CNB INTERVENTIONS: END IS NEAR.

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1 CNB INTERVENTIONS: END IS NEAR. WHAT WILL HAPPEN AFTERWARDS? MARTIN LOBOTKA, (+420) , CNB exit is very near, not because recent inflation rise is sustainable, but because CNB finally can get rid of the previous Board s legacy CNB will exit suddenly, though by now it shouldn t be a surprise for anyone. After the exit, CZK will be volatile and likely weaken above 27 before re-entering the long & slow strengthening trajectory at about 2%-a- year rate. This is not an April s joke: CNB s hard commitment 1 ends today and so effective the tomorrow the end of the intervention regime can come anytime. The 3 1/3-year long intervention regime whose original end was scheduled for early 2015 ( ) and which saw CNB buy well over CZK 1000 bn. in foreign currency to prevent CZK from strengthening below 27 is thus now closest it s ever been to being discontinued. The three key questions of importance to all now are the following: WHEN will it happen? HOW will it happen? WHAT will happen afterwards? 1 This has been a staple of post-meeting statements for long time: The Bank Board states that the CNB will not discontinue the use of the exchange rate as a monetary policy instrument before 2017 Q2. I already wrote extensively on these in other materials but think it is now timely to summarize the views, which admittedly evolved somewhat over time, on these issues in one place. EXIT IS NEAR BECAUSE CNB FINALLY CAN EXIT, THE UNCONVINCING INFLATION OUTLOOK NONETHELESS Timing of the exit, as I ve always held, should be dictated solely by the inflation and its outlook, and CNB is generally behaving in accordance with this view. Although there was a time when I was afraid other factors (such as massive increase in FX reserves or pressure from President) might force CNB into premature exit, this has not materialized. I have always said that the key pre-condition for the exit was that the (forecast) post-exit evolution of monetary-policy relevant inflation (MPRI) is such that CNB will not be forced to re-enter the FX market, and that it will gradually be able to normalize the policy via usual monetary policy instruments, i.e. via rates. This pre-supposes (or, encompasses) two things: that currency will have little tendency to appreciate substantially after the exit (because were it to be the case, the strong currency would dampen import prices and thus inflation) and, that the inflation increase (that almost necessarily must predate the exit 2 ) is of permanent nature. 2 As regards the predating of exit by inflation increase, strictly speaking CNB should make decisions based on forecast inflation in 42 FS Market Research CNB exit and what happens next Special report 1

