CBI a big player in the FX market

nullThe Central Bank (CBI) has been extremely active in the foreign exchange market in the past two months. Its share of market activity in January was the largest in over four years. From end-November until end-January, the CBI added EUR 107 m (about ISK 17 bn) to the foreign exchange reserves, stepping up the pace as the ISK appreciated over the course of the two months. This can be read as a sign that the Monetary Policy Committee (MPC), which sets policy on the bank’s FX market activity, considers the current exchange rate reasonably appropriate in view of the state of the economy and the inflation outlook.

Hefty market share

nullThe CBI began buying currency on 29 November, following a 1% appreciation of the ISK against the euro. In December it bought EUR 33 m in the market, and in January it bought a total of EUR 68 m, including EUR 35 m on a single day, 29 January. The CBI accounted for over 32% of total interbank FX market turnover in December and nearly 44% in January. This is a radical departure from its average market share of just under 9% over the first 11 months of 2013. The bank continued its buying spree at the beginning of February and shows no signs of pulling back.

Wintertime cheer following policy switch

Last May the CBI announced a change in its FX market intervention policy. Instead of its regular currency purchase programme, which it had suspended at the end of 2012 because of unfavourable FX flows, it instituted a more active policy aimed at mitigating exchange rate volatility, with the overarching objective of smoothing out fluctuations in inflation and inflation expectations. The bank emphasised at the time that the foreign currency purchased during periods of strong foreign exchange inflows would be used to support the króna when the flows reversed.

nullIt is likely that few observers suspected at the time the policy was announced that the dark days of winter would prove to be an advantageous time to stockpile foreign currency. In recent years, foreign exchange flows have been negative in the depths of winter, and only a year ago the CBI sold EUR 42 m from its reserves between December and mid-February in order to shore up the króna, which still fell by nearly 3% against the euro during that period. This year brings with it a new season, however, with the ISK strengthening by 4% against the euro since late November, when the CBI began bolstering the reserves. It is not entirely clear why FX inflows are so strong at present, although relatively modest foreign loan payments, the year-on-year surge in tourist visits to Iceland, Landsbankinn’s abundant FX liquidity position, and the increase in demersal fish quotas are all possible contributors.

Is the CBI content with the current exchange rate?

It is noteworthy that the CBI seems to be responding sooner to FX market inflows than it did a year ago. Although it is difficult to draw sweeping conclusions from such a short period of activity, there is a clear difference in the bank’s response this year to movements in the market. One way to explore this is to examine accumulated movements of the ISK versus the euro on the day the bank intervenes in the market and the two days prior. The CBI intervened a total of 13 times during the period in question. A comparison of December 2013 and January 2014 shows that, in December, the bank intervened following an average uptick of 0.6%, while in January the average pre-intervention uptick was 0.2%. In other words, the CBI intervened following much more modest ISK appreciation in January than in December, reflecting the fact that the EURISK exchange rate rose by 2.7% in December and 1.2% in January. Excluding 29 January, the day of its big binge, the bank’s purchases in the two months were about equal; if that day is included, the January total is about twice the December total.

Because the MPC is the architect of the bank’s FX market activity, it is tempting to conclude that the Committee decided to prioritise currency accumulation over ISK appreciation in January. The year-end exchange rate was quite a bit higher than the CBI had projected in its November forecast. In view of the need to maintain a current account surplus to service foreign debt and/or bolster reserves in the near future, it is eminently sensible to take advantage of this windfall and use the unexpected winter inflows to amass foreign currency rather than push the real exchange rate upwards, to the detriment of Iceland’s competitive position, as accumulating currency now gives the bank more scope to shelter the ISK against depreciation when the tailwinds reverse. At all events, it will be interesting to read the CBI’s discussion of exchange rate movements next week, when the interest rate decision and the new issue of Monetary Bulletin are published.