.
  - Additional capital requirements for specific loans could possibly have slowed excessive lending.
- Lithuania
  - Authorities’ calculations: limits on LTV and LTI ratios could have reduced the loan for housing purchases portfolio by 8.6 percent.
  - Under those limits, the number of loans granted during the period 2006-2008 would then have been 7,000-8,000 lower.
  - These calculations subsequently led to the introduction of regulations on responsible lending in November 2011.
- Iceland
  - Suggested focus on financial regulation as first line of defense (consistent with IMF framework).
  - Measures listed by authorities that would have helped limit credit expansion include higher capital and reserve requirements, FX loan limits, stricter regulation on currency and maturity mismatches, and stricter liquidity requirements.

### Policy responses to capital outflows and IMF engagement
- Iceland
  - Capital controls enforced in November 2008 to stabilize the exchange rate of the krona and prevent destabilizing outflows.
  - IMF provided technical assistance on design and compliance with Iceland’s international obligations, including IMF’s Article VIII.
  - Capital controls designed to block all capital transactions while protecting an undisturbed currency exchange market for current transactions; FDI not subject to capital controls.
  - Circumvention increased; in October 2009 new rules enabled inflow in foreign currency through a “new investment” channel and introduced new restrictions on inflows in domestic currency (the “off-shore krona”), which are still in place today.
  - Foreign Exchange Act amended in March 2012 to prevent circumvention via the bond market and tighten control on capital flows related to winding-up of failed Icelandic banks.
  - Foreign Exchange Act amended again in March 2013: sunset clause revoked and other structural improvements implemented.
- Latvia
  - When Latvian authorities bailed out Parex Bank in November 2008, they introduced a partial deposit freeze to maintain financial stability.
  - IMF approved the partial deposit freeze under Article VIII of the IMF Articles of Agreement.
  - Following Parex restructuring, the partial deposit freeze was attributable to a minor proportion of deposits and was fully removed in December 2011.
- Iceland’s exit from capital controls
  - Capital controls were listed as temporary measures in the Icelandic authorities’ initial Letter of Intent.
  - About half a year after imposition, deliberations on an exit strategy commenced; a document on the exit strategy was published in August 2009.
  - In March 2011, during the fifth review of the IMF-supported program, authorities and the IMF agreed on a gradual, conditions-based exit strategy; IMF provided expert advice on structure and communication.
  - Preconditions for exit: sustainability of public finances, a strengthened banking sector and the building up of sufficient international reserves.
  - Strategy objective: lift controls in stages to avoid jeopardizing foreign exchange market stability; focus on transferring unstable krona assets into long-term investments.
  - Strategy stages are not time-bound and are conditional on measures such as lengthening resident borrowers’ foreign financing, acceptable settlement of failed banks’ estates, and a permanent channel for non-residents with short term krona positions.
  - Strategy divided into two phases: first reducing offshore krona positions and second removing controls on onshore krona.
  - First phase commenced in late 2011; regular auctions by the Central Bank of Iceland from February 2012 over a two-year period significantly reduced short-term krona positions.

