In the wake of this appreciation episode, the ISK is roughly 3% weaker in trade-weighted terms than it was, on average, in 2019. As the chart shows, the exchange rate held relatively stable during the year before COVID-19 struck. However, after a steep plunge in the first six months of the pandemic, it has strengthened steadily and is now closing in on its pre-pandemic level.

The CBI has intervened frequently in the market over the past two years in a bid to mitigate exchange rate volatility. Intervention peaked in autumn 2020, with the bank selling a total of EUR 615m (just over ISK 87bn at the current exchange rate) in the interbank foreign exchange market over the last four months of that year.

Since spring 2021, however, the CBI has reversed course, after discontinuing its regular currency sales programme at the end of April. From that time on, the bank has been far more active on the buying side of the market, with net purchases totalling EUR 115m (just over ISK 16bn at the current exchange rate) from the beginning of May until the year-end. As the chart suggests, the CBI intervened deftly over that period, trading on the selling side during depreciation episodes but otherwise remaining poised to buy currency. The bank made sizeable FX purchases in June, in response to large-scale inflows in connection with foreign investors’ securities purchases.

The CBI remained on the sidelines from early October until end-2021 but began buying currency again after the turn of the year. The vast majority of these purchases, which totalled EUR 69m, took place between 28 January and 8 February.

As the chart indicates, the CBI’s purchases have not halted the appreciation of the ISK but instead appear to have served their stated purpose effectively, mitigating short-term exchange rate volatility and temporarily deepening the FX market. In other words, the ISK has appreciated rather steadily, both before intervention began in earnest and during the intervention phase.

Where does the appreciation come from?

But what has caused the ISK to appreciate as much as it has thus far in 2022? For one thing, preliminary figures from Statistics Iceland (SI) suggest that January was the first month in three years to see a surplus on external goods trade. In addition, foreign tourist numbers somewhat exceeded our expectations, clocking in at nearly 68,000 for the month. On the other hand, payment card turnover data imply that Icelanders’ overseas spending far outpaced foreign tourists’ spending in Iceland in January, and on the whole, we think it unlikely that goods and services trade have generated the surge in FX inflows we have seen year-to-date.

We think it likelier that the ISK appreciation in 2022 stems from the financial account. In this context, we notice two factors in particular:

• First, foreign investment in Iceland has been brisk in recent weeks and months. For example, recent media coverage has focused on foreign investors’ purchases of Iceland’s three largest data centres in the final months of 2021. Although these transactions probably did not entail large-scale FX market activity, we do think it likely that some portion of the sales proceeds have been, or will be, converted to Icelandic krónur. The amounts involved are substantial, and a small share of the total would suffice to generate sizeable FX market inflows. Furthermore, foreign investors’ interest in Icelandic Treasury securities appears to be picking up again. According to figures from Government Debt Management (GDM), the stock of foreign-owned Treasury securities grew in nominal terms by ISK 1.4bn in January, the largest single-month increase since May 2021. This amount is not large in the grand scheme of things, but it could have contributed to the appreciation episode in January.
• Second, in mid-2021, the CBI significantly relaxed the rules on derivatives trading. There are still some limits on the total amount of such derivatives; for instance, each of the commercial banks may hold forward FX positions amounting to a maximum of 50% of its capital base. On the other hand, derivatives trading is now permitted irrespective of whether its purpose is to protect the balance sheet and operations, whereas this was previously a requirement for forward currency contracts. A portion of the year-to-date appreciation could therefore be linked to position-taking that, in essence, represents betting on (or hedging against) the appreciation of the ISK later this year. When such contracts are made, they typically have an immediate effect on the underlying asset class. If this is the case here, it could be said that a part of the ISK appreciation that would otherwise occur later this year has already come to the fore.

Significant further appreciation would be unsustainable

In our most recent macroeconomic forecast, published at the beginning of this year, we projected that by 2024, the final year of the forecast horizon, the ISK would be 8-9% stronger than it was at year-end 2021. As is noted above, a generous half of that appreciation has already taken place. It goes without saying that developments in currency exchange rates have often left forecasters flummoxed, and our projections should be interpreted with this in mind. On the other hand, our forecast reflects our opinion about what the forces affecting the FX market are likely to deliver in the coming term, and how much room there is for further appreciation before the external balance of the economy is jeopardised. For instance, a significant appreciation of the ISK further ahead will be more likely to erode the competitive position of Iceland’s export sectors, increase consumers’ power to purchase foreign goods and services beyond sustainable levels, and cause the current account surplus envisioned for 2022 (and hopefully 2023 as well) to flip to a deficit.