Last updated: March 25, 2008 7:08 pm

Concern for Iceland grows after rate rise

Fears that Iceland could be the first country to fall victim of the global financial turmoil grew on Tuesday when its central bank abruptly increased interest rates 1.25 percentage points to 15 per cent in an attempt to restore confidence in its struggling currency and stave off a full-blown economic crisis.

The bank said “deteriorating financial conditions in global markets” had contributed to the emergency move. Confidence in the krona, Iceland’s currency, has been shattered this year because of perceived economic imbalances in the economy and fears the banking sector is in danger of collapse. The krona has weakened by 22 per cent against the euro so far this year.

The rapid weakening of the currency prompted the central bank to adopt unusually blunt language on Tuesday, warning if the decline was not reversed Iceland faced “spiralling increases in prices, wages and the price of foreign exchange”.

“Only time will tell if this works,” Ingimundur Fridriksson, governor of the central bank, told the FT. “We are a small open economy and we are obviously affected by moves in the international economy.”

Tuesday’s move saw the krona gain as much as 6.3 per cent against the dollar, while the country’s benchmark index of the 15-most traded stocks had its biggest gain in more than 15 years, rising 6.2 per cent.

The bank last raised rates in November 2007 and said then it would leave them unchanged until the middle of this year, but was prepared to take extraordinary action if the krona depreciated severely. Inflation was 6.8 per cent in February and has outpaced the central bank’s target of 2.5 per cent since 2004.

“It will be necessary to continue to pursue a very tight monetary policy in order to bring inflation and inflation expectations under control, and increase confidence in the krona,’’ the central bank said. Thor Herbertsson, co-author of an influential report in 2006 on Iceland’s economy with Fredric Mishkin, a member of the US Federal Reserve board, said Iceland could be thrust into crisis as a result of the global economic situation. “Let’s say Iceland is not in more danger than some Wall Street banks,” he said.

But at the same time as international investor confidence in Iceland has fallen sharply, policymakers and economists have tried to reassure markets by drawing attention to the country’s economic fundamentals and the underlying strength of the banks.

Richard Portes, president of the Centre for Economic Policy Research, and the author of a respected report on Iceland’s economy last year, has urged investors to pay more attention to the data.

He points out overheating is being tackled, with economic growth slowing, hitting 2.9 per cent in 2007 and zero this year.

He adds that Iceland’s current account deficit – the source of many of the concerns about the economy – has narrowed from 26 per cent of GDP in 2006 to 16 per cent in 2007.

He has also made clear that Iceland’s banks are sound by international standards, with deposit ratios in line with international norms, high capital adequacy ratios by European standards and credible funding profiles.

Finnur Oddsson, managing director of the Icelandic Chamber of Commerce, said: “The global turmoil is certainly hurting the financial sector, but the danger of things toppling over here is greatly exaggerated.”

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