Cur­rency war spurs rate in­crease in Western Europe

The Pak Banker - - FRONT PAGE -

While most cen­tral banks across the 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 sev­en­day 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 con- tinue to drive the econ­omy on such a huge mar­gin, be­cause that will bring about other prob­lems, such as the carry trade."

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.

"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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