Foreign investment-related flows are not the only determinant of exchange rate movements, however; foreign exchange transactions for trade in goods and services also have a strong impact on the FX market. The pension funds’ transactions are a factor as well, although they usually have a much milder short-term impact than the aforementioned factors do.

The pension funds made an agreement with the CBI to keep their net FX purchases at a minimum from April through September 2020, as can be seen in CBI data on the funds’ FX market activity. The pension funds stepped up the pace again over the course of autumn 2020, but notably, they sharply reduced their FX purchases in the final weeks of the year, and in December their net purchases were negative. Presumably, this is because some of the funds’ foreign assets were close to their internal benchmarks in the wake of steep share price increases abroad (and probably exceeded the benchmarks in a few cases), which would have necessitated portfolio rebalancing before the year-end. The relatively rapid ISK appreciation towards the end of 2020 was due in part to this shift in FX market activity.

In 2021 to date, the pension funds’ net FX purchases have been relatively stable, averaging just over ISK 6bn per month – apart from June, when they bought ISK 10bn more than they sold.

As is well known, Iceland’s year-2020 trade balance was more favourable than was widely feared after the collapse of tourism revenues. But it is well to bear in mind that recorded goods and services trade and FX market flows are not necessarily equal quantities. For example, transactions with ships and aircraft are seldom accompanied by commensurate FX flows, as purchasers generally own enough foreign currency to cover a portion of the purchase, and any financing they obtain will take place largely outside the FX market. Furthermore, some services revenues and expenses are recorded rather erratically, even though the flows themselves are steady. Examples of this include December 2020 and April and July 2021. On the whole, however, flows relating to goods and services trade have probably been slightly negative since early August, as the sizeable goods account deficit and Icelanders’ growing zest for travel have more than offset revenues from foreign tourists.

The CBI has successfully smoothed out exchange rate volatility

In recent quarters, the CBI has intervened nimbly in the FX market, mitigating short-term market volatility quite effectively. In 2020, for instance, the bank sold EUR 830m in excess of its purchases. Most of these sales took place in the autumn, when pressure on the ISK was greatest. At that time, the CBI embarked on a regular FX sales programme in order to offset the shortage of tourism-generated FX revenues and deepen the market, maintaining its ad hoc intervention policy throughout. The depreciation of the ISK a year ago would probably have been much steeper, in fact, had the CBI not intervened in this fashion.

In 2021, the FX market has been better balanced, reducing the need for large-scale intervention by the CBI. The bank discontinued its regular EUR sales at the end of April, but since then it has intervened in the market on both sides so as to smooth out short-term fluctuations. In June, for instance, the bank bought EUR 124m in the market, as FX inflows were strong at the time, and since then it has both bought and sold EUR, changing its tack as the wind shifts in the market.

The flows described above can be summarised as follows:

The chart shows clearly that from the onset of the pandemic until the present, CBI intervention has largely mirrored flows relating to new investment, external trade, and the pension funds’ FX purchases. Actually, it can be inferred from the chart that in certain months – June 2021 is a good example – the bank has concentrated its intervention on the side of the market where flows were strongest. But it is worth noting that the flows from each of these contributing categories can occur at various times within any given month; furthermore, actual FX flows may not equal the amounts recorded under these categories in CBI accounts.

A managed float, past and future
In our opinion, the overall picture is that not only has the CBI’s intervention deepened the market and mitigated short-term volatility, but it has also smoothed out medium-term fluctuations in the exchange rate. Therefore, as the chart shows, the CBI’s foreign reserves have continued to reflect underlying FX flows stemming from external trade and capital transactions, as they have for most of the past decade.

To put it succinctly, the CBI’s FX market transactions have a dual purpose at present:

• They mitigate intraday volatility in the market, deepen the market, and prevent spiral formation, as limited flows can cause outsized exchange rate movements within a single day or over a short period of time.
• They are an element in a monetary policy regime referred to by CBI executives as a managed float. A managed float does not entail aiming at a given exchange rate or attempting to decouple the market from underlying economic developments; instead, it involves softening the links between them, reducing the impact on the exchange rate, and thereby smoothing out fluctuations in inflation and the real exchange rate.

The Governor of the CBI has said repeatedly that he wants to ensure that households and businesses can “take the ISK outside the parentheses” in their planning and decision-making. It is difficult to interpret those words otherwise than to mean that the CBI will continue to lean against FX market currents to some degree, especially when flows become unusually one-sided, as they were in the mid-2010s and in the wake of the pandemic.

ISK appreciation in the cards further ahead

The FX market appears to have achieved a temporary balance in recent weeks, with the EURISK exchange rate in the neighbourhood of 150. The CBI appears to be reasonably satisfied with that exchange rate despite current inflationary pressures. Presumably, the bank takes the view that if the ISK were to strengthen in the immediate future, the tourism industry would suffer for it, and the economic recovery expected for next year could be put in jeopardy. Consequently, we consider it a given that the CBI will continue to mitigate exchange rate volatility in both directions until export-generated FX inflows firm up.

It looks as though H1/2022 will be a watershed in this regard, however. Iceland’s biggest capelin season in nearly two decades lies ahead, and the outlook is for a swift increase in tourist arrivals over the course of the winter and spring. In our opinion, the ISK will ultimately appreciate, and next year CBI could find itself in the same position as in the mid-2010s: buying significant amounts of currency in the FX market so as to contain the appreciation of the ISK and shore up its net FX reserves once again. In the end, a stronger ISK will pull inflation downwards without the CBI’s having to manhandle the exchange rate.

In our recent macroeconomic forecast, we project that in 2023, the ISK will be approximately 10% stronger than the 2020 average, with exchange rates of EURISK 140 and EURUSD 120, or thereabouts. Although it should be unnecessary to repeat the old adage that it is all but impossible to give precise predictions of currency exchange rates, it is difficult to ignore the fact that Iceland’s strong external position, a favourable outlook for the current account balance, widening interest rate spreads, and foreign investors’ modest Icelandic securities holdings all point in the same direction: that a stronger ISK is in the offing. The question is therefore not if it will happen, but when and how much, and to what extent the CBI will respond by intervening in the FX market and topping up its reserves.