Fitch Ratings, the international rating agency, hastoday affirmed the Republic of Iceland's Long-term foreign and local currencyratings at 'AA-' (AA minus) and 'AAA' respectively and the Short-term foreign currency rating at 'F1+'. The Outlooksfor the Long-term ratings are Stable.
In a press release, Fitch says that 'the Ratings and the Outlook areunderpinned by Iceland's proven ability to manage shocks, high qualityinstitutions, prudent fiscal policies, and an excellent growth and exportoutlook as major aluminium smelter investment projects get underway.
'Iceland engineered a remarkable soft landing in 2001-02 following a periodof overheating and a credit boom. By 2003 the economy had rebalanced and growthreturned vigorously, reaching 4%. However, some vulnerabilities appear to haveresurfaced: an unexpected fiscal deficit of 1.4% of GDP, a widening in thecurrent account deficit to 5.6% of GDP from near balance, and a surge inexternal debt beyond the impact of the construction of the Alcoa aluminiumproject and mainly reflecting banks' external borrowing. The latter fuelled aboom in private sector credit and asset prices, with equity prices all butdoubling in the last 12 months. Gross external debt rose to 155% in 2003 from132% of GDP in 2002, while net debt edged up to 106% of GDP, among the highestin the world.
'Iceland has now entered a period of high growth with at least two largeprivate sector aluminium and hydro-energy projects going ahead at a total costequivalent to almost 30% of 2003 GDP through to 2008. These projects willincrease growth and export potential, and diversify the economy. However, as theprojects take off, there are increasing risks of overheating, and Iceland canill afford any major increase in its net debt beyond what is warranted by thelarge investment projects.
'Fitch sees some signs of strain. Asset prices and private sector credit havebeen growing above their trend, and there has been some real appreciation of thekrona. These elements, when appearing together, may signal pressures and anincreasing risk of reversal that might in turn put the banking sector understress. Household indebtedness is high at 180% of disposable income and so ishouseholds' debt service. Banks' external borrowing is likely to remainstrong particularly if Iceland's positive interest rate differentials vis-à-visthe key currency areas remain substantial. A part of this borrowing is lent inforeign currency to domestic borrowers without foreign currency income.
'Fiscal policy has a key role to play in averting a possible overheating ofthe economy. The 2004 budget aims at a tiny positive balance and the governmentforecast a surplus of 1.1% of GDP in 2005. Fitch notes that for this to beachieved, the envisaged tax cuts equivalent to 2½% of 2003 GDP in the period of2005-2007 may need to be delayed. Moreover, fiscal policy may need to be tighterthan envisaged today.
'Fitch considers government's plan to bring its Housing Financial Fund('HFF') under the supervision of the financial supervisory authority a step inthe right direction. Yet in Fitch's view, HFF's dominance over Iceland'smortgage market is a source of structural inefficiency. The bonds of the HFF aregovernment-guaranteed, giving it a comparative advantage that raises the barrierto market entry. This also explains, to some extent, the relatively small sizeof Iceland's banking sector, as well as the banks' increasing lending abroadthat is financed by external borrowing.'
For further information, contact Birgir Ísleifur Gunnarsson, Chairman of theBoard 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