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Economics analysts Moody’s have kept Iceland’s rating the same from last spring, giving mixed reviews of the state of the economy, while indicating that legal proceedings over Icesave could change the country’s rating for better or worse.
As has been the case since last April, Iceland’s rating remains at Baa3 – a less than ideal rating for a country hoping to attract foreign investment. Why would this be the case if the country’s economy has, by Moody’s own assessment, been improving over the past year?

The economy has finally started to improve since Q3 2010 and is expected to rebound moderately this year and over the medium term, stimulated by the weak exchange rate and new investment in power-intensive industries. However, there are significant uncertainties, in particular regarding the outlook for investment which depends to an important extent on the speed with which the strict capital controls will be abolished.
Iceland’s ratings are limited by the government’s strained balance sheet, which has been significantly damaged because of the assumption of large financial liabilities following the banking and currency crisis.

Even while acknowledging that the income of the average Icelander is still far above the global average, the small size of the economy makes Iceland susceptible to major economic shocks. Moody’s also noted a delicate balance needs to be struck between capital controls and liberalisation.

Iceland is considered to have a high susceptibility to event risk, mainly on account of the risks entailed in the process of capital control liberalisation. On the one hand, the lifting of the capital controls and renewed access to external funding are crucial elements for a sustained recovery in Iceland. On the other, a too rapid relaxation of capital controls risks creating excessive exchange rate weakness. Foreign investors – trapped in the country when the capital controls were introduced in late 2008 – hold an estimated ISK465 billion (approx. 30% of GDP) in assets in the country. Most, if not all, will want to exit as soon as possible, with significant implications for the exchange rate, if their exit is not properly sequenced and managed. Once there is a track record of successful steps in liberalising the capital controls, we will probably consider moving our assessment of susceptibility to event risk back to moderate.

One interesting note is that, like EFTA, Moody’s has also not forgotten about Icesave, and cite it as a factor in contributing to future ratings for Iceland.

The rating could be downgraded if the current commitment to fiscal consolidation showed signs of declining or the remaining legal risks related to a resolution of the Icesave issue resulted in a significantly higher liability for the government than is currently expected.

The full report can be read here.