ISK strengthens on foreign markets

29.04.2009

Islandsbanki Research: The ISK exchange rate quoted abroad has risen considerably recently and Reuters now lists a EUR/ISK cross rate around 220 off-shore, similar to that of around six weeks ago. During the interim period, however, the EUR has appreciated by over 14% against the ISK on the domestic interbank market, reducing considerably the rate differential between on-shore and off-shore markets. Currently the EUR price is 28% higher on foreign markets than in Iceland, whereas according to the Reuters dealing system the difference was 90% or more a month ago. The differential has not been less since the last weeks of January this year.

No single explanation
Just what lies behind the opposite trends on these two markets is difficult to say. Clearly, however, the incentive to circumvent currency controls increases the higher the arbitrage potential. One possible explanation is that the outflow following interest payments in mid-March eventually boosted demand for ISK abroad, since foreign investors prepared to hold their ISK positions could sell the EUR they were able to obtain for their interest payments and buy ISK from other foreign investors in a greater hurry to dispose of such assets. In addition, decreasing risk aversion abroad, as reflected in lower CDS spreads, may have dampened foreign investors' eagerness to dispose of ISK assets at rock-bottom prices. Thirdly, the possibility cannot be excluded that FX is to an increasing extent is finding its way around the controls; less isolation of markets should, as a rule, reduce the price differential between them.

Moving towards removal of currency controls
If this trend continues, it should facilitate relaxation of capital controls, since the ISK exchange rate abroad indicates the rate at which impatient foreign investors are prepared to extricate themselves from ISK positions. Recent comments by the Governor of the Central Bank of Iceland, to the effect that a solution allowing investors to withdraw trapped capital from Iceland would likely be announced before the summer, could also be a factor here. Achieving this, together with the conclusion of the restructuring of the banking system and a further decline in risk aversion internationally, are major steps toward refloating the ISK fully and removing currency controls.

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