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Oops, they did it again: S&P warns it could cut Iceland to ‘junk’

These are stories Report on Business is following Friday, July 26, 2013.

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Oops, they did it again
When you think meltdown, you think Iceland and Greece.

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The difference, of course, is that Iceland has been on the mend.

Today, however, Standard & Poor's cut its outlook on Iceland to "negative from stable," warning it could slash the country's credit rating to junk status.

At issue is the new coalition government's plan to aid families hurt by mortgages tied to inflation. While the government of Prime Minsiter Sigmundur Gunnlaugsson hasn't spelled out the details, S&P warned that "the contemplated household debt forgiveness could pose a significant fiscal risk to Iceland."

Today's warning means there's a one-in-three chance it could cut Iceland's BBB- rating over the next two years. So far, there's a working plan, with the details expected in November.

"The outlook revision reflects our view that we could lower the ratings if household debt forgiveness – as promised by the new government in its coalition agreement – substantially worsens Iceland's fiscal ratios or weakens our assessment of the effectiveness and predictability of policymaking," S&P said.

"The contemplated debt writeoffs, if funded through a haircut imposed on existing creditors to the defaulted Icelandic banks (the old banks), could also damage foreign investors' confidence in Iceland and further delay the lifting of capital controls," the U.S.-based credit rating agency added in its statement.

"The scope, overall cost, and financing of the writedown remain unclear, but we consider the risk of bringing additional debt from the private sector onto the public sector balance sheet to be significant."

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It warned the writedown could top 10 per cent of this year's gross domestic product, and potentially far more.

The trouble lies in inflation-linked loans  whose principle surged between 2007 and 2012 as the island's currency eroded and inflation spiked.

This comes as Iceland recovers from its financial crisis, which preceded the collapse of several European economies. So it's a bad time for the country given what S&P said is its "prosperous and flexible economy, and its institutional capacity to address financial sector problems and build an environment more conducive to job creation and sustainable economic growth."

Absent this, S&P believes Iceland's economy will expand at an average annual pace of almost 2 per cent in the next three years.

Markets mixed
Global markets are mixed so far this morning.

Tokyo's Nikkei lost a whopping 3 per cent, while Hong Kong's Hang Seng inched up 0.3 per cent.

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In Europe, London's FTSE 100 and Germany's Dax were down by between 0.5 per cent and 0.7 per cent by about 9:10 a.m. ET, while the Paris CAC 40 was up by 0.3 per cent.

Dow Jones industrial average and S&P 500 futures also dipped.

Who will be next Fed chief?
There's quite the controversy in the United States over who will succeed Ben Bernanke as chairman of the Federal Reserve.

Speculation has it that it has come down to a choice of Janet Yellen, who's vice-chair of the U.S. central bank, and former Treasury chief Larry Summers.

President Barack Obama is said to favour Mr. Summers, but there are many who don't want him.

As The Financial Times reports today, several Senate Democrats are pushing for Ms. Yellen in a letter they're circulating given that the policies of Mr. Summers have rubbed several the wrong way.

"The Larry Summers boomlet is now looking like a Larry Summers backlash," Tony Fratto of Hamilton Place Strategies told the news organization, noting it would be difficult to get the one-time adviser to the White House "through the Democratic caucus."

Japan sees inflation
Prime Minister Shinzo Abe's economic renewal program got another boost today as a new report showed the highest rate of inflation in about five years in Japan.

The government and the central bank have been trying end years of deflation, and, according to the statistics bureau, consumer prices rose 0.4 per cent in June from a year earlier when you strip out fresh food.

But some analysts question what's meant by that headline number.

"The headlines are misleading in that they confuse a relative price shock in the context of no wage growth for a generalized lift to inflation," said Derek Holt and Dov Zigler of Bank of Nova Scotia.

"The economic consequences to these two types of inflation are different."

Energy prices, they said, are really the only thing pushing up the overall rate, partly because of the impact of the impact of the yen's depreciation on imports. Other prices are falling.

"We fear that future planned policy moves will only make the possible outcome worse," the Scotiabank economists said.

"This is because next April's planned sales tax increase is likely to operate against the backdrop of still weak wages such that inflation-adjusted wages will decline further," they added in a research note.

"The second round effects will be to spend even less. Japan should have learned that lesson in the 1990s when it last raised the sales tax, but a sharp deterioration in public finances since then with a 250-per-cent debt-to-GDP ratio is giving the country little hope in avoiding it."

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