Make Trade, Not War. ECONOMIC & STRATEGY RESEARCH 31 July MiFID II

Transcription

1 ECONOMIC & STRATEGY RESEARCH 31 July 2018 Quarterly report Czech Economic Outlook Make Trade, Not War MiFID II Information about our offer istock Czech economy decelerating but labour market remains tight We have revised our growth outlook for this year down to 3.0%. The economy has hit its capacity constraints and productivity gains are smaller than we expected. Yet, the slowdown will not impact the labour market. It will remain tight, propelling strong wage growth. Inflation to remain above 2% Inflation surged surprisingly in the second quarter. Its core dynamics have stabilised above 2%. This will also ensure that the headline does not dip below 2%. Weak koruna triggered major hawkish twist A weaker koruna and surge in inflation have made the CNB s May forecast obsolete. Given the surprise hike in June, we now expect two more this year. We also believe the CNB has revised its forecast. In our view, the rates trajectory has been moved significantly higher. Koruna to appreciate later than expected It is now expected to reach EUR/CZK25 in the middle of next year despite the widening interest rate differential. The koruna is paying for external risks and a strong US dollar. Strong issuance and higher Bund and CNB rates behind bond yield rise CZGB yields look set to rise faster than in our previous forecast on the back of strong supply and a faster increase in Bund and CNB rates. Tighter monetary policy will also drive further yield curve flattening. Jan Vejmělek Viktor Zeisel Jakub Matějů Monika Junicke Jana Steckerová David Kocourek (420) (420) (420) (420) (420) (420) jan_vejmelek@kb.cz viktor_zeisel@kb.cz j_mateju@kb.cz monika_junicke@kb.cz jana_steckerova@kb.cz david_kocourek@kb.cz Please see back page for important disclaimer Date and time of the compilation: 31 July 2018, 11:31 AM

2 Jan Vejmělek (420) Risks rising and Czech economy slowing The main topics on the global scene in recent weeks are the very topics that are most likely to have an impact on the Czech economy, unfortunately. As early as November 2016, when Donald Trump was elected as US President, we began drawing attention to the risk of protectionism and trade wars, which could have a potential significant impact on the global economy, and at that time we attached a 15% probability to this risk. Three months ago, we already rated the US President s activities as the greatest threat to the global economy. And the situation has since escalated. Indeed, anything that poses a threat to international trade can have an adverse impact on the Czech economy due to its strong export orientation. We have therefore decided to devote a number of special boxes to this issue in our latest edition of our Czech Economic Outlook. What conclusions have we reached? Monika Junicke notes that the currencies of emerging economies, including Central European ones, will suffer from muscle-flexing in the form of import custom duties. The unexpected weakening of the koruna, beginning in the second quarter, primarily reflects the risk of increasing protectionism. Jana Steckerová discusses the impacts of these custom duties on the global economy. Although the adverse effect should be pretty negligible at the global level, impacts on specific geographies (China and its Asian subcontractors) and sectors (the steel industry) may be significant. From the Czech economy s perspective, the main issue is the potential imposition of duties on automobiles exported from the EU to the US. While direct exports of final products to the US are negligible, a risk hangs over the components that the country supplies to EU automotive manufacturers that export automobiles to the US. David Kocourek reveals that possible increase of duties on cars imported into the US to 25% would jeopardise no more than 0.4% of Czech GDP. The other issue that should be watched closely are the developments surrounding Brexit. The cabinet that is to negotiate future arrangements for relationships between the UK and the EU appears to be crumbling in Prime Minister Theresa May s hands. Indeed, the situation is so serious that the Prime Minister herself will now negotiate with Brussels. The risk of a Hard Brexit, i.e. a divorce without a negotiated deal on the single market, is growing. Trade between the UK and the EU would follow then WTO rules, which would mean in the case of automobiles, for instance, 10% duties imposed on both sides. But external risks are not the only issue tormenting the Czech economy. At home, the ongoing issue is the extremely tight situation in the labour market and the related wage increases. Combined with higher prices of other inputs, this is causing heavier pressures on business profit margins. The disappointment caused by the national account figures for 1Q18, combined with the downward revision of the time series for 2017, have also led us to significantly revise our overall growth forecast for This year, we expect the Czech economy to grow at a rate of 3%, i.e. almost one percentage point lower than we expected just three months ago. In view of the recent koruna weakening we have postponed the reaching of the EUR/CZK25 level to mid The weaker koruna and stronger wage growth then imply that the CNB will hike rates every quarter. And we wouldn t even rule out the possibility of a proposal to hike the key rate by 50bp being tabled at the CNB Board meeting in August. 31 July

3 Contents Risks rising and Czech economy slowing... 2 External Environment and Assumptions... 4 Solid growth despite trade wars... 4 US: current expansion could end up as longest in US history... 4 Euro area: second half of year will likely be better... 4 Germany: pro-cyclical policy balances external uncertainty... 6 CEE region: investment in full swing... 6 Box 1: Trade wars playing with fire... 7 Macroeconomic outlook... 9 Economy slowing but labour market to remain tight... 9 Industrial production slowing Box 2: US car tariffs could endanger 0.4% of Czech GDP Investment to deliver half of GDP growth Fiscal policy: Revenues not catching up with rising spending State budget performing worse than last year but municipalities offset the deficit Revenues to slow in line with GDP deceleration Labour market to remain tight despite GDP slowdown Inflation to remain high Risks: FX volatility remains the most imminent risk Key economic indicators CNB Weak koruna triggered major hawkish shift at CNB CNB forecast to bring back-loaded hikes forward Board to pursue rate normalisation, but at a gradual pace Czech FX Market We ll have to wait up to a year for EUR/CZK Koruna slips amid emerging-market currency sell-off Higher interest rates will eventually help koruna Risks: Sell-off pressures on CZK should intensify further Box 3: Global events drag on currencies of small open economies EUR/CZK Technical Analysis (updated on July 27 at 4:17pm) Breaches upward sloping trend support Czech Government Bonds and the IRS Market Faster growth at the short end of the curve Supply in 2H18: larger volume in 3Q and annually Supply in 2019: larger volume due to higher bond redemptions CZGB yields to rise in 2H18 and 2019 due to CNB and strong supply CZGB holding structure to stabilise CZK interest rate swaps: yield curve flattening set to continue Banking Sector Interest rates on rise Disclaimer July

