Effectiveness of Capital Controls in a Financial Crisis: The Case of Iceland

Sammanfattning: The purpose of this thesis is to evaluate the effectiveness of the capital controls on outflow implemented in Iceland in October 2008 following a severe systemic crisis caused by the default of the three largest Icelandic banks. Specifically, we assess to what extent Icelandic capital controls curtailed capital outflows, supported the ISK, reduced exchange rate fluctuations, and increased monetary policy independence. A GARCH model on daily nominal exchange rates is employed, and we found that Icelandic capital controls stabilized the exchange rate and prevented further depreciation of the domestic currency. However, capital controls did not seem to enhance monetary autonomy. Regarding the effectiveness of capital controls in reducing outflows, the empirical results from a panel fixed effect model on capitals flows and descriptive statistics were largely inconclusive. Furthermore, the amendments to the capital controls that directly addressed leakages to the unofficial off-shore exchange rate market appear to have been successful in increasing the risk premium for circumvention. We conclude that although capital controls in Iceland did not achieve all of their policy objectives, they may indeed have been a necessary policy response to the financial crisis.