Iceland has no plans to revert to a free floating krona after its banking collapse proved the island’s currency is too small to survive without controls, Economy Minister Arni Pall Arnason said.
“We will have to have some sort of restrictions on completely free movement of the currency,” Arnason said in an interview in Copenhagen yesterday. “The only scenario that we can really be confident that should allow us completely full and open access is the adoption of the euro.”
The island is still recovering from its 2008 banking meltdown, which sent the krona down about 80 percent against the euro offshore before the central bank halted the sell-off with capital controls. Since then, the country has used the currency restrictions to protect its economy as it tries to appease creditors seeking to recoup some of the $85 billion Iceland’s banks defaulted on almost three years ago. The government wants European Union accession talks, started in July last year, to result in euro membership as early as 2015.
“Monetary policy will have to enable us to adopt the euro if we decide to be members of the EU,” Arnason said before speaking at the Institute for Corporate Governance. “It will have to give us as much stability as possible during the time up until we adopt the euro.”
Krona Gains
Iceland’s krona has gained 3.2 percent against the euro since the beginning of August, making it the fourth-best performing emerging-market currency in the period. Since the end of 2008, when capital controls were introduced, the krona is up 5.4 percent versus the euro. Gross domestic product will grow 2.8 percent this year, the central bank estimates. That compares with 1.6 percent average growth for the 17 countries sharing the euro, according to a May 13 estimate by the European Commission.
As central banks in Europe and the U.S. resort to crisis easing to counter the fallout of the latest bout of market turmoil, Iceland’s central bank has resumed monetary tightening. The bank raised its main interest rate on Aug. 17 by a quarter point to 4.5 percent, the first increase since its financial industry collapsed three years ago. Policy makers are increasing rates to buoy the krona as they ease the capital controls in stages. The restrictions are preventing foreign investors from taking out $4.3 billion in krona assets, the bank estimates.
Iceland’s government says it needs some form of foreign exchange protection to avoid the kind of speculative currency trades that exacerbated its banking crisis three years ago.
Currency Flows
Monthly krona flows peaked at 1.2 trillion kronur ($10.6 billion) in March 2008, seven months before Iceland’s biggest banks failed. Gross domestic product was 1.5 trillion kronur for that whole year. Flows surged as the central bank pursued a tightening cycle that brought the benchmark rate to 15 percent in March 2008. The rate reached 18 percent that year before the bank finally imposed capital controls to protect the currency from a sell-off. Monthly krona turnover in July 2011 was 5.6 billion kronur.
The government wants to impose tougher prudential rules “to limit foreign operations of banks,” Arnason said. “There will have to be some sort of limitations in place if our independent monetary policy is to be a long-term solution.”
Iceland is looking for ways to maintain access to international bond markets after completing a 33-month program with the International Monetary Fund last month, Arnason said. Though the June sale of $1 billion of five-year dollar bonds helped ensure the island is funded through 2016, Iceland needs to ensure it can tap markets at any time, he said.
Bond Markets
Given “these uncertain times now, when sovereign ratings are quite unstable and sovereign bond markets are quite unstable, we are always looking at options,” Arnason said. “We have not made any decision on any new steps in that direction.”
Finance Minister Steingrimur J. Sigfusson said in July Iceland was considering selling foreign-currency debt with longer maturities after the June sale was twice oversubscribed. Investors have rewarded the Atlantic island for delivering austerity cuts that created trade surpluses and narrowed its budget deficit.
Iceland’s debt is graded junk at Fitch Ratings, and carries the lowest investment grade at Standard & Poor’s and Moody’s Investors Service.
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