The economic outlook has deteriorated since Russia invaded Ukraine, and the economic recovery in Iceland could lose steam as a result. Global commodity prices have skyrocketed, and inflation is expected to rise further. Iceland’s terms of trade will probably deteriorate, and pressure on the domestic price level is likely to affect consumption. Weaker GDP growth among trading partners could have a dampening effect on Iceland’s exports, particularly to include tourism. Increased global uncertainty and the deterioration in terms of trade could also put downward pressure on the exchange rate of the króna, although Icelandic households are well positioned, with significant accumulated savings and strong equity. The magnitude of these effects is highly uncertain and will be determined both by global developments and by how long the war lasts.

Foreign exchange transactions have been unrestricted in Iceland since mid-2021. Since the end of 2020, investors and companies have speculated on the appreciation of the króna via forward foreign exchange contracts, which totalled 139 b.kr. at the end of February. Because of this, future foreign currency flows have already had some upward impact on the exchange rate. If the exchange rate develops unfavourably as a result of external conditions such as the war in Ukraine, growth in derivatives positions on one side of the market, like those currently in place, could put downward pressure on the króna, particularly if they involve volatile investments.
There are limits, however, as the Central Bank’s rules on derivatives trading require that each commercial bank’s gross forward position be no greater than 50% of its capital base.

Real estate prices have continued to rise in recent months, and the market is characterised by severe mismatches between supply and demand. By February 2022, the number of flats advertised for sale in the capital area had fallen by 69% since the beginning of 2020. At the same time, the average time-to-sale has fallen to a historical low. The twelve-month rise in the capital area house price index measured 13.8% in real terms in January. Imbalances between property prices and their determinants have grown more pronounced. Concurrent with this, household debt has grown apace, and first-time homebuyers have higher loan-to-value ratios and heavier debt burdens than before. All of this indicates that risk in the housing market has mounted in the recent term, and the likelihood of stagnation or a correction in the market has increased.

The large commercial banks are strong. Profits have increased, cost-to-income ratios are down, and arrears have declined on both household and corporate loans. At the end of 2021, the banks held 280 b.kr. in liquidity over and above the minimum required by the Central Bank, and their excess liquidity has increased by 48 b.kr. thus far in 2022. Credit spreads in the banks’ foreign funding markets have risen rapidly in recent weeks, as they have in credit markets around the world. The banks’ strong foreign liquidity position and their limited near-term refinancing risk enables them to cover all of their upcoming payments without refinancing in the next several months.

Cyberattacks are a growing problem, and financial market infrastructure is not excluded from the risk they entail. Attempted cyberattacks have grown more frequent in the wake of the Russian invasion of Ukraine. Financial institutions must be prepared for this risk. They must ensure that their systems are secure and adopt contingency measures to guarantee business continuity. It is also important to strengthen the framework for the system as a whole, develop alternate routes, and coordinate
action plans in response to increased risk in this area. This work requires the participation of financial institutions, financial market infrastructure operators, the Central Bank, and the Government.