Monday, March 28, 2011 Publisher: Íslandsbanki Research - - Resp.Editor: Ingólfur Bender

Capital controls to remain in place
It appears unlikely that further steps will be taken to lift the capital controls in the near future, with the exception of measures to release pressure due to offshore krónur. As a result, the authorities will probably utilise most of the latitude provided by the extension of the statutory authority for the capital controls through 2015, as the Minister of Economic Affairs plans to propose before Parliament. 

Near-term emphasis on offshore krónur
The newly published capital account liberalisation strategy states, among other things, that offshore krónur will be the focus of near-term measures. Three measures will be implemented at first, while the fourth will be added towards the end of the first phase of the strategy:

1. Pension funds - and possibly, other owners of foreign-denominated assets - will be permitted to swap foreign currency with owners of offshore krónur. The Central Bank will act as an intermediary and will possibly charge a commission for itself and the Treasury, in a manner similar to that used in the Avens deal last year. Pension funds will then buy long Treasury bonds for the krónur, and that investment will be committed for a period of five years.

2. Foreign long-term investors will be given the chance to buy offshore krónur from current owners. The arrangement will be similar to that in Measure 1 above, with the exception that investment will be permitted only in special closed investment funds and the investors must contribute 50% of the value of their investment in foreign currency.
3. Residents and non-residents that have owned offshore krónur since before the crash, as well as non-residents that purchased offshore krónur between the crash and the publication of the strategy (or acquire them henceforth in Central Bank auctions), will be permitted to place their krónur in a closed fund for a period of five years, thus investing in the domestic economy. Such an investment must be matched by foreign currency totalling 50% of the full investment amount. Residents that are hedged against foreign exchange risk will be permitted to take foreign loans for 50% of the purchase of offshore krónur in connection with such investments. This option will not be available until after one or more auctions according to Measures 1 and 2.

4. When Measures 1-3 have been executed in full, an exit route will be opened for a limited period of time. It will consist of two parts:
 a) An exchange auction, where owners of ISK-denominated Treasury bonds are given the chance to swap them for foreign-denominated Treasury bonds. The price and maturity of the latter bonds will be determined by market conditions.
 b) Owners of offshore krónur in domestic banks will be authorised to exchange them for foreign currency in return for a gradually declining exit levy that will, at the outset, equal the difference between the offshore and onshore ISK exchange rates.
Liberalisation subject to numerous conditions
When the above-described measures are at their final stages, removal of controls on other ISK assets will commence in at least two steps. Before that can occur, however, a number of other requirements must be fulfilled: 
- The balance of payments outlook must be positive; 
- The Treasury and domestic financial institutions must be able to obtain foreign credit on acceptable terms; 
- The financial sector must be able to withstand fluctuations in capital flows;
- The offshore ISK exchange rate must remain close to the onshore rate; 
- Limitations must be imposed on financial institutions¿ foreign exchange risk and their authorisations to grant foreign-denominated loans to households; 
- Iceland's future monetary policy regime must have been decided, either through EU membership and the adoption of the euro or a so-called inflation targeting-plus framework.
It should be quite clear that this latter action will not be taken in the near future, and we are of the opinion that it is unlikely to begin during 2011. The uncertainty about when it will be possible to tick off all of the items on the liberalisation checklist is such that this part of the strategy could be delayed quite some time. On the other hand, the intention is to implement this stage of the strategy rather quickly because it will be difficult to control the loopholes that develop once general liberalisation begins. We think it likely, however, that there will be some restrictions on movement of capital and associated foreign exchange transactions in the foreseeable future, even though most of the current controls are lifted in accordance with the liberalisation strategy.
Pension funds' foreign assets less prominent than before
In coming years, pension funds will probably be subjected to more stringent requirements for foreign exchange purchases than will other investors. As a result, it will likely be some time before their foreign assets return to the levels of recent years, and it is well to ponder whether it is wise to restrict the pension funds' risk diversification in this manner.
The Icesave referendum will have no effect on the timing of the first steps of the strategy. On the other hand, the strategy states explicitly that rejection in the upcoming referendum will probably cause delays in Phase II and the latter steps of Phase I, due to the requirement that the Treasury and other domestic entities be able to obtain credit in foreign markets.

