The Icelandic government has stepped in to relieve pressure on the economy in a two-pronged strategy.

The Icelandic krona has been under increasing pressure on the foreign exchange markets recently due to the country’s limited supply of foreign currency reserves – a problem the government acknowledged when it allowed permission to borrow up to ISK 500 billion in foreign currencies at the end of May. At the time, it was not sure how much of that entitlement, if any, would actually be used.

There will now be a supplementary issue of treasury notes on the domestic market up to the value of ISK 75 billion. Experts in the Icelandic banking sector expect the auction to be well-received and for the yield on treasury notes to increase to a level closer to their long term average as a result.

The second part of the government’s relief package is a restructuring of the Housing Finance Fund (HFF), in an effort to reinvigorate the housing market. New measures will aid the banks and savings banks in providing and refinancing mortgages, while other measures will make it easier and more attractive for private customers to access HFF money directly.

It will now be possible for consumers to access mortgages with interest rates as low as 5.05 percent. Also, the fire insurance value reference for HFF lending will be discontinued, and instead the reference amount will be up to 80 percent of the purchase price of the property. The maximum HFF loan amount will be ISK 20 million instead of the previous ISK 18 million.

In a press release, Nordic bank Glitnir welcomed the developments, but stated that the government still has not gone far enough. “The measures are likely to have positive effect on markets in the short term,” the Bank believes. “But (at) the end of the day it will be the long term effect that matters the most.”

According to a recent forecast from the International Monetary Fund, Iceland’s economic growth in 2008 will be higher than the IMF had predicted in its previous forecast from last year, reports Iceland Review.

Despite the severe economic slowdown currently facing world markets, the Icelandic economy is predicted to grow 0.4 percent in 2008, thus avoiding the recession some experts had predicted.

Although the forecast predicts slower growth for 2009, it states that Iceland will likely reach the average growth rate for industrialised nations again by 2012.

The current period of economic readjustment comes at the end of over a decade of unprecedented growth in Iceland, which has seen the island nation become one of the richest countries in the world per capita of population. Iceland currently ranks top of the United Nations Human Development Index, measuring countries’ wealth and living standards.

Unemployment in Iceland is still below one percent, but a recent report by Nordic bank Glitnir stated that it could peak as high as four percent in 2009 – a rate still lower than many European countries at present.

The Prime Minister of Iceland, Geir Haarde, said the economy could evade a recession forecast by the Ministry of Finance and the Icelandic Central Bank, reports Bloomberg.

“I am not so sure we will actually have negative growth rates,” said Haarde in Latvia last week. It is “one of the objectives of the government to ensure that we don’t go into a recession.”

Both the Ministry of Finance and the Central Bank have said the Icelandic economy will contract in 2009 after interest rates rose to a record 15.5 per cent in response to heightened inflation.

A 24 per cent drop in the Icelandic krona (ISK) against the euro this year has helped push inflation to an 18-year record of 12.3 per cent in May.

However, growing exports have slashed Iceland’s trade deficit to 600 million kronur ($7.7 million) in May from 7.3 billion kronur in 2007, boosting economic growth as imports slow.

Haarde said the krona “is more likely to come back up than go down. I think it will find a new equilibrium at a level quite a lot higher than it is now.”

The krona has fallen following concerns that the credit crunch may limit Icelandic banks’ access to funding, though Nordic bank Glitnir last week reported that the real exchange rate of the ISK rose in May according to figures from the Central Bank.

The Prime Minister’s comments follow moves by the Central Bank to increase its reserves of foreign currency. The government recently approved a bill allowing the bank to borrow as much as 500 billion kronur ($6.4 billion) in foreign currencies, equivalent to more than a third of Iceland’s GDP.

A research report published by Glitnir Bank has set out to demystify the future of the Icelandic economy.

The Nordic bank predicts that growth in the Icelandic economy will be negligible this year and next, but that the economy can expect to expand significantly in 2010 (3.8 percent) and 2011 (4.6 percent).

The two year cooling down period is contributed to the high price of oil and commodities, the global credit crunch and Iceland’s recent completion of large-scale industrial projects, as well as the recent cut in fishing quotas.

Inflation and slowly-increasing levels of unemployment will force down consumer growth. But cooling consumer demand and decreasing house prices will combine to allow the Central Bank to quickly lower the base rate.

Glitnir believes that the current 15.5 percent benchmark interest rate could be as low as eight percent by the end of next year, and that inflation will fall to the Central Bank’s target of 2.5 percent by mid 2009.

