Will the ISK get some wind in its sails?

The ISK exchange rate has sagged a bit since early summer, after strengthening markedly over the first five months of this year. The dollar has appreciated substantially against the ISK in 2022 to date, while the euro and pound sterling have weakened. The outlook for external trade in coming quarters is more ambiguous than before, but a current account surplus is in the cards further ahead.

After appreciating by nearly 3% in 2021, the ISK continued to strengthen in trade-weighted terms over the first five months of 2022. From the beginning of January through end-May, it appreciated by an average of just over 7%, but in June through September it reversed course and depreciated by nearly 4%.

Developments vis-à-vis major currencies have varied greatly, however, as global FX markets have been highly volatile and the US dollar has strengthened significantly against other key currencies thus far in 2022. The dollar is up 9% year-to-date against the ISK, for instance, whereas the euro has depreciated by about 5 krónur and the pound sterling by 9 krónur over the same period.

This is extremely important for Icelandic entities’ competitive position relative to other currency areas. For example, Iceland is roughly as expensive a destination for American tourists as it was a year ago – cheaper, in fact, if the comparison is based on the Harmonised Index of Consumer Prices (HICP) – as the appreciation of the dollar more than compensates for the high inflation that has plagued Iceland over the past year. But conversely, inflation and internal exchange rate movements have made Iceland a much costlier destination for travellers from the UK and the eurozone.

New FX flow determinants

This year’s developments in the ISK exchange rate cannot be explained in terms of the underlying factors that have generally determined its movements in recent years. For example, Iceland ran a current account deficit of ISK 84bn in H1/2022, flows relating to new investment by non-residents most often went outwards rather than inwards (except in April), and the pension funds’ net foreign currency purchases over the first eight months of the year came to ISK 58bn.

On the other hand, increased position-taking with the ISK via forward contracts probably played a role in the appreciation early in the year despite the hefty current account deficit. Consequently, a large part of the appreciation that would otherwise accompany FX inflows later this year has already materialised. From April through June, the commercial banks’ net forward position increased by nearly ISK 76bn, to ISK 192bn at the end of June. The banks’ forward FX position reflects the reverse of the position held by customers, many of whom entered into forward contracts to sell currency during the period. As the chart shows, however, the forward position grew far more slowly in July and August, totalling ISK 197bn at the end of August.

The CBI supported the ISK in September

The CBI has greatly reduced its FX market intervention recently, although it takes action when temporary imbalances occur, particularly when they involve investment-related flows. Such imbalances developed in September, in fact, around the time the Icelandic equity market was moved up by one category in the FTSE market indices. In all, the CBI sold EUR 42m in exchange for ISK in the interbank market during the month, making September the bank’s biggest month for currency sales since March 2021. Notwithstanding this activity in September, the CBI bought EUR 126m net of sales over the first nine months of the year.

ISK likely to strengthen further ahead

The near-term outlook for external trade has dimmed somewhat in recent months, as there was a sizeable current account deficit in H1. Furthermore, the Q3 deficit on goods trade totalled ISK 95bn, considerably more than we had anticipated. The outlook is for a current account deficit in 2022 as a whole, and for a smaller surplus in 2023 than we had projected. As a result, the tailwinds supporting the ISK will probably be weaker in the coming term than previously appeared. Even so, a current account surplus is in the cards further ahead, with a fairly large interest rate differential, a strong external position, more favourable growth prospects than is widely envisioned abroad, and non-residents’ securities holdings at a historical low.

On the other hand, the pension funds are likely to invest heavily abroad in the coming term. National saving in excess of investment will therefore be channelled to a large extent towards long-term investments in foreign assets.

The scope and timing of exchange rate movements is always highly uncertain, but we forecast that the ISK will be approximately 6% stronger at the end of the forecast horizon than at end-August 2022. The real exchange rate in terms of relative consumer prices will then be broadly as it was in 2018-2019.


Jón Bjarki Bentsson

Chief economist