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Economic and Financial Stability via Exchange Rate Volatility: The Case of the Czech Republic

Economic and Financial Stability via Exchange Rate Volatility: The Case of the Czech Republic. Jan Frait Economic Research and Financial Stability Department. „The Modern Role of Central Banks in Small Open Economies June 26-27, 200 9, Tbilisi , Georgia. Outline.

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Economic and Financial Stability via Exchange Rate Volatility: The Case of the Czech Republic

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  1. Economic and Financial Stability via Exchange Rate Volatility: The Case of the Czech Republic Jan Frait Economic Research and Financial Stability Department „The Modern Role of Central Banks in Small Open Economies June26-27, 2009, Tbilisi, Georgia

  2. Outline • Rise and fall of fixed exchange rate regime • Inflation targeting under exchange rate volatility • Miracle of a tough live with floating • Conclusion: Success calls for currency flexibility.

  3. 1. Fixed exchange rate period • Fixed exchange rate era was a traditional story. • At the outset of transition the Czechoslovak authorities opted for a fixed exchange rate regime as the nominal anchor. • Koruna (CZK) was pegged to a basket of five currencies in 1991, in 1993 CZK pegged to a basket with German Mark (DEM) - weight 65% and US Dollar (USD) - weight 35%. • Three successive devaluation steps at the end of 1990 resulted in nearly 100 percentage decline of nominal value of Koruna against key currencies • After the last devaluation the CZK/USD exchange rate was set to 28 CZK/USD (today 19,5 CZK/USK) and 18 CZK/DEM (today eq. 13,8 CZK/DEM) • Policy of monetary-targeting with fixed exchange rate attempted …

  4. 1. Fixed exchange rate period • In 1995 full liberalization of financial account, full convertibility achieved (or mis-achieved?). • Capital inflows combined with lax lending standards of banks lead to excessive credit and money supply growth. • Not surprisingly rise in the net foreign assets in the base money, and a loss of control over the money supply. • The Czech National Bank (CNB) responded by sterilizing monetary effects of the capital inflows. • Macroeconomic imbalances were accumulating while the authorities were not willing to increase exchange rate flexibility.

  5. 1. Fixed exchange rate period • Deteriorating macroeconomic situation caused by overly expansionary policies was first mirrored in the worsening current account - deficit represented more than 4% of GDP in 1995 and nearly 8% of GDP in 1996. • Trade balance - in 1995 the deficit in the trade balance reached nearly 8% of GDP and 11% of GDP in 1996. • Situation became unsustainable and the authorities were forced to switch to a managed float on May 26, 1997 - the initial effect was depreciation of Koruna against key currencies by approximately 15%. • Restrictive fiscal and monetary policies adopted. • Sharp recession and major problems in banking sector. • Shift to inflation targeting in 1998.

  6. 1. Fixed exchange rate period • … and what happened then was not much traditional …

  7. 2. Inflation targeting period • Inflation targeting (IT) introduction was not in line with textbook recommendations. • IT chosen inreaction to jump in inflation expectations. • CNBused IT initially as a tool for disinflation compatible with flexible exchange rate in a destabilised economy. • IT was introduced in a period of strong exogenous shocks (Russian crisis, volatile oil and food prices, etc.). • Major modification of the system over the years (targets, escape clauses, communication, ER management, co-operation with government, etc.) • Target currently set as a „permanent“ point target with a tolerance band for headline inflation, compared to a continuous declining corridor for headline inflation (2002-2005) or end-year targets for “net inflation” (till 2001).

  8. 2. Inflation targeting period • Currently a 3% target (2% from January 2010).

  9. 2. Inflation targeting period • Nominal interest rates were high until 1998-99; • Disinflation process led to their fall to low levels.

