This article appeared on page 2 of the Friday April 11, 2008 issue of the Financial Times.
By David Ibison
Iceland has the highest interest rates in Europe after the central bank raised rates by 50 basis points to a record 15.5 per cent yesterday as it storve to restore confidence in its struggling currency and quench fears of a banking crisis.
The move puts the tiny North Atlantic nation above Turkey's rate of 15.25 per cent and comes just two weeks after it imposed an emergency 1.25 percentage point rise to 15 per cent, underscoring the depth of its problems.
On top of the aggressive action taken by the central bank, the authorieis are also considering further moves to ease investors' fears, such as co-ordinated action by Nordic central banks to provide additional liquidity, if needed.
There was disappointment that this proposed action plan was not unveiled yesterday.
"A sluggish reaction will hurt the financial system, financial stability and the authorities' credibility," said Glitnir Research, the research arm of the Icelandic bank, in a report. "Moreover, non-action will also play a large role in the credit rating of Iceland's sovereign debt, which is on negative outlook at all three major rating agencies, Moody's, Fitch and S&P."
But the central bank did make clear it was prepared to bolster Iceland's foreign exchange reserves in the near future.
"A policy rate increase in and of itself does not solve the problems that have developed in the FX swap market," it said. "Increased issuance of risk-free bonds that are accessible to foreign investors should open up other channels for currency inflow."
Confidence in the krona, Iceland's currency, has been damaged this year because of economic imbalances in the economy and fears over the viability of the banking sector. The krona has weakened by some 25 per cent against the euro this year.
The inflation rate was 8.7 per cent in March, well above the government's target of 2.5 per cent, and the central bank said yesterday it expected inflation to peak at 11 per cent by the third quarter of this year, pushing interest rates up further.
"Persistent inflation will be most damaging to indebted businesses and households and can undermine financial stability for the long term," it said. "It is therefore of paramount importance that inflation be brought under control."
Iceland's economic weaknesses have been exacerbated by the deterioration in global financial markets, which have led to a drastic reassessment of risk and undermined confidence in its highly leveraged banks.
On top of these macro-economic pressures, the authorities in Iceland also believe the country's financial markets may have been weakened via a speculative attack by international hedge funds.