OREANDA-NEWS. January 20, 2016. Fitch Ratings has affirmed Iceland's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BBB+' and 'A-', respectively with Stable Outlooks. The issue ratings on Iceland's senior unsecured foreign and local currency bonds have also been affirmed at 'BBB+' and 'A-', respectively. The Country Ceiling has been affirmed at 'BBB+' and the Short-term foreign currency IDR and CP at 'F2'.

KEY RATING DRIVERS
Iceland's ratings are underpinned by a very high level of income per capita compared with 'BBB' rating peers (USD48,800 compared with the rating peer median of USD9,200), and indicators of human development and governance more akin to the highest-rated sovereigns.

Public debt sustainability is improving. Fitch estimates that the general government deficit was 0.2% of GDP in 2015, little changed from 2014. The 2016 budget includes a series of expansionary fiscal measures, overall worth around ISK27bn (around 1.2% of GDP). The main discretionary tax changes are cuts in income tax and import duties.

Capital controls remain in place but the process leading to their liberalisation will bring about a sizeable, one-off improvement in fiscal balances in 2016. The estates of the failed banks (mainly Glitnir, Kaupthing and Landsbanki) will deliver stability contributions to the Icelandic state, having completed their composition agreements in Icelandic courts. This will then allow the estates to settle claims with creditors of the old banks. Most of these will accrue this year, and will improve the government balance by around ISK338bn (around 14.8% of GDP). We then expect the government balance to re-adjust to a 0.6% of GDP surplus in 2017. Overall, the estates of the failed banks will deliver total payments to the authorities of around ISK490bn (around 21.5% of GDP) in stability contributions, tax payments and recoveries by the central bank's asset management company in connection with the estates' settlement.

Excluding this one-off improvement, we expect both revenue and expenditure ratios to fall back over the forecast horizon, translating into an improvement in the fiscal balance. However, the fact that the economy is operating above capacity indicates that the fiscal policy stance is expansionary, in contrast with the central bank's monetary policy stance.

We estimate that the general government debt to GDP ratio fell to 69.2% of GDP in 2015, from 81.4% in 2014. The estimated primary surplus (4.3% of GDP) and the growth-interest differential only accounts for around one-third of the fall in the debt ratio. Stock-flow adjustments account for two-thirds of the decline in debt. Over 2015, the Icelandic Treasury paid down a number of debts; including at year-end ISK50bn (just over 2% of GDP) of the outstanding balance of the bond issued to the Central Bank of Iceland.

For 2016, we do not assume that the one-off revenues will translate to a one-for-one decline in the debt ratio. This is due to the illiquid nature of some of the assets transferred to the state as part of the stability contributions (in particular the equity stake in Islandsbanki and a collateralised bond due from the Kaupthing estate). Allowing for the repayment of the outstanding balance on the central bank bond (around ISK90bn), under Fitch's baseline macroeconomic assumptions, we expect the debt to GDP ratio to fall to 57.4% this year, before falling further to 53.0% in 2017.

Our estimates imply that between 2011 and 2015 the debt-to-GDP ratio declined by 26 percentage points. At the same time, government debt is still above the 'BBB' median (42.7% of GDP). State guarantees are sizeable, amounting to around 50% of GDP (three-quarters of which accounted for by the Housing Finance Fund).

Over the first three quarters of 2015 the Icelandic economy expanded by 4.5%. Domestic demand remained the main driver of growth, with private consumption and investment growing at an annual rate of 4.4% and almost 16%, respectively. Despite the continued strength of the tourist sector, import growth outstripped exports, implying a negative net trade contribution. We expect this pattern of growth to continue over the forecast horizon. Strong income growth and improving household balance sheets will continue to drive consumption growth and survey data points to continued growth in investment. We forecast a slowdown in GDP growth to 3.4% in 2016 and 2.9% in 2017, as monetary policy is tightened further to address inflationary pressures.

As a very small, open economy, Iceland is more susceptible to growth and inflation volatility than larger developed countries. The Icelandic central bank has already raised interest rates by 0.75 percentage points since the last review and has signalled that further policy tightening will be needed over the coming months. Inflation remained low in 2015 thanks to low import and petrol prices (+0.2% on the HICP measure). However, generous wage settlements, low unemployment and a positive output gap will put upward pressure on inflation. We have revised down our forecast of inflation since the last review, but still expect HICP inflation to rise to 2.8% this year and 3.5% in 2017.

The upward pressure on the exchange rate last year, deriving also from increased capital flows (the krona has appreciated in nominal terms by 3.2% and 4.1% against the dollar and euro respectively since the last review), was partly offset by acquisitions of foreign exchange. The central bank conducted FX purchases for ISK228bn (around 10% of GDP) in the year to November 2015. At November 2015, FX reserves were ISK548bn, around 24% of GDP. The authorities' strong FX position has been utilised to pay down the remaining obligations to the IMF from the Stand-By Arrangement following the financial crisis in 2008 (about USD334m, ISK44bn).

The combination of rising labour costs, expansionary fiscal policy, and a strong nominal exchange rate support the real exchange rate. In unit labour cost terms, the real exchange rate over 1Q-3Q15 was 8.2% higher than the same period a year earlier. Cost and price dynamics suggest this trend will continue over the next two years with a negative impact on competitiveness. We expect the current account balance to narrow from an estimated 3.2% of GDP in 2015 to 1.6% in 2017.

The completion of the old bank estates' composition agreements in the Icelandic courts in December implies that end-year net external debt (and international investment position) will be adjusted downwards as the liabilities associated with the old bank estates are netted off. We estimate that net external debt at end-2015 was 49.8% of GDP, still substantially higher than the rating peer median.

Capital controls remain in place, pending the completion of the government's liberalisation strategy. Over the next few months, the authorities will provide detailed plans for a currency auction to unwind the 'locked-in' non-resident ISK assets (ISK336bn, USD1.0bn, around 14.6% of GDP).

RATING SENSITIVITIES
The Outlook is Stable. Consequently, Fitch's sensitivity analysis does not currently anticipate near-term developments with a high likelihood of leading to a rating change. However, factors that could, individually or collectively, result in positive rating action include:
-A track record of continued economic growth without excessive macroeconomic imbalances.
-Continued improvements in debt dynamics, supported by prudent fiscal policy.
-Continued improvements in the external balances.

The main factors that could lead, individually or collectively, to negative rating action are:
-Evidence of excessive overheating in the domestic economy, for example through wage-price spirals, sharp interest rate rises, and adverse effects on household and corporate balance sheets.
-A weakened commitment to fiscal consolidation, for example through continued pro-cyclical fiscal policy stances that would reverse or stall the trajectory of declining public debt.
-Excessive capital flows after the lifting of capital controls, leading to external imbalances and pressures on the exchange rate.

KEY ASSUMPTIONS
The ratings and Outlooks are sensitive to a number of assumptions.

Fitch assumes that the government's strategy for capital controls liberalisation will be implemented broadly as planned.

In its debt sensitivity analysis, Fitch projects that government debt as a share of GDP will decline to 34.5% by 2024. In a negative scenario with low growth, a substantial one-off depreciation, and higher interest rates and inflation, the debt ratio would stabilise at 57%.