### Lessons learnt
- General observations
  - Ex post identification of mistakes is easier than ex ante due to uncertainties about the economic cycle and regulatory frameworks.
  - Shortcomings existed in macroeconomic policies and financial supervision in the Nordic and Baltic regions.
  - Capital inflows per se were not considered the thrust of the problem.
  - If the IMF’s policy framework had been in place before the crisis build-up, potential problems may have been pinpointed earlier and addressed with appropriate measures.
- Macroeconomic policy lessons
  - Fiscal policy was underused to moderate large capital inflows.
  - In Iceland, the monetary/fiscal policy mix was suboptimal with too heavy a burden on monetary policy; higher policy rates attracted more short-term capital.
  - Iceland could have used fiscal policy more to restrain aggregate demand growth and build buffers to combat reversal of capital flows.
  - Baltic countries’ monetary policy was constrained by currency boards; fiscal policy should have been tightened earlier to curb domestic demand and credit expansion.
  - Structural policies, e.g., tax incentives for debt financing, exacerbated imbalances; tax incentives were only reduced in Estonia.
- Macroprudential and supervisory lessons
  - Macroeconomic policy alone could not have managed large capital inflows; macroprudential measures should be implemented early.
  - Some countries found macroprudential measures insufficient; additional prudential measures would have been warranted.
  - Risks from large amounts of lending in foreign currency could have been mitigated through increased risk weights on such loans.
  - In Iceland, given suboptimal policy conditions, macroprudential tools and higher capital requirements could have been assessed and used.
  - Icelandic banking supervision suffered from insufficient resources and data gaps; these were addressed as part of the SBA program and stricter stress tests were implemented.
  - Lithuanian authorities addressed risk awareness and introduced responsible lending regulations for credit institutions.
- Institutional and cross-border cooperation lessons
  - Continuous development of institutions and appropriate regulation and supervision is necessary, especially where banking systems are large and based on cross-border activities.
  - Cross-border banking supervision and liquidity management must be ensured cooperatively.
  - Moral suasion was underused; example: despite Sveriges Riksbank publishing Baltic country risk warnings from 2005, Swedish banks continued to fuel Baltic credit growth.
  - Estonian requests in 2005 for Swedish authorities to impose stricter capital requirements on Swedish banks’ affiliates were turned down by the Swedish FSA because group capital already exceeded legal minimums on a consolidated basis.
  - National authorities should share information multilaterally and be prepared to take measures addressing risks associated with cross-border activities.
  - In August 2010, Nordic and Baltic central banks, relevant ministries and financial supervisory authorities agreed on a cooperation agreement on cross-border financial stability, crisis management and resolution.
    - Initiatives include a cross-border stability group and the Nordic-Baltic Macroprudential Forum to coordinate macroprudential policy frameworks and identify regional risks.
- Use of capital flow restrictions
  - Latvia’s partial deposit freeze was a minor capital flow restriction and was agreed as necessary by the IMF; it was fully removed in December 2011.
  - Iceland’s temporary capital controls were used as a last resort and broadly achieved objectives of stabilizing the foreign exchange market.

### Overall assessment of IMF support in Iceland and policy implications
- Iceland’s overall experience of the IMF’s support in the design of and exit from capital controls has been a positive experience and in line with the IMF policy of constructive advice and strong domestic ownership of program design and implementation.
- The design and implementation of the exit strategy, including completion of the settlement of the failed banks, has proved to be a more challenging and lengthy process than was probably foreseen at the commencement of the capital controls.
- When the IMF provides advice on capital controls an exit strategy should be an integral part of the original design.
- IMF role, surveillance, and regional perspective:
  - The IMF has an important role in advising on capital-account policies and monitoring cross-border capital flows.
  - Need to strengthen financial sector analysis in Article IV Reports and enhance regional surveillance and inclusion of capital accounts in regular IMF surveillance.
  - The Nordic-Baltic constituency views an eventual explicit IMF mandate for monitoring capital-account policies as beneficial for the global economy.
- Working with the IMF on capital controls and liberalization:
  - The Fund can provide expert advice on preconditions and sequencing for lifting controls and can develop best practices regarding CFMs and macroprudential measures.
- Concluding policy mix and prudential remarks:
  - Traditional macroeconomic and structural policies were underused; no substitute exists for sound macroeconomic policies.
  - IMF should assist members to implement the proper policy mix, advise on timing of prudential measures, and, as a last resort if necessary, advise when to introduce capital controls.
  - A credible exit strategy for lifting capital controls needs to be developed as soon as possible after introduction.

### Annex A — IMF policy framework key elements (high level)
- Aim: provide consistent policy advice to member countries regarding capital flows; not intended to create new obligations under Fund surveillance.
- Structural reforms and prudential measures that strengthen financial-sector resilience can be introduced at any time.
- In response to surges in inflows, use macroeconomic policy options and appropriate macroprudential policies; CFMs may be appropriate as a complement under certain circumstances.
- CFMs should be transparent, targeted, temporary and preferably non-discriminatory.
- Illustrative guidance includes:
  - Allow exchange rate to appreciate when undervalued on a multilateral basis.
  - Purchase foreign exchange reserves—sterilizing the impact when inflation is a concern—if reserves are not more than adequate from a precautionary perspective.
  - Lower policy rates, or tighten fiscal policy to allow space for monetary easing, consistent with inflation objectives and when overheating is not a concern.
  - Use CFMs if (a) the exchange rate is not undervalued, (b) reserves are in excess of adequate prudential levels or sterilization costs are too high, and (c) the economy is overheating (e.g. the inflation outlook is not benign or credit/asset price booms are developing), precluding monetary policy easing, and there is no scope to tighten fiscal policy.
  - Do not deploy CFMs if the exchange rate is undervalued or as a substitute for necessary policy adjustments; CFMs could complement fiscal tightening plans already in place.
  - Give precedence to CFMs that do not discriminate on the basis of residency over residency-based CFMs.
  - Ensure intensity of CFMs is commensurate to the specific macroeconomic or financial stability concern.
  - Lift CFMs when the risks they were designed to address recede.
  - Strengthen institutional frameworks; prudential and structural measures that do not differentiate on residency or currency and are designed to strengthen resilience can be used at any time if not aimed at influencing inflows.

