Why the turnaround in the ISK?

A number of factors help to explain why the ISK exchange rate has reversed course in recent weeks. The outlook is for a steady improvement in the current account balance as the year advances, and in our opinion, the likelihood of a further ISK appreciation will grow over the months to come.

The ISK has gotten some wind in its sails in recent weeks, after a marked decline early in the year. Last Friday, in fact, it rose to its strongest in 2023 to date. As of this writing, a euro costs just under ISK 150 and a US dollar just over ISK 140. The euro peaked at ISK 157 and the US dollar at ISK 146 in January.

What is behind this, and what is on the horizon for the ISK?

The pension funds bought unusually small amounts of foreign currency in February

The Central Bank’s (CBI) recently published Financial Stability report contains the customary review of the external position of the economy and currency flows. It also includes a number of interesting titbits that could shed light on recent developments in the foreign exchange market. For instance, the report presents a summary of the pension funds’ FX transactions, itemised by month. The pension funds are usually prominent purchasers of foreign currency, as they allocate a large share of paid premiums net of pension payouts and operating expenses to direct and indirect purchases of foreign securities.

In February, their FX purchases came to ISK 4.5bn, the smallest single-month total since February 2022. In comparison, they bought currency for an average of nearly ISK 9bn per month in 2022 as a whole. In the final four months of the year, when the ISK was losing considerable ground, their FX purchases averaged ISK 11bn per month. The Financial Stability report notes that the funds’ larger FX transactions took place on the days when the ISK was strengthening, even if those days came on the heels of a depreciation. The CBI opines that the pension funds appear to be absorbing a portion of excess short-term inflows.

Presumably, the funds’ lacklustre FX market activity in February does not set the tone for the months to come. But the CBI points out that a number of funds have lowered their foreign asset benchmarks between years rather than increasing them. That said, the pension funds generally plan to increase their ratio of foreign assets to total assets by 3.5 percentage points relative to year-end 2022 over the next several years.

Fluctuations in inward foreign investment

The Financial Stability report also contains a summary of registered new investment through January 2023. According to that summary, net new investment totalled ISK 81bn in 2022, including ISK 25bn for investment in listed equities and Treasury bonds. On the other hand, it points out an inconsistency with data from Nasdaq, which indicate that inflows for portfolio investment were roughly ISK 16bn more than is captured by the data on registered new investment. In addition to this, two foreign acquisitions of Icelandic companies make their mark on the numbers. As can be seen in the chart above, inflows for new investment declined sharply in the final months of 2022 and January 2023 as compared with last autumn. However, March should weigh more heavily in these figures than, say, January, as the final phase of Iceland’s promotion to secondary emerging market classification by index provider FTSE Russell took place during the month.

The current account deficit: is the worst behind us?

In addition to the above, flows due to cross-border goods and services trade are naturally an important factor in FX market developments at any given time. On that score, matters have somewhat improved after last autumn’s spate of outflows, as we have discussed recently. In 2023 to date, the goods account deficit has averaged around ISK 20bn per month, as compared with nearly ISK 34bn per month in H2/2022.

Furthermore, the winter tourist season should bolster the sector somewhat. Nearly 260,000 tourists visited Iceland in January and February combined, or around 90% of the total from the same period in 2019. Our rough estimates of combined goods and services trade year-to-date suggest that January was broadly in balance, while February showed a deficit of ISK 10-12bn. The services account fluctuates widely between seasons, and we think it probable that it will show a surplus well in excess of the goods account deficit once the peak tourist season arrives this summer.

Position-taking with the ISK has increased again

Developments in the commercial banks’ forward FX position give quite an accurate view of current market expectations about near-term exchange rate movements. Last year, the forward FX position ballooned in H1, as “customers hedged against the appreciation of the króna or took positions with it”, to borrow the wording from Financial Stability (p. 10). Those positions turned around as the year progressed, however, shrinking by nearly ISK 50bn from end-August through end-November.

In the recent past, however, commercial bank customers’ position-taking with the ISK has grown handsomely once again. The net forward position totalled ISK 174bn at the end of January, an increase of ISK 27bn since the beginning of December. Firms and investors are therefore hedging once more against the potential appreciation of the ISK, either now or by betting on such an appreciation in the next few months.

Tailwinds supporting the ISK grow more likely over time

As we discussed in our recent macroeconomic forecast, the likelihood of tailwinds buoying up the ISK will grow steadily over the quarters to come. The outlook is for a bountiful tourist season this summer and autumn, the capelin season now coming to a close will probably generate more export revenues than was anticipated at the turn of the year, marine product prices are generally high, and robust growth lies ahead in exports of farmed fish and services sectors such as intellectual property and specialist services.

Of course, imports are also expected to grow apace in the near future, but volumes are unlikely to grow at a rate comparable to the nearly 20% seen in 2022. The trade deficit should therefore be somewhat narrower than it was last year, and the current account deficit accordingly smaller.

As a result, near-term exchange rate movements probably depend less than before on whether there is a current account deficit and more on whether inflows for inward foreign investment and/or foreign lending for domestic investment offset outflows stemming from such things as the pension funds’ FX purchases. In this context, it is worth noting that foreign investment in Icelandic securities remains modest, and the outlook is for the domestic securities market to become more connected with markets abroad as Icelandic equities are included in more international indices. Furthermore, foreign financing could provide a hefty share of the capital needed for investment in, for instance, infrastructure and export sectors, which will require large-scale financing in the coming term.

With all of this in mind, it seems to us that the ISK is likely to be stronger 1-2 years from now than it was at the turn of this year, as we posit in our macroeconomic forecast. According to our forecast, the ISK will be approximately 8% stronger in the mid-2020s than it was at year-end 2022, which means that a euro will cost roughly ISK 142 as 2025 advances.

It should be noted, though, that the FX market is an unpredictable beast, and the ISK will doubtless fluctuate widely in the coming term. Furthermore, the outlook could change if prices in foreign markets develop favourably for Iceland or if unforeseen shocks like the COVID-19 pandemic strike once again. Hopefully, though – and presumably – the ISK has hit bottom for the present, and it is safe to say that help from that direction will be a most welcome ally in the bid to ease inflationary pressures.


Jón Bjarki Bentsson

Chief economist