Iceland: A European Exception

LONDON -

Iceland is cracking under the pressure of the financial crisis. Its currency is plunging, its sovereign credit rating is at risk and its teetering financial sector pushed the government to nationalize banking firm Landsbanki on Tuesday--only a week after nationalizing another bank, Glitnir.

In an interview with Forbes.com, Pierre Cailleteau, head of sovereign risk at Moody's, explains the significance of Iceland's turbulent situation and why it seems to be more exposed than the rest of Europe to a crisis in confidence.

Forbes.com: Iceland now has effectively nationalized two banks and guaranteed domestic deposits. What is your assessment of Iceland's creditworthiness in the current situation?

Pierre Cailleteau: The issue for us is twofold. Firstly, is there a liquidity problem for the government itself? This is unlikely, because of the [modest] size of the government's debt, and also because it has benefited from outside support.

But more importantly, to what extent is the government going to use the balance sheet of public finances to cover the cost of the collapse of the banking system? We must ask ourselves whether we think the government can absorb a high level of debt for a few years and restore the situation, or whether we think the creditworthiness of Iceland is impaired in a structural fashion.

Your rival, Standard & Poor's, cut Iceland's sovereign credit rating at the end of September. Why have you not followed suit?

We have put the rating under review for downgrade some weeks ago, but we think the situation is fluid. In addition, the probability is clearly that the government is going to repay its own debt. Iceland's debt is very low and there are considerable assets. It is not very clear to us that the situation is so dire from this specific standpoint. But the big issue of course is : will there be a sustained ballooning of the balance sheet of the government? This is very likely. To what extent is the solvency of the country will deteriorate in comparative terms?

The Icelandic prime minister said Monday night that there was a possibility of "national bankruptcy." Do you agree?

That would only be a possibility if the government was to assume all the debt of its banks. No government is going to bankrupt itself to save the creditors of banks .

Do you think Iceland will manage to keep the crisis under control?

I think it depends on how they manage the crisis, and whether they have a clear plan.

We must also consider whether Iceland will be disciplined enough to really control its balance sheet. For instance, they might use a lot of the reserves they have received as loans to support the currency. Although understandable, this may not be the most productive use of their assets.

What would be more productive?

We are not in the business of advising countries, but what would be more productive is to make sure there is no run on local currency deposits.

Do you think the government's suggestion that pension funds repatriate their money is a productive one?

If you ask pension funds to repatriate their investments, to invest de facto in government bonds, then you have funding. This is why we have not rushed to any conclusion on Iceland's sovereign debt rating, because the government has no clear funding strains.

Why is this happening in Iceland rather than any other country?

Iceland is an exception partly because of its economy's small size, relative to its banking sector. But also it is an exception, compared to the countries of the European Union, and certainly of the euro zone, because it may face a liquidity problem, a refinancing risk problem.

Why is that?

Because, for one, Iceland has its own currency and the magnitude of its banking system's foreign-currency liabilities. Having its own currency is also true for the U.K,. but the U.K. has a strong Aaa rating and is not subject to liquidity risk. Just think about what would have happened in Europe without the euro zone. It may well be that some countries would have faced a foreign-currency crisis.

So do you think Iceland will face pressure to join the E.U> and then the euro zone?

Well this is certainly an issue in Iceland. But personally, I think it is too late, because this is a political process. There is no quick fix in joining either the E.U. or the euro zone. For the U.K., I don't think we can make a clear case that being in the euro zone would be much more protective.

Could other countries in Europe follow Iceland?

There are already countries that we have put under review, in the Balkans and the Baltic, whose ratings and whose outlooks we changed recently. Latvia and Bulgaria are countries that share some of the characteristics of Iceland. They have huge current account deficits. But again, the big difference is that being in the E.U. to a large extent creates some degree of security in terms of banks' financing. There are crisis-management processes at E.U. level for banking systems.