The stability of the ISK in the face of the past few years’ sizeable current account deficit stems from several factors. Trade-related foreign currency flows have been far more favourable than might have been surmised at first glance, as a large share of the current account deficit was financed directly by non-residents. Furthermore, last year’s buoyant peak tourist season affected the FX market more than it would have otherwise because such a small share of the summer’s FX revenues were sold in forward contracts. Moreover, the pension funds bought only modest amounts of currency in 2025, and companies borrowed reasonably large sums in foreign currency.

We have recently discussed fluctuations in the ISK relative to currencies in neighbouring countries, and in that discussion we came to a conclusion similar to the one expressed by officials from the Central Bank (CBI) in recent weeks: The ISK serves its purpose as a floating currency better than it did in the past, and its fluctuations do not stand out in comparison with the patterns seen in neighbouring countries.

The real exchange rate is high

The nominal ISK exchange rate has been rising gradually in the recent term, and at the same time, wages and prices have increased far more quickly in Iceland than in trading partner countries. This has caused the real exchange rate to rise considerably during the period in question. A more detailed explanation of how the real exchange rate is calculated can be found on the Central Bank website, but to encapsulate, the real exchange rate is a calculated variable where changes in the nominal exchange rate are converted so as to take into account comparative developments in other countries’ prices or wage costs. The real exchange rate therefore reflects how competitive or “expensive” Iceland is compared to trading partner countries.

As the chart shows, the real exchange rate in terms of relative consumer prices is quite high at present – in fact, it is close to its highest level in recent decades. On the other hand, the CBI has repeatedly pointed out that the conventional method of calculating it does not fully capture the comparison with other countries, owing to the weight of the housing component in the Icelandic consumer price index (CPI). As a result, the CBI has added a third real exchange rate measure: the real exchange rate in terms of the harmonised index of consumer prices (HICP), which is calculated for all countries in the European Economic Area (EEA). As can be seen in the chart, developments in the past year are similar by that measure, but the real exchange rate of the ISK is both closer to its historical average and farther from its previous peaks when calculated in terms of the HICP than when calculated in terms of the CPI.

There is a reciprocal relationship between currency areas’ real exchange rate and their current account balance, and the impact is reciprocal as well. Therefore, a high real exchange rate often leads to a growing current account deficit because the competitive position of the relevant country or currency area is weaker. This often ends with a correction in the real exchange rate, either through a nominal depreciation of the currency or (less frequently) through a decline in wage costs and prices in the economy concerned.

In the same way, a sizeable current account surplus can often cause the currency in question to appreciate, owing to net foreign currency inflows, resulting in a repricing in the foreign exchange market so as to restore equilibrium. As can be seen in the chart above, this reciprocal tug-of-war between the current account balance and the real exchange rate has also occurred in recent decades in Iceland. A growing current account deficit in the final years of the 20th century was a major reason why the ISK exchange rate dropped so abruptly after the currency was floated early in 2001. Furthermore, the historically low real exchange rate during the years immediately following the financial crisis played a part in supporting the rapid growth of tourism in the early 2010s, which in turn weighed heavily in the hefty current account surplus Iceland enjoyed until nearly the end the decade.

The past few years’ developments in the current account balance and the real exchange rate are reminiscent of this. But in the present case, it should be borne in mind that the recent current account deficit stems from massive importation of investment inputs for the export sector, particularly the data centre industry. Because these imports have been financed abroad for the most part, and because their purpose is to generate export revenues, they have not affected the foreign exchange market or the real exchange rate as they would have under other circumstances.

Real exchange rate to remain high; nominal exchange rate to soften

In our recently published macroeconomic forecast, we discussed developments in the ISK exchange rate and prospects for the nominal and real exchange rates in the years ahead. As before, the ISK will be supported by a number of factors in the near future. The current account deficit is expected to narrow, the net international investment position (NIIP) is strong, Iceland’s international reserves are sizeable, the foundations of the economy are solid, and the interest rate differential with abroad will remain fairly wide. The ISK could weaken, however, if next winter’s tourist season is sluggish, investment-related inflows of foreign capital contract sharply, or terms of trade worsen materially in coming quarters.

Even so, the real exchange rate is likely to remain historically high, provided that export sectors do not suffer more of a setback than we have projected. But because wages and prices rise faster in Iceland than in trading partner countries, the nominal exchange rate will have to fall at some point, either slowly and steadily or in a steep drop later on.

Our exchange rate forecast assumes a gradual depreciation rather than an abrupt correction. If our assumption holds, the ISK will depreciate bit by bit, ending the forecast period roughly 5% weaker than at the end of 2025. This equates to an EURISK exchange rate of 153 and a USDISK exchange rate of approximately 132, based on the two currencies’ end-2025 rates. But it need hardly be mentioned that this forecast is highly uncertain, as exchange rate forecasts usually are.