Iceland should keep the crown currency in a tightly managed float if it stays outside the European Union and does not adopt the euro, its central bank governor said, the first time he has sketched out such an idea. Mar Gudmundsson also told Reuters the central bank would have to put strict limits on any future international expansion by Icelandic banks unless the country joins the euro zone.
The central bank, Sedlabanki, sees the euro as the best option for Iceland should it choose to abandon the crown, which has been sheltered by strict capital controls since a banking crash in 2008 sent the economy and currency into a tailspin. But if Iceland doesn't join the 27-nation EU, something it is currently negotiating, unilaterally adopting the euro or any other currency would not be the best bet.
"A better option then is to keep the crown, not free-floating but (in) a very tightly managed float - to have a macroprudential policy that deals with capital flows and all risk in the system," Gudmundsson said. Iceland is in accession talks with the EU, but opinion polls show most people would vote against EU entry in a referendum.
If the opposition wins parliamentary elections in April it might also call off the accession talks. "We'd lean against the wind of capital inflows and buy some of those into reserves and be much, much more active on all fronts, use all tools to keep the economy and the financial system stable," the central bank chief added. The issue of whether to adopt a more stable currency has been debated on the north Atlantic island since the crash. Lifting capital controls is expected to take years. All of Iceland's major banks collapsed within one week in 2008 under the weight of huge debts built up during an aggressive overseas expansion. Gudmundsson said the second crucial thing for Iceland to do if it stays outside the euro zone would be to drastically limit the international activities of its banks.
"We have to tell them 'look, your lender of last resort is the central bank and we can only lend you crowns, therefore you cannot build up huge balance sheets in foreign currencies'." "That means that if you want to open abroad you'll have to do so through subsidiaries and we, in the Icelandic Republic, are not going to rescue any of that, at any time." That would mean the idea of having an internationally active banking system in Iceland is dead, Gudmundsson said.
"This will probably be the price of not being in the euro zone - that we will have to have some restrictions, in the form of prudential rules, on the financial sector's international activities." With or without euro membership, Icelandic banks will not in the foreseeable future embark on an expansion binge like the one leading up to the 2008 crash, Gudmundsson predicted.
"We will make sure it doesn't happen again." Sedlabanki this month left its key rate unchanged at 6.0 percent, after an 18 month hiking cycle to rein in inflation as the economy recovers. It said further moves would depend on the outcome of wage talks early next year.
Gudmundsson said he was "cautiously optimistic" those talks would result in wage increases consistent with inflation reaching its 2.5 percent target around mid-2014, as forecast. "Conditioned on such wage development it is our view that the hiking cycle is paused for the time being," he said. "At this point, and provided our baseline forecast materialises, it is our view that for the coming months there is not a need to tighten in nominal terms." In November, inflation was 4.5 percent.