Recent CBI figures on FX market turnover show that in October, the bank sold a total of EUR 231m in the interbank market. Of that amount, the CBI’s regular daily currency sales accounted for EUR 66m. But the rest, some EUR 165m, is attributable to discretionary intervention, most of which took place in the final third of the month. Of that total, the CBI sold EUR 45m on 30 October, the last business day of the month. This massive wave of currency sales comes on the heels of the EUR 150m sold in September and another EUR 100m sold in August. In all, the CBI has sold nearly half a billion euros from its FX reserves since the beginning of August.

Tidal wave of FX sales since early August

Over the past few months, the CBI has been selling foreign currency on a scale utterly unlike anything seen in the past decade. For comparison, in the first seven months of the year, the bank’s net FX sales totalled EUR 119m and EUR 91m in the preceding two years combined. Before then, the CBI had amassed large reserves and was a particularly active FX purchaser during the ISK appreciation period from 2015-2017.

Although the trade balance has taken a turn for the worse with the arrival of the COVID-19 pandemic, trade-related currency flows can hardly explain this sustained pressure on the ISK in recent months. The trade balance has indeed been slightly negative in the past few months, but we estimate the Q3 deficit at only about ISK 6bn, and preliminary goods trade figures for October (deficit ISK 0.4bn) indicate little or no combined trade deficit during the month .

The agreement between the pension funds and the CBI, under which the former refrained from FX purchases, expired in September and was not renewed. The pension funds’ FX market activity may have played some part in pressurising the ISK.

Blue whales take to the high seas

The most important source of outflow pressures in recent months comes from another direction entirely, though. In the CBI’s latest Financial Stability report, issued at the beginning of October, it is noted that net new investment using foreign capital was negative in the amount of ISK 12bn in June-August. This was due primarily to Treasury bond sales by non-resident investors. According to a recent news report, the pace of the Treasury bond sales accelerated in September and October. If this report proves true, the bond sales in these three months come to tens of billions.

Foreign investors’ ISK-denominated Treasury bond holdings have shrunk markedly in the past two years. As the chart shows, they totalled ISK 111bn at the end of 2018, and if the above-mentioned media reports are borne out, they may be down to less than one-third of that amount. This is a puzzling situation, given that the ISK exchange rate and the yield on Icelandic Treasury bonds should make the bonds an attractive option for foreign investors who receive little or no returns on Government-guaranteed bonds elsewhere.

Deploying the FX reserves is a logical choice …

Given the sizeable amounts that have probably been swimming around in the FX market over the past three months as a result of these asset sales, it is logical that the CBI should respond with large-scale currency sales. The CBI’s reserves totalled just over EUR 6bn at the beginning of the year, the equivalent of just over ISK 970bn at the current exchange rate. The bank holds these vast reserves for the express purpose of providing a counterweight to volatile foreign-owned ISK assets and limiting the risk of an excessive depreciation if investors should embark on a selling spree. Presumably, the CBI, which has better information than anyone else about non-residents’ investments, has chosen to offset a large share of the impact that would have materialised if such large amounts of money had been funnelled through our tiny FX market this autumn.

To cut a long story short: The depreciation of the ISK and the CBI’s large-scale currency sales in the recent past are not a sign that the underlying currency flows are creating lasting pressure on the ISK; instead, it appears that this is by and large a temporary situation. The fact remains that the CBI has enormous FX reserves at its disposal, and by now, the stock of volatile foreign-owned assets is very small in comparison. The reserves totalled EUR 5.8bn at the end of September, and our calculations indicate that they come to just over EUR 5.5bn now, in spite of the sales conducted in October. Of that amount, just under EUR 4bn are financed with krónur, and approximately EUR 1.6bn are financed with an FX debt to the Treasury.

… and there is still room for further intervention

It will be interesting to keep tabs on the ISK exchange rate in coming weeks, as many factors suggest that the wave of foreign-owned asset sales is subsiding. Presumably, the ISK will still have an uphill climb while tourism is in a medically induced coma and the Covid Crisis rages on. But the CBI will continue on the path it has staked out, intervening both ad hoc and under its regular currency sales programme, for as long as this situation persists. In September, the bank declared itself ready to sell up to EUR 240m in regular transactions through the year-end. At the beginning of November, it had yet to sell about half that amount, or the equivalent of roughly ISK 21bn. On the other hand, there will probably be a small deficit on goods and services trade for the remainder of the year, and the pension funds could buy foreign currency for sizeable sums in order to bulk up on foreign assets.

As time passes, however, we think the ISK is more likely to strengthen than to weaken. The current exchange rate and interest rate level in Iceland must surely attract the attention of foreign investors, even though the sellers mentioned above have jumped ship. Furthermore, trade-related foreign currency flows will probably turn more positive once the appetite for travel increases and restrictions are lifted. When this will happen is difficult to say, however, and depends mainly on the behaviour of the pandemic, which until now has proven more stubborn that was initially hoped.

The CBI’s international reserves are still well above reserve adequacy thresholds, and the risks the reserves are designed to safeguard against have receded for the moment. It therefore appears that it would be wise for the CBI to continue weaponising the reserves this winter in order to prevent excessive ISK depreciation, solidify inflation expectations, and reduce short-term uncertainty. But if the current situation persists, the bank will ultimately have to be more cautious with its FX reserves.