Tomáš Holub (Doing Business in the Czech Republic 2014/2015)
The Czech economy sank to the bottom of the economic cycle during 2013. The anti-inflationary effect of long-term decline in the domestic economy contributed to the reduction of inflation and there was a real danger of a deflationary spiral. Since the end of 2012, any room for further reduction of monetary policy interest rates had ceased to exist and so it was necessary to start using a new tool for the required easing of monetary policy. In line with previous CNB communications, the exchange rate was adopted as an additional tool in November 2013. The following text will outline the reasons why the CNB took this step, the expected impacts, and how it is currently reflected in the development of the Czech economy.
2013 – ECONOMY EMERGES FROM RECESSION WITH DIFFICULTY; INFLATION BELOW THE CNB TARGET
The Czech economy did not begin 2013 in good shape: it was still in a prolonged recession and falling ever deeper below its potential. In the middle of the year it reached the bottom of the economic downturn; nonetheless, even subsequent to this milestone it was still not possible to point to any significant recovery. At the same time, the growth of wages significantly slowed and unemployment increased. The anti-inflationary domestic conditions caused a decline of inflation at the beginning of the year below the 2% CNB target, despite a January increase in indirect taxes, while at the same time core inflation remained negative. The long-term economic recession and the continuing downturn in the labour market, together with a decline in commodity and energy prices, then led during the year to a further reduction of inflation. This happened despite the fact that the koruna rate – depreciated by the CNB’s announcement of its preparedness for foreign exchange interventions in case of a need to ease monetary policy – was having an effect in the opposite direction through import prices. Additionally, during the year predictions of future inflation development were becoming increasingly dire. The CNB analysis from autumn 2013 indicated a significant drop in inflation at the beginning of 2014, which without a strong monetary policy easing could lead to an annual decrease in price levels.
RISKS WITHOUT CNB INTERVENTION
Prices for many items in the consumer basket had been decreasing for a long time and there was a danger that Czech consumers and companies would take falling prices for granted, and that these prices would be reflected in price and wage expectations and negotiations. At the same time, this would spark a tendency to put off purchasing certain consumer and investment goods, which would happen despite record- low nominal interest rates. The consequence would be the additional reinforcement of anti-inflationary pressures in the economy. Without afurther easing of monetary policy by the CNB, the hitherto relatively stable exchange rate development could be interrupted and the koruna could start to significantly appreciate. There was a much higher risk that the Czech economy would slide into a long-term price level fall. That would lead to further strengthening of the exchange rate and deflationary expectations, edging the Czech economy into a deflationary spiral. Cases from history show us that a deflationary spiral usually has very unfortunate economic and social consequences. In addition, halting deflation is very difficult and time consuming, and it requires very radical measures. Prevention is therefore better than any attempts at subsequent cure. The CNB decided therefore to intervene to eliminate the above-mentioned risk in accordance with its mandate to look after price stability. It was necessary, furthermore, to ease monetary policy and return inflation to the central bank’s 2% target, which is at a safe enough distance from the danger of deflation.
EXCHANGE RATE AS AN ADDITIONAL MONETARY POLICY TOOL
In the light of the fact that interest rates had reached technical zero, it was necessary to use a different tool for easing monetary policy. In line with CNB announcements since autumn 2012, the preferred instrument was the exchange rate, or more precisely an asymmetric exchange rate commitment. In November 2013, the CNB Bank Board announced its decision to depreciate the koruna to a level close to CZK 27 / EUR, i.e. by 4.5%, and to subsequently prevent it from appreciating under this level. The CNB simultaneously communicated its resolve to intervene in the foreign exchange market to a potentially unlimited degree in order to fulfil its exchange rate commitment. In fact, interventions were only needed in the first few days after the decision. After depreciating above CZK 27 / EUR, the koruna shortly thereafter stabilised at a level of about CZK 27.5 / EUR, without any further intervention from the central bank. This indicates that the exchange rate commitment had quickly and powerfully established its credibility. At the same time, the described exchange rate developments correspond to the asymmetric nature of the commitment of the CNB, which is ready to intervene to prevent any strengthening below the level of 27 CZK / EUR, if necessary. On the weaker side of that threshold, the CNB will let the exchange rate move according to developments of supply and demand in the foreign exchange market.
