As yet, there has been no simple explanation for this sudden upswing. Presumably, though, it stems from the financial account; i.e., it reflects a shift of capital from FX assets to ISK-denominated assets rather than flows deriving from revenues and expenditures. For instance, IT company Sensa was recently sold to Norwegian buyers for just over ISK 3bn. Yet it is unlikely that this alone explains the shift, except to a limited degree. Another factor is the deficit on goods trade, which was a modest ISK 5.5bn in November, according to preliminary figures from Statistics Iceland (SI). It is unlikely that services trade generated much of a surplus in November, though, as figures for 2020 to date indicate that the services account has been broadly in balance or even shown a slight deficit during the months most severely affected by the pandemic and associated response measures.

It is important not to underestimate the impact of expectations on exchange rate movements. Although there are few avenues for outright speculation in the FX market at present, many players have considerable flexibility in how they handle their FX trading, including exporters and owners of capital who are interested in shifting their assets between currencies. Positive news about COVID-19 vaccines and investment in Iceland, together with the turnaround in the exchange rate early in November, may well have motivated owners of foreign currency to convert it to ISK, thereby fuelling a sort of snowball effect, strengthening the ISK and prompting others to jump on the bandwagon and sell their FX before prices become less favourable.

Central Bank dusts off its "buy" button

With the ISK enjoying stronger tailwinds, the Central Bank (CBI) has found itself in a more relaxed position as regards FX market intervention. Nevertheless, it has continued the regular EUR sales programme it launched with the aim of deepening the market. Presumably, the CBI’s FX sales, which totalled EUR 87m in November, have done much to slake the pension funds’ thirst for foreign currency to invest abroad. Outside the regular intervention programme, where the bank had committed to selling EUR 3m daily in the FX market, the CBI’s FX sales totalled EUR 24m, the smallest irregular intervention amount since June.

In a newsworthy move, the CBI responded last week to the rapid strengthening of the ISK by buying EUR 18m, after selling its predetermined daily dose of EUR 3m that morning. It was the bank’s first FX purchase in the market since June. With that purchase, the CBI has shown its willingness to mitigate short-term volatility in both directions, particularly if the fluctuations stem from temporary one-off factors.

In 2020 to date, the CBI has sold nearly EUR 680m from its international reserves, just over 11% of the gross reserves at the beginning of the year. But even so, the bank is still well-heeled. At the beginning of 2020, its international reserves came to just over EUR 6bn, less EUR 1.4bn in FX liabilities, most of the latter due to the Treasury’s FX deposits with the bank. At the end of November, its gross reserves came to EUR 5.4bn, and net reserves totalled EUR 3.8bn. Therefore, by most measures – as a share of imports, short-term external liabilities, or GDP, for instance – the reserves are still sizeable, giving the CBI considerable scope to intervene in the FX market to mitigate short-term volatility.

ISK depreciation versus USD and GDP largely reversed

The appreciation of the ISK over the past few weeks has reversed much of the decline earlier in the year. Furthermore, exchange rate movements have differed greatly from one currency to another, as foreign FX markets have been quite turbulent in the wake of the Corona Crisis. For example, at the close of business on 7 December, one euro cost ISK 153 and had risen in price by 12.5% year-to-date. The US dollar, on the other hand, cost ISK 126, a 4% increase YTD, and the pound sterling had risen by just over 6%, to ISK 169.

As these figures show, there is a significant difference in how much imported costs have risen, depending on the currency of origin. In other words, imports from the eurozone are a full 12% more expensive than at the turn of the year, while imports from the US are 4% more expensive. Likewise, FX gains on external assets have differed from one currency to another. It is well to bear in mind here that a large share of the pension funds’ external assets are denominated in dollars, as the US securities market is the largest in the world.

What are the near-term prospects for the ISK?

The appreciation of the ISK is surely a most welcome development for many, after the slide in the autumn, but it can be a mixed blessing, as it erodes the competitiveness of Iceland’s export sectors. On the other hand, it is also detrimental when the ISK fluctuates as sharply as it has in recent weeks without any obvious reason. Such volatility exacerbates uncertainty for those whose operations or assets are highly exposed to exchange rate effects. In this light, we consider the CBI’s mitigating action a positive move, as short-term uncertainty is pronounced enough in any case.

We think, however, that the ISK will remain weaker for a while than it has been in recent years. Iceland’s export revenues are still down by about a third relative to recent years, and as long as tourism remains in hibernation, the current account balance will be fighting an uphill battle. Without doubt, short-term movements stemming from investments, cross-currency loans, and changed expectations will continue to affect the FX market until the spring.

A lower real ISK exchange rate is favourable for the present, as it gives exports a bigger boost. In particular, the tourism sector will benefit from a relatively weak ISK when international travel resumes and foreign travellers compare costs as they take their first post-COVID trips.

But we expect FX revenues to increase steadily as the summer approaches and tourism resumes its position as a key source of FX revenue generation. Positive news of vaccine development and distribution strengthen our opinion in this regard. As 2021 advances, it is quite likely that external trade will once again generate a surplus and the ISK will eventually appreciate. When and how much it does so remains to be seen, however.