  10. 2. Inflation targeting period • Explicit application of “escape clauses” since 1999. • Major deviations of the CZK’s exchange rate unconnected with domestic economic fundamentals and domestic monetary policy; • Substantial deviations of global prices of raw materials, energy sources and other commodities; • Marked changes in the conditions for agricultural production having an impact on agricultural prices; • Natural disasters or similar extraordinary events having cost and demand impacts on prices; • Regulated price changes deviating substantially from the normal magnitude and changes in indirect taxes (since introduction of CPI targeting); • Currently the clauses are used less explicitly, except for indirect taxes.

  11. 2. Inflation targeting period • IT period started with excessive success – unexpected reversal of exchange rate. • A painful but effective tool for regaining antiinflationary credibility.

  12. 2. Inflation targeting period • Achieved disinflation under the inflation targeting; • Inflation often below the targets.

  13. 2. Inflation targeting period • The two most pronounced periods of inflation target undershooting (and negative output gap) followed the ER overvaluation episodes.

  14. 2. Inflation targeting period Inflation Expectations of Analysts • 1Y expectations more volatile, but in line with targets; • 3Y expectations below the 3% target in recent years (reflection of the CNB‘s and CZK‘s track records?); • 3Y expectations above the new 2% target (no major change).

  15. 2. Inflation targeting period • Frequently below potential for a long period of time; • Role of ER appreciation in two gap-widening episodes; • Rapid and severe impact of the world economic crisis.

  16. 2. Inflation targeting period • Exchange rate shocks explain 40 - 50 % of variability in output gap and in the deviations of inflation from targets; • Justifies great attention paid to these shocks by the CNB.

  17. 2. Inflation targeting period • Summary: • Challenging conditions; • Regime evolving over time; • Frequent undershooting of targets (overshooting in 2007/08); • Three periods of negative output gap; • Appreciation contributing to these periods of difficulties; • Exchange rate developments impacted policy rates setting; • Inflation expectations relatively well anchored; • Low inflation enabled to keep interest rates on a low level; • Current crisis severe but the economy and financial sector in a good shape.

  18. 3. Living with floating • Managed float declared in 1997, de facto free float from 2002. • Both nominal and real exchange rates exhibited long-term appreciation trend. • Accumulation of relatively large amount of FX reserves: • proceeds from privatization deals, • purchases from open market (mainly in 2001-2002), • interest accrued in recent years. • Huge unrealized valuation losses on FX reserves holdings and sizeable negative own capital. • High volatility from the onset of global financial turmoil in August 2007.

  19. Relatively long periods of no interventions; Interventions against appreciation only; February-July 1998; October 1999-March 2000; 2001-02; Since 2002 no interventions. 3. Living with floating

  20. Increased volatility since Feb 1996 / May 1997; Trend appreciation since 1999; Periods of fast appreciation in 1998, 2001-02 and 2007-08. 3. Exchange rate policy and issues Nominal Exchange Rate (EUR; USD)

  21. 3. Living with floating • The reaction of private agents to currency appreciation contributed to the flexibility of the economy. • The CNB was explaining that these were the global pressures behind nominal appreciation that a small economy could not avoid. • The public gradually accepted the idea that exchange rate is not something that the central bank should try to manage. • Exporters and their workers gradually adjusted to the appreciation trend: • The exporters factored in future development of ER into their expectations. • The labour unions realized that currency appreciation improves the purchasing power of workers’ wages which helped to discipline the wage dynamics.

  22. 3. Living with floating • Combination of currency appreciation and low interest rates environment helped to maintain financial stability. • Sustained appreciation worked against the formation of overly optimistic expectations in the corporate sector which tamed the potential for a corporate sector credit boom. • Currency appreciation was also shifting part of existing domestic demand from nontradeables to tradeables along the long-term trend towards higher consumption of non-tradeables, contributing to a more balanced macroeconomic and structural dynamics. • Households did not have any incentive to borrow in foreign currencies which had made their balance sheets insulated from exchange rate risk. • Households had strong incentives to save and deposit in domestic currency.

