As is noted above, the ISK depreciated markedly in Q4/2022. By the year-end, it was nearly 5% weaker than at the beginning of October, with half of that depreciation occurring in November. The Central Bank (CBI) intervened at the peak of FX market volatility in November, selling euros for nearly ISK 5bn in a bid to restore some sort of balance. But in spite of sizeable sales from the international reserves during the autumn, the CBI’s net EUR purchases outpaced sales by ISK 13bn in 2022 as a whole. The international reserves totalled ISK 893bn (just over EUR 6bn) at the end of November and presumably held broadly unchanged until the year-end.

A hefty goods account deficit …

We have recently discussed Iceland’s record deficit on goods trade in autumn 2022, which totalled ISK 145bn in September through November; however, the patient rallied somewhat in December. According to preliminary figures from Statistics Iceland (SI), the balance on goods trade was negative by just under ISK 13bn in December, the smallest monthly deficit since January 2022. The improvement in goods trade figures stems from a surge in exports (which totalled ISK 101bn) concurrent with a month-on-month contraction in goods imports (which came to ISK 114bn) in ISK terms. The jump in exports is due in part to record aluminium exports in December (ISK 44bn) after two sluggish months in October and November. On the imports side was a contraction in imports of fuels and investment goods. December saw record-breaking motor vehicle imports totalling roughly ISK 15bn, however, presumably owing in part to a year-end change in taxes on new cars.

Figures on services trade in the final months of 2022 are not yet available, but based on passenger numbers, payment card turnover, and so forth, we project that the balance on services will show a surplus for the period. Overall, combined goods and services trade may well have been broadly in balance in December, after a hefty deficit during the months beforehand.

… investment-related outflows …

Of course, trade in goods and services is only one of several factors affecting the ISK exchange rate at any given time. Another factor that doubtless made a strong impact in 2022 is the flow of capital relating to the financial account; i.e., FX flows related to changes in Iceland’s external assets and liabilities,

including the pension funds’ foreign investments. In the first eleven months of 2022, the pension funds’ net FX purchases totalled ISK 92bn, an increase of 70% year-on-year. Presumably, the funds continued to buy currency in December, as falling share prices abroad gave them greater scope for foreign investment in 2022 than in 2021.

In addition, inflows from new inward foreign investment probably shrank markedly in the closing months of 2022, after a surge relating to domestic companies’ sales of subsidiaries to foreign owners in September and October. The second phase of the Icelandic equity market’s inclusion in certain FTSE Russell indices may well have led to some inflows in the last few weeks of the year, though, as some international index funds are required to invest in Icelandic shares. It could be that reduced net outflows for goods and services trade coupled with more favourable flows relating to the financing balance explain a fair share of the stability of the ISK in December relative to the months beforehand.

… difficult financing conditions abroad …

In addition to the aforementioned FX flows relating to changes in cross-border securities holdings, changes in loans could be reflected in exchange rate movements at any given time. It is more difficult to pinpoint these flows over the short term, however, owing to a lack of timely data.

For example, financing conditions in foreign currencies could affect FX market flows, as the interest environment in major currency areas has changed radically in the past year. Base interest rates in all major currencies have skyrocketed, and interest rate spreads have widened significantly. For example, according to data from Refinitiv, the benchmark yield on five-year European corporate bonds with a BBB- rating rose from 0.6% to just over 4% in 2022. This includes the impact of the borrower risk spread vis-à-vis the risk-free rate, which was more than a percentage point larger at year-end 2022 than it was a year earlier.

According to the recently published minutes of the CBI Financial Stability Committee’s (FSN) December meeting, the Icelandic banks’ foreign funding conditions have deteriorated in the recent term and credit spreads on their foreign-denominated bonds have risen. The FSN mentioned this as one of the risks to financial stability.

The foreign-denominated financing terms offered by Icelandic banks to domestic firms are inevitably based on the terms available to the banks themselves. As a result, tighter funding conditions could affect Icelandic firms’ refinancing, perhaps prompting them to shift their financing from foreign to local currency. All else being equal, such a shift would lead to deleveraging in foreign currency and call for outflows when borrowers buy FX to retire foreign loans. We think it highly likely that something quite like this occurred in H2/2022, affecting the ISK accordingly.

… and changed expectations have all made an impact

We recently published a post-mortem report encapsulating how our January 2022 exchange rate forecast had materialised. To put it as briefly as possible, our forecast of the average 2022 exchange rate was very close to accurate, but developments within the year differed markedly from our expectations. In this regard, we have identified yet another culprit: forward position-taking and how it develops at any given time.

Concurrent with the appreciation of the ISK in H1/2022, the banks’ net forward FX position – which reflects their customers’ position-taking with the ISK – increased by ISK 75bn, presumably driven by expectations of growing FX inflows over the course of the year. As a result, most of the appreciation that would otherwise have come in the wake of the peak tourist season probably showed up earlier in the year.

From end-August to end-November, this same position shrank by ISK 50bn, to ISK 147bn at the end of the three-month period. At its December meeting, the FSN considered it likely that this was due to changed expectations about the ISK exchange rate. Others have pointed out, though, that margin calls relating to this position-taking may also have put downward pressure on the ISK. We think it probable that developments in forward transactions affected intrayear exchange rate movements, and it will be interesting to see how the position develops in the months to come.

Tailwinds supporting the ISK more likely as the year advances

What, then, is the outlook for all of these factors – and for the ISK exchange rate – in 2023?

We consider it likely that Iceland’s current account will move towards better equilibrium later this year, after hefty deficits in 2021 and 2022. A sizeable deficit on goods trade could remain, however, and the surplus on services is unlikely to offset it in full before the peak tourist season arrives in June.

The outlook is still for large-scale FX purchases by the pension funds, as incoming premiums exceed pension benefits and operating expenses by a comfortable margin, and most of the funds are inclined to step up their foreign investments rather than scaling them down. On average, the pension funds bought FX for just over ISK 8bn per month in 2022 (apart from December), and we estimate that they will at least keep up this pace in quarters to come.

Inflows relating to securities investments are more uncertain. It is worth noting, though, that the third and final phase of Iceland’s inclusion in the FTSE Russell indices will take place in March. Furthermore, foreign investors’ holdings in Icelandic securities are on the low side, both in historical terms and in international comparison, and it is quite likely that there will be some investment-related inflows this year, as there were in 2022.

Conditions in foreign funding markets are still challenging and could remain so for some time. They are likely to improve as the year progresses, although it is impossible to predict developments with any certainty.

It is also difficult to foresee how position-taking with or against the ISK will play out, as it depends largely on developments in the above-mentioned factors and expectations about them. That said, these ISK positions appear to have become more balanced over the course of Q4/2022, if the chart above is any indication.

In sum, we consider it likely, based on the above-described factors, that the ISK will be on the defensive in the next few months. The outlook for FX flows grows steadily brighter as the year advances, although it is impossible to pinpoint when, and to what extent, more favourable flows will cause the ISK to appreciate. In general, though, a strong international investment position, a more favourable GDP growth outlook than in trading partner countries, declining inflation, and various interesting investment options in Iceland should support the ISK in the coming term.