CNB-triggered depreciation should be temporary
The CNB may intervene, but likely at much stronger levels
At its September meeting, the Czech National Bank cut its base rate to a new all-time low of 0.25%. It also cut its discount rate, at which banks may deposit funds with the CNB, to 0.1%. In addition, Governor Singer admitted that the central bank might intervene against the koruna in the future, if it decides to ease its monetary policy further.
While the bugbear of possible interventions may discourage the koruna from a greater appreciation, it should not completely prevent the Czech currency from strengthening.
The main reason is that the interventions are likely to occur at much stronger levels. As Governor Singer has remarked, the question of interventions is not relevant at the moment; in addition, the CNB Board is not united in respect of the interventions. Our opinion is that particularly the hawkish group (Janáček, Zamrazilová) and the opponents of alternative monetary policy instruments (Hampl, Řežábek) would have a problems with such interventions. Therefore, interventions are unlikely to occur until the koruna hits approximately CZK 24.00 per EUR, where it starts to diverge from the fundamental range that we have predicted (see item 3 – long-term domestic fundamentals). In its forecast, the CNB itself anticipates that, in the extreme scenario, the koruna is unlikely to strengthen beyond CZK 24.10 per EUR by the end of this year, and CZK 23.70 per EUR in the first quarter of 2013.
This basically means that there is still latitude for the koruna appreciate somewhat on the back of an improvement in the global risk sentiment.
Political and other risks
Beside well known risks for positive outlook stemming from Greece and Spain, we see also growing political risks. The current Czech government has gained market confidence mainly because it has kept most of its pre-defined budgetary objectives. The rate of its deficit reduction, by approximately 1% a year, with the aim of cutting the deficit to less than 3% of GDP by the end of 2013, was also viewed by markets as adequate. At the moment, however, the government coalition is losing the required support because of a rupture in the parliamentary caucus of the largest ruling party, the Civic Democratic Party (ODS), and because of the earlier breakup of the smallest coalition partner, Public Affairs (VV). The government is also losing the support of the President, who has vetoed numerous important bills, which the Cabinet has decided to combine with a vote of confidence. Hence, in the extreme scenario, the current situation might result in the fall of the government.
The Czech koruna is typically not very susceptible to domestic political tension. At present, however, investors focus their attention, much more than in the past, on budgetary discipline, and an escalation of political tension would certainly take the wind out of the sails of Czech bonds as well as the koruna.
Long-term domestic fundamentals: EUR/CZK should not get below 24.00
The long-term appreciation of the Czech koruna has been based on catching up with the economies of the Czech Republic’s main trading partners in real terms, which was accompanied, unlike for Poland and Hungary, by continuously low inflation. This combination is the breeding-ground for the nominal appreciation of the Czech currency.
However, with the U.S. financial crisis (after the fall of Lehman Brothers), the rate of real convergence has decelerated significantly. In 2012, the Czech Republic is likely to grow at a rate slower to that of the eurozone (our forecast of -1.1% for the Czech Republic and -0.6% for the EMU). Also, inflation in the Czech Republic will accelerate (beyond the 3% target) this year and the next, and this is not a factor to encourage a koruna strengthening (in fundamental terms) either.
Thus, the current long-term real fundamentals are not very encouraging for the koruna. Our long-term models, based on slow growth and higher inflation, indicate that not even in the extreme scenarios should the exchange rate leave the range of CZK 24.0-29.5 per EUR, thus providing only limited space for gains
Naturally, this may change over the course of time, and much will also depend on further developments in the eurocrisis. If the eurozone manages its transformation to an economic union well, the outcome of the current crisis may be positive for the Czech Republic. We believe that this is a crisis of the balance of payments rather than of debt.
According to our optimistic scenario, the long-term adjustment mechanism inside the monetary union should work in such a way that the eased financial conditions within the EMU will heat the German economy, while a parallel fiscal restriction will take place at the periphery of the eurozone. This should speed up economic growth, inflation, and wage growth in Germany, whereas headline inflation in the EMU would remain above the ECB target of 2.0% in the long term. Such a scenario, based on the longterm overheating of the German economy, should be a blessing for the Czech economy (and consequently for the koruna) because its trading links with Germany are very strong.