4 External Environment and Assumptions Jana Steckerová (420) Real household consumption set to gather pace. Solid growth despite trade wars The US economy is enjoying one of its longest phases of expansion ever. We think this will last until the turn of 2019/2020, when the drivers of the current cycle will dissipate. GDP growth in the euro area has eased, though due to the interplay of several adverse factors rather than a change of trend. The outlook for 2H18 and 1H19 is favourable. The risk to our prognosis is the trade wars, which have caused confidence indicators to worsen but have not weakened GDP growth as of yet. US: current expansion could end up as longest in US history The US economy grew by 4.1% qoq annualised in 2Q18. Net exports contributed a large portion (1.1pp), but this is unlikely to be reported. Real consumption jumped by 4.0%, but this is likely to return to the average of the past two years of 2.7%, in our view. Tax cuts will probably increase saving rates among households, with real consumption remaining decent but not seeing marked growth. Declining unemployment, which we expect to be at 3.5% at the end of this year, also favours consumption. Investment is likely to do well. We forecast GDP growth of 2.8% for this year. Next year, we see GDP decelerating to 1.6%. Several factors lead us to this estimate. The unemployment rate is below NAIRU, which creates upward pressure on wages. This, together with rising interest rates, will depress corporate profit margins. Thus, we expect a decline in investment and overall economic growth. US: GDP growth in 1Q18 was solid 5 Fed real interest rates still negative Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 Sep-17 Mar-18 Source: Bloomberg,, Economic & Strategy Research, Komerční banka -6 Aug-07 Nov-08 Feb-10 May-11 Aug-12 Nov-13 Feb-15 May-16 Aug-17 Source: BEA, Datastream, Bloomberg, SG Cross Asset Research/Economics Fed intends to hike rates further. Euro area economy weakened in 1Q18 given extraordinary factors. Fed hikes rates by another 25bp in June to %, in line with expectations. The Fed s median interest rate (dot) for the end of this year shifted slightly, moving from 2.1% to 2.4%. The FOMC vote was however relatively tight, and seven members think that rates will go up twice this year, while five expect just one hike this year. Our forecasts assume one more hike in 2018, in September. The Fed intends to continue hiking in 2019 and There will be three hikes in 2019, according to the dot plot, and just one in Our prognosis, is however, less optimistic. We expect the US economy to slow at the turn of 2019/2020, so we do not see any further tightening of monetary conditions in 2019 and Euro area: second half of year will likely be better In 1Q18, the euro area economy grew by 0.4% qoq. This was a slowdown in comparison with recent quarters, when GDP growth reached 0.7% qoq. The economy was however hit by 31 July

5 several extraordinary factors, including a flu epidemic, bad weather, strikes connected with wage bargaining, and an impact from the earlier timing of the Easter. The second quarter was affected by trade-war fears, which damaged the confidence indicators. Euro area outlook remains positive. Outlook for rest of year remains favourable. Household consumption is being well supported by declining unemployment (which we expect at 8.2% at year-end) and by higher wages, while investment is rising owing to insufficient production capacity. There has also been good news from the construction sector, which has bottomed out after eight years of declines and is now showing strong signs of revival. We see EU economy growth printing at 2.2% in 2018 after coming in at 2.5% in The economic impact of President Trump s protectionist policies on the euro area has been limited up to now. A significant deceleration in the economy would have to be sparked by a larger external shock, which we do not expect right now. In , euro area GDP growth is set to decelerate due to the expected recession in the US and the negative impact of Brexit (GDP growth of 1.9% in 2019, 0.6% in 2020). Inflation, which is unlikely to move over 1.5% on average within the next five years, remains the euro area s Achilles heel. Euro area: solid GDP growth set to continue Euro area: inflation (%) 3.0 EMU GDP 3.0 EMU CPI Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Jul Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Jul-19 July forecast May forecast July forecast May forecast Source: SG Cross Asset Research/Economics, Source: SG Cross Asset Research/Economics QE coming to an end. Euro likely to strengthen from last quarter of this year. In June, ECB announced that QE will end in December. The monthly pace of net asset purchases will be reduced to 15bn from September. Nevertheless, even after the end of QE, the ECB will reinvest maturing bonds to some extent. Despite announcing the end of asset purchases, President Draghi managed to sound dovish given the announcement that interest rates will remain unchanged at least through the summer of next year. Our forecasts assume that interest rates will rise in June 2019 (depo rate up 15bp to -0.25%) and then in September (all rates up 25bp, depo rate to 0%, repo rate to 0.25%). In doing so, the ECB would eliminate negative deposit rates. The announcement of the end of QE, however, has not strengthened the EUR versus the USD. We think the EUR will have to wait for the last quarter of the year for this. Until then, geopolitical uncertainties, the political situation in Italy and trade-war fears will likely keep the euro at weaker levels. The progress of Italy s ruling coalition, formed of populist parties the League and Five Star Movement, in pushing through its programme will be closely watched by the financial markets. This programme involves marked but unrealistic fiscal stimulus that would deepen the public finance deficit to 5% of GDP. However, given that the governing coalition is not the most stable, most of its election promises will probably not be pushed through. Nonetheless, we think that the Italian public finance deficit will grow to 3% from this 31 July

