Everyone is wondering what the future holds for Iceland. In the spring, a pair of surprise interest rate hikes had many investors worrying, but since then it appears that the situation has grown steadily worse. On June 4, the Organisation for Economic Co-opeation and Development (OECD) said that an Icelandic recession was “imminent” and forecasted a GDP of -0.4 per cent for 2009.

The OECD report stated: “Economic growth is projected to fall sharply and unemployment to rise markedly. Following a large depreciation of the exchange rate, inflation is likely to soar this year but fall subsequently as this effect passes.” Geir Haarde, the country’s prime minister, shot back that he was not convinced a recession was certain, pointing out that one of the government’s main objectives was to avoid negative growth.

There are enormous question marks over how its pension funds will react to soaring interest rates, a sluggish currency and a fading economy. Early indications suggest that the solution could be in both emerging markets and alternatives, and that in the coming months Icelandic pension funds will be flocking to these assets. The OECD recommended that the authorities keep monetary policy restrictive, accumulate foreign exchange reserves and continue to strengthen bank supervision.

Stefan Halldorsen, chief executive officer for the €300m Engineers’ Pension Fund, believes Icelandic funds will put more effort into tactical asset allocation to respond to the short-term crisis. This would include more attention and possible allocation increases to some fixed income products, equities and alternatives and a general move away from structured products.

He said: “There’s increasing pressure to move abroad, but the weak currency makes it expensive. But we will once the local inflation goes down.”

Diversifying away from a heavy reliance on domestic bonds has been a slowly emerging trend. Asgeir Thordarson, head of the Nordic region at Fidelity, believes it makes a lot of sense for Icelandic funds to diversify into other asset classes and into more foreign assets.

“It carries a relatively high risk to invest all pension assets in such a small economy. The regulatory environment has held pension funds back, but it is slowly liberalising. Going forward, I think Icelandic pension funds will have the same opportunities to invest in foreign assets and alternatives as elsewhere,” he said.

While it is still prudent to have a large allocation to Icelandic government and corporate bonds, Mr Thordarson thinks pension funds should be looking abroad for equities.

Meanwhile, the €1bn Stapi pension fund is moving towards a more defensive strategy by increasing its allocation in cash. While the fund has also increased its fixed income and absolute return assets and cut equities, its way forward is decisively low-risk.

The fund’s managing director, Kari Karason, believes that, while the economy may slow down, the state is strong enough to get through it. However, he did voice concerns about a protracted recession and indicated that 2008 would be a tough year.

The country’s pension fund association (IPFA) has acknowledged that scheme returns are down markedly from previous years, which typically posted double-digit figures. While the organisation remains optimistic, it does recognise that the investment climate is challenging.

Hrafn Magnusson, managing director at the IPFA, said: “The actuarial position of pension funds will be very good, but it’s too early to predict the actuarial position in the end of this year. The current investment climate has not been very good for pension funds in the last couple of weeks and the situation is still very unstable.”

Iceland’s central bank is giving out mixed signals. It recently issued new rules on the foreign exchange balance for financial institutions that decreed that an institution’s foreign currency assets and liabilities can not exceed 10 per cent of its assets. Under the previous regime, this ceiling was 30 per cent.

However, it has given no hint that an interest rate cut is on the horizon, making it clear that its main concern is inflation. In a statement, the bank said: “It is of paramount importance that a short-term burst of inflation not be allowed to generate a spiral of rising wages and prices and a falling [Icelandic] krona.

OUR VIEW

After a decade of booming growth, it is only natural that Iceland experiences a correction along with the rest of the world. This will be a particularly challenging period for pension fund managers, with a run of new mandates and allocation changes expected. Fortunately, Icelandic funds did not go overboard in the boom years, so they are well funded and in good condition to handle a recession.

But it is the government that is to blame here, and it is the government that should act rather than the pension funds. However, it has nowhere to hide. The obvious move would be cutting its sky-high 15.5 per cent interest rates, but with inflation at an 18-year high of 12.3 per cent there is little room for manoeuvre. Furthermore, with a currency that is losing its clout, not as much help can be found outside the country.

A modest cut in interest rates would be a good start. Something is needed to kickstart the economy, and a 25 to 50 basis point cut could help while not making inflation significantly worse. Besides, with interest rates already extremely high, inflation should not have much higher to go. But the government should take a long look at itself. Interest rates over 15 per cent do not happen overnight. The Icelandic government should look back at how this all happened and learn from its mistakes.

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