Iceland’s Krona Is Undervalued by Market, Gudmundsson Says

By Omar R. Valdimarsson

Aug. 26 (Bloomberg) -- Iceland’s krona is undervalued even after the country imposed capital restrictions to prevent a sell-off and following 11 consecutive months of trade surpluses, new central bank Governor Mar Gudmundsson said.

“The exchange rate of the krona is currently well below reasonable estimates of the medium-term equilibrium rate,” said Gudmundsson, 55, who took over on Aug. 20. “The significant trade surplus that we’ve seen in past months hasn’t been enough to counter the effects of other outflows and the pressures from foreign holders of krona-denominated assets.”

Gudmundsson, former deputy head of the monetary and economy department at the Bank for International Settlements in Basel, aims to guide the western nation hardest hit by the credit crisis to recovery. Capital controls, imposed last year to halt a sell-off of the krona after Iceland’s biggest banks failed, didn’t prevent a 8.2 percent slump against the euro this year. The island relies on an international bailout to avoid default.

“The Monetary Policy Committee will always have to take the value of the krona” into consideration, Gudmundsson said in an interview in Reykjavik yesterday.

As of Aug. 21, the bank, or Sedlabanki, had intervened three times to support the krona, compared with 10 interventions in July and 19 in June, according to Islandsbanki hf. The krona is the third-worst performer of the 26 emerging market currencies tracked by Bloomberg since the end of March.

Erode

“The krona has started to erode once more, which is a cause for considerable concern in view of the situation of Icelandic companies and households,” Ingolfur Bender, an economist at Islandsbanki, said in a note to clients last week.

Household debt as a percentage of disposable income stood at 272 percent on average at the end of last year, with about a fifth of that in foreign currencies, according to Islandsbanki.

Sedlabanki kept the benchmark interest rate on hold at 12 percent at its Aug. 13 meeting. Svein Harald Oygard, who was interim governor after the government removed David Oddsson in February, said there remained a “strong case” against lowering rates and higher rates couldn’t be ruled out should the krona need extra support.

The bank’s main challenge is to “find opportunities to bring down interest rates with domestic economic circumstances in mind without putting pressure on the exchange rate of the krona and at the same time start the process of removing capital controls,” Gudmundsson said.

‘Advisable’ Euro

Iceland will ease the restrictions starting on Nov. 1 in two main stages. In the first, foreign-currency inflows linked to new investments will be exempt from the restrictions. The second will target foreign-exchange outflows, though the central bank will block short-term holdings.

Iceland last month cleared the first procedural hurdle to joining the European Union after EU foreign ministers called on the European Commission to prepare an assessment of the island’s prospects for membership. Prime Minister Johanna Sigurdardottir has said membership, with euro adoption an ultimate goal, will help Iceland avoid a repeat of last year’s financial collapse.

“I’m not certain that the krona is right for Iceland in the long run,” Gudmundsson said. “Running an independent monetary policy at the same time as we are economically and financially integrated with the rest of the world is difficult and it’s therefore advisable to look into participating in a monetary union; but the decision is of course a political one.”

Systemic Failure

The three biggest banks failed in October after they were unable to secure short-term funding following a debt-financed boom that saw their balance sheets swell to more than 10 times the size of the economy. Creditors of the failed lenders are still waiting to recoup as much as $80 billion in debt. The island turned to a group led by the International Monetary Fund in October for a $5.1 billion loan.

The four biggest banks, Kaupthing Bank hf, Landsbanki Islands hf, Glitnir Bank hf and Straumur-Burdaras Investment Bank hf, passed stress tests set by the Financial Supervisory Authority less than two months before the collapse. Their finances were “solid” and able to “withstand considerable financial shocks,” the FSA said then.

Gudmundsson said regulation linked to the functioning of an economy should be steered by the central bank rather than a separate regulator.

“I’m more inclined to favor that issues that have to do with systemic risk should be dealt with by the central bank,” Gudmundsson said. “We have limited manpower and financial resources and therefore I’m more inclined to believe that prudential supervision should be moved from the FSA to the central bank, or, alternatively, we could merge these two institutions.”

Iceland’s economy will contract 9.1 percent in 2009 as household spending falls 19.7 percent and investment slumps 48.4 percent, the central bank said on Aug. 13.

To contact the reporter on this story: Omar R. Valdimarsson in Reykjavik valdimarsson@bloomberg.net.