### Annex B — Macroprudential and structural tools (high level)
- Prudential and structural measures:
  - Capital requirements for specific loans or foreign currency loans (increased risk weights or capital surcharges).
  - The countercyclical capital buffer in Basel III will not in itself limit the size of capital flows nor likely significantly reduce credit growth associated with asset price inflation, but will result in a better capitalized and more resilient financial system.
  - Direct restrictions on credit such as maximum loan-to-income (LTI) or loan-to-value (LTV) requirements may dampen credit growth but can be circumvented.
  - Liquidity requirements such as ceilings on banks’ net open FX positions or liquidity requirements related to FX-liabilities; Basel III’s NSFR24 and LCR25 help reduce risks from short-term foreign funding.
- Other capital flow management measures:
  - Reserve requirements can be used to reduce the risk of disruptions and affect banks’ incentives to borrow in foreign exchange or hold liquid assets.
  - A levy on banks’ non-deposit foreign exchange liabilities (as recently introduced in Korea26) aims to dampen domestic credit growth due to large inflows; shorter maturity liabilities can be subject to higher levy rates.
- Residency-based CFMs:
  - Reserve requirements on non-resident deposits and taxes on equity and bond inflows.

### Annex D — Iceland’s and Latvia’s experience of IMF advice on CFMs
- Iceland: introduction of capital controls
  - Emergency Laws in early October 2008 coincided with severe foreign currency liquidity pressures and rationing of foreign currency to secure imports.
  - Political difficulty of reintroducing capital controls given full liberalization in 1995 and prior history of exchange controls.
- IMF advice on design, implementation, and circumvention
  - Technical assistance requested in November 2008; controls implemented on November 28, 2008.
  - IMF advice sought to ensure compatibility with IMF Articles of Agreement, EEA agreement and OECD best practices.
  - General principles applied:
    - Current transactions allowed without restrictions and outward capital transactions of residents fully blocked.
    - Equal treatment and non-discrimination of foreign entities in line with the AoA; capital transactions of non-residents allowed between non-residents.
    - Avoid creating multiple currency practices and prevent official action from causing unreasonable exchange rate spreads.
  - IMF provided expert advice on classifying transactions, issuing exemptions and containing common circumvention methods; some current transactions were later limited following IMF consultation.
- Iceland’s exit strategy
  - Controls initially seen as temporary; first exit strategy designed in July 2009 with sequencing differences between authorities and IMF staff.
  - Authorities favored early foreign currency auctions; IMF staff preferred auctions only at later stages once long-term legacy krona holdings were mostly eliminated.
  - A gradual liberalization of long-term assets was chosen; strategy designed by Icelandic authorities with IMF involvement through Article IV and program reviews.
  - Conclusion: Iceland’s overall experience with IMF support on design and exit from CFMs has been positive and aligned with IMF constructive advice and domestic ownership.
- Latvia: partial deposit freeze on Parex Bank
  - Only minor restrictions imposed; partial deposit freeze was proposed by Latvia and agreed necessary by the IMF.
  - Following restructuring, the partial deposit freeze was only attributable to a minor proportion of deposits and fully removed in December 2011.

*Source: _wp13242 - introduction of Basel II principles, in 2008, however, the risk weights on mortgage lending were*

### introduction of Basel II principles, in 2008, however, the risk weights on mortgage lending were

### _wp13242 - introduction of Basel II principles, in 2008, however, the risk weights on mortgage lending were

### Risk weights, Basel II, and mortgage lending
- With the introduction of Basel II principles, in 2008, the risk weights on mortgage lending were decreased to 60 percent and after a two-year transition period harmonized with the EU directive to 35 percent.

