In September 2008, Iceland was the first country to be seriously disrupted by the global financial crisis evolving. In a matter of weeks, the country’s three biggest banks collapsed following their failure in refinancing short-term debt and a run on deposits by account holders based mainly in the United Kingdom and The Netherlands. Up till this very day the consequences of Iceland’s banking crisis is being felt by Icelandic investors, as their options to invest in assets denominated in foreign currencies are limited following the capital controls which were introduced in November 2008.
Immediately after the financing problems of Iceland’s banks had come to the fore in August, the Icelandic Krona (ISK) started a freefall. In less than two months time the currency had depreciated by more than 30% versus the euro. Compared to the beginning of 2008, its value had even more than halved. In order to stop the withdrawal of capital from the country and the subsequent slide of the Krona, the government then moved to ban the conversion of funds held in Krona into foreign currency. Later the capital controls were increased to also include any movement of capital into or from Iceland. Though the capital controls were imposed as a ‘temporary measure’ to stabilise the Icelandic economy and the exchange rate of the Krona, they have been in place until this very day.
Involuntary exposure to the domestic economy
As a consequence, Iceland’s wealth managers cannot increase their investments in foreign assets. The country’s pension schemes and insurance companies therefore invest the premiums paid by their members and clients in local equity and debt out of necessity. Their heavy exposure to the domestic economy makes it difficult for local investors to generate returns much in excess of Iceland’s GDP growth, which amounted to 3.3% in 2013.
The Icelandic fund selectors our researcher spoke to still hold about 20% to 30% of their investments in foreign currency. These holdings stem from the period before capital controls were imposed. Iceland’s fund selectors are allowed to move around these assets freely but, as mentioned above, they cannot increase them.
The only thing they can do to weaken the dilution of their foreign investments as a percentage of total assets under management, is reinvesting the returns they generate from their investments denominated in foreign currencies. Consequently, foreign investments have a much larger risk exposure than the rest of their portfolio.
Looking for alpha
As Icelandic investors’ exposure to foreign investments is limited and the large majority of their domestic investments is in fixed income, they go for relatively risky equity exposure in order to add alpha to their portfolios. About a fifth of their foreign currency assets are traditionally invested in private equity. The relative size of their private equity portfolios is shrinking slightly though, as most fund selectors our researcher interviewed are currently channelling the returns they generate from private equity investments into global equities.
Global equities are by far the most important foreign asset class for Iceland’s fund buyers. The fund selectors our researcher spoke to have between 60% and 70% of their holdings abroad invested in the asset class. Two reasons were widely cited for this focus on global stocks. Firstly, the fund selectors said global equities is the only asset class that gives them a reasonable diversification within the equity sphere, because the amount of foreign currency they are able to invest is so limited as a consequence of the capital controls.
Besides that, most fund selectors from the country, which only has a population of some 326,000 people, said they do not have enough resources available to more specific country- or region-based research. Still, a number of them said they widened their equity exposure to emerging market equities recently. Most Icelandic investors also own Nordic equity funds. Investments in equities from the Nordic countries constitute about 10% of their total equity exposure. Iceland traditionally has strong cultural and economic ties with the other Nordic countries. Therefore Iceland’s fund selectors know this market well, and feel relatively comfortable in investing there.
Source of frustration
For all of Iceland’s fund buyers, the capital controls which have been in place for 5.5 years now are a tantalising frustration. They have all witnessed equity markets in the US and Europe rising over the past two years, but haven’t been able to capitalise on that. Though they understood the reasons behind the capital controls, they feel they have already been waiting for far too long a time for the controls to be lifted or even eased.
But so far Iceland’s central bank has not been willing to accommodate them. It points out the combined Krona assets held by foreigners amount to 30% of GDP and could rise to 50% of GDP if the assets of Iceland’s failed banks that are held by foreigners are collected in full. As a consequence, it feels capital controls cannot be lifted without jeopardising economic and financial stability. It fears abolishing the restrictions on capital flows would result in massive capital outflows, sink the exchange rate and drive inflation up. The central bank decides together with the Icelandic Ministry of Finance how and when the capital controls will eventually be lifted, but when and how this will eventually happen remains a mystery.