April 2023
The CNB’s hesitation to face up to inflationary pressures with a stricter credit policy is hard to understand. Several months have passed since her last intervention. Since then, the value of financial assets of households and employees have decreased by some 10-15%, to which the CNB did not and still does not respond. During the same period, Czech companies were able to maintain their revenues and incomes by increasing prices of their products and services. Their inflationary expectations were restrained neither by tougher credit conditions nor by competition.
The central bank is also not helping itself in its fight against inflation by its exchange rate policy, for which it is also responsible. Anti-inflationary interventions by central banks are typically “anti-growth” and should always be accompanied by other measures that would support growth (employment) and minimize the risk of recession. Of course, this rule applies across the whole range of policy instruments. For the CNB this means that monetary policy should be conducted together with a reasonable exchange rate policy. Unfortunately, the CNB understands its exchange rate policy primarily as an anti-inflation instrument, and not as an instrument leading to sustainable growth – unlike, for example, the Fed. The CNB has been using the exchange rate as a “fixed anchor” for a long time in support of its interest rate policy and treat the exchange rate policy only as an tool of stabilization of the price level.
The problem of the fixed exchange rate policy is the impact of this policy on the competitiveness of the Czech economy and thus on economic growth and employment and on macroeconomic stability. The diametrically different performance of the Czech economy from that of foreign economies must eventually manifest itself in a deteriorated trade balance or in slowed growth or both. Macroeconomic indicators are not good. Inflation is now at the level of roughly 12-15% in CR compared to the same period last year, while in the EU it is half. At the same time, the Czech crown appreciated by, say, 10% against the euro. The real appreciation of the course is, therefore, close to double. In this constellation, it is highly unlikely that there has been real productivity growth of 15-20% per year during the same period.
The question that the CNB may be asking itself but is not answering is – what is the impact of its exchange rate policy? Exchange rate policy affects not only the price level, but also real economic growth. The Czech economy is critically dependent on the performance of firms producing for export markets and firms that compete with imported products and services. The slowdown in export dynamics must be reflected in a slowdown of economic growth, possibly leading to the recession we are going through. The 20 percent increase in the real exchange rate cannot be absorbed even by the relatively efficient Swiss economy. A recession and the high rate of inflation that we have here is the worst combination that central banks can face.
The news is also not good when considering the trade numbers. Compared to 2018, the real value of exports decreased in almost all sectors. However, the most dramatic situation is in the case of exports of cars, transport means and machinery, which is the driver of Czech exports and represents almost 60% of total exports. Compared to 2018, those exports are almost a quarter lower at constant prices!! Of course, this must have dramatically affected the growth of the domestic economy. This indicates a loss of competitiveness in several industries. Several factors have also contributed to the loss of competitiveness of those exporters (lack of chip, chain problems, etc.), but the currency rate policy also played its role. For example, the strong koruna led to the pressures on firms to switch to debt financing using the euro area, which reduced the effectiveness of fiscal and monetary policies. The loss of dynamism in the engineering sector has not been replaced by dynamism in other, less traditional sectors, for which the exchange rate of the koruna plays a very important role.
What role does the exchange rate play in this situation? Let’s look at the example of food trade. Although the Czech Republic is not a significant producer of food on global markets, food prices play an important role in shaping inflation in the Czech Republic and, given their high share in the consumption package of households, also influence wage demands and wage growth. Real food imports have been roughly the same lately, but at much higher import prices (45% compared to 2018, 32% compared to 2020!). In other words, the strong koruna stimulated imports of food without leading to a pressure to reduce the rate of increases of food prices in the domestic market – against the expectations of the CNB!! On the contrary, it most likely supported the rise of prices of food by domestic producers and the growth of wages in agriculture, which even outpaced the growth of wages in industry. In 2023, the strong crown and loopholes in the control of food imports also stimulated imports of cheap cereals from Ukraine, with which the Czech producers cannot compete.
The strong koruna also plays an unusual role on the food export side. The value of food exports increased – despite the strong koruna (by 43% compared to 2020!!!). Perhaps the CNB could not have foreseen that. However, this increase was not realized by higher performance, but by higher prices. Export prices in Euro increased by an incredible 43% in the same period (46% compared to 2018). The only explanation for this trend is that the strong koruna stimulated “price fixing” (and profits), which characterizes the position of large Czech exporters, probably wholesale holdings such as Agrofert.
A recent study of the behavior of American companies in an inflationary situation points to a similar behavior of companies in various fields whereby they sacrifice volumes – either due to competitive pressure or voluntarily – in favor of higher prices. This “price-over-volume” strategy originated during the pandemic, which led to shortages of materials, raw materials and labor.
I see the problem of exchange rate policy primarily as a problem (1) of a strong koruna, which distorts incentives for foreign trade and threatens the stability of the exchange rate and the balance of payments. The exchange rate policy led to a strengthening of the currency, which is difficult to defend from the point of view of “economic fundamentals”. i.e. is therefore overvalued. A strong koruna, (2) works against the interests of new companies trying to penetrate foreign markets and stock exchanges and has greatly worsened the competitiveness of SMEs; (3) increases the income differences of firms. Large companies are often “price-makers” and are also able to borrow on the Euro market at much lower loan rates than is the case with Czech small and medium-sized companies. This practice is also common for large Czech companies in agriculture, as reported by A. Babiš in the case of Agrofert. The strong koruna (4) is also destabilizing for companies such as the VW holding and Škoda which are looking for greater stability, lower risk and thus lower costs by switching to euro accounting. (5) A strong koruna does not effectively suppress the imported sources of inflation, as assumed by the CNB. As we can see from the performance of the food market, the strong koruna supported the inflationary growth of prices of domestic producers. (6) Last but not least, a strong koruna is a great incentive for short-term and often highly speculative capital, which increases liquidity in the banking sector and contributes to the appreciation of the koruna.
With its policy, the CNB relies excessively on the financial market as a stabilizer of the external balance. Relying on interest policy and rejecting the importance of exchange rate flexibility as a tool for both internal and external balance, i.e. including adequate economic growth and employment, leads not only to the loss of competitiveness of the real economy, but also unnecessarily strengthens the role of the destabilizing short-term foreign capital. We are still attractive to foreign capital given both the amount of foreign currency reserves and the proclamations of the authorities to control the fiscal deficit and inflation. However, the CNB must hope that this capital will not find more attractive markets elsewhere or that the loss of competitiveness of the Czech economy will not turn into a continuing recession and unemployment.
And one final note. The history of stabilization programs is littered with cases of central banks relying on a fixed exchange rate. Most of them ended painfully.
May 22, 2023
Dr. Zdenek Drabek