### Policy measures taken in the Baltic countries and Iceland during credit booms
- Latvia
  - With the first signs of overheating in 2004, authorities increased reserve requirements, significantly broadened the reserve base and increased official interest rates.
  - IMF advice: enhance supervision and prudential measures.
  - Anti-Inflation Plan measures included:
    - obligation for banks to require borrowers’ to provide a statement of legal income;
    - a minimum down payment of 10 percent.
  - The minimum down payment requirement was abolished by the authorities in June 2008.
- Lithuania
  - Tackled excessive credit growth by gradually improving financial regulation and supervision.
  - IMF recommendations implemented included:
    - enhancing monitoring of borrowers’ credit quality;
    - limiting the inclusion of current-year profits in capital;
    - introducing stricter risk weights for commercial real estate.
  - In 2006 IMF staff flagged “aggressive lending practices” and encouraged forward-looking supervisory analysis and additional supervisory measures.
  - In 2007 IMF staff suggested identifying and raising bank-specific capital requirements.
  - A further increase in capital buffers and closer cooperation with banks, parent banks and home authorities were recommended in 2008.
  - Implementation did not substantially counteract fiscal incentives such as residential mortgage subsidies and the absence of a property tax.
- Estonia
  - Authorities viewed prudential measures as more effective with joint efforts and support from home-country authorities.
  - Effectiveness of LTV or LTI restrictions considered unclear prior to the crisis.
  - Most macroprudential measures apply only to local banks and subsidiaries and leave branches untouched, potentially harming the level playing field.
- Iceland
  - Prior to the crisis, few measures other than tighter monetary policy were introduced; CFMs were not recommended by the IMF and were not introduced.
  - Authorities argued measures dealing with free capital flows must be directed at financial regulation.
  - Suggested measures that could have limited credit expansion:
    - higher capital and reserve requirements for banks;
    - limitation of FX-denominated loans to households and non-financial corporates;
    - stricter regulation on currency and maturity mismatches in banks’ balance sheets;
    - stricter liquidity requirements.

### Macroeprudential tools and capital flow management measures (CFMs) — assessments and estimates
- Estonia
  - Authorities judged the impact of alternatives to higher risk weights and reserve requirements to be negligible because large parent banks could overcome them easily.
- Latvia
  - Authorities considered a restriction on maximum LTV as the most powerful tool to curb speculative real-estate activity; introduced at a very late stage.
  - An earlier introduction of a comprehensive credit register would have prevented the build-up of speculative private debt.
  - Additional capital requirements for specific loans could possibly have slowed excessive lending.
- Lithuania
  - Authorities’ calculations: limits on LTV and LTI ratios could have reduced the loan for housing purchases portfolio by 8.6 percent.
  - Under those limits, the number of loans granted during the period 2006-2008 would then have been 7,000-8,000 lower.
  - These calculations subsequently led to the introduction of regulations on responsible lending in November 2011.
- Iceland
  - Suggested focus on financial regulation as first line of defense (consistent with IMF framework).
  - Measures listed by authorities that would have helped limit credit expansion include higher capital and reserve requirements, FX loan limits, stricter regulation on currency and maturity mismatches, and stricter liquidity requirements.

