Icelandic Financial Market Digest 09. ágúst

Publisher: Íslandsbanki Research • Resp.Editor: Ingólfur Bender

ISK still cruising in calm waters

The exchange rate of the Icelandic króna has been quite stable in recent quarters, even though most of the capital controls have been liberalised and the Central Bank (CBI) has held itself aloof from the foreign exchange market. Although volatility increased at the peak of the summer, the ISK has continued to fluctuate within a relatively narrow range, and there are no clear signs of a trend towards either appreciation or depreciation.

According to newly published CBI figures on foreign exchange market activity in July, total turnover amounted to ISK 12.2bn,  less than a third of the total for July 2017. This is most likely because the three commercial banks that constitute the interbank foreign exchange market (together with the CBI) have to a large extent been able to pair their customers’ FX purchases and sales internally.

ISK largely unaffected by newfound freedom

Even though short-term fluctuations in the ISK exchange rate increased in July, and volatility was at its greatest since September 2017, the exchange rate was broadly the same at the month-end as at the beginning. The ISK has shown no visible upward or downward trends in recent quarters; in fact, the average exchange rate has moved within a range of about 7% since August 2017. It should be noted as well that the CBI done no FX market trading at all in 2018 to date. Until mid-2017, CBI intervention accounted for a significant share of FX market turnover, and it mitigated the exchange rate volatility that would doubtless have been much more pronounced over that period.

To a large extent, we attribute this relatively unexpected stability to three interlinked factors:

  1. FX inflows and outflows have been well balanced in the recent term. There is still a surplus on the current account, and inflows due to inward foreign direct investment (FDI) were strong earlier in the year. On the other hand, outward FDI has also been considerable. In addition, investment flows appear rather sensitive to movements in the ISK exchange rate. A temporary appreciation dampens foreign investors’ interest in buying domestic securities and stimulates domestic investors’ interest in investing abroad, and a temporary depreciation has the reverse effect.
  2. There are still considerable restrictions on movement of capital between currencies and indirect foreign exchange transactions in Iceland. For instance, the CBI’s so-called capital flow management measure places tight restrictions on non-residents potentially interested in investing in ISK-denominated bonds or deposits. Furthermore, derivatives trading is permitted only for hedging purposes, limiting the range of opportunities for speculation.
  3. Increased confidence in the Icelandic economy — as a result of a vastly improved international investment position, reduced public and private sector debt, improved credit ratings, and other factors — prompts investors to be more patient with short-term fluctuations and therefore reduces the likelihood of capital flight.

There was discernible tension among FX market participants about whether the exchange rate would change substantially this summer, and in what direction. In recent years, the period from June until early winter has been a lively one in terms of exchange rate movements, as the chart above indicates. The summer uptick in 2015-2016 was largely due to surging inflows caused by the rapid growth of tourism and financial institutions’ attempts to reduce their foreign exchange imbalances. As yet, however, there are no strong indications that the exchange rate will move significantly from now until early winter, although it is always wise to remember that currency exchange rates can defy expectations, and FX market conditions can change at short notice.



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