Analyses and simulations conducted by the CNB clearly showed that a depreciation of the exchange rate would have a positive effect in terms of achieving price stability and promoting economic recovery. In the initial phase, depreciation leads to an increase in the price of imported goods and thus to headline inflation, which prevents a fall in inflation expectations far below the central bank’s target or into the deflationary zone. Households and businesses accordingly conclude that it is not worth waiting for a further price drop, and some of them start to consume more and invest. At the same time, the weaker exchange rate leads to the increased price competitiveness of Czech producers in international markets, which is then reflected, with a slight time delay, in an increase of exports. The weaker exchange rate simultaneously encourages demand for domestic goods also in the Czech market. Czech companies sell more and generate higher revenues, workers will have longer working time and there will be renewed growth in wages. This is expressed in turn by higher incomes and household consumption, higher profits and business investment. The CNB has estimated that the Czech economy will grow one percentage point faster in 2014 and that there will be roughly 35,000 more job vacancies compared to the situation had the CNB not intervened. The economic recovery will gradually play an increasingly significant role in returning inflation to its target and stabilising inflation expectations close to this figure. Considering that the CNB used the exchange rate commitment as a tool for achieving price stability in a situation of zero interest rates, and at a time when there was no other effective monetary policy instrument, this step was also supported by the International Monetary Fund (IMF) and by the Organisation for Economic Cooperation and Development (OECD).
BENEFITS OF EXCHANGE RATE DEPRECIATION ALREADY APPARENT
Subsequent developments have confirmed the expected positive effects of depreciating the koruna. Inflation was very low in the first half of 2014, mainly due to the decrease in regulated prices and an unexpectedly rapid halt in the growth of fluctuating food prices. Without having depreciated the exchange rate, deflation would have been significant, at least -1%, meaning that the Czech economy would already have entered deflation for an extended period. However, thanks to the exchange rate depreciation, the threat of deflation caused by a lack of demand and a downturn in the economy passed. Despite a significantly greater anti-inflationary effect abroad than was expected at the end of 2013, core inflation returned to positive values after nearly five years.
Economic activity in the last quarter of 2013 switched to growth (1.1%), thereafter it accelerated noticeably in the first half of the year (to 2.6% in the second quarter). The depreciation of the exchange rate actually accelerated the recovery of household consumption. Increased turnover in retail trade suggests fundamental changes to consumer behaviour. Some households and companies stopped postponing their purchases and investment, while consumer confidence has significantly improved. The depreciation of the koruna also boosted real export growth, which is growing around 10% year on year, i.e. significantly more than the increase in foreign demand in the main trading partner countries of the Czech Republic. Companies’ operating results, especially for exporters, have significantly improved. Unemployment is decreasing even slightly faster than the CNB had forecast. Adjusted for seasonal influences, the number of vacancies is slowly increasing. At the same time, average working hours are no longer being cut back. Wages have begun to increase slightly after the decrease at the end of 2013. In general, after a long pause real household income is once again rising.
The CNB prediction from its Inflation Report III/2014 expects that, as a result of accelerating foreign demand and monetary policy easing, the Czech economy will grow by nearly 3% in 2014 and that it will maintain a similar growth rate in the next two years. Headline inflation will gradually increase until it reaches the 2% inflation target in the second half of 2015. The prediction expects market interest rates to remain stable at the current very low level and usage of the exchange rate as a monetary policy instrument in the third quarter of 2015. The subsequent return to normal monetary policy will not mean allowing the currency to appreciate to the level before the onset of CNB interventions, because in the meantime the depreciated exchange rate has been absorbed into prices and other nominal values. At a policy meeting in July, the Bank Board evaluated the risks of the prediction as slightly anti-inflationary, and as a consequence decided to continue using the exchange rate as an instrument of monetary policy at least until 2016.