6 year s expected 1.7%. Concerns around Italy should calm after the approval of the budget. In the last quarter of this year, we think that the euro will strengthen. We forecast it at EUR/USD1.22 at year-end. Next year, we see it climbing to USD/EUR1.36 given tightening monetary policy in the euro area. Germany: pro-cyclical policy balances external uncertainty Promising outlook for second half of year. In 1Q18, German GDP growth decelerated versus previous quarters, coming in at just 0.3% after the 0.6% seen in 4Q17. Investment contributed the most to growth, followed by household consumption, while government consumption and net exports represented a drag. In the first quarter, uncertainty surrounding wage bargaining hit the economy, while in the second quarter, trade-war fears and the political situation in Italy came into play. This led to substantial drops in Germany s leading indicators the June ZEW index fell to the lowest level since The correction also affected consumer confidence and the IFO index. However, we don t think that the recent slowdown will develop into a trend. The negative impact of the trade war should be offset by tax cuts, wage growth and relaxed monetary and fiscal policy. This year, we forecast GDP growth at 2.2%. The US slowdown will likely affect the German economy in 2019 and 2020, when we expect growth of 1.9 % and 0.8% respectively. Germany: recent GDP growth and forecasts to Contributions to GDP growth Domestic demand Net exports Inventories GDP (% yoy) Source: SG Cross Asset Research/Economics CEE region: investment in full swing Solid GDP growth in the CEE region should continue. Countries in the CEE region are doing well. In 1Q18 Poland posted the best GDP growth at 1.6% qoq. Hungary came second with 1.2% while Slovakia was third with 0.9%. The Czech Republic ranked fourth with 0.4% qoq. Growth was driven mainly by investment, and in Slovakia and Poland inventory contributed significantly as well. Household consumption remained the traditional driver of economic growth. On the other hand, net exports were a drag. The shortage of labour in the region should continue to support investment activity. Investment is also supported by a considerable drawing of EU funds. Household consumption should remain a strong engine of CEE growth, boosted by fast-growing wages (wage growth reached 10.9% in Hungary in May and 7.5% in Poland in June). The risk is that wage growth will continue to outperform labour productivity. This would push corporate profit margins down further and force them to pass on rising labour costs to final product prices. In that case, tightening monetary conditions in the region could come earlier (for Poland and Hungary). A major risk for the CEE region is the introduction of customs duties on car imports. We focus on this topic in Box July

7 Inflation in the CEE region (%, yoy) GDP in the region (%, yoy) Feb-06 Feb-08 Feb-10 Feb-12 Feb-14 Feb-16 Feb Czech Republic Slovakia Poland Hungary Source: Macrobond, Eurostat, Economic & Strategy Research, Komerční banka Czech Republic Slovakia Hungary Poland Source: Macrobond, Eurostat, Economic & Strategy Research, Komerční banka In Poland, we expect the first rate hike in 3Q19. Inflation in the region gathered pace. Global oil prices have driven this trend, but food and core prices are rising as well. In Hungary, inflation accelerated to 3.1% in June, slightly exceeding the 3% inflation target. This was reflected in the Hungarian Central Bank s new forecast, as they upped inflation this year from 2.5% to 2.8%. At the same time, the Central Bank suggested that monetary policy easing may end sooner than previously expected. According to the Central Bank, the current loose monetary conditions can no longer prevail through the end of the 5 to 8-quarter monetary policy horizon. The Central Bank decided to change its guidance given the significant domestic currency weakening, under pressure from the loose monetary policy and rising inflation. The Hungarian forint looks set to remain under pressure in our view. We expect it to trade at EUR/HUF333 in one year. Inflation accelerated even in Poland. The 2.5% inflation target is still far away (CPI at 1.9% in June). For tighter monetary conditions in Poland, we will therefore have to wait. We expect the first rate hike in 3Q19. Thanks to the healthy Polish economy, EU dispute moderation, and hopes for an upgrade in Poland s credit rating, we expect the Polish zloty to strengthen gradually. In one year we forecast it at EUR/PLN4.16. Box 1: Trade wars playing with fire In March this year, the United States began playing with fire by imposing new duties on steel and aluminium imports of respectively 25% and 10%. In retaliation, the EU imposed a 25% duty on imports of steel, aluminium, agricultural products and other products (motorcycles, whiskey, jeans, etc.). The measure concerned 2.8bn in imported goods. Donald Trump responded by threatening to raise tariffs on car imports from the EU by 20%, but after J.C. Juncker s visit to the White House in July, this threat appears to have been averted, at least for the time being. However, the most powerful dispute sprang up between the United States and China. Since 6 July, a 25% duty has been imposed on Chinese products, of which annual exports total $34bn. Tariffs on $16bn of products are still being decided. China reacted by introducing tariffs on US imports of the same value. President Trump responded with the threat that if China does not change its practices, it will introduce 10% tariffs on $200bn in Chinese imports, and in July he warned he might even impose tariffs on all goods imported into the US (roughly $500bn). The question is what impact these measures will have on global economic growth. According to SG economists, the introduction of tariffs should not be a significant drag on US GDP growth, even if they were worth $ bn. The impact on GDP growth would be approximately 0.2% per year. This reasoning is that the introduction of free trade 31 July

