Government Debt Management: New policy instrument to temper and affect the composition of capital inflows

The Central Bank of Iceland has published the Rules on Special Reserve Requirements for New Foreign Currency Inflows in accordance with the new Temporary Provision of the Foreign Exchange Act, no. 87/1992. The main purpose of the Temporary Provision is to provide the Central Bank of Iceland with a new policy instrument, generally referred to as a capital flow management measure, to temper inflows of foreign currency and to affect the composition of such inflows. It is therefore intended to reduce the risk that could accompany excessive capital inflows under the current regulatory framework for foreign exchange, support other aspects of domestic economic policy, and contribute to macroeconomic and financial stability.

The Central Bank's capital flow management tool is based on the application of special reserve requirements for new inflows of foreign currency, in accordance with rules set by the Bank on the basis of the Foreign Exchange Act. The capital flow management measure is structured so as to reduce the risk potentially accompanying strong capital inflows by directly affecting the incentives for carry trade. The tool is therefore intended, among other things, to support effective monetary policy transmission. Furthermore, the structure is intended to ensure that the measure is flexible, effective, and efficient in implementation so as to make it possible to respond quickly to changed circumstances.

The Rules contain provisions on the implementation of special reserve requirements for new foreign currency inflows, including the special reserve base, holding period, special reserve ratio, settlement currency, and interest rates on deposit institutions' capital flow accounts with the Central Bank of Iceland. The special reserve base is defined as new inflows of foreign currency in connection with specified types of capital, particularly to include new investment in electronically registered bonds and bills, and deposits. In addition, new inflows related to loans taken for investment in such instruments can create the special reserve base. Further details regarding the special reserve base are provided in the Rules. The Foreign Exchange Act states that the holding period may range up to five years and that the special reserve ratio may range up to 75%; however, the Rules set the holding period at one year and the special reserve ratio at 40%. The Rules also set the interest rate on capital flow accounts with the Central Bank of Iceland at 0% and specify the Icelandic króna as the settlement currency.

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