Iceland facing crisis as central bank raises rates to 15%

FEARS THAT Iceland could be the first country to fall victim to global financial turmoil grew yesterday when its central bank abruptly increased interest rates 1.25 percentage points to 15 per cent in an attempt to restore confidence in its struggling currency and stave off a full-blown economic crisis.

The bank said "deteriorating financial conditions in global markets" had contributed to the emergency move. Confidence in the krona, Iceland's currency, has been shattered this year because of perceived economic imbalances in the economy and fears the banking sector is in danger of collapse. The krona has weakened by 22 per cent against the euro so far this year.

This prompted the central bank to adopt unusually blunt language yesterday, warning if the decline was not reversed Iceland faced "spiralling increases in prices, wages and the price of foreign exchange".

"Only time will tell if this works," said Ingimundur Fridriksson, governor of the central bank. "We are a small open economy and we are obviously affected by moves in the international economy."

Yesterday's move saw the krona gain as much as 6.3 per cent against the dollar, while the country's benchmark index of the 15 most traded stocks had its biggest gain in more than 15 years, rising 6.2 per cent.

The bank last raised rates in November 2007 and said then it would leave them unchanged until the middle of this year, but was prepared to take extraordinary action if the krona depreciated severely.

Inflation was 6.8 per cent in February and has outpaced the central bank's target of 2.5 per cent since 2004.

Thor Herbertsson, co-author of an influential report in 2006 on Iceland's economy with Fredric Mishkin, a member of the US Federal Reserve board, said Iceland could be thrust into crisis as a result of the global economic situation. "Let's say Iceland is not in more danger than some Wall Street banks," he said.

At the same time, though, as international investor confidence in Iceland has fallen sharply, policymakers and economists have tried to reassure markets by drawing attention to the country's economic fundamentals and the underlying strength of the banks.

Richard Portes, president of the Centre for Economic Policy Research and the author of a respected report on Iceland's economy last year, has urged investors to pay more attention to the data. He points out that overheating is being tackled, with economic growth slowing, hitting 2.9 per cent in 2007 and zero this year.

Finnur Oddsson, managing director of the Icelandic Chamber of Commerce, said: "The global turmoil is certainly hurting the financial sector, but the danger of things toppling over here is greatly exaggerated." - (Financial Times service)