By Christopher Jeffery (Central Banking Journal 10. 11. 2015)
The governor of the Czech National Bank speaks to Christopher Jeffery about transparency challenges, lifting exchange controls, China's slowdown and flaws in Basel III.
The Czech National Bank (CNB) has a strong reputation for transparency. What is your philosophy when it comes to transparency?
It is important to consider the audience. For the CNB there are three key stakeholders that we consider. The first group involves parties that are needed to set market interest rates and exchange rates. With them, we try to be as transparent as possible, as transparency helps the market understand what we want to achieve. This, in turn, helps us shape expectations and prices – whether it is the interest rate, the exchange rate or whatever else.
Then you have transparency with your own public. We learned a lot from the introduction of our exchange rate floor in 2013. We found out that, despite our efforts to communicate as well as possible through traditional forms, the world had moved on and we were a little out of touch. So we worked hard in 2013 and 2014 to bridge the gap and communicate across many channels. The fact that our board members are now blogging often draws attention. But equally important are our outreach efforts with the public and the heads of companies. They promote a much better understanding of what we want to achieve. In general, our communication has improved. We want to be as transparent as possible within the monetary policy framework.
Then there is an area that should not be that transparent: supervision. Here, a lot of our colleagues have found transparency is not helpful. For example, as soon as the public learns that one bank is drawing on an emergency facility and the others are not, the consequences can be severe. As an emergency liquidity provider, you don’t want to be that transparent. If supervision is transparent, there is a danger of generating negative self-fulfilling prophecies. We need to provide clear information without singling out individual banks. For example, we still have some doubts about the way stress tests are communicated in Europe.
What we do here is that we announce how many banks have failed this or that level of capital, or solvency in the case of insurers, and state the amount needed to bridge the failure – but nothing more. We simply say, for example, three banks have been found to be short of capital and the total shortfall is 15 billion Czech korunas, or whatever. This is a low enough number not to cause concern even under certain tough stress tests. It gives a clear picture without singling out the institutions.
But wouldn’t this create intense speculation about the culprit, with the potential to drag the entire sector as people assume any of their counterparties could be in trouble, even if they have been well managed?
Not really. We are talking about adverse scenarios in stress tests. Everybody understands that the shortfall is bridgeable and we will work with banks, even forcing them to create buffers. This information is enough for the public. We do not get too many questions about who these banks are, as the problem is solvable. So, in terms of the financial stability and supervisory framework, singling out individual institutions is not necessary and I believe this sort of practice could create stability problems in the future.
What do you make of your blog? What other efforts have you made to increase transparency?
The major advantages of the blog are its speed and flexibility. We have found that its message works its way into the media quite easily. But we have also done other important things. Before 2013, we just gave a presentation about the monetary policy meeting. Now we have a simple announcement, too. We have a text that the media can take out and copy and paste, which is much more helpful. We did a lot of things and we believe the result is working.
You are cautious about transparency in the area of supervision. But when it comes to the more open areas, where do you define the frontier? Are you ever concerned that disagreements among board members continue to rumble on, for example, well after a certain course of action has been taken that could prove to be counterproductive?
The board members have individual mandates and are appointed by the president. They should be able to communicate as clearly as possible. It is reasonable to be open. Of course, one does not publicly disclose one’s thinking on foreign exchange intervention. Nobody does this, due to the potential impact on the market. But in normal monetary policy decision-making, everybody’s vote is known to the markets so why shouldn’t the member’s views also be known? In monetary policy-making, this openness should be expressed so that market participants can form an opinion.
Do you believe market practitioners understand the CNB’s reaction function?
I believe they do.
Yet it seems that a lot of forecasting at central banks is still inaccurate. What are the challenges here?
We live in an uncertain world where central banks are at the edge of the policy borders in terms of their ability to use some tools. Imprecise forecasts are a natural consequence of the situation we are in.
But should the aim be to try and make the forecast as accurate as possible?
I don’t think it’s possible. I do not believe that most of the developed central banks can improve the precision of their forecasts by being more transparent.
Do you think this whole area of big data, which has the potential to help understand some of the dynamics of how the economy really works, may offer some help?
We are benefiting a lot at the CNB by being a central bank and an integrated supervisor at the same time. This enables us to know much more about the financial system. It is mutually enhancing. With respect to big data and the use of other statistical sources, such as internet sources and so on, we are using them. They have helped us make some improvements, but I wouldn’t say they put us on a different level of understanding. However, I expect a lot of progress as the data sources are integrated and we learn which sources are reliable or not. This will lead to improvements, but it will not give us a significantly higher level of accuracy for the foreseeable future.
