Iceland review - 2006, Side 111

108 BUSINESS SUPPLEMENT BUSINESS SUPPLEMENT 109
EXPANSIONARY EPISODE
The investment phase currently underway in
the aluminum sector started in 2004 and is
very large relative to the size of the Icelandic
economy. Increased production capacity will
begin to come on stream in 2007. Compounded
by changes in the mortgage finance market,
this strong investment activity led to a surge in
domestic demand. Inflation pressures grew and
the current account of the balance of payments
deteriorated. The Central Bank began to tighten
its monetary stance in the spring of 2004. By
the end of March 2006, it had raised its policy
interest rate to 11.5 percent. High interest rates
pushed the exchange rate to a historically high
level, which the Bank stated was unsustainable
in the long run. It was bound to depreciate
sooner or later – and indeed an exchange rate
adjustment would be a necessary element in
reducing the current account deficit and other
imbalances in the economy.
The króna depreciated from that very high level
in the early months of 2006. This development
occurred a little earlier than the Central Bank
had expected and will make it a greater
challenge to bring inflation, 4.5 percent at the
latest measure, towards the target in the near
term. It was one of the reasons behind the
Central Bank’s decision to raise its interest rate
by 0.75 percentage points at the end of March.
The Bank also declared its intention to fulfill its
mandated task of steering inflation towards
the target. In the Bank’s view, this is its most
effective contribution to bringing about an
orderly adjustment of the economy.
External debt of the economy has grown in
pace with the current account deficit. At the
same time, residents’ foreign assets holdings
have grown so rapidly that the net international
investment position only deteriorated slightly
in 2005 and was negative by 86 percent of
GDP at the end of the year.
Factors explaining Iceland’s relatively high
internal and external indebtedness include
the age structure of the comparatively young
population, an exceptionally large proportion of
privately owned housing and capital-intensive
investment in power generating facilities
financed by long-term borrowing.
One of the most notable developments in the
Icelandic economy in recent years has been
the expansion of financial activities to other
countries. The risk diversification resulting from
a broader operating base leaves the Icelandic
banks far less dependent now on cyclical
economic movements in Iceland. Banks have
recorded very strong profits with solid capital
adequacy ratios. They are subject to effective
banking supervision in Iceland, including
stringent stress tests on a regular basis, which
they have consistently met.
The medium-term prospects for the economy
are good. Its solid and diversified structure,
along with effective macroeconomic policy,
should generate strong growth and continued
prosperity in the years ahead.
INTERNATIONAL CREDIT RATINGS
The Republic of Iceland has been assigned
credit ratings by the main international rating
agencies. They are as follows:
Moody’s gives the Republic its highest rating
with a stable outlook. Long-term foreign and
domestic currency ratings are Aaa and short-
term foreign and domestic currency ratings are
P-1.
Standard and Poor’s rates long-term foreign
currency AA- and long-term local currency
ratings are AA+. The ratings for short-term
foreign and local currency are A-1+. The outlook
is stable.
Fitch ratings for long-term foreign and local
currency are AA- (AA minus) and AAA
respectively. The country ceiling is AA and the
short-term foreign currency rating F1+. The
outlook is negative.
In their assessments of the Republic of Iceland,
the rating agencies have identified Iceland’s
main strengths in factors such as stable
political institutions, a wealthy and flexible
economy, healthy public finances, low direct
debt, strengthening financial system regulation
and supervision, high labor force participation
rates, low unemployment, a young population,
well-funded pension system and increasing
diversification. Among the weaknesses,
the rating agencies have recently pointed
to very high levels of debt, off-budget and
contingent liabilities, volatile macroeconomic
performance, challenges in macro policy and
external imbalance.
BUSINESS SUPPLEMENT
The medium-term
prospects for
the economy are
good. Its solid and
diversified structure,
along with effective
macroeconomic
policy, should
generate strong
growth and continued
prosperity in the
years ahead.
An important
characteristic of the
Icelandic economy
is its resilience and
adaptability.
BALANCING STABILITY & GROWTH:
Detailed information on the Icelandic economy is available on the Central
Bank website: www.sedlabanki.is