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SUB-SOVEREIGN

CREDIT OPINION

28 February 2019

Government of Faroe Islands

Update to credit analysis

Summary

The credit profile of the

Government of Faroe Islands (Aa3, stable)

reflects its fiscal

autonomy resulting in a high level of revenue and expense flexibility combined with a track

record of prudent budgeting. The stable and historical relationship with the

Government of

Denmark (Aaa, stable),

with joint matters clearly defined under the 1948 Home Rule Act,

is also credit positive. While the Faroese economy has a high dependence on the fishing

industry, this is somewhat offset by regular fish stock control and a push to diversify the

country's trade partners. The rating also takes into account the government's very strong

liquidity buffer, which mitigates refinancing risk. Debt metrics are on a moderate level but

declining.

Exhibit 1

RATINGS

Faroe Islands, Government of

Domicile

Long Term Rating

Type

Outlook

Denmark

Aa3

LT Issuer Rating - Fgn

Curr

Stable

Please see the

ratings section

at the end of this report

for more information. The ratings and outlook shown

reflect information as of the publication date.

Financial surplus to be reported

Contacts

Harald Sperlein

+49.69.7073.0906

VP-Senior Analyst

[email protected]

Joe Griffin

+44.207.772.1098

Associate Analyst

[email protected]

Sebastien Hay

+34.91.768.8222

Senior Vice President/Manager

[email protected]

CLIENT SERVICES

Americas

Asia Pacific

Japan

EMEA

1-212-553-1653

852-3551-3077

81-3-5408-4100

44-20-7772-5454

Gross operating balance and financing result (in DKK million)

Gross operating balance (in DKK mn.)

1500

Financing result (surplus or deficit) (in DKK mn.)

1000

500

-500

-1000

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018p

2019b

Note: 2018 is preliminary data (Moody's adjusted); 2019 shows budget data

Source: Gjaldstovan; Moody's Investors Service,

Credit strengths

Fiscal autonomy and flexibility allow for reform implementation

Stable relationship with the Kingdom of Denmark

Financing surpluses and large liquidity buffer

Credit challenges

Faroese economy's dependence on fishing and fish farming sector

Moderate debt levels and some off-balance liabilities

Some refinancing risk due to debt structure

FÆU, Alm.del - 2018-19 (1. samling) - Bilag 10: Indberetning nr. 2/2019 fra Rigsombudsmanden på Færøerne, inkl. rapport fra det økonomiske analyseinstitut Moody’s.

MOODY'S PUBLIC SECTOR EUROPE

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Rating outlook

The outlook is stable. This reflects the successful implementation of a long term deficit reduction plan, improved macroeconomic

metrics and a stable relationship with the Kingdom of Denmark.

Factors that could lead to an upgrade

A combination of the following could have positive rating implications: 1) a return to long-term structurally balanced budgets; 2) a

steady reduction in debt to pre-recession levels; or 3) a reduced reliance on short-term borrowing.

Factors that could lead to a downgrade

One or a combination of the following could have negative rating implications: 1) a weakening of the Faroe Islands' relationship with

Denmark; 2) an adverse shock impacting the Faroese fishing industry; and 3) a materially increased debt level or guarantees above

current projections.

Key indicators

Exhibit 2

Faroe Islands, Government of

2014

2015

2016

2017

2018p

Net direct and indirect debt / operating revenue (%)

Gross interest expenses / operating revenue (%)

Gross operating balance / operating revenue (%)

Cash financing surplus (requirement) / total revenue (%)

Intergovernmental revenues / total revenue (%)

104.6%

1.8%

1.4%

-3.8%

12.7%

107.2%

1.6%

4.1%

-1.2%

14.0%

99.8%

0.9%

6.4%

2.8%

14.5%

97.9%

1.1%

11.4%

7.3%

10.0%

89.7%

0.3%

8.5%

2.6%

9.5%

Note: 2018 is preliminary data.