The full economic report is available at www.glitnirbank.com

The government of Iceland is currently considering enacting legislation to allow the country to borrow up to ISK 500 billion (USD 6.91 billion) in foreign currencies this year. The law is intended to secure the Icelandic krona and stabilise the Icelandic economy.

Iceland’s finance minister, Arni Mathiesen told Reuters: “We are proposing this legislation because we want to be in a position to react and be prepared for a crisis, should the situation on foreign markets change for the worse”.

This latest possible boost to Iceland’s economy comes just a fortnight after the deal with three Nordic central banks, allowing the country to swap kronur for up to 500 million euros if it needs to. The government said the deal was to bolster confidence in Iceland, and that it did not envisage taking advantage of the offer.

It is expected that if the legislation passes, the government will seek to make use of the facility. “”I cannot say when, but we expect to use at least a part of this authorisation to take a loan when situations in foreign markets allow us to do so,” Mathiesen said.

For more information on the Icelandic economy, see Glitnir’s recent research report at www.glitnirbank.com

Credit default swap (CDS) levels on Icelandic banks have fallen considerably following credit agreements between Iceland and the central banks of Sweden, Norway and Denmark.

On Friday the Central Bank of Iceland announced a bilateral swap facility with its Nordic counterparts, borrowing up to 1.5 billion Euros ($2.3 billion) to help strengthen the country‘s reserves of foreign currency.

The CDS level for Glitnir has fallen from 410 basis points to 365bp yesterday, whilst Landsbanki has fallen 75bp to 185bp. Kaupthing now stands at 430bp, having fallen 30bp since the agreement was announced.

Furthermore, the CDS on the Icelandic krona (ISK) has fallen by 30bp, making it easier for the Central Bank to boost its reserves of foreign currency by means of additional credit deals.

Icelandic Prime Minister, Geir Haarde, has said that further measures by the government and the Central Bank are in the pipeline. Glitnir Bank speculates that direct foreign borrowing would be the most likely move, potentially bilateral swap facility agreements with the Eurpean Central Bank or the Bank of England.

Three Nordic central banks have lent Iceland credit of up to 1.5 billion euros ($2.3 billion) to strengthen the country‘s foreign currency reserves, reports The New York Times.

The deal, which was announced by the central banks of Sweden, Denmark and Norway on Friday, saw the Icelandic krona (ISK) appreciate 4.5 percent, reversing a slide of as much as 26 percent this year.

The liquidity boost will give the Central Bank of Iceland access to as much as 500 million euros from each of the Nordic banks through currency swap agreements.

The funds will almost double the foreign exchange reserves held by the Icelandic Central Bank which had promised to support the country’s banks if they defaulted on their foreign loans.

“In times of uncertainty and turmoil, the central banks have a responsibility to cooperate,” Stefan Ingves, the governor of Sweden’s Riksbank, said in a statement.

The deal hopes to calm the financial markets in Iceland which have been uneasy since the beginning of the year when rumours of a banking crisis led speculators to bet against the country’s currency.

Analysts welcomed the agreement, saying it would provide Iceland with much-needed assistance in its efforts to steady its currency and its image in global markets.

“The chances are good that this will be a turning point for Iceland,” said Fridrik Mar Baldursson, a specialist in finance at Reykjavik University. “It should increase confidence in Iceland and make it easier for the government of Iceland to borrow money at a reasonable rate.”

Icelandic banks, often described as the likely trigger for a collapse, also appear to have improved their positions. The spreads on credit default swaps (CDS) have narrowed, indicating that investors are less worried about the possibility of the banks going bust. The credit default swaps for Icelandic banks decreased by 50 to 55 points when the Nordic Stock Exchange in Iceland opened on Friday morning.

The CEOs of Iceland’s three largest commercial banks Kaupthing Bank, Glitnir Bank and Landsbanki Bank were pleased with the measures taken by the Icelandic Central Bank and believe it will have a continued positive influence on the market.

Glitnir Bank was recently able to raise capital in Norway through a covered bond issue for NOK 7 billion (EUR 900m) and has held preliminary talks with international investors about taking a stake in the bank. Shares of all the major banks also rose on Friday.

“We’ve already seen a degree of turning in the situation,” said Richard Portes, an economist and expert on Iceland at the London Business School. “People are waking up to the fact that these are well-run banks.” He also said the amount of credit provided by the Nordic central banks could probably be increased if necessary.

