Nicholas Watson in Prague -

When Czech Deputy Finance Minister Eduard Janota was quoted by the local daily Hospodarske Noviny on Thursday, November 6 as saying that growth next year could well be less than the already-reduced official forecast of 3.7%, he let slip an open secret that the economy is set for more trouble than many have cared to admit. The Czech National Bank's swingeing interest rate cut of 75 basis points on the same day is an acknowledgment of this.

The Finance Ministry had based the 2009 budget draft on a 4.8% growth rate forecast for next year, which was some way worse than the 6.0%-plus recorded in 2005-07. But given the deepening and widening financial crisis since Lehman Brothers went bust in September, the ministry was forced to slash this to 3.7% in late September. "I cannot exclude that we get to a number even lower, rather it is a reality," Janota said. Given that a 1% slowdown in growth would cause a CZK10bn shortfall in the budget revenues, the planned 2009 deficit of CZK38.1bn looks hopeless.

Several hours later and the market was stunned by the announcement that the Czech National Bank (CNB) had not cut its key two-week repo rate by 25 bps, as had been widely expected, nor by the "outside possibility" described by one analyst of 50 bps, but by a huge 75 bps to 2.0% - the lowest rate in Europe. The move came alongside other big moves by Europe's central banks - the European Central Bank cut its minimum bid rate on the main refinancing operations of the Eurosystem by one-half percentage point to 3.25%, the Bank of England cut its key lending rate by 1.5 percentage points to 3% and the Swiss central bank cut its key rate by one-half percentage point.

Painfully slow

There are several reasons why the Czech central bank decided, 4-1, to cut by 75 bps. First and foremost, the Czech economy is clearly slowing faster than most had predicted. The CNB now puts next year's GDP growth at 2.9% and inflation to come within its target of 2% in the first quarter of 2010. The country was always going to be hit harder than some in Central Europe by the global slowdown, mainly because it has a comparatively open and export-driven economy, especially towards Germany. Poland, on the other hand, is not expected to suffer so badly. "The larger cut was driven by a sharp drop in inflation connected with a deceleration of growth," Czech Governor Zdenek Tuma told reporters. "The Czech economy is exposed mainly to the Eurozone and that is expected to slow down significantly."

The risks seen by bank board also include: a deeper slowdown abroad, commodity/energy price falls, lower food prices, and the Czech crown is still stronger than the CNB had assumed before. Governor Tuma said that bank's monetary policy board couldn't remember a time when the risks were so much on one side. "The year 2009 will be the year where the strong crown and global financial crisis will show up in the economy," predicted Komercni Banka before the cut.

The result is that economists are expecting more cuts over the next few months. "With this forecast [of 2.5% GDP growth in 2009 and inflation decline to 2.2%] is consistent with another cut, we expect cumulatively another 50 bps, which means a bottom at 2.25% in 2009," says David Navratil, chief economist at Ceska sporitelna.

Komercni Banka expects another cut at the December meeting by 25 bps and another 50 bps in the first quarter of next year, lowering its key rate to the level of 2.0%.

The Czech bank's move also increases the likelihood of rate cuts in other countries in the region. Analysts polled by Reuters had expected Polish policymakers to wait until the first quarter of 2009 before cutting rates from 6.0%, but that will change after the head of the Polish central bank, Governor Slawomir Skrzypek, indicated that a cut could come sooner. "After the Czech central bank decision, I'm now even more convinced an easing cycle in Poland should be started," he told Reuters.

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