The OECD’s smallest economy was in the spotlight this week as it hiked its main interest rate by 1.25% to 15% to prop up its ailing currency.
Iceland’s health “can have global ramifications”, said David Ibison in the FT. Its “dramatic transformation” from oceanic backwater to diverse, booming North Atlantic tiger economy – whose businesses have snapped up assets, including famous UK retailers such as House of Fraser – has put it “firmly on the map for international investors”. But imbalances stemming from the boom have exacerbated fears that rapid expansion of the economy, coupled with that of the banking sector, may have created “a house of cards poised to topple”.
What has the result been?
A 20% slide by the krona against the euro since January and big spikes in the credit default swap market (a form of insurance against non-payment of corporate debt) for the country’s main banks and slumping stocks. Iceland’s annual inflation hit 6.8% in February, far above the 2.5% target. Getting that rate under control is likely to mean a recession, said an FT leader, but it “needn’t involve a financial crisis”.
The fundamentals don’t look too bad. The current-account deficit, which hit 26% of GDP in 2006, has narrowed to 16% and the government runs a strong fiscal surplus. However, none of that will matter “if a confidence-driven run takes hold”. Foreign investors would then withdraw their money, prompting a collapse in the currency, higher inflation and a sharp contraction in GDP.
Iceland is seen as a bellwether for emerging markets, as Johan Carlstrom noted in The Wall Street Journal. So other emerging nations with large current-account deficits and high inflation are set to follow Iceland’s interest rate lead soon, with Romania first off the mark. And growing risk aversion means investors have also punished the South African rand and Turkish lira – down 18% and 6% respectively this year against a struggling dollar.