Sixth Review Under the SBA and Proposal for Post-Program Monitoring—Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iceland
This staff statement provides an update on developments and their implications for the program since the issuance of the Staff Report. These developments do not alter the thrust of the Staff Appraisal.
The Monetary Policy Committee (MPC) of the Central Bank of Iceland (CBI) raised policy interest rates by 25 bps on August 16. The move is in line with the policy shift towards a tightening bias announced at the previous MPC meeting, and follows the rise in headline and core inflation in recent months. The decision reflects the MPC's concerns about inflation expectations becoming entrenched at levels above target and potential pressure on the krona. Despite the announced shift towards the tightening bias, the interest rate decision was largely unexpected by markets, and interest rates increased markedly across the yield curve (by around 50 bps).
To date, Iceland has been largely unaffected by the recent turmoil in international financial markets. The onshore exchange rate has remained stable, domestic financial markets remain calm (the recent increase in interest rate seems attributable to the MPC decision), and CDS spreads have remained broadly unchanged. Nonetheless, risks to Iceland’s recovery have increased, particularly if global growth slows, financing for investment projects becomes more difficult, or commodity prices decline markedly.
The global turmoil has, however, had an impact on the most recent auction under the authorities’ capital account liberalization strategy. As discussed in the previous staff report, the initial step of the strategy entails the CBI selling foreign currency to offshore krona holders (the “first leg” auction) and then repurchasing foreign currency in exchange for krona (the “second leg” auction) in order to preserve reserves. Following a successful first leg auction in mid-July, the CBI conducted a second leg auction to repurchase Euros in exchange for krona in mid-August. The coverage of the second leg auction was very limited, as bids represented only about 5 percent the offered amount (all offers were accepted at the price of 210 krona per Euro). The turbulence in global markets and investor risk aversion appear to have played a key role in the low auction coverage. In particular, the Icelandic pension funds (which hold large foreign assets and were key participants in the previous set of auctions) were reportedly reluctant to divest foreign assets at a time of significant market volatility. As noted in the previous staff report, the authorities’ capital account liberalization strategy is flexible and is designed to adjust the pace of liberalization in response to adverse domestic or global developments.