8 since the beginning of the 1990s has contributed to an increase in US GDP of about 0.2pp per year. So if America loses some of these benefits, it would not affect its GDP growth by much more. The Fed is not worried about the negative impact of the trade wars on GDP growth. It is aware of the risks associated with the trade wars but despite this, it actually increased its GDP growth forecast in June (to 2.8%). The impact of the new tariffs on inflation should, in our opinion, be of a one-off nature, with consumer prices mainly affected indirectly. This is because the USTR seeks to put tariffs only on industrial goods, not on imported consumer goods. One exception was a duty on washing machines at the beginning of this year, which then led to a one-off increase in the price of those products. Looking at the impact of the trade wars, China will probably be worse off. If the tariffs are fully implemented, the impact on China s GDP would be close to 1pp per year. Full-scale tariffs could also have a negative impact on the Chinese labour market. According to SG economists, 3-4 million jobs could be destroyed. If duties were introduced from the first list of goods ($50bn), we estimate the impact on Chinese GDP at 0.1pp per year. Global supply chains, Taiwan, Malaysia, Korea and Singapore would be significantly affected by the tariffs as well (1-2% of GDP per year). Rather than having an impact on overall US GDP growth, the trade wars would affect specific goods and specific regions. For example, the introduction of steel tariffs will have a major impact on the steel industry, production that is closely tied to it, and regions where such firms are located. On average, however, the impacts on the entire industrial sector will be small. More strikingly, tariffs may hit international firms that have thus far benefited from globalisation and have built production facilities in China. The introduction of tariffs could force these firms to withdraw their activities from China and thus harm their profit outlook. Looking at the scale of the impacts, it will be important to see whether the tariffs will only be temporary and how any subsequent dialogue between the countries with the tariffs will play out. The worst option is of course the imposition of full tariffs and the unwillingness of countries to negotiate. The impact on the global economy would then be much more significant. 31 July

9 Macroeconomic outlook Viktor Zeisel (420) Main changes GDP: We have revised our full-year GDP growth forecast for 2018 down to 3.0% from 3.8%, while we have increased our projection for 2019 from 2.7% to 2.9%. Inflation: We revise our inflation forecast up by 0.2pp to 2.1%, as all the main components have surprised on the upside. Inflation should remain at 2.1% next year. Economy slowing but labour market to remain tight The Czech economy has been slowing, as it has hit its production limits and extensive growth is thus no longer possible. Productivity gains are now slower than we expected. Labour market tightness persists, as there is still excess demand for labour. This, together with salary rises in the public sector, is driving wages up and ensuring healthy consumption levels. However, import-intensive consumption and investment are dragging on external trade, which has become a negative contributor to GDP growth. Inflation has accelerated in recent months and is set to remain above or close to the CNB s 2% target. GDP growth easing due to worsening external trade balance (% yoy) Change to our GDP outlook (%) F 2019F HH Cons Gov Cons Investment Inventories NX Others GDP Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka Jul-12 Jul-14 Jul-16 Jul-18 July forecast June update Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka Change in our inflation outlook (%) Jul-12 Jul-14 Jul-16 Jul-18 July forecast May forecast Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka After a very strong performance in the first half of last year, the Czech economy has since turned sluggish, growth averaging 0.6% qoq. The labour market is depleted, and the economy has hit capacity constraints. Investment activity, which should help boost productivity, has increased, but the productivity gains are still GDP growth decelerating since second half of last year 2.5% 2.0% 1.5% 1.0% 0.5% % -0.5% -1.0% 1Q 11 1Q 12 1Q 13 1Q 14 1Q 15 1Q 16 1Q 17 1Q 18 GDP (qoq) GVA (qoq) Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka relatively low. Consumption is the main growth driver, benefiting from very low unemployment and rapid wage growth. Import-intensive consumption and investment are weighing on the external trade balance, which has deteriorated significantly, causing GDP growth to slow. The second quarter of this year fully reflected this, and we expect 2Q GDP growth to print at 0.7% qoq (down to 2.5% yoy from 4.2% due to strong base effect). Consumption and investment continued growing, in our view, while net exports likely contributed negatively again. 31 July

10 Industrial production down; we do not see it accelerating in near term. Industrial production slowing In the first five months of the year, Czech industrial production increased by only 2.7% on seasonally adjusted basis. The former growth driver, the automotive sector, lost momentum. Some producers have hit capacity constraints and desperately need additional staff. They would like to increase productivity, but that is a long-term process. This is one of the reasons we believe that the industrial production is not set to accelerate. We expect output growth of 2.8% this year and 3.1% next year. Production should move toward goods with higher value added, as price pressures will likely drive low-value-added producers out of the market. Demand for cars strong but Czech producers not benefitting much Industrial production easing; unlikely to accelerate in near term Aug-10 Feb-12 Aug-13 Feb-15 Aug-16 Feb-18 Export of cars (SA, WDA, mld. CZK, SITC 781) New car registration in EMU (SWDA, rhs) New car reg. in Germany (SWDA, ths., rhs) Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Jul-19 GDP (real, yoy) Industrial production (yoy) Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka Construction sector in strong position. Since the beginning of the year, the construction sector has been printing very good figures. There is strong demand in the building sector, though the civil engineering sector is lagging somewhat. The weak performance of the engineering sector is a puzzle, as we are seeing more capital spending from the public sector. On the other hand, the good performance of building Building construction driving sector Aug-10 Feb-12 Aug-13 Feb-15 Aug-16 Feb-18 Czech construction (index, swda) Buildings (index, swda) Civil engineering works (index, SWDA) Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka construction is not surprising. Housing demand has been growing rapidly, and businesses are investing more into production. The construction sector is experiencing capacity constraints, with labour force shortages reportedly the biggest impediment to output. We expect construction to increase 11.1% this year and 5.1% in the next, and we think that prices in the sector will accelerate as demand exceeds supply. Box 2: US car tariffs could endanger 0.4% of Czech GDP US President Donald Trump has announced that his government might impose up to a 25% tariff on vehicles imported to the US. That is more than double the tariff currently imposed on US imports to the EU. The US currently charges a 2.5% tariff on vehicle imports from Europe 31 July

