ICELAND ECONOMIC SITUATION EXPECTED TO DETERIORATE FURTHER

C O N F I D E N T I A L SECTION 01 OF 02 REYKJAVIK 000015

SIPDIS

E.O. 12958: DECL: 1/22/2019
TAGS: EFIN ECON PGOV IC
SUBJECT: ICELAND ECONOMIC SITUATION EXPECTED TO DETERIORATE FURTHER
BEFORE IMPROVING

Classified By: Amb. Carol van Voorst for reasons 1.4 (b) and (d).

REFS: A) Reykjavik 13 B) Evans - Reykjavik Morning Update emails
1/23/09

1.(C) Summary: The Ministry of Finance's report on Iceland's economic
health this week forecast a dismal eighteen months before recovery.
This assessment was echoed by the new Chairman of the Government
Coordinating Committee, Mats Josefsson, who is charged with creating
a framework for restructuring the banking sector. Restructuring has
been slow, but seems to be headed in the right direction, and
Josefsson is confident that the IMF will be satisfied with their
mid-February review. However, problems persist, such as the lack of
an overall "Economic Czar" for Iceland to deal with other issues like
the currency depreciation. Recent public unrest and uncertainty on
the political scene are also complicating. Also unresolved are the
issues with the old banks' creditors and the negotiations to settle
the unsecured IceSave deposit accounts. Overall, the situation is
tough and stressful and is testing the fortitude of the Icelandic
people as well as their government. We expect that matters will
deteriorate further before recovering. End Summary.


2. (U) "The Icelandic economy is heading for a deep recession in 2009
that is forecast to reach a trough in the first half of 2010,"
concludes the Ministry of Finance produced national economic forecast
released this week. The summary goes on to say that Real GDP
declined by a small margin in 2008, but is predicted to decline by
9.6 percent in 2009. Unemployment, previously at 1.7 percent in
2008, is predicted to average 7.8 percent in 2009 and 8.6 percent in

2010. Inflation, calculated at 12.4 percent in 2008, is expected to
increase to 13.1 percent in 2009 and then decline to average 2.7
percent in 2010. The report recognizes that there "is considerably
more uncertainty than before about most elements of the forecast" as
the model relied on historically measured relationships, some of
which have likely changed since the collapse of the banking system.


3. (C) Mats Josefsson, newly appointed Chairman of the Coordination
Committee, and Gudmundur Arnason, newly assigned Director of Special
Projects at the Prime Minister's Office, echoed these predictions to
Econoff on January 23. Josefsson's mandate is to create a framework
for restructuring the banking sector, and Arnason "makes sure the
recommendations of the Committee are implemented by the ministers."
Josefsson remarked that the government had let the banks handle
everything over the last ten years and there was not the
infrastructure in place to deal with the crisis. This led to
inaction, and in hindsight, more could have been done more quickly in
October. However, Josefsson said that the attitude is changing in
the government and "there is a realization that things have to
happen." He also said that he has advised the Icelanders that it is
better to do things on their own before being told by the IMF to do
things "the IMF way." Josefsson said that changes take time, but the
direction is good and he was optimistic that the IMF will be
satisfied with the first review.


4. (C) Regarding the banking sector, Josefsson said the new banks
still need to be capitalized and must start lending, as a functioning
banking system is necessary for the economy to recover. He said the
business plans of the banks are OK, but the new banks need "to be
cleaned up." He further clarified that since the creation of the new
banks, some of the healthy assets moved from the old banks to the new
banks have deteriorated. Most of these are related to corporate
loans and this debt needs to be restructured. (Note: Businesses are
heavily in debt with foreign currency loans and with the krona's
devaluation, and many are unable to service their debt. End Note.)


5. (C) Josefsson said that since the old banks are in moratorium
(court administration),creditors must address issues with the
Resolution Committees, and not lobby the Prime Minister's office. He
said that the Resolution Committees need to be affirmed by the court
to prevent committee members, or the Government who appointed them,
from being sued. Financial advisors are in place at the banks, but
the Government of Iceland, which is also a creditor, needs to have
its own voice before these Committees. Once that official, whom
Josefsson called a "spokesperson," is in place, then all the parties
can get together to talk. Josefsson said there has been discussion
about the bond or instrument that the new banks would provide as
value for the assets removed from the old banks. He saw these bond
negotiations taking two to three months, because some want to wait
until the new banks start increasing in value to pass some of this
value to the old banks, but the government did not want to pass back
all of the value. He said the old banks' value still needs to be
assessed and there has been some delay because it is very expensive
to hire the necessary experts, who Josefsson felt were "taking
advantage" of the situation for financial gain.


6. (C) When the U.S. Department of Treasury Deputy Assistant
Secretary visited Reykjavik December 8 - 9, 2008, there was a visible
lack of an "Economic Czar." It took two full days of meetings to
obtain a coherent picture of the economic situation. In December,
the Advisor at the Prime Minister's Office Bjorn Runar Gudmundsson,
described his office as playing a coordinating role, but conceded

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there was a lot of misunderstanding and difficulty in getting
"everyone to talk the same language." Gudmundsson had noted that the
initial crisis was not managed well, coordination had been difficult,
and that tensions in the political arena had been stirred up.
Gudmundsson had mentioned three priorities - the currency, the fiscal
policy, and the banks. Now in January 2009, it appears Josefsson has
the banking sector reform laid out, but Josefsson was clear that his
mandate does not extend to exchange rate issues. Also complicating
matters is the current uptick in public unrest (Ref A) and the
announcement the Prime Minister will retire from politics in March
because he has cancer of the esophagus (Ref B). Josefsson said
political stability is important as there has to be a government in
place to implement these necessary changes.


7. (C) Further unresolved are the negotiations with the U.K., the
Netherlands and Germany on the unsecured IceSave deposit accounts.
At the Ministry for Foreign Affairs, Martin Eyjolfsson, the lead
negotiator, said that the parties have agreement on the principle of
paying the EU minimum deposit guarantee. However, to make the
payments, Iceland will have to borrow from the other states in the
short term, and disagreements persist on the interest rate, length of
loan, grace period, and other terms. In mid-December, Eyjolfsson
described the British and Dutch representatives as presenting a
united front in the meetings, but having separate views on interest
rates. The British wanted a 6.7 percent loan, which Eyjolfsson said
could block Iceland from meeting the Maastricht requirements and bar
Iceland from the Euro. Eyjolfsson said for every one percent in
interest on the loan, there will need to be a corresponding 1.5
percent decrease in the state budget. Eyjolfsson told Econoff
January 22 that negotiations were still ongoing and the next meeting
with the British, Dutch and Germans together, was set for the first
week of February.


8. (C) Comment: Overall, the aftermath of the October 2008 banking
sector meltdown continues to test Icelandic fortitude, inside and
outside government. All indications are that the economic situation
will deteriorate further before recovering. Icelanders have a
tradition of being flexible and hardworking. If they can adapt and
endure the next six to 18 months, then they will have made it through
the worst. However, the recent political turmoil and grave illnesses
of the leaders of both Coalition parties only adds to the
difficulties of recovery. End Comment.



VAN VOORST