REYKJAVIK (Reuters) - Crisis-hit Iceland’s central bank boosted interest rates by a massive 6 percentage points to 18 percent on Tuesday, a move that aimed to please the IMF and restore trust in a shattered currency.
Coming just two weeks after borrowing costs had been eased to soften the impact of the country’s financial meltdown, the central bank promised to do all it could to make its currency functional again.
The Icelandic crown traded internationally for the first time in a week after the announcement. London dealers said it slumped to 240 per euro compared with Monday’s central bank fixing at 152.
The rate rise, which one economist called extreme, meant investors get 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,” central bank Sedlabanki said in a statement.
Sedlabanki Governor David Oddsson, speaking at a news conference, acknowledged that Icelanders would suffer from the higher borrowing costs.
“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 who has recently faced calls to resign from some politicians and the public, said the island 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.”
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 materialize, the policy rate will be reduced in accordance with rapidly subsiding inflation, it added.
Dresdner Kleinwort analyst Jon Harrison said the move would help but more work was needed before people felt comfortable trading the Icelandic crown. “That’s started today, but it’s still very illiquid,” he said.
Two weeks ago, the central bank cut rates by 3.5 points to 12 percent.
“This has come a bit out of the blue following the latest interest rate cut,” BNP Paribas Emerging Markets strategist Elisabeth Gruie said.
“And it reflects a desperate attempt to restore a degree of confidence in the local market and restore trading in the Icelandic krona, which has been completely frozen.”
Even before Iceland publicly linked the rate rise to the International Monetary Fund, economists detected the hand of the Washington lender. The IMF has been criticized in the past for pushing painful measures. Last week it agreed on a program that could lead to a $2 billion stand-by loan for Iceland.
The island nation’s financial system has all but collapsed since the country was forced to take over three of its biggest banks earlier this month.
A Gallup survey on Tuesday gave evidence of the extent to which the financial mayhem has hit households, showing that consumer confidence fell to a new record low this month.
Icelandic Finance Minister Arne Mathiesen, in Helsinki with Prime Minister Geir Haarde to discuss possible loans from Iceland’s Nordic cousins, said rates should fall again once the crown had stabilized.
“It was not forced on us, but it was in line with the agreement that we reached with the IMF,” Mathiesen told a news conference. He said that if was Iceland successful in stabilizing the currency, high rates may be needed only for a short time.
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.
The Icelandic government, which like the head of the Sedlabanki, has faced calls to resign for failing to avert the crisis, has said it needs another $4 billion in loans on top of the $2 billion it wants from the IMF.
The IMF has faced criticism it places excessively onerous demands on countries in exchange for offering financial assistance and some analysts said the massive tightening of policy on Tuesday bore the hallmark of the fund’s policy.
“We are basically seeing the IMF program 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.”
Reporting by Omar Valdimarsson in Reykjavik, Niklas Pollard, Anna Ringstrom and Adam Cox in Stockholm, Peter Apps and Veronica Brown in London; editing by Mike Peacock, Patrick Graham and Victoria Main
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