11 and a 25% tariff on light truck and van imports. These considerations have been postponed after a meeting with J. Juncker. Nevertheless, this ease in trade is valid, as we have been accustomed to, only until the next tweet of the US president on this issue. Hence, it is still important to asses the possible impacts of this step on the Czech economy. Announcement of possible introduction of trade tariffs on cars imports from EU to the US Source: Twitter.com, Economic & Strategy Research, Komerční banka Another issue is the importance of the EU s automotive exports to the US, as these are five times the size of US exports to the EU. The highest trade surplus from the EU s standpoint is seen in fully produced cars. The trade balance for car parts and other automotive segments is positive for the EU (accounting for 32% of the total trade balance between the US and EU). The EU is highly sensitive to these tariffs, as automobiles account for 13% of the region s total exports to the US. Volume of automotive trade between EU and US (positive exports from EU, negative exports from US; lines depict the balance for each automotive segment; bn) Vehicles Parts and accesories Other Source: Eurostat, Economic & Strategy Research, Komerční banka Rising tariffs can hit the Czech automotive manufacturing sector via to two channels. The direct impact will likely be negligible, as just a little over 0.4% of the country s 31 July

12 automotive exports are shipped to the US. Moreover, 94% of these exports are parts, for which tariffs are unlikely to be imposed and if so then as these components will be delivered any way as they are needed for US production. Czech automotive exports to the EU ( bn) Vehicles Parts and accessories Rest Source: CZSO, Economic & Strategy Research, Komerční banka Czech automotive exports to the US ( bn) Vehicles Parts and accessories Rest Source: CZSO, Economic & Strategy Research, Komerční banka Therefore, the main channel through which the proposed tariffs will impact the Czech automotive industry is supplies to car manufactures in the EU. We assume only car parts and accessories will be hit. These account for 11.5bn out of the 29bn in the whole automotive exports to the EU in We have not seen any evidence showing that final cars produced in the Czech Republic will be re-exported from other EU countries to the US, so counting the full amount would overestimate the impact. Because we do not have more detailed information about the contribution of Czech exports to EU automotive exports to the US, we adjust the Czech exposure to US tariffs by the share of EU exports to the US out of the EU s total automotive manufacturing (6.5%). This implies that roughly 0.7bn of Czech exports is endangered by the proposed US tariffs. This translates into 0.4% of GDP. However, to more accurately estimate the impact, we would need to know the price elasticity of the EU s automotive exports to the US. We think price elasticity should be rather low, since mostly luxury vehicles are exported to the US. David Kocourek david_kocourek@kb.cz Private investment showing strong growth in recent quarters; public sector investing more. Investment to deliver half of GDP growth Lack of capacity and strong wage growth are forcing businesses to invest. Investment is the only way to increase productivity, which in turn is the only way that output will increase in an economy operating at full capacity. The GDP statistics reflect this, with investment creating roughly half of the growth. However, businesses now have to pay more for wages and other inputs, including energy, and credit has become increasingly expensive. We expect investment growth to accelerate to 6.7% this year before decelerating to 2.1% next year. Investment should also be supported by the public sector. We expect public capital spending to accelerate in the coming quarter. 31 July

13 Investment to grow hand in hand with construction (%) Jul-12 Jan-14 Jul-15 Jan-17 Jul-18 Jan-20 Construction (yoy) Investment (yoy) Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka Capital formation driven by NFIs (%, yoy) Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 NFI FI Government Households Non-profit org. Total Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka Fiscal policy: Revenues not catching up with rising spending The ministry of finance plans to run a deficit of CZK50bn this year after last year s balance of -CZK6.2bn. It is not planning any new measures for revenues, which should grow in line with economic growth. In contrast, expenditure has gained strong momentum. To a large extent, this is due to current spending, but more funds are also being allocated for investment. Municipalities budgets will pull the balance of the whole public sector into the black this year. In 2019, public sector finances should see a negative balance. Central government budget to see deficit on back of rising expenditures. State budget performing worse than last year In the first half of the year, the state budget developed less favourably versus the same period last year. In the first six months, it recorded a deficit of CZK5.9bn, while it saw a surplus of CZK4.6bn in July However, the yoy comparison is distorted by a couple of one-offs that have deepened the deficit (payments to Export Guarantee and Insurance Corporation and extraordinary revenues from privatisation accounts in 2017). Budget revenues increased by a strong 6.7% in the first half of this year, while budget expenditure grew by 10.2%. Expenditure was driven by non-investment spending, reflecting a 15% pay rise for teachers and 10% for other public servants. On the revenue side, inflows have been increasing from VAT and income tax. The former is connected to growing consumption and the latter to the tight labour market, which has caused sound wage growth. but municipalities offset the deficit Public sector finances (ESA2010 methodology) saw a surplus of 1.6% GDP last year, and the favourable trend continued in the first quarter of this year. A surplus was delivered thanks to municipal budgets, while the central government ran a deficit. In the yoy comparison, public debt declined, reaching 35.82% of GDP in 1Q. The budget trends seen at the beginning of the year are set to persist for the remainder of the year. We expect an increase in current spending, reflecting pay rises in the public sector, and a 5% increase in pensions. The government also plans to amplify the business cycle in the next year, as the budget incorporates another 15% pay rise for teachers and 6% for other public servants. On the other hand, it plans eliminate payrolls where there are unoccupied vacancies. However, the savings will be much lower than the amount to paid out for salary rises. Expenditures will also increase in the science, higher education, sports and health care sectors. 31 July

