Fitch Ratings, the international rating agency, has today affirmed the Republic of Iceland's Long-term foreign and local currency ratings at 'AA-' (AA minus) and 'AAA' respectively and the Short-term foreign currency rating at 'F1+'. The Outlooks for the Long-term ratings are Stable.
In a press release, Fitch says that 'the Ratings and the Outlook are underpinned by Iceland's proven ability to manage shocks, high quality institutions, prudent fiscal policies, and an excellent growth and export outlook as major aluminium smelter investment projects get underway.
'Iceland engineered a remarkable soft landing in 2001-02 following a period of overheating and a credit boom. By 2003 the economy had rebalanced and growth returned vigorously, reaching 4%. However, some vulnerabilities appear to have resurfaced: an unexpected fiscal deficit of 1.4% of GDP, a widening in the current account deficit to 5.6% of GDP from near balance, and a surge in external debt beyond the impact of the construction of the Alcoa aluminium project and mainly reflecting banks' external borrowing. The latter fuelled a boom in private sector credit and asset prices, with equity prices all but doubling in the last 12 months. Gross external debt rose to 155% in 2003 from 132% of GDP in 2002, while net debt edged up to 106% of GDP, among the highest in the world.
'Iceland has now entered a period of high growth with at least two large private sector aluminium and hydro-energy projects going ahead at a total cost equivalent to almost 30% of 2003 GDP through to 2008. These projects will increase growth and export potential, and diversify the economy. However, as the projects take off, there are increasing risks of overheating, and Iceland can ill afford any major increase in its net debt beyond what is warranted by the large investment projects.
'Fitch sees some signs of strain. Asset prices and private sector credit have been growing above their trend, and there has been some real appreciation of the krona. These elements, when appearing together, may signal pressures and an increasing risk of reversal that might in turn put the banking sector under stress. Household indebtedness is high at 180% of disposable income and so is households' debt service. Banks' external borrowing is likely to remain strong particularly if Iceland's positive interest rate differentials vis-à-vis the key currency areas remain substantial. A part of this borrowing is lent in foreign currency to domestic borrowers without foreign currency income.
'Fiscal policy has a key role to play in averting a possible overheating of the economy. The 2004 budget aims at a tiny positive balance and the government forecast a surplus of 1.1% of GDP in 2005. Fitch notes that for this to be achieved, the envisaged tax cuts equivalent to 2½% of 2003 GDP in the period of 2005-2007 may need to be delayed. Moreover, fiscal policy may need to be tighter than envisaged today.
'Fitch considers government's plan to bring its Housing Financial Fund ('HFF') under the supervision of the financial supervisory authority a step in the right direction. Yet in Fitch's view, HFF's dominance over Iceland's mortgage market is a source of structural inefficiency. The bonds of the HFF are government-guaranteed, giving it a comparative advantage that raises the barrier to market entry. This also explains, to some extent, the relatively small size of Iceland's banking sector, as well as the banks' increasing lending abroad that is financed by external borrowing.'
For further information, contact Birgir Ísleifur Gunnarsson, Chairman of the Board of Governors of the Central Bank of Iceland, and Jón Þ. Sigurgeirsson, Director, International Department, tel. +354 569-9600.
No. 12/2004
May 19, 2004