Nevertheless, the ISK appreciated somewhat in the third week of November, and since the last week of the month it has been quite stable against the euro. The euro is the main foreign currency in the Icelandic FX market, as market transactions take place in euros and krónur, and the euro accounts for a large share of external trade and capital flows to and from Iceland.

But why has the ISK behaved this way in H2/2023? There are several explanatory factors, as we see it. First of them is trade in goods and services. As in 2022, the autumn was a difficult season for trade-related flows. In October 2023, the goods account showed a deficit of just over ISK 50bn, Iceland’s largest in twelve months, as we have reported recently, but that deficit shrank markedly in November. Tourism-generated FX inflows also eased over the autumn months, although fortunately, the seismic activity on Reykjanes peninsula did not cut severely into tourists’ appetite for travel to Iceland in the final months of the year. The deficit on combined goods and services trade was just over ISK 18bn in October, putting an end to the string of surpluses dating from the spring, but it is likely that the deficit narrowed again in November and December, as the difference between imports and exports of goods probably shrank during the period.

External trade is only one factor of many

In a forward-looking and reasonably deep FX market, such seasonal fluctuations should not affect exchange rate developments, as expectations should already have been priced into the exchange rate. But the Icelandic market is shallow in international context, and the group of market participants is probably less diverse than in larger markets abroad, where speculation and hedging play a more prominent role. Furthermore, new coverage of issues such as the geological unrest on Reykjanes peninsula probably affected market agents’ expectations about developments in the ISK in late autumn and early winter.

Currency flows due to listed new investments have been far more sparse this autumn than over the same period in 2022. According to recent figures from the Central Bank (CBI), such investment-related inflows totalled just under ISK 8bn in September, October, and November combined, as compared with ISK 65bn for the same period in 2022, which made a major difference in offsetting trade-related outflows that autumn.

Here it is worth noting, however, that the settlement of the foreign acquisition of biotech firm Kerecis does not appear to have been included in these CBI data. On the other hand, it is included in CBI data on the financing balance, where net inward foreign direct investment in the amount of ISK 140bn is recorded in Q3.

The Kerecis transaction can also be seen clearly in figures on FX deposits with Icelandic banks, which show a steep increase in US dollar deposits in summer 2022, to a historical high of nearly USD 1.9bn at the end of August. The balance of USD deposits with the banks contracted significantly thereafter, to just under USD 1.3bn by end-November, which is nevertheless well above the recent average.

The pension funds’ FX transactions are another factor that can affect the ISK exchange rate at any given point in time. The pension funds invest heavily in foreign securities each month, as their income from premiums is well in excess of their cost outlays due to pension benefits and operating expenses, and many of them aim to boost the share of foreign assets in their portfolios.

On average, the funds’ FX purchases net of FX sales totalled nearly ISK 7bn per month in the first eleven months of 2023. As the chart indicates, however, these FX purchases tapered off in the last four months of the year, totalling only ISK 0.5bn in November. This pattern is reminiscent of 2020 and 2021, when the funds finished both years with a small amount of net FX sales. As was the case then, this phenomenon is probably due to a fairly weak ISK and rising foreign markets, both of which tend to increase the share of foreign assets in the pension funds’ portfolios. It can be said, then, that the pension funds had a countercyclical impact on the ISK in 2023, as they often have in the past.

Forward FX contracts have played a larger role in exchange rate developments in recent years, after authorisations for such contracts have been expanded once again. At the beginning of 2021, the commercial banks’ net forward FX position came to only ISK 11bn, but by mid-summer 2022 it had peaked at ISK 197bn. As the chart shows, there frequently seems to be a strong correlation between forward FX balances and the ISK exchange rate, the latter of which actually reflects customers’ position-taking with the ISK at the time in question.

Position-taking with the ISK has shrunk markedly since mid-2023. After totalling nearly ISK 190bn at the end of June, the balance was down to ISK 137bn, its lowest since early 2022. This is presumably another explanation for the depreciation of the ISK during the autumn.

The outlook is relatively favourable for the coming year

As is noted above, the ISK exchange rate has been quite stable in the past month or so, which we take to be a sign of a fairly well balanced FX market. How long that equilibrium will last, however, is impossible to say with certainty. Nevertheless, we continue to expect developments over the coming year to be favourable to the ISK. The tourism industry is buoyant, and 2024 looks set to be a record year for visitor arrivals. Growth in domestic demand has tapered off markedly, as developments in imports show clearly. Finally, we are optimistic that investment-related inflows will offset outflows relating to foreign investment by the pension funds and other domestic agents, as has been the case in the recent past. It is worth noting in this vein that Iceland’s interest rate differential with abroad has widened considerably in the past few months, as we have discussed recently. In our macroeconomic forecast, published in September, we projected that the ISK would be an average of 5-6% stronger in 2024 than it is this year. We still think this forecast will hold.