Iceland seeks loan as inflation rises

Iceland seeks loan as inflation rises

By David Ibison

Published: May 27 2008 23:00 | Last updated: May 27 2008 23:00

Iceland is seeking permission from parliament to borrow up to IKr500bn, its largest ever loan, in a move that would more than double existing foreign exchange reserves and provide further support for its troubled currency and banking system.

The proposed loan is the latest attempt by the government to fend off the effects of the global credit crisis following an announcement this month that three Nordic central banks would provide a €1.5bn ($2.4bn, £1.2bn) emergency funding package if needed.

The measures have been designed to help restore international investor confidence in the tiny north Atlantic country, which has been destabilised by domestic macroeconomic imbalances, fears over the viability of the banking sector, and growing global aversion to risk.

“The government and the central bank of Iceland have for some time been preparing measures to reinforce the currency reserves. The bill supports speculation that such borrowing is under way,” said Glitnir Research, the research arm of the Icelandic bank.

It is not known when any borrowing will take place or how much of the IKr500bn ($6.9bn, €4.4bn, £3.5bn) will be utilised, but the authorities want the power to conduct a sizeable borrowing programme on short notice if needed.

If the government receives permission from parliament to borrow the full IKr500bn, it would add considerable weight to the war chest it is building to defend its currency and offset the risk of a systemic banking crisis.

The central bank currently holds foreign exchange reserves of IKr207bn, and now has access to €1.5bn from the three Nordic central banks and an existing back-up line of €1bn.

The additional funds are needed because the banks are exposed to swings in international investor sentiment following a period of rapid expansion financed by overseas debt. They now have combined assets of about 10 times Iceland’s gross domestic product.

The severity of Iceland’s problems was highlighted on Tuesday with the announcement that inflation had hit a new 20-year high of 12.3 per cent in May, up from 11.8 per cent in April.

Inflation is being driven upwards by the sharp depreciation of the Icelandic krona, which has lost up to a third of its value this year despite the central bank raising interest rates to 15.5 per cent, the highest in Europe. The central bank targets inflation of 2.5 per cent.

Despite the emergency funding measures, the imbalances in Iceland’s economy are expected to level off in coming months. Economic growth hit 2.9 per cent in 2007 and will be about zero this year.

The current account deficit – the source of many of the concerns over the economy – has narrowed from 26 per cent of gross domestic product in 2006 to 16 per cent in 2007.

Iceland’s banks are also sound by international standards.