Iceland Credit Rating Slashed Again

August 5, 2010 Updated: August 5, 2010

[xtypo_dropcap]L[/xtypo_dropcap]ast week, Moody’s Investors Service lowered Iceland’s credit rating from Baa3 to negative after the island’s government passed a law prohibiting any type of foreign exchange-linked loans and the continuing uncertainty looming around its Icesave program.

Iceland’s Economy Minister Gylfi Magnusson is unhappy about the downgrading, saying: “Moody’s is taking it too far … [the rating] is lower than is merited; saying that the grade could possibly be lowered further is undeserved,” regarding the rumors that soon Moody’s could downgrade the rating even lower to junk. “The Treasury is far from defaulting.” He sought to reassure the world that Iceland is not looking as bad as the credit rating agencies depict.

The new law prohibits locals from taking out loans in currencies other than Iceland’s currency, the krona. Loans that have already been taken out in foreign currencies will be converted to krona. In addition to converting foreign currency loans to krona, the interest rate will also be raised to accommodate the local standard.

“A further ruling of the Supreme Court related to the applicable interest rate in case of loan conversion from foreign to domestic currency is expected in the autumn,” said Moody’s official statement.

"Although banks have some buffer to absorb losses due to their currently high capitalization levels, Moody's does not rule out that Iceland's banks will be faced with further losses following the Supreme Court decision", says Kathrin Muehlbronner, the vice president at Moody’s Iceland. "Moreover, this could in turn require the government to inject further capital into the banks as the only realistic provider of additional capital."

In 2008, Iceland’s financial crisis was partly sparked by this type of loans, which were mostly borrowed in Swiss francs and Japanese yen and then repackaged in krona by the local banks. In a matter of few months following the global economic crisis, the krona lost 30 percent of its value against the franc and 38 percent against the yen. As a result the Iceland’s lenders went bankrupt, as they simply couldn’t catch up with the free falling krona exchange rate. Afterward the government was forced to take over the situation and nationalize the banks.

At the moment, Iceland’s debt is 150 percent of its GDP and the government is trying all possible ways to reduce it. Laws affixing a higher interest rate and prohibiting taking out foreign currency loans are aimed primarily at reducing the country’s high debt level.

However, Moody’s is seeing Iceland’s actions as harmful to the recovery of Iceland’s economy and could result in another government bailout to save the troubled banking sector.

“The Supreme Court ruling has the potential to cause substantial bank losses on foreign currency-denominated loans to domestic borrowers and may therefore require additional government support to the banking system,” said the official statement from Moody’s.
The second major reason why Moody’s lowered the credit rating to negative is the unresolved conflict around the looming Icesave deal in the background.

Icesave was originally a lucrative investment opportunity that lured many English and Dutch investors to put their money in Iceland, hoping to get high returns. After Iceland’s financial system collapsed, it couldn’t pay back those investments, leaving the troubled English and Dutch businessmen stranded. In order to help them, both English and Dutch governments have repaid depositors and now Iceland owes U.K. and the Netherlands the Icesave money, which amounts to $5.1 billion.

“A solution to the Icesave dispute with the U.K. and Dutch governments is also still outstanding. In Moody's opinion, this could potentially exert renewed pressure on the funding provided by the IMF and the Nordic governments and the timeframe for the lifting of capital controls. While acknowledging that recent economic data have largely been positive, Moody's believes that these significant and persistent uncertainties have the potential to undermine Iceland's recovery,” said the official statement from Moody’s.

Meanwhile, the International Monetary Fund (IMF) has postponed its dealings with Iceland until September partly because of the unresolved conflict of the Icesave deal that brings substantial political pressure to bear between Iceland, U.K., Netherlands and the Nordic countries.

“The financing that was supposed to come [with the IMF program] is quite a bit behind schedule,” Magnusson said. “This has delayed the process of taking bold steps in removing the capital controls. That’s a disappointment, but we have to work with it,” he added.

“A failure to resolve the Icesave dispute could lead the Nordic countries and the IMF to withhold future disbursements to the Icelandic government,” said Moody’s, in justifying its decision to lower Iceland’s credit rating to negative.