### Policy responses to capital outflows and IMF engagement
- Iceland
  - Capital controls enforced in November 2008 to stabilize the exchange rate of the krona and prevent destabilizing outflows.
  - IMF provided technical assistance on design and compliance with Iceland’s international obligations, including IMF’s Article VIII.
  - Capital controls designed to block all capital transactions while protecting an undisturbed currency exchange market for current transactions; FDI not subject to capital controls.
  - Circumvention increased; in October 2009 new rules enabled inflow in foreign currency through a “new investment” channel and introduced new restrictions on inflows in domestic currency (the “off-shore krona”), which are still in place today.
  - Foreign Exchange Act amended in March 2012 to prevent circumvention via the bond market and tighten control on capital flows related to winding-up of failed Icelandic banks.
  - Foreign Exchange Act amended again in March 2013: sunset clause revoked and other structural improvements implemented.
- Latvia
  - When Latvian authorities bailed out Parex Bank in November 2008, they introduced a partial deposit freeze to maintain financial stability.
  - IMF approved the partial deposit freeze under Article VIII of the IMF Articles of Agreement.
  - Following Parex restructuring, the partial deposit freeze was attributable to a minor proportion of deposits and was fully removed in December 2011.
- Iceland’s exit from capital controls
  - Capital controls were listed as temporary measures in the Icelandic authorities’ initial Letter of Intent.
  - About half a year after imposition, deliberations on an exit strategy commenced; a document on the exit strategy was published in August 2009.
  - In March 2011, during the fifth review of the IMF-supported program, authorities and the IMF agreed on a gradual, conditions-based exit strategy; IMF provided expert advice on structure and communication.
  - Preconditions for exit: sustainability of public finances, a strengthened banking sector and the building up of sufficient international reserves.
  - Strategy objective: lift controls in stages to avoid jeopardizing foreign exchange market stability; focus on transferring unstable krona assets into long-term investments.
  - Strategy stages are not time-bound and are conditional on measures such as lengthening resident borrowers’ foreign financing, acceptable settlement of failed banks’ estates, and a permanent channel for non-residents with short term krona positions.
  - Strategy divided into two phases: first reducing offshore krona positions and second removing controls on onshore krona.
  - First phase commenced in late 2011; regular auctions by the Central Bank of Iceland from February 2012 over a two-year period significantly reduced short-term krona positions.

### Lessons learnt
- General observations
  - Ex post identification of mistakes is easier than ex ante due to uncertainties about the economic cycle and regulatory frameworks.
  - Shortcomings existed in macroeconomic policies and financial supervision in the Nordic and Baltic regions.
  - Capital inflows per se were not considered the thrust of the problem.
  - If the IMF’s policy framework had been in place before the crisis build-up, potential problems may have been pinpointed earlier and addressed with appropriate measures.
- Macroeconomic policy lessons
  - Fiscal policy was underused to moderate large capital inflows.
  - In Iceland, the monetary/fiscal policy mix was suboptimal with too heavy a burden on monetary policy; higher policy rates attracted more short-term capital.
  - Iceland could have used fiscal policy more to restrain aggregate demand growth and build buffers to combat reversal of capital flows.
  - Baltic countries’ monetary policy was constrained by currency boards; fiscal policy should have been tightened earlier to curb domestic demand and credit expansion.
  - Structural policies, e.g., tax incentives for debt financing, exacerbated imbalances; tax incentives were only reduced in Estonia.
- Macroprudential and supervisory lessons
  - Macroeconomic policy alone could not have managed large capital inflows; macroprudential measures should be implemented early.
  - Some countries found macroprudential measures insufficient; additional prudential measures would have been warranted.
  - Risks from large amounts of lending in foreign currency could have been mitigated through increased risk weights on such loans.
  - In Iceland, given suboptimal policy conditions, macroprudential tools and higher capital requirements could have been assessed and used.
  - Icelandic banking supervision suffered from insufficient resources and data gaps; these were addressed as part of the SBA program and stricter stress tests were implemented.
  - Lithuanian authorities addressed risk awareness and introduced responsible lending regulations for credit institutions.
- Institutional and cross-border cooperation lessons
  - Continuous development of institutions and appropriate regulation and supervision is necessary, especially where banking systems are large and based on cross-border activities.
  - Cross-border banking supervision and liquidity management must be ensured cooperatively.
  - Moral suasion was underused; example: despite Sveriges Riksbank publishing Baltic country risk warnings from 2005, Swedish banks continued to fuel Baltic credit growth.
  - Estonian requests in 2005 for Swedish authorities to impose stricter capital requirements on Swedish banks’ affiliates were turned down by the Swedish FSA because group capital already exceeded legal minimums on a consolidated basis.
  - National authorities should share information multilaterally and be prepared to take measures addressing risks associated with cross-border activities.
  - In August 2010, Nordic and Baltic central banks, relevant ministries and financial supervisory authorities agreed on a cooperation agreement on cross-border financial stability, crisis management and resolution.
    - Initiatives include a cross-border stability group to prevent financial crises and the Nordic-Baltic Macroprudential Forum to coordinate macroprudential policy frameworks and identify regional risks.
- Use of capital flow restrictions
  - Latvia’s partial deposit freeze was a minor capital flow restriction and was agreed as necessary by the IMF; it was fully removed in December 2011.
  - Iceland’s temporary capital controls were used as a last resort and broadly achieved objectives of stabilizing the foreign exchange market.

