Iceland yesterday moved to head off a crisis of confidence in its currency when it raised interest rates by more than expected following a two-month slide in the krona that has unsettled foreign exchange markets.
Meanwhile, New Zealand, another small country with high-yielding assets that has seen a sharp run on its currency, said a further slide in the kiwi could jeopardise an expected cut in its high interest rate later this year.
The Icelandic central bank raised interest rates by a greater than expected 75 basis points to 11.5 per cent. "We have the will to do what it takes [to bring inflation down]," David Oddsson, central bank governor said.
"The economy needs to take a break after a period of phenomenal growth."
Iceland and New Zealand have been beneficiaries of the global carry trade, in which seemingly everyone from US hedge funds to Japanese retail investors borrowed in cheap dollars, euros and yen to chase better returns in higher interest rate countries.
Michael Cullen, finance minister and deputy prime minister of New Zealand, said a continuing slide in the kiwi would "put the Reserve Bank under pressure to keep interest rates higher for longer".
Many commentators want the bank later this year to trim New Zealand's interest rate of 7.25 per cent - the highest in the industrialised world - to kick start sluggish economic growth.
This is expected to fall to 1 per cent against the backdrop of a record current account deficit of NZ$13.7 billion (€ 6.9 billion).
The Icelandic krona has fallen 12 per cent against the US dollar so far this year, with the New Zealand dollar tumbling 10.7 per cent.
The carry trade has started to unwind as synchronised rate tightening in the US and euro zone, and the risk that Japan may follow suit later in the year, threatens to mop up global liquidity as well as to narrow the rate differentials of the high yield currencies.
Countries with large external imbalances such as Iceland and New Zealand, as well as Hungary, where the forint has fallen 5.1 per this year, Turkey, Australia and South Africa are seen as most vulnerable as foreign investors head for the exits.
Mr Oddsson said he was prepared to raise short-term rates "substantially from the current level, perhaps by several percentage points" to bring inflation back towards the bank's target.- (Financial Times service)
