By Gene Frieda, 4Cast email@example.com
Go With the Flow
In the wake of the Czech National Bank’s rate cut and concurrent intervention to halt the rise of the CZK, a number of market participants have talked up tightening monetary conditions as the main driver of these central bank actions.
The argument goes that real exchange rate appreciation risks cutting off recovery in its tracks. While Czech recovery is indeed lagging within the region, the evidence suggests that CNB intervention and rate cuts are more pre-emptive than reactionary. Going forward, the CNB’s proposal to create an offshore fund for privatisation receipts provides the best hope for limiting exchange rate appreciation, but such hopes are likely to prove fleeting due to political realities.
The CZK will continue to appreciate in the year ahead. Any CZK weakness resulting from near-term CNB statements should prove to be a medium-term buying opportunity.
Assessing Monetary Conditions
We’ve constructed an index of monetary conditions to quantify recent movements in the real exchange rate and nominal interest rates. The lack of historical data generally, and the structural changes that have taken place since the transition from communism, limit the usefulness of using a monetary conditions index (MCI) to judge whether policy is appropriate for a given level of output. However, the MCI still shows whether policy is easing or tightening. The further difficulty is judging how to weight interest rates and the real exchange rate in the index.
Normally, an MCI is based on changes in nominal interest and real exchange rates, weighted on the basis of the economy’s sensitivity to changes in each variable. The lack of data again prevents serious estimation of these sensitivities, but using correlations and measures of the relative openness of the economy, we have assumed that a 3% appreciation in the real exchange rate is equivalent to a 1% change in nominal interest rates.
The Czech Republic is a small, relatively open economy with exports equivalent to roughly 51% of GDP, a fact which justifies a relatively higher weight for the real exchange rate (as opposed to, say, the US, where exports are quite small, and hence the real exchange rate much less significant).
The results show that while monetary conditions are indeed tighter than those prevailing between March and July, they are still quite easy. While the relationship between industrial production and the MCI is poor, our index can nonetheless show how monetary conditions have changed. Changes in monetary conditions resulting from the 5% appreciation of the real exchange rate between end-April and end-September do not, in their own right, appear to explain the underperformance of the Czech economy.
Monetary Sensitivities Go Awry
One possibility is that financial sector fragility has temporarily reduced the relative importance of the interest rates in the transmission of monetary policy. Further, exports do appear relatively sensitive to changes in the real exchange rate with a three month lag (although the relationship is probably distorted by the sharp devaluation in 1997 and the export response which followed). On this basis, there is clearly a stronger argument for acting to quell the further real appreciation, which is threatened by heavy foreign direct investment inflows.
CNB proposals for a fund to hold privatisation receipts offshore look prudent given the non-reversing nature of such inflows, and the delays in productivity gains that will (hopefully) result from the transfer of state-owned enterprises to the private sector. The authorities have few additional tools to handle the problem, and the most likely of these few – fiscal policy – is too inflexible to provide a likely offset to the impact of inflows.
Political Reality Dominates Economic Theory
In sum, monetary conditions do not appear excessively tight. The CNB’s actions and proposals look prudently preventive. Fiscal policy may be tightened modestly in the year ahead, but not to an extent that will quell upward pressure on the Crown from large FDI inflows. And the CNB’s proposal to hold privatisation receipts offshore, while a good one, is likely to prove ineffective in preventing a further tightening in monetary conditions because the weak government has already committed the proceeds to spending projects.
Unlike the case in, say, Poland, where the NBP can credibly threaten the government to tighten policy if the fiscal accounts aren’t kept in check, the CNB has no stick with which to beat the weak minority government. FX intervention is an unsustainable tool for reining in pressure on the CZK, due to the low level of reserves. If recent CNB policy moves prompt any further weakness, look to buy the CZK. Then, the big question for the year ahead will not be whether the Crown weakens, but how much it appreciates.
* This report is part of a series on Czech monetary policy and exchange rate prospects. The others can be accessed via 4CAST at www.4cast.net or on the Reuters Web.