Króna stabilises in H2/2017

Even though most of the capital controls have been lifted and the Central Bank (CBI) has largely refrained from intervening in the foreign exchange market, the ISK exchange rate has been relatively stable since mid-year. In fact, it is virtually the same now, at the year-end, as it was in the beginning of 2017. This indicates both that the liberalisation process has been successful and that capital inflows and outflows are well balanced at present, with outflows from the capital account plus CBI foreign currency purchases earlier in the year offsetting inflows due to the current account surplus. 

This year can be divided into three parts as regards the FX market environment. From the beginning of January through mid-March, the market was largely as it had been in the years beforehand: broad-based capital controls were in place and the CBI was relatively active in the interbank FX market. From mid-March, when the controls were lifted, through the end of May, most types of capital transfers were unrestricted, yet the CBI was still a relatively active player in the FX market. Since the beginning of June, however, the CBI has intervened in the market rarely, and then primarily to prevent the development of spirals featuring large exchange rate movements with low underlying trade volumes. 

As the chart above indicates, the CBI’s role in the market has changed substantially this year. In 2016, the bank accounted for 55% of all interbank market trading. It accounted for just under 30% in H1/2017 and less than 2% of total turnover in H2. 

It can be said, then, that Iceland’s unrestricted foreign exchange market has matured rapidly this year. Short-term exchange rate volatility increased markedly during the first weeks following liberalisation and again during the summer, in response to a sudden, steep drop in the exchange rate. Since mid-August, however, volatility has subsided once again, and in the past few months it has been rather modest, compared with what could have transpired in a vastly freer market coupled with reduced CBI intervention. 

It is interesting to compare overall exchange rate developments in 2017 and the years before then. In recent years, the CBI has managed the FX market closely through the capital controls and its own intervention policy. The bank’s market activity served two purposes: to mitigate exchange rate volatility and to expand the CBI’s net foreign exchange reserves. As the chart below shows, the exchange rate was virtually unchanged from Q2/2014 until summer 2015. From July 2015 through year-end 2016, however, the ISK appreciated strongly in spite of the bank’s intervention in the market. 

As 2017 comes to a close, the exchange rate is virtually the same as it was a year ago, albeit with some month-to-month fluctuations. It is worth remembering that only a short while ago it was generally deemed highly likely that capital account liberalisation would trigger a substantial depreciation of the ISK. Events have turned out quite differently, though: liberalisation has strengthened and deepened the FX market, and foreign currency flows to and from Iceland have been broadly in balance.

This is due to two offsetting factors. On the one hand, net trade-related FX inflows have been substantial, with the current account surplus for the year looking set to measure about ISK 120-130 bn. On the other hand, it appears that net outflows through the capital account – stemming from outward investment net of inward investment and lending activity, plus the CBI’s foreign currency purchases in H1/2017 – have been roughly the same size as the current account surplus. It should be borne in mind, however, that capital controls remain in place, in the form of the special reserve requirement on foreign capital inflows invested in króna-denominated instruments at Icelandic interest rates.