Moody's returns outlook on Iceland's ratings to stable

Moody’s rating agency issued a press release this morning changing the outlook on Iceland’s sovereign credit rating to stable from negative for both foreign and local currency obligations. The outlook on the foreign currency bond and deposit ceilings were also changed from negative to stable. The agency's announcement states that its action was prompted mainly by the improvement in Iceland's external liquidity due to the restoration of financing from the IMF and Nordic governments. In Moody’s estimation these financial inflows into the country should also boost confidence and support ongoing economic recovery.

Only a short time ago Moody’s altered its outlook for Iceland’s sovereign rating from stable to negative due to uncertainty concerning the country’s external liquidity. The agency mentioned primarily concerns of the Treasury’s ability to finance external maturities in late 2011 and early 2012. Moody’s is now of the opinion that the recent approval of the Second Review of Iceland’s IMF programme and re-instalment of multilateral credit lines from the Fund and Nordic countries has substantially improved external liquidity, as well as the government's possibilities of fulfilling its obligations.

Moody's also notes that although the Icesave dispute with the UK and the Netherlands remains unsolved, this has not prevented a reinstatement of credit to Iceland, as evidenced by the passage of the Second Review and the disbursement of Nordic loans. It also appears likely, Moody’s suggests, that a new Icesave deal will be more favourable for Iceland’s public finances than the previous arrangement. The eruption of the volcano Eyjafjallajökull is not expected to have a material impact on Iceland's economy, as it is in a relatively remote location and air transport was only closed for a few days. In concluding, Moody's points out that continued fiscal consolidation is imperative to reduce public debt ratios to sustainable levels. 

It is too soon to tell whether this development marks a turning point for the Republic's ratings, but the government may feel some satisfaction that it's negotiations are beginning to bear some fruit

Important milestones reached

The IMF is, generally speaking, pleased with the progress of the economic recovery programme agreed by the Fund and the Icelandic government. In its Staff Report, published Wednesday in connection with the Second Review of Iceland’s Stand-by Arrangement, the IMF states that three major milestones have now been achieved. The exchange rate has been stabilised, an effective strategy to ensure sustainability of public debt is in place and the restructuring and recapitalisation of the banking sector is now in its final stages, with the recapitalisation of the savings banks all but complete. All relevant performance criteria for the programme at this stage have therefore been met. Numerous tasks still remain, however, with the Third Review scheduled for 15 July this year and reviews at quarterly intervals after that. The reviews will be seven in all, with the last scheduled for August 2011, when the programme is now scheduled to conclude. In the IMF’s estimation it is primarily delays in resolving the Icesave dispute which overshadow the policy agenda in Iceland, and its report places major emphasis on Icesave.

Removal of currency controls dependent upon resolution of Icesave

It hardly comes as a surprise that the spotlight is on Icesave in the IMF report, as capital account liberalisation is one of the issues dependent upon progress on the Icesave issue. It was hoped that movement could begin towards relaxing currency controls following the Second Review, but it is now evident that this will not happen in the near term. In the IMF’s estimation, relaxing of controls is not advisable until currency reserves have been further bolstered, the balance of payments outlook is more favourable and foreign financing has been secured.
This uncertainty concerning foreign financing is due to the withholding of further loans from Nordic countries until the Icesave dispute is resolved. The Nordic countries have nonetheless disbursed two tranches of the credit promised to Iceland, or half of the total. According to the IMF report, the remaining EUR 900m will not be made available until Icesave is resolved. While the IMFexpects the programme to continue despite the delays in disbursement of these loans, this does postpone the liberalisation of capital outflows and the Central Bank needs to consider reinforcing its reserves through FX purchases on the market, if the ISK strengthens further in coming months. If the matter is delayed by more than a year, the Central Bank will have to seek new ways to boost its currency reserves and the IMF therefore places major emphasis on the resolution of Icesave as soon as possible.
 

Final steps in debt restructuring

One of issues the government is committed to concluding before the next review on 15 July is the adjustment and restructuring of household and corporate debt. In the IMF’s estimation, a lack of focus in debt restructuring has increased domestic uncertainty and encouraged expectations of generous debt relief packages in the future. Uncertainty in this regard dampens private consumption and domestic demand, acting as a brake on economic recovery. It is important, in the estimation of IMF, that the government present an improved, comprehensive action package in this regard and sends at the same time a clear message that no more is to be expected. IMF has given the government until the end of June to act in this regard, and the Third Review in July can be expected to focus on the success in this area.