Exchange rate depreciation, interest rate cut and tighter liquidity

Financial markets and Central Bank measures 1
Exchange rate depreciation, interest rate cut and tighter
liquidity
On March 27 it was announced that the fluctuation band of the exchange rate would be abolished, and
the reform took effect the following day. Over the days prior to that, the króna came under serious pres-
sure. The exchange rate slid even further after the reform and has now weakened by 7.3% since the
beginning of the year. Of this figure, 5.2% occurred in the period after the March reform. At the same
time as the new exchange rate framework was adopted, the Central Bank lowered interest rates on its
repo agreements by half a percentage point. The interest rate cut was based on the assessment that infla-
tion would decelerate next year and that the overheating targeted by the Bank with its measures over the
past few years would ease. The interest rate differential with abroad changed little, however, and has
remained relatively stable since mid-January. Bond yields have fallen somewhat and share prices have
lost more than 14% since the New Year.
After a relatively slow weakening of the króna ...
publication of a new national economic forecast and
Following the short-lived impact of extensive
the review of the Central Bank Act were viewed as
Central Bank intervention at the end of January, the
the main indicators of a pending change. Pressure
króna continued to weaken, albeit without major
then began to build up and the exchange rate of the
swings. The exchange rate index stood at 121.74 on
króna rapidly slid. The impact of extensive interven-
January 26 but had reached 122.02 on the 31st of the
tion on March 23 proved short-lived. Sharp swings
same month. A short-lived strengthening began on
took place during the day and at the most severe
February 2, but on February 9 the Bank deemed there
point the index jumped by 0.25% in the space of sev-
to be grounds for further intervention when signs of
a shortage of foreign currency appeared. From
February 10 until March 23 the index rose relatively
Chart 1
Exchange rate of Icelandic króna and
steadily, but apart from two days remained below
volume traded on the foreign exchange market
122. Forex market trading volumes were relatively
Daily data, January 3 - April 26, 2001
low throughout this period.
B.kr.
Dec 31, 1991=100
24
132
22
Total volume traded on interbank market
... the exchange rate index jumped upwards when the
20
for foreign exchange (left-hand axis)
130
18
Exchange rate index (right-hand axis)
market thought a change in policy was likely
16
128
As the Central Bank’s annual meeting approached, a
14
12
126
rumour spread that a change in the exchange rate
10
framework would be made on that occasion. Wide-
8
124
6
spread media coverage of inflation targeting, the
4
122
2
0
120
January
February
March
April
1. This article uses data available on April 26, 2001.
MONETARY BULLETIN 2001/2
15

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eral minutes. This tension continued until the annual
Chart 2
meeting and the Central Bank intervened in foreign
3 mo. T-bills interest rate differential with abroad
exchange market trading. In all, it sold US dollars for
Weekly data, Oct. 11, 2000 - April 24, 2001
the equivalent of 3.6 b.kr. over these days, and trad-
Percentage points
ing volume ran extremely high to reach 34.4 b.kr. in
6.8
all during the last three days before the change.
6.6
Nonetheless, the Bank kept the króna within its fluc-
6.4
tuation band. It seems obvious that, when the rumour
started to spread, investors began to make early set-
6.2
tlements of agreements which were based on the
6.0
assumption that the fluctuation band would endure.
5.8
A monetary framework reform was announced at
5.6
the Bank’s annual meeting on March 27, taking im-

