Investing.com -- Fitch Ratings has confirmed Iceland's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'A', maintaining a Stable Outlook. This affirmation reflects Iceland's high income per capita, strong governance indicators, and robust policy buffers such as large pension fund assets, a sound banking system, and resilient private sector balance sheets. However, the small size of Iceland's economy and limited export diversification limit the rating.

Iceland's economy, which experienced a strong post-pandemic recovery, cooled significantly in 2024, with a mild contraction of 0.5%. Factors such as moderate growth in real incomes and high interest rates affected domestic demand. The country also saw a larger-than-expected negative contribution from net exports, due to slow tourism activity in the first half of 2024, lower marine production, and a one-time surge in imports of investment goods. Fitch forecasts a recovery of real GDP growth to 1.6% in 2025 and 2.8% in 2026, supported by declining inflation and easing monetary policy.

The Central Bank of Iceland (CBI) cut its policy rate for the first time since mid-2021 in October 2024. The CBI made two additional 50 basis point cuts, reducing the policy rate to 8.0% in February 2025. Fitch expects further disinflation and additional policy rate cuts in 2025. The agency projects inflation to average 3.5% in 2025 and 2.9% in 2026, down from 5.8% in 2024.

Despite the economic cooling, Iceland continues to make steady progress in diversifying its economy into higher-value sectors such as pharmaceuticals, information and communications technology, and biotechnology. Investments in energy-intensive data centers have also been attracted by the country's abundant renewable energy sources, cool climate, and competitive energy prices. However, traditional sectors like aluminum, tourism, and marine products still account for the majority of Iceland's total exports (67% on average), leaving the country vulnerable to specific trade shocks.

Iceland's 2025 Budget was approved under a caretaker government before snap elections in November 2024. The new governing coalition, led by Prime Minister Kristrún Frostadóttir from the Social Democratic Alliance, is expected to present an updated plan this Spring, aligning with fiscal targets already outlined in the current Fiscal Plan (2025-2029), which aims for a balanced budget by 2029.

Fitch forecasts Iceland's general government deficit to reach 1.8% of GDP in 2025, down from 3.7% in 2024 and 2.0% in 2023. This decline reflects the absence of one-off costs related to seismic activity on the Reykjanes peninsula and lower interest costs and indexed expenditures.

Iceland's general government debt ratio, estimated by Fitch at 61.8% of GDP at the end of 2024, is above the median debt ratio of 'A' category peers (57.4%). However, Fitch anticipates a gradual reduction in this ratio, predicting a drop to 55.8% of GDP by 2027. This decline will be supported by modest primary fiscal surpluses and the use of accumulated cash deposits.

Iceland maintains strong external buffers, with large net tourism flows, a high goods import dependency, and a large pool of international foreign exchange reserves worth 19% of GDP in 2024. The country's positive net international investment position (40.2% of GDP in 3Q24) is notable among 'A' category peers, reflecting its significant pension fund sector.

In terms of ESG considerations, Iceland scores highly for Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality, and Control of Corruption. These high scores reflect the country's stable political transitions, well-established rights for political participation, strong institutional capacity, effective rule of law, and low corruption levels.

Fitch outlines that a marked deterioration in the debt/GDP ratio or a severe economic shock could lead to a downgrade in Iceland's rating. Conversely, a sharp and sustained decline in government debt/GDP ratio or evidence of economic diversification that reduces Iceland's vulnerability to external shocks could lead to a positive rating action.

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