Is the ISK at equilibrium?

The foreign exchange market has been well balanced in the past month, the ISK has been stable versus the euro, and interbank market turnover has been extremely limited. Although it is difficult to say how long such stability will last, there are strong grounds for the assertion that the ISK exchange rate is currently at a level that should contribute to balanced FX flows in the quarters to come.

The EURISK exchange rate has been virtually unchanged for nearly a month. At the close of business on 12 June 2019, a euro cost ISK 141.5, the mid-rate in the interbank market, and as of this writing (11:00 hrs. on 11 July), it costs ISK 141.8. Day-to-day volatility has been all but absent in the interim, and interbank market turnover has been negligible. Apparently, then, interbank market participants’ FX flows are well balanced at the moment, given that the market’s role is to smooth out intraday differences in FX supply and demand in the market.

Participants in the market conduct trades with euros and krónur, and this activity determines the EURISK exchange rate in the market each day. Other currencies’ exchange rates versus the ISK are then determined by the aforementioned movements in the EURISK exchange rate and fluctuations in those currencies’ exchange rate versus the euro.

As is mentioned above, there has been extremely limited trading in the FX market since 12 June, and the EURISK exchange rate has hardly moved over those 20 business days. According to figures from the Central Bank (CBI), there were two trades in the combined amount of EUR 4m on 13 June, one trade amounting to EUR 2m on 26 June, and another EUR 2m trade on 8 July, for a total of only EUR 8m over the entire period.

Although the FX market was quite a bit livelier during first third of June than it has been in recent weeks, total trading volume was very low during the month as a whole. Total turnover was EUR 70m (ISK 9.8bn) in June, the smallest single-month total in EUR terms since May 2018. The obvious interpretation of these figures is that FX market inflows and outflows have been in good balance over the period.

How strong is the ISK actually?

In 2019 to date, the ISK has fallen by about 3% versus a basket of major trading partner currencies, and in the past twelve months it has fallen by over 12%. Export sectors have welcomed the depreciation, as it makes manufacturing sectors’ more competitive and makes Icelandic prices more tolerable for foreign tourists. The ISK exchange rate is now at around the 2016 average.

According to newly published data from the CBI, the real exchange rate in terms of relative consumer prices averaged 91 points in Q2. The real exchange rate is a measure of how expensive or competitive a given country or currency area is in comparison with others. It is calculated by adjusting the nominal exchange rate to account for differences in the relevant countries’ or currency areas’ wage costs or price levels. The real exchange rate is calculated as a unitless index, and its value as such means little unless placed in historical or international context.

Just like the nominal exchange rate, the real exchange rate of the ISK has fallen markedly in the recent term, as price developments in Iceland have not differed so radically from those in trading partner countries, even though average inflation has indeed been somewhat higher in Iceland. In the past two years, the real exchange rate has fallen by nearly 12%, so it can be said that as regards the general price level, Iceland is a correspondingly less expensive destination.

But is the real exchange rate “low enough” to support exporters and truly offset supply shocks such as WOW Air’s collapse and Icelandair’s Boeing 737-Max troubles?

As the chart shows, the real exchange rate of the ISK is somewhat above its long-term average. But in our view, given the magnitude of the changes taking place in the Icelandic economy over the past decade, such a historical measure can be misleading. For instance, Iceland’s international investment position has changed radically and is now at its best in the history of the Republic. External assets currently exceed external liabilities by about one-fifth of GDP. Other things being equal, this should lead to a higher equilibrium exchange rate, as net financial income from abroad should, over time, prove to be a windfall if the situation remains as is or improves further.

Our rough econometric assessment suggests that a 10 percentage point improvement in Iceland’s net international investment position (NIIP) relative to GDP could coincide with an approximately 0.5 percentage point improvement per year in the current account balance relative to GDP, absent other changes. And it just so happens that this accords nicely with the simplified long-term assumption that returns on net external assets should be around 5%. To reiterate: this is a substantial simplification, and a large number of other factors affect the equilibrium real exchange rate. But it cannot be denied that a change in the NIIP from being negative by more than half of GDP in 1995-2005 (to take an example predating the banks’ expansion) to being positive by about 20% of GDP (the current level) has a major impact on our ability to maintain higher living standards than we could otherwise.

To make a long story short, we think the current nominal exchange rate reflects a real exchange rate consistent with well balanced external trade. The equilibrium in the FX market should therefore come as no surprise, although to be sure, it is impossible to predict when the situation will heat up and the ISK’s Pax Romana will come to an end. In our opinion, the probability distribution of such future exchange rate movements is broadly symmetrical.


Jón Bjarki Bentsson

Chief economist