Rising current account deficit hurts Iceland
Icelands current account deficit widened to 200 billion Krona (b.kr.) in 2007. The current account shortfall stood at 15.6% of the economy, much higher than IMF prediction of 11.6% in 2007. Krona is the currency of Iceland.
The deficit on the current account was 91 b.kr. in Q4/2007, compared with 29 b.kr. in the third quarter. The principal explanation for the deficit is a turnaround in the income account in the amount of 68 b.kr. This is due primarily to a considerable reduction in the earnings from shares, which stems from negative reinvested earnings.
The current account deficit, which was equivalent to a quarter of the $16 billion economy in 2006, has been slow to improve after aluminum companies including Alcoa Inc. delayed production. At the same time, quota restrictions on the fishing industry are hampering the island's other major export. The rising imports and lower exports have triggered current account deficit. The economy witnessed a trade deficit of 136 b. kr. in 2007 with imports rising to 588 b. kr. and exports to 451 b.kr.
Adding to pressure on the current account, unemployment at 1 percent is fueling wage growth, which accelerated to an annual 6.8% last month. That's lifting demand for imports.
Icelands international investment position was negative by 1,845 b.kr. at end of 2007, after deteriorating by 492 b.kr. in the last quarter. Foreign short-term liabilities rose by 523 b.kr. during the quarter. Foreign long-term borrowings rose by 219 b.kr. in Q4.
Deteriorating financial conditions in global markets mean that it has become more difficult to finance current account deficit. Adjustment of the national economy with a contraction of demand will thus be not escaped. It will only be more painful if inflation is allowed to get out of hand, the central bank said in a statement.
The central bank of Iceland stated Inflation has been higher than forecast and inflation expectations have risen. Demand has also been stronger than was expected. The exchange rate of the krna has depreciated more than entailed in an alternative scenario published in Monetary Bulletin in November. It assumed that such a development would be met with a higher policy rate. The real exchange rate of the krna is now very near a long term historical low which it reached in November 2001.
If that development is not reversed and a period of persistent inflation would be ahead with spiralling increases in prices, wages and the price of foreign exchange. The depreciation of the krna in recent weeks also undermines the Balance Sheet of indebted households and businesses and thus financial stability looking further ahead. It is therefore crucial that the depreciation of the krna is reversed as quickly as possible.
The krona has tumbled 17% against the euro in the past three weeks on concern that the global financial turmoil would make it harder for Iceland to finance one of the world's largest current account deficits.
Sedlabanki raised its key interest rate by a record 1.25 percentage points to 15% at an emergency meeting to halt a slump in the krona and a surge in inflation. As a result, Iceland's Krona made its biggest ever jump against the euro.
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