RATING ACTION COMMENTARY

Fitch Af rms Iceland at 'A'; Outlook
Negative
Fri 26 Mar, 2021 - 5:03 PM ET
Fitch Ratings - London - 26 Mar 2021: Fitch Ratings has af rmed Iceland's Long-Term ForeignCurrency (LTFC) Issuer Default Rating (IDR) at 'A' with a Negative Outlook.
A full list of rating actions is provided below.

KEY RATING DRIVERS
The 'A' rating is driven by Iceland's very high income per capita, strong performance on governance,and human development and doing-business indicators that are more consistent with those of 'AAA'and 'AA' rated countries. Very large pension-fund assets and sizeable deposits underpin nancingthat result in vulnerability to external shocks and capital-account risks.
The Negative Outlook re ects the impact of the coronavirus pandemic on the Icelandic economy andthe resulting deterioration in the public nances. The scal de cit has widened materially andgovernment debt is set to increase sharply from pre-pandemic levels over the next few years. As asmall and highly open economy with a sizeable concentration in tourism and commodity exports,
Iceland is heavily exposed to the pandemic shock.
The general government de cit widened to 7.3% of GDP in 2020 from 1.5% in 2019. The outturn was
better relative to our expectations at the October 2020 rating review (-10.9% of GDP), owing tohigher- than-expected revenues, lower-than-budgeted expenditures and a more resilient economic

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exibility. The rating is constrained by the small size of the economy and limited export diversi cationperformance. It is also below the A-peer current median (-9.5% of GDP). General government debt
rose to 80% of GDP in 2020 from 68% in 2019, well above the A-peer current median (58%).
We expect the general government de cit to widen further to 8.1% of GDP in 2021 due to additional
stimulus measures outlined in the 2021 budget, but we also assume that spending will not reach the
maximum set out in the budget. We estimate the direct cost of scal-policy measures at 3.5% of GDP
in 2021. We expect the de cit to narrow to 6.5% of GDP in 2022. We believe expenditures will decline
only gradually relative to GDP as we expect political pressure to maintain higher spending after the
pandemic, particularly in welfare and healthcare but also with aim of boosting infrastructure
investment.
Fitch forecasts gross general government debt to increase to 83.7% of GDP in 2021 and 84.7% in
2022, from 79.9% in 2020. We expect public debt to reach a peak of 85.3% in 2023 and to decline
slowly thereafter. Parliamentary elections in 2021 could lead to a scal strategy with a slower debt
reduction path, but Fitch believes that broad political support for rebuilding scal buffers and a strong
record of public debt reduction of 70pp of GDP in 2011-2019 support scal-policy credibility over thelong run.
Following data revision, general government debt levels have been revised signi cantly higher due tothe inclusion of several state-owned entities (SOEs) into the general-government scope. At the sametime, the revision implies that the size of contingent liabilities is markedly smaller. Prior to thereclassi cation, we had treated SOE debt as contingent liabilities for the sovereign's balance sheet.
Iceland has high exibility to nance large scal de cits arising from its response to the pandemic
shock over the next few years. Icelandic private-pension funds managed 194% of GDP in assets, withroughly 66% invested domestically at end-2020. The government also has strong access to theinternational bond market, a large cash deposit buffer (around 12% of GDP at end-2020) and is

The Icelandic economy has proved more resilient to the pandemic shock relative to our initialexpectations. Preliminary data from Statistics Iceland indicate that real GDP contracted 6.6% in 2020,
a better outturn relative to the 8% contraction at our October 2020 rating review, mainly due tostronger domestic demand. Strong household balance sheets and government-support measurescontributed to a rebound in private consumption in 2H20.
Gross xed investment was more dynamic on the back of stronger activity in residential construction,
re ecting strong demand and easing nancial conditions. The impact of the pandemic on the other two
major industries ( shing and aluminium products) has been less negative than initially expected.
Iceland has suffered fewer Covid-19 cases and fatalities and containment measures have been lessstrict relative to the rest of Europe. However, on Wednesday 24 March the government announced

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supported by robust liquidity in the banking system.

new domestic restrictions (expected to last for three weeks) following a spike in Covid-19 cases. The
new restrictions come a few days after the announcement of the re-opening of the borders to all
vaccinated foreigners arriving from outside the Schengen/European Economic Area from 6 April.
We expect the recovery to be subdued this year with real GDP growth of 2.6% as foreign tourism willtake longer to gain sustained momentum. In contrast, public investment should pick up on thegovernment's 'Investment and construction initiative' (0.9% of GDP in 2021). A stronger carryover
effect from growth in 2H21 and our expectation that social-distancing rules and travel restrictions will
be relaxed signi cantly across Iceland's trading partners underpin our view that real GDP growth will
accelerate to 4.2% in 2022. For 2022 we expect a stronger rebound in tourism ows with occupancy
rates 20% below their end-2019 level.
In the event of a more prolonged slowdown in the tourism sector, we see risks spilling over to othersectors of the economy such as real estate and banks. Commercial banks' loan exposure toconstruction, real estate and retail account for 25% of the total at end-2019, with the tourism sector
estimated at 9% of the loan book. The expiration of pandemic-related loan moratoria has led to a
substantial increase in loans in forbearance mostly in sectors related to tourism. We expect nonperforming loans, particularly in the corporate sector related to tourism including commercial realestate, to increase over the coming months but the extent will depend on the pace of the recovery intourism activity.
Banks are highly capitalised with an aggregated capital adequacy ratio of 24.5% in 3Q20, improved
from 2019 and are in a fairly strong position to absorb shocks to asset quality. Non-performing loans
were low at 3.2% of total loans in 3Q20 (2019: 2.9%) and corporate insolvencies declined 5% in 2020.
ESG - Governance: Iceland has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights
and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the casefor all sovereigns. These scores re ect the high weight that the World Bank Governance Indicators
94th percentile, re ecting strong institutional capacity and effective rule of law.

