After an episode featuring large-scale sales of foreign exchange from its international reserves, the CBI has once again started topping up its FX holdings. As of this writing, the bank has bought currency for at least EUR 115m in June, with only transactions for the last day of the month still to be added to the data. As the chart shows, the vast majority of the purchases took place between 16 and 22 June. Presumably, the trades are related to inflows from foreign investors’ purchases of domestic securities, and the CBI wanted to temper the rise in the exchange rate and prevent spiral formation in the FX market.
Central Bank reverses course in the FX market
The Central Bank (CBI) has started buying foreign currency in the market again recently, on the heels of a selling spree during the height of the pandemic. Although the bank has sold nearly a billion euros from its international reserves in recent quarters, to support the foreign exchange market and the ISK exchange rate, the reserves remain ample. It will probably buy large amounts to replenish the reserves in the coming term.
Intervention: planned and impromptu
June was the second month since mid-2020 to see the bank buy currency in the market, the first instance occurring only a month earlier, in May, when it bought EUR 15m. Between mid-2020 and mid-2021, however, it had sold currency to the tune of nearly a billion euros in two types of transactions:
- Ad hoc intervention in which the bank responded to temporary flows in the market in order to deepen it and mitigate short-term exchange rate volatility. This included a few transactions executed in consultation with specific parties, as the CBI Governor noted at a press conference last autumn.
- The bank’s regular currency sales programme. Last September, the CBI announced plans to sell euros in the market on a daily basis in order to deepen the market and improve price formation. From mid-September through the end of March, the bank sold EUR 3m each business day. In April it scaled back to EUR 3m three times a week, and at the end of April it discontinued the programme altogether.
The peak month for market intervention was October, when the bank sold EUR 234m. At that time, the then-largest owner of ISK-denominated Treasury bonds was closing out its position, so in essence, the CBI indirectly sold this party most of the foreign currency needed to execute the trades. After this was done, the bank steadily reduced its FX sales. From the beginning of the year, the regular sales programme constituted the vast majority of CBI currency sales, and since the end of April the bank has not sold any currency in the market.
At the peak of its activity, the bank was a prominent presence in the FX market, accounting for nearly 54% of total trading in Q4/2020. The CBI’s share of market activity eased steadily in early 2021 – until June, when it accounted for 44% of total trading.
In our opinion, the bank’s intervention in the FX market has been highly successful. Were it not for the CBI’s hand on the rudder, the ISK would probably have depreciated markedly in the autumn. This would very likely have exacerbated the uncertainty facing the private sector, pushing inflation even higher and bringing on the usual inflation-related disruption. Furthermore, a lower exchange rate would have been of less benefit to exporters than in a normal environment, as Iceland’s largest export sector lay in a medically induced coma and other export sectors were best by a variety of constraints.
The precedent for large-scale FX trading
As the chart indicates, there is a precedent for the spate of FX market activity over the past year or so. In 2016, for instance, the CBI accounted for approximately 54% of market turnover. It should be noted that the interbank market reflects only a portion of foreign exchange transactions in the financial system. Each of the commercial banks tries first to match its customers’ trades internally, and only when imbalances between supply and demand become excessive do they go to the interbank market.
Although some observers doubtless thought the CBI was overdoing it by selling so much currency after the pandemic struck, the bank had a hefty nest egg to draw on after several years of bolstering the reserves. Between 2014 and 2018, it bought over EUR 6.3bn. At the beginning of 2020, the gross International reserves came to EUR 6.1bn, and net of the CBI and Treasury’s FX debt they totalled EUR 4.7bn.
At the end of May, they amounted to EUR 5.7bn (gross) and EUR 3.3bn (net). So the CBI has used a relatively small portion of its reserves to support the FX market and prevent the ISK from plunging during the pandemic. Now that the pandemic is hopefully on the wane, tourist arrivals are increasing, and foreign investment in domestic securities are likelier than not to rise, we expect the CBI to be an active participant on the buying side of the FX market.
Stockpiling on the horizon once again?
In our macroeconomic forecast from May, we discussed the CBI’s reserve management activities, positing that the bank’s FX market activity had mitigated both the appreciation of the ISK in the mid-2010s and the depreciation episode of the past couple of years. We projected that the ISK would continue to strengthen through end-2023. As we see it, the situation is returning to where it was in the mid-2010s, when the bank’s hefty FX purchases went hand-in-hand with the appreciation of the ISK. We hope, however, that the CBI’s share in the FX market will be more modest in the coming term than it was during that episode. The recent amendments to the regulatory framework for derivatives transactions involving the ISK and other currencies – essentially allowing such transactions up to specified levels without requiring that they be used for hedging purposes – should help with this.