As a small, highly open economy with a large tourism and commodity export concentration, Iceland is exposed to a severe recession, increased fiscal deficits, and a considerable increase in government debt. Iceland has taken a rather strong start in the COVID-19 crisis with a small average government budget in 2017-2019, a low net government debt, a strong household balance sheet and large foreign reserves. homes
Fitch forecasts real GDP growth contracts by 8.5% in 2020, a significant decline from 1.9% growth in 2019. Although our basic scenario assumes the economic recovery in 2021, there are major downside risks associated with uncertainty about the scope and length of the pandemic.
The pandemic of coronavirus will seriously affect the tourism industry in Iceland that accounts for some 9% of GDP (excluding indirect effects) and 35% of total exports. Passenger traffic was already declining during the first quarter of the year (-25 percent yeast), caused by a decrease in airline seating capacity following the bankruptcy of the 2019 Wow Air budget airline and the establishment of Boeing Max jets in Icelandair, Germany. As a result, we predict that foreign tourist arrivals will decrease this year by 80 percent. While we anticipate a recovery in 2021, we predict that our arrivals will remain 40 percent below 2019.
With five times more than a decade of growth, the tourism industry was one of the main drivers of Iceland's economic growth, wage growth, foreign labour, and higher real estate prices. We expect the tourism sector in Iceland to be especially vulnerable to the ongoing shock, due, for instance, to over-supply of tourism infrastructure in the area, which is expected to increase hotel capacity in the capital by about 25% over the next three years.
We see risks from prolonged decline in the sector to other economic sectors, including real estate and banks. The exposure of the commercial banks to their loans for construction, property and retail at 25 percent at the end of 2019 is estimated at 9 percent of the total loan book in the tourist sector. A sharp decline in property prices could further weigh growth due to wealth effects and depressed bank lending.
At the same time, Iceland's two other major export industries, aluminum and fishing, account for 35% of overal exports, are being challenged by a coronavirus pandemic. A sharp decrease in global economic activity has resulted in a sharp fall in prices for aluminum and weighs on aluminum demand. The fishing industry was also vulnerable, despite some diversification into frozen products, to the continuing health crisis, which curbs the demand for fresh fish from restaurants (30% of Iceland's marine exports).
Fitch forecasts that the current account balance turns into a 2.3 percent deficit of GDP in 2020 from a year earlier surplus of 5.8 percent. Capital account flows have been resilient to date, supporting FX reserves that are expected to remain robust for over seven months. The capital account will be backed by pension funds (167% of GDP in total assets), which have agreed to temporarily end increased investment abroad with the Central Bank of Iceland. This does not remove, however, the risk of strong capital outflows from the funds, in particular by reducing the difference with international interest rates.
Fitch projects that the fiscal deficit will sharply increase to 9.0% of GDP in 2020 from a 1.0% deficit in 2019, reflecting an increase in automatic stabilizers' expenditure and support measures from the Government. In Fitch's view, there is a potential to increase fiscal stimulus beyond our current forecasts in the medium term. The government has announced ISK129.4 billion in stimulus measures (4.8 percent of GDP). To date, the Government has introduced three support packages mainly focusing on part-time wage subsidies (recently extended up to the end of August, equivalent to 1,3 per cent of GDP), notice wage subsidies (0,7 per cent of GDP) and 2020 investment accelerations (0.6 percent of GDP). At the same time, Fitch expects revenue to be affected by lower economic activity and higher unemployment. Tax deferrals estimated to be ISK 100 billion (3.7% of GDP) were also announced in 2020 to support the economy.
The deficit increase, krona depreciation effect and probable crystallization of some of its contingent liabilities should lead to a 53.3 percent increase in government debt at the end of 2020. This compares to 37.1% of GDP in 2019 and the all-time high of 92.0%. Fitch is expected to add around 20 per cent of the total amount earmarked for bridge and support loans to the government balance sheet (ISK 19.6 billion or approximately 0.7 per cent of GDP).
In our basic scenario, Fitch expects the fiscal deficit to decrease to 4.5 percent of GDP in 2021, as expenditure pressures fall and income growth recovers in line with employment stabilization. This should help to reduce public debt/GDP by 51.9% in 2021. The record of Iceland's prudent fiscal policies and its ongoing reduction in debt in 2012-2019 supports our view that fiscal consolidation and debt reduction are likely in the medium term. We forecast that, under our underlying public debt dynamics, debt/GDP will decline slightly to 50.4 percent by 2024, even if downside risks remain.
The 'A' IDRs in Iceland also reflect the following key drivers:
The high level of Iceland's wealth and relatively low private sector indebtedness are key strengths. The per capita income of Iceland is above the USD 23,184 medians for 'A' and 'AAA' at USD 60,236 at USD 71,142 in 2019.
In recent years, the increasing share of foreign labor in employees has supported labor market flexibility. Expected outflow of foreign labour, but with additional negative effects on private consumption, could help reduce the unemployment rate through the crisis. The lock-down was markedly impacted by labor market dynamics despite government fiscal measures to support the economy, with the registered unemployment rate increasing to 9.2% in March, up from an average of 3.6% unemployment rate in 2019. At the same time, about 17% of the employees have registered for the short-term work system.
The balance sheets of households are strong, with assets at 256.5% of GDP far exceeding the liabilities at 77.1% of GDP based on Eurostat data. The bulk of this is pension savings, which in times of economic stress have been used as an additional financial cushion in the past. Under the government stimulus package, individuals are again able to withdraw money from voluntary retirement savings of up to ISK800,000 (USD5680) per month.
Private sector deleveraging and buffer accumulation was reflected in the improvements to Iceland's external position. In 2018, the net international investment position was positive, and by the end of 2019 it increased to 22.5% of GDP. Net external debt, according to the 'A' rated median, also decreased to 19.4% of GDP in 2019.
Large domestic assets under private pension fund management, international bond market access, a large cash deposit buffer (approximately 9 percent of GDP) and a solid liquidity system will contribute to finance the deficits in 2020-2021.
Icelandic banks with a combined capital adequacy ratio of 22.9 percent are highly capitalized on 3Q19, at largely the same level as in 2018, comfortably above regulatory threshold. Liquidity is ample, with a liquidity ratio of 166% at December 2019, well above a regulatory minimum of 100%. At the end of 2019, non-performing loans were 2.6 percent small, but were slightly higher than 2.2 percent in 2018, due to the shock on the tourism sector due to the collapse in March of last year of the turbulent budget airline Wow Air.
The overhaul of fiscal and external buffers over the last decade has led to broad political consensus among the political parties in macroeconomic and fiscal policies, giving Iceland fiscal and monetary space to respond to the current shock. In Fitch's opinion, the rapid government response to the health crisis has led to a rapid decline in new infections, thereby preventing a severe economic lockdown.
ESG – Governance: Iceland has an ESG Relevance Score of five for both political stability and rights, as is the case for all sovereigns, as well as for the rule of law, institutional and regulatory quality, and control of corruption. These scores reflect the high weight given in the proprietary Sovereign Rating Model by the World Bank Governance Indicators (WBGIs). Iceland has a high 93rd percentile ranking of WBGI, which is better in line with the AAA median, reflecting its well-established right to political participation, strong institutional capacity and an effective rule of law.