RATING SENSITIVITIES
Factors that could, individually or collectively, lead to a negative rating action are:- Public Finances: Evidence that the government's economic and scal strategy fails to arrest theincrease in government debt/GDP over time.

Feedback(WBGI) have in our proprietary Sovereign Rating Model (SRM). Iceland has a WBGI ranking at the- Macro: Severe and prolonged economic weakness, for example due to a delayed recovery in exportoriented sectors, sustained correction in the real-estate market and material adverse impact on thebanking sector.
- External nances: Capital out ows on a scale that precipitates macroeconomic instability or erodes
scal buffers.
Future developments that could, individually or collectively, result in a positive rating action:- Public Finances: Greater con dence that government debt/GDP will decline over time once theCovid-19 crisis has subsided.
- Macro: Greater con dence of a sustained economic recovery, for example supported by evidence
that export-oriented sectors, particularly tourism, have been resilient to the pandemic shock.

SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Iceland a score equivalent to a rating of 'A-' on the LTFC IDR scale.
In accordance with its rating criteria, Fitch's sovereign rating committee decided not to adopt thescore indicated by the SRM as the starting point for its analysis. The SRM output has migrated to 'A-'
from 'A', but in our view this is potentially a temporary worsening and the model score borders thethreshold between these two indicative ratings. Consequently, the committee decided to adopt the 'A'
rating as the starting point for its analysis, unchanged from the prior committee.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables
based on three-year centred averages, including one year of forecasts, to produce a score equivalent
to the SRM output to assign the nal rating, re ecting factors within our criteria that are not fully
quanti able and/or not fully re ected in the SRM.

BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a bestcase rating upgrade scenario (de ned as the 99th percentile of rating transitions, measured in apositive direction) of three notches over a three-year rating horizon; and a worst-case rating
downgrade scenario (de ned as the 99th percentile of rating transitions, measured in a negative
direction) of three notches over three years. The complete span of best- and worst-case scenario

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to a LTFC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment

credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit
ratings are based on historical performance. For more information about the methodology used todetermine sector-speci c best- and worst-case scenario credit ratings, visit[https://www. tchratings.com/site/re/10111579].

KEY ASSUMPTIONS
The global economy performs broadly in line with Fitch's latest Global Economic Outlook published on
17 March 2021.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATINGThe principal sources of information used in the analysis are described in the Applicable Criteria.
ESG CONSIDERATIONS
Iceland has an ESG Relevance Score of 5 for Political Stability and Rights as WBGI have the highest
weight in Fitch's SRM and are therefore highly relevant to the rating and a key rating driver with a highweight.
Iceland has an ESG Relevance Score of 5 for Rule of Law, Institutional and Regulatory Quality andControl of Corruption as WBGI have the highest weight in the SRM and are therefore highly relevantto the rating and a key rating driver with a high weight.
Iceland has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as the Voice and

Iceland has an ESG Relevance Score of 4 for Creditor rights as willingness to service and repay debt isrelevant to the rating and is a rating driver, as for all sovereigns
Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a scoreof 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies),
either due to their nature or to the way in which they are being managed by the entity(ies). For more
information on Fitch's ESG Relevance Scores, visit www. tchratings.com/esg.

RATING ACTIONS

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Accountability pillar of the WBGI is relevant to the rating and a rating driver.

ENTITY/DEBT

RATING

Iceland

LT IDR

PRIOR
A Rating Outlook Negative

Af rmedA Rating
Outlook
Negative•

ST IDRF1+

Af rmed

F1+

•

LC LT

A Rating Outlook Negative

Af rmedA Rating

IDR

Outlook
Negative

•

LC ST

•

Country

F1+

Af rmed

F1+

A+

Af rmedA+

IDR

Ceiling

VIEW ADDITIONAL RATING DETAILSFITCH RATINGS ANALYSTS
Michele Napolitano
Senior Director
Primary Rating Analyst+44 20 3530 1882
Fitch Ratings Ltd
30 North Colonnade, Canary Wharf London E14 5GN
Malgorzata Glowacka
Secondary Rating Analyst+49 69 768076 279
Charles Seville
Senior Director
Committee Chairperson+1 212 908 0277
MEDIA CONTACTSPeter Fitzpatrick
LondonFeedback

Associate Director

+44 20 3530 1103
peter. tzpatrick@the tchgroup.com
Additional information is available on www. tchratings.com
APPLICABLE CRITERIACountry Ceilings Criteria (pub. 01 Jul 2020)
Sovereign Rating Criteria (pub. 26 Oct 2020) (including rating assumption sensitivity)

APPLICABLE MODELS
Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing
description of model(s).
Country Ceiling Model, v1.7.1 (1)Debt Dynamics Model, v1.2.1 (1)Macro-Prudential Indicator Model, v1.5.0 (1)Sovereign Rating Model, v3.12.1 (1)ADDITIONAL DISCLOSURES
Dodd-Frank Rating Information Disclosure Form
Solicitation Status
Endorsement Policy

IcelandUK Issued, EU Endorsed

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