After sparking a slump in the Icelandic krona at the end of February and sending jitters through current-account deficit countries, Fitch has returned to the offensive against the tiny Nordic economy, warning that a “hard landing” looms.
Fitch’s criticism has provoked a bitter spat with Iceland’s banking community, which analyst Paul Rawkins yesterday described as “the villains of the piece” because of their rapid accumulation of foreign debt. In an interview with Emerging Markets last month, Halldor Kristjansson, Chief Executive of Landsbanki, accused foreign observers of “misundertanding” his country.
“We’ve been through these storms before and we’ve always come out very well adjusted and stronger than before. The overall economy is extremely strong,” Kristjansson, who runs Iceland's No. 2 bank, said.
Rawkins disagrees: In terms of “The risk of a hard landing- a sharp drop in output, unemployment and incomes – I think the risk of that is higher than it was [in the past]. It does raise concerns about the most indebted sectors of the economy.”
Iceland’s 300,000 inhabitants have a debt-to-disposable income ratio of more than 200% and corporate debt is more than 200% of the island’s GDP. Combined with a current account balance which has swung from a 2002 surplus to a deficit of 16% of GDP last year, this threatens disaster, according to Fitch.
Kristjansson reckons the deficit will disappear in a year or so but Rawkins predicts it will take much longer. Similarly, while Kristjansson sees the currency having settled at a new equilibrium, Rawkins forecasts further depreciation.
“It’s probably too early to say this is the end of the process,” Rawkins said. With inflation climbing, the real exchange rate is rising again, requiring a further nominal depreciation of the krona, Fitch argues.
While Iceland is most certainly not a developing country - it has one of the highest per capita income rates in the OECD – it matters for emerging markets because its currency volatility and high interest rates have encouraged similar trading strategies to those used in its less developed peers.
The plummeting currency in February and March dragged down the Hungarian forint and Turkish lira, among others, as investors pulled out of a range of carry trades.
The Icelandic central bank has lifted its main policy rate towards 15% and will have to go higher, according to Rawkins. In doing so it risks encouraging speculation and prompting more domestic borrowers to take on foreign currency risk. Unlike in New Zealand, another open island economy, the government is not contributing a tighter fiscal policy to assist the central bank, threatening Iceland’s AA status. Standard & Poor’s this month followed Fitch in moving Iceland to a negative outlook.