Feb. 19 (Bloomberg) -- Iceland is hinting its currency may be too small to survive in the volatile world left behind by the global financial crisis.
Less than five months after Finance Minister Katrin Juliusdottir said the krona probably will never be restored to a free floating regime, central bank Governor Mar Gudmundsson is signaling the same.
“We’ve said that Iceland can live with the krona, but then we have to do this and that,” Gudmundsson said in a telephone interview from Reykjavik. “And it may well be the case that we don’t like all the things we have to do. Then we have to consider other options. Another option is to join a large currency union.”
After its biggest banks defaulted on $85 billion in 2008, Iceland imposed currency controls to cauterize the outflow of capital. The International Monetary Fund and economists, including Nobel laureate Paul Krugman, praised the step as necessary. Now, even as Iceland outgrows much of Europe, the nation is holding on to the currency restrictions amid concern the krona won’t survive on its own.
Offshore investors have about $8 billion in kronur locked behind the controls. That compares with Iceland’s total economic output in 2012 of $13 billion. A slump in the krona would drive inflation higher and hurt households in the Atlantic island, where loans linked to the consumer price index made up 83 percent of all borrowing as of September 2012.
Even with the controls, the krona has lost almost 6 percent against the euro in the past 12 months. Versus the dollar, it’s declined almost 5 percent in the period. Annual inflation held at 4.2 percent in January, the statistics office said Jan. 29.
Though the currency restrictions are protecting the krona from even steeper losses, they come with a different set of risks, Gudmundsson said.
“The restrictions have long-term costs for the economy and its international links,” he said. “Also, it might lead to asset bubbles and other such things, which we still haven’t seen much of yet. However, over the short- and medium term, there are benefits to the capital controls as they maintain stability. As soon as the long-term costs are greater than the medium-term benefits, we should abolish the controls. We have, however, not arrived at that juncture.”
While policy makers responsible for some of the world’s smallest currencies are struggling to protect their markets, the world’s biggest economies have also focused on exchange rates as the debate shifts from debt reduction to trade competitiveness.
Group of 20 finance chiefs meeting in Moscow over the weekend signaled Japan has scope to keep stimulating its economy as long as policy makers don’t publicly advocate a weaker yen. The group pledged not “to target our exchange rates for competitive purposes” following signs that some governments were descending into a contest to help exporters through devaluations.
“This isn’t only a problem for Iceland,” Gudmundsson said. “This is a discussion that’s taking place all over the world. As the country is smaller, the more difficult it is.” Gudmundsson stopped short of calling it “impossible” for a small currency to survive in a free-float regime.
In the Nordic region that Iceland is a part of, Sweden and Norway have free-floating currencies. Denmark pegs its krone to the euro, while Finland is a full euro member. Sweden’s krona soared to a four-month record against the euro last week, while Norway’s krone touched a nine-year high in August as capital poured into the AAA rated nations.
Yet the direction of those flows has varied as investors try to gauge whether the euro area is over the worst of its crisis, or whether they need to keep buying safer assets.
For Sweden’s krona, one-month implied volatility -- a measure of expected moves in the exchange rate -- has averaged 14.96 percent since the start of 2008, compared with 10.2 percent in the five years leading up to the financial crisis that broke out in 2007. Volatility on the Norwegian krone was 14.4 percent since the start of 2008, compared with pre-crisis average of 10.2 percent.
While Sweden has signaled it won’t resort to policies that target a weaker krona, exporters in the nation have complained about the competitive disadvantage they say they’re struggling against. In neighboring Norway, central bank Governor Oeystein Olsen said last week he’s ready to cut rates should the krone appreciate too much. Both Sweden and Norway rely on exports for about half their total economic output.
Iceland has passed a series of milestones on its path to economic resurrection. The nation won a court battle against the U.K. and Netherlands last month, freeing it of as much as $2.6 billion in damages for not honoring depositor claims. That victory prompted Moody’s Investors Service to raise the outlook on Iceland’s Baa3 grade to stable, while Fitch boosted its rating to BBB from BBB-.
According to Fridrik Jonsson, an economist at the Washington-based World Bank, even those successes aren’t enough to protect the island from an external shock. He warns that the restoration of a free-floating krona would trigger “another economic collapse,” unless Iceland takes “radical action.”
For Iceland, which started European Union membership talks in 2010, the lesson of the euro crisis is that being inside a larger currency group isn’t always the best protection. The key is having an economy that’s aligned with the currency bloc a nation plans to enter, according to Anders Svendsen, an economist at Nordea Bank AB in Copenhagen.
Euro membership “may have short-term benefits, but those may be outweighed by longer-term downsides accompanied by actually tying yourselves up while the economy is not anywhere near an equilibrium,” Svendsen said by phone.
Iceland’s policy makers are mindful that “there’s a lot of risk” associated with maintaining a small currency, Gudmundsson said. “Everyone needs to be aware of the risks and we need to have rules that regulate the risks.”
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