Arnaldur Halldorsson/Bloomberg

Currency War Spurs Western Europe’s Only Rate Increases

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While most central banks across western Europe are busy preventing their currencies from appreciating, there’s one facing an entirely different challenge.

In Iceland, policy makers are worried their steps toward scaling back capital controls this year will trigger a krona selloff. Arion Bank hf, Islandsbanki hf and Landsbankinn hf all say the central bank will probably raise the benchmark seven-day collateral lending rate by 50 basis points on Wednesday, bringing it to 6.25 percent after a similar move in June.

Iceland is also responding to a bout of domestic overheating, brought on in part by capital controls, that has triggered demands for higher wages across most industries. Inflation is close to 2 percent, but may rise fast should wage pressures feed through to consumer prices, the central bank has warned. The uniqueness of Iceland’s economic challenges may prove a hurdle in itself.

“The central bank needs to take into consideration the interest rates in other countries,” Valdimar Armann, an economist at Reykjavik-based asset manager GAMMA, said by phone. “We can’t continue to drive the economy on such a huge margin, because that will bring about other problems, such as the carry trade.”

Crisis Management

Iceland is close to completing the final stage of its journey from crisis basket-case to rehabilitated economy as it starts to unwind capital restrictions in place since the end of 2008. Back then, it was responding to a plunge in its currency that followed the failure of a banking system whose debts had ballooned to more than 10 times the size of the whole economy.

Part of the reason Iceland’s banks were able to amass such a huge pile of debt in the first place was that investors were attracted to the high interest rates the country offered. Before 2008, Iceland was a major target for investors seeking to profit from so-called carry trades, in which funds were borrowed in currencies backed by low interest rates and placed in markets where returns were higher.

At the beginning of 2008, about nine months before its banks started failing, Iceland’s main central bank rate was 13.75 percent. At the time, the European Central Bank’s key rate was 4 percent.

Foreign Reserves

“The carry trade is one of the lessons we need to learn from what happened here,” Finance Minister Bjarni Benediktsson said in an interview in Reykjavik. “There are external boundaries to how much higher interest rates can be in Iceland compared to the surrounding countries, if we don’t want an abnormal amount of capital inflows. That must be one of the things that the central bank has to take into consideration when it sets rates; to not create this risk by raising rates too much.”

Iceland’s government is exploring ways to help keep rates lower, he said.

“We need a better agreement between the government and the members of the labor market in Iceland, in putting an emphasis on lower interest rates,” he said in an interview in Reykjavik.

Benediktsson says Iceland is a little better prepared for the kinds of imbalances triggered by carry trades because the central bank has been building up its currency reserves to ensure it has a buffer should markets turn. Foreign reserves reached 620 billion kronur ($4.7 billion) in July, their highest since August 2012, according to central bank data.

“At the moment, the carry trade isn’t a specific matter of concern,” Benediktsson said. “But I think we need to learn from our experience.”

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