Following considerable volatility in the past year, the ISK has been mostly in a strengthening phase year-to-date – at least until the end of August. In terms of the Central Bank’s (CBI) exchange rate index, it averaged 6% stronger against foreign currencies in August than in December 2022. Since the start of September, though, it has lost ground again and, as of this writing, is broadly where it was in mid-July; i.e., roughly 4% stronger than at the turn of the year.
Modest ISK appreciation in the offing
The ISK has appreciated by 4% in 2023 to date, despite having weakened since the beginning of September. The foreign exchange market has been better balanced recently than it was in 2022. The outlook is for the ISK to strengthen somewhat in the coming term, although a high real exchange rate will put constraints on further appreciation after the middle of the decade.
A better balanced FX market
The CBI discusses developments in the FX market over the first eight months of the year in its newly published Financial Stability report. The bank points out that the market has been stable in recent quarters, with modest turnover, no CBI intervention since January, and relatively little exchange rate volatility.
In our opinion, one reason for greater market stability is better balanced external trade than in recent years. In H1/2023, Iceland’s current account deficit was only ISK 4bn, as compared with ISK 76bn in 2022 as a whole. In addition, the CBI’s books show net new investment totalling ISK 15bn in the first eight months of 2023, although this figure does not include flows relating to the sale of biotech firm Kerecis to foreign buyers, as the CBI’s accounts only cover transactions in which foreign currency is converted to ISK. The stated selling price in the Kerecis transaction was ISK 175bn, so inflows connected with it could ultimately prove sizeable.
Furthermore, the pension funds’ FX market activity has been relatively stable in recent months, following a period of wide month-to-month swings during the first quarter of this year. In all, the funds’ FX purchases totalled ISK 68bn over the first eight months of 2023.
Finally, it is worth noting that forward position-taking with the ISK has subsided since mid-year. At the end of August, the net position in forward contracts with the domestic banks totalled ISK 159bn, a reduction of more than ISK 30bn relative to end-June. It will be intriguing to see how it has developed this autumn, during the ISK depreciation of the past few weeks.
The ISK looks set to strengthen somewhat in the coming term
The near-term outlook for external trade is rather favourable in comparison with the past two years. The outlook is for a small current account surplus in 2023 and 2024, after a two-year deficit. The surplus could come to an average of roughly ISK 25bn per year during the forecast horizon. It also appears as though the interest rate differential with abroad will remain relatively wide. Iceland’s external position is strong, and the stock of foreign-owned securities is low in historical and international context.
Offsetting potential FX inflows is continued foreign investment by the pension funds, whose maximum ratio of foreign assets to total assets has been increased relative to previous years. Other domestic entities could also step up their foreign investment in the future, particularly if the ISK strengthens to any marked degree.
It is impossible to pinpoint with any certainty the timing of future exchange rate movements, and the magnitude of such movements is highly uncertain as well. According to our newly published macroeconomic forecast, the ISK will be roughly 5% above its August 2023 average by the end of the forecast horizon. This translates to a price of ISK 137 per euro.
Such an appreciation, together with rapid wage growth and higher inflation than in trading partner countries, will push the real exchange rate sharply upwards. As the chart indicates, the real exchange rate will probably be near a historical high two years from now, if our exchange rate and inflation forecasts are borne out. But here it is appropriate to point out that the equilibrium real exchange rate has probably risen somewhat from the level prevailing until the last decade, owing to an improved international investment position, productivity growth in export sectors such as fishing and energy-intensive industry, an increased number of export revenue-generating sectors, and other factors.
A high real exchange rate will make Iceland “more costly” in international comparison, however, thereby incentivising imported consumption and eroding the competitive position of Iceland’s tradable sector. The probability of a further ISK appreciation therefore tapers off over time, and further ahead, the likelihood of a depreciation will increase steadily if domestic wages and prices rise significantly faster than those abroad over a protracted period of time.