Iceland decides to uphold its currency

Bloomberg

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Iceland’s central bank left the benchmark interest rate unchanged, ending a series of cuts that began in January and bowing to International Monetary Fund warnings that monetary policy should support the krona.

Policy makers at Reykjavik-based Sedlabanki kept the repo rate at 12 percent, the bank’s spokesman Stefan Stefansson said Thursday.

Sedlabanki interim Governor Svein Harald Oygard said on June 4 that it’s the central bank’s "privilege" to set benchmark interest rates, adding that policy makers’ decision to lower the key rate last month was mainly steered by the outlook for the domestic economy.

Iceland’s economic collapse, sparked by the failure of its biggest banks in October, forced the island to impose capital restrictions to prevent a sell-off of the krona.

Those controls weren’t enough to prevent the currency losing 3.4 percent against the euro since June 1, the worst performer of the 18 emerging-market currencies tracked by Bloomberg.

The island’s reliance on imports means krona losses spur inflation.



Warnings from the IMFrepresentative

"Rising inflation and signs of rising inflationary expectations suggest the need for caution," Franek Rozwadowski, the IMF’s resident representative, said in an interview Wednesday. "The monetary policy advice of the fund is to use stabilization of the exchange rate as the principal instrument to stabilize inflation."

Inflation accelerated to an annual 12.2 percent in June, from 11.6 percent in May, the statistics office said on June 24. Inflation is accelerating even as the central bank predicts the economy will contract 11 percent this year, as consumer spending plunges 24 percent and fixed investment plummets 45 percent.

Iceland is relying on a $2.1 billion IMF loan to avert default and received the first $827 million installment in November after the loan was approved, with a further eight equal disbursements yet to be paid. The Nordic states of Sweden, Norway, Finland and Denmark this week signed off on a further $2.5 billion in loans, and said that disbursement remains contingent on IMF reviews.

The decision to keep rates on hold comes even as labor unions have lobbied for lower borrowing costs to help underpin a recovery of the domestic economy. "Clearly, the pressure from the social partners and the government for a rate cut is considerable," Ingolfur Bender, head of research at Islandsbanki hf in Reykjavik, said in a note before the decision.

Labor unions and employers groups agreed last month to back 20 billion kronur ($158 million) in budget cuts and tax increases necessary to ensure the continued inflow of bailout funds. The government of Prime Minister Johanna Sigurdardottir has said Iceland must join the European Union, with euro adoption an ultimate goal, to avoid having a weak currency. The government on June 25 pledged to announce by Aug. 1 a program that would abolish capital controls and said new investments will be exempt from capital restrictions by Nov. 1.

The moves come as part of a stability agreement between the government, municipalities, labor and employer’s unions. The government is also calling for interest rates to be cut to below 10 percent.