Nicholas Watson in Prague -

It was Vice President Dick Cheney who famously once told an interviewer that "Reagan proved deficits don't matter." And as the Hungarian forint, Polish zloty, Czech crown and Romanian leu continue to post fresh highs against the euro and dollar, it's tempting to think he was onto something.

Under economic orthodoxy, currencies of countries with large current account deficits should fall against those countries with surpluses, stimulating exports and thus narrowing the trade gap that lies behind much of the current account deficit. And so the US, which today has the world's largest current account deficit (just as it did during the 1980s under the late president Ronald Reagan), has seen the dollar fall substantially against the world's other currencies, especially those in Central and Eastern Europe.

Over the past week, the Czech crown for the first time reached below the 15.00-level to the dollar and posted a record high of 23.516 to the euro. Poland's zloty also hit an all-time high of 3.302 to the euro, the Romanian leu hit the year's high against the euro so far at 3.5211, and the Hungarian forint broke through the key 230-level against euro and hit a record high of 229.55.

The Czech crown is the world's fastest appreciating currency against the euro, rising about 18% over the past year, while the zloty has appreciated about 12% and the forint 5%. At the other end of the scale among CEE currencies, the Turkish lira is down by more than 10% against the euro over the last year. And quite rightly so - its current account deficit has been growing continuously for the past year, and on July 10 the central bank said it rose 28.8% in May from the year before. However, Poland, Hungary, Romania and, to a much lesser extent, the Czech Republic are also running deficits, so why are their currencies still appreciating? And, crucially, for how long will this continue?

It's the fundamentals, stupid

To paraphrase another former US president, Bill Clinton, it's the fundamentals, stupid.

The Czech crown, in particular, is being regarded as a something of a safe haven in today's uncertain financial markets: its economy is growing at a perky 5%-plus, inflation is moderately high but stable at 6.7%, it has a low current account deficit by regional standards, and interest rates are higher than those in the Eurozone.

This last reason is one of the main explanations economists use to explain the perverse rise of currencies of countries with large deficits. The "carry trade" is a common foreign exchange strategy whereby international investors, looking for yield, borrow in low-interest currencies like the yen and euro and invest in higher-interest currencies like those found in emerging markets, thus pushing the latter currencies even higher.

Also bolstering the Czech crown and other CEE currencies like the zloty is the large flows of foreign direct investment, especially since many began the process of joining the EU, which countries use to finance the deficit. According to Adam Zolnowski of PricewaterhouseCoopers, since Poland's accession to the EU, the inflow of FDI has increased 2.5 times. "Before the accession, FDI constituted 2.4% of Poland's GDP; after our joining the EU, it rose to 4.4%," says Zolnowski. For the Czech Republic, several large privatisations on the docket could continue that process, particularly Prague's Ruzyne airport, which the Finance Ministry expects to go for more than CZK100bn (€4.3bn).

However, there are growing signs that the end is nigh for these currencies' appreciation and, in some cases, could be followed by a sharp correction.

Unhedged

Anne Bluher of Societe Generale predicts that disappointing export performance and industrial production in the Czech Republic will inevitably take its toll on the currency. Indeed, on July 11, industrial production growth came in at a lower-than-expected 3.4% in May. Bluher attributes the limited impact of the crown's rise on exports so far to many of those exporters being hedged strongly against such moves. "However, according to the Export Association, many hedges are maturing or about to mature shortly and hence exporters will start facing huge difficulties from the strong crown on one hand, and higher wage and commodities costs on the other," she notes. "All in all, an exchange rate correction is needed or the economy will face difficulties.

Automaker Skoda recently complained that its hedging positions were about to mature, though one Prague-based financier said this was alarmist, as bankers at Ceska Sporitelna, which looks after much of Skoda's hedging activities for it, say the firm is firmly hedged for another two years.

While the outlook for the Czech crown is perhaps not so clear, the zloty and forint look far more overvalued and, thus, more likely to suffer a sharp correction in the near term. As investors become more risk averse, inevitably they will begin to focus more on the fundamentals and countries like Hungary and Poland, which both have large, growing current account deficits, are most at risk.

Raiffeisen released a research note on July 9, entitled "Trading idea: Buy EUR against HUF", which, as the title suggests, predicts that the strengthening trend seen especially in the forint, which has gained 15% against the euro since February, is simply too strong to be sustainable. "Apart from the support by rising interest rates, a lot of speculation has pushed the forint higher, while the uncertain political situation, the dependency on exports in a weakening growth environment, high inflation and still poor growth data have been ignored," the bank's strategists wrote. "We would expect to see some profit-taking by investors in the coming weeks and therefore open the trading idea to buy the euro against the forint at 230. Our target is EUR/HUF 240 with the stop loss at EUR/HUF 227."

For Slovakia, the problems of an appreciating/depreciating currency will be a thing of the past from January, as it's due to join the euro. However, the problems from the recent strengthening of the Slovak crown against the euro could remain with the country for some years to come. In May, Slovakia was forced to revalue its crown's rate in the ERM-2 exchange rate mechanism - a precursor to joining the euro - by 17.65%, meaning that its new central peg rate of 30.1260 has been picked as the rate at which the crown will be convertible into the euro. Unlike Greece, which actually devalued its currency prior to joining the euro, such a move could have far reaching implications for years to come on Slovakia's competitiveness.

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