mediate effect the following day. The fluctuation
Oct. 11Oct. 25Nov. 01Nov. 15Nov. 28Dec. 12Dec. 29Jan. 16Jan. 26Feb. 01Feb. 13Feb. 27
March 13
March 22
March 27April 09April 18April 24
band, which allowed a ±9% deviation in the foreign
currency index from its central value of 115.01, were
since significant signs had emerged that overheating
abolished and the króna was floated. This reform is
was on the wane and the economy could be expected
discussed in more detail in a separate article on the
to continue to cool over the following months. Inter-
monetary policy framework elsewhere in this
est rates on day loans and certificates of deposit were
Bulletin.
not lowered as much as the policy rate, in order to
encourage credit institutions to implement more
The króna weakened after the flotation
active liquidity management, in addition to which it
When the forex market opened on March 28, the
was hoped that the measure would help to reinvigo-
exchange rate dropped in the space of several min-
rate the interbank domestic market.
utes, but it rallied quickly later the same day. The
index was fixed at 126.22 on March 28 but the cur-
The interest rate differential has not changed much,
rency strengthened considerably over the following
despite the cut in Iceland
day to 124.51. Since then, the króna has weakened.
Little change has taken place in the interest rate dif-
For a while it remained more or less stable at 128.2,
ferential with abroad. Since mid-January 2001 the
then rose on April 17. On April 24 it rose to 131.04,
differential for three-month T-bills has fluctuated
the highest value until that time. From the beginning
within a relatively narrow range between 6.4 and 6.7
of the year until April 26 the index rose by 7.9%.
percentage points. The impact of the Central Bank’s
Uncertainty in connection with the fishermen’s strike
interest rate cut at the end of March was short-lived,
may have had a negative effect on the exchange rate,
since the US Federal Reserve lowered its policy rate
but the large rise in the CPI in April may also have
again in mid-April. So far this year it has cut its rate
played some part.
four times, by a total of 2 percentage points. The
Central Bank of Japan lowered its rate by 0.15 per-
Interest rate cut and a change in the interest rate
centage points. The European Central Bank has not
structure
altered its interest rates since October. The Bank of
The Central Bank’s annual meeting was informed of
England lowered its rate by 0.25 percentage points at
the Board of Governors’ decision to lower the Bank’s
the beginning of April and the Bank of Canada like-
policy rate by 0.5 percentage points. However, this
wise around the middle of that month.
cut did not extend across the entire interest rate spec-
trum, the overnight loan rates remained unchanged
High interest rates in the interbank domestic market
and the rate on certificates of deposit was reduced by
For the past five months, short-term interest rates in
only 0.2 percentage points. This cut was made on the
the interbank market have remained very high. It is
assumption that the near-term inflation outlook was
worth noting that interbank rates have been higher
in line with the Bank’s newly set inflation targets,
than the Central Bank’s policy rate on many occa-
16
MONETARY BULLETIN 2001/2

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Chart 3
Chart 4
Monthly turnover on the interbank market
Lending rates in the interbank market
January 1998 - April 2001
March 1, 2001 - April 26, 2001
B.kr.
%
80
14.0
1998
1999
2000
2001
13.5
Day loans
Two weeks
Three months
70
13.0
60
12.5
12.0
50
11.5
40
11.0
30
10.5
10.0
20
9.5
10
9.0

0
April 2
April 9
Jan. Feb. Mar. April May June July Aug. Sep. Oct. Nov. Dec.
March 5
March 12
March 19
March 26
April 17April 23April 26
sions during this period, which is inconsistent with
money creation, since base money covers all the cru-
an active and well-informed market since it presents
cial factors in this respect. Base money has fluctuat-
participants with an obvious arbitrage opportunity by
ed somewhat during the year, as usual, but overall it
borrowing from the Central Bank. There may be
has not increased, cf. Chart 5.
many reasons for these high interest rates in the inter-
As said previously, on March 27 the Central Bank
bank market, but the root cause is a shortage of
announced a reduction in its repo yield. All things
domestic currency. In one sense it may seem para-
being equal the expected response from the interbank
doxical for the exchange rate to weaken at the same
market would have been a reduction in interest rates
time as there is a shortage of the domestic currency
on short-term agreements.
in the Icelandic financial markets. Thus it is clear that
As Chart 4 shows, the interest rate cut had virtu-
market participants are not prepared to sell foreign
ally no effect in the interbank market. Interest rates
currency in order to ease the shortage of domestic
on day loans fell immediately by 2.2 percentage
currency, which at the same time would contribute
points the day after the announcement, but went back
towards strengthening the króna.
up straight away and at the time of writing are some-
The main reasons behind the shortage of domes-
what higher than before the rate was lowered. The
tic currency in Iceland’s financial markets is Central
interest rate adjustment does not seem to have any
Bank interventions in the forex market, which have
impact on loans with a longer maturity than one day
amounted to 11.9 b.kr. so far this year, and the trea-
in the interbank market. Commercial banks, however,
sury’s strong position on its current account with the
Central Bank, while the credit institutions’ higher
Chart 5
required reserve can be expected to have had some
Repo balance and base money
effect as well. Offsetting this is the growth in market
March 1998 - March 2001
B.kr
participants’ repurchase agreements with the Central
60
Bank, which has increased the outstanding repo bal-
Total outstanding repurchase agreements balance
50
Base money
ance by more than 15 b.kr., or just over 29%. At the
same time as Central Bank repo trading has grown,
40
required DMB reserves have been increasing, for
30
example by 23% since December 2000. The growth
20
in repos since the beginning of the year is largely
explained by the higher required reserves and forex
10
market intervention. Changes in the Central Bank’s
0
base money are actually a much better indicator than
M M
J
S
N
J
M M
J
S
N
J
M M
J
S
N
J
M
1998
1999
2000
2001
repurchase agreements of its contribution towards
MONETARY BULLETIN 2001/2
17

