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Are Scandinavian Banks Sucking the Blood of the Baltic States

Monika POŠKAITYTĖ


This autumn, the name of Poland was resounding in economic publications all across the world – the country has nationalised half of the assets present in private pension funds, transferred these assets to its balance sheet and announced having reduced the public finance debt that amounted to 52 percent of the gross domestic product (GDP). The only thing that has been left for Polish fund managers is to search for justice at courts of law, but discussions with regard to the stopping of contributions to the second-pillar funds are not only rising in this country.


Since 1999, the Polish pension system has been based on dual pension accumulation: one portion of employees' salaries and wages was measured out and went to the Social Insurance Institution (Zakład Ubezpieczeń Społecznych, ZUS), and another portion mandatorily went to a private fund which could be selected by the taxpayer himself (a third pillar for retirement accumulation also exists, but it's not popular in the country). Given such a system, pension funds soon became a rather powerful player: according to the data of the Polish Financial Supervisory Authority (Komisja Nadzoru Finansowego, KNF), before the moment of the latter reform they had a bit more than 16 million participants, and the total value of the funds had reached approximately 86 billion U.S. dollars, or almost one fifth of the country's GDP.


Investments of the Polish pension funds were strictly controlled: up to 40 percent of the contributions could be invested in regulated-exchange equity securities, up to 10 percent – in regulated over-the-counter equity securities, up to 40 percent – in debt securities, up to 10 percent – in closed-end mutual funds' certificates, bank deposits and bank securities, and up to 15 percent – in open-end mutual funds' securities. The most important thing is that 95 percent of all investments had to be made inside the country. This system had considerably contributed to the development of the Warsaw Stock Exchange, since domestic companies were given an opportunity to increase their capital by selling equity and debt securities as well as by enhancing the capital market's liquidity. However, the Court of Justice of the European Union declared in 2012 that Poland's requirement to invest within the country violates the European Union's (EU) principles of free movement of capital. To put it more simply, a state that releases in accordance with the mandatory procedure a portion of the pension contributions to private funds cannot control where this money is invested so strictly.


If no control is permitted, then take it away


When control became impossible and the public finance deficit was menacingly approaching the limit of 55 percent of GDP, the Poles were not too modest and in September, 2013, announced that as of the February of 2014 approximately half of the funds' value, or approximately 37 billion U.S. dollars, were going back to ZUS's accounts. Requirements to invest in the country will soften – it is planned that 10 percent of the funds' value will be allowed to be invested abroad as of July, 2014, and by 2016 this limit should gradually reach 30 percent – however, the funds will no longer be mandatory and advertising thereof is intended to be prohibited. Who would like to become a participant of a fund whose money can be nationalised at any time if you can choose and aren't assailed by any advertisements? Although the latter measures are just in the stage of active discussions, it is obvious that they pose a threat to private funds. Hence, it's not strange whatsoever that fund managers called the government's decision anti-constitutional and intend to search for justice at courts of law.


The benefit of such drastic decisions of the Polish government is also raising discussions. According to critics, a populist argument that the money appropriated from the funds will be purportedly used to fill in the ZUS's hole also means that Poland, having suspended the growth of its debt, will be able to borrow in the international market, and one or another injection into the economy before the elections, which are to be held in 2015, might seem quite attractive to the politicians. On the other hand, committing the funds to invest inside the country was beneficial to the Warsaw Stock Exchange, which has not responded to the new policy course very well – by a drop of 5 percent and by a reduction of the growth forecast for 2013 from 2.2 down to 1.5 percent. However, even if the politicians have just populistically made use of the situation, the main problem in this story does not change: if a private player is willing to take a share in the tax funds with the state, but is not willing to represent national interests, there exists an extremely high probability that the state will be adversely predisposed towards such a player. It is obvious that the problems faced by Poland's ZUS require a long-term structural solution, and debts could be reduced by, for example, tightening the possibilities of earlier retirement. But it seems that it's easier to tell the electorate that it is the funds that are to be blamed for the ZUS's debt.


How to plug those leaky pockets?


Structural state-pension problems also happen to be encountered by the Baltic States. The state pension system that is currently operating there was already created in the world at the beginning of the XX century and is simply not adapted to today's current issues of the demographic situation. Therefore, the countries that follow it must over time either extend the retirement age or raise taxes, or apply both measures.


In the meantime, when Latvia and Estonia are extending the retirement age and are increasing contributions to private funds, Lithuanians had to decide by the end of November, 2013, as to whether they would like to accumulate for their pension in the second-pillar pension funds as previously, to return to SODRA (State Social Insurance Institution), or to voluntarily add 1 percent (from 2016 – 2 percent) to the second-pillar pension fund's contribution and to additionally receive 1 percent off the average wage (from 2016 –2 percent respectively) from the state to the second-pillar fund's account. It's all very simple if not for the fact that at the beginning of October, the Prime Minister's adviser on financial matters, Mr. Stasys Jakeliūnas, also proposed to halt contributions to the second-pillar pension funds from January, 2014, whatsoever, then to undertake SODRA's reform and only then to consider where and what accumulation proportions should go. "My argument is that if the second pillar is to be funded from SODRA, which has a huge debt and a continuous deficit, the funding itself and the second pillar are financially unsustainable", said Mr. S. Jakeliūnas.


