20 November 2007

Republic of Iceland Outlook To Negative On Macroeconomic Imbalances; Ratings Affirmed

FRANKFURT (Standard & Poor's) Nov. 20, 2007--Standard & Poor's Ratings Services said today it revised its outlook on the sovereign credit ratings on the Republic of Iceland to negative from stable. At the same time, the 'A+/A-1' foreign currency and 'AA/A-1+' local currency issuer credit ratings were affirmed.

The outlook revision reflects the continued build-up and persistence of macroeconomic imbalances in the Icelandic economy, compounded by an insufficiently tight fiscal policy. Although the central bank's short-term real interest rate has risen to over 8%, the effectiveness of monetary transmission is constrained by the rapid rise in foreign currency borrowing by households, and the weak reaction of mortgage rates to monetary tightening.

A renewed surge in consumption and delayed export growth imply that the current account deficit will not fall as quickly as previously expected. Continued strong mortgage lending is further driving up housing prices, interrupting the downward trend in inflation. This has prompted the central bank to again raise its policy rate to 13.75% in November 2007.

Economic growth has remained high during the recent investment, credit, and real-estate booms, but is set to slow considerably as the economy cools off. Considerable downside risks to economic growth remain and could emanate from nominal adjustments in the exchange rate, the property market, or the credit market.

Public finances improved considerably during the economic boom, with general government surpluses averaging 5.6% of GDP over 2005-2007. Together with sizable privatization receipts, this will help push net general government debt to below 10% of GDP in 2007, from 38% in 2003. At the same time, however, contingent liabilities from the financial sector have grown rapidly, due to fast growth in domestic credit.

The negative outlook reflects the increased risk of a hard landing for the Icelandic economy. The economic slowdown currently under way will facilitate an unwinding of macroeconomic imbalances, but the process is likely to be impeded by the planned rapid acceleration in public expenditure, as well as sustained failure to reform the HFF. In combination with high and rising domestic and international interest rates, this exacerbates the risk of a hard landing for the Icelandic economy.

"The ratings could be revised downward should a disorderly unwinding of imbalances take place, affecting public finances as government deficits increase and contingent liabilities materialize," said Mr. Stukenbrock. "Conversely, should imbalances unwind in an orderly fashion and the concomitant risks be contained, the outlook could revert back to stable."

No. 20/2007
November 20, 2007