UNCLAS SECTION 01 OF 02 REYKJAVIK 000217

USDOC FOR LEAH MARKOWITZ
TREASURY FOR LAWRENCE NORTON
STOCKHOLM FOR FCS

SIPDIS

SENSITIVE

E.O. 12958: N/A
TAGS: ECON EFIN PGOV IC
SUBJECT: ICELANDIC GOVT TO RUN FIRST DEFICIT IN FIVE YEARS, KRONA
CONTINUES SLIDE

REFS: A) Reykjavik 213
B) Evans-Norton email 10/01/08


1. (SBU) Summary: Counter to the hopes of the Icelandic
government, saving Glitnir Bank has not saved the economy, as the
krona has fallen by 15 percent over the last two days and Iceland's
credit ratings have dropped. In the midst of the bad news, the
first budget deficit since 1996 was announced and banks are trying
every means possible to shore up their holdings. Politically, the
government's visibility has somewhat been dwarfed by David Oddsson,
the Chairman of the Icelandic Central Bank Board of Governors and
former Prime Minister. Prime Minister Haarde's annual "State of the
Union"-equivalent address on October 2 had difficulty getting
attention over reports that Oddsson is calling for a unity
coalition. While Haarde's Political Advisor dismissed these rumors,
the government is struggling to give the impression that it is in
control of events here. End Summary.


2. (U) After the Icelandic Government's purchase of a majority
share in the country's third-largest bank on September 29 (ref A),
many had hoped the economic situation would stabilize and the
krona's slide would stop. In this atmosphere, the October 1
presentation of the 2009 government budget bill offered little
comfort. For the first time since 2003, the government anticipates
a deficit (approx. ISK 56.9 billion, or $517 million). Earlier
forecasts had predicted a deficit of ISK 20 billion, or $182
million, for 2009, but estimates have changed in the last few weeks.
Further, the last time a budget bill was presented with a deficit
was in 1996. For the past three years, the state treasury has
delivered a total surplus of ISK 283 billion, or $2.57 billion.
Further doom and gloom comes from the fact that the budget proposal
was completed for printing prior to last weekend's banking crisis
and therefore does not account for the GOI's purchase of a 75
percent stake in Glitnir Bank and the further depreciation of the
krona. The changed economic situation will probably be considered
in the parliament's handling of the bill. After the nationalization

of Glitnir on September 29, Standard & Poor's and Fitch Ratings
downgraded Iceland's sovereign credit ratings.


3. (U) After the credit rating downgrades, the Icelandic krona
tumbled nearly 15 percent from September 29 to October 3 to ISK
112.99 against the dollar, which is the the weakest since the
Central Bank of Iceland quit restricting its movement in March 2001.
Over the last five days, the krona has come under heavy selling
pressure, also falling 12 percent against the euro. In addition,
credit default swap (CDS) spreads for Icelandic banks have soared. A
wider CDS spread means that yields on riskier debt rose sharply,
while those of safe government bonds fell. The krona's sell-off was
precipitated by turmoil in the overleveraged banking sector, which
in turn is posing serious risks to Iceland's overall financial
stability.


4. (U) The three major Icelandic banks are rapidly trying to shore
up cash. On October 1, Iceland's number two bank Landsbanki said it
will reverse its recent expansion and sold the majority of its
overseas corporate finance and brokerage platforms to
Reykjavik-based Straumur-Burdaras Investment Bank for 380 million
euros, or $525 million. The deal strengthened Landsbanki's capital
position and leaves it focused on commercial and corporate banking.
Nonetheless, Fitch cut its long-term rating on Landsbanki from A to
BBB, and Moody's put its A2 long-term rating of Landsbanki up for a
possible downgrade. Meanwhile, Kaupthing, Iceland's biggest bank by
value, said in February it would sell its asset finance and
commodity trade finance businesses in Britain. It sold part of this
in August. On October 2, the spokesman of Kaupthing's Danish unit,
FIH, Jonas Sigurgeirsson, said the bank had no plans for further
sales. He added that Kaupthing had been very successful in raising
deposits, meaning it was less reliant on wholesale funding, which
has become very difficult to find and very expensive for Icelandic
banks in the current market climate. "The liquidity and the
position of Kaupthing is very strong," Sigurgeirsson said.
Additionally, Kaupthing is still pressing ahead with its recent plan
to acquire a major Icelandic savings bank in order to add to its
deposit holdings.


5. (SBU) Adding to the government's headaches, on October 2
newspapers reported that David Oddsson, the Chairman of the Board of
Governors at the Central Bank of Iceland (and previously PM and
Independence Party chair from 1991-2005), has mentioned twice in the
last few days in meetings at the Central Bank and at the Prime
Minister's Office that forming a unity government (including all
parties in the parliament) should be considered in light of the
serious economic situation in Iceland. This has raised eyebrows,
while pundits have pointed out that the current coalition government

REYKJAVIK 00000217 002 OF 002


enjoys a strong parliamentary majority and would be unlikely to
yield to such a coalition. The general public is increasingly
calling for action, while PM Haarde and the government, in press
statements and interviews, maintain that the economic situation will
get better. In a conversation with PolOff, Haarde's Politicl
Advisor put the Oddsson rumors down to a groupwithin the IP that
wants to sow discord and possily rid themselves of their Social
Democratic Allance coalition partners. This group supposedly has
never liked the current coalition and would rather re-form an
alliance with the Progressive Party. Haarde's Advisor cautioned
that this was an "extremely dangerous time" to be playing politics
and said Haarde would be pressing ahead regardless.


6. (U) Haarde's annual policy address to the Althingi (parliament)
went forth against this backdrop on the evening of October 2, and
while offering little in the way of policy specifics was praised by
leading daily Morgunbladid for showing optimism and determination in
the face of the current challenges. While the opposition parties
unanimously criticized the PM's lack of specificity, Left-Green
Chair Steingrimur Sigfusson was notable in his cheerleading for the
Icelandic people to rely on their strengths and the country's
resources (something of a departure for the often-critical
Sigfusson). Perhaps inspired by Oddsson's comments about a unity
government, Sigfusson also encouraged the PM to call the leaders of
all major elements of society together to hammer out a national
consensus on a way forward.


7. (SBU) Comment: The general public listened anxiously to
Haarde's speech to hear what proposals the government might have.
Though Haarde's cautious optimism may have offered a calming effect,
he will have to work hard to overcome the image -- eagerly reported
by the media here -- of an inactive government shell-shocked by
recent events. Results in securing outside guarantees or added cash
reserves to back up the krona would do much to calm anxieties here,
and Haarde and his team appear to know that the pressure is on. End
Comment.

VAN VOORST