Iceland’s Economy, Financial Markets and Pension System

Már Gudmundsson Chief Economist, Central Bank of Iceland* North European Pensions & Investing Summit Stockholm, May 30-31, 2002 * Views expressed are mine and do not necessarily reflect the views of the CBI

Plan of the presentation

 The economy and financial markets: A summary  The pension system  Pension fund assets: Developments, composition and foreign investment  Current developments

Iceland is small but rich

 Iceland has a population under 300 thousand, a GDP amounting to 8½ b. USD, a foreign exchange market with a daily turnover of only 50 million USD and a stock market capitalisation around 1/10 of a moderate size US company  GDP per capita (PPP) 2000: around US$ 28 thousand, or eighth among OECD-countries.

Economic structure

 Diversified economic structure and foreign trade  Fishing sector: No. 6 in the world in terms of net exports. 10% of GDP and around half of foreign exchange earnings  Extensive hydro and geothermal energy resources  High labour participation rates (77% on average) and a flexible labour market

Figure 4.2

Breakdown of GDP by indus try in 2000 Other 9.1% Government services Finance, insurance, real estate etc.

T ransport and communic.

Fishing and

10,1%

10.1% 1.8% industries 12.9% water supply 4.9%

8,9%

8.9% Commerce

Source:

National Economic Institute.

A typical industrialised service economy apart from the size of the fishing sector

Financial markets

 Internal capital market liberalisation around the middle of the 1980s and capital movements free in the middle of the 1990s  Traditional markets exist but are small  Forex: Daily turnover of 50 m. USD (2001)  Money: Daily turnover of 20 m. USD (2001)  Bond: 6.2 billion USD (end 2001)  Equity: 4.1 billion USD (end 2001)

The bond market

 Major issues (>5 yrs) are linked to CPI  Majority government guaranteed 

Most liquid issues

are housing bonds (state guaranteed)  10 liquid bonds - state funded market making agreements in place to provide liquidity and transparency  Duration between 2 to 13 years – most liquid issues 8 and 13 years dur.



Real

yields between 5 and 6%.

The Icelandic bond market at end of 2001 in millions of USD

Total size: 6.2 b.USD. Thereof government guaranteed 3.7 b.USD

The equity market

 Fast growing during the 1990s  Leading index: ICEX 15  5-10 liquid companies  Greatest market value is in financial institutions

Equity listed on the Iceland Stock Exchange 1991-2001

Number of companies 60 % of GDP Market capitalization % of GDP Number of companies 45 80 60 30 15 40 20 0 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

An organised equity market was born in the 1990s with market capitalisation going from almost zero to over 50% of GDP (from 2 to 72 companies)

The problem of ageing

 Smaller than among most developed European countries:  Younger nation  High labour participation rates of the elderly  Mandatory membership of fully funded pension funds (at least 10% of wages)

The pension system

 The Icelandic pension system is developing according to the three pillar principle: – A tax financed and means tested public pension, – A mandatory membership in occupational pension funds – A free individual pension saving with tax incentives  43 fully operational pension funds: Thereof 13 with employer’s guarantee and 30 without, but with a high degree of risk sharing between members

Net assets of pension funds

100 % 80 Percentage of GDP Percentage of total assets of the credit system 60 40 20 0 1965 1970 1975 1980 1985 1990 1995 2000

Pension fund assets are predicted to be at least 1½ times GDP in the middle of this century

Pension fund assets ( 2nd pillar) as a percentage of GDP in EU and EFTA-countries 1998 % 140 120 100 80 60 40 20 0 Luxembur g ItalySpain Nor way Gr eece B elgi um France and Port ugal Aust ria Ger many Denmar k Ir eland Sweden Icel and UK Swi tzerl Net and herl ands

Source

: EFRP.

Iceland is fourth among EU and EFTA-countries

Legislation and investments

 Total foreign exchange risk: 50% of assets  Ceiling for equity, municipality bonds, bank bonds and other bonds is 50% for each class of assets  10% ceiling for unlisted securities (with conditions)  Individual credit risk: 10% of assets, 15% of the stock of a single company and 25% of shares in mutual or equity funds

Housing (33. 9%) Composition of pension fund assets 1990 and 2001 1990 Fund members (21. 8%) Financial institutions and mutual funds (23. 6%) 2001 Housing (22. 6%) Fund members (11. 4%) Other (15. 1%) Financial institutions and mutual funds (21. 2%) Other (21. 9%) Equity and equity funds (1. 2%) Equity and equity funds (27. 3%) The shares of lending for housing finance and direct lending to pension fund members have fallen but the share of investment in equity has increased very significantly ….

15 10 5 0 25 % 20 Share of foreign assets in pension fund postfolios 21.2% 1.9% 1995 2001 … and the share of foreign assets has taken a jump

Net real rate of return on pension assets fund 1991-2001 1 4 1 2 1 0 4 2 8 6 0 -2 -4 % 1 9 9 1 7 1 9 9 2 1 9 9 3 7 ,6 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 7 ,4 ?

