VZCZCXYZ0004
RR RUEHWEB

DE RUEHRK #0134/01 1021429
ZNR UUUUU ZZH
R 121429Z APR 06
FM AMEMBASSY REYKJAVIK
TO RUEHC/SECSTATE WASHDC 2705
INFO RUEHCP/AMEMBASSY COPENHAGEN 0296
RUEHLO/AMEMBASSY LONDON 0106
RUEHNY/AMEMBASSY OSLO 0238
RUEHSM/AMEMBASSY STOCKHOLM 0125
RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHINGTON DC

UNCLAS REYKJAVIK 000134 
 
SIPDIS 
 
COMMERCE FOR 4212/ITA/OEURA/LMARKOWITZ 
 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: EFIN ECON IC
SUBJECT:  INTERNATIONAL MEDIA CONTINUES TO DISSECT ICELANDIC 
ECONOMY, THOUGH ANALSYSTS NOT AGREED ON WHETHER IMBALANCES 
REPRESENT SERIOUS THREAT TO ECONOMIC STABILITY 
 
REF: REYKJAVIK 78 
 
¶1.  Summary.  Over the past two months, credit rating 
agencies and other international financial firms have 
released a torrent of reports raising questions about the 
state of the Icelandic economy and the activities and 
stability of Iceland's major banks.  These reports have been 
widely covered in the international financial press, causing 
a marked drop in the value of the Icelandic Krona and of 
shares listed on the Icelandic stock exchange.  This new 
level of scrutiny is also making it more challenging for 
Icelandic banks to secure financing on international 
markets.  There is no question that certain imbalances have 
emerged in the Icelandic economy, including a high current 
account deficit, high inflation and high private sector debt 
levels.  It remains an open question, however, whether these 
imbalances render Iceland particularly vulnerable to an 
economic crisis.  Financial analysts have articulately 
argued both sides of the case.  End summary. 
 
¶2.  The release of a report by the credit rating agency 
Fitch in mid-February expressing concerns about overly risky 
practices on the part of Icelandic banks and troubling signs 
for the Icelandic economy provoked a sudden drop in the 
value of the Icelandic Krona and the main stock exchange 
index (the ICEX).  The Fitch report has subsequently been 
followed by a slew of other reports from international 
rating firms such as Moody's and Standard and Poor's, and 
from investment and commercial banks including Merrill 
Lynch, Morgan Stanley and JP Morgan.  Speculation and 
analysis about Iceland's economy now appears almost daily in 
the international press, including leading publications such 
as the Wall Street Journal, Financial Times, and The 
Economist. 
 
¶3.  The various reports run the gamut from concluding that 
the Icelandic financial sky is falling to the view that 
despite a few economic indicators being out of balance, the 
Icelandic economy is sound and the negative prognostications 
wildly exaggerated.  In any case, just the fact that the 
Icelandic economy is now under the microscope -- fairly or 
unfairly -- has made the domestic and international markets 
jittery about the Icelandic Krona and Icelandic securities. 
As a result, the Krona has fallen 15 percent against the 
dollar since the beginning of the year, and the stock 
exchange index has dropped 18 percent since reaching an all- 
time high on February 16. 
 
---------------------------------------- 
The Case for Looming Economic Difficulty 
---------------------------------------- 
¶4.  The main areas of economic concern most often cited by 
analysts are Iceland's large current account deficit (some 
16 percent of GDP), high inflation (4.4 percent), high 
personal indebtedness, and high levels of short-term foreign 
debt carried by Iceland's three major banks -- debt that the 
banks are now having some difficulty rolling over except by 
agreeing to pay higher interest rates.  In addition, some 
analysts maintain that Iceland's major banks (all of which 
do both commercial and investment banking) engage in overly 
risky practices and have "incestuous" relationships with the 
other banks and major domestic conglomerates   These 
factors, it is argued, indicate that serious challenges and 
difficulties are looming on the horizon for the banks and 
the economy generally. 
 
