Iceland Cuts Rates, Delays Removal of Krona Controls

Iceland cuts key rate to 8% as Krona strengthens
The logo of the central bank of Iceland is displayed at their headquarters in Reykjavik. Photographer: Arnaldur Halldorsson/Bloomberg

Iceland’s central bank cut the benchmark interest rate by 0.75 of a percentage point as inflation eased and signaled capital controls needed to shield the krona may stay in place longer than first indicated.

Sedlabanki lowered the seven-day collateral lending rate to 5.5 percent. The bank also cut the deposit rate to 4 percent from 4.75 percent. Policy makers have reduced the benchmark 13 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 Reykjavik-based bank may continue to cut interest rates if the krona “remains stable or appreciates and inflation subsides as forecast,” it said in a statement on its website today. Policy makers will present a revised plan on the timing of removing capital controls next quarter, the bank said.

Capital restrictions, imposed after the failure of Iceland’s three biggest banks in October 2008, have protected the krona. The currency has gained 19 percent against the euro over the past year, while the inflation rate fell 0.4 point to 3.3 percent last month, the lowest since June 2005.

“They needed a deeper cut now to stimulate the economy; there’s a real risk of deflation next year and the bank has to anticipate that and react,” said Asgeir Jonsson, head of research at Arion Bank hf in Reykjavik. The bank may also try to keep rates low as capital controls are removed to prevent investors turning to kronur for so-called carry trades, a transaction that exacerbated the island’s crisis two years ago, he said.

Interbank Market

Iceland’s overnight interbank deposit rate slumped 150 basis points to 4.63 percent, the biggest decline since April 2005 to the lowest since June 2004, according to data available on Bloomberg. The three-month rate dropped the lowest in a year.

Governor Mar Gudmundsson said today the new plan on removing capital controls is due to be ready by March 2011. Before the plan is completed, no further steps will be taken to ease controls, he said. That compares with earlier signals to scale back restrictions as early as this year.

The setback follows a ban on some forms of foreign currency lending and debt relief reforms that may harm lenders capital adequacy levels, according to the central bank.

“Given the issue of a potential short-fall in the capital position of the banking system might not be fully address until year-end, it is not realistic” to take further steps to remove currency controls, Gudmundsson said.

Inflation Slumps

The rate of price gains has dropped to a fifth of the pace that plagued Iceland during the peak of the crisis. Inflation soared to 18.6 percent in January last year after the krona lost about 80 percent against the euro offshore in 2008. The krona was trading 0.2 percent higher against the euro today at 154.63 at 9:29 a.m. in Reykjavik. Against the dollar, the krona gained 0.3 percent to 110.03.

The IMF resumed its program with Iceland on Sept. 29, freeing a $167.5 million payment. The lender’s fourth review of the island’s economic program is scheduled for December, Prime Minister Johanna Sigurdardottir said yesterday.

The central bank estimates foreigners are locked into about $3.6 billion in krona assets, mostly in the form of krona Eurobonds that have remained in limbo since the controls were imposed. The bonds, known as Glacier bonds, will probably be the last to be exempt from currency restrictions, Governor Mar Gudmundsson said in September. Bonds with the longest maturities will be the first to be released from the controls, Deputy Governor Arnor Sighvatsson said at the time.

Iceland’s economy, which contracted an annual 8.4 percent in the second quarter, will return to growth in 2011, the central bank estimates, as the island emerges from its longest period of economic decline since records began in 1944.

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