UNCLAS REYKJAVIK 000055

SIPDIS

USDOC FOR LEAH MARKOWITZ
TREASURY FOR LAWRENCE NORTON
STOCKHOLM FOR KEITH CURTIS

SENSITIVE

SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN IC
SUBJECT: IS ICELANDIC GOVERNMENT DOING ENOUGH TO HALT ECONOMY'S
SUDDEN DOWNFALL?


1. (SBU) Summary: Iceland's economy has recently gone wobbly, with
the currency depreciating to a near record low and consumers facing
sudden price hikes of near ten percent. In response to inflationary
pressures, the Central Bank raised its prime rate 1.25 percent on
March 25 to a new record high of 15 percent. International media
commentary on Iceland's financial sector may be fueling much of the
anxiety. To calm jitters, government officials argue publicly that
the economy has faced the worst and is now on the upturn. The
Central Bank also accused foreign speculators of trying to bring
down the financial system, and called on Iceland's Securities and
Exchange Commission equivalent to pursue lawsuits. It is still
unclear if the government will be successful at positively
influencing the situation. So far, the results are uneven at best:
two foreign ratings companies recently changed their outlook on
Iceland's sovereign credit rating to negative, with one directly
citing the lack of information on Iceland's strategy to address
economic policy issues. End Summary.


2. (SBU) Iceland's economy has been in turmoil in recent months.
The Icelandic stock market has lost 32 percent of its value over the
last year, which has affected access to credit through leveraged
loans. The Icelandic krona, which some experts say was overvalued
to begin with, depreciated 20 percent to reach a near historic low
index, even against the US dollar. Although Icelandic fish
exporters rejoiced (fishing remains the largest sector of the
economy), most consumer goods are imported and the media was quick
to highlight instantaneous 10 percent price hikes. Director of
University of Iceland's Economic Institute Gunnar Haraldsson told us
that despite little exposure to the global subprime mortgage market,
Iceland's financial sector is suffering from worldwide tightening of
credit, and the resulting slowdown is coinciding with a forecasted
slowdown related to the scheduled completion of capital intensive
energy and aluminum smelter projects.


3. (U) On March 25, in response to inflationary pressures and the

depreciating krona, Iceland's Central Bank Board met in an emergency
meeting and raised the interest rate 1.25 percent to a new record
high of 15 percent. The krona and the stock market responded
immediately, reversing slightly some of the losses. At the same
time, government officials began a public campaign to bolster
confidence in the economy. In a speech at the annual meeting of the
Central Bank on March 28, Prime Minister Geir Haarde emphasized that
Iceland's government has almost no debt, and the Treasury and
Central Bank could provide assistance should the need arise. During
Haarde's address to the Parliament on March 31, he stated the bottom
of the devaluation of the krona had been reached. Haarde allowed
that the devaluation had been faster than anyone had expected but
was sure it would not last. He has also given a series of upbeat
interviews with the Financial Times to counter generally negative
international coverage.


4. (U) Meanwhile, the search for scapegoats is well underway. On
March 30, the Central Bank asked the Financial Supervisory Authority
(Iceland's equivalent to the Securities and Exchange Commission) to
investigate foreign investors who "attacked" the krona for
speculative gains. The media reported the next day that British
investor Hugh Hendry of Eclectica Asset Management had gloated in
2006 that he would become famous for bringing down the krona. The
Prime Minister told the media on April 1 that Iceland was
considering all options available to influence the financial
situation. He emphasized that foreign investors were to blame and
that Iceland would consider "setting a bear trap" to punish them.


5. (U) The idea that foreigners are responsible for the economic
mess is a welcome distraction for Icelandic consumers, many of whom
have, in addition to paying higher prices for food and consumer
goods (most of which are imported), acquired foreign currency car
loans and mortgages. These loans, typically in Swiss Francs or
Japanese Yen, are low in interest but carry the risk of currency
fluctuations. With the sudden krona depreciation, consumers are
seeing their monthly payments rise immediately. Truck drivers began
daily traffic-snarling protests all over Iceland on March 27 against
spiking diesel prices.


6. (U) Notwithstanding the government's spin attempts, international
attention remains on the situation. In the New York Times on March
31, Paul Krugman blogged about the krona speculation and likened it
to the situation with Hong Kong in 1997-1998. During the April 2
Congressional testimony, Federal Reserve Chairman Ben Bernanke was
asked about Iceland and speculative hedge funds. The markets appear
to be equally concerned: on April 1, both Fitch and Standard and
Poor's changed their outlook on sovereign credit rating to negative,
with the latter directly citing a lack of information on Iceland's
strategy to address economic policy issues.



7. (SBU) Comment: Only time will tell if the government will be
successful at positively influencing the situation. Experts at the
University of Iceland and the Ministry of Finance tell us that much
depends on the global availability of credit. Haarde's government
has its work cut out. It may take more than a few pep talks to
repair investor confidence.

Van Voorst