Source: Issuer, Moody's Investors Service; Moody's adjusted figures

Detailed credit considerations

The credit profile of the Faroe Islands, as expressed in an Aa3 stable rating, combines (1) a baseline credit assessment (BCA) of a2, and

(2) a strong likelihood of extraordinary support coming from the Government of Denmark (Aaa, stable) in the event that the entity

faced acute liquidity stress.

Baseline credit assessment

Fiscal autonomy and flexibility allow for reform implementation

The Faroe Islands consist of 18 islands located in the Atlantic Ocean, between Scotland and Iceland with a population of slightly above

51,000 inhabitants. While part of the Kingdom of Denmark, the Faroe Islands are governed by the Home Rule Act, which gives the

Faroese government full powers and flexibility to set its tax rates and fees. This broad control over revenue supports Faroese financial

flexibility; approximately 90% of the Faroese government's operating revenues are derived from sources under its control. The Kingdom

of Denmark provides an annual block grant of around DKK 0.7 billion which accounts for about 10% of the Faroes' operating revenues.

This grant is for “Joint Matters” that have not been transferred to Faroese control. The grant is intended and indeed is spent on social

welfare, schools and health sectors, though the Faroese government does maintain freedom over how the grant is used. The Faroese

government has in the past implemented substantial cuts in spending when required. Unemployment in the Faroe Islands is currently

very low at well below 2%, edging below the Danish national average since the end of 2013. The choice of expansionary spending was

effective at stimulating the Faroese economy. More recently, as the Faroese economy has entered a stage of recovery with dynamic

real GDP growth

of favorable 5% in 2017. GDP per capita has improved substantially and has surpassed the Danish GDP per capita in

2017 (see Exhibit 3) and is expected to have done so in 2018.

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on

www.moodys.com for the most updated credit rating action information and rating history.

28 February 2019

Government of Faroe Islands: Update to credit analysis

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Exhibit 3

Faroese GDP per capita exceeded Danish GDP per capita since 2016

Nominal GDP per capita in DKK thousands, by year

500

Denmark

400

300

200

Faroe Islands

100

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

GDP per capita for the Faroe Islands for 2014-2017 are estimates

Source: Statistics Denmark, Hagstova Foroya (Statistics Faroe Islands)

The government has pledged to deliver certain reforms, including fishing and pension reforms that will enhance and sustain the

government's long term public finances.

The fishing reform was recently implemented, with the Act on the Management of Marine Resources, which was approved by

parliament on 18th December 2017, aiming to foster sustainable management of fisheries, including legal and administrative

frameworks to promote equal rights and wider access to the fish stock while increasing government revenue (see also:

Fishing Policy

Reform - Issuer In-Depth Report, published October 2018).

In addition, pension reforms aim to control public pension liabilities in the medium and long run. All citizens have to pay a certain

percentage of their income into a pension scheme. Contributions will increase every year by 1% until 2026. This means that by 2026,

all citizens will pay at least 12% of their income into a pension scheme

, helping reduce the public pension liability. The government's

pension reform also includes an increase to the retirement age (up to 68 in 2030) as well (currently at 67 years). Beyond 2030,

retirement age is planned to further increase with life expectancy, up to the retirement age of 70 years in 2050.

The Faroe Islands are discussing tax reform and are considering municipal reforms. The islands' 29 municipalities vary widely in terms

of size, from fewer than 50 inhabitants to approximately 20,000. Municipalities vary also widely in terms of financial strength, with

stronger ones including Klaksvikar and Torshavnar. Tax reform and a financial equalisation system similar to that seen in other Nordic

countries could be credit positive

Stable relationship with the Kingdom of Denmark

Although there were discussions about a referendum, we do not see that the current government will put this forward. We understand

that based on what has been discussed so far, there is not a concern about a material change in the relationship with Denmark. The last

general elections held in September 2015 resulted in a Social Democrat led coalition, which sees the link with Denmark as favourable

and public debate surrounding the topic has slowed down. The next election is in August 2019.

