Introduction of the capital controls
The capital controls were introduced in November 2008, after Iceland was struck by an unusually severe banking crisis in October 2008. The ensuing collapse of confidence in Icelandic financial assets created the risk of massive capital outflows, with potentially dire consequences for the exchange rate of the króna, which had already fallen steeply. Heavy capital outflows (both immediately and later on) could have triggered an even deeper decline in the exchange rate, pushing inflation even higher than it actually was. Because households and businesses were heavily leveraged, with a large proportion of foreign-denominated and inflation-indexed debt, this could have catalysed a wave of default, with serious consequences for the domestic economy. Because of this, the Central Bank of Iceland took action on 10 October 2008, temporarily restricting foreign currency outflows. In view of the enormous risk to the economy, it was thought that capital controls, while unfortunate, were an inevitable element in a plan of action aimed at stabilising the króna once the interbank foreign exchange market opened again in early December 2008.
The Basis for the capital controls
The fundamental principle of free flow of capital is provided for in Articles 40 and 41 of the EEA Agreement. The restrictions on capital movements imposed in Iceland have been rationalised with reference to the provisions of Article 43 of the EEA Agreement, which authorises the contracting parties to take such action if it proves necessary in order to respond to various types of difficulties or disturbances in the financial markets of the country concerned.
Article 43 of the EEA Agreement provides for exemptions from the free movement of capital as described in Article 40 of the Agreement. According to Article 43, Paragraph 2, in instances where movement of capital will lead to a disturbance in capital markets in EFTA states, the country concerned may take protective measures in this area. Furthermore, Paragraph 4 of the same Article states that “[w]here an EC Member State or an EFTA State is in difficulties, or is seriously threatened with difficulties, as regards its balance of payments either as a result of an overall disequilibrium in its balance of payments, or as a result of the type of currency at its disposal, and where such difficulties are liable in particular to jeopardize the functioning of this Agreement, the Contracting Party concerned may take protective measures.”
With the EFTA Court ruling in Case no. E-3/11, handed down on 14 December 2011, the Court issued an advisory opinion on questions referred to it by the District Court of Reykjavík concerning the interpretation of Article 43 of the EEA Agreement, which authorises deviations from the rules on free flow of capital. The Court concluded that the substantive conditions for taking protective measures according to Article 43, Paragraphs 2 and 4 of the EEA Agreement had been fulfilled, and that the Icelandic restrictions on movement of capital that were under scrutiny in that case were in compliance with the Agreement.