The Prague Post Online: Business: Currency strength raises alarm

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November 23rd, 2008

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Currency strength raises alarm

Firming crown pads global fallout as inflation levels rocket

By Claire Compton
Staff Writer, The Prague Post
July 30th, 2008 issue

The runaway ascent of the Czech crown is tempering inflation and insulating the country from a global economic crisis fueled by record oil prices and the U.S. recession, presenting the Czech National Bank (ČNB) with the dilemma of slowing growth while hitting inflation targets.

As the bank considers intervention, politicians and economists debate with concerned exporters and analysts who warn that speculation is driving the crown’s strengthening to record highs and is not supported by corresponding economic growth.

Such debates caused the crown — which hit consecutive records over the past few months, notably crossing the 23 Kč/euro level last week — to slip July 25 after ČNB Governor Zdeněk Tůma said the bank may lower interest rates in August to stabilize the currency. Following this statement, the crown closed at 23.39 Kč to the euro and 14.78 Kč to the U.S. dollar, down 0.37 Kč and 0.31 Kč respectively from that morning’s numbers.

The current rate kepps the price of imported consumer goods down at a time of record food and energy prices. Driven by the crown’s growth, inflation targets are being hit faster than expected, raising national concerns that the rapid strengthening may destabilize the economy. “The ČNB board could have spoken earlier about the psychedelic trip of the Czech crown, but, given the risk of rising inflation, they’ve been in a hard situation,” said Raiffesenbank analyst Michal Brožka.

The Organisation for Economic Co-operation and Development (OECD) expects local inflation levels to hit 6.8 percent this year, but to slow to 2.9 percent next year. The Finance Ministry also expects a 2009 fall in inflation, which the rising food, cigarette, alcohol and housing prices boosted this year.

Senior OECD economist Andreas Woergoetter said he’s similarly confident. The Czech Republic’s macroeconomic policy mimics that of the European Union, he said, and the ČNB has a successful record of maintaining price stability.

“Despite the current spike in inflation, linked on one hand to international food and energy price developments and on the other hand to a welcomed shift from direct to indirect taxation, I’m confident inflation levels will [fall] within the course of next year,” he said.

The crown has also dispelled ripple effects from the U.S. economic crisis. Although global exports to the United States have slowed due to the weakening dollar, interest in local goods remains strong in other economies such as Germany and Slovakia, which together take in 39 percent of Czech exports. “The U.S. economy has minimal direct impact on the Czech one,” Sklenář said. “Czech exports to the United States represent just 2.2 percent of total exports.”

Trendy and safe

Sklenář attributes the unexpected pace of the crown’s growth to various circumstances. International investors have made a clear move away from riskier investments since last summer, he said.

Many investors now conider the crown a safe haven in the region due to its low volatility and stability, making it a “bridge over troubled water” for some. Positive economic results have further boosted this confidence, as GDP rose 5.3 percent year on year in the first quarter of 2008.

The crown, along with its reputation as a safe bet, is also considered trendy, Sklenář said.

“CEE economies — not only the Czech one — have shown good conditions in comparison with other parts of the world. ... They have been minimally affected by the current global financial crisis,” he added. “The Polish złoty and the Hungarian forint have hit all-time highs as well.”

The safe-haven attraction of the crown will only wane if external market conditions correct themselves and the global trend of aversion to high-risk investments declines, or if investors see an economic decline in the Czech Republic, Brožka said.

Since the fall of communism, the country has enjoyed a boom in foreign investment and a decade of accelerated growth. The market may finally be exhausted, however, and the country will need to build up existing investments and increase domestic productivity, Woergoetter said.

“The days of the Czech Republic as an attractive location for investments relying on relative cost advantages and low production costs are more or less finished,” he added. “For those investments that are here, it will be important to improve their productivity.” The government will need to focus on policy that encourages entrepreneurship and domestic growth, while employers will need to drive harder bargains with employees to keep wages down, he added.

To meet this goal, the Justice Ministry recently made extensive amendments to the Commercial Code and announced plans to draft an entirely new code in the near future. The recent amendment has lowered business startup costs from 20,000 Kč ($1,300) to 1,000 Kč.

Meanwhile, Foreign Direct Investment (FDI) has slowed to a stable level over the past two years, and the current FDI is funded mainly by reinvestments, Sklenář said. In 2007, 120 billion Kč of the 158 billion Kč FDI represented reinvested profits. “The current economic growth is definitely based on previous FDI inflow,” he added.

Exporters, the group hardest hit by the crown’s strength, have been the most vocal advocates of euro adoption. Giants like Škoda have already converted 80 percent of their transactions to the euro to fight losses caused by the strengthening crown. “[Certain exporters] have been forced to cut their profit margin or even leave the market,” Sklenář said.

Despite their current losses, these companies may benefit in the long run. The strengthening crown has forced companies to compete with cheaper imports, contain wage increases and improve productivity and quality, Woergoetter said, giving them a push toward improving domestic productivity.

“The strong appreciation of the past year pushes them a bit harder and forces companies to make steps to increase productivity a little earlier,” he said. “It’s an issue of speed, not direction.”

Verbal Exchange

“The strong crown may be unpleasant for exporters, but not for consumers. The real threat is high inflation, which the strong crown offsets.”

Mirek Topolánek, prime minister

“The Czech region is one of the oldest high income generating areas in Europe. It has been one of the leading locations for doing business in the past century, and I see no reason why that shouldn’t be the case in the future.”

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Andreas Woergoetter, OECD senior economist

“If the crown keeps its current rates or strengthens … a discussion about how much we should lower interest rates may be on the table.”

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Zdeněk Tůma, Czech National Bank (ČNB) governor

“I consider the statements of Governor Tůma just [verbal] intervention against the strong crown. The ČNB and the government tried to make the same steps … since February, but it did not stop the crown’s strengthening.”

Michal Brožka, Raifeissenbank analyst

Claire Compton can be reached at ccompton@praguepost.com

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