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(Updates Czech exchange rate in 11th paragraph)

July 4 (Bloomberg) -- European Central Bank efforts to combat falling consumer prices are raising the prospect of retaliation through the currency markets as smaller neighbors grapple with their own deflationary risks.

Nordic-region central banks may need to impose caps to hold down their foreign-exchange rates, according to analysts at HSBC Holdings Plc and UBS AG, which are among the five biggest currency traders worldwide. The Czech central bank said today that it wouldn’t rule out moving its lid on the koruna to a weaker level. Switzerland says the exchange rate it introduced in 2011 to counter a rapid appreciation of the franc is still justified.

The threat of European nations getting sucked into the type of deflation that left Japan with 15 years of stagnant growth is raising the prospect of competitive devaluation often referred to as a currency war. While the ECB, which cut interest rates to a record in June, says the exchange rate isn’t a policy target, President Mario Draghi also said yesterday it’s an important variable for the region’s inflation outlook.

“The interest-rate cut presents serious policy dilemmas for the euro zone’s smaller neighbors,” Geoffrey Yu, a senior currency strategist at UBS AG in London, wrote in e-mailed note yesterday. “They all fear that deflation will be aggressively exported to their countries and there is now a race to the bottom to ensure that such price expectations do not become entrenched. In extremis, the Riksbank and Norges Bank may need to think about the option of adopting an exchange-rate target.”

Unconventional Measures

Sweden’s krona tumbled to the weakest level in almost three years against the euro yesterday as the Riksbank lowered its main interest rate by 50 basis points, a greater reduction than analysts had forecast. The risk is that with the rate now at 0.25 percent, the central bank is running out of conventional monetary-policy measures, should the currency appreciate.

“We’re that much closer to the zero interest-rate bound” in Sweden, said Daragh Maher, a foreign-exchange strategist at HSBC in London. “If you do want to do something else to prevent inflation falling further then it’s going to be unconventional in nature and obviously a floor is one of the options there.”

HSBC is the fifth-biggest currency trader and UBS is fourth, according to Euromoney Institutional Investor Plc rankings. Citigroup Inc. is the largest, the data show.

Swedish consumer prices declined an annual 0.2 percent in May, falling for a fifth month. To help revive euro-area inflation that has been below half the ECB’s 2 percent target for nine months, the central bank took its deposit rate below zero on June 5, one of a series of measures designed to ward off the threat of deflation that may also weigh on the currency.

Worst Performer

Sweden’s currency has fallen 4.8 percent in the past three months, making it the worst performer of 10 developed-nations currencies tracked by Bloomberg Correlation-Weighted Indexes. The second worst is Norway’s krone, which declined 3.5 percent. The euro weakened 1.1 percent.

Analysts at SEB AB, including Stockholm-based chief foreign-exchange strategist Carl Hammer, wrote in a June 17 note that a currency floor is “highly unlikely” as there is little evidence to suggest Sweden’s krona is overvalued.

Any shift in that direction would mimic the central banks in the Czech Republic and Switzerland. The Czech central bank said in the minutes published today of its June 26 meeting that it would keep its pledge to cap against koruna gains until at least the second quarter next year. The regulator weakened the currency in an intervention in November and said it won’t allow it to gain too much beyond 27 per euro, to avert the risk of falling prices. The koruna traded at 27.444 per euro as of 4:11 p.m. in London.

Swiss Haven

The Swiss National Bank set a cap of 1.20 per euro on the franc three years ago, citing the risk of deflation and a recession, as the Swiss currency rapidly appreciated when investors sought it as a haven from the euro-area’s debt crisis. Central bank President Thomas Jordan said last month the strength of the franc still justifies the currency limit that was introduced in September 2011.

Inflation in Norway has been slowing since January and last month Norges Bank Governor Oeystein Olsen said a further weakening of the outlook for the nation’s economy may warrant a reduction in the key policy rate. Since the day before the central bank said on June 19 that monetary tightening would probably not begin until the end of 2015, the currency has plunged about 3 percent against the euro.

Norway’s krone traded at 8.4158 per euro, after depreciating to 8.5477 yesterday, the weakest since November 2009. Sweden’s krona was at 9.3060, after touching 9.3887 yesterday, the weakest level since September 2011.

To contact the reporter on this story: Eshe Nelson in London at enelson32@bloomberg.net To contact the editors responsible for this story: Paul Dobson at pdobson2@bloomberg.net Todd White

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