When it became clear that the COVID-19 pandemic and the responses to it would deal a body blow to the economy, it was equally clear that the Government would have to take aggressive countervailing measures and apply countercyclical economic policy in order to cushion against the blow to the extent possible. The big picture was clarified considerably with the publication of the fiscal budget proposal for 2021 and the fiscal plan for 2021-2025.

The fiscal plan shows that financing the next few years’ budget deficit and servicing existing Treasury debt will require ISK 1,431bn over the next five years. Assuming that current creditors will be willing to roll over most of the existing debt, as is likely, the remainder – which the Treasury must raise between now and the middle of the decade – will be just over ISK 900bn, nearly a third of estimated year-2020 GDP. Where in the world can such an amount be found?

IL Fund

Fortunately, there are indeed deep pockets in many places, both in Iceland and abroad. One such can be found at Arnarhváll itself, next door to the Ministry of finance, where IL Fund is currently located . This is a legacy institution from the publicly run Housing financing fund that was shut down at year-end 2019, and manages its balance sheet (mostly CPI-indexed mortgage loans) while it is being run down. The Treasury intends to borrow ISK 95bn from the Fund this year and another ISK 95bn in 2021, but no further borrowing from that source is expected after next year.

The Central Bank

The Central Bank (CBI) has declared itself willing to buy Treasury bonds for as much as ISK 150bn in order to keep long-term interest rates lower than they would be otherwise. This is similar to the measures taken by central banks the world over, which have embarked on large-scale indirect money printing of this sort in the recent term. Some of them, in fact, never stopped the money printing spree that began with the onset of the financial crisis a dozen years ago. Others have rebooted their money printers with the advent of the Corona Crisis and are running them at full tilt while they can.

If the CBI utilises the scope available to it for Treasury bond purchases, it will be the source of one out of every six ISK in new financing over the next five years. But it has stayed its hand thus far, and its bond purchases to date come to less than ISK 1bn. Given how much long-term bond market yields have risen in recent months, the CBI surely must be gearing up to take action sooner rather than later.

Pension funds

The pension funds have long been reliable buyers of Treasury bonds. The most recent data show that their Treasury bond holdings totalled ISK 345bn at the end of August. But that amount has been virtually unchanged since 2017, while the pension funds’ total assets have grown by about ISK 1,900bn over the same period. Treasury bonds currently account for 6.3% of the pension funds’ total assets, the smallest share in a decade. In this context, it is also worth noting that in the past decade, the pension funds’ holdings in Housing Financing Fund (HFF) bonds – which in most respects are the equivalent of Treasury bonds – have declined markedly as a share of total assets. As the custodians of the majority of Icelanders’ long-term savings, it is fitting that the pension funds should be involved in financing these countercyclical efforts, as it will ultimately be in the best interests of their clients to keep the downswing from being excessively deep and long-lasting.

Financing from the pension funds could be structured in two ways: first, with Treasury bond purchases, which have hitherto been the Treasury’s main way to obtain capital from the funds; and second, with participation in project financing, where individual large projects are financed separately. This is mentioned in the fiscal plan, where it is pointed out that this option could be suited both to State-funded projects and to public-private partnerships. It would be a sensible way to finance the Sundabraut project or other large infrastructure projects where investment costs and operating costs can be separated fairly easily from general public expenditures.

Mutual funds

Domestic mutual funds held Treasury bonds and bills in the amount of ISK 134bn at the end of August. Although such funds will not play a key role in the financing of the new debt overhang, it can be assumed that they will be involved to some degree, in line with the trends in Icelanders’ saving behaviour.

Foreign capital

Foreign investors could participate in Treasury financing in three ways:

• By buying króna-denominated bonds
• By buying foreign-denominated bonds
• Through lending from multinational credit institutions.

It would probably be most favourable to spread financing efforts over all three of these options.

Foreign investors have at times been prominent holders of króna-denominated Treasury bonds, but their holdings are currently limited. According to the most recent figures from Government Debt Management, non-residents held ISK 72bn worth of ISK-denominated Treasury bonds at the end of August, and if recent reports in the media are any indication, these holdings have shrunk quite a bit since then. In comparison, non-residents held nearly ISK 111bn in Treasury securities at the beginning of 2019.

For foreign investors, there are two main factors that determine whether ISK-denominated Treasury bonds are an attractive option: the interest rate differential between the ISK and major currencies, and the ISK exchange rate. Both of these factors should make Treasury bonds quite appealing once pandemic-related uncertainty starts to recede. For example, the yield on 10-year US Treasury bonds is currently 0.8%, and for 10-year German bonds investors pay nearly 0.6% in negative returns. When this is compounded by the argument that the ISK probably has some room to appreciate once tourism recovers, the calculus should start to look reasonably favourable for those foreign investors that are willing to invest in small currencies.

Furthermore, the Icelandic Treasury is considering issuing foreign-denominated bonds and using the proceeds to finance deficit operations. In recent years, the currency obtained through such issues has been held in the CBI’s international reserves, and the Treasury currently holds the equivalent of about ISK 220bn in such deposits with the CBI. It would be possible to tap these deposits to some degree, and presumably, the authorities are considering issuing foreign-denominated bonds and converting the proceeds to ISK. In addition to the purchases themselves, both of these options would boost the supply of foreign currency in the market and could therefore support the ISK exchange rate. Given that the authorities seem to think the ISK is on the weak side and further depreciation detrimental, it could be appropriate to embark on such financing sooner rather than later.

Asset sales

An investment initiative like the one being planned will significantly expand the assets side of the Treasury balance sheet. It could therefore be sensible to divest a few other assets instead of relying entirely on debt financing during a period of deficit spending. The fiscal plan notes that it could be effective to cover a portion of the financing need by selling the State’s holdings in the banks later in the term of the plan. The book value of the Treasury’s share in the two banks was entered in the 2019 Government accounts at ISK 340bn, an amount that would quickly make a difference if the holdings were sold by the middle of the decade.

Financing challenges ahead

It will be a considerable challenge for the Treasury to obtain credit financing in the next few years, but not an insurmountable one, as the analysis above indicates. On the other hand, if credit financing is not to become that much more complex and costly, there is little room for error. It is therefore vital that the authorities do not deviate from their goal of reining in Government operations again once the Corona Crisis has passed. Preferably, they should try to rebalance them sooner than is currently planned.