2 As for the latter condition - one of the permanency of the (recent) inflation increase - I will explore it more in the next Special report, but some comment is needed here as well in order to make the presentation self-contained. Let me put it out there at the beginning: most of the increase in recent four months was due to energy and food prices. Consider this: the MPrelevant price level increased by 1.8% cumulatively between October 2016 and February 2017, out of which, and as seen in the picture below, 1.2 pp of was due to food and fuel prices. 3 But food and fuel prices (and especially the latter) are unlikely to grow as much as they ve done recently: oil increase is capped by tenacity of US producers who re waiting on the sidelines to reenter the market should price rise above 60 USD/brl. while world food prices rose 20% in last year, a rate unlikely to be repeated this year. Moreover, increase of food and fuel prices tends to lower spending on other, discretionary things, thereby depressing demand inflation. Contribution (in pp) of the respective categories to the cumulative increase of Czech MPRI between February 2017 and October 2016 Regulated prices 0,2 0,0-0,1 Secondary effect of indirect taxes Adjusted inflation excluding fuels and food (=demand inflation) Food prices (including alcoholic beverages and tobacco) Fuel prices SOURCE: CNB / 42 FS 1,0 That said, the demand inflation did contribute positively to MPRI increase: it rose 1.4% over October 2016 February 2017 and thus was responsible for 0.7 pp of the 1.8% rise of MPrelevant price level over that period. The rise of demand inflation was, however, partially fueled by 6 quarters, not based on current one. However, because current inflation is a good predictor of the future one and in order to be on the safe side (i.e., to ensure not having to return to interventions after exit), seeing inflation increase towards the target before initializing exit is a necessary precondition. 3 The regulated prices and the secondary effects of indirect taxes were small negative contributors. 0,7 (implementation of) EET 4 which lifted the prices in hospitality segment. In the annual comparison (February 2017 vs. February 2016), the contribution of hospitality to (2.5% y/y) rise of MPRI is 0.3 pp, which translates into 0.55 pp contribution to the (2.1 % y/y) increase of demand inflation 5. In other words, (one-off) EET in restaurants / hotels appears to have been major contributor to the increase of demand inflation. Demand inflation averaged 1.2% over 1Q15-3Q16 but rose to 2.1% y/y in February. Without EET, it would have risen to just 1.6%. The recent increase of inflation was thus only in smaller part driven by increase of (probably sustainable) demand inflation and in bigger art by factors which are unlikely to be sustainable. Fundamentally, thus, there is no reason to exit, and there will be none until late next year when demand inflation will reach 2% sustainably. The former pre-condition that currency not have tendency to appreciate after the exit is, on the contrary, likely to be met, especially in the first year(s). CNB says that this will be so for two reasons: first, that weaker CZK will by the time of the exit have passed through to prices and other nominal categories and, second, because of speculative inflows. I agree with the latter and disagree with the former. As for the latter, the massive speculative inflows in the run-up to the exit CZK 810 bn. over twelve months ending in January indeed lower to very close to zero the probability of fast post-exit strengthening of the CZK that speculators bet on. I mean, who s going to take the other side of the speculators exit (sell CZK, buy EUR) trade if annual current account surplus is 5 times smaller than last year s speculative capital inflow? 4 EET is Czech abbreviation for Electronic record of sales. More on that here. 5 Demand inflation is about 55% of the headline inflation. 6 February probably saw some more inflows still but March indicates if the sell-off in CZGBs is of any data value - that some of those flows may have been reversed in realization of the crowded nature of the short EURCZK trade. 42 FS Market Research CNB exit and what happens next Special report 2

3 Cumulative current account surplus (without reinvested earnings) and cumulative FX interventions of CNB since June 2015, CZK bn EURCZK vs. Productivity growth in CZ Difference in cumulative productivity gains since 2000 (=gain in CZ since year 2000 minus gain in EMU over the same period, in pp) Average EURCZK VI-15 VIII-15 X-15 XII-15 II-16 IV-16 VI-16 VIII-16 X-16 XII-16 SOURCE: CNB / 42 FS Actual EURCZK vs. model-based* EURCZK (yearly averages) As for the former (pass-through argument), and despite what CNB might want to believe you, the truth is that not much of the pass-through happened over last 3 1/3 years as net increase of Czech inflation over its Eurozone counterpart was negligible. Perpend this: over November January 2017 period, the Czech core HICP inflation cumulatively rose 3.4% whereas it rose 1.4% in Eurozone (but 2.9% in Germany). In other words not only it is a testament to the dismal inflationgenerating result of the interventions but, and more importantly here, it shows that not much of a nominal convergence happened via inflation channel (i.e., because of inflation being higher here than in Eurozone). Consequently, since real and nominal exchange rates are not aligned, CZK, once set free, does & will have a natural (fundamental) tendency to strengthen. The only thing that stands in the way - as our recent special report explains will be the speculators. To illustrate the fundamental tendency to strengthen, consider the following picture depicting the relationship between the cumulative productivity differentials between CZ and Eurozone and the nominal exchange rate. This admittedly simple but fairly accurate model of nominal exchange rate points to fundamental value of EURCZK being around SOURCE: 42 FINANCIAL SERVICES, DATA ON PRODUCTIVITY TAKEN FROM ECB STATISTICAL DATA WAREHOUSE *MODEL IS BASED ONLY ON PRODUCTIVITY DIFFERENTIALS, SO IT IS RUDIMENTARY, BUT IT DOES SHOW & TELL THE STORY. To conclude, CNB can now be, owing to the speculators, reasonably certain CZK will not strengthen for possibly a long time after the exit even though it fundamentally would want to. Taking into account the fact that the recent inflation increase, although only in small part sustainable and thus not providing necessary conditions for exit, opened the window of opportunity to get rid of the legacy of the previous Board of CNB, a window that will likely close in 2 nd half of this year and 1 st half of next as food & fuel price increases vanish from the base, CNB feels compelled to exit soon. And will likely act on that compulsion soon. 7 As early as next week is 7 The yesterday s meeting of CNB reinforces this view: CNB s statement omitted the sentence found in many previous statements that the Bank Board considers it likely that the commitment will be discontinued around the middle of CNB also formally ended the hard commitment and said the risks to its recent forecast are pro-inflationary for the remainder of this year. 42 FS Market Research CNB exit and what happens next Special report 3

