Iceland: Risk Assessment

Country Rating¹

Rating: A4

Business Climate Rating¹

Rating: A1

Risk Assessment²

A major economic and financial crisis
The continuing decline in household disposable income, the deterioration of their property and financial assets and the still high level of unemployment undermined private consumption in 2010. Although still negative the trend nonetheless constitutes a virtual recovery compared to the collapse suffered in 2009. The trend for corporate investment has developed in a similar manner albeit undergoing a less violent contraction. Tourism, meanwhile, after being hit hard by the Eyjafjöll volcanic eruption in Spring, recovered in the second half of the year. But the current account balance, affected by the debt service payment, continues to show a slight deficit.

Recovery likely in 2011
After two years in recession and a growth shock of over 10 points from 2007 to 2010, economic activity is expected to be positive again in 2011. Growth will be underpinned by household consumption and investment. The continued decline of inflation, around 2.5%, will support private spending with most mortgage loans indexed to the cost of living. After the spectacular contractions suffered these past two years, residential investment will begin to grow again and is even likely to makeup much of the ground lost in 2010. The expected easing of controls on capital movements will spur foreign investment in manufacturing (notably the extension of production capacity of the Rio Tinto Alcan aluminium foundry in Straumsvik) and large energy projects like construction of the Budarhals hydroelectric station. Manufactured goods exports and tourism will stop contracting. Focused mainly on euro zone countries, Great Britain, and Norway, sales abroad will benefit from an Icelandic krona exchange rate that remains favourable.
The fiscal deficit will narrow in a manner quite consistent with the conditions set by the IMF. Growth of public and foreign debt will decelerate but remain high. The Central Bank is expected to maintain its policy of buying foreign currencies on a regular basis and monetary easing while keeping the krona on an even keel and controlling inflation.

The recovery in 2011 could be hampered by the consequences of two crucial issues
The first issue stems from the Supreme Court decision handed down in June 2010 establishing the illegality of indexing clauses on loans granted in Icelandic krona between 2004 and 2009 to foreign currencies. That ruling contributes to relieving households from part of their debt burden. Conversely, it will have negative consequences on the balance sheets of banks forced to take on additional large losses and even to recapitalise. The second issue involves the Icesave digital bank (subsidiary of Landsbanki Islands), which operated mainly in the United Kingdom and the Netherlands. After the rejection of the March 2010 referendum intended to ratify the agreement concluded with the British and Dutch governments on reimbursement of the deposits of citizens of these two countries, the negotiations had resumed and a new agreement had been reached with Iceland winning for better terms for repayment. This agreement failed to pass the new referendum last April. this result should have decisive consequences in several crucial areas: continuation of the confirmation agreement with the IMF, return of Iceland to world capital markets (essential to resumption of foreign direct investment inflows), and continuation of the negotiations associated with admission to the European Union.

Strengths

• Significant tourism potential
• Renewable energy resources, abundant geo-thermal and hydroelectric resources five times larger than Iceland's needs
• Favourable geostrategic position
• Political consensus on restoring macroeconomic equilibrium, independence of monetary policy
• Trade surplus
• Good population structure and education level

Weaknesses

• High foreign debt by advanced country standards
• Public finances hobbled by the cost of the financial system bailout
• Concentration of production and exports (aluminium and products from the sea)
• Small size of the economy
• Convalescent banking system
• Vulnerability of the Icelandic krona despite exchange controls
• Capital controls reduce the financing available to the economy