The ISK has been in a relatively solid and steady appreciation phase since last November. In 2021 to date, it has strengthened by a good 5% in trade-weighted terms and by more than 6% against the euro. As of this writing, it is approximately 5% weaker against the euro and 7% weaker against the pound sterling than it was, on average, in January 2020, the last month before COVID-19 made its imprint on the FX market. The pandemic-induced depreciation versus the US dollar has reversed in full, however, and the ISK is now 3% stronger against the dollar than it was in January 2020.
ISK gains steam as it emerges from the pandemic
The ISK has appreciated by a full 5% in 2021 to date. The Central Bank (CBI) has stopped selling foreign currency in the market, and in the near future its FX market activity is more likely to be concentrated on the buying side. Although it is not guaranteed that the ISK will appreciate further with the increased tourist traffic expected in the next few months, the overall outlook is for a higher exchange rate in the coming term.
Although it has been generally expected that the ISK would rally once the pandemic started to recede, we assume that few observers expected it to strengthen as much as it has in advance of the upcoming tourist season. Actually, the pandemic-related depreciation was less severe than many feared given the knock-out punch delivered to Iceland’s exports when the tourism industry seized up last spring.
The CBI played a major role in halting the slide of the ISK in 2020 and, in our opinion, has probably fostered this year’s appreciation to a degree as well. The bank’s net FX sales in 2020 totalled EUR 830m, the equivalent of ISK 133bn, with a sizeable share of transactions taking place in the autumn, when the largest foreign investor in Icelandic Treasury bonds closed out its position and converted the proceeds to foreign currency.
The CBI continued its established pattern in the early months of 2021, selling nearly EUR 260m in the first four months of the year. It changed tack in May, however, discontinued its regular FX sales programme, and actually bought EUR 15m in the market that month. That transaction marked the first time since July 2020 that the CBI went to the market on the buying side.
This shift by the CBI is understandable in view of the overall equilibrium in the FX market at present, and furthermore, it will be better for the upcoming resurrection of tourism if Iceland is not overly expensive relative to other travel destinations. In this context, the real exchange rate is a more useful measure than the nominal exchange rate. Based on the real exchange rate in terms of relative consumer prices, Iceland is nearly 3% less expensive than it was at the beginning of 2020. The difference is greater, however, relative to the peak of the tourism boom in mid-2017. Since then, the real exchange rate of the ISK has fallen by a full 17%. That said, we do not think it would be desirable for the real exchange rate to return to that level, as it has come to light that returns in the tourism sector were weak at that point, in spite of rapid growth.
Is further ISK appreciation around the corner?
Now that foreign tourists have begun to arrive in Iceland in greater numbers, the question arises: Is further appreciation of the ISK in the cards, and will the exchange rate move back towards the level seen in 2017-2018, when tourist numbers were at their peak?
Our recent macroeconomic forecast includes an exchange rate forecast. That forecast assumes that, in terms of annual averages, the ISK will strengthen by just over 3% year-on-year in 2021, nearly 5% in 2022, and just over 1% in 2023. This translates to an average trade-weighted exchange rate index (TWI) value of just under 195 points this year, just over 185 next year, and 183 in 2023. In the first five months of 2021, the TWI averaged 198.2 points, so there is room for some strengthening in the remainder of the year if our forecast is to materialise. Yesterday, 9 June, the TWI stood at 190.9. For comparison purposes, the index should average 192 from now until the year-end if our forecast is to be borne out to the letter.
Naturally, we need not belabour the point that forecasting exchange rate movements is an inexact science at best. But even so, we think our May forecast is still valid, and if it does materialise, the ISK should remain broadly at its current level (on average) for the rest of the year.
The outlook is certainly for increased export revenues as the year advances and tourists begin to arrive in earnest. Furthermore, there could be some net FX inflows from foreign investment in the offing, given that the Icelandic market was recently reclassified from standalone to frontier market status by index provider MSCI and foreign investors’ securities holdings in Iceland were at rock-bottom this spring.
On the other hand, Iceland’s pension funds are likely to step up their foreign securities purchases in coming months, particularly if the ISK appreciates further in the near future. In addition, imports will probably increase as domestic consumption and investment pick up, and import prices of fuels and various commodities have risen steeply year-to-date. In our macroeconomic forecast, for instance, we assume that the current account surplus will measure only a scant 1% of GDP despite strong growth in services exports.
And last but not least, it is quite possible that the CBI will be more active on the buying side of the FX market if currency inflows surge temporarily. The bank could make valid arguments for buying currency to shore up its international reserves in a bid to replace at least a fair share of the billion euros it sold between March 2020 and April 2021, particularly in order to create a counterweight to the expansion of the foreign-owned stock of volatile domestic securities if non-resident investors go on a buying spree in coming months.
In our macroeconomic forecast, we specify that although we project that by 2023, the ISK will be stronger than in 2020 by an average of roughly 10%, it is impossible to predict the timing of such an appreciation. But we are convinced that there is hardly scope for a much larger appreciation over the forecast horizon than the forecast provides for. If the ISK appreciates earlier than we expect, it will impede growth in export revenues and fuel imported consumption, with the associated impact on the current account balance. A strong ISK in the immediate future will also weaken foreign investors’ interest in buying domestic securities and will give the pension funds greater incentive to invest abroad. We think such a turn of events would ultimately reduce the likelihood of further ISK appreciation and/or increase the risk of a depreciation later on.