Aleš Michl, člen bankovní rady ČNB
Projev na konferenci Life outside the Euro
European Studies Centre, St Antony’s College
Oxford, 23. ledna 2020
I am from the Czech Republic, and, as you hopefully know, we do not have the euro. Our currency is the Czech koruna. But just like every EU country, we spend a lot of time discussing whether to adopt the euro or not.
From my point of view (Michl, 2016):
The Maastricht criteria are not good indicators for deciding whether to join the euro area…
…because they do not take into account the role of the exchange rate in restoring competitiveness in recessions…
…while the real exchange rate reflects the competitiveness of a country.
Let’s establish a new criterion based on the real exchange rate formula.
∆Real ER = ∆Nominal ER + ∆Relative costs
This gives us the textbook adjustment mechanism for an economy in recession: a nominal depreciation improves competitiveness.
Does it really work outside of the textbook?
If it holds, having your own currency is a good thing.
If not, the main argument for sticking with your own currency disappears.
So let’s find out if it works. The test question is: Does a nominal depreciation improve the competitiveness or profitability of companies?
We all know this basic equation Profit = Revenues - Costs
The equation can be extended as: Profit of export company per unit = (export price x ER) – (wages + price of domestic components driven by domestic inflation + import price of foreign components x ER)
To test whether a depreciation in a recession boosts profits, we have to look more closely at four variables from the formula:
the export price, the import price, domestic inflation and wages…
…and answer five simple questions…
…well, not so simple questions…
- How do export prices react to a weakening of the exchange rate? (A weaker exchange rate should help exporters…)
- How do import prices react? (Costs will increase due to higher prices of imported parts and more expensive commodities…)
- How does domestic inflation react? (A weakening of the currency can also imply an increase in overall inflation in the national economy…)
- How do wage costs react? (Trade unions can start to demand significant wage hikes, which could offset the previous boost to exports…)
- Overall, what will most influence real GDP and employment in the event of a weakening of the exchange rate – higher revenues from exports or higher inflation?
To conclude: The Maastricht criteria are a necessary but not a sufficient condition for adopting the euro.
When a nominal depreciation leads to a significant real depreciation in recessions, the country should stick with its own currency. Otherwise, it would give up one of the tools that can lead it out of recession.
Appendix
The average Czech wage stood at 44.7% of the euro area average in 2018 (CNB, 2019). Since the end of 2017, the Czech economy had been converging only through the price channel. Now it seems that both channels of convergence are working again.
Nominal exchange rate channel: the Czech koruna has appreciated by 3% against the euro since August 2019. In good times, a gradual nominal appreciation is a good thing – it is an incentive for export companies to improve their competitiveness. Based on developments in the past 15 years, companies can increase their market share despite an appreciating exchange rate. According to the WTO, the world market share of Czech exporters increased from 0.75% in 2005 to 1.1% in 2019. Of course, this does not hold in the case of appreciation bubbles, as in 2002.
Inflation channel: CPI inflation stood at 3.2% y-o-y in December; in the euro area it was 1.3%. In the first half of 2020, we expect inflation above 3 %. Some monthly readings could even reach 3.7 %. From my point of view, it is better to have a 3.7% inflation rate than a 0.3% one. Since 2009, the Czech Republic recorded 43 months of y-o-y headline inflation below 1% and 12 months above 3%.
What can tame the domestic inflationary pressures? Incoming data confirm that manufacturing is flirting with an ordinary recession (Michl, 2019). Our internal CNB analysis shows that the weakening of foreign demand affected domestic subcontractors most of all. They are dependent on foreign developments – 76% of their revenues came from abroad in 2018. Subcontractors started to lay off staff and we saw their short-term operating loans increase by 50% in the first three quarters of 2019; in the same period, long-term loans declined by 18 %. It can be seen that they are in trouble with margins.
Such market-driven cooling of the economy is a way to improve the health of the labour market and ease inflation pressures. Like cooling down after a workout, which gradually brings your heart rate and blood pressure to their normal levels.
Our macroprudential measures (maximum LTV for new mortgages at 80%) helped to cool credit markets. The volume of new mortgages (adjusted for refinanced and refixed loans) increased by 7% in 2018. For 2019 as a whole, the CNB expects a decline of 13.6%.
In my view, monetary policy should remain in wait-and-see mode. Therefore, interest rate stability is the best stance going forward.
References:
CNB (2019). Analyses of the Czech Republic’s Current Economic Alignment with the Euro Area.
Available at https://www.cnb.cz/export/sites/cnb/en/monetary-policy/.galleries/strategic_documents/analyses_of_alignment_2019.pdf
Michl, A. (2016). Nová kritéria pro přijetí Eura [New Euro Convergence Criteria]. Politická ekonomie, 2016(6), 713–729.
Available at https://polek.vse.cz/artkey/pol-201606-0005_Nova-kriteria-pro-prijeti-Eura.php?back=%2Fjel.php
Michl, A. (2019). Czech Manufacturing is Flirting with an Ordinary Recession.
Available at https://www.cnb.cz/en/public/media-service/speeches-conferences-seminars/speeches/czech-manufacturing-is-flirting-with-an-ordinary-recession/