Czech rates cut to the bone as economic slump continues

By bne IntelliNews November 1, 2012

bne -

The Czech National Bank sliced a further 20 basis points (bp) from its benchmark interest rate on November 1, to leave it at 0.05%, as the country continues to battle recession. With the government refusing to ease its harsh austerity programme, the central bank has now run out of space on monetary policy, and unconventional action remains on the cards.

The CNB postponed the announcement of its decision by one hour. No reason was given. The cut - widely debated by the market - brings interest rates to a record low, and follows a pair of 25-bp cuts this year in June and September.

However, the recession-led approach to zero interest rates has not been accompanied by government policy. Prague continues to push the austerity that has made the country so popular with bond investors. Yet the market has increasingly begun to question the wisdom of that fundamentalism. Heavily exposed to export demand out of the Eurozone, the Czech economy fell into technical recession in the first quarter and GDP shrank another 0.2% in the second quarter.

The CNB's new forecast, announced after the rate cut, retained its September prediction of a full-year contraction of 0.9% for 2012, but slashed the outlook for 2013 to just 0.2% growth from the 0.9% it previously hoped to see. At the press conference, Governor Miroslav Singer admitted that rates are on "a technical zero," and pledged to keep them at that level for a "longer horizon until inflation pressures increase significantly" - an event the CNB doesn't foresee before 2014.

Tight corner

The government's refusal to budge thus far puts the central bank in a corner. "With the economy mired in recession and the government wedded to fiscal austerity, monetary policy will have to provide the maximum possible support," point out analysts at Capital Economics, although they also suggest the decision may not have been as straightforward as many assumed.

"The fact that the announcement was delayed by an hour could be a sign that the decision was carried by the narrowest of majorities," they posit, "Alternatively, it might suggest the Board is treading very carefully with regards to its communication of what might happen next, and in particular to the possibility of a move towards unconventional policy easing."

Reinforcing the pressure on the CNB, data released on October 31 showed that the Czech manufacturing sector's performance dropped for the seventh straight month in October. In fact, the pace of deterioration has gathered momentum, as the headline reading fell from 48.0 to 47.2, the lowest since the depths of the global crisis in August 2009.

At the same time, the problem for the CNB is that the German October Purchasing Managers' Index (PMI) surprised on the downside, meaning that in the short term, no matter what the authorities try, export orders are unlikely to perk up. While it's a bellwether for much of CEE as a whole, the Czech Republic's huge dependence dictates that whence Germany leads, so it goes.

The CNB has been saying in recent weeks that it's determined to try however, suggesting the local currency, the koruna, is the next tool it is set to put to work, using intervention to weaken the currency and thus spur exports. However, the market has expressed scepticism that the central bank is ready to extend such verbal intervention into actual action.

For the moment, that seems the case. Singer did no more than confirm once more that intervention is the most likely next option. Capital Economics says it's not surprised. "Any move towards unconventional measures is unlikely to happen quickly," they write. "Despite today's decision, the CNB remains a highly conservative institution. What's more, big questions still hang over next year's budget, and we suspect that policymakers at the Bank will want to make a full assessment of fiscal policy before leaping into unconventional monetary policy. All of this suggests that further monetary stimulus may not come until early next year."

Politics to the fore

All of this takes place against a backdrop of political risk that would appear startling in practically any other country, with the government having lost its majority in parliament on October 31 and the senior coalition party, the ODS, set for a showdown at its congress this weekend.

Despite the wobbles that the party's petty infighting has produced for the government, the smart money says the incredible self-preservation instincts of its politicians will triumph once more. That was illustrated by yet another delay this week for a parliamentary vote on the government's latest austerity measures, which includes a VAT hike and increased taxes on higher earners.

The bill comes with a confidence vote attached, and should the coalition fall, it faces almost certain annihilation at the polls to the left-leaning opposition, which has promised to ease the fiscal consolidation efforts that have so impressed the debt markets.

However, investors have hardly batted an eyelid through several close calls on the government's collapse already this year, driving yields on sovereign debt to record lows. In fact, the one notable drawback was seen last week, as recent announcements from Warsaw that it will relax austerity to help perk up growth saw Polish yields drop below those of its neighbour for the first time ever.

However, normal relations were restored following the rate cut announcement, with Czech five-year bond yields tumbling by 22 bp - the biggest ever single-day drop recorded by Bloomberg, to leave them at 0.79%. Meanwhile, the koruna slid 0.5% to to 25.227 per euro by 3:16pm - the currency's weakest level since August.

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