Iceland - NZ to a greater degree?

Iceland Unexpectedly Raises Benchmark Rate to 14.25%
By Tasneem Brogger

Dec. 21 (Bloomberg) --

Iceland's central bank unexpectedly raised its benchmark interest rate to a record 14.25 percent after a widening current account deficit threatened to weaken the krona and push up inflation.
Sedlabanki increased the repurchase rate by a quarter-point, the 18th increase since May 2004, the Reykjavik-based bank said on its Web site today. Six out of eight economists surveyed by Bloomberg had forecast rates would be left unchanged.
Higher borrowing costs may spark a recession in an economy that was one of Europe's fastest growing last year, expanding 7.5 percent. Investment in aluminum smelters, which fueled growth, has sucked in imports, pushing the current account deficit to 27 percent of gross domestic product in the third quarter.
They ``needed to do this to maintain their credibility,'' said Lars Christensen, a senior strategist at Danske Bank A/S in Copenhagen, one of two analysts to predict today's move. ``They're watching the krona. If it remains stable until the next meeting, then this is the peak, but they're not out of the woods yet.''
The krona dropped 4.7 percent against the euro last month on concern Iceland will struggle to finance the current account gap. Declines in the krona have fueled inflation, which at 7 percent in December was almost triple the 2.5 percent target.
The krona dropped 0.6 percent against the euro, after earlier gaining as much as 0.5 percent, to trade at 92.05 as of 3:37 p.m. in Reykjavik.
`Hard Landing'
Hedge funds poured money into Iceland last year, sparking a 10.3 percent gain in the currency, as they sought to take advantage of high yields as both U.S. and European interest rates hovered at record lows. Demand for Icelandic securities also helped push up the index of the country's top 15 stocks 59 percent in 2005.
``The risk is that the bank's stance will contribute to a hard landing and recession, and this may be the reason why the krona is weakening despite the rate support,'' said Beat Siegenthaler, a senior strategist at TD securities in London.
Economic growth slowed to an annual 0.8 percent in the third quarter from 2.6 percent in the second, the statistics office said last week.
The central bank is ``risking a hard landing, considering the latest economic data,'' said Thora Helgadottir, an economist at Kaupthing Bank hf in Reykjavik, Iceland's biggest lender, which also forecast the rate increase.
At 14.25 percent, Iceland's benchmark rate is 9 percentage points higher than the U.S. Fed Funds rate and 10.75 points higher than the key rate shared by the 12 euro member countries. Turkey overnight borrowing rate is currently 17.5 percent, while Brazil's benchmark rate is 13.25 percent.
Labor Market
The bank said today's move responded to a ``very tight'' labor market, with unemployment at 1.1 percent, adding it sees ``little likelihood of a substantial improvement'' in the current account gap this quarter.
Inflation and further moves from the central bank ``depend heavily on the krona remaining relatively strong,'' the bank said.
The central bank has raised rates after inflation soared, peaking at 8.6 percent in August, fueled by a 30 percent drop in the krona against the euro in the first six months of the year. The krona decline came after Fitch Ratings Ltd. on Feb. 21 cut to negative its outlook on Iceland's debt rating, citing the current account deficit, external debt and overheating.
Eighty-five percent of the country's external debt, which stood at four times the size of the economy in September, stems from its three biggest banks, Kaupthing Bank hf, Glitnir Bank hf, and Landsbanki Islands hf, according to central bank data. The banks have sold debt to fund expansion outside the borders of the island of 300,000 inhabitants.
The economy expanded last year, led by a 38 percent jump in investment, as companies including Alcoa Inc. the world's biggest aluminum maker, took advantage of hydropower and geothermal energy to build smelters.
Sedlabanki ``is caught in a very difficult position,'' as evidence mounts that the economy may be heading toward recession, Fitch Senior Director Paul Rawkins said in an interview yesterday. ``It wouldn't be surprising if there were a few quarters of negative growth.''