The board said if the inflation outlook deteriorated, a monetary policy adjustment would be on the table. What would be the first move? Would it be to adjust the exchange rate commitment? What other tools are available?
All the tools are available. However, we believe that controlling the exchange rate was a natural choice, given the openness of our economy and the overall liquidity in our financial markets. That said, one of the surprises of the last two years is that several central banks have used a negative exchange rate – something we were always a little bit sceptical about. There was a fear that at some lower bound, people would move into physical cash due to a ‘tax’ on bank accounts. And in an economy such as ours – less advanced than the most advanced economies such as Sweden and Switzerland – this rate may be closer to zero. Anyway, our concern is that the interest rate differential makes our monetary policy rather less relaxed than we intended it to be.
Having said that, we have not been discussing these issues that often. The economy is broadly where we expected it to be. Hopefully, it will stay on this path. If not, we can always reconsider. One of the things that even some experienced market participants have a problem understanding is that central banks do not really have to bother themselves with what they are going to do six months from now. We are much more obsessed with our next moves than with what we would do if this or that were to happen in a year and a half, as we could have had six to eight monetary policy meetings by then. This is sort of a dynamic programming problem.
But more the Swedish levels than the Swiss levels of negative rates?
Yes, although in some sense we are already there with our government borrowing at these interest rates, without us moving there. But we can afford to be patient.
Why did you decide to set the exchange rate at 27 korunas to the euro?
At the point when we moved, it looked like it would generate a bit of overheating for the economy, given the global economic forecast. In retrospect, the consensus on the variables used for the eurozone was obviously wrong. We moved in November 2013, when the PPI forecast for the eurozone was +2%, but within a year we had -2%. That entered our economy as a deflationary surprise. The idea was to build enough pressure to enable us to exit this policy soon enough. Obviously, the policy has been in place much longer than we expected. But it seems the economy is increasingly happy with it. Wage pressures are growing and some significant inflation looks likely soon.
The International Monetary Fund made a case for when the time comes abolishing the exchange rate in one step rather than gradually. Would that be the first stage of a tightening cycle, with a normalisation of interest rates to follow?
In our discussions with our IMF partners, I believe we understand each other quite well. While it is difficult to talk about the tactics of a move that is unlikely to happen in the immediate future, it makes sense to abolish the floor in one move. We would aim to return to a policy framework in which we would not rule out taking action against sharp movements in the exchange rate.
So that means you would potentially remove the floor but calm any excessive volatility?
Yes.
The Swiss National Bank removed its floor earlier this year, causing sharp moves in the currency. It sounds like this is not the model you would like to follow, is that correct?
The Swiss situation was completely different, as the Swiss franc is a reserve currency. Also, the policy setup of the Swiss central bank is different to ours. I don’t think anybody would like us to surprise the market by dramatically changing our policy like the Swiss did. Also, I believe we will be exiting in a different position. Our economy has already started creating significant signals that wage pressures will go up. That means our foreign trade will start to deteriorate. It is likely we will exit at a time when some major currencies will have positive interest rates. They should be much more attractive than currencies with de facto negative interest rates, or zero interest rates. Many things will be different to the Swiss experience – oligarchs, frankly, are not putting their savings into Czech korunas for long-term asset protection purposes!
So you wouldn’t do it as a sudden event?
Yes, that is what I mean. The Swiss were obviously over-anxious not to create any suspicion that anyone had advance knowledge of the move, which is understandable given the problems experienced by the previous governor when they introduced the floor.
A recent CNB test showed that the Czech banks and insurance companies would stand a strong recession accompanied by deflation thanks to their capital buffers. Are you confident in the resilience of the financial system?
I would say the world is about as we expected it to be. There are hiccups in China, but other economies appear to be showing more robust growth than might have been expected. That said, we run very severe stress tests. All the European supervisory authorities conducted stress tests for the Czech Republic, but they assumed much milder scenarios than we did.
Do you think your stress tests are tougher than those in the US?
The only way to learn this would be if the Americans made some assumptions about the Czech economy, but they don’t.
I believe that earlier this year you had a positive balance sheet for the first time in years due largely to the strong performance of your equity reserves allocation. Do you still have a positive balance sheet, given the slide in equities over the European summer?
Most likely not – but I don’t know, frankly. And I don’t care. A central bank’s balance sheet is not an important issue. Negative equity in a central bank’s balance sheet does not matter as long as it is caused by the right monetary policy. We have had negative balance sheets for almost every year of our existence. It doesn’t matter as long as this is done by currency appreciation, which creates surpluses in our reserves, which you have to hold anyway. Israel, Chile, Mexico and Slovakia all have negative balance sheets. Either you provide money or you take money out of the market. It doesn’t really matter – you just have to offer more advantageous rates than the market does. People say, what happens if the central bank loses credibility because it has a negative balance sheet? Suppose it did lose its credibility, what would happen? In many situations, the exchange rate would weaken, so the balance sheet of the central bank would improve immediately. It is a self-correcting problem.
