Iceland's central bank left its main interest rate unchanged for a second month today and warned of greater risks for the economy due to a dispute with Britain and the Netherlands over bank debts.
Analysts believe the central bank's monetary easing cycle has probably bottomed out, but have not ruled out further cuts in light of the fragility of the island's economic recovery.
The central bank cut its economic growth forecasts for the coming three years and said the outlook for employment had deteriorated - arguments for lowering rates - but said inflation expectations had drifted upwards.
"The result of the Icesave referendum on April 9th has tilted risks to the exchange rate to the downside, as it may affect the sovereign credit rating and hence the terms at which Iceland can borrow in foreign capital markets," the central bank said.
It left its key seven-day collateralised lending rate, which has fallen from a peak of 18 per cent over two years, at 4.25 per cent, largely in line with analysts' expectations.
Icelandic voters turned down a deal earlier this month to repay more than $5 billion to the British and Dutch for money lost due to the collapse of Landsbanki in 2008, creating further uncertainty over the prospects for the crisis-hit country.
"This may limit the MPC's (monetary policy committee's room for manoeuvre over the medium term. It may also affect the pace of capital account liberalisation," the bank said.
It added, however, that this was mitigated by the likelihood that its IMF programme would be unaffected.
Iceland says Britain and the Netherlands will get their money back from the estate of the bankrupt bank, but the two countries are pursuing the case in a European court.
The bank trimmed its growth forecast for 2011 to 2.3 per cent from a previous forecast for 2.8 per cent seen in February.
Analysts said the bank had turned less bullish about overall prospects for the economy and currency in light of the referendum result and said the real worry now was over the country's credit rating.
Standard & Poor's has said Iceland's credit ratings could be downgraded to "junk" status in the wake of the vote while Fitch has said the result diminished prospects of Iceland regaining an investment grade rating in the near future.
Failure to resolve the issue could delay progress in loosening currency controls and deter investment.
"The risk is definitely there for a reduction in the sovereign rating," said Ingolfur Bender, head of research and chief economist at Islandsbanki.
"It could affect how easily Iceland can obtain foreign capital. For investment to pick up here, for companies to access foreign funding and for the recovery of the economy this is definitely important," he added.
Reuters
