SI assumes that inflation will continue to decline, measuring 2.3% in 2011 and then hovering around the Central Bank inflation target for the rest of the forecast horizon. It also assumes that the króna will continue to appreciate gradually throughout the horizon.


Euro countries hit heavy weather ...

Ireland's banking system difficulties are common knowledge, of course, and just this weekend it was announced that the European Union (EU) had formally approved the Irish government's request for financial assistance from the EU, the International Monetary Fund, and the European Central Bank, making Ireland the second eurozone country to seek assistance from these bodies. Clearly, there is considerable tension in the European markets at present. Moreover, Spain's sovereign CDS spread is at a record high, measuring 282 at yesterday's market close. All of these factors indicate that the aftermath of the global financial crisis is still affecting indebted eurozone countries.

... while Iceland treads water
The rumblings in Europe appear not to have had much impact on Iceland's sovereign credit spreads, which have remained relatively stable throughout the recent turmoil. At yesterday's market close, the five-year spread on the Republic of Iceland's euro-denominated debt was 275 points, broadly in line with the past few weeks' levels and relatively low compared to this year's range. Only recently, Iceland's sovereign CDS spread spiked with every minor ripple of risk aversion. The recent episode of stability is attributable to the Central Bank of Iceland's purchase of the Treasury's outstanding euro-denominated debts, as we have stated before. Moreover, Iceland's five-year spread now is lower than Spain's. This is the third time this has happened, with the first occurrence on the 10th of this month. At present, Iceland is in fifth place among Western European countries for which credit default swaps are traded, behind Greece, Ireland, Portugal, and Spain. Iceland's five-year spread has remained below 300 points since 12 October 2010, a rather positive development for the Treasury.

Out of sync with credit ratings
It is instructive to compare the credit ratings of the countries specified above with their five-year CDS spreads. A simple average of the credit ratings assigned to these countries by the four major agencies that rate the Republic of Iceland - Moody's, Fitch, Standard & Poor's (S&P), and R&I of Japan - reveals that these two measures of risk are at variance with respect to the countries' internal credit risk. For example, Spain has the highest average credit rating (Aa1/AA+), followed by Ireland (Aa3/AA-) and then Portugal (A3/A+).

Clearly, the rating agencies place Iceland in a class with Greece, as both countries have two speculative-grade ratings and two in the lowest investment-grade category. As a result, the difference between Iceland's credit rating and those of Spain, Ireland, and Portugal is a full 5-8 notches, which is quite at odds with the sovereign CDS spreads on the countries concerned. Yet it is clear that this comparative status could change dramatically in the near future, as most of the ratings have been assigned a negative outlook by the agencies in question. Just yesterday, Moody's put Ireland on review with an eye to a possible downgrade, stating that it is not unlikely that the country's ratings will be lowered by several notches. Furthermore, according to a news release from Bloomberg, a successful resolution of the Icesave dispute could result in a sovereign rating upgrade from Moody's, which would be a very positive development for Iceland. This is in line with repeated statements from Fitch and S&P, and it will be interesting to see the agencies' response in the event that a resolution is finally achieved in the dispute between the Icelandic Government and the UK and Holland.