Iceland's Currency Speculation Opens Rift in Ruling Coalition

(Bloomberg) -- As they search for a permanent exchange-rate framework, Iceland's policy makers are finding they may disagree on some pretty fundamental issues.

Power politics in the 340,000-people nation are being laid bare, as the nation's prime minister, who heads the establishment Independence Party, and its finance minister, a former publishing executive who leads the newly created Reform Party, are pushing different messages on the currency regime that Iceland may adopt.

"It's somewhat concerning that Finance Minister Johannesson hints at what should be Iceland's monetary regime while the government has already appointed a group of three economists to give their proposal,” said Lars Christensen, founder and chief executive officer at Markets & Money Advisory. “Furthermore, there seems to be a direct conflict between what the finance minister is now saying and what we earlier have heard from the prime minister."

Prime Minister Bjarni Benediktsson over the weekend pushed back on comments made by Finance Minister Benedikt Johannesson that the government is heading toward a currency peg, a flare-up that is being covered widely in the local press. To make the issue even more poignant, the two are also first cousins. The center-right government, commanding the thinnest majority possible, took more than two months to cobble together after snap elections last year.

The premier underscored the value of a freely floating currency in enabling Iceland's economic rebound after its 2008 collapse and dismissed as flawed the notion that a fixed exchange-rate regime was the only path to future economic success.

“There are no magic bullet solutions that reduce fluctuations and retain stability,” Benediktsson said in a phone interview from Reykjavik on Sunday. “Different solutions will present us with different challenges.”

After dismantling its capital controls in March, Iceland has set up a panel to find a framework for the island's exchange rate and monetary policy. The goal is to settle on a model that promotes economic growth, while maintaining stable inflation and low unemployment. It's expected to deliver its results later this year.

The panel is “carrying out that work on the premise that the krona will be our currency for the foreseeable future,” Benediktsson said.

The Financial Times reported that Iceland was considering pegging the krona to either the euro or the pound, citing the finance minister. He was quoted by the newspaper as saying that the “status quo” is “untenable.” Johannesson later told local media that he mentioned the idea of a peg as one of a number of possible solutions, and that “people assumed” that such a policy “was looming when I said that this was just one of the options.”

Benediktsson underscored the value of having a free-floating exchange rate as a useful mechanism to help economies adjust.

“The krona's role in the collapse and subsequent resurrection is undisputed," the prime minister said. “The depreciation of the krona during the collapse led to our export industries being better equipped to lead the resurrection and made Iceland a more desirable tourist destination.”

The krona's onshore rate weakened to almost 200 to the euro at the end of 2008. Three years earlier, Icelanders only needed to part with about 70 kronur to buy one euro. Though inflation surged, and index-linked household debt swelled, the massive devaluation also came with benefits. A trade deficit quickly turned into a surplus and, more recently, tourism has emerged as a major export success for Iceland.

The upshot has been a stunning economic recovery, with policy makers now wondering how to cool the pace of growth. In the fourth quarter of 2016, gross domestic product expanded more than 11 percent, on an annual basis. Wage growth has hit double digits and unemployment is below 3 percent.

Given the breathless pace of Iceland's recovery, the government is keen that any monetary policy framework agreed on should promote “economic and financial stability," Benediktsson said.

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

To contact the editors responsible for this story: Jonas Bergman at jbergman@bloomberg.net, Tasneem Hanfi Brögger