* Iceland cbank leaves key policy rate unchanged at 12 pct
* Cbank's unchanged July rate follows four straight cuts
* Says plans to ease FX controls a factor for rate decision (Adds quotes from news conference)
By Adam Cox and Mia Shanley
STOCKHOLM, July 2 (Reuters) - Iceland's central bank paused in its interest rate-cutting campaign on Thursday, leaving borrowing costs at 12 percent to bolster the crown as it paves the way for the removal of capital controls later this year.
The central bank has aggressively slashed rates by six percentage points since March in an effort to help the island nation get back on its feet after its banking system and currency collapsed last year.
But the International Monetary Fund (IMF) has warned the Sedlabanki to be cautious on rate cuts for fear of weakening the Icelandic crown and making it difficult to remove controls introduced because of the country's economic meltdown.
"The abolition of capital controls will be one of many elements in steering future decisions on the policy rate," interim central bank Governor Svein Harald Oygard told a news conference.
The central bank is trying to lay the groundwork for the removal of capital controls introduced last year to stem a massive outflow of funds as its banks and currency collapsed.
"The central bank probably prefers to be on the prudent side and have higher rates when they deregulate," said Petter Sandgren, head of emerging markets at SEB.
Inflation could also prove problematic for the island.
Iceland's consumer price index rose 1.38 percent in June from May for a year-on-year increase of 12.2 percent.
The central bank said a deteriorating current account balance also gave it good reason to hold back on further policy easing following four straight reductions.
"It becomes even more important to provide sufficient incentive to hold kronor assets, bolstering the case against an interest rate decrease," Oygard said.
REDUCTIONS IN STORE?
Oygard, who will be replaced by a senior official at the Bank for International Settlements on August 20, declined to say whether reductions were in store but added that fiscal consolidation would help increase the scope for policy easing.
Some analysts had expected a 50 basis point cut in July -- as opposed to the 100 to 250 basis point cuts in recent months -- while others said they were prepared for the possibility of a pause.
Sandgren said that if the currency is stable, the central bank could resume policy easing in August but he doubted rates would fall below 10 percent.
"Single digits are unlikely as the IMF wants them to start deregulating. The central bank probably prefers to be on the prudent side and have higher rates when they deregulate."
But what economists agree on is that the island's economy is still in dire straits and will ultimately need some rate relief.
"The economy however continues to undergo a painful correction and the government has been forced to implement painful cutbacks in public spending," 4CAST wrote in a note to clients.
"Exchange rate considerations complicate matters at present with these a temporary barrier to further cuts," it said.
The island's key interest rate was as high as 18 percent after the crisis -- a condition set by the IMF, which led a $10 billion rescue package.
(Editing by Andy Bruce)