14 Capital expenditure showing signs of more robust revival. Capital expenditure has accelerated versus last year given improved EU fund absorption. More projects have rolled out and will need more funding in the coming months. We expect capital expenditure to grow further, and we see a bigger risk of higher deficits. Ministries might also tap investments approved in previous years. On the other hand, we still see no progress in the big infrastructure projects. In addition, army procurement has halted. Thus, some of the planned investment might not go ahead. Government investment gaining momentum Capital expenditures, 12m cum., CZKbn 60 Aug-10 Feb-12 Aug-13 Feb-15 Aug-16 Feb-18 Source: Finance Ministry, Macrobond, Economic & Strategy Research, Komerční banka Revenues to slow in line with GDP deceleration Revenues have been very strong so far this year. They have benefited from the cyclical stage of the Czech economy, which is going through the late expansion phase. This is reflected in wage growth, high employment and elevated turnover of businesses. The budget parameters on the revenue side have not changed much. The one big change, which will however only have a temporary effect, is the inclusion of privatisation funds in the budget. That will act as a one-off support to revenues. Otherwise, revenues are set to ease in line with GDP deceleration. Public finance dynamics f 2019f 2020f 2021f 2022f Balance (% GDP) Fiscal effort (pp GDP) Public debt (CZKbn) 1,749 1,754 1,779 1,829 1,839 1,829 Debt ratio (% GDP) Source: CZSO, Macrobond, Finance Ministry, Economic & Strategy Research, Komerční banka We keep our view that this year s central government budget will print a deficit of CZK40bn. Nevertheless, the risks are still tilted towards a more negative result. Revenues might be jeopardised by economic deceleration, while expenditures might be boosted by investment activity. We now revise our outlook and expect a budget deficit of CZK50bn in 2019, in line with the MoF s plans. We see the risks tilted more towards a deeper deficit in 2019 too. 31 July

15 Public finance balance (% of GDP) Public debt (% of GDP) KB forecast General goverment debt KB forecast General goverment balance Maastricht criteria Source: CZSO, Economic & Strategy Research, Komerční banka Source: CZSO, Economic & Strategy Research, Komerční banka In July, almost nine months after the general election, the Czech government won a confidence vote in parliament. The coalition has a left-wing character, and its program suggests numerous reforms and new expenditures. However, there has been nothing concrete yet in terms of the planned measures, except for the pension increase at the beginning of next year. If the current economic expansion continues, budgets will likely see easily financed deficits in the coming years. Local budgets will pull the general public sector balance into the black. According to the ESA2010 methodology, the public sector balance should see a surplus of 0.4% of GDP. However, we see a risk of a deficit, as municipalities might also start investing in infrastructure, though developments in the first quarter do not suggest this. We think local budgets will deteriorate in the coming years, and as a result, we see public finances coming in at a deficit of 0.1% of GDP in The public debt is set to marginally increase in absolute terms this year. As a percentage of GDP, it is set to decrease to 32.8% from last year s 34.6% due to still-solid economic growth. The trend of decreasing debt will be slowed by the public finance deficit next year. It should drop to 31.6% of GDP. Labour market to remain tight despite GDP slowdown Slowdown of economy not reflected in labour market. The recent slowdown of the economy is not being reflected in the labour market. The unemployment rate is no longer falling and is so low that it does not have much room to decline further. On the other hand, the number of vacancies keeps growing, showing that demand for labour is still very high. The unemployment rate (ILO methodology) should remain very close to the current level of 2.3%. The labour force shortage should thus persist and translate into further wage growth. We expect nominal average wages to increase 8% this year, supported by strong pay rises in the public sector and a catch-up effect from previous years. Next year, wage growth should ease but will likely remain solid at 5.5%. The favourable economic outlook and tight labour market will likely be reflected in household confidence and consumption. We expect households to increase spending by 4% this year and 3% next year. 31 July

16 Consumer confidence remains near historical high Extremely low unemployment propels wage growth (%) Aug-10 Feb-12 Aug-13 Feb-15 Aug-16 Feb-18 Industry Construction Trade Services (rhs) Consumers Overall Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka Jul-12 Jan-14 Jul-15 Jan-17 Jul-18 Jan-20 Unemployment rate (ILO, SA) Average nominal wage (%, yoy, rhs) Source: CZSO, Macrobond, Economic & Strategy Research, Komerční banka Inflation to remain high At the beginning of the year, it seemed that Czech inflation had lost momentum and would hover below the 2% mark. However, the second quarter showed that inflationary pressures are still alive, and yoy price growth was supported by all the main components. While the surge in food and fuel prices might be short-lived, we think core inflation and regulated prices will ensure that headline inflation does not fall below 2% any time soon. We expect it to print at 2.1% on average this year and next year. Inflation to remain above 2% 4% Core inflation accelerates again after short pause 3.0% % 2.0% % 1% 0% -1% Jan-11 Jan-13 Jan-15 Jan-17 Jan-19 Inflation target Monetary policy inflation (yoy) CPI (yoy) Source: CZSO, CNB, Macrobond, Economic & Strategy Research, Komerční banka 1.0% % -1.0% -2.0% Jan-11 Jan-13 Jan-15 Jan-17 Jan-19 Core inflation (yoy) EUR/CZK (rhs) Source: CZSO, Bloomberg, Macrobond, Economic & Strategy Research, Komerční banka Core inflation to remain strong. Poor harvest suggests higher food prices. Core inflation eased significantly at the beginning of the year. We had feared that wage pressures would not pass through into inflation, but they did eventually. We cannot attribute all the recent core price growth to rising wages, but it seems that they are now playing a role. Businesses will likely either have to accept reduced profit margins or transfer part of their rising costs to consumers. We would expect the latter. On the other hand, the koruna should start appreciating again, which would be anti-inflationary. We expect core inflation to remain above 2%, printing on average at 2.1% this year and 2.3% next year. Food prices have been very volatile. At the beginning of the year, they quickly corrected last year s strong growth and contributed strongly to the slump in inflation. In 2Q, they surprisingly recovered, but a recent preliminary survey from the national statistics office shows that they 31 July

