The ISK: jumping the gun?

The exchange rate of the ISK is now broadly where it was in late April, after weakening marginally this summer. The appreciation over the first five months of 2022 is probably due in large part to position-taking with the ISK, driven by expectations of improved FX flows later in the year. The outlook is for the ISK to strengthen somewhat in the coming term, but significant appreciation would ultimately upset the external balance of the economy.

Against a basket of major currencies, the ISK has been fluctuating in a rather narrow band over the summer. In terms of the trade-weighted exchange rate index (TWI), it actually softened slightly against other currencies in July. According to the TWI, it is broadly back to its end-April level, and a good 2% weaker than at the end of May.

ISK gains ground … except against the USD

This should not be understood to mean that major currencies overall have strengthened against the ISK. The depreciation according to the TWI is due for the most part to the past few months’ appreciation of the US dollar against most currencies, including the ISK. As of this writing, the USD is trading at ISK 136.8, an appreciation of nearly 8% since the end of May. As the chart shows, however, both the euro and the pound sterling have held broadly unchanged over the same period.

In terms of the TWI, which is compiled by the Central Bank (CBI), the ISK has appreciated by just under 4% in 2022 to date. But like the figures above, this reflects differing developments against specific currencies. Against the USD, the ISK has weakened by 5.6%. But against the euro, which weighs heaviest by far in Iceland’s external trade (and therefore in the TWI), the ISK has appreciated by nearly 5%, and against the pound sterling it has strengthened by more than 5%. A similar trend can be seen against other major currencies.

The obvious reason for this divergence in movements against foreign currencies is the enormous appreciation of the USD thus far in 2022. Against the euro, for instance, the dollar has strengthened by over 9% year-to-date, and in mid-July the euro was a hair’s breadth from falling below parity with the USD for the first time in nearly twenty years. Interest rate hikes and a brighter economic outlook in the US than in most other industrialised countries go far in explaining this strengthening of the USD, together with investor flight to the world’s largest reserve currencies during times of market unrest such as we have seen in 2022.

What explains the ISK’s behaviour in 2022?

But why did the ISK appreciate until summer began, and why has it slid marginally since then?

It cannot be due to intervention by the CBI. The CBI has been modest in its FX market intervention thus far in 2022, apart from April, when it bought around EUR 130m (roughly ISK 18bn) to stash in its FX reserves. This is discussed in the minutes of the Financial Stability Committee’s June meeting, published at the beginning of July:

“The foreign exchange market had been quite stable and fluctuations had been moderate. […] As a result, the Central Bank had not needed to intervene much in the market, apart from large transactions in April, when the Bank bought foreign currency in direct trades in response to capital inflows relating to foreign investments in Treasury bonds.”

According to a news article on the Icelandic business news web Innherji, this refers to European investment fund BlueBay’s purchase of nominal Treasury bonds in a Government Debt Management auction. This summer, however, the CBI has left the FX market entirely alone, as intraday fluctuations have been moderate and there have been no signs of spiral formation requiring the bank’s intervention.

Nor can this year’s movement in the ISK be attributed to trade-related FX flows. Iceland ran a current account deficit of just over ISK 50bn in Q1/2022, and available data on goods trade, cross-border payment card turnover, and the like suggest that Q2 will show a sizeable deficit as well.

Moreover, the explanation can hardly be found in large-scale investment-related inflows. According to CBI data, net inflows from new investment were indeed positive in the first five months of the year – by around ISK 16.5bn. But the bulk of these inflows reflect the aforementioned bond purchases, which the CBI mainly dealt with through direct trades and therefore wouldn’t have affected the FX market. On the other hand, the pension funds’ net FX purchases over the same period totalled nearly ISK 40bn, as we have discussed recently.

In our assessment, the appreciation through this spring stems from market participants’ position-taking with the ISK. CBI data show that the commercial banks’ forward FX position increased by ISK 54bn over the first five months of the year, to a total of ISK 171bn by end-May. This position mirrors position-taking by customers who have entered into corresponding forward contracts in which they use ISK to buy foreign currency. The nature of such transactions is that the exchange rate impact shows in the market at the time they are entered into. As a result, it can be said that expectations of a stronger ISK later in 2022 came to the fore in the appreciation seen earlier in the year. No new data on the forward FX position are yet available, but when they are, it will be interesting to see how the forward position has developed so far this summer.

ISK likely to benefit from tailwinds in the coming term

But is there a valid reason for market participants to take position with the ISK as they have done? We think there are grounds for expecting the ISK to enjoy tailwinds in the market in coming months. Iceland’s current account balance is probably improving rapidly these days, buoyed up by swiftly increasing tourism-generated FX revenues and rising marine product prices at a time when imported commodity and input prices are easing. Furthermore, we expect private consumption and investment to grow more slowly in the coming term than they have in the past few quarters.

In broad terms, we expect this year to fall into two parts as regards external trade, with a current account deficit in H1 flipping to a surplus in H2. In addition to this, the outlook is for considerable investment-related inflows this autumn, when the Icelandic stock market is upgraded to secondary emerging market status in international financial institutions’ indices. As a result, mutual funds that invest in accordance with those indices will have to add Icelandic shares to their portfolios. And finally, it is worth mentioning that Iceland’s interest rate differential with abroad is sizeable and its economic outlook rather sanguine relative to many others, at a time when its strong international investment position should support a higher real exchange rate than the economy could otherwise have supported.

However, the real exchange rate has risen significantly since the peak of the pandemic and is now roughly at the pre-pandemic level. As a consequence, the ISK can hardly appreciate much more before it starts to eat away at Iceland’s competitive position, erode the current account balance, and have a negative impact on the net external asset position.

In our macroeconomic forecast from May, we assumed that the ISK had room to appreciate by another 5%, give or take, relative to the end-April level. As we have noted above, it is now close to that end-April value. In the main, our opinion from May is still basically unchanged, although it is impossible to predict how the exchange rate will move in the short run, let alone over a longer horizon.


Jón Bjarki Bentsson

Chief economist