--------------------------------------------- -- 
The Case that Analysts' Warnings Are Overstated 
--------------------------------------------- -- 
¶5.  Nonetheless, significant arguments have also been put 
forward that the threats posed by certain imbalances in the 
economy, and by extensive international borrowing on the 
part of the banks, have been exaggerated and misinterpreted, 
and do not pose the danger many have posited.  For example, 
the high current account deficit is in large part due to the 
three huge capital investment construction projects 
currently underway in Iceland -- two huge aluminum smelter 
facilities (including one owned by Alcoa) and a massive 
hydroelectric power plant.  These projects represent some 
$2.5 billion being pumped into a $15 billion economy over 
just a couple of years.   When these projects are all 
completed, sometime during 2007, the current account 
situation will likely return to normal (from 2000-2003 the 
 
 
average deficit was minus 4 percent).  The Krona's recent 
return to a more realistic level will also help even out the 
current account deficit by dampening imports. 
 
¶6.  It is also pointed out that government debt at 30 
percent of GDP is low by most standards (and about half the 
level as in the U.S., Germany and France).  As for 
inflation, when real estate price increases are removed, the 
"core" rate of inflation is a mere 1.8 percent.  While the 
banks have indeed been borrowing heavily to finance 
Icelandic conglomerates' investments abroad, these foreign 
investments have largely been in non-speculative, low-risk 
sectors such as banking, pharmaceuticals and clothing and 
food retailing.  Another argument holds that rather than 
suggesting underlying weakness or instability, the fact that 
Icelandic banks now find it more difficult (i.e., costly) to 
tap financing most likely implies the banks will simply have 
to curtail their recent expansive lending activity and 
settle for "normal" growth instead of the torrid double- and 
triple-digit growth rates of the last few years. 
 
¶7.  The most compelling analysis offered to date in defense 
of the Icelandic banks, the soundness of the economy, and 
the government's ability to handle any financial crisis 
comes from the well-respected U.S. credit rating firm 
Moody's.  In a report entitled "Iceland's Solvency and 
Liquidity Are Not at Risk," issued April 4, Moody's offers 
the following conclusions: 
 
-- "While we have warned of the risks that may accompany 
increased leverage in the economy, Iceland has our top 
rating with a stable outlook, and we believe these concerns 
have recently been exaggerated." 
 
-- "Iceland is a very wealthy country engaged in a major 
process of economic diversification.  It possesses ample 
sources of alternate external liquidity above and beyond the 
banks own liquidity positions that should enable the 
government and banking system to weather a period of market 
turbulence." 
 
-- "Iceland is well positioned to deal with any potential 
claims on government resources that might emanate from a 
systemic problem in any sector of the economy.  Our Aaa 
rating for Iceland is compatible with such an extreme 
scenario." 
 
--------------------------------------------- ------- 
Government Defends Economy, but Warnings not Ignored 
--------------------------------------------- ------- 
¶8.  While the government has reacted to the current furor by 
consistently reiterating the message that the economy is 
sound and there is no need to worry, economic policymakers 
have also clearly taken some of the warnings on board.  For 
example, the Central Bank raised its official rate by a more- 
than-expected 0.75 percent (to 11.5 percent) at its last 
rate-setting meeting.  This action sent a signal that the 
government is indeed determined to rein in inflation, while 
also helping to ease the decline of the Krona.  The Central 
Bank has also sought to quell market jitters through 
reassuring statements that Iceland's financial system stands 
up to all its stress tests.  In addition, a new (though long 
in the works) joint Central Bank-Financial Supervisory 
Authority committee has been established to watch for signs 
of weaknesses in the financial sector and to formulate 
contingency plans for correcting them. 
 
--------------------------------------------- ---------- 
Consequences of Altered Economic Conditions/Perceptions 
--------------------------------------------- ---------- 
¶9.  Comment: Certainly going forward the banks will have to 
curtail their lending activity now that foreign financiers 
are less willing to continue extending easy credit.  And the 
Icelandic stock market's phenomenal growth rate will 
undoubtedly return to more realistic levels now that 
Icelandic firms will be compelled to take a more incremental 
approach to foreign expansion in response to changed market 
conditions.  This evolving economic landscape has government 
forecasters envisioning Icelandic GDP growth going from 6 
percent in 2005 to 4.5 percent in 2006, and cooling further 
to between 0 and 2.0 percent in 2007. 
 
¶10.  Comment continued: Given the intense financial media 
 
 
scrutiny Iceland has been under for the past two months, it 
can be argued that the country's economy, major 
conglomerates, banks, and financial markets have actually 
weathered the storm fairly well (e.g., the currency and 
stock market declines might have been far worse).  As the 
Wall Street Journal put it in an April 10 article, "The jury 
is still out on whether it (the current economic turmoil) is 
anything more than a rough spot."  End comment. 
 
van Voorst