Brisk bond market activity

The bond market has responded strongly this morning to the capital account liberalisation strategy, which was published after the market close on Friday. Trading volumes have been high, with significant buying pressure on longer nominal bonds. As of this writing (11:30 hrs.), today's turnover in benchmark bonds totals just over ISK 16 bn. Yields on the three longest nominal bonds have fallen by 22-24 basis points since markets opened this morning and now lie in the 6.23-6.98% range. In addition, the yield on RIKB16 has declined by a full 18 bp in this morning's trading and now stands at 5.07%. Yields on some of the shorter nominal series have risen, however. RIKB11 has risen by 22 bp and RIKB12 by 14 points. Yields on the indexed side of the bond market are broadly unchanged since Friday's close, however, and the breakeven inflation rate has eased downwards a bit, particularly for the longer term.

This morning the Central Bank announced that Government Debt Management would follow bond market developments closely during the day and would stand ready to respond to volatility by buying and/or selling Treasury bonds. This press release probably played a role in mitigating price fluctuations, as Friday's announcements probably made a strong impact on expectations concerning near-term supply and demand for Government-guaranteed bonds.

Successful LSS auction

Response was keen on Friday, when Municipality Credit Iceland Plc (LSS) auctioned its LSS150224 bond series. Bids were received for ISK 1.45 bn, at yields between 3.55% and 3.90%, and the Fund decided to accept just under one-third of bids, or about ISK 445 million nominal value, at a yield of 3.60%, some 27 basis points below the final yield in the last auction of these bonds. In addition, the final yield was well below the market yield for that day, which was 3.83% at the market close. In our opinion, LSS can be well satisfied with these results. The series is now just under ISK 24.8 bn in size.

The week's statistics: inflation and expectations
Several interesting statistics are up for publication this week, chief among them the consumer price index (CPI) for March, which will be published by Statistics Iceland (SI) tomorrow. We forecast that the CPI will rise 1.0% in March. If this forecast materialises, headline inflation will rise from 1.9% to 2.3% during the month.

In our forecast, three main factors combine to raise the CPI: end-of-sale effects, the depreciation of the ISK year-to-date, and the recent surge in oil and commodity prices. As a result, we expect post-sale rises in clothing, footwear, housewares, and other goods to contribute nearly 0.5% to the rise in the CPI in March. It should also be borne in mind that many of the products that replace sale goods were probably bought with weaker domestic currency; moreover, foreign cost prices have risen in many cases because of higher commodity and energy prices. We project that the steep increase between SI's February and March petrol price measurements will raise the CPI by 0.3%. On the other hand, the service components of the index are likely to increase very little, and the housing component will probably remain broadly unchanged.

Gallup Consumer Sentiment Index for March
The Capacent Gallup Consumer Sentiment Index for March will be published tomorrow. It will be interesting to see whether the reigning downbeat trend has dissipated at all, as Icelanders appear to have difficulty recovering from last fall's surge of pessimism. In February the index fell by 1.6 points month-on-month, to 59.9 points, down from its post-crisis peak of 69.9 points in August 2010. Even though the February value of the index indicates general unease about Iceland's economy, Icelandic people are clearly much more optimistic than they were a year ago, when it measured only 46.2 points. The Consumer Sentiment Index measures consumers' expectations concerning the economy and the labour market: when it is below 100 points, pessimistic sentiment outweighs optimistic sentiment.

Minutes from the Monetary Policy Committee meeting
It will be instructive to study the minutes of the Central Bank of Iceland Monetary Policy Committee's last meeting when they are published on Wednesday. The Committee decided to keep interest rates unchanged in March, in line with our forecast and with general expectations. In our opinion, the Committee's arguments were more consistent with a rate cut than with keeping interest unchanged; thus it will be interesting to see whether MPC members were unanimous in their decision. The reasons given for the decision were that inflation is low and appears set to remain below the inflation target in coming months, that the exchange rate had yielded by about 1% since the previous interest rate decision date, and that national accounts figures suggest more spare capacity in the economy than previously thought. Consequently, it will be intriguing to see whether the minutes shed any further light on the decision.

