As the chart shows, exchange rate movements in 2023 were similar in many respects to those in 2022. Both years featured an appreciation early on, followed by a depreciation later in the year. In Q1 of both years, for instance, the ISK appreciated by virtually the same amount, just over 3%.

Key drivers of exchange rate movements

What are the factors driving the ISK exchange rate at present, and what may lie ahead?

The CBI’s recently published Financial Stability report explores a number of these factors. It contains a discussion of developments in the banks’ forward FX positions, which reflect their customers’ position-taking. Investors take such positions both for hedging purposes and because they expect the ISK to strengthen or weaken against various currencies. The report shows that alongside a reduction of ISK 37bn in the banks’ net forward FX position (and therefore in their customers’ positions with the ISK), forward contracts with the ISK declined in number by 40%. This indicates that many investors in the market closed out their positions late in Q3, after the strong appreciation in the first half of the year.

The net forward FX position bottomed out at ISK 137bn at the end of November but increased again by ISK 12bn from then until the end of January. As the chart indicates, there is some correlation between the forward FX position and the ISK exchange rate, and after comparing the two, we conclude that changed expectations about exchange rate movements have affected the FX market to an increasing degree in the recent term.

Exchange rate forecasts often take into account the pension funds’ FX market activity. The Governor of the CBI has said repeatedly, for instance, that a reasonably large current account surplus is needed to offset the pension funds’ foreign asset purchases. Actually, we consider that a somewhat reductive view of the connection between the current account balance and FX flows. In fact, the past few years have shown us that foreign investors’ inflows can easily counterbalance the pension funds’ outflows – often with room to spare – although obviously, it is better to avoid financing a current account deficit over the long term by selling assets to foreign investors or borrowing more money abroad.

All that said, though, the pension funds have bought substantial amounts of currency in recent years and will continue to invest abroad in the years to come. There are two reasons for this.

• Net inflows into the pension funds are positive, as paid premiums are well in excess of pension payments and operating expenses. In 2022, for example, net inflows into the funds totalled just over ISK 100bn. Flows will balance out further ahead, but probably not until sometime in the 2030s at the earliest.
• The pension funds’ investment authorisations are scheduled to increase year by year, owing to a recent statutory amendment. The cap on their ratio of unhedged FX assets to total assets increased by 1.5% at the end of 2023 and is now 51.5%. It is set to rise in increments until it reaches 65% in 2036. According to the aforementioned Financial Stability report, the pension funds’ combined foreign asset ratio was 38.5% at the end of 2023.

The funds bought FX for ISK 83bn during the year, some ISK 21bn less than in 2022. The 2023 total is equivalent to nearly ISK 7bn per month. In the first two months of 2024, the pension funds bought currency for a total of ISK 16bn. It is pointed out in Financial Stability that according to the funds’ investment strategies for 2024, their targeted foreign asset ratio averages just over 39%, and about half of the funds held their targets unchanged or lowered them between years. Apparently, they are planning to maintain some elbow room as they step up their foreign asset holdings in coming quarters.

Foreign investors look to Treasury bonds

According to Financial Stability, net new investment was positive by just under ISK 27bn in 2023, including net inflows for listed equity securities purchases in the amount of ISK 17bn. It is worth bearing in mind that data on new investments represent inflows of foreign currency converted to Icelandic krónur for investment in Iceland. As such, they do not include investments such as the acquisition of Kerecis, which was paid for in US dollars, as we have discussed previously.

In the recent past, foreign investors’ inflows for new investment in ISK assets have been allocated mainly to equity securities (blue bars) or inward foreign direct investment (yellow bars). This pattern changed later in 2023, however. In Q4, foreign investors’ net Treasury bond purchases (grey bars) totalled over ISK 13bn, as compared with under ISK 5bn for the first nine months of the year combined. These bond purchases have continued in 2024 to date. They totalled nearly ISK 24bn in January and February combined, and there are a number of signs that a few more billion will be added to that total in March.

We are planning to discuss foreign investors’ Treasury bond purchases and how they relate to the interest rate differential in the weeks to come. But at any rate, it is clear that FX inflows for these bond investments have been significant in the past few months, and they have doubtless helped stabilise the ISK in spite of seasonal fluctuations in external trade and other factors. Actually, inflows were strong enough at the time of Government Debt Management’s February Treasury bond auction, when foreign investors bought bonds for nearly ISK 15bn, that the CBI intervened in the FX market (its only intervention year-to-date) and bought foreign currency for ISK 9bn.

Seasonal trade deficit

No less important as a driver of developments in the FX market is external goods and services trade. Iceland’s current account surplus measured 1% of GDP in 2023. Trade in goods and services was broadly in balance, and the overall CA surplus stemmed from a surplus on primary income, as we have discussed.

The trade account is always faced with an uphill climb over the winter, owing to seasonal fluctuations in tourism. In the first two months of 2024, the goods account showed a deficit of just over ISK 40bn. We estimate that the services account was in surplus by around ISK 15bn over the same period, which gives a deficit on combined goods and services trade in the neighbourhood of ISK 20bn on a balance of payments basis, when account is taken of the fact that the goods trade deficit is generally somewhat smaller on a BoP basis than a direct reading of Statistics Iceland’s FOB/CIF goods trade figures would indicate.

In our macroeconomic forecast from late January, we projected that this year’s current account surplus would amount to just under ISK 30bn, or approximately 0.7% of GDP. Since then, prospects for growth in tourism have dimmed, and it looks as though the fishing industry is indeed heading for a capelin catch failure this year. As a result, the trade balance could turn out less favourable than we projected in January, although a large current account deficit is unlikely.

Furthermore, inflows for investment in domestic securities will probably continue, owing to the interest rate differential and to growing foreign interest in domestic equities following Iceland’s inclusion in several international share price indices. The pension funds’ foreign investments will pull in the opposite direction, though.

We think it probable that developments over the course of 2024 will be similar to those in recent months, with a slow appreciation of the ISK. In January, we forecast that the ISK would be 2-3% stronger, on average, than in 2023, and while uncertainty about external trade has grown, we still consider that forecast broadly valid. Naturally, we must always add the caveat that forecasting exchange rates has long proven a tricky business, and the remainder of the year will doubtless include some unexpected plot twists that affect the ISK. Recent developments indicate strongly, though, that the ISK is on a relatively solid footing at present, which reduces the risk of exchange rate volatility.