Iceland is in trouble. Its currency is in freefall and the credit markets have dried up. Worse still, the Central Bank of Iceland refuses to change its monetary policy while interest rates sit at a startling 13.75 per cent. It believes a tight policy is necessary to sort out the credit markets – the opposite approach of the Federal Reserve and Bank of England – and, despite investor demand for a Valentine’s Day rate cut on February 14, the bank failed to deliver.

But the market is getting used to bad news. Icelandic banking giant Kaupthing recently pulled out of a deal to acquire NIBC, citing “instability in the financial markets”. Then Moody’s Investors Services said it was leaning towards downgrading practically every major Icelandic bank, including Kaupthing, Glitnir and Landsbanki.

Perceptions of instability

Kimmo Rama, vice-president and senior analyst at Moody’s, says: “Moody’s has concerns with regard to the Icelandic banks’ market-sensitive business model, in which the majority of income is derived from investment banking and corporate banking-related activities. Given the difficult market conditions going forward, this could bring additional volatility to the bank’s earnings in 2008. Indeed, the banks’ Q4 2007 results were already significantly affected by adverse market conditions.”

Landsbanki and Glitnir’s pre-tax profits in the fourth quarter of last year were down by more than 50 per cent compared to2006. However, if the banks are worrying, they are certainly not showing it.

Magnus Bjarnason, executive vice-president for international banking at Glitnir, says: “Obviously there is a difficult economic situation in the world today and we feel it is important that everyone involved understands the situation and reads it. We have every reason to believe companies and the government will react in the right way. If you look at the history of Iceland’s economy, it has been very flexible and has shown it can adjust quickly to these situations.”

Worse than ever before

However, Icelandic pension funds are not as encouraged. While they admit their situation could be a lot worse, Stefan Halldorsson, chief executive officer for the e300m Engineers’ Pension Fund, says it is facing more volatility than it has ever seen.

He says: “I would say that the primary challenge for a fund like ours is the volatility and big swings in fluctuations in our main asset classes. We have seen both domestic and foreign equity fluctuations while the Icelandic currency has been very volatile.”

Much of this sentiment is shared by Kari Karason, managing director of the e1bn Stapi pension fund. In his opinion, 2008 will be a difficult year. He says much of problem has to do with inflation, the global credit crunch and a depreciating Icelandic krona.

He says: “We have reduced equity holdings both internationally and domestically and gone more into absolute return strategies, mainly diversifying away from equities. From the beginning of the year, we are close to zero in performance, which, given the circumstances, is okay.”

Poor timing

Both men agree that now is a good time to make investments in fixed income, but believe that, with the state bank about to lower interest rates, the window to do this could be closing. An imminent rate cut is not expected, but cuts are broadly expected by spring.

Mr Halldorsson says: “I think that Icelandic industry and families cannot live with these kinds of interest rates for a long time, though, temporarily, it can be justified to fight inflation. But, over the long term, they have to go down. The likelihood of a change this month is one in three, but it’s more likely they will remain on hold for longer. Inevitably, they will come down in the spring. Sometime during the next three or four months, it must start.”

However, the delays in cutting rates or taking proactive measures to fight a slowing economy have been widely unpopular with many asset managers. One fund manager based in Reykjavik has accused the government of incompetence.

Speaking on the condition of anonymity, he told nrpn: “They are idiots. Instead of finding an answer, the politicians claim that nothing is wrong and that things must continue as they are. But now they have to cut rates or credit markets will completely dry up.”

Other possible measures to boost the economy concern regulation. Currently, Icelandic pension funds are prohibited from direct investments in real estate. All investments have to be domiciled in OECD countries or come from a recognised stock market. Equities and alternatives have 60 per cent and 10 per cent maximum allocations respectively, and any excess assets over liabilities have to be returned to scheme members by either bonuses or increases in monthly payments.

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