Thóarinn G Pétursson: Currencies - buffers or amplifiers of shocks?
Presentation by Mr Thóarinn G Pétursson, Deputy Governor of the Central Bank of Iceland, in the panel discussion "Currencies - buffers or amplifiers of shocks?", at the Reykjavik Economic Conference, Reykjavik, 28 May 2026.
The topic of this panel is Currencies: Buffers or amplifiers of shocks? - a topic that is central to the trade-off facing small open economies. The question is whether exchange rate variability helps to absorb shocks or if it amplifies shocks through inflation, balance sheet risks and over-all risk sentiment. The key question is: when does exchange rate variability help and when does it hurt? I think the experience of Iceland over the last few decades captures these trade-offs particularly well.
Let me start at the beginning of the century. Iceland had recently abandoned its exchange rate peg and adopted inflation targeting in 2001, but soon afterwards serious macroeconomic imbalances began to build up. The banking system was privatized in the early years of the century and large capital inflows followed. Macroeconomic imbalances built up, a credit boom ensued and borrowing in foreign currency became widespread among households and firms. The current account deficit ballooned to 25% of GDP. The economy overheated, and then, it all came to a tragic end. There was a sudden stop in capital inflows which resulted in a sharp depreciation of the currency. The vast majority of Iceland's banking system collapsed during the crisis, as all three major banks failed within a matter of days. The depreciation of the krona by almost 50% had a devastating effect on domestic balance sheets. Therefore, one can argue that the krona served as an amplifier of shocks in the pre-GFC period.
Something changed after the financial crisis. As the saying goes one should never let a good crisis go to waste; the aftermath of a crisis often provides a unique window for reform and Iceland certainly did not miss that opportunity, as the finance minister discussed earlier this morning. The first task was to reduce the large macroeconomic imbalances that had built up prior to the crisis. The current account shifted from a deficit of 25% of GDP to a surplus of roughly 6%. The net international investment position improved from a negative of roughly 150% of GDP to a positive 40%. Foreign currency balance sheet exposure was reduced by limiting households' ability to take foreign currency loans.