COMMENT: A Czech central banker’s nightmare scenario: Switzerland 2015

COMMENT: A Czech central banker’s nightmare scenario: Switzerland 2015
The Czech National Bank building in Prague.
By Peter Bukov of TopForex January 26, 2017

In his last public statement on the subject, the Czech National Bank governor Jiri Rusnok said that the central bank will maintain its interventions in the currency market that are keeping the local currency capped at CZK27 to the euro until the end of the first quarter, while the “highest probability of an exit [from the low-koruna policy] is somewhere around mid-year”.

The long-desired rate of inflation goal of around 2% has been achieved and, moreover, the original estimated time for the termination of interventions was passed at the end of 2016. Yet, according to our estimates, the Czech central bank might currently be still purchasing around €1bn daily on average.

So the key question has ceased to be “when” the policy will be terminated; rather it is a question of “how” the exit from the intervention scheme will look like, which seems to be the decisive factor for the value of the currency at that time. The CNB has declared repeatedly that a return to a standard monetary policy will probably be followed by the appreciation of the koruna above the level before the start of the interventions, when the koruna had been “slightly overvalued“. Verbal interventions, namely the central bank’s readiness to take immediate action against excessive volatility (appreciation) of the crown, will also play a significant role in the intervention exit. Translated into clear language this means that the exchange rate should take the course up to CZK26.50 against the euro at current interest rates, as per the CNB’s expectations.

The governor of the CNB is already making verbal interventions. For example, an indication that it is ready to deploy negative interest rates on deposits with the central bank just before “CZKexit”, thereby reducing speculators’ anticipated profit from the appreciation of the koruna. Such warnings, however, can be a sign of central bankers’ worries about further developments.

The CNB may not have the process of exit entirely under control. The question is how the market and investors – speculators – will behave during the course of the termination of interventions. From past experience, we have the case of Switzerland. The Swiss central bank had pegged the Swiss franc against the euro at CHF1.20 since 2011, but the unexpected release of the cap in January 2015 caused a dramatic appreciation of the Swiss franc, which was the last thing the Swiss National Bank wanted. The Swiss franc strengthened against the euro by 30-40% within an hour as panic hit the markets, with Swiss stocks falling as export-focused companies predicted losses of a significant portion of their revenues. The EUR/CHF exchange rate fell from €1.20 to €0.80, but was able to recover and in the time since it is has settled around €1.09, which is approximately 10% below the level before the end of the previous monetary policy.

Why might the Swiss scenario not also happen in the Czech market? Unlike the Swiss currency market, the Czech one is too small for most investors and the koruna falls short from having a reputation as a safe currency like the Swiss franc has. There is also not nearly as strong a pressure on the koruna’s appreciation in the market, unlike that which was affecting the Swiss franc. Also, the CNB states that, compared to Switzerland, it is going to manage the float after the termination of the policy: in other words, it will continue to take active steps (see the table below). Although it can be assumed that the impact on the koruna will probably not be so strong as what happened to the Swiss franc, nevertheless the end of interventions could sent the Czech currency to the zone of around CZK25.00 per euro, implying an appreciation of about 8%. Consequently, investors considering this level as already a good buying price could enter the market and the exchange rate could stabilize around CZK26 per euro.

The appreciation of koruna, of course, also speaks for the decent performance of the Czech economy, especially its exports, and therefore the trade surplus. But this is a long-term economic logic. In the short term, however, the koruna could actually fall to the level of CZK28 or even lower. Why? According to our estimates, the speculative capital that has flowed into the Czech koruna with a view to its appreciation since November 2013 amounts to CZK950bn. If a significant portion of these investors try to get rid of their koruna after the interventions at the same time, paradoxically, a state of significant surplus of supply over demand could rule in the market with corresponding impacts on the exchange rate.

Such volatility is certainly not in the interest of the Czech economy, nor that of the CNB. It is therefore not surprising that central bankers are applying verbal interventions, delaying the termination of the policy and trying to make all other efforts to prepare the ground for a smooth ‘CZKexit’. And we cannot blame them for that. After the lesson learned from November 2013, when the CNB was heavily criticized for starting up the interventions, the central bankers know (though they do not want to admit it) that even more important than the stability of the currency is a general confidence in the economic environment – and therefore the predictability of the CNB decisions.

CNB on the difference between the Swiss and Czech monetary policy regimes
(London, 24 January, 2017):

Peter Bukov is Senior Analyst for TopForex, a comprehensive global investment services provider.