*Document: _wp13242 - introduction of Basel II principles, in 2008, however, the risk weights on mortgage lending were*

### conclusion,  Iceland’s  overall  experience of  the IMF’s  support  in  the  design of and  exit  from

### _wp13242 - conclusion,  Iceland’s  overall  experience of  the IMF’s  support  in  the  design of and  exit  from

### Overall assessment of IMF support in Iceland
- Iceland’s overall experience of the IMF’s support in the design of and exit from capital controls has been a positive experience and in line with the IMF policy of constructive advice and strong domestic ownership of program design and implementation.
- The design and implementation of the exit strategy, including completion of the settlement of the failed banks, has proved to be a more challenging and lengthy process than was probably foreseen at the commencement of the capital controls.
- When the IMF provides advice on capital controls an exit strategy should be an integral part of the original design.

### IMF role, surveillance, and regional perspective
- The IMF has an important role to play in giving advice to countries when it comes to capital-account policies.
- The experience in the Baltic countries and Iceland supports the main elements of the policy framework as proposed by the IMF.
- The Fund has a global reach and is therefore uniquely placed to also monitor the volume, composition and direction of cross-border capital flows to identify associated risks.
- As financial markets have become closely interconnected there was a need to strengthen the financial sector analysis in the Article IV Reports (which staff have addressed in recent Article IV reports).
- The increased financial linkages between countries both in our constituency and around the world also underlines the importance of:
  - enhanced regional surveillance;
  - inclusion of capital accounts in regular IMF surveillance, as this would be an important step towards enhancing the Fund’s global financial stability mandate.
- The recent Nordic Regional Report19 was a relevant step towards enhancing regional surveillance.
- The Nordic-Baltic constituency’s view is that it will also be in the best interests of the global economy if the IMF’s mandate in the long run also includes an explicit mandate for monitoring policies relating to the capital account.

### Working with the IMF on capital controls and liberalization
- The constituency has good experiences of working with the IMF; the Fund can provide expert advice to help countries in designing appropriate measures and developing strategies regarding preconditions and sequencing for lifting controls.
- IMF staff have shared their knowledge and provided timely advice regarding various proposals following the implementation of capital controls.
- As experience is gained, the IMF can inform its advice and develop best practices regarding capital flow management measures, both for implementing macroprudential measures and when the use of capital controls can be considered appropriate.

### Concluding remarks on policy mix and prudential measures
- The use of traditional macroeconomic and structural policies was far from exhausted in managing the consequences of capital inflows in the cases examined in this study; there are no substitutes for sound macroeconomic policies.
- Several prudential measures can be taken; the IMF should assist member countries to:
  - implement the proper policy mix;
  - give advice on when to introduce prudential measures;
  - advise, as a last resort if necessary, when to introduce capital controls.
- In hindsight, if the framework for managing capital flows had been in place, the IMF might have been tougher in its recommendations and delivered them at an earlier stage. Assuming that countries follow the IMF’s recommendations, the build-up of systemic risks could possibly have been mitigated.
- An institutional view from the IMF was not the only ingredient lacking in the build-up of the crisis and would not have been the whole solution.
- The international community is currently building on lessons learned from the financial crisis when developing and implementing macroprudential tools; this will be an ongoing process for many years to come.
- While temporary capital controls were recognized as an option in Iceland, the Nordic-Baltic view continues to be that they should be a last-resort measure to maintain macrofinancial stability.
- A credible exit strategy for lifting capital controls needs to be developed as soon as possible after the introduction of such measures.