If Lithuanians opt for the larger accumulation, it is likely that the sum of 1.3 billion EUR that is currently present in the second-pillar pension funds will substantially increase. In Estonia, already today, employees born after 1983 must become participants of the second-pillar pension fund, so the size and power of Estonian funds will be increasing in the future as well. Besides, according to the data of the Organisation for Economic Cooperation and Development (OECD), Estonians are inclined more than Lithuanians or Latvians to opt for a risky investment strategy – 75 percent of the participants of the second-pillar pension funds in Estonia go for an investment strategy that is more oriented towards stocks and not towards bonds. Fuel is also added to the fire by the fact that borrowing under Basel III requirements will become more expensive and more complicated, so it will be increasingly more important for companies to attract funds within the market. Companies can do that by way of initial or secondary public offerings, but that requires a developed capital market, and the Baltic States cannot boast of such. Their stock market capitalisation is very small: according to the World Bank's data of 2012, in Lithuania it reached 9.4 percent of GDP, in Latvia – 3.9 percent of GDP, and in Estonia – 10.7 percent of GDP. For comparison: the OECD average – 71.8 percent of GDP and the EU average – 43.1 percent of GDP.


The second-pillar pension funds of all the three Baltic States presently possess 3.6 billion EUR, part of which could enliven the Baltic States' stock exchanges and help attract more foreign investors. In this context, it is obvious that where and how the money present in pension funds will be invested should be of concern not only to the state or fund participants, but also to the business that seeks domestic investments as well as to the fund managers themselves.


Today, less than one third of the funds present in the Baltic States' pension funds stays inside the country where those funds were collected. It should also be kept in mind that the data presented includes both stocks and bonds, so in reality, at each country's stock exchange there settles a much smaller amount of the pension funds' money. For instance, according to the data of the Bank of Lithuania, barely 0.5 percent of the total pension portfolio value is invested in the stocks of Lithuanian companies.


Own money is closer to the pocket


Such a situation is to be explained in this way: firstly, the small markets of the Baltic States are characterised by a rather low liquidity, so when a somewhat bigger amount of stocks needs to be sold there arises a risk of facing a fluctuation in stock prices. However, this argument is questionable, since one of the reasons why the market is shallow is that pension funds do not invest in it. Secondly, the stocks of domestic companies are not very attractive to the funds because such investment is risky; it requires a lot of supervision and it still does not guarantee better investment results. Hence, investments in the stocks of domestic companies would increase costs for fund managers, but, as fund managers themselves maintain, there is no evidence that this would allow the generation of higher returns. Thirdly, it has been talked for quite a long time that the amount of funds present in the Baltic States' pension funds is just too small that it would be worth it for their head offices in charge of main decisions to reconsider any investment directions of the Baltic States' funds. Though today these funds already amount to over 3 billion EUR, and the amount is only going to grow.


The most interesting thing is that Scandinavian banks, which barely leave 30 percent of the pension funds' money in the Baltic States, are more inclined to leave their citizens' money in their own country. For instance, according to the data of OECD, Norway's second-pillar pension funds only invest abroad 26.8 percent of the funds' value, whereas Sweden's biggest pension fund "Alecta" likewise invests 54 percent of the funds in Sweden. More than 73 percent of the fund money is left by the Danes in their own country as well – their pension funds are considered one of the most successful in Europe. However, unlike in Poland, the state here is not planning to regulate funds' investments. According to Mr. Søren Dijon, Chief Economist of one of the biggest Danish pension funds, funds and strong trade unions that have existed in Scandinavia for decades are operating on the principle of collective insurance agreements, and if one collective entity brings a considerable amount of money into a fund, it can most legitimately raise requirements for the investment directions of that amount. Therefore, Danish funds not only leave a large portion of their funds inside the country, but are also intensively financing start-ups and strategic projects. Whereas Estonians, who have opted for a riskier– a larger share of stocks – investment strategy, instead of investing in domestic start-ups and refining their image as a country of technologies, are allocating a big portion of funds, alas, not to Estonian companies.


Political and investment populism


When it comes to attracting funds accumulated in the second-pillar pension funds, the issuance of bonds worth 20 million EUR by the Latvian "Latvenergo" company at the beginning of the year 2013 could be mentioned as a successful example. The decision to raise funds for strategic projects in this manner proved to be successful: 25 buyers were interested in the bonds, among which – pension funds as well, and the price of the bond issue reached more than 42 million EUR. It is planned that "Latvenergo" will issue bonds worth 70 million EUR in total, and for the money received it will modernise production facilities, distribution and transmission networks.


Namely the funding of strategic projects, according to the experts of the Bank of Lithuania, is one of the directions along which the Baltic States' fairly young pension funds could and should move. However, we must acknowledge that pension funds controlled by Scandinavians, at least so far, are moving very slowly with investing funds in the Baltic States. And this turns out to be the main reason why a young and poorly developed Baltic financial market is growing old and does not evolve.


Most weird is that fund managers' arguments – logical or not very much, which should justify their reluctance to invest in the Baltic States' markets, actually fail to explain why, regardless of the rapid growth of these countries' economies, they deem that it is not worth investing here.


One of the arguments is really related to a high risk: should investments be made in the Baltic States, the risk of bubble formation would grow, and consequently, more attention would need to be devoted to risk management and to the efforts of solving the long-lasting problems that are troubling the pension system. Alas, one patently noticeable effort is the focus on saving the pension funds' income and not the pursuit to ensure the quality functioning of the entire system. Such a standpoint from the pension fund managers is no less populist and irresponsible than that of politicians who also avoid solving long-lasting systemic problems, but who can very easily propose fixing the systemic holes of the pension system at the expense of the funds.

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