17 are set to plunge again. In the medium term, we think food prices will grow again. The crop harvest looks like being poor this year given the lack of rain in spring and summer. That should result in higher food prices in autumn 2018 and spring We expect food prices to grow by 1.4% this year and 1.5% next year, but the risks are tilted to the upside. Both FX and oil price to favour cheaper fuel. Electricity prices set to go up, partly this year but mostly at beginning of Koruna highly volatile during political turmoil. Brent oil touched USD80/bbl in May and has since stayed above USD70/bbl. This is the main reason for the rise in domestic fuel prices, while koruna depreciation has amplified the move. We believe that global oil prices will correct in the coming months, stabilising at around USD65/bbl. Koruna levels should support cheaper imports, and prices at domestic petrol stations should thus fall over the remainder of the year. However, due to the high levels at the beginning of the year, average fuel price growth should print at 5.8% this year. Stabilisation next year should result in prices falling by 1.3%. After several years of sluggish or no growth, regulated prices increased notably at the beginning of this year. The move was mostly due to higher electricity and gas prices, reflecting higher prices on global markets, but the regulator also allowed dealers to increase distribution prices. The current market pricing suggests that energy dealers will raise prices further, partly this year but mostly at the beginning of the next year. We believe that administered prices will grow 2.1% this year and 2.4% next year. Risks: FX volatility remains the most imminent risk The uncertain global environment is generating several risks. We see the overall risks tilted to the downside. However, the risks arising from the domestic economy are tilted more towards stronger growth. The main risks include: Fuel prices surge but are set to come back down 20% 10% 0% -10% -20% Jan-11 Jan-13 Jan-15 Jan-17 Jan-19 Fuel price (yoy) Brent Oil in CZK (yoy, %, rhs) Source: Bloomberg, CZSO, Macrobond SG Cross Asset Research/Economics, Economic & Strategy Research, Komerční banka 80% 40% 0% -40% -80% CZK volatility. The koruna has shown that it is prone to react to political turmoil. The risk of strong depreciation is thus high should an unfavourable global economic/political event occur. Sluggishness of EMU growth will continue in coming quarter. While domestic demand remains solid, external demand is fragile. If the recent tepid growth in the euro area were to persist, it would curb Czech economic growth. Weaker demand for cars in Europe would significantly hit the Czech automotive industry, one of the main drivers of the current economic boom. The lack of available workers might curb investment, as some businesses could be afraid of having no one to operate new machines. 31 July

18 Key economic indicators 2Q18 3Q18 4Q18 1Q19 2Q19 3Q19 4Q19 1Q GDP and its breakdown GDP (real, yoy) Household consumption (real, yoy) Government consumption (real, yoy) Fixed investments (real, yoy) Net exports (contribution to yoy) Inventories (contribution to yoy) Monthly data from the real economy Foreign trade (CZK bn) (*) (***) Exports (nominal, yoy) (*) Imports (nominal, yoy) (*) Industrial production (real, yoy) Construction output (real, yoy) Retail sales (real, yoy) Labour market Wages (nominal, yoy) Wages (real, yoy) Unemployment rate (MLSA) Unemployment rate (ILO 15+) Employment (ILO 15+, yoy) Consumer and producer prices CPI Inflation (yoy) Taxes (contribution to yoy inflation) Core inflation (yoy) (**) Food prices (yoy) (**) Fuel prices (yoy) (**) Regulated prices (yoy) (**) Producer prices (yoy) Financial variables 2W Repo (%, average) M PRIBOR (%, average) EUR/CZK (average) USD/CZK (average) External environment GDP in EMU (real, yoy) GDP in Germany (real, yoy) CPI in EMU (real, yoy) Brent oil price (USD/brl, average) EURIBOR 1Y (%, average) EUR/USD (average) Source: CZSO, MLSA, Bloomberg, Macrobond, Economic & Strategy Research, Komerční banka Note: (*) foreign trade according to cross border statistics; (**) these parts of inflation are adjusted for the primary effect of indirect tax changes; (***) the quarterly data are seasonally adjusted. 31 July

19 Viktor Zeisel (420) CNB Focus Weak koruna triggered major hawkish shift at CNB While the May CNB forecast suggested a virtually flat rates trajectory, the surge in the koruna tore that forecast apart. The bank board had already delivered a surprising hike in June showing that it would react to FX deviations despite uncertainty about the global environment. It is clear that CNB will revise up its expected rate trajectory while the FX appreciation should slow in line with our recently revised rates and FX calls. We expect the CNB to hike 25bp every quarter until 3Q19. CNB forecast to bring back-loaded hikes forward May s CNB forecast suggested a flat rates path for this year, as inflation was to remain muted at just below 2%. CNB described two risk scenarios; one factored in lower productivity growth which would push inflation higher, while the second mentioned a weaker koruna. At the end of the day, both pro-inflationary risks came true. GDP growth fell behind expectations mainly due to poor productivity dynamics and EUR/CZK has surged on the back of global uncertainty. Moreover, domestic inflation surpassed all expectations when it printed at 2.6% in June, 0.7pp above the CNB forecast. According to CNB s chief economist Tomáš Holub, twothirds of the surprise must be attributed to food and energy prices, while the rest is due to an unexpected increase in core inflation. The CNB reacted with a rate hike in June. In his interview for Reuters 1, Holub stated that the upcoming forecast (released on 2 August) will present a major revision to the expected PRIBOR trajectory suggesting that CNB is willing to tighten its monetary policy. If FX does not do its job, the bank board is prepared to move rates. Inflation to remain safely above 2% (%) GDP to decelerate notably (%) CNB Inf lation Target Q17 4Q17 2Q18 4Q18 2Q19 4Q19 CNB Forecast (May 2018) KB forecast (July 2018) 2.0 2Q17 4Q17 2Q18 4Q18 2Q19 4Q19 CNB Forecast (May 2018) KB forecast (July 2018) Source: CNB, CZSO, Macrobond, Economic & Strategy Research, Komerční banka Source: CNB, CZSO, Macrobond, Economic & Strategy Research, Komerční banka The exchange rate surged as a result of the turmoil on the Italian political scene. Shortly after that, more political uncertainties emerged (more Brexit uncertainty, trade wars, and German political clashes) and the koruna was thus unable to correct its move. We have covered the situation in depth in recent reports in which we also revised our FX and rates forecasts and The bottom line is that CZK is now much more vulnerable to external shocks and shows only limited reactions to domestic news July

