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ISK softens briefly in March

The ISK exchange rate dipped in the first week of March but righted itself as the month progressed. Presumably, increased position-taking in forward contracts has played a major role in the appreciation of the ISK since last autumn, together with fluctuations in the pension funds’ foreign currency transactions. The ISK looks set to strengthen further over time, although the impact of the war in Ukraine could pose a hindrance in the next few months.

The ISK fluctuated quite a bit in March. In the first week of the month, it fell by over 3% against major currencies, erasing most of the gains from January and February. It soon turned around, however, and by the end of March it had more or less recouped the losses from earlier in the month.

As in the recent past, the Central Bank (CBI) intervened in a bid to mitigate exchange rate volatility. The bank sold EUR 60m in the interbank market in early March, when the depreciation was at its fastest, and then intervened on the buying side when the appreciation picked up steam later in the month, buying back nearly half of the euros it had sold in early March.

CBI continues to mitigate exchange rate volatility

March is the first month since September 2021 to see the CBI sell foreign currency in the market rather than buying it. As the chart indicates, the bank has generally leaned against the current in the market ever since it discontinued its regular currency sales programme in spring 2021, buying currency during appreciation phases and selling it when the ISK weakens. In doing so, the CBI has greatly mitigated short-term volatility, as the EURISK exchange rate has remained in the 140-151 range over the past year, despite significant economic turmoil and investment-related currency flows.

Increased position-taking with the ISK a factor in appreciation

The appreciation of the ISK between last autumn and end-February has been noteworthy in that the trade balance [current account balance?] has probably been in a more or less constant deficit from Q3/2021 to date. The current account deficit in Q4/2021 measured just over ISK 44bn. In Q1/2022, the goods account showed a deficit of nearly ISK 38bn, according to figures from SI, and available payment card data suggest that Icelanders’ overseas travel and zest for spending abroad strongly counteracted services revenues from foreign tourists in Iceland.

At least part of the ISK appreciation during this period is probably due to resident investors’ interest in entering into forward contracts, either to hedge against or to speculate on the strengthening of the ISK in the coming term. This trend is discussed in Financial Stability 2022/1, published by the CBI in mid-March. According to that report, domestic commercial banks’ net forward position went from close to zero at the beginning of 2021 to being positive by ISK 139bn at the end of February 2022. All else being equal, this increase in the forward position calls for corresponding spot trades in which foreign currency is sold in exchange for ISK in the market.

As the chart shows, the two periods featuring a steady increase in the forward position have gone hand-in-hand with an appreciation of the ISK. It is therefore highly likely that the appreciation in H1/2021 and again from September 2021 through February 2022 is due in part to the aforementioned position-taking. To borrow the CBI’s wording, it can be said that “… expected currency flows have already begun to affect the exchange rate of the króna to some extent.” This means, then, that when external trade turns around, as we expect later this year, the ensuing ISK appreciation may well be less pronounced than it would have been otherwise. By the same token, it could be that the depreciation in early March is due in part to a reduction in the forward position; i.e., to the closure of some of the forward contracts.

Seasonal fluctuations in pension funds’ FX purchases

The CBI also discusses the pension funds’ foreign exchange market activity in its Financial Stability report, providing interesting insights into FX flows in the recent past. The funds’ FX assets totalled ISK 2,535bn at the end of 2021, after growing by more than a fifth during the year. FX assets accounted for nearly 38% of the pension funds’ total assets. As the chart shows, the pension funds’ FX market trading has fluctuated widely in the fourth quarter of the past two years, with net purchases close to zero both times. This trend reflects a few funds’ attempts to align their foreign asset ratios with their internal benchmarks as the year-end approaches. The ISK appreciated somewhat in the final months of both years, probably due in part to this temporary turnaround in the pension funds’ FX flows.

Under current law, the pension funds’ unhedged FX assets may not exceed 50% of total assets. A bill of legislation recently introduced before Parliament proposes that this maximum be increased in stages over the next few years, until it reaches 65%. Pension fund executives have called for this process to be expedited, as the funds will grow steadily in the years to come, and it would be more favourable to increase their risk diversification outside the Icelandic financial market.

The pension funds’ foreign currency purchases have been far more modest in the past two years than in 2018 and 2019. In 2020 and 2021, they purchased just over ISK 50bn per year, about half of the total from the two years beforehand. As yet, there are no signs in CBI data that the funds are stepping up the pace again in foreign asset purchases, but there is little doubt that they will do so in coming quarters and that the associated foreign currency transactions will put a damper on the appreciation of the ISK, as they did for most of the last decade.

ISK likely to appreciate further over time

The exchange rate is still slightly below the average seen before COVID-19 spread around the globe, laying waste to Iceland’s export revenues. Based on the most recent trade-weighted exchange rate index published by the CBI, the ISK is still a full 4% below its 2019 average.

As before, we assume it will appreciate somewhat in the coming term. That said, uncertainty about near-term developments has escalated since Russia invaded Ukraine, pushing the price of fuel and various commodities sharply upwards. Although this is offset in part by higher prices for many of Iceland’s export products, the short-term impact on the current account balance and related foreign currency flows is negative. Even so, we expect the recent current account deficit to flip to a surplus later this year. In addition, FX inflows in connection with securities investments could prove to be sizeable in 2022. Foreign investors’ holdings in Icelandic securities are at a low ebb, and with FTSE Russell’s classification of the Icelandic stock market as a secondary emerging market, effective in September, foreign mutual funds’ investments in the Icelandic market could increase considerably. Based on all of this, the ISK is likely to gain momentum further ahead, although there will doubtless be a mixture of headwinds and tailwinds, as there always has been.


Jón Bjarki Bentsson

Chief economist