Iceland’s economic imbalances are waning and the inflation rate and current account deficit are coming down, the latter from a record level in 2006. The financial sector is on a firmer footing than a year ago. The headline of the Central Bank’s Financial Stability report for 2007 was The commercial banks are more resilient. However, the battle is not over and risks may still be present. The current account deficit is still large. Tighter conditions for funding it could undermine the exchange rate and rekindle higher inflation and instability. While the banks have strengthened their liquidity and have a larger share of deposits on the liabilities side of their balance sheets and fewer challenges in their refinancing, they still rely on easy access to international credit markets. A shift in investor sentiment about the banks, or in general risk assessment in the markets, could tighten liquidity and lead to less favourable borrowing terms. Thus prudence is called for, along with contingencies for facing tighter conditions and awareness that changes can take place very suddenly. Iceland’s currency is the smallest in the world with an inflation targeting framework and a floating currency. The króna probably tends to be more volatile than currencies of larger countries, which will cause sharper fluctuations in yields on króna-denominated investments. While major currencies are certainly prone to volatility, the crucial consideration is that exchange rate movements have a much greater impact on small, open economies than on larger ones.
As it turned out, the three largest commercial banks reported record profits in 2006 and ended the year with their strongest capital adequacy ratios since the Basel Accord went into effect, as well as building up very strong liquidity. In the autumn the banks announced that they had completed refinancing of all their loans maturing that year and virtually all their 2007 maturities, thereby dispelling doubts about their ability to refinance outstanding debt. The liquidity risk that loomed in the first half of 2006 was a thing of the past. In their refinancing arrangements the banks rested the EMTN market that had been their main source of capital and successfully tapped others, mainly in the US but also in Australia and Japan. Some have now successfully returned to the EMTN market. The first signs of a change in foreign investor sentiment towards the Icelandic banks appeared in higher CDS spreads for their bonds in secondary markets, which had been in the range of 0.1 to 0.15%. They began to inch up late in 2005, rose sharply in the first half of 2006 and peaked around  2  BIS Review 60/2007  mid-year close to 0.8%. At that time, this trend was very much at odds with CDS spreads on issues by comparable banks in other countries. Towards the end of last year spreads began to decrease again and have narrowed steadily to only marginally higher than before the market turned uneasy at the end of 2005, at near 0.2% to 0.25%.