Upside potential for the ISK?

The ISK has held broadly stable year-to-date. Prospects for export growth in 2024 have dimmed, but the current account looks set to be in balance. The outlook is for a modest appreciation of the ISK in the coming term, but a high real exchange rate increases the likelihood of a depreciation later on.

The ISK exchange rate fluctuated widely in 2023. It rose early in the year, then lost considerable ground until the autumn before rallying again towards the year-end. Presumably, intrayear exchange rate movements stem from trade-related flows, financial flows, and changes in positions with the ISK.

The exchange rate has been relatively stable thus far in 2024. The EURISK exchange rate, for instance, lay between 148 and 151 from the turn of the year through the beginning of June. This stability reflects reasonably good equilibrium in external trade (with the surplus on services offsetting the deficit on goods) and in flows within the financial account; i.e., in transactions with securities and other financial assets, and in cross-border financing activities.

Statistics Iceland’s (SI) newly published preliminary figures on the goods account balance in May 2024 indicate a much smaller deficit than in April. The May deficit came to just under ISK 21bn, as compared with over ISK 47bn in April, and it was hardly more than half the size of the May 2023 deficit. The year-on-year improvement in goods trade was due to stronger exports – primarily an increase in exports of manufactured goods, farmed fish, and marine products – and to reduced imports of investment goods, transport equipment, commodities, and consumer goods apart from food and beverages.

The modest size of the May 2024 goods account deficit relative to the months beforehand is probably due in part to the stability of the ISK in May, despite indicators implying that it was a rather sluggish month for tourism. Tourism activity was fairly tepid in April, as we have discussed previously. Tourist departures via Keflavík Airport declined by 3.5% YoY during the month, and foreign nationals’ overnight stays at all types of registered guest accommodation fell even more sharply, or almost 13%. As is noted above, a number of indicators suggest that May will turn out similarly weak for the tourism industry.

Possibility of a modest appreciation … for the present

Included in our newly published macroeconomic forecast is a discussion of projected near-term developments in the ISK exchange rate. Prospects for external trade in the near future are still relatively favourable, even though the outlook for 2024 has darkened since our previous forecast, issued at the beginning of the year. The outlook is for a modest current account surplus in each year of the forecast horizon. The surplus could come to an average of almost ISK 40bn per year during the period.

Furthermore, the interest rate differential with abroad, which attracted significant foreign capital to Iceland last winter, looks set to remain wide in the coming term. For instance, non-residents’ holdings in Icelandic króna-denominated Treasury bonds increased by ISK 42bn in nominal terms between end-September 2023 and end-April 2024, according to the Government Debt Management website. Furthermore, Iceland’s external position is strong, as we discussed here, and the stock of foreign-owned securities remains modest in historical and international context.

Offsetting potential FX inflows from the above-mentioned sources are the pension funds’ continued foreign investments, which totalled ISK 83bn in 2023. Other domestic entities could also step up their foreign investment in the future, particularly if the ISK strengthens temporarily by more than we expect.

As is typically the case, short-term ISK volatility can be expected in the years to come. According to our forecast, the ISK will be approximately 5% stronger at the end of the forecast horizon than it was at the end of 2023. This translates to a price of ISK 143 per euro, which represents a less pronounced appreciation than we previously expected, not least because of rather bleaker prospects for export growth.

Among key uncertainties about the exchange rate is the question of how developments in tourism play out in the coming term. If tourism-generated export revenues in 2024 remain flat or contract relative to last year’s total of nearly ISK 600bn, an ISK appreciation in coming quarters will grow accordingly less likely and a depreciation this coming winter more likely. On top of this are the usual uncertainties about developments in import and export prices and about cross-border investment flows and credit financing.

If our projections about Iceland’s exchange rate, wages, and prices are borne out, such an ISK appreciation – together with more rapid wage growth and higher inflation than in trading partner countries – will push the real exchange rate close to its previous high by 2026, which is the end of the forecast horizon. As a result, the prospect of further strengthening grows dimmer over time. Similarly, a depreciation further ahead becomes more likely unless there is a change in wage growth and inflation. This would be in line with the consistent pattern of recent decades, where the real exchange rate has ultimately rebalanced through a nominal currency depreciation.


Jón Bjarki Bentsson

Chief economist