Corporate bankruptcies in February
On Thursday, SI will publish figures on new company registrations and corporate bankruptcies in February. The January numbers, which revealed 95 bankruptcies during the month, indicated that many firms are still faced with an extremely difficult operating environment. This is nonetheless an improvement over January 2010, when 103 firms were declared insolvent. These figures are unsurprising, however, given the long delay in corporate restructuring and the general slump in the economy. It will be intriguing to see the February figures and compare them to February 2010, when a total of 84 companies were declared bankrupt.


Date: Subject: Most recent release: Source:
Mar.28.11 Tourist accommodation 2010 Statistics Iceland
Mar.29.11 Population development 2010 Statistics Iceland
Mar.29.11 Consumer price index in March 2011 Mar.17.11 Statistics Iceland
Mar.29.11 Consumer Confidence Index for March 2011 Feb.22.11 Capacent Gallup
Mar.30.11 Producer price index in February 2011 Statistics Iceland
Mar.30.11 Earnings in the private sector 2010 Feb.24.11 Statistics Iceland
Mar.30.11 Minutes of the Central Bank's Monetary Policy Committee Mar.16.11 Central Bank of Iceland
Mar.31.11 New registrations and insolvencies of limited liability companies in February 2011 Feb.25.11 Statistics Iceland
Mar.31.11 Wage index 2010 Mar.22.11 Statistics Iceland

NASDAQ OMX ICE, 3/25/2011
Category Volume
Equities 2,752
Bonds 96
Total 2,848
Icelandic Bonds, 3/25/2011
ID Vol. Yield
HFF150914 8 0.72% 4
HFF150224 6 2.39% -5
HFF150434 53 0
HFF150644 109 3.16% -3
RIKB 12 0824 70 3.13% -1
RIKB 13 0517 163 3.00% 0
RIKB 16 1013 84 5.21% -2
RIKB 19 0226 474 6.40% -7
RIKB 25 0612 440 6.84% -8
RIKB 31 0124 480 7.17% 4
RIKS 21 0414 221 2.82% -2
REIBOR Market, 3/25/2011
O/N 3.60% 3.85%
SW 3.90% 4.15%
1M 3.75% 4.25%
3M 3.75% 4.00%
6M 3.70% 3.95%
12M 3.50% 3.75%
Exchange Rates, 3/25/2011
  pr.ISK 3m.Libor 3m.fwd.
USD 115.30 0.31% 1.0
GBP 184.36 0.82% 1.4
Vt. ISK 214.56 1.03% 1.5
EUR 161.87 1.16% 1.1
JPY 1.41 0.20% 0.0
Currency Crosses, 3/28/2011
GBP 0.878    
USD 1.404 1.599  
CHF 1.291 1.471 0.920
JPY 114.663 130.594 81.675
NOK 7.882 8.977 5.614
SEK 8.973 10.220 6.392
Icelandic Equities, 3/25/2011
ID Vol. Yield
ICEAIR 14 4.41 0.68%
MARL 6 125.50 -0.40%
FO-BANK 3 124.00 0.00%
OSSR 1 196.00 0.26%
FO-ATLA 0 214.50 0.00%
Volume in ISK m.
Íslandsbanki's Research News & Reports are compiled by the staff of Íslandsbanki's Research Division. The information contained in these summaries is based on domestic and international sources and news networks, which are considered to be reliable, in addition to official information and the division's own estimates and opinions in each case. Íslandsbanki cannot, however, be held liable for the accuracy, reliability or correctness of this information. Íslandsbanki's Research News & Reports are only published for informational purposes and should therefore neither be looked upon as recommendations/advice to partake in or not partake in specific investments nor as an invitation to buy, sell or register with any specific financial instruments. Íslandsbanki and its staff cannot be held liable for any trading that may be carried out on the basis of the information published in Íslandsbanki's Research News & Reports. Any parties that intend to engage in trading are advised to seek expert advice and to fully acquaint themselves with the various investment options available. Investors will always be exposed to various types of financial risk, including, among other things, exchange rate volatility. One should bear in mind that past results are no guarantee of future results. Íslandsbanki's Research News & Reports offer brief summaries that should not be looked upon as exhaustive coverage of all the available information on the topics it focuses on in each case.

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