The ISK has gained considerable steam against most major currencies since the beginning of September and is now close to its strongest year-to-date in trade-weighted terms. It has appreciated by nearly 5% against both the euro and its chief satellite currency, the Danish krone. The appreciation versus the pound sterling measures almost 3%, and against the Japanese yen the ISK has strengthened by just over 6%. The exception to this rule is the US dollar, which itself has been appreciating throughout this autumn, as the ISK has. The USDISK exchange rate is broadly as it was in late summer, although it has fluctuated somewhat in the intervening months.
ISK gains steam as the days grow shorter
The ISK has strengthened markedly since the beginning of September, despite Iceland’s Q4 trade deficit. Capital inflows for securities investments, changed expectations, and modest investment-related outflows are probably major factors in the past few months’ appreciation. Although the ISK is presumably still within a band indicating relative equilibrium, a sizeable additional appreciation could call forth growing imbalances and lead to a depreciation in the future.
We discussed the short-term exchange rate outlook in early October. At that time, we pointed out that the ISK could run into headwinds in the final quarter of the year, and we mentioned a few likely factors that could contribute to such a turn of events. It is therefore interesting, as the holidays draw near, to take stock of developments in recent months and make an effort to envision how things might unfold in the coming term.
Current account set to be broadly in balance this year
The autumn has been rather more favourable for external trade than was widely feared. New figures from the Icelandic Tourist Board on departures via Keflavík Airport show that November was the fifth consecutive month to see a year-on-year increase in tourist departure numbers, after a sudden drop in Q2/2024. According to those numbers, foreign nationals’ departures were up more than 9% YoY, the largest increase by that measure since February 2024.
Nevertheless, it should be borne in mind that departure numbers can be of uncertain reliability, as the Nevertheless, it should be borne in mind that departure numbers can be of uncertain reliability, as the online medium ff7 has recently pointed out. The same applies, actually, to data on guest arrivals and bed-nights in Statistics Iceland’s (SI) books, which have apparently been affected by incorrect classification of domestic and foreign guests. On the other hand, the Central Bank’s (CBI) payment card turnover figures indicate that in spite of everything, the autumn tourist season was reasonably buoyant and generated somewhat more foreign exchange revenues than in the same period of 2023.
In the past decade or so, the current account has been characterised by a tug-of-war between the surplus on services trade and the deficit on goods trade. As we have discussed recently, the surplus on services trade has tended to outweigh the goods account deficit in 2024 to date. According to SI data, the combined surplus on goods and services trade came to just over ISK 64bn in Q3, as compared with a deficit of ISK 56bn in H1.
Goods trade figures are generally published well before corresponding figures on services trade become available. For instance, SI recently released preliminary figures data on goods trade in November. According to those figures, the goods account deficit totalled almost ISK 32bn in November, while the October deficit was nearly ISK 49bn. The deficit for Q4 therefore exceeds ISK 90bn and is ISK 20bn larger than the deficit for the same period of 2023.
In all likelihood, then, the goods account deficit for Q4/2024 as a whole will be considerably larger than the services account surplus, and the trade balance will show a deficit close to the 0.4% of GDP (approximately ISK 20bn) that we projected in our macroeconomic forecast from late September. Because total export revenues from goods and services trade are likely to exceed ISK 1,900bn and expenditures due to imports will be broadly similar this year, it can be said that in this context, imports and exports of goods and services will be fairly well balanced even though the final outcome will probably be slightly in the red.
There’s more to the FX market than external trade
The foreign exchange market reflects far more than just the activity underlying cross-border trade. When exports appear to be fairly well balanced, as is currently the case, other factors may take on greater importance in determining short-term exchange rate movements.
An example of such a factor is currency flows relating to changes in Iceland’s assets and liabilities. The pension funds, for instance, take a portion of their net revenues from pension contributions and financial income and use it to invest abroad, mostly in UCITS funds and equities. According to data from the CBI, the pension funds’ net foreign currency purchases totalled ISK 51 over the first eight months of this year. Although this was ISK 17bn lower than in same period last year, the fact remains that in 2023, most of the pension funds were approaching their internal target ratio of foreign assets to total assets, according to the CBI.
Furthermore, the funds expect to receive substantial foreign assets in the near future. These assets will take the form of either euros or shares paid out upon the takeover of Marel by US company John Bean Technologies (JBT). As of this writing, Marel’s market value is ISK 467bn, and the pension funds own just over a third of shares in the company. There are many signs that the pension funds have had limited interest in making hefty FX purchases in the final third of 2024.