### Annex A: IMF policy framework for managing capital flows — key elements
- Aim: help Fund staff provide consistent and evenhanded policy advice to member countries regarding capital flows and related policies; not intended to create new obligations under Fund surveillance.
- Structural reforms and prudential measures that strengthen financial-sector resilience and absorption capacity are always good and can be introduced at any time.
- In response to a surge in inflows, a country should use macroeconomic policy options and appropriate macroprudential policies to counter risks to financial stability (see Annex B).
- As a complement, under certain circumstances (e.g., limited room for macroeconomic adjustment or slow policy response), "capital flow management measures" (CFMs) may be appropriate.
- CFMs should be transparent, targeted, temporary and preferably non-discriminatory.
- CFMs are defined as tax, prudential or administrative measures specifically designed to influence capital flows; illustrative guidance includes:
  - Allow the exchange rate to appreciate when it is undervalued on a multilateral basis.
  - Purchase foreign exchange reserves—sterilizing the impact when inflation is a concern—if reserves are not more than adequate from a precautionary perspective.
  - Lower policy rates, or tighten fiscal policy to allow space for monetary easing, consistent with inflation objectives and when overheating is not a concern.
  - Use CFMs if (a) the exchange rate is not undervalued, (b) reserves are in excess of adequate prudential levels or sterilization costs are too high, and (c) the economy is overheating (e.g. the inflation outlook is not benign or credit/asset price booms are developing), precluding monetary policy easing, and there is no scope to tighten fiscal policy.
  - Do not deploy CFMs if the exchange rate is undervalued or as a substitute for necessary policy adjustments; CFMs could complement fiscal tightening plans already in place.
  - Give precedence to CFMs that do not discriminate on the basis of residency (e.g. currency-based prudential measures) over residency-based CFMs.
  - Ensure intensity of CFMs is commensurate to the specific macroeconomic or financial stability concern.
  - Lift CFMs when the risks they were designed to address recede.
  - In designing CFMs, consider country-specific circumstances and effectiveness/efficiency criteria.
  - Strengthen the institutional framework on an ongoing basis; prudential and structural measures that do not differentiate on residency or currency and are designed to strengthen financial-sector resilience can be used at any time, provided they are not assessed to have been designed to influence inflows.

### Annex A: Additional multilateral elements
- National policymakers of both source and recipient countries should take into account how their policies affect others.
- National authorities should share information multilaterally on the objectives and implementation of their policies affecting capital flows.
- National prudential authorities should be mindful of risks associated with cross-border activities and be prepared to take measures:
  - Consider the effects of capital flows on financial stability in macroprudential frameworks.
  - Enhance capacity to identify and mitigate risks associated with capital flows through regulated and non-regulated institutions and monitor responsiveness of cross-border activities to policies.
  - Seek agreement on “reciprocity” in application of macroprudential policies.
- National authorities should complete and fully implement reforms of the international regulatory and supervisory architecture expeditiously and actively minimize scope for regulatory arbitrage.

### Annex B: Macroprudential and structural tools (high-level review)
- Prudential and structural measures:
  - Capital requirements for specific loans or foreign currency loans (increased risk weights or capital surcharges) to make banks hold more capital for such loans.
  - The countercyclical capital buffer in Basel III will not in itself limit the size of capital flows nor likely significantly reduce credit growth associated with asset price inflation, but will result in a better capitalized and more resilient financial system.
  - Direct restrictions on credit such as maximum loan-to-income (LTI) or loan-to-value (LTV) requirements may dampen credit growth but can be circumvented.
  - Liquidity requirements such as ceilings on banks’ net open FX positions or liquidity requirements related to FX-liabilities; Basel III’s NSFR24 and LCR25 help reduce risks from short-term foreign funding.
- Other capital flow management measures:
  - Reserve requirements can be used to reduce the risk of disruptions and affect banks’ incentives to borrow in foreign exchange or hold liquid assets.
  - A levy on banks’ non-deposit foreign exchange liabilities (as recently introduced in Korea26) aims to dampen domestic credit growth due to large inflows; shorter maturity liabilities can be subject to higher levy rates.
- Residency-based CFMs:
  - Reserve requirements on non-resident deposits and taxes on equity and bond inflows.