20 The June hike had only a very short-lived effect and Holub s remarks about a major upward revision to the expected rate path moved the koruna up by only 0.5%. We believe the koruna is the main driver behind the forecasted rise in the PRIBOR trajectory. In CNB s view, the lower productivity growth that led to subdued GDP growth at the beginning of the year amplifies the inflationary pressures. The tight labour market is inducing rapid wage growth while productivity gains are falling way behind. Thus NFCs must either increase prices to transfer rising costs to consumers or tap their profit margins. We expect the economic slowdown to continue as the economy hits its production frontiers and productivity gains appear more slowly than we expected. Meanwhile, the situation on the labour market will not allow any significant deceleration in wage growth. Thus the labour market should further generate inflationary pressure which will be only partially absorbed by a reduction in profit margins. CNB will thus raise its interest rate trajectory as already indicated by Holub. When asked by Reuters whether the new forecast could show a 100bp increase compared with the current one, he replied that it is not entirely out of the ballpark. Mr Holub also indicated that the FX outlook would see the koruna weaker for longer. In our view, this will bring the back-loaded hikes from the last CNB forecast further forward. We believe the new CNB outlook will show 2-3 hikes for this year and a further 2-3 hikes next year, while the FX should show a much slower rate of appreciation than suggested in the previous forecast. We would not be so surprised if the monetary department recommended the board raise rates by 50bp at its August meeting. Back-loaded hikes to come front CZK appreciation to be much more gradual M PRIBOR (%) EUR/CZK Q17 4Q17 2Q18 4Q18 2Q19 4Q19 CNB Forecast (May 2018) KB forecast (July 2018) Q17 4Q17 2Q18 4Q18 2Q19 4Q19 CNB Forecast (May 2018) KB forecast (July 2018) Source: CNB, Bloomberg, Economic & Strategy Research, Komerční banka Source: CNB, Bloomberg, Economic & Strategy Research, Komerční banka Board to pursue rate normalisation, but at a gradual pace The board members did not make many public appearances since the June meeting. Traditional hawks Hampl and Benda have urged for a steeper hiking path, but their words did not surprise the markets as they have been voicing this opinion for some time now. The rest of the CNB board is usually more cautious. Yet, their common narrative is that they want to see the repo rate at equilibrium; they only differ on timing. We believe most board members will want to use the current situation to raise the rates, but will closely watch the developments on the FX market. That said, we expect the bank board to increase rates at the August meeting and then consequently every quarter until 3Q18. Even though the board is expect to deliver only a 25bp hike at the August meeting, they could actually discuss 50bp increase. Together with the revised forecast, this would send a strong hawkish message 31 July

21 which could have a notable impact on swaps. CZK would also react with appreciation, but this might only be short-lived as global events could easily override it. 31 July

22 Czech FX Market Jan Vejmělek (420) Koruna down 0.8% on average in 2Q18 We ll have to wait up to a year for EUR/CZK25 Contrary to our forecast and the CNB's assumptions, the koruna did not strengthen in 2Q18, instead weakening significantly. After almost a year, the exchange rate has approached EUR/CZK26 again. Even gradual increases in Czech interest rates have not been enough to eliminate the negative impact of the external environment. The koruna s strengthening trend will likely gather further momentum, but EUR/CZK25 is unlikely to be seen until next summer. Koruna slips amid emerging-market currency sell-off This year's second quarter was the first since the final quarter of 2014 in which the Czech koruna weakened against the euro. Consequently, the risk scenario presented in the last issue of our Czech Economic Outlook publication has materialised. The unfavourable external environment has outweighed the positive impact on the exchange rate of domestic developments, including the widening interest rate differential. Koruna almost back to where it was a year ago Good year for koruna vs other CE currencies ( = 100) EUR/CZK 108 EUR/CZK EUR/PLN EUR/HUF Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Source: Bloomberg, Economic & Strategy Research, Komerční banka 98 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Source: Bloomberg, Economic & Strategy Research, Komerční banka Koruna weakens but outperforms regional peers EUR/USD evolution this year EUR/USD Jan-18 Mar-18 May-18 Jul-18 Source: Bloomberg, Economic & Strategy Research, Komerční banka EUR/CZK has changed behaviour since 2Q18. We discuss here the reasons that the correlation between Central European currencies and EUR/USD increased so significantly. External factors have started to play a key role in determining the EUR/CZK exchange rate. Global investors no longer distinguish between the koruna and other emerging market assets. Thus, the koruna weakened in April along with other regional currencies. Nevertheless, it has outperformed its regional peers. Positive koruna/zloty correlation at its highest since 2012, as is negative correlation between regional currencies and EUR/USD Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Corr EUR/CZK, EUR/PLN Source: Bloomberg, Economic & Strategy Research, Komerční banka Corr EUR/CZK, EUR/USD 31 