Will the CNB activate a foolproof way for the CZK?

The Czech inflation – back to the Future

It has been now one year and one month since the Czech National Bank (CNB) deliberately weakened the koruna exchange rate in an effort to avoid deflation. According to the CNB forecast at the time, Today’s inflation rate should have been easily above 2% and gradually approaching 3%. However, the reality is quite different. According to just released inflation figures for the December 2014 it slips back to zero (0.1% y/y). Although this is largely due to what is happening abroad, the question being raised more and more is to what extent the central bank policy is relevant for the Czech economy and, in particular, for inflation in general. In other words, for the CNB’s pro‐inflationary policy to be really effective, will the central bank have to repeat its devaluation exercise, perhaps several times? Or will it have to weaken the koruna even more aggressively?

A foolproof way for the Czech liquidity trap

The Czech economy, which, unlike its neighbours, was unable to start growing steadily after the 2009 crisis, found itself in a previously unknown situation in 2012 when the (CNB’s) official interest rates reached zero. Textbooks describe this as a ‘liquidity trap’. In other words, it is the moment when the central bank loses its primary monetarypolicy instrument – the interest rate – because the rate has fallen to zero bound and cannot be cut to stimulate demand in the economy any more.

Like other central banks, the CNB rightly decided to combat this situation – in which the economy was concurrently struggling with deflation but could not be stimulated by lower interest rates – by means of other monetary policy instruments. With the Czech economy being small and extremely open, the exchange rate of the koruna, i.e., the targeted weakening of the exchange rate, was used as an alternative instrument to ease the monetary conditions.

Hence although, at first glance, the CNB’s efforts to get out of the liquidity trap (and thus out of a deflationary situation) may look quite different to the expansive policies of the Fed or the Bank of England, from the monetary perspective they are essentially variations of the same theme. The CNB’s expansion, just like that of the Fed or the BoE, quickly inflates the central bank’s balance – in the Czech case through foreign currency bonds rather than through purchases of domestic (government) bonds. Thus the CNB ‘prints’ or is ready to ‘print’ korunas to place them (if needed) into the forex market with the aim of weakening the koruna. If an intervention against the koruna takes place, bonds or other assets denominated in euros are added to FX reserves. The CNB’s intermediary (macro‐) objective is evident – to use the weakened currency to promote the competitiveness of the Czech Republic, to stimulate demand, thus increasing employment and ultimately activating inflationary pressures to the extent that year‐on‐year inflation returns to its 2% target (for details, see the BOX: World according to the CNB versus our model view).

The above‐mentioned transmission mechanism, which generally describes how to drive an open economy out of a liquidity trap, was described by Swedish monetary policy expert Lars Svensson as long ago as the turn of the 20th and 21st centuries, and the CNB, as the bank itself admits, was obviously inspired by his theoretical recommendations. To predict the CNB’s future behaviour, it is crucial that Svensson more or less advises on what to do if inflation is not rising and the economy is stuck in a liquidity trap, which may still be the case with the Czech economy in late 2014.

If the currency devaluation did not work the first time, Svensson’s work implies that the move ought to be repeated, i.e., he even recommends pursuing a monetary and exchange rate policy of repeated and targeted devaluations to ensure that the economy is ‘navigated’ to a clearly positive inflation target. Svensson called this method, guaranteed to help a (small) open economy overcome its liquidity trap and generate inflation (The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap). Clearly, we cannot rule out the possibility that the CNB is going down this route today.

Another devaluation? Mind the public

Although macroeconomic conditions may favour more devaluation during 2015, we believe that the CNB may not necessarily resort to it in the end, i.e., it will prefer postponing it for as long as possible. Apart from the logical argument that the Czech Republic’s very low inflation comes from the euro area and low commodity prices, concerns about the low popularity of such a move may prevail among CNB Board members. The Czech public did not accept the targeted weakening of the koruna very positively in 2013, and the same would be true if the move was repeated. Possible reactions from abroad if more devaluation takes place is another question.

Repeating the devaluation and stepping in the same late‐ 2013 river twice would not be pleasant for the CNB mainly because of the strong media criticism by the domestic public. This is not exactly surprising. In fundamental terms, Czech households are greater savers than borrowers, and therefore most of them could not have been and, in the foreseeable future, will not be impressed that there are efforts to undermine the real purchasing power of their savings (in addition, most of their deposits are denominated in korunas, and therefore they cannot profit from any further depreciation from the exchange rate perspective).

Let us add that given the low importance of capital markets in the Czech Republic, Czech households, unlike their US or British counterparts, will not significantly benefit from the fact that the Czech version of quantitative easing (i.e., the interventions against the koruna) will cut long‐term interest rates and consequently boost stock and bond prices (for example, the market capitalisation of the Prague Stock Exchange is only 14% of Czech GDP, as opposed to Wall Street’s 169% of US GDP). Hence the only side effect of the wealth ‘increase’ may be felt in the Czech Republic rather through the stimulation of real estate prices, which is again a phenomenon that may not be necessarily seen as a purely sound development.

As concerns the business sector, it is generally assumed that the devaluation of the koruna must be mostly welcome, given the export‐led nature of the Czech economy. Nevertheless, even there CNB Board members saw after November 2013 that it is not easy to please everyone. The devaluation did not lead to any general satisfaction – for example, a brief survey conducted among exporters by ČSOB showed that only 41% of exporting firms had seen their financial results improve owing to the devaluation (see the graph). Naturally, the low level of enthusiasm stems from the fact that exporters (rightly) hedge their positions against exposure to exchange rate risk, and the targeted weakening of the koruna pushed those exporters to the wrong side and they could not take full advantage of the weak koruna. However, the fairly low level of satisfaction with the weaker koruna may also stem from the fact that half of Czech industry is held by foreign owners. These post the profits of their subsidiaries in euros and therefore the devaluation of the koruna (which will reduce one of their cost items – wages) may not always be a clear advantage. Of course, this applies to ‘exporters’ who generate a significant portion of their sales in the Czech market.

Finally, we should realise that if the CNB repeats its devaluation exercise, or even repeats it several times, it will gradually start to get on the nerves of foreign institutions, perhaps including those that supported the fomenting of the Czech currency wars (led by the IMF). For the sake of completeness, let us add that, given the low importance of the Czech economy, tolerance for the Czech version of the ‘beggar‐thy‐neighbour’ policy among official institutions or governments (and central banks) is not that surprising; nevertheless, we are already hearing private trading partners (from the euro area) complain about the competitive devaluation policy of the Czech Republic. If the devaluation of the koruna was repeated, this exasperation would certainly increase.

Our view on the CZK – unchanged so far

Although this paper implies some important conclusions – notably the fact that the CNB’s ability to generate significantly positive inflation under current global conditions through the depreciation of the koruna is fairly limited – the conclusions have not (for the moment) changed our baseline scenario for the koruna. Our baseline scenario still envisages that the CNB will not eventually resort to more devaluation and, in the event of another unexpected fall in demand and inflation, as a first step the Bank Board would rather be another extension of its commitment to intervene against the koruna. It is also possible that the CNB Board will be satisfied with weakening the koruna through verbal communication as was recently delivered by CNB’s vice‐governor Tomšík in his commentary for the Czech business daily. In the meantime, the CNB might wait and watch for more macroeconomic data from both the Czech Republic and the euro area and for another ECB’s policy action.