*Source: _wp13242 - conclusion,  Iceland’s  overall  experience of  the IMF’s  support  in  the  design of and  exit  from*

### Annex D: Iceland’s and Latvia’s experience of IMF’s advice on CFMs

### Annex D: Iceland’s and Latvia’s experience of IMF’s advice on CFMs

### Introduction of capital controls in Iceland
- Immediately after the introduction of the Emergency Laws in early October 2008, the foreign reserves of the Central Bank came under pressure as the foreign currency liquidity of the Icelandic banking system had been reduced dramatically.
- Foreign banks netted deposits of the Icelandic banks against claims and the British authorities froze the assets of Landsbanki under anti-terrorism legislation, and initially also named those of the Central Bank and the Republic, which had serious repercussions for payments and settlement.
- Proceeds from exports partly stopped flowing because foreign banks became reluctant to transfer money to the domestic banks and partly because exporters chose to keep their money abroad.
- For a period, this led to a temporary rationing of foreign currency out of the foreign reserves, which had already been reduced because of an emergency collateralized loan to the Kaupthing Bank.
- Foreign currency was rationed in order to secure uninterrupted imports of food, medicine, fuel and other necessities.
- The reintroduction of capital controls was difficult politically because the capital account had been fully liberalized only as recently as in 1995 when Iceland joined the EEA; prior to that Iceland had a long history of exchange controls.

### IMF advice on design, implementation, and circumvention
- Technical assistance on capital controls was requested from the IMF in November 2008 and controls were subsequently implemented on November 28, 2008.
- The IMF provided expert advice on the introduction of capital controls in 2008, including the design of legislation and regulations that were compatible with the international obligations of Iceland, especially with regard to the IMF’s Articles of Agreement (AoA) but also in relation to the EEA agreement and OECD best practices.
- General principles advised and applied:
  - Current transactions would be allowed without restrictions and outward capital transactions of residents would be fully blocked.
  - Equal treatment and non-discrimination of foreign entities in line with the AoA; capital transactions of non-residents would be allowed between non-residents.
  - Avoid creating multiple currency practices and prevent official action from causing exchange rate spreads and cross rate quotations to differ unreasonably from those arising from normal commercial costs and risks of exchange transactions.
- Implementation challenges and IMF support:
  - The demarcation between domestic and foreign entities created complications, as trade proceeds sometimes took on the character of capital transactions to circumvent controls.
  - The IMF supplied expert advice on how to classify transactions and put in place appropriate conditions and regulations.
  - The IMF provided expert advice on common methods of circumvention and ways to contain such activities.
  - Some current transactions in financial markets, as defined by the IMF, were used to circumvent controls (most notably interest payments and moderate amortization of bonds); this practice was subsequently limited following consultation with the IMF.
  - The IMF provided proposals on the issuance of exemptions, permits and the practical supervision of exchange controls and followed the implementation with timely advice as appropriate.

### Iceland’s exit strategy
- The controls were initially seen as a temporary policy tool to buy time while the authorities tackled the economic crisis.
- When designing the first exit strategy in July 2009, differences arose between the Icelandic authorities and IMF staff regarding sequencing.
  - The authorities suggested the use of foreign currency auctions to address potential pressure from capital outflows from the lowest pressure point.
  - The IMF staff’s view was that auctions should only be used at later stages when long-term legacy krona holdings had been mostly eliminated; the Fund stressed a liberalization strategy as a prior action for the intended review in August 2009 and would not support an auction process in the first part of a liberalization strategy.
  - A gradual liberalization of long-term assets was chosen.
- The views on exit strategy ultimately converged:
  - The present strategy has been designed by the Icelandic authorities with IMF involvement mostly through Article IV and program review discussions.
  - The IMF has given expert advice on the structure of the officially published strategy and communication.
  - Sequencing and proper conduct of capital-account liberalization has been extensively discussed and presented in various IMF publications.
  - The Icelandic authorities will benefit from the knowledge and experience obtained by member countries with regard to the capital-liberalization process.
- Conclusion: Iceland’s overall experience of the IMF’s support in the design of and exit from capital flow management measures has been a positive one and in line with the IMF’s policy of constructive advice and strong domestic ownership of program design and implementation.

### Latvia’s partial deposit freeze on Parex Bank
- Only minor restrictions on capital flows were imposed in Latvia; the partial deposit freeze was the only exceptional measure implemented in the case of Parex Bank.
- The partial deposit freeze was proposed by Latvia, and the IMF agreed with the necessity of the measure.
- Following the restructuring of Parex Bank, the partial deposit freeze was only attributable to a minor proportion of deposits and was fully removed in December 2011.

*Annex D: Iceland’s and Latvia’s experience of IMF’s advice on CFMs — source document content.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13242.pdf_