  23. No FX-denominated credits of Czech households; Deposits of Czech banks exceed the volume of loans, no reliance on foreign financing of credits; Much better situation in comparison with other CEE countries. 3. Living with floating

  24. 3. Living with floating • The key driver behind demand for foreign currency loans is clearly differential between lending rates in home and foreign currency. • Fixed exchange rate regime is what drives people to ignore the exchange rate risk. • The share of FX loans provided to households is the lowest in two countries with a history of profound and sustained nominal currency appreciation - Czech Republic and Slovakia. • This is despite the fact that taking a loan in foreign currency if the domestic currency appreciates is ex post „cheaper“. • The effect might go via currency denomination of deposits - currency structure of borrowing must be linked to the one of saving. If people have long-term incentive to save in domestic currency, they will also view as natural to borrow in it.

  25. 3. Living with floating • Real ER appreciation (stronger than in the NMS) backed by supply-side improvements; • Increase in GDP price level from 41 % of EU-27 in 1997 to some 70 % in 2008.

  26. 3. Living with floating • Current account in the CZ was developing quite well - surplus of G&S trade vs. incomes deficit; with self-financed reinvested profits no external financing needs from current account now. • NMS: trade balance still in a deficit, deeper current account deficit.

  27. 3. Living with floating Global crisis - Phase I: corrections in FX markets until Lehman • The koruna with a status of „safe haven“ currency remained solid in the same way as in previous corrections. This time however a bit overacted. • Negative interest rate differential motivated investors to use CZK for carry trades: in times of corrections investors unwind positions in carry trades = appreciation of financing currency (CZK).

  28. 3. Living with floating Global crisis - Phase I: corrections in FX markets until Lehman • Between summer 2007 and summer 2008 the koruna managed to beat any traded currency. • Declarations of currency overvaluations relative to fundamentals was not much efficient.

  29. 3. Living with floating Global crisis - Phase II: after Lehman (September 2008-February 2009) • Negative economic outlook for CEE countries increased the risk aversion towards the CEE region as a whole. • Resulting currency depreciation aggravated the situation in countries with high share of FX loans => further increase in risk aversion and higher roll-over risk.

  30. 3. Living with floating Global crisis - Phase III: post-Lehman • Investors started to differentiate between countries. • Koruna stabilized and returned to its long-term trend. • High volatility continues. • Sharp moves on both sides likely.

  31. Exchange Rate Criterion and ERM2 The future exchange rate policy – ERM II The Eurosystem position: „… ERM2 offers a meaningful framework for combining nominal and real convergence and should be seen as a useful regime on its own right …“ "That's the most important piece of evidence we've heard yet." said the King … "I don't believe there's an atom of meaning in it." said Alice … "If there's no meaning in it, that saves a world of trouble, as we needn't try to find any." said the King. Lewis Carroll, Alice's Adventures in Wonderland, Chapter XII, Alice's Evidence

  32. Concluding remarks: Success calls for flexibility • Fixed exchange rate in a dynamic emerging market economy is a risky adventure. • Success in attracting FDI inflows and speeding up GDP convergence is likely to deliver real exchange rate appreciation. • Resulting optimistic expectations will boost demand for credit. • The exchange rate flexibility can then play and important role in addressing the challenges associated with the process of real economic catch up. • If the authorities want to succeed with fixed exchange rate instead, they must often accompany fixed exchange rate with some other measures, resign on using interest policy in managing domestic demand and still have plenty of luck.

  33. Concluding remarks: Success calls for flexibility • Allowing domestic currency to appreciate over time may bring low interest rates and low demand for loans in foreign currencies which supports the financial stability. • The timing of an increase in the exchange rate flexibility is of utmost importance - in a situation of prevailing depreciation pressures might actually lead to a flight from the national currency. • Nominal currency appreciation is easier to achieve under floating then via realignment under fixed exchange rate regime. • It makes no sense to idealize floating either – it may bring more volatility and periods of misalignment.

  34. Thank You for Your Attention! Contact:Jan FraitEconomic Research & Financial Stability DepartmentCzech National BankNa Prikope 28CZ-11503 PragueTel.: +420 224 414 430E-mail: jan.frait@cnb.cz

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