09 November 2006

Fitch Affirms Iceland at AA-/AAA; Outlook Negative

Fitch Ratings-London 09 November 2006: Fitch Ratings today affirmed Iceland´s foreign and local currency Issuer Default ratings (“IDRs”) at ‘AA-’ (AA minus) and ‘AAA’ respectively, both with Negative Outlooks. The Short-term foreign currency rating is affirmed at ‘F1+’ and the Country Ceiling is affirmed at ‘AA’.

“Affirmation of the current ratings with a Negative Outlook reflects the fact that Iceland remains a highly leveraged economy that has yet to address some of the key issues highlighted in our rating action in February 2006” says Paul Rawkins, Senior Director in Fitch’s Sovereign team in London. “Fitch draws comfort from the confidence-building developments that have occurred in the financial sector, but continues to view with concern Iceland’s macroeconomic imbalances and the manner in which they may ultimately unwind.”

Fitch notes that Iceland is in the midst of a supply side driven expansion entailing huge investment in the aluminium and associated energy sectors. Over the medium term these projects are expected to broaden the export base, boost foreign exchange earnings and enhance external debt sustainability. In the short term, they have posed a considerable challenge to macroeconomic stability, exacerbated by a restructuring of the housing market and the rapid expansion of Icelandic banks and corporates abroad, funded by heavy international borrowing at relatively short maturities.

Fitch says Icelandic banks treated February´s sovereign credit event as a wake-up call that obliged them to re-examine their overseas expansion aspirations and secure longer-term external funding to cover a forthcoming bunching of maturities in 2007. With the successful conclusion of the latter, a substantial source of near-term uncertainty, not just for the banks themselves, but also the broader Icelandic economy has now been addressed. However, serious macroeconomic imbalances remain which could take much longer to work themselves out.

A sharp depreciation of the krona in H106 has triggered higher inflation of 7%-8% prompting the Central Bank to raise interest rates to 14%, while the general government turned in a surplus of 5.5% of GDP in 2005. Nonetheless, Fitch says a rebalancing of the economy still looks some way off, as the authorities struggle to contend with strong aggregate demand and a renewed strengthening of the exchange rate on the back of short-term capital inflows attracted by a wide interest differential with the rest of the world. Private consumption and investment have been slow to respond to policy tightening and the current account deficit will breach 20% of GDP this year, up from 16% in 2005, driving gross external debt up to some 360% of GDP, a more than three-fold increase over comparable ratios in 2000.

Fitch acknowledges that net external debt ratios are lower on account of a rapid build up of financial assets abroad, but says that at 357% of current external receipts in 2005 Iceland remains the most heavily indebted of any Fitch-rated sovereign. This constraint, coupled with the current size of Iceland’s macroeconomic imbalances leaves it vulnerable to external shocks such as global monetary tightening and/or a sudden deterioration in investor sentiment. Such developments and the likely policy responses that would follow could tip Iceland into a much deeper recession than the short sharp adjustment that followed a similar investment boom in the late 1990s, with potentially adverse consequences for households, corporates and banks that are much more indebted now than before.

Weighing in the sovereign rating balance, argues Fitch, are the facts that Iceland is an advanced country with strong, transparent institutions, a long tradition of stable coalition politics and longstanding membership of many international institutions. Allied to these deep-seated attributes, a wave of structural reforms since the mid-1990s, robust public finances and the adoption of a floating exchange rate have made the economy more resilient to shocks and responsive to change. However, while such factors have proved their worth in the current environment, Fitch argues that in contrast to rating peer New Zealand, for example, Iceland has yet to forge a convincing track record of managing economic volatility in more highly indebted circumstances.

A copy of the report will be available to subscribers on the Fitch website shortly and Fitch will hold a teleconference on Monday 13 November at 15.00 GMT to discuss the agency’s views.

CONTACT: Paul Rawkins, London, Tel: +44 (0)20 7417 4239/ paul.rawkins@fitchratings.com; Brian Coulton, London, Tel: +44 (0)20 7862 4097/ brian.coulton@fitchratings.com

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

No. 41/2006
November 9, 2006