Iceland's economic recovery is inflating domestic asset prices as capital controls persist. And the consequent lack of investment opportunities is restricting pension funds' room for manoeuvre, writes Nina Röhrbein

While the euro countries in southern Europe continue their daily struggle with austerity measures and debt repayments, things are looking up for their most northwestern European neighbour, Iceland.

The country's banking crisis of 2008 led to the collapse of its domestic financial markets and a sharp devaluation of the Icelandic króna.

But by late 2010, the economy had stopped contracting and in August 2011, the IMF programme was completed.

GDP grew by 3.1% in 2011, according to Statistics Iceland, and is projected to grow by 2.5% in 2012, according to the Central Bank of Iceland, and by 2.4% in both 2012 and 2013 according to the OECD.

The improving scenario can be attributed to the devaluation of the Icelandic króna, the boom in tourism and fisheries and the fact that foreign exchange-rate linked loans of households such as mortgages were ruled illegal by the Supreme Court and recalculated as Icelandic loans with the lowest non-indexed interest rate from the Central Bank of Iceland, all of which has boosted household income and consumption. In addition, the government extended and increased the withdrawal limit for private third pillar pension assets to just over ISK6m (€36,000) and until October 2012.

In February 2012, the rating agency Fitch upgraded Iceland's long-term sovereign credit rating from speculative to investment grade rating, from BB+ to BBB-, following on from S&P, which maintained its BBB- rating, but revised its outlook on the country from negative to stable in November 2011.

In March, Iceland repaid obligations of $443.4m (€337.3m) to the International Monetary Fund (IMF) almost a year ahead of schedule. The early payment equates to about one fifth of the $2.1bn the country borrowed from the IMF in a stand-by arrangement from 2008, which after another early payment in February is projected to be repaid during 2012-16.

"The Icelandic economy has shown several signs of improvement but still lacks positive indicators on a few major parameters," says Thorey Thorðardottir, managing director of the Icelandic Pension Fund Association. "The unemployment rate, for example, now stands at 7.3%, which is still well above historical numbers over the past 30 years. And with 6.3% inflation over a rolling 12-month period, inflation is higher than the central bank's target of 2.5%. Nevertheless, the county's trade surplus is positive and helps in rebuilding the currency reserve."

"There are positive factors such as the strong improvement in the fiscal deficit that has been tackled quite successfully," agrees Ólafur Ísleifsson, assistant professor at the School of Business at Reykjavik University. "But the investment level is at a historical low, inflation, which measured 6.4% in the first quarter of 2011, is significant and of course tax increases enacted to combat the fiscal deficit, are less than conducive to growth."

According to Björn Ásgrímsson, pension analyst at the Icelandic Financial Supervisory Authority (FME), based on the levels of contributions going into the second pillar pension system - a minimum of 12% of the total salary - a full recovery is not yet under way. He points out that while contribution levels have improved slightly they are not yet back at the same levels they were in 2007.

One pension fund that has experienced higher contribution levels is Stapi, the scheme for blue-collar workers in the north and east of Iceland.

"Payment problems have been decreasing and we have lower rates of non-performing securities and loans," says Kári Arnór Kárason, managing director at Stapi Pension Fund whose funding level has improved to 94% currently. "Payment problems are at a historical low in our fund."

The biggest obstacle in the way of faster recovery and free flow of money between countries now appears to be the currency controls. "The lack of investment opportunities and currency controls are the biggest issues on the pension funds' agenda today," says Thorðardottir.

The capital controls were introduced by the Central Bank of Iceland in 2008 to restrict currency outflows. And it is the fear of further devaluation of the króna - if controls were lifted it is feared foreign currency would flood out and króna in - that keeps the capital controls in place for now.

In fact, the controls were even tightened in March to stop outflows of payments from government bonds on due maturity debt.

As part of the removal of the controls on movement of foreign currency, the Central Bank of Iceland has held foreign exchange auctions in which it has purchased foreign currency in exchange for Icelandic krónur to be used for domestic, long-term investment, and in which investors can participate.

