The reason for the capital controls is because there a lot of money in the country that wants to get out. Assets and money owned by foreigners but also Icelanders who want to invest abroad, mostly the pension funds. It is expected that billions of dollars are waiting to get out of the Icelandic economy. The foreign-exchange reserves of the CBI are currently around 4 billion USD, but most of the reserves financed by long term foreign loans, for example from the IMF. Foreign-exchange reserves minus short term debt is around 3.7 billion USD.
Why aren't the capital controls lifted?
If the capital controls were suddenly lifted it is almost certain that the Icelandic krona would depreciate, and it could depreciate very much. This would put those with foreign loans but income in ISK (for the most part) in big trouble, for example the Government, municipalities, Reykjavik Energy and many firms. This might trigger defaults on a large scale.
Lifting the controls would increase inflation because imports become more expensive. Most of the mortgages in Iceland are fully price indexed. So the loans go up one to one with inflation, and this could trigger mass defaults since many households are already in trouble.
The financial institutions in Iceland would then be in trouble because of mass defaults on the loans to the banks. Some financial institutions might even default.
So there is a good reason for the capital controls being in place, since the benefits outweigh the drawbacks, for now.
The government aimed at lifting the capital controls in 2013 but the IMF has suggested to have them in place at least for three more years allowing the CBI to build up foreign-exchange reserves and to extend the outflow over more years. It is likely that the controls will be in place for some years to come, further damaging the economy.
ISK or Euro?
The Central Bank of Iceland recently released a 600 page report on the options that Iceland has in currency matters. The CBI says that the only realistic options for Iceland are keeping the Icelandic Krona or to switch to the Euro. Keeping the Krona would mean that the current capital controls would stay for some time. Also when they are lifted, free flow of capital could not be allowed and would have to be managed in some way, and foreign loans would have to be limited. The problem is that according to the EEA agreement Iceland has to have free flow of capital. A solution to this problem could be found, but some say that Iceland has to exit the agreement, which could have very damaging effects like tarrifs on exports to the EU.
Entering the Euro would mean that the EU (EMU) would help Iceland with lifting the capital controls and then when we have the Euro there would be a free flow of capital. Recent polls however suggest that the majority of Icelanders is opposed to joining the EU.
It is therefore expected that Iceland will use the Icelandic krona for many years to come, and that the capital controls will be in place for some years to come.