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WRAPUP 4-Iceland, in nod to IMF, boosts rate to kickstart crown

(Writes through, adds prime minister comments, quotes from resident)

REYKJAVIK, Oct 28 (Reuters) - Crisis-hit Iceland’s central bank boosted interest rates by a massive 6 percentage points to 18 percent on Tuesday, a surprise move that aimed to please the IMF and restore trust in a shattered currency.

The step came just two weeks after policy-makers eased borrowing costs 3.5 percentage points to soften the impact of the country’s financial meltdown, and the central bank vowed to do all it could to make its currency functional again.

Prime Minister Geir Haarde, in Helsinki for a Nordic leaders’ conference, said he believed rates would not stay at such lofty levels for long.

“I think it will be a short-term rate hike. As soon as we get inflation under control, rates will come back down,” he told reporters, adding that he expected the Icelandic crown to stabilise “relatively fast”.

In the wake of the central bank's move, the crown traded internationally for the first time in a week. London dealers said it slumped to 240 per euro compared with Monday's central bank fixing at 152 ICEX.

The rate rise, which one economist called extreme, will offer investors a much higher return for putting money back into the North Atlantic island’s crippled financial system.

“It is of overarching importance to restore stability in the foreign exchange market and support the exchange rate of the crown,” the central bank, Sedlabanki, said in a statement.

Sedlabanki Governor David Oddsson, who has faced calls to resign for failing to avert the crisis, acknowledged at a news conference that Icelanders would suffer from costlier credit.

“This rate will obviously be very hard on the public and businesses. It should not come as a surprise given the enormous blow when 85 percent of the banking system collapses,” he said.

But the central bank chief, a former prime minister, said the small island nation would bounce back.

“At the end of all this, my guess is that the biggest surprise will be how fast we were back on our feet given the enormity of the blow.”

RESTORING TRUST

Tuesday’s rise takes Icelandic borrowing costs back to record levels and came as a shock to residents, already shaken by the scale and speed of Iceland’s reversal of fortune.

“I’m in the same situation as many others with housing loans that will now only go up and up, which will make it so much harder to make ends meet for the families in this country,” said public relations consultant Arni Hallgrimsson, 52.

A Gallup survey on Tuesday showed that consumer confidence fell to a new record low this month.

The central bank said it expected a contraction in demand to push the volcanic island’s current account out of deficit, which would help lead to appreciation of the crown.

“If forecasts materialise, the policy rate will be reduced in accordance with rapidly subsiding inflation,” it added.

Dresdner Kleinwort currency strategist Jon Harrison said the rate rise would help but that more work was needed before people felt comfortable trading the crown. “That’s started today, but it’s still very illiquid,” he said.

IMF’S HALLMARK

Even before Iceland publicly linked the rate rise to the IMF, economists detected the hand of the Washington lender, which has been seen in the past as a purveyor of painful steps.

“We are basically seeing the IMF programme at work,” said Beat Siegenthaler, strategist at TD Securities in London.

“It signals that the objective is to return to a market-based floating exchange rate regime. In order to do so, the central bank needs to set rates where they need to be in order to protect the currency.”

Last week the fund agreed on a programme that could lead to a $2 billion stand-by loan for Iceland after its financial system all but collapsed and the state took over three of its biggest banks.

Central bank chief Oddsson said the rise was required by the IMF package before the fund’s board signed off on a deal. He said approval was likely to be on Thursday.

“It was not forced on us, but it was in line with the agreement that we reached with the IMF,” said Icelandic Finance Minister Arne Mathiesen, who was in Helsinki with Haarde to discuss possible loans from Iceland’s Nordic cousins.

The Icelandic government, which like the head of the Sedlabanki, has been urged to step down in recent weeks, has said it needs another $4 billion in loans on top of the $2 billion it wants from the IMF. (Reporting by Omar Valdimarsson in Reykjavik, Niklas Pollard, Anna Ringstrom and Adam Cox in Stockholm, Peter Apps and Veronica Brown in London, Sakari Suoninen in Helsinki; editing by Stephen Nisbet)

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