1 9 9 9 2 0 0 0 2 0 0 1 Returns have become more volatile with a bigger share of equity and foreign assets

The pension funds are big players in domestic financial markets (2001)

 P.f. assets equivalent to 34% of the zise of the credit system (13% in 1980)  44% of the stock of marketable bonds  Hold around half the stock of housing bonds  P.fs. owned domestic equity and shares in equity funds amounting to 11% of the size of the organised equity market

Outlook for the pension funds

 Reforms in the late 1990s: – Comprehensive legislation on pension funds – Reorganisation of public sector pension funds – Tax incentives for private pension saving  Not major changes ahead: – The challenge of earning satisfactory return for rapidly growing funds in a less favourable environment – Mergers and bigger funds

The economic boom is over and the big current account deficit is shrinking rapidly

Output gap and inflation 1991-2002

4 3 2 1 0 -1 -2 -3 -4 -5 % of GDP Output gap (left-hand axis) Inflation (righ-hand axis) % 9 8 2 1 0 7 6 5 4 3 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 The overheating is turning into a slack, leading to a reduction in inflationary pressures

-3 -4 -5 -6 5 4 3 -1 -2 2 1 0 General government financial balance % of GDP Structural Actual 1994 1996 1998 2000 2001: Estimate. 2002: Projection.

Sources:

National Economic Institute, Central Bank of Iceland 2002 Government finances were consolidated during the upswing but a small structural deficit is currently emerging

Monetary policy

 Interest rates were increased during the upswing and the exchange rate appreciated  The current account deficit, inflationary pressures and worse growth prospects created significant pressures on the exchange rate from the spring of 2000  Iceland adopted inflation targeting and floating exchange rate on March 27th 2001

Inflation targeting



2½% long run target (2003)



±1½% tolerance limits



Higher tolerance ceilings 2001 and 2002: 6% and 4½%

The nominal effective exchange rate of króna January 1998 - May 2002 (end of month) 1 100 105 110 115 120 125 130 135 140 145 150 Dec. 31 1991=100 Fluctuation limits (abolished in March 2001) Exhange rate Inflation target J M M J S N J M M J S N J M M J S N J M M J S N J M M J S N 1998 1999 2000 2001 2002 Iceland abandoned exchange rate targeting at the eleventh hour and went on an inflation target under very difficult conditions on March 27 th 2001

Exchange rate volatility 12-month moving average 0,8 % 0,7 0,6 0,5 0,4 0,3 Daily volatility (left-hand axis) % 4 3 2 0,2 0,1 Monthly volatility (right-hand axis) 0,0 J M M J S N J M M J S N J M M J S N J M M J S N J M 1998 1999 2000 2001 2002 1 0 Exchange rate volatility increased considerably

Central Bank inflation forecast 10 10 8 8 6 6 4 4 2 2 0 0 -2 -2 50% confidence interval 75% confidence interval 90% confidence interval CPI Inflation target Lower tolerance limit Upper tolerance limit 10 10 8 8 6 6 4 4 2 2 0 0 -2 -2 2001 2001 2002 2002 2003 2003 But the imbalances were finally contained and inflation is currently falling rapidly

12 11 10 9 8 5 4 7 6 % 1999 Central Bank Repo- rates Jan u ary 5 , 1 9 9 9 - May 2 2 , 2 0 0 2 | 2000 | 2001 | The CB has therefore started the process of interest rate cuts

12.0

11.5

11.0

10.5

10.0

9.5

9.0

8.5

8.0

7.5

% J Long-term nominal treasury bond yields Daily data 5 yrs. to maturity Latest: May 24 1½ yrs. to maturity F M A M J J 2 0 0 1 Á S O N D J F M A M 2 0 0 2 Nominal bond yields have also fallen along with lower inflationary expectations and lower CB rates. The slope of the nominal yield curve reflects confidence in lower inflation.

6.5

% 6.0

5.5

5.0

Yields on indexed long-term bonds End of month Latest: May 24 4.5

4.0

15 year treasury bonds Housing bonds 3.5

J M M J S N J M M J S N J M M J S N J M M 1999 2000 2001 2002 But real interest rates have remained high

The equity market 31/12 ’97 =1,000 1,900 1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 ICEX-1 5 ICEX-MAIN To tal sh ares tu rn o v er 2001 40 35 30 25 20 15 10 5 | 2002 0 2000 | The equity market has recovered. ICEX-15 has inreased by 30% from its low in late summer 2001 and by 11% in 2002.

Some useful websides

 The economy: – – – Central Bank of Iceland: www.sedlabanki.is

National Economic Institute: www.ths.is

Statistics Iceland: www.statice.is

 Financial markets: – – For foreign investor: www.bond.is

Iceland Stock Exchange: www.vi.is

– Financial Supervisory Authority: www.fme.is

 Pension funds: – National Association of Pension Funds: www.ll.is