The Czech koruna, the currency of an economically relatively small country, recently has gained much attention by an increasing number of speculators. They have been positioning themselves to benefit from a possible appreciation of the Czech currency. For three years, the Czech National Bank (CNB) has kept the koruna above the determined level of 27 CZK per EUR, not allowing it to appreciate further against the Euro (Chart 1). During this time, if necessary it intervened in the foreign exchange markets by selling koruna. Now, the question is whether the Czech National Bank (CNB) is further committed and able to defend the Czech koruna from appreciating.
The CNB’s exchange rate commitment
The floor was first introduced in November 2013 in the pursuit to fight disinflation. After years of recession, this was a prime concern of the central bank. Nowadays, with inflation spiking (inflation rate from 0.5% in October 2016 to 2.5% in February 2017) and strong economic data, this threat seems to be overcome and there is pressure building up on the floor.
We remember the case of Switzerland which also had in place a floor of the Franc against the Euro. Finally, due to increasing losses, the Swiss National Bank could not sustain further interventions in the currency markets anymore. Suddenly, in January 2015 after years of keeping the exchange rate at 1.2 Francs per Euro, the Swiss National Bank surprisingly abandoned the price floor, sending foreign exchange markets around the globe into chaos.
Chart 1: EUR/CZK exchange rate (source of chart data: Thomson Reuters)
Similarly, the Czech National Bank incurs increased costs defending the exchange rate. As of 28 February 2017, the foreign exchange reserves of the central bank have spiked to 105,386.8 million Euro, increasing by 7.5% from February, after the balance had already grown by 21.24% in January. It may be even appropriate to question the official numbers provided by the CNB and assume larger interventions in the foreign exchange markets. At the official levels of the end of February, the reserves amount to almost 60% of national GDP and have further increased strongly during March. As opposed to the Swiss case however, when investors were caught off-guard by the central bank´s decision, there is certainty that at some point in 2017 the CNB will abandon the currency floor. Some investors have already positioned themselves in the trade in order to profit from the possible appreciation. However, the question remains when this event will occur and how the koruna will react.
Chart 2: Foreign exchange reserves of the CNB in million € (source of chart data: Thomson Reuters)
In the face of growing inflation, strong economic data and currency speculation there was much interest about whether the CNB would announce some monetary policy measures after its meeting on 30 March 2017. However, the bank board decided to keep the two-week repo rate at 0.05%. Further, the commitment to maintain the price-floor of 27 CZK per EUR was confirmed again. Regarding the growing inflation rate the bank has argued that it is uncertain whether the current high inflation can be expected to be persistent or rather passing such as in the neighbouring Eurozone. There, inflation in March decreased to 1.5% after it had reached the 2% percent target in February. The CNB further has punctuated that there would be no intervention in the case of a possible depreciation of the koruna. In this case supply and demand would determine the currency’s value.
The central bank has had a strong commitment to maintain the floor until the end of March. With the beginning of the second quarter, there is less certainty as to how long the floor can be sustained. The Czech National Bank has announced to reduce itself to a “soft guidance” from this date onward. It has already been hinted that the floor may be removed in the second half of the year or even earlier.
However, markets expect the situation to resolve itself much more quickly. By many financial analysts the next meeting on 4 May is expected to lead to the abandonment of the currency floor. May the 4th seems a likely date since it is the next regularly scheduled monetary policy meeting. The CNB most likely does not want to seem to be pressured by the markets to hold an extraordinary meeting. This makes the start of May the most probable date. But the possibility that the decision is made during an ordinary bank board meeting, of which there will be four in April, has to be considered as well. The next likely meeting will take place on 13 April and may be a plausible choice. This is because on 10 April there will be the publication of Czech CPI data for March, probably once more reporting an increase in prices. This would add further pressure on the CNB to tighten monetary policy. Additionally, given the fact that eventually the peg will be terminated, the CNB may want to abandon it sooner rather than later in order to avoid further accounting losses from its interventions in the foreign exchange market.
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