Iceland’s Aaa ratings at a ‘crossroads’

Iceland‘s Aaa ratings are at a crossroads, according to Moody’s Investors Service in a new special comment. The report does not announce any change in ratings.

In Moody’s view, Iceland compares favorably to many other advanced industrial countries also rated Aaa, given its low government debt, consensus-based political system, and well-functioning institutions.

However, the Icelandic government is also potentially more vulnerable to a confidence crisis than other Aaa-rated sovereigns because of the country’s large, internationalized commercial banks.

“Iceland enjoys high per capita incomes, well-developed political, economic and social institutions, favorable demographics and a fully-funded public pension system,” said Moody’s sovereign analyst Joan Feldbaum-Vidra, author of the report. “Its government debt ratio is less than half the average of the Eurozone member countries.”

Still, the decidedly more challenging situation in the global financial markets has not left the highly leveraged economy unaffected, as the recent widening of funding spreads reveals. The continued international expansion of the Icelandic commercial banks has caused the government’s contingent liabilities to rise above normal comfort levels.

Moody’s report explains in detail the rationale for Iceland‘s Aaa sovereign ratings, and examines the government’s and the banks’ ability to weather a stressful scenario.

“According to Moody’s analysis, the Icelandic authorities would likely be able to fend off a liquidity crisis, protect depositors, and avoid payment disruptions, even in a quite extreme scenario,” said Feldbaum-Vidra.

“However, Moody’s has been watching carefully the growth in the banking system’s foreign currency liabilities over recent years.

Eventually, this expansion would stretch the authorities’ ability to manage a crisis, at least in a way that would be compatible with the current Aaa ratings.”

She said the breathing room for the government to absorb the impact of any future crisis might be provided by a tighter regulatory framework governing banks’ own liquidity, or other structural measures that would  reduce the burden of the Icelandic authorities’ lender of last resort function in foreign currency.

“Any such changes would tilt the balance of financial risks for the Icelandic government in a more favorable direction,” said Feldbaum-Vidra.