INTERNATIONAL MEDIA CONTINUES TO DISSECT ICELANDIC

UNCLAS REYKJAVIK 000134

SIPDIS

COMMERCE FOR 4212/ITA/OEURA/LMARKOWITZ

SIPDIS

E.O. 12958: N/A
TAGS: EFIN ECON IC
SUBJECT: INTERNATIONAL MEDIA CONTINUES TO DISSECT ICELANDIC
ECONOMY, THOUGH ANALSYSTS NOT AGREED ON WHETHER IMBALANCES
REPRESENT SERIOUS THREAT TO ECONOMIC STABILITY

REF: REYKJAVIK 78


1. Summary. Over the past two months, credit rating
agencies and other international financial firms have
released a torrent of reports raising questions about the
state of the Icelandic economy and the activities and
stability of Iceland's major banks. These reports have been
widely covered in the international financial press, causing
a marked drop in the value of the Icelandic Krona and of
shares listed on the Icelandic stock exchange. This new
level of scrutiny is also making it more challenging for
Icelandic banks to secure financing on international
markets. There is no question that certain imbalances have
emerged in the Icelandic economy, including a high current
account deficit, high inflation and high private sector debt
levels. It remains an open question, however, whether these
imbalances render Iceland particularly vulnerable to an
economic crisis. Financial analysts have articulately
argued both sides of the case. End summary.


2. The release of a report by the credit rating agency
Fitch in mid-February expressing concerns about overly risky
practices on the part of Icelandic banks and troubling signs
for the Icelandic economy provoked a sudden drop in the
value of the Icelandic Krona and the main stock exchange
index (the ICEX). The Fitch report has subsequently been
followed by a slew of other reports from international
rating firms such as Moody's and Standard and Poor's, and
from investment and commercial banks including Merrill
Lynch, Morgan Stanley and JP Morgan. Speculation and
analysis about Iceland's economy now appears almost daily in
the international press, including leading publications such
as the Wall Street Journal, Financial Times, and The
Economist.


3. The various reports run the gamut from concluding that
the Icelandic financial sky is falling to the view that
despite a few economic indicators being out of balance, the
Icelandic economy is sound and the negative prognostications
wildly exaggerated. In any case, just the fact that the
Icelandic economy is now under the microscope -- fairly or
unfairly -- has made the domestic and international markets
jittery about the Icelandic Krona and Icelandic securities.
As a result, the Krona has fallen 15 percent against the
dollar since the beginning of the year, and the stock
exchange index has dropped 18 percent since reaching an all-
time high on February 16.

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The Case for Looming Economic Difficulty
--------------

4. The main areas of economic concern most often cited by
analysts are Iceland's large current account deficit (some
16 percent of GDP),high inflation (4.4 percent),high
personal indebtedness, and high levels of short-term foreign
debt carried by Iceland's three major banks -- debt that the
banks are now having some difficulty rolling over except by
agreeing to pay higher interest rates. In addition, some
analysts maintain that Iceland's major banks (all of which
do both commercial and investment banking) engage in overly
risky practices and have "incestuous" relationships with the
other banks and major domestic conglomerates These
factors, it is argued, indicate that serious challenges and
difficulties are looming on the horizon for the banks and
the economy generally.

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The Case that Analysts' Warnings Are Overstated
-------------- --

5. Nonetheless, significant arguments have also been put
forward that the threats posed by certain imbalances in the
economy, and by extensive international borrowing on the
part of the banks, have been exaggerated and misinterpreted,
and do not pose the danger many have posited. For example,
the high current account deficit is in large part due to the
three huge capital investment construction projects
currently underway in Iceland -- two huge aluminum smelter
facilities (including one owned by Alcoa) and a massive
hydroelectric power plant. These projects represent some
$2.5 billion being pumped into a $15 billion economy over
just a couple of years. When these projects are all
completed, sometime during 2007, the current account
situation will likely return to normal (from 2000-2003 the


average deficit was minus 4 percent). The Krona's recent
return to a more realistic level will also help even out the
current account deficit by dampening imports.


6. It is also pointed out that government debt at 30
percent of GDP is low by most standards (and about half the
level as in the U.S., Germany and France). As for
inflation, when real estate price increases are removed, the
"core" rate of inflation is a mere 1.8 percent. While the
banks have indeed been borrowing heavily to finance
Icelandic conglomerates' investments abroad, these foreign
investments have largely been in non-speculative, low-risk
sectors such as banking, pharmaceuticals and clothing and
food retailing. Another argument holds that rather than
suggesting underlying weakness or instability, the fact that
Icelandic banks now find it more difficult (i.e., costly) to
tap financing most likely implies the banks will simply have
to curtail their recent expansive lending activity and
settle for "normal" growth instead of the torrid double- and
triple-digit growth rates of the last few years.


7. The most compelling analysis offered to date in defense
of the Icelandic banks, the soundness of the economy, and
the government's ability to handle any financial crisis
comes from the well-respected U.S. credit rating firm
Moody's. In a report entitled "Iceland's Solvency and
Liquidity Are Not at Risk," issued April 4, Moody's offers
the following conclusions:

-- "While we have warned of the risks that may accompany
increased leverage in the economy, Iceland has our top
rating with a stable outlook, and we believe these concerns
have recently been exaggerated."

-- "Iceland is a very wealthy country engaged in a major
process of economic diversification. It possesses ample
sources of alternate external liquidity above and beyond the
banks own liquidity positions that should enable the
government and banking system to weather a period of market
turbulence."

-- "Iceland is well positioned to deal with any potential
claims on government resources that might emanate from a
systemic problem in any sector of the economy. Our Aaa
rating for Iceland is compatible with such an extreme
scenario."

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Government Defends Economy, but Warnings not Ignored
-------------- --------------

8. While the government has reacted to the current furor by
consistently reiterating the message that the economy is
sound and there is no need to worry, economic policymakers
have also clearly taken some of the warnings on board. For
example, the Central Bank raised its official rate by a more-
than-expected 0.75 percent (to 11.5 percent) at its last
rate-setting meeting. This action sent a signal that the
government is indeed determined to rein in inflation, while
also helping to ease the decline of the Krona. The Central
Bank has also sought to quell market jitters through
reassuring statements that Iceland's financial system stands
up to all its stress tests. In addition, a new (though long
in the works) joint Central Bank-Financial Supervisory
Authority committee has been established to watch for signs
of weaknesses in the financial sector and to formulate
contingency plans for correcting them.

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Consequences of Altered Economic Conditions/Perceptions
-------------- --------------

9. Comment: Certainly going forward the banks will have to
curtail their lending activity now that foreign financiers
are less willing to continue extending easy credit. And the
Icelandic stock market's phenomenal growth rate will
undoubtedly return to more realistic levels now that
Icelandic firms will be compelled to take a more incremental
approach to foreign expansion in response to changed market
conditions. This evolving economic landscape has government
forecasters envisioning Icelandic GDP growth going from 6
percent in 2005 to 4.5 percent in 2006, and cooling further
to between 0 and 2.0 percent in 2007.


10. Comment continued: Given the intense financial media


scrutiny Iceland has been under for the past two months, it
can be argued that the country's economy, major
conglomerates, banks, and financial markets have actually
weathered the storm fairly well (e.g., the currency and
stock market declines might have been far worse). As the
Wall Street Journal put it in an April 10 article, "The jury
is still out on whether it (the current economic turmoil) is
anything more than a rough spot." End comment.

van Voorst