Concurrent with the funds’ apparent waning interest in buying currency, foreign investors have shown greater interest in buying securities denominated in ISK. This includes shares of stock (not least shares in Marel) and Treasury securities, which form the foundation for the yield curve in the Icelandic bond market. It is difficult to obtain timely data on such changes in share ownership. Government Debt Management (GDM) maintains similar data on Treasury bonds, however. The most recent figures from GDM show that foreign investors’ holdings in ISK-denominated Treasury bonds totalled ISK 104bn at the end of November, an increase of 0.7 b.kr. relative to end-October.
In September and October combined, however, non-resident investors bought ISK-denominated Treasury bonds for only a scant ISK 11bn. As the chart indicates, this is on a par with the average for the first five months of 2024, apart from February. In February, non-residents bought Treasury bonds worth nearly ISK 19bn, as the ISK appreciated markedly during the month despite large-scale FX purchases by the CBI. Presumably, non-residents’ Treasury bond purchases contributed to the strengthening of the ISK during the autumn.
Another factor in the FX market is forward FX contracts, which are used mostly for hedging purposes, as well as for speculation. Although the contracts involved represent FX transactions to be executed in the future – just as the name implies – they tend to affect the market at the time the contracts are made. In other words, an increase in the banks’ net forward FX position, which reflects corresponding net positions held by their customers, often contributes to an appreciation of the ISK at any given time, and conversely, a decrease in the net forward FX position can put downward pressure on the ISK.
During the first two months of 2024, the net forward position grew by about ISK 26bn, but it shrank steadily during the period to follow. By the end of October, the banks’ net forward FX position had shrunk by over ISK 50bn since the beginning of March, to a total of just over ISK 43bn, its lowest by that measure since early 2021. It will be interesting to see updated figures from the CBI in the weeks to come, and we would not be surprised if there were something of a turnaround in November, given the appreciation of the ISK during that month.
Just how strong is the ISK?
Despite a few month-to-month fluctuations, the trade-weighted ISK exchange rate has been about the same in 2024 as in 2023, on average. The trade-weighted index (TWI) averaged 195.2 points in 2023, and its average in 2024 to date, with only a couple of weeks to go until the year-end, is 195.3. As the chart shows, the TWI has ranged between 185 and 200 since the beginning of 2021. At present, it lies close to the middle of this range.
The real exchange rate tells a different story, however, as it reflects how expensive or competitive a market Iceland is in international context, after adjusting for relative consumer prices or labour costs. Iceland’s real exchange rate has risen steeply in the recent term. In November, the real exchange rate in terms of relative consumer prices was at its highest since autumn 2018. The real exchange rate in terms of relative unit labour costs paints a similar picture, although the increase has not been as steep in recent quarters. This is because wages in Iceland have risen more modestly than often before, and because wage growth in trading partner countries has accelerated in the recent past.
As the chart indicates, the real exchange rate has not returned to the high level seen during the boom years preceding the financial crisis and again during the tourism boom of 2017-2018. Of course, Iceland’s economy was very different in the latter period than it was in the former. Around the mid-2000s, the country was running an enormous current account deficit, and massive inflows of volatile capital pushed the real exchange rate very high. In the past decade, however, the rise in the real exchange rate was driven primarily by a sizeable current account surplus.
It is difficult to pinpoint an “appropriate” real exchange rate at any given time, as the estimated equilibrium real exchange rate is affected by the method used to carry out the estimate, and factors such as terms of trade and the external position of the economy change the situation from one period to another.
At a glance, though, it seems to us that the current ISK exchange rate is consistent with a decent internal and external equilibrium in the economy for the coming term. In other words, the exchange rate does not appear to have risen to a level where a weaker competitive position and an ISK with abnormally high purchasing power would cause a gaping current account deficit. Nevertheless, all else being equal, it can be assumed that there is little scope for further ISK appreciation without the emergence of such imbalances.
To encapsulate briefly: We conclude that the ISK exchange rate is relatively high these days, but not excessively so. In our macroeconomic forecast from late September, we assumed that the ISK would strengthen modestly in coming months, putting the TWI at around 194 points in 2026 and giving an average EURISK exchange rate of 148.
As sometimes happens, our forecast has materialised with room to spare, some three months later. As of yesterday, the TWI stood at 192 and the EURISK exchange rate just below 146. There will doubtless be developments in the coming term that will affect the exchange rate outlook in the short or long run. As things look now, it appears to us that exchange rate uncertainty is broadly symmetric for the coming term. As always, uncertainty grows greater further out the horizon, and higher inflation and faster wage growth in Iceland than in neighbouring countries could push the real exchange rate steadily upwards, which would ultimately call for an adjustment in the form of a nominal ISK depreciation.