4 possible if you are going to do it because you finally can, it makes little sense to wait but waiting for March inflation data (April 10) or for next monetary-policy meeting (May 4) makes more sense to me. May is my favorite: remember that 20 years will have elapsed this May since CNB was forced, back in 1997, to let CZK float. Although history does not repeat itself, it does rhyme. CNB WILL EXIT SUDDENLY, THOUGH BY NOW NOT SURPRISINGLY & VOLATILITY WILL REIGN THEREAFTER Now, HOW it will happen has always been simple to answer. Here, I long held that CNB will do one sudden exit and that it will not follow a staggered exit, i.e. a sequence of floors. This latter strategy may have made sense back in 2015 when the intervention regime was (first) scheduled to end and when CNB could have been afraid of market response to exit. But with so many postponements of exit data & speculative inflows that ve come over last 1 ½ years, CNB is well-advised to pull the plug suddenly. Unlike in November 2013 when possibility of intervention was much less medialized (though reader of CNB s statements could not have been entirely surprised by Nov 13 decision), this time around CNB cannot be accused of springing a surprise on unsuspecting economy. The media coverage of the exit is such that whoever will be surprised when it happens must have been comatose last 6 months. Moreover, CNB can be confident not much happens after the exit. First, because it can always silently & ad hoc intervene after the formal end of interventions: CNB, after all, will be returning to managed float regime which CZK has had before Second, because of the said speculative inflows lower probability of post-exit EURCZK jump downward. And, third, because, as CHF experience shows, not much happens even with large and completely surprising movements of currency exchange rate. 8 Finally, WHAT happens after the exit was already adumbrated above. For EURCZK, one can expect high volatility. Immediately after the exit, I expect quotes to move down to around but then CZK will weaken. This weakening will, with very high probability, be one of EURCZK climbing above 27, possibly even significantly so, as speculators realize it will take years to see any profit on their short EURCZK bets and that, even when that profit materializes, it will not be large. Real convergence of Czech economy, and thus rate of strengthening of nominal CZK, will be much slower than over At some level above 28, though, I expect CNB to start selling some of its FX reserves: for a profit & for some braggadocio down the road. CZK will strengthen eventually, but it will take long time before it is a sustained strengthening. For bonds, the exit from short EURCZK trade will be accompanied with a sell-off: the massive increase of share of CZGBs in foreign hands over last year hints at that much. If speculators unwind their short EURCZK bets, they will also have to sell bonds in which most of their CZKs were placed CZGB holdings by non-residents, CZK bn. and % of total SOURCE: 8 Central banks generally tend to overestimate the effects of FX movement. See for example how little difference massive weakening of CZK made to Czech vs. Slovak exports, how little benefit German industry derived from post-2014 EURUSD slide or, after all, how little Czech inflation / industry / retail sales experience since November 2013 differed from that in Poland, Slovakia or Hungary FS Market Research CNB exit and what happens next Special report 4

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