This can be seen clearly in the chart above, which shows flows relating to new investments registered by the CBI in recent year. It is worth noting, however, that if the above-mentioned investments were partially hedged with currency swaps at the outset, the currency flows associated with them may be far less than the figures on the chart suggest. This could explain in part why the aforementioned sale of Arion shares appears not to have put undue pressure on the ISK in Q1/2021.

Pension funds sold currency during Advent

The Icelandic pension funds have also been relatively big buyers of foreign currency in the recent past, as they are growing by leaps and bounds and need to invest in foreign securities. In the past few quarters, however, the situation has been quite interesting, if the CBI’s figures are any indication.

The impact of the pension funds’ agreed hiatus on FX purchases from mid-March to mid-September can be seen clearly in the chart above. Between April and August 2020, the funds purchased the equivalent of a net ISK 3bn each month, as opposed to over ISK 9bn per month over the twelve-month period beforehand. The agreement with the CBI expired in September, however, and the funds resumed their FX purchase at roughly the pre-pandemic pace. But a shift occurred late in the year, and in December the pension funds sold nearly ISK 2bn more currency than they bought.

In the Financial Stability report, the CBI posits that some of the funds’ foreign asset ratios may have been closing in on their internal benchmarks, prompting them to rebalance their portfolios. According to the CBI, foreign assets accounted for just under 34% of total assets held by the pension funds at the end of 2020, after increasing by almost 4 percentage points during the year.

Large-scale sales from the reserves …

The CBI has responded to the above-mentioned outflows and the pause in tourism-generated FX inflows by selling currency from its reserves. The chart above shows how the bank has counterbalanced these latter outflows by intervening ad hoc in the market, in addition to the regular FX sales programme it introduced in mid-September. In all, these sales by the CBI totalled the equivalent of ISK 167bn from the onset of the pandemic through end-March 2021. On the buying side, non-residents sold equities for ISK 62bn and Treasury bonds for ISK 29bn over this period, in addition to ISK 23bn in offshore ISK that exited via the FX market. Over this same period, the pension funds’ net FX purchases totalled nearly ISK 56bn. Therefore, these buyers’ combined demand for foreign currency could very well have been close to the amount sold by the CBI. It is worth noting, though, that some portion of the securities holdings may have been hedged against exchange rate risk with forward currency contracts.

… but the reserves remain strong

These large-scale sales of currency definitely affect the CBI’s international reserves. At the beginning of 2020, the reserves amounted to EUR 4.7bn, or nearly ISK 640bn. By the end of March 2021, however, the bank’s net FX reserves – i.e., FX assets net of FX liabilities – came to EUR 3.4bn, or ISK 510bn. But the gross reserves have changed less than this, as the Treasury deposited EUR 750m with the CBI at the beginning of the year after issuing a eurobond in that amount. At the end of March 2021, then, the gross reserves weighed in at ISK 857bn, up from ISK 822bn at the beginning of 2020 (both figures at spot exchange rates).

Some observers might wonder whether the CBI is being too free with the reserves, given that a country with a tiny floating currency like the ISK has to provide itself with the shelter afforded by abundant international reserves. Actually, we do not share these concerns, as the bank has had good reason to take these steps in the recent past. Furthermore, its reserves remain ample, and relative to other economic variables they are adequate and then some.

One of the roles of international reserves is to cushion against excess exchange rate volatility caused by temporary outflows – when non-residents sell highly liquid ISK assets, for instance. But such assets are at a minimum these days, having exited the market in large amounts over the past year, as the above discussion indicates.

The chart above gives a simplified comparison of new investment by non-residents since the beginning of 2015, on the one hand, and the FX reserves, on the other. It is hard to conclude that the CBI will have any difficulty providing currency to the market for all of the assets that remain. It is also worth noting that according to the Financial Stability report, the reserves currently equal 168% of the International Monetary Fund’s reserve adequacy metric (RAM), which is designed to give an indication of whether an economy’s reserves are sufficient to forestall a steep depreciation or a currency crisis in the event of a shock.

Furthermore, the FX reserves are not the only thing supporting the ISK at the moment. Iceland’s international investment position (IIP) is very strong, with external assets exceeding external liabilities by one-third of GDP at the turn of this year. This robust position greatly reduces the likelihood of disorderly outflows via the FX market in the near future.

When the COVID-19 pandemic finally comes to an end and tourism resumes, currency inflows will increase markedly and the CBI can presumably pull back from its hands-on approach to the FX market. Actually, FX flows have been well balanced in recent weeks, and the CBI has already scaled down its activity in the market, both by reducing the amount of currency it sells regularly and by intervening less often. It is even conceivable that sooner rather than later, the bank might find itself in the position it enjoyed in 2016-2017, when it bought large amounts in the FX market in order to expand the reserves and lean against the appreciation of the ISK.