Icelandic krona exchange rates reflect recovery of national economy

Written by Tom Cleveland, foreign exchange market analyst: While the major foreign exchange event of the past decade would surely be the highly successful introduction of the euro, many may have overlooked the results of the more northern “crown” currencies, those belonging to Scandinavian countries and the Republic of Iceland. Each has tracked well with the success of the euro, but disruption and divergence marked the paths of these currencies following the global economic downturn in 2008. Iceland, hit especially hard, imposed modified currency controls, to prevent the immediate withdrawal of foreign currency investment monies, but conditions are appearing favourable enough to consider their gradual termination at present.

The national currency, the Icelandic krona (“ISK”), still floats in the Forex market, but economists believe that if present controls were removed too soon, then the current scenario of an appreciating national currency and recovering economy could be placed in jeopardy. The five-year history of relationships to the Euro and the U.S. Dollar tell the story of Iceland quite well as shown below:

For the first five years of the new millennium, the krona followed the euro’s gradual appreciation as the success of its introduction began to take hold in the forex market. Depreciation of the currency then overtook the headlines, as the worst recession in the past eighty years swept the globe. A major banking crisis of monstrous proportions swept over Iceland and its progressive economy, exacerbated by what is generally referred to as the “carry trade”. The Monetary Policy Committee, the “MPC”, installed modified currency exchange controls on various investment securities to prevent a wholesale diminution of the krona from occurring.

The krona has appreciated versus the euro and the US dollar over the past year. However, central bank and government officials have hopefully learned a few lessons from its national banking collapse that has been termed, relative to the size of its economy, the largest banking failure to befall a single country in economic history. Prior to the 2008 crisis, Iceland was a leader in real GDP growth, unemployment was low, and there was a remarkably even distribution of income throughout the country. The fishing industry was prospering, and foreign investment was pouring in for opportunities in geothermal and hydropower facilities.

Following the deregulation of the banking sector in the early 2000’s, domestic banks expanded their operations aggressively into foreign markets by taking foreign deposits and borrowing on the interbank market. By mid 2008, banks held over EUR 40 billion in foreign debt when Icelandic GDP was 20 percent of that figure. As the global financial condition worsened in 2008, the krona fell precipitously versus other major currencies. The depreciating national currency suddenly placed domestic banks at high risk, due to their increased foreign debt exposure, an unsustainable position that resulted in the failure of Iceland’s three largest commercial banks in late 2008.

A loan package of USD 10 billion was arranged with the IMF and other countries to protect the value of the krona and stabilise the financial sector. Currency controls were established, the banks were taken over, the stock market lost 90 percent of its market capitalisation, interest rates were raised to 15.5 percent to counter inflation, and criminal investigations were commenced to determine if business leaders or politicians had any undue influence over lending practices within the three commercial banks. Amidst mounting public protests, the then-Prime Minister, eventually accused of negligence by the special investigative committee, and the Commerce Minister both stepped down in January of 2009.

However, the Icelandic economy is making a comeback. The MPC recently decided to allow interest rates to remain at their current levels, representing the end of a long line of interest rate cutting decisions in the past. Inflation concerns have subsided to a degree, if a 1.9 percent rate is cause for celebration. Typically, inflation is a leading indicator of economic recovery. Much attention has been placed on the sudden increase in both hard and soft commodity prices over the past seven months. Gold, silver, cotton, corn, and rare earth metals have all grabbed the headlines of late, signifying a global economic recovery in progress, but emphasising the point that raw material resources are limited.

The financial crisis has had disastrous consequences for the economy of Iceland and its external trade relations, but as economic stability returns, as evidenced by a strengthening krona, the possibility of joining the European Union and securing the broad security that the euro offers has gained wider support. A recent economic study on the issue reported that, “The Icelandic krona acts as a barrier to international trade, and that by joining the EU and adopting the euro, Icelandic trade could increase by 60 percent.” An application was filed in 2010, but the recent debt crisis in Europe has made many query if joining the Eurozone would be best for Iceland in the long term.

For the present, Iceland’s economy is improving, making debates about the future all the more lively. Icelanders remain mixed in their opinion about the benefits of disbanding their national currency in favour of the euro. Time will tell if independence is still a viable strategy.

Tom Cleveland has had an extensive career in the international payments industry with over 30 years of experience in executive management, corporate governance and business development. Tom served as CFO for various Visa International entities from 1980 until 1999, retiring with the title of Group EVP and Treasurer. Tom currently works as a market analyst for Forex Traders, an online resource for the foreign exchange market.

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