Jan Cienski in Prague -

The region-wide resurgence of inflation has hit the Czech Republic harder than most, but the head of the central bank, Zdenek Tuma, insisted during a recent interview with bne at his offices in central Prague that the problem is under control and the rate should return to within the bank's target by the beginning of next year.

Inflation is currently running at 6.8%, higher than in neighbouring countries like Slovakia and Poland, and far above the 3% target. Much of the rise is due to external factors like rising food and fuel prices, but part of the reason is also due to government reforms that increased VAT and cigarette taxes as well as health care fees. The central bank has been trying to squelch inflation with a series of interest rate increases over the last year. Rates now stand at 3.75%, still a quarter point below the rate set by the European Central Bank and far below the rates in Poland and Hungary.

"Our present forecast calls for a slowing of the economy to 4.6% of GDP in 2008 and the fall of inflation at the beginning of 2009," Tuma said. "We believe that inflation should fall relatively quickly and should be back to our target by the beginning of next year."

That's quite a forecast, as the bank's inflation target is 3% with a band of 1 percentage point. Luckily for the bank, though, a good deal of the heavy lifting in the battle with inflation is being done by the soaring Czech crown, which has risen by 18% against the euro in the past year and by 40% against the dollar, making it the world's second-best performer against the greenback. "I expect it will push prices downwards and that there will be some effect on economic performance," Tuma said.

That economic performance has, so far been outstanding. The Czech financial system has been unswayed by the global credit crunch and the economy is expected to continue growing much more strongly than western Europe for the next couple of years. "The Czech financial system as well as the financial system of many emerging economies has not been hit by the financial turmoil too much," said Tuma. "One reason is that Czech banks and more generally the Czech financial sector focused on the domestic market and not on looking for higher yields elsewhere, that is why direct exposure was very limited. The second important point is that we are in a very positive stage of the business cycle."

Feeling a stitch

Despite Tuma's bullishness, there are signs that the Czech economy is slightly winded. GDP growth came in at 5.3% year-on-year in the first quarter of 2008, down a percentage point from the last quarter of 2007. In 2006, the economy grew by 6.8% and last year it expanded at 6.6%.

While the country itself has not been directly affected by the turmoil unleashed by the US credit crisis, the Czech Republic is one of the world's most open economies - with combined imports and exports totalling more than 120% of GDP - and a slowdown in western Europe could quickly make itself felt. "In an economy like ours, which is medium sized but very open, there are indirect effects. If the global economy slows down it must hit Europe and through foreign trade the Czech economy cannot avoid it completely," said Tuma.

Despite the occasional worries from the economic unrest in other parts of the world, the Czech Republic is doing so well that there is little pressure for it to race towards the euro, which is likely to be adopted by neighbouring Slovakia next year. So far the right-wing government of Mirek Topolanek, the prime minister, assisted by the famously euro-sceptical President Vaclav Klaus, has shown no inclination to set a target date for joining the common currency.

Using the on-one-hand and on-the-other-hand argumentation so beloved of economists, Tuma said views on the euro were mixed: "On the one hand you could get rid of exchange rate risk, and a significant part of the business sector would welcome that. On the other hand the floating exchange rate has contributed to a very stable macro economic environment in terms of low inflation and low interest rates. Both arguments are legitimate so there are pros and cons."

Tuma said that the economy would be ready to join the euro between 2012 and 2014, but that the government could argue that it is more focused on its current programme of economic reforms and may not find the political energy to push through the project. "To me it is a very political decision," he said.

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