Capital controls, financial crisis and the investment saving nexus: Evidence from Iceland

We investigate the Feldstein and Horioka (1980) hypothesis for Iceland. First, we analyse the saving-investment (S-I) correlation for the period of restricted capital mobility between 1960 and 1994. We then add a period of free capital mobility between 1994 and 2008 and estimate the correlation for the period 1960-2008. Finally, we extend our analysis to the 2008 to 2014 period, when capital controls were imposed in response to the financial crisis. Finding cointegration between savings and investment for all the three regimes, the evidence shows that the S-I correlation is stronger during the period of capital controls that prevailed in 1960-1994 and becomes weaker when the capital mobility regime is included. However, the correlation weakens further when the post-crisis regime of capital controls is included, which implies that savings and investment are not related during the recent period of crisis and capital controls. The implications of our findings for post-crisis policy making are discussed.