But the capital controls and the collapse of the stock market in 2008 severely limit the menu of investments available for the pension funds.

"The currency controls prohibit Icelandic pension funds from increasing their foreign asset exposure, which makes their investment set smaller and less diversification possible," says Thorðardottir. "This is why the entire pension industry is forced to look domestically for investment opportunities. Pension funds are trying to hedge their index-linked liabilities through any secure index-linked paper available on the market although issuance from the government and municipalities is now limited."

But Stefán Jóhann Stefánsson, editor at the governor's office at the Central Bank of Iceland, points out that new domestic investment is unrestricted, and the sale proceeds of such investments are exempt from the restrictions on foreign exchange transactions and export.

"Firms that can demonstrate that they have at least 80% of their revenues and expenses abroad may apply for a broader exemption that includes foreign borrowing," says Stefánsson. "Interest and dividend payments are exempt from restrictions on foreign exchange transactions and export. And it is permissible to apply for exemptions. In processing the applications, consideration is given to the interests of the party in question and the impact on stability."

Because of the amount of capital wanting to leave Iceland, the restrictions need to be lifted gradually over the coming years with some side constrictions to stop the pressure on the króna.

By law, they are scheduled to be lifted by the end of 2013 - however, many market participants believe this to be overly optimistic.

"The plan for the dismantling of the capital controls is somewhat lofty without any real definite dates," says Ísleifsson.

With their hands tied by the restrictions on foreign investments, Icelandic pension funds mainly invest in domestic government bond, municipal bonds, cash accounts, members' mortgage loans and to a limited extent in domestic listed and unlisted equity.

Government-issued bonds made up 43% of the asset allocation of Icelandic second pillar pension funds at the end of 2011, according to the FME, and together with municipal bonds almost half of the asset allocation.

Stapi's exposure to government bonds has increased from 20% in 2008 to 55% today. But according to Kárason there is not much left in this sector.

"It is riskier now too so we do not intend to increase our allocation to government bonds further this year," he says. "We are looking for alternatives and deploy money in other areas, such as real estate, the corporate sector - both bonds and equities - and infrastructure. There is a limited supply of quality opportunities but they are increasing and when we deploy money in these areas we try to do it cautiously."

"If government issuance is going to decrease, we need to get more alternative investments," says Sigurður Gudjon Gislason, a fund manager at Iceland Funds, responsible for the private pension of VIB, the asset management division of Islandsbanki. "We need more listings on the stock market, bonds issued both from the banks and corporates or something else to fill that gap."

But the supply of municipal bonds is not growing. Cities and towns need to deleverage so the only issuance expected from them in the near future is when they need to restructure or refinance.

"Hopefully, we will get a supply of corporate bonds in the near future," says Gislason. "Today the corporate market is going through the banks and the banks have just started issuing a small number of covered bonds, both indexed and non-indexed. The major interest from pension funds is on the indexed part of the covered bonds with a lifetime of 5-25 years."

With an average allocation of only 25-30% to foreign assets and a lack of access to alternative investments and growing funds, it is difficult for Icelandic pension funds to generate their guarantee of 3.5% real return in the current low interest rate environment.
"But this year the foreign stock market has risen considerably, while the króna has depreciated," says Gislason. "Both boosted the returns of pension funds."

Diversification is difficult and of less importance to Stapi at the moment.

"We have one priority at the moment and that is not to lose money," says Kárason. "We trade our portfolio more actively than we have done in the past and are looking for tangible assets such as private equity vehicles to generate the guaranteed rate but so far the process has been slower than we expected it to be. The private sector is still heavily indebted, which is why some debt needs to be taken out and be replaced with equity. Initially it should be done with private rather than public equity but the Icelandic Pension Fund Act limits our exposure to private equity. More private equity would speed up the restructuring process in the private sector where companies are not yet ready for listing. But politicians think this would be too much of a risk. They do not understand the risk that comes from only being able to invest in low-yielding government bonds."