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lowered their rates by the same amount as the Central
Chart 7
Bank immediately after the cut was announced.
Bond inflation premium
Tighter liquidity increases Central Bank repos
January 3, 2001 - April 26, 2001
%
The outstanding repo balance has invariably reached
5.2
its highest levels around the end of the year.
5.0
4.8
Fluctuations in DMB liquidity resulting from season-
4.6
al changes in the treasury’s position with the Central
4.4
Bank are the cause. The total outstanding repo bal-
4.2
4.0
ance at the end of last year was almost 47 b.kr. and is
3.8
now (April 26) more than 60 b.kr., having dropped
3.6
by over 4 b.kr. from its peak the week before.
3.4
3.2
Two main factors explain this large growth in
3.0
repo transactions. Central Bank intervention in the
January
February
March
April

forex market dries up the supply of krónur in the
domestic market, and the treasury’s liquidity position
and yields have fallen accordingly, as shown in
may also have some impact. One function of repos is
Chart 6.
as an instrument to enable the Central Bank to meet
Generally speaking, market participants expect a
the credit institutions’ liquidity requirements, but
further fall in yields, for reasons including the con-
they are not conceived as a permanent source of
traction in housing bond issues, lower supply of
finance for lending. There is a strong link between
treasury paper and stronger demand for bonds, which
repurchase agreements and forex market interven-
is partly at the expense of equities.
tion, which suggests that lending is not funded by
Yields on bonds with the longest lifetimes have
repos. Repos are known to be used for financing
dropped by 0.5 percentage points since the beginning
derivatives. As mentioned earlier, the growth in
of the year and on benchmark housing bonds and
Central Bank repos has hardly proved sufficient to
housing financing bonds by 0.23-0.53 percentage
counteract the factors that have led to tighter bank
points. The yield on treasury bonds maturing in 2005
liquidity. Thus Central Bank base money has not
stood at 7.05% on January 3 but has fallen sharply
increased during the year.
and was 5.94% at the time of writing. Housing bond
yields have also dropped, but by less. On January 3,
Bond market yields have gone down
housing bonds maturing in 2022 carried a 6.11%
So far this year, bond market trading has picked up
yield, which had gone down to 5.81% on April 20.
Institutional investors, who last year substantially
increased their domestic and foreign equity stock,
Chart 6
might re-enter the bond market to a growing extent in
Treasury bond and housing bond real yields
search of favourable investment opportunities
because of the drop in equity prices both in Iceland
Daily data, January 1, 1996 - April 26, 2001
%
7.5
7.5
and abroad.
T-bonds (14.4 yrs to maturity)
In pace with the recent depreciation of the króna,
7.0
Housing bonds (21.7 yrs to maturity)
7
Housing bonds (36.7 yrs to maturity)
the inflation premium on bonds has risen steeply.
6.5
6.5
T-bonds (4.0 yrs to maturity)
Immediately after the Central Bank cut its interest
6.0
6
rates on March 27, a large drop was seen in the infla-
5.5
5.5
tion premium, but following the depreciation of the
5.0
5
króna it sharply once again.
4.5
4.5
The inflation premium (measured as the spread
4.0
4
between buying rates for the bond classes RIKB 03
3.5
3.5
and RIKS 03) reflects investor expectations of an
1996 1997 1998 1999 2000 01
upward trend in inflation in the next few months.
18
MONETARY BULLETIN 2001/2

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Equity prices still falling
Chart 8
The ICEX main index has fallen by 14.3% so far this
The ICEX-15 equity price index
year and by more than 36% in a single year.
January 3, 2001 - April 26, 2001
Dec. 31, 1997=1,000
Domestic equity price trends can be described as
1,300
similar to those on international markets, for exam-
1,280
ple the Dow Jones and Nasdaq indices, which have
1,260
1,240
also dropped significantly. In Iceland, the greatest
1,220
fall has been in IT company shares, at 34.7% so far
1,200
this year, and in manufacturing at 29.6%. Equity
1,180
prices for service companies have gone down by
1,160
4.3% and fisheries companies by 6.6%.
1,140
In spite of the sharp downward trend, not all
1,120
industrial sectors have fallen. Prices of shares in the
1,100
January
February
March
April

pharmaceutical industry have risen by 3.4%.
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