The Faroese relationship with Denmark is stable. In 1948, the Faroe Islands were granted Home Rule, and in 2005 it gained further

authority over matters described below. The Faroese control “Special Matters” covering the economy, finances (independence to raise

taxes), industry, foreign trade, mineral rights, and the education system

. “Joint Matters” are administered by the Danish government

according to the laws of the Kingdom of Denmark, although some may be wholly or partly assigned to the Faroe Islands, or undertaken

by Danish and Faroese authorities jointly. Currently, matters under the Danish realm comprise the police force, judicial system and

banking supervision.The Faroe Islands elect their own parliament (Lagtinget) and the islands are governed by the Faroese government

(Landsstyret), which is responsible for their own finances. In addition, the Faroe Islands have two seats in the Danish parliament, which

historically have had some influence in Danish politics, particularly in parliaments with thin majorities.

28 February 2019

Government of Faroe Islands: Update to credit analysis

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Financing surpluses and large liquidity buffer

Based on preliminary figures, the Faroe Islands have reported a favorable gross operating surplus of DKK613 million in 2018, compared

to DKK834 million in 2017. This operating balance amounts to roughly 10% relative to operating revenues, a positive development of

results and considerable improvement from a few years earlier. Given strong operating performance, the government could easily cover

capital expenses and finally report considerable financial surplusses. In 2018, we expect a financing surplus of DKK192 million, which

is DKK500 million lower than the government reported surplus. This is explained by an adjustment made to capital expenses, which

included the write-off of a loan granted by the Danish government. The 2017 financing surplus was DKK537 million (see Exhibit 1).

The rapid improvement of financial performance was the result of dynamic tax revenue growth but also some measures on the

expenditure side of the budget. Meanwhile, the government seeks to cut capital expenditures, following the end of its 2011-2016 fiscal

deficit reduction programme. For 2019, government budget foresees an outcome at slightly above 2018, which we view as realistic (see

Exhibit 1).

The Faroe Islands have a large liquidity reserve, amounting to DKK3.7 billion as of end December 2018 (compared to DKK3.4 billion

in Dec. 2017), which is well above the internal minimum liquidity threshold of DKK2.8 billion. According to internal best practice, this

reserve is only to be used during times of heightened market stress - if the reserve is drawn upon and drops below 15% of GDP, it is

expected to be addressed and again reach internal limits during the next borrowing round. The 2018 liquidity reserve represented

nearly 20% of Faroese GDP. The reserve amount exceeds necessary borrowing requirements in any single year and this mitigates the

refinancing risk associated with their reliance on short term borrowing (see section below). The liquidity pool is sufficient to cover

scheduled debt repayments for the next two years. We expect the government to use its excess liquidity (i.e. above 15%-threshold) to

pay down a part of the DKK1.1 bn. maturing bond in 2019 an only refinance the remaining amount. The fund is invested in a portfolio of

highly rated securities with investments being spread across various assets classes with defined limits in order to maximise the returns.

At least 70% of the total liquidity pool is invested in Aaa-rated securities.

Faroese economy's dependence on fishing and fish farming sector

The Faroese economy continues to rely on the fishing industry with fishing accounting for around 20% of national GDP and for around

95% of total export values of goods. This high exposure introduces economic volatility as the economy is susceptible to exogenous

factors. The variability in fish prices, factor inputs such as oil prices, and the risks of stock depletion would have a direct impact on the

Faroese economy. Over the last years, a combination of high global demand and low oil prices has benefited the Faroese fishing sector,

and indirectly government receipts. In recent years, this has particularly been true for the pelagic and fish farming industries which have

grown substantially and have contributed to the economic growth of the country. However most recently, pelagic fishing quotas are

slightly lower.

On the other hand, the traditional demersal fishing industry (cod, haddock, etc.) has remained stagnant due to low stock levels. Most

recent indicators show however that cod and haddock catches are trending upwards, potentially a result of increasing stocks according

to experts.

To reduce dependencies, the Faroe Islands have also increased trade with non-EU countries, from around one third ten years ago to

more than 50% now. We view the diversification in both fish species and trade partners as a partial mitigant to the concentration risk

as it reduces exposure to species-specific shocks and potential trade sanctions.