The development of CDS spreads on Icelandic banks has reached a turnaround point and is now moving away from the peak it reached at the end of March, reports Nordic corporate and investment bank Glitnir.

The 5-year CDS level for Kaupthing now stands at 710 basis points (bp), which is 340bp less than at the beginning of April when the spread peaked at 1,050bp. The spread on comparable CDSs for Glitnir has fallen by 280bp from its peak and is now 720bp. The spread on Landsbanki has fallen by 400bp from the end of March when Landsbanki’s 5-year CDS level peaked at 800bp.

The Icelandic Prime Minister and a number of Icelandic banks, financial institutions and international analysts have attributed the recent surge in the CDS of Icelandic banks on market manipulation by foreign investors and hedge funds. This so-called ‘attack’ is now being investigated by the Financial Supervisory Authority in Iceland.

Hedge funds and investors had bought CDSs on Icelandic banks with the view of profiting from the financial instability in the country. According to Glitnir Bank and economics professor Dr. Richard Portes, this is however not likely to prove the case. They say that many people who have bought CDSs for this purpose can be expected to close their positions in due time.

As a result of this, CDS spreads on Icelandic banks are forecast to move closer to levels corresponding to their real default risk. The recent CDS turnaround indicates that this development has already started and a further correction can be expected in coming months, says Glitnir.

Meanwhile risk aversion in global markets has abated in recent days with CDS levels on large European corporate falling considerably this week.

The Financial Services Authorities (FSA) in the UK and Iceland have been warned about a London-based hedge fund which disapproved of a British professor‘s positive assessment of the Icelandic economy, reports visir.is and Iceland Review.

Dr Richard Portes, professor in economics at the London Business School and President of the Centre for Economic Policy Research, was allegedly contacted by the hedge fund which urged the professor to consider his reputation when reporting on Iceland and Icelandic banks.

Dr Portes is the author of a number of influential reports on the financial situation in Iceland and has recently portrayed the Nordic country and its banks in a more positive light than many other foreign analysts and media outlets.

The hedge fund in question is one of the four foreign hedge funds that Sigurdur Einarsson, Chairman of Kaupthing Bank, has accused of instigating an attack on the Icelandic financial market and Icelandic banks.

“I quickly realised what was happening and decided to listen carefully and take notes,” Dr Portes said. He then contacted the FSAs in both the UK and Iceland to report the incident.

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Lansdowne Partners, one of the four hedge funds named by Chairman of Kaupthing Bank for the recent ‘attack’ on the Icelandic market, has denied the bank´s allegations according to a number of reports in the Icelandic media.

Andrew Honnor, spokesman for Lansdowne Partners, said “Such allegations – that we are manipulating share prices – are extremely serious. We absolutely deny it.” His comments appeared on the Icelandic news sites visir.is and Iceland Review on Thursday.

Chairman of Kaupthing bank, Sigurdur Einarsson, told visir.is on Wednesday that four hedge funds based in London had instigated a systematic attack on the Icelandic financial market and Icelandic banks, and had gone to great lengths to profit from taking short positions in stocks and credit default swaps (CDS).

Einarsson named the hedge funds involved as Trafalgar Fund, Ako Capital, Cheney Capital and Lansdowne Partners.

According to Einarsson, these funds systematically contacted the UK media and analysts from UK banks in an attempt to widen CDS spreads and bring down the share price of the banks.

Einarsson said that although the funds’ plans have succeeded in the short term, they will inevitably fail in the long term. He believes that foreign media and analysts are now approaching financial news on Iceland with more caution than before. “You can’t fool people over and over again,” he said.

The denial by Lansdowne Partners follows comments made by the Central Bank of Iceland which attributed the recent rapid devaluation of the Icelandic currency to a speculative ‘attack’ by ‘unscrupulous dealers’. The Icelandic krona (ISK) has fallen by as much as 25 percent against the euro this year.

The Prime Minister of Iceland, Geir Haarde, said at a meeting of Nordic political leaders in Sweden on Wednesday: “It’s clear that there are people out there trying to make money at our expense, and we want to get them off our backs.”

The Central Bank has already asked the Icelandic Financial Services Authority to investigate whether or not investors had deliberately spread false rumours to the media in order to bring turmoil to the Icelandic financial markets.

Meanwhile the Central Bank raised its key interest rate to 15.5% on Thursday in order to protect the currency and control mounting inflation.