Iceland Cuts Benchmark Interest Rate to 8% as Krona Gains, Inflation Eases

Iceland’s central bank cut the benchmark interest rate by half a point after international lenders said the island’s efforts to rebuild its financial system were on track, supporting the krona as bailout flows resumed.

Sedlabanki lowered the seven-day collateral lending rate to 8 percent, the Reykjavik-based bank said on its website today. The bank also cut the deposit rate to 6.5 percent from 7 percent. Policy makers have reduced the benchmark 10 times from a record 18 percent since obtaining a $4.6 billion loan from a group led by the International Monetary Fund at the end of 2008.

The Washington-based fund resumed its program with Iceland in April, freeing a $160 million payment and helping send credit default swaps lower as investors bet the government is better positioned to service its debt. Central bank capital controls have also supported the krona, which has gained about 19 percent against the euro since a Nov. 12 low, stemming consumer price gains. Inflation slowed 0.8 point to 7.5 percent last month.

“Conditions are ripe for a further easing of the tight monetary stance,” said Ingolfur Bender, head of research at Islandsbanki hf. “The krona has appreciated by over 5 percent since the last policy rate decision meeting and inflation has dropped and is, moreover, expected to decrease even further in the months ahead.”

Bond Repurchase, Reserves

The krona slipped 0.1 percent against the euro, after having traded as much as 0.2 percent higher earlier in the day. The currency was trading at 156.85 at 10 a.m. local time.

The central bank yesterday said it repurchased $236 million in bonds coming due in 2011 and 2012 to reduce Iceland’s reliance on external funding. The yield on the 8 percent note due July 2011 fell to the lowest in at least a year on June 16, when the bank first invited offers to buy back the debt. Since the IMF resumed its program in April, credit default swaps on five- year debt have eased 65 basis points to 317.

The bond repurchase is designed to reduce the risk premium on Iceland’s credit default swaps, Asgeir Jonsson, head of research at Arion Bank hf in Reykjavik, said in a phone interview. “The bank must always be considering that eventually the Treasury and energy companies have to return to the international financial markets.”

Difficult Position

Iceland imposed capital restrictions at the end of 2008 to protect the krona from a selloff after the failure of the island’s three biggest banks in October of that year precipitated an 80 percent krona slump against the euro in the offshore market.

“It’s difficult to be in the position that Iceland has been in, that is, not to have access to international financial markets,” Jonsson said. “With this, they’re trying to facilitate a return to those markets.”

The bank has also drawn 639 million euros ($784 million) from a credit line provided by the Nordic countries and Poland, it said yesterday. Those funds will be used to boost reserves, the bank said, offsetting the impact of the bond buyback.

Iceland’s economy will return to growth in 2011, when the central bank estimates output will expand 3.4 percent. Gross domestic product contracted a record 6.5 percent last year and will shrink a further 2.6 percent this year, marking the island’s longest period of economic decline since records began in 1944.

Editors: Tasneem Brogger, Chris Kirkham.

To contact the reporter on this story: Omar R. Valdimarsson in Reykjavik valdimarsson@bloomberg.net.

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