Moderate debt levels and some off-balance liabilities

The Faroese government's expansionary fiscal policy following the global financial crisis (2008/2009) has resulted in increased debt

levels. The government largely issued debt to finance large scale infrastructure projects, spending an average of DKK274 million per

year on fixed capital construction between 2012-2017, around 50% higher than the pre-crisis average annual spend of DKK179 million

between 2003-2007. As a result of ongoing financing deficits from 2008 to 2015, net direct and indirect debt as a percentage of

operating revenue was above 100% of operating revenues from 2011 to 2015, but is now on a declining trend.

28 February 2019

Government of Faroe Islands: Update to credit analysis

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Exhibit 4

The Faroese Government's total (direct and indirect) debt portfolio of DKK8.6 billion is made up primarily of direct debt

Total direct and indirect debt in DKK million, 2017

Tunnel debt (indirect debt)

DKK 435

Direct debt: short-term

DKK 833

10%

Municipal debt (self-supporting)

DKK 1,109

13%

Unfunded pension liability

(indirect debt)

DKK 1,038

12%

Direct debt: long-term

DKK 5,144

60%

Note: Tunnel debt and municipal debt is considered self-supporting.

Source: Moody's Investors Service; Issuer

The Faroese government has guaranteed an unfunded pension liability of approximately DKK1 billion under Foroya Livstrygging (LIV)

and this is therefore included in our indirect debt calculations. The previously outlined pension reforms are not expected to impact this

government exposure, which was fully self-funded up to 2008. Since the onset of the financial crisis and the subsequent low interest

rate environment, LIV’s self-funding ratio has fallen below 100%. We will continue to monitor the progress of this off balance sheet

scheme, as it impacts the government's total debt metrics over the long run.

Municipal debt is considered self-supporting as the government does not provide a guarantee on their debt and they may only incur a

total debt burden up to their level of total tax income in any one year.

The Faroese government has provided a minimum revenue guarantee, which exposes the government to construction and operational

risk by underwriting the major infrastructure project that involves two sub-sea tunnels, Eysturoy and Sandoy. The tunnels represent the

biggest infrastructure deal in the history of the Faroe Islands with an expected cost of approximately DKK2.64 billion. (see:

FAQs About

the Sub-Sea Tunnel Plans, Minimum Traffic Guarantee, published 6th March 2017).

The drilling of the Eysturoy tunnel is expected to be

completed in May 2019, which will reduce construction risk.

Despite taking into account the risk of this project during the construction phase, our debt projections now foresee a declining debt

level over the next five years. We treat the debt associated with the tunnel as indirect debt given the government-owned tunnel-

project company and the minimum revenue guarantee. We note the difference in financial viability between the tunnels, with the

future earnings from the Eysturoy tunnel expected to cover the majority of the debt service requirements. The Sandoy tunnel remains

financially non-viable on a standalone basis and once operational will only contribute approximately 10% of total combined income

over the next 40 years.

Some refinancing risk due to debt structure

The Faroe Islands historically had a relatively high share of short-term borrowing. In 2017, the Faroe Islands refinanced at very low

interest rate (on average below 1%) a maturing DKK1 billion loan with long-term new loans

, which we consider to be credit positive, as

it reduces the exposure to interest risk. The government also has rolling short-term creditor debt that is repaid each year.

The Faroe Islands' average maturity of its outstanding debt is relatively low, at a level we consider exposes the Faroes to have some

refinancing risk. However, this has allowed the Faroe Islands to benefit from the low interest rate environment in the recent past.

Current interest rates are still very low. Mitigating the refinancing risk is the Faroe Islands' liquidity buffer currently at DKK3.7 billion or

close to 20% of GDP, which could cover the scheduled repayments coming due over the next few years. We expect the government to

use its excess liquidity (i.e. above 15%-threshold) to pay down a part of the DKK1.1 bn. maturing bond in 2019 and only refinance the

remaining amount.

