ingimundur fridriksson : turbulence in iceland's financial markets in 2006 keynote address by mr ingimundur fridriksson, governor of the central bank of iceland, at the ubs conference “ annual reserve management seminar for sovereign institutions ”, thun, switzerland, 4 june 2007. * * * where is iceland? what is it? why do we want to know about it? in the first half of 2006, hardly a day passed without iceland and icelandic banks being mentioned in newspapers and financial journals around the world. although attention is often welcome, this was not necessarily true of all the discussion about iceland and its banks a year ago. the coverage was highly critical, in some ways rightly so but in other ways not. when i was asked to address this conference, the turbulence in the icelandic financial markets in the first half of 2006 was doubtless fresh in the organisers ’ minds. so i was asked to discuss that episode and how the central bank of iceland monitored it and responded. as well as covering this topic i shall add some comments on recent developments and prevailing conditions. but first a few facts and a brief description of the background are needed. iceland is an advanced industrial economy with one of the highest national incomes per capita in the world. through membership of the european economic area, iceland is part of the european single market and has the same financial infrastructure as in the european union. the icelandic economy has witnessed huge changes in recent years following the deregulation of cross - border capital movements in the 1990s and market liberalisation. in the 1990s, the central bank of iceland adhered to a fixed exchange - rate regime with tolerance limits, which was supposed to provide an anchor for the core policy of keeping inflation under control. the arrangement was successful then and for much of that decade inflation in iceland was close to or below the oecd average. over time it became increasingly clear that a fixed exchange rate was incompatible with full deregulation of capital movements. bearing this in mind and because a floating exchange rate would arguably suit the icelandic economy better, the tolerance limits were extended in phases from 2. 25 % at the beginning of the 1990s to 9 % early in 2000. in the course of the 1990s, an episode of overheating began. it originated in a massive increase in foreign investment in the aluminium sector but gradually became driven by private consumption. inflationary pressures amplified and the current account deficit widened sharply to 10 % of gdp in 2000. market expectations

through the purchase and sale of foreign currency. given the conditions that prevailed in 1997, there was clearly a danger of overheating which led the central bank to pursue a tight monetary policy. after the bank had raised money market rates in the fall of 1996 the differential between domestic money market rates and those in main trading partner countries widened to 3 percentage points. this was a necessary response to the growing uncertainty about the outcome of the pending wage negotiations, and it led to an acceptable equilibrium for some time. however, some currency outflow was experienced during the first weeks of 1997 until the outline of the wage settlements began to emerge. the wage settlements eased fears of rising inflation and increased confidence in a stable exchange rate. the central bank, nevertheless, maintained unchanged interest rates, and considerable currency inflow took place through july. international reserves grew to a peak of 36. 2 billion kronur at the end of july, up 5. 2 billion kronur from the beginning of the year despite the repayment of some of the treasury ’ s foreign debt. the central bank thought it desirable that the exchange rate of the krona should strengthen somewhat to lessen pressures on the domestic market and dampen inflation pressures. the bank ’ s measures undoubtedly contributed to lower inflation than expected. monetary developments changed course at the beginning of august. currency outflow commenced anew and bond market yields began to rise. this change was the result of increased purchases of foreign securities by residents, a stop in the relending of foreign loans and an increase in general bank lending. the differential between domestic and foreign money market rates had also narrowed because of interest rate rises in some neighbouring countries. when it had become clear that this was not a temporary situation, the central bank responded by raising interest rates by 0. 3 percent in mid - november. the interest rate had an immediate impact, the exchange rate of the krona strengthened and the currency outflow stopped. at the end of the year, the exchange rate index was 0. 9 percent below the central rate of the fluctuation range after having strengthened on the whole by 1. 4 percent in the course of the year. international reserves stood at 27. 8 billion kronur at year - end, down 3 billion kronur from a year earlier. reserves are now about 27 billion kronur. the central bank ’ s short - term foreign liabilities were close to zero at year - end, where they in fact remain. the bond market bond market reforms