The ‘best’ balance sheet in domestic currency was probably held by the Zimbabwean central bank when it had around $100 in its wallet! In domestic currency, the balance sheet must have been perfect during the years of hyper-inflation. It doesn’t matter as long as the central bank’s role has not changed to finance a dictator who is using up reserves for his own purposes or something similar. For a normal country with an independent central bank, the balance sheet is not a problem. If it is a problem, it is a problem of the political setup.
Presumably, your reserve policy won’t change based on whether the balance sheet is positive or negative. But was your move into equities a good move?
Yes, very much. We crunched some data on this recently and it was a good move, even given the current equity plunges.
Will you do more?
No. We will keep the allocation as a fixed per cent of our reserves. That is reasonable given the risks and the rate of return.
What do you make of the Federal Reserve’s plans for interest rate normalisation?
We would be happy to see a Fed normalisation. It would be a beneficial thing. Not least because it would mean the largest economy is ‘getting out of the woods’ and exiting non-standard policies, which would lead to normalisation everywhere.
We’ve been waiting for a while even in the face of much more positive unemployment data. Is the Fed ready for lift-off?
I’m ready for a US lift-off, but I don’t think that the Fed cares!
Do you think the Fed has been addressing spillovers and spillbacks more than it has in the past?
At the Bank for International Settlements we have a working breakfast for governors from small open economies around the world, such as Chile, Malaysia and Norway. Many of these countries had to buy up currency a few years ago to stop appreciation stemming from non-standard Fed policies. Now they will use some of the reserves they accumulated to provide a bit of a buffer on the opposite side if it is needed. Some of them are under pressure from commodity price falls, which may mean they will need to let their currencies depreciate a bit for a month or so, but the world is not the same as it was three years ago. Overall, normalisation will be beneficial for most of the world. Of course, countries that allowed great imbalances to emerge will experience more pronounced currency depreciation at a time when they are facing other crisis issues. But this is not the situation of the Czech Republic.
Some have argued that we have entered a period of secular stagnation and we will just keep waiting for a US rate rise in a similar manner to Japan. What do you think?
Japan was a very specific case. Overall, I am more optimistic about the US.
We have seen $5 trillion wiped off what was a ‘frothy’ equity market in China over the past three months as well as a slowdown in imports and exports. Do you think China can experience 7% growth over the next few years?
I would say China is in a situation – and the Chinese authorities are well aware of it – where it needs to change its economic model, and it does have a lot of areas to exploit. There are a few Chinas. For example, there are the coastal areas, which are heavily involved in world trade, and then there are the inland provinces, which are less intensively involved in world trade.
One thing China can and should do is promote more channels of intra-China trade and flows of capital and labour. This would immediately solve some of its problems. This is more of a political challenge, as there is a need to utilise a lot of investment, to get permission to be there and so on. It’s a little bit like New York taxis’ medallion licences. How do you persuade people that bought medallions – meaning the right to work in Shanghai or somewhere else – that they will be devalued as others will be moving in? But this is necessary for China to increase its intra-trade.
Other reforms are needed as well. China is moving to a more liberalised capital account. If China moves in the right direction its GDP statistics will have completely different components. I have been in China and its growth model worked successfully for years. The regional bosses worked together with the regional banks to promote GDP growth, and this was achieved. It worked for years. Now, they need to move away from this model and the growth statistics may be lower. But it will be much more substantial, market-justified GDP growth. That is not such a bad thing. I do not think the stock market correction in China is such a big problem. The bad debts and non-performing loans are a much bigger issue. That said, I’ve seen a lot of empty buildings and so on. Yet at the same time you know that many people would love to move to these cities. Sometimes it is a problem not of insufficient demand but of barriers preventing people from moving. These barriers are there because the authorities are worried that those city dwellers are the privileged ones and they will lose some of their privileges.
At the same time, the erosion of China’s overall profits is actually due to the fact that people’s wages are rising. That is not necessarily a bad thing. And there is space to accommodate more people in productive regions, to build trade channels inland rather than in the Pacific provinces. It is hard, but it is doable. And the hiccup on the stock market is about half of the scale of the last one in China – the volatility has decreased.
Do you think enough improvement has been made in market mechanisms to warrant SDR inclusion?
I don’t want to comment on this. I’m not an expert.
Turning to local government debt here in the Czech Republic, I noticed that the Czech banks and credit institutions hold up to twice the European average on their balance sheet. Is that a cause for concern for you?
