Iceland economy stabilised, but recession to linger into 2010

In its annual credit report on Iceland, Moody's Investors Service said that the country's economy has stabilized somewhat following its massive banking and currency crisis, but fiscal tightening and weak investment will cause the recession to linger well into 2010.
The recovery is also threatened by the continued failure to reach an agreement over the terms of repaying the UK and the Netherlands for their citizens' deposits in the overseas branches of the failed Icelandic bank Landsbanki. The failure to resolve the so-called Icesave dispute has delayed the resumption of financial flows into the country.
The stable outlook on the Icelandic government's Baa3 rating reflects Iceland's adequate external liquidity following the recent restoration of financing from the IMF and Nordic governments.
"The stable outlook balances the fragile economic stabilisation and gradually improving fiscal situation against the external vulnerabilities stemming from the ongoing Icesave dispute and the eventual removal of capital controls," said Kenneth Orchard, Senior Credit Officer in Moody's Sovereign Risk Group.
Moody's evaluates the Icelandic government's financial strength as "low."
Iceland's debt affordability metrics (the share of government revenues consumed by interest payments) are among the worst of any investment grade sovereign.
"The government's enormous gross debt burden, which is a legacy of the collapse of the country's large banking system in late 2008, poses serious challenges for policymakers," said Orchard.
"Nevertheless, significant fiscal tightening is expected to gradually bring the budget into surplus and to reduce the debt to a more manageable level."
Moreover, the government expects the recovery of assets from the failed Landsbanki to offset a sizeable portion of the gross liabilities that it will assume from Icesave, so the gross debt metrics somewhat exaggerate the near-term government debt burden. New investment in the aluminium and power sectors should support a gradual recovery towards the end of 2010, but economic growth is expected to remain tepid for at least several years. The analyst emphasized that returning economic growth to a moderate rate is also crucial for ensuring the long-term sustainability of public finances.
Moody's deems Iceland to be susceptible to a "medium" level of event risk.
"The stalled Icesave negotiations, if not resolved, could complicate the government's ability to refinance its 2011 and 2012 eurobonds in the international capital markets and delay the removal of capital controls," said Orchard. "However, the recently-approved IMF and Nordic loans mean that the central bank should have ample resources to repay the bonds when they mature, if refinancing is not available."