Deflation fears prompt Czech central bank currency intervention

By bne IntelliNews November 8, 2013

Tim Gosling in Prague -

After months of trying to talk down the Czech koruna and much hand-wringing over a move into unconventional monetary policy, the Czech National Bank surprised markets with the launch of direct currency intervention on November 7. The announcement sent the koruna tumbling against the euro despite a cut in rates from the European Central Bank, and analysts are divided on the wisdom of the move.

As deflation fears grow, the CNB voted at its monthly meeting to ease monetary policy further via intervention in the foreign exchange market to weaken the crown. Few details were provided, except that the central bank aims to keep the currency "close to" CZK27 to the euro.

At the post-meeting press conference, Governor Miroslav Singer said the CNB would be willing to purchase any amount of foreign exchange to weaken the koruna and that forex intervention would stay in place "for as long as needed". Immediately following the announcement, the CNB went directly onto the market to buy around €500m at CZK26.6. The crown lost around 4% against the euro, dropping to CZK26.8, reports Danske Bank. It had started the day around CZK25.8.

The launch of intervention was somewhat of a surprise because the original motivation for such a move from what is an inherently conservative central bank has steadily dissipated in recent weeks. It was first discussed publicly close to a year ago as the CNB sought extra tools to offer stimulus to an economy in recession. With exports a huge driver of the Czech economy, weakening the currency was an obvious move.

Left as the sole source of economic stimulus during the government's harsh austerity measures over the last couple of years or so, the central bank has maintained interest rates at effectively zero (0.05%) for the past year. However, the economy finally emerged from recession in the summer and has begun to exhibit signs of a building recovery.

However, as in many European economies the Czech central bank has been eyeing the threat of deflation warily recently. Consumer prices fell to 1% in September, from 1.3% in August, to hit their lowest since March 2010.

Dividing opinion

Analysts are divided on the move. Some note that the caution the central bank has shown over launching intervention is not misplaced. David Navratil at Erste Bank insists that with Czech manufacturing data at three-year highs, the real economy needs no further support. Further, they fret that intervention will not help inflation, and could instead knock the recovery.

"The CNB wants to increase inflation through higher import prices," the analysts write in a note. "However, inflation deceleration is driven by supply side factors. Moreover, the short-term effect of intervention would be negative, as higher prices may slowdown consumption recovery because higher inflation will decrease real disposable income."

However, Danske Bank suggests the CNB has little choice, and in fact should have moved some time ago due to the growing risk of deflation not only in the Czech Republic, but in the wider neighbourhood and across the Eurozone. "We have been calling for the need of further monetary easing in the Czech Republic for more than a year," they note. "The actual risk of a possible deflation has increased considerably lately."

With that in mind, the ECB also launched a surprise just after its Czech peer as it announced a cut of interest rates to 0.25%. "Following [the] rate cut by the ECB, the [CNB] may find that the scale of its intervention needs to be larger than originally anticipated," suggests William Jackson of Capital Economics.

Meanwhile, Citigroup points out that the ongoing recovery may not be as solid as some headline figures suggest. "Despite signs of export/industrial recovery," writes Jaromir Sindel, "the construction sector has remained weak, and consumer demand has been fragile, albeit improved."

The political stalemate in the country following parliamentary elections in late October provides an additional threat. Failure to form a new government and form a 2014 budget by the end of the year will see a temporary fiscal plan limit government spending to 2013's austerity-led limits.

Erste suggests that the CNB will want to see inflation hit at least 1.5% before it leaves the currency to its own devices. Citi estimates that it could take more than two years for the threat of deflation to retreat.

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