There is no end in sight to capital controls, despite the government’s tentative first steps towards easing the restrictions that have been in place since 2008, writes Carlo Svaluto Moreolo

Iceland has moved a step closer to the removal of capital controls that prevent domestic investors from moving assets out of the country. This July, the finance ministry announced that it had contracted international advisers to devise a plan to lift the controls.

However, no timetable has been set, nor any specific information revealed.

Pension fund managers are realistic that reverting to the pre-crisis state, with free movement of assets, may take years. In the meantime, they are left to deal with the diversification conundrum.  

Kári Arnór Kárason, managing director of the ISK143bn (€926m) Stapi pension fund, describes the situation as a “staring contest” between the country’s political class, financial industry, and the foreign owners of assets belonging to collapsed Icelandic banks. 

The programme for the removal of capital controls was announced in 2011 but, so far, activity has focused on rebuilding the country’s capital markets while keeping economic indicators – particularly the value of the currency – in check. 

Last summer the government said it had hired lawyers Cleary Gottlieb Steen & Hamilton LLP and UK consultants White Oak Advisors, as well as Johns Hopkins University professor and former IMF deputy Anne Krueger, to work on the plan for the removal of capital controls. A committee of four Icelandic executives is working with the firms to provide local expertise. 

This September, the ministry released a progress report, saying that the advisers and the committee were “working closely towards an overall solution which would include all aspects of the capital controls” and that they will “deliver specific proposals on options of their removal”.

The ministry said the work of the advisers focuses on “the macroeconomic conditions for removal of controls and granting of exemptions”.

The report added the central bank has requested that the question of ‘speed limits’ on the increase of pension funds’ foreign assets is examined. 

The establishment of capital controls after the 2008 financial crisis meant pension funds could not shift assets out of the country but were still able to reinvest abroad income from foreign assets. 

The Icelandic Pension Funds Association estimates that with capital controls still in place, pension funds need to re-invest 22.4% (around ISK9bn) each year to maintain their current proportion of foreign assets, provided that the exchange rate remains constant.

The association considers the ideal proportion of foreign assets in pension funds’ portfolios to be between 40% and 50%.

However, the financial community recognises that in the current environment, given the volume of non-ISK assets and liabilities held by the failed banks, it would not be safe to let pension funds shift assets out at once. 

Marinó Tryggvason, chief investment officer at the ISK132bn Frjalsi pension fund, says that the essential condition for the removal of capital controls is strong, sustainable economic growth – and that kind of growth is going to be export-led.

Meanwhile, restricting the movement of assets poses a threat – the creation of asset bubble. Icelandic financial markets seem to have dodged the bullet so far, as there are no signs that asset prices are unreasonably high. 

The government has taken steps to monitor the level of systemic risk in the economy. In October, the Systemic Risk Committee held its first meeting. The committee, which will meet quarterly, is tasked with “assessing the current situation and outlook for the financial system, systemic risk, and financial stability in Iceland”. 

But the danger persists, and according to Gunnar Balvdinsson, managing director of the ISK138bn Almenni pension fund and chairman of the Icelandic Pension Fund Association, institutional investors can do their bit to keep it at bay. “Pension funds can reduce the likelihood of [an asset bubble] by investing gradually and by selecting investments carefully”.

However, Baldvinsson says the association has made the point that “pension funds should be first in line to invest abroad to increase asset diversification in the system” once the capital controls are lifted. 

After the crisis, pension funds were called upon to participate in the reconstruction of an economy that had been built around an overinflated banking sector. They pumped money into the country’s capital markets relatively quickly, but capacity may be tightening. 

Sara Sigurðardóttir of FME, the Icelandic financial supervisory authority, says: “Pension funds’ investments have had an impact on other large investors as well. But they are such large investors that they tend to hold on to their assets, and as a consequence we do not see much turnover in the stock market.” 

The result, adds Sigurðardóttir, is that asset prices are not developing as they should. 

Iceland’s competition commission has warned pension funds about the impact on competition between listed companies, says Sigurðardóttir.

But the biggest challenge, according to Baldvinsson, remains investing in a closed economy and diversifying between asset classes and sectors as much as possible.

In the quest for diversification, pension funds have turned their attention towards private equity and infrastructure.

Given the circumstances, Baldvinsson argues, it is essential to invest in infrastructure projects and companies that are exposed to foreign markets and thus capable of generating foreign cash flows. 

Baldvinsson still sees opportunities in the Icelandic stock market as well as the energy sector, given Iceland’s “unique position in the production of green energy”.

Tryggvason of Frjalsi says his fund is seeking private equity investments in Icelandic companies that generate revenue from trade with foreign entities. 

In theory, there is no shortage of opportunities. “The pipeline is very healthy now. The blueprints are there and the projects should come to market in five to six months”, says Tryggvason.

Most of the blueprints involve metal and IT operations. Investors are trying to leverage the cost of energy, which is cheaper in Iceland compared with Europe. The possibility of listing the companies in five to 10 years adds to their attractiveness.

“The big question is, however, whether these projects will be profitable”, says Tryggvason.

Kárason of Stapi notes that, while there is a real need for private equity and infrastructure investment, the number of actual deals has been small.  

The scarcity of deals is not only linked to economic uncertainty. It is also due to the limits that pension funds face on exposure to unlisted assets, in which pension funds can only invest up to 20% of their portfolios. 

Kárason believes such regulatory restrictions have added to the industry’s woes. He explains: “Many funds, including us, have participated in private equity deals in Iceland. There is still a huge need for investment in the unlisted corporate sector in the country, and that is the part of the market where growth is most likely to be strong. But investment has been lower than it could have been and should have been.”

Such limits clash with one of the lessons learnt from the crisis, which is the importance of diversification within pension fund portfolios: “If we did not have foreign assets before the crisis, I don’t think we would have a private pension fund sector right now,” adds Kárason. 

In order to attract pension funds’ assets to the unlisted sector, some specialised funds have been set up for such investments and they raise capital by issuing listed bonds, which Kárason says can create cashflow mismatches.

The restrictions on unlisted assets are being reviewed. A committee has been formed to propose changes to the pension fund law that sets those limits, although there has not yet been agreement. 

This adds to issues Iceland has to deal with, not all of which are financial. Kárason says: “It’s no longer an economic crisis. Now it’s more a political crisis – the politics of Iceland has yet to recover. We really do not know if the political class has the courage to lift the capital controls, which will lead to uncomfortable experiences.”