Icelandic farce continues

Fitch ratings agency, whose note on Iceland last year originally kicked off the Icelandic banking crisis, yesterday downgraded Iceland’s government bonds from AA- to A+. The Icelandic krona fell 1% against the sterling on the news. Fitch said that “the downgrade reflects new data on the balance of payments and the international investment position that points to a material deterioration in Iceland’s external balance sheet, amplifying concerns about external debt sustainability” and that the highly leveraged Icelandic economy was “poorly positioned to surmount a prolonged bout of global risk aversion and/or higher international interest rates”.

The downgrade may in part be Fitch highlighting Moody’s incompetence (Moody’s controversially upgraded Iceland’s banks to Aaa on the basis that they would be bailed out by Iceland’s government), but there is no doubt that Iceland’s incestuous economy faces great challenges ahead. The Central Bank of Iceland has hiked interest rates from 5.3% in mid 2004 to 14.25% in order to apply the brakes to its overheating economy. Further rate hikes are probably necessary to slow the economy, where inflation reached a peak of 8.6% in August last year.

A slowing economy would be very bad news for Iceland’s banks (click on image to see Iceland’s complicated bank structure). Iceland’s three main banks own a large slug of Iceland’s companies, and these companies in turn have significant interests in each other. The huge degree of cross ownership is clearly a substantial economic risk, and within the M&G Optimal Income Fund I have bought protection on bonds issued by Kaupthing, one of the “big three” banks exposed to this risk.