The ISK has weakened by 11% so far this year, and as can be seen in the chart, the vast majority of the depreciation took place in March. Actually, the ISK was remarkably stable from the beginning of 2019 until February 2020, despite threats and uncertainties in Iceland and internationally.
Do we need a weaker ISK?
The exchange rate of the ISK is roughly back to where it was just before the mid-2010s, early in the tourism boom. Developments year-to-date are reminiscent of other depreciation episodes in recent years. There are valid grounds to argue that the current exchange rate is close to the level needed to maintain balanced external trade once the tourism sector recovers.
After mid-February, however, it softened quickly, and the Central Bank (CBI) saw fit to sell EUR 60m from its reserves in order to mitigate the most severe day-to-day volatility, in line with its stated FX market intervention policy. It should be remembered, though, that the CBI still has approximately EUR 6 billion in its FX reserves. In concrete terms, this means the reserves are sufficient to cover 8-9 months’ worth of Iceland’s imports, based on 2019 figures. It is also worth noting that turnover in the interbank foreign currency market totalled less than EUR 400m for the first three months of 2020 combined.
Familiar depreciation pattern
It has sometimes been said that the ISK takes the stairs on the way up and takes the lift on the way down. In other words, the currency generally appreciates slowly and steadily but depreciates rapidly, especially when shocks strike. In this light, it is interesting to compare the past few months with other depreciation episodes in recent decades. To conduct such a comparison, we selected four periods: the year 2001, when the exchange rate peg was discontinued and the ISK was floated (in March); the depreciation in 2006, which came in the wake of critical news coverage of Icelandic business expansion abroad; the run-up to the currency crisis in 2008; and the WOW Air-related depreciation in H2/2018.
As the chart indicates, the past few weeks’ depreciation follows a familiar pattern. With the exception of H2/2008, which can be labelled an outlier because it eventually featured a currency shortage and required the imposition of strict capital controls, the exchange rate generally appears to settle temporarily at a level roughly 10% lower than before the depreciation episode began. It should certainly be borne in mind that the circumstances during each of these periods differed in many ways, as did the reasons for the depreciation in each case.
Misery loves company?
One of the main distinctions between this depreciation episode and its predecessors is that this time the ISK’s behaviour is much less anomalous than it has been in the past. In general, global currency markets have been quite uneasy since mid-February, when the spread of COVID-19 began to affect the economic outlook in a major way. Actually, during the first weeks of the epidemic, the ISK was unusually stable in global terms, probably owing, at least in part, to the fact that it is difficult to speculate in the ISK because of the controls still in effect.
As often happens when the markets turn sour, financial market players have fled to secure and liquid assets. This is no less true of currency markets, which have seen an exodus from smaller currencies to the largest ones. As a result, it is unsurprising that the ISK should have weakened relative to major currencies. But Iceland is not alone in this regard. The Norwegian krone, for instance, has fallen by 18% against the euro, whereas the ISK has fallen by 14% year-to-date. The NOK, of course, is heavily influenced by oil prices, which have plunged by more than half since the beginning of the year.
The ISK stands out less among the so-called high-yielding currencies it used to be grouped with. For example, the South African rand (-26%) and the Brazilian real (-27%) have fallen much more versus the euro, while the New Zealand dollar (-10%) has behaved much like the ISK has. The rand and the real are often highly sensitive to commodity market movements, which presumably has contributed to their depreciation, compounding the overall impact described above.
How weak an ISK does the economy need?
The real exchange rate of the ISK has fallen substantially from its peak at the height of the tourism boom three years ago. In terms of relative consumer prices, it has fallen by about 15% over this period. This makes Iceland a considerably more competitive tourist destination than it was when tourist arrivals peaked. The same is also true of other tradable sectors in Iceland. By this measure, Iceland is about as expensive a destination as it was in H1/2016.
To be sure, the medium-term economic outlook is still firmly up in the air at this point. One critical factor will be how the tourism sector fares once it emerges from the travel bans and other repercussions of the COVID-19 pandemic. In our opinion, however, the ISK depreciation has already given export sectors quite a boost – provided, of course, that the exchange rate is still at the current level once travel restrictions are lifted. As the chart shows, the 2010s marked a turning point in external trade as compared with the 2000s and the decades beforehand.
Although foreign currency revenue generation will unavoidably suffer this year, expenditures will probably contract significantly as well, and furthermore, the pension funds – Iceland’s biggest FX purchasers in recent years – will probably refrain from buying currency until the situation improves. As a result, we do not consider it a given that a lower real exchange rate is needed to maintain balanced external trade further ahead. In fact, it could be argued that some rebound could be accommodated in the future, without jeopardising foreign currency flows and the current account balance.