Not so far, but we did issue a warning about this in our financial stability report, including a plan on how we are going to proceed with these sovereign debt holdings and how we are going to evaluate them on banks’ balance sheets. This was aimed at preventing a dramatic increase in holdings. It is not an immediate concern. It may be a concern in the future. The way we work is to single out future concerns fast enough so banks can make the necessary adjustments to mitigate them. The major focus is not to increase the proportion of Czech government bond holdings. Having said that, I should stress that the Czech Republic is one of the least indebted countries in Europe.
What do you think of all the Basel III rules? Are they fit for purpose?
We have no power to influence the discussion about the usefulness or not of Basel III. I believe the last financial crisis was more closely linked to supervisory culture than to supervisory rules. I am very sceptical about the detailed rules and about the shift from Basel II to Basel III. Basel II regulation has worked very well for us. I understand we are outliers and one of the few European countries that did not have to prop up its financial sector. We have been outgunned in the debate about the need for new, more detailed rules. But reading the new rules, I am broadly sceptical about the ability of supervisors to really implement them. I still believe culture is much more important than the wording of the rules.
It was a similar situation with some of the Asia-Pacific countries, including Japan. Did their support not help with pushing back in any area?
We are in Basel III and we can fulfil Basel III. I am just saying that I don’t think it’s a real improvement. I think the only big improvement would come with a different supervisory culture.
We have seen counter-cyclical capital buffers, where they have been implemented in Switzerland, as not being that effective. What do you think of them?
They can do a little bit to help, but people should not over-rely on them.
How has the launch of quantitative easing (QE) affected the Czech economic outlook?
It has helped the EU economic outlook, especially through the exchange rate channel. The eurozone is our biggest trading partner. What benefits the eurozone benefits us.
Do you think given the package of tools that are now being implemented, the ECB will be able to get to its 2% inflation target?
Well, we are all dealing with the puzzle of commodity price developments. However, I believe these things will factor out at some time from the inflationary numbers. Europe will change position with respect to the US and North American economies, particularly because there is a long-term cycle for European exchange rates – for the euro and before that the deutschmark. We are close to the bottom of the cycle at the moment and the European economy will be helped by this fact, as it is becoming much more competitive. To understand the full scope one must remember that the value just after the turn of the millennium was $0.8, versus around $1.6 at the peak of the Lehman Brothers crisis in 2008 – so the euro appreciated dramatically. Did European institutions and structures really improve by such a significant amount between 2001 and 2008, I don’t think so. A lot of Europe’s problems can easily be explained by the fact that Europe priced itself out of competitiveness in the world market. Now, it’s simply regaining part of this competitiveness. Consequently, I’m optimistic about the European economy.
If we strip out the commodity pass through, do you think that the ECB’s QE programme will get inflation back to 2%?
Well, if you get significant wage pressure why shouldn’t it get there? In our case, the wage pressures are already there.
It looks like the ECB will make a loss on its QE programme and the Fed probably won’t. Is that a problem?
It shouldn’t be a problem. I’m not sure of the exact wording of European contracts and primary legislation on ECB capital. But the sign on the equity line of an independent central bank’s balance sheet should not matter. If it matters, it is a problem of the founding principles of the ECB, not a problem related to QE.
There are many contradictions and complexities, but what are your observations of the ECB’s handling of Cyprus and Greece?
We are not eurozone members, just observers. But the level of frustration with the Greek authorities was unprecedented. I’ve seen people coming out of meetings at which they discussed Irish, Spanish and other problems. Greece was a completely different case. People were completely frustrated with the attitude of the authorities.
Is the ECB a credible lender of last resort, given it cannot issue euro bonds and is not the party in the negotiations that ultimately decides if a country remains in the eurozone or not?
The ECB is much more credible as a lender of last resort after these crises than it was before them.
What’s your view on the Czech economy and the conversion criteria for joining the euro? Do you think they need to change in light of the problems we have observed?
It depends much more on political will rather than being an issue related to the convergence criteria. I do not believe that the political will has increased as a consequence of the crises in eurozone countries. Also, despite all the talk about how well integrated we are with the eurozone, our independence to set monetary as well as fiscal policy seems to offer some benefits.
Are you strongly in favour of an independent currency?
It is not for me to have any strong opinion. It’s for politicians, government and representatives of our people.
What is better from your perspective as head of the central bank?
We are in a situation where the eurozone is changing its institutions, so it is probably time to wait and see how they shape up and how they will work. In the long run our major trade partner is Germany, so if the euro area becomes a healthier currency area, it is unlikely we will have a different currency than that of our major trading partners in the long run.