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ISK likely to firm up over time

The ISK exchange rate has fluctuated quite a bit in 2023 to date but is now broadly where it was at the turn of the year. The tailwinds supporting it in the coming term are likely to be weaker than we had previously anticipated, owing to less favourable external trade. Even so, the outlook is for some appreciation further ahead, with the possibility that a euro will cost approximately ISK 142 in late 2025.


After strengthening markedly over the first five months of last year, the ISK fell steadily from early summer until the year-end. It lost ground noticeably in the autumn, even though the tourism industry had a brisk autumn season. On average, the ISK was 3% stronger in 2022 than in 2021.

Increased position-taking with the ISK via forward contracts probably played a role in the appreciation early in the year despite the hefty current account deficit. This position-taking reversed in H2, however, while trade remained unfavourable and the pension funds bought large amounts of foreign currency. As before, the Central Bank intervened in the market to mitigate short-term volatility. Over the year as a whole, its net foreign exchange purchases totalled just over ISK 13bn.

The ISK has been fairly volatile year-to-date, depreciating by nearly 4% against the euro from the year-end through 25 January and then bouncing back. As of this writing, a euro costs ISK 151, as compared with ISK 152 at the beginning of the year. The exchange rate versus the US dollar has boomeranged in a similar manner: a dollar cost ISK 142 at the turn of the year and is now ISK 141.

According to our recent macroeconomic forecast, the near-term outlook for external trade has deteriorated somewhat relative to our September 2022 forecast. As a result, the tailwinds supporting the ISK will probably be weaker in coming quarters than we had anticipated. The current account looks set to be broadly in balance further ahead, however, due to continuing export growth, weaker growth in domestic demand, a slight improvement in terms of trade, and a more favourable contribution from primary income, to mention a few factors. The interest rate differential is also relatively large and appears likely to widen rather than narrowing. Moreover, Iceland’s international investment position is strong, its near-term GDP growth outlook is better than many other countries can boast, and the stock of foreign-owned domestic securities is relatively small in both historical and international context.

On the other hand, the pension funds will probably continue to invest heavily abroad in the coming term, and other domestic entities are likely to scale up their foreign securities holdings as the global market outlook improves.

The size and timing of exchange rate movements is always highly uncertain, but in our macroeconomic forecast we project that the ISK will be approximately 8% stronger at the end of the forecast horizon than at year-end 2022. This would give an exchange rate of roughly ISK 142 per euro towards the end of 2025. The real exchange rate in terms of relative consumer prices will then be about the same as in 2019. The real exchange rate entails a comparison of domestic prices and wage costs with the same variables abroad, after adjusting for nominal exchange rate movements.

Analyst


Jón Bjarki Bentsson

Chief economist


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