Some pension funds are invested in the Icelandic Enterprise Investment Fund (FSI), a special purpose vehicle, which invests in companies that were in difficulties after the crisis but have potential to list on the stock market.

"It is a good vehicle to have in the current environment because many distressed companies needed restructuring and that extra step before listing or going into the bond market," says Gislason.

Currently eight companies are listed on the main Icelandic Stock Exchange, while four are listed on the alternative exchange First North.

The Iceland Stock Exchange expects another 10 companies to be listed by the end of 2013. Seven of them have already publicly announced their intention to list.

But Kárason says: "We have been slightly disappointed in how aggressively the listed companies have been priced so far. Because people expected more activity in the Icelandic stock market, there is money on the sidelines that is destined to go into equities, although there is limited upside in the companies already listed. These are mainly companies taken out of restructuring by banks that are now being sold. The banks are trying to maximise their recovery on those companies but we are reluctant to get exposure to those. If you want to build up the market you will have to leave some value for the equity buyers to come in."

In general, companies listing on the stock market are welcomed by pension funds despite the fact that 95% of the stock market was wiped out in 2008. But due to the lack of opportunities, worries about a bubble forming in domestic equities and real estate but particularly government bonds are emerging.

"Icelandic pension funds are stuck with a large portion of their portfolio in the scope of Icelandic investment and therefore we see a little bit of an asset bubble in Iceland, especially in the government bond market," says Gislason. "It has also started to drift into the Icelandic stock and real estate market. In the popular areas of Iceland, property has risen by 10% although we are still some way off a problematic asset bubble."

"We have to remember that the real value of residential property has fallen by 30% since 2008 and with rising employment figures and increasing purchasing power it is only natural for prices to rise," adds Kárason. "In commercial real estate, there is more talk than real price movements despite plenty of interest. There is also a risk that the prices of equities, which are in very limited supply, will rise - however, compared to government bonds they are relatively inexpensive. The only real bubble going on is in the government bond sector, which, as we are locked in by the capital controls, could last for a while."

Since the financial crisis, risk management has played a bigger role in the day-to-day activity of pension funds in Iceland. In December, the first risk management guidelines for Icelandic pension funds were issued by the FME in order to enhance the risk perspective on their balance sheet. The rules are being implemented throughout 2012 and expected to be fully functioning by the fourth quarter. 

The new risk guidelines have generally been well received. But they have had little impact on Stapi, as the pension fund already complied with most of the rules.

And so, as the country emerges from the ashes, its pension fund landscape may start to look different.

The vast majority of Iceland's pension funds are DC schemes, some of which have had to cut benefits due to the financial crisis. This sets them on collision course with the DB schemes for government and municipal workers, which although more severely underfunded than their DC counterparts, left the pension rights untouched, a move that has been highly criticised.

There has also been some talk about taxing pension contributions rather than taxing pensions when they are being paid out.

"This would change the set-up of the pension funds," says Gislason. "With income tax at about 40% their total assets would shrink considerably and annual nominal growth would be lower in the near future. The need for new investments would then decrease."
Over the last few years, some pension funds have merged. And industry insiders expect more mergers of the country's 33 pension funds, as smaller schemes in particular struggle to follow all the regulations.

"There is still talk about merging all the pension funds into one," says Kárason. "This is possible but would have a major impact on domestic capital markets and I cannot see a fund like that functioning unless it is prohibited from investing in Iceland. Instead of having a limit on what we can invest in abroad, we should have a limit on what we are allowed to invest in domestically."

Ísleifsson warns of the dangers of channelling such a high proportion of pension assets into government debt: "All of this disguises the big threat hanging over the Icelandic pension system. The general labour market pension system is built on the accumulation of funds but the limited menu for new investments available to pension funds today - with government paper dominating the selection - only serves, if unintentionally, to transform the funded, second pillar system into a pay-as-you-go system."