It is also well balanced at present, and while the Central Bank (CBI) intervened actively from the onset of the pandemic until mid-2021, it has more or less watched from the sidelines from then until now. Actually, in November the CBI conducted no transactions in the market at all, for the first time since the pandemic struck. Its net FX market sales in 2021 to date total EUR 141m, well below last year’s total of EUR 830m.

The ISK doesn’t stand alone

The recent trend in the ISK versus major currencies is not an outlier. Other countries that have floating currencies and independent monetary policy, are small players on the global stage, and rely heavily on international trade have also seen their share of exchange rate volatility. In general, these countries’ currencies weakened early in the pandemic, particularly to include currencies from countries whose tourism sector plays a large role in the economy. As often happens when the markets turn ornery, many investors responded to mounting pandemic-related uncertainty by fleeing to the safety and greater liquidity of major currencies.

As the chart shows, these currencies moved in various directions against the euro after the initial depreciation passed. Relative to the euro, the ISK is now broadly at a level similar to the Polish złoty, the Hungarian forint, and the South African rand. But it should also be borne in mind that the euro itself has fluctuated markedly against other major currencies this year. To give an example, it is now nearly 8% weaker against the US dollar than it was at the beginning of the year.

The real exchange rate tells a multitude of tales

Although the nominal ISK exchange rate is still much lower than before the pandemic, developments in prices and wages relative to other countries should also be borne in mind in any consideration of how much “head room” the ISK will have once external trade normalises after the pandemic has passed. Remarkably enough, even though domestic inflation is high, Iceland does not stand out from the crowd in this regard. In November, inflation measured 4.8% in Iceland, as compared with 6.8% in the US and 4,9% (on average) in the eurozone, while in the UK it stood at 4.2% in October. The real exchange rate in terms of relative consumer prices has therefore developed broadly in line with the nominal exchange rate in the recent term and is still approximately 5% below its 2019 average, for instance.

But the real exchange rate in terms of relative unit labour costs paints a different picture. Based on the CBI’s most recent data, which extend through Q3/2021, it is broadly back to the 2019 average, although it is still somewhat below the peak of the mid-2010s. The main determinant here is that wages have risen considerably faster in Iceland than in trading partner countries.

How sustainable would an ISK appreciation be?

It is difficult to pinpoint where the equilibrium exchange rate will lie in the coming term. There are two main reasons for this.

• First of all, the external balance of the Icelandic economy has improved markedly from where it was until the past decade. Iceland’s international investment position has undergone a sea change, with net external assets totalling over 41% of GDP at the end of September. This mirrors the turnaround in external trade, where current account surpluses – previously a rare occurrence – have become the general rule in the past decade or so. This change for the better supports a higher equilibrium exchange rate than could otherwise be expected.
• Second, developments in inflation and wage costs will determine in large part how much the ISK can strengthen without upending external trade, which could easily happen if Iceland’s competitive position deteriorates and Icelanders’ purchasing power relative to the rest of the world rises more than can be sustained in the long run.

But as before, we are of the view that the ISK will appreciate when external trade strengthens, fuelled by the recovery of tourism, a bountiful capelin season, and continued growth in exports of intellectual property, aquaculture products, and various industrial goods. In our macroeconomic forecast, published in September, we projected that the ISK would be an average of around 6% stronger in 2023 than it is this year. In rough terms, this means the euro would cost around ISK 140, the US dollar ISK 120, and the pound sterling around ISK 165 in 2023. It goes without saying, however, that such forecasts are highly uncertain as regards both timing and the size of the change in the exchange rate. In addition, the exchange rate projections above are based on the specified comparison currencies’ average exchange rates in 2021, but as we have seen recently, their position relative to one another is hardly etched in stone.

Two closely linked factors – whether Iceland can control inflation and whether wage costs adjusted for productivity growth develop reasonably well in line those in trading partner countries – will be of vital importance for the future. If this does not materialise, a rise in the exchange rate could prove nothing more than a brief respite, and the ISK could end up on the downward slide we have seen all too often in the past.