The economic outlook is broadly in line with the Central Bank’s February forecast. The króna is weaker than in February, however, and the short-term inflation outlook has deteriorated somewhat from the forecast prepared at that time. Further ahead, there is the risk that inflation will remain above the Bank’s inflation target for a longer period than projected unless the króna appreciates in coming month The extent to which closing the loopholes in the Foreign Exchange Act affects the exchange rate will emerge in the near future.

Moving forward it will be necessary to withdraw the current degree of monetary accommodation as the recovery progresses and the slack in the economy diminishes. The degree to which such normalization takes place through higher nominal Central Bank rates will depend on future inflation developments. In the absence of an improvement in the inflation outlook, a further increase in nominal interest rates will probably be required in the near term in order to bring the monetary policy stance, which is still quite accommodative, to an appropriate level.

The Bank is emerging from crisis mode as the Icelandic economy continues to lift itself from the 2008 meltdown. The country is attempting to lift capital controls that were put into place at the end of 2008 without allowing a sell-off of the Icelandic króna. The currency has slipped nearly 5% against the euro this year, more than double the Bank’s projected 2.5% target. Last week, Iceland’s Parliament closed a loophole in capital controls that had allowed short-term investors to speculate on the króna.

Specifically, Iceland tightened controls on inflation-linked debt and on creditors of Kaupthing Bank hf, Glitnir Bank hf, and Landsbanki Islands hf. The law is designed to maintain króna stability, as controls on other currency transactions are lifted, and prohibits the liquidators of the three failed banks from paying creditors in foreign currencies. Further, the law blocks the owners of Icelandic bonds from transferring annuity and interest payments into other currencies and then transfer payments out of the country.

According to the parliament’s website, the law will allow Iceland’s Central Bank to “impose rules that would allow payments to creditors that conform with stability. In addition to preventing the possible instability in the foreign-exchange market, the changes to the foreign-exchange act proposed in the bill will level the position of parties in regards to the capital controls and prevent unnatural profits” gained by circumventing the law.

Efforts to ease capital controls are being tempered after the króna weakened 5% versus the euro this year.

The transaction represents the pre-payment of SDR 289 million (the equivalent of ISK 55.6 billion) to the IMF, and EUR 366 million (the equivalent of ISK 60.5 billion) to the Nordic countries.

According to the Central Bank, the pre-payment amounts to just over 20% of the funding from the IMF and the Nordic countries in connection with the IMF-led Stand-By Arrangement.

The March transaction is an element in paying down Iceland’s short-term debt, thus reducing the expense associated with the holding of the Central Bank’s foreign exchange reserves, without increasing re-financing risk or depleting the reserves.

According to the release, the decision to make the payment was made in view of the Treasury and the Central Bank’s relatively strong foreign currency liquidity position in the near-term. The repayment to the IMF covers maturities in 2013, and the payments to the Nordic countries cover maturities coming due in 2014 and 2015, as well as a portion of 2016.

The original loans from the IMF amounted to EUR 3.4 billion, or ISK 564 billion, at the current exchange rate. The pre-payment does not affect the Treasury’s net debt, but reduces Treasury’s gross debt by approximately 3.4% of Iceland’s GDP. Iceland’s external liabilities decline overall by about 6.6% of GDP as a result of these changes, but the net debt position is unchanged.

The Central Bank said in its release that the maturity profile of Treasury and Central Bank foreign debt shows clearly that the prepayment significantly reduces the burden of foreign debt service over the next four years, or until 2016.

Grimsson, who previously indicated that he would not be running again, said he would seek another term after he was presented with a petition signed by more than 30,000 Icelanders urging him to see re-election.

The President gained popularity after twice blocking a parliamentary resolution aimed at repaying British and Dutch Icesave depositors after the failure of Landsbanki in 2008. Icelandic voters subsequently rejected a proposed agreement in a referendum last year, which would have used taxpayer money to settle the matter. The matter, which has not yet been settled, is expected to be resolved through an international tribunal.

In a statement released by the IMF last week, it expressed concern about budgetary deviations, “especially in light of considerable risks to the revenue projections in 2012 and the medium term.” The IMP also expressed concern regarding over-expenditures, which might also affect the medium term.

Iceland completed a 33-month long IMF program in August following the country’s 2008 financial collapse, and has outperformed members of the euro area in its economic recovery. It is projected that the $12 billion economy will grow 2.5 percent this year. Still, the IMF has recommended additional measures this year, equivalent to 0.5 percent of its GDP to achieve a fiscal goal of an overall budgetary balance by 2014. This would enable debt to decline from approximately 100% GDP to around 80% by 2016.

Iceland has started easing capital controls that were implemented after its collapse to protect the county’s currency. The Central Bank has started currency auctions as it scales back the krona controls. However, the gradual lifting of these controls while tightening monetary policy remains a key challenge for the country moving forward. The IMF has suggested that, given the uncertainty in the global markets, consideration be given to an extension of the capital controls to beyond 2013.

The government took over the country’s largest banks in 2008 after they defaulted on approximately $85 billion in debt, and now operate under the names Landsbankinn, hf, Islandsbanki hf, and Arion Banki hf. The 2008 banking collapse led the country into an economic crises that sent unemployment surging and a recession that lasted through 2010.

In 2010, Iceland’s Supreme Court ruled that loans indexed to foreign currency rates were illegal. The decision meant that borrowers with such loans were obligated only to repay the principal in kronur. Since 2008, lenders have written off approximately 108 billion ($875 million) of currency-indexed loans.

After the banking collapse, in October 2008, the Central Bank of Iceland estimated that household debt in foreign currency ranged from 300-350 billion kronur. The financial crisis was exacerbated by the banks having borrowed in foreign currency in order to take advantage of their lower interest rates, and then repackaging the loans in krona before passing them off to their clients, an act subsequently deemed impermissible by the Supreme Court.

The Central Bank of Iceland indicated in early February that it was ready to raise interest rates in order to cap inflation. However, the Bank earlier this month left its benchmark rate unchanged at 4.75 percent for a second consecutive meeting, after last year raising borrowing costs for the first time since the country’s banks failed in 2008.

The Central Bank expects inflation to slow to 4.6 percent this year, 3.2 percent by the end of 2013, and 2.6 percent by the end of 2014, it said in a 8 February statement. Sedlabanki, which targets annual price growth of 2.5 percent, raised its forecast for economic growth in 2012 to 2.5 percent from 2.3 percent previously. The bank estimates that inflation will slow to 6 percent in March and taper off steadily for the remainder of the year.

Link to Statistics Iceland: http://www.statice.is/

The auction was intended to introduce more foreign currency into the country, and particularly with respect to Icelandic pension funds. Officially, the auction has been referred to as an element in the removal of restrictions on capital account transactions, and will reduce the annual Treasury’s refinancing needs. The Bank requires foreign currency reserves before it can repay loans from the IMF, which had the purpose of stabilizing the Icelandic economy after the country’s 2008 economic collapse.

The accepted exchange rate in the 15 February auction was 240 ISK for each Euro. The official exchange rate is 162 ISK to the euro, so the auction ostensibly benefited those investing in the Icelandic krona. Overall, the Icelandic currency has been deemed weak due to low demand as a result of the current restrictions on currency. The upcoming auctions to be held by the Central Bank in 2012 are an initial step in the lifting of these capital controls.