28 February 2019

Government of Faroe Islands: Update to credit analysis

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Extraordinary support considerations

We consider Faroe Islands to have a strong likelihood of extraordinary support from the Kingdom of Denmark. This reflects our

assessment that the current relationship with the Kingdom of Denmark is unlikely to change in the medium-term and the intensive

extraordinary support provided to the islands in response to the financial crisis of the 1990s.

While Denmark has no formal obligation to provide extraordinary support to the Faroe Islands, it has historically supported the Faroese

government on a number of occasions. In the 1990s, the Faroese government borrowed - largely from Denmark, given the scale of

the crisis - in order to fund the nationalisation of Føroya Banki and Sjovinnubankin and to bridge the deficits of the recovery plan were

established, the Faroese began standalone borrowing, ultimately using these and other reforms' funds to repay Denmark. In 2010,

Denmark (through Finansiel Stabilitet) also assumed control over EiK, a failing bank with operations in both the Faroes and the Danish

mainland. This action is consistent with Denmark being responsible for financial regulation (the banking sector). The relationship with

Denmark remains important as a likely source of liquidity support, were independent financing to be tested.

Rating methodology and scorecard factors

The matrix-generated BCA of aa3 reflects (1) an idiosyncratic risk score of 4 (presented below) on a 1 to 9 scale, where 1 represents

the strongest relative credit quality and 9 the weakest; and (2) a systemic risk score of Aaa, as reflected in the Denmark's Aaa stable

sovereign bond rating.

The assigned baseline credit assessment (BCA) of a2 is below the matrix-generated suggested BCA and the two-notch differential

includes an additional factor. This includes the Faroese industry's concentration on the fishing sector and the islands' small population

size limiting revenue generation.

For details about our rating approach, please refer to

Rating Methodology: Regional and Local Governments,

16 January 2018.

Exhibit 5

Government of Faroe Islands

Faroe Islands

Baseline Credit Assessment

Value

Sub-Factor

Score

Sub-Factor

Weighting

Sub-Factor

Total

Factor Weight

Total

Factor 1: Economic Fundamentals

Economic strength

Economic volatility

Factor 2: Institutional Framework

Legislative background

Financial flexibility

Factor 3: Financial Performance and Debt Profile

Gross operating balance / operating revenues (%)

Interest payments / operating revenues (%)

Liquidity

Net direct and indirect debt / operating revenues (%)

Short-term direct debt / total direct debt (%)

Factor 4: Governance and Management

Risk controls and financial management

Investment and debt management

Transparency and disclosure

Idiosyncratic Risk Assessment

Systemic Risk Assessment

Suggested BCA

4.14 (4)

Aaa

aa3

30%

1.50

97.9

32.3

8.9

1.1

12.5%

25%

4.0

30%

1.20

50%

1.0

20%

0.20

99.5

70%

30%

6.2

20%

1.24

Note: based on 2017 data.

Source: Moody's Investors Service

28 February 2019

Government of Faroe Islands: Update to credit analysis

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Ratings

Exhibit 6

Category

FAROE ISLANDS, GOVERNMENT OF

Moody's Rating

Outlook

Issuer Rating

Source: Moody's Investors Service

Stable

Aa3

Endnotes

The Faroe Islands do not have a GDP deflator. Instead, the Consumer Price Index (CPI) in the Faroe Islands is used to calculate real GDP.

Those persons who already pay 15% or more of their income into a pension scheme will not be required to pay more than what they already do.

See

Nordic Local Governments: Credit quality boosted by support expectation and inherent strengths,

published May 2016.

For more information on the division of tasks, see

Delivery of Faroe Islands' Fiscal Plan Supports Creditworthiness,

published July 2015

for information on outstanding government bonds, see

http://www.landsbanki.fo/en-gb/liquidity-and-debt/debt/national-treasury-bonds

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28 February 2019

Government of Faroe Islands: Update to credit analysis

FÆU, Alm.del - 2018-19 (1. samling) - Bilag 10: Indberetning nr. 2/2019 fra Rigsombudsmanden på Færøerne, inkl. rapport fra det økonomiske analyseinstitut Moody’s.

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28 February 2019

Government of Faroe Islands: Update to credit analysis