* Iceland lifts controls imposed at height of crisis
* Banking instability spread through sector
* Fears that Icelandic economy could overheat (Adds currency movement, background, quote)
By Ragnhildur Sigurdardottir and Daniel Dickson
REYKJAVIK, March 14 (Reuters) - Iceland lifted its remaining capital curbs on Tuesday, ending more than eight years of controls on businesses and citizens put in place after its banks collapsed during the financial crisis.
Icelandic lenders buckled under the weight of huge debts amassed over years of overseas expansion, spreading instability through other European nations and making the country a symbol of the excesses that helped to trigger the financial crash.
The government started dismantling capital controls last year by easing restrictions for local residents in a nation of only around 330,000 people. The end of the last controls, first announced on Sunday, came into force at midnight.
Iceland hopes the move will open the way for investment by Icelandic pension funds abroad and improve prospects for foreign investment in the country.
A small and volatile currency has exacerbated Iceland’s economic troubles and will need to be carefully managed.
The Icelandic crown remains at historically strong levels but posted its biggest one-day decline in eight years on Monday as the end of controls was expected to trigger initial outflows of pent-up foreign and domestic money.
The currency continued to weaken on Tuesday, dropping about 1 percent against both the dollar and the euro. Iceland’s central bank declined to comment on the currency movements ahead of its interest rate decision tomorrow.
Sedlabanki kept its key deposit rate unchanged at 5.0 percent in February, but with capital controls lifted, Finance Minister Benedikt Johannesson hoped interest rates could be cut. “I have no idea what they will do, but at least we are trying the create the conditions for them to make it easier to reduce the interest rate,” he said on Tuesday.
Authorities have been preparing for the scrapping of restrictions, with the central bank amassing 815 billion Icelandic crowns ($7.4 billion) of currency reserves at the end of last year to ease the transition.
“We have a foreign currency reserve much bigger than we have ever had before,” Johannesson said in a telephone interview with Reuters. “That of course makes it easier to stabilise the currency rate.”
Jon Sigurdsson, CEO of Icelandic prosthetics maker Ossur which has more than 2,500 employees worldwide, said the removal of the controls was a positive step for the local business community.
“The only thing I hope will not happen is that this will lead back to the same as before the crisis,” he said.
“Even though history shows us people rarely learn from mistakes, I hope in this case we do.”
The government has created a task force to review monetary and currency policies in order to create a more stable exchange rate. The task force will report at the end of 2017 and could, for instance, recommend a currency peg.
The economy is also at risk of overheating -- it expanded 11.3 percent in the final quarter of 2016 -- but finance minister Johannesson said that would be managed by running a budget surplus rather than spending the money on reforms.
“It is clearly a risk that they again come into the same problems as before the financial crisis -- that the economy overheats and they build up external liabilities,” said Danske Bank chief analyst Jakob Christensen, adding that a small country could easily be overwhelmed by capital flows.
“But I think the financial supervisors of Iceland are very well aware of these risks, so I think they would be more strict with these vulnerabilities this time around.”
Iceland has been locked in a dispute with domestic and overseas funds that owned more than $1 billion worth of krona-denominated assets that were frozen by Icelandic authorities.
To facilitate the lifting of capital controls, the central bank said on Sunday it had agreed to purchase offshore crown assets for close to 90 billion Icelandic crowns ($836 million) at an exchange rate of 137.5 crowns per euro. Remaining asset holders have two weeks to accept the same conditions.
Finance minister Johannsson urged them to take the offer, saying currency rate changes could work against the funds.
“That is their decision but I think it would be a wise decision to take.”
$1 = 110.4900 Icelandic Crowns Additional reporting by Helena Soderpalm in Stockholm Writing by Niklas Pollard and Johan Ahlander; Editing by Keith Weir and Catherine Evans