April 4, 2017 / 9:55 AM / 6 months ago

Iceland needs euro peg like cod needs bicycle

An illustration picture shows Iceland Krona coins in ice in Reykjavik March 6, 2012. REUTERS/Ingolfur Juliusson

LONDON (Reuters Breakingviews) - It’s hard to fault Iceland’s sense of humour. The North Atlantic state’s finance minister chose April Fools’ Day to mull the idea of pegging the domestic currency, the crown, to the euro – reviving a short-lived policy from 2008. The theory is this could help reduce volatility. It didn’t work very well then, and wouldn’t help much now either.

The peg proposed in October 2008 was a vain attempt to steady the crown after one of Iceland’s biggest banks, Landsbanki, hit the skids. It failed because Reykjavik lacked the reserves and credibility to defend its plummeting currency. In 2017, the country has the opposite problem – the crown jumped by 19 percent in trade-weighted terms last year in advance of a lifting of capital controls. Iceland’s gross domestic product grew 7 percent in 2016, and tourist numbers jumped by two-fifths.

Anchoring the crown to the euro now might protect Icelandic fishing and mining exports from becoming less competitive in international markets. Assuming the euro itself were stable, it might check the currency’s appreciation. Iceland could live with a bit of inflation caused by an artificially cheap currency: the strong crown means consumer prices are currently growing more slowly than the central bank’s 2.5 percent annual target. A pegged Iceland could swiftly turn from frozen to red hot if a too-low currency caused a credit boom.

Ideas are already circulating about how to square the circle. The number of crown-inflating tourists could be controlled by slapping a quota on airline passengers permitted each year, according to economist Lars Christensen – with an independent panel judging the number to grant each year based on infrastructure, pollution and congestion. The central bank could target domestic wage growth more than it targets inflation. If Iceland really wants a peg, it could hitch itself to the currency of a more similar, resource-focused economy like Canada.

The least-bad option would be no peg at all. Unlike other crisis-era casualties that were locked into a too-high exchange rate – like Greece – Iceland’s currency acted as a pressure release valve rather than a tightening noose. As of last June, the central bank already has powers to curb foreign inflows. Domestic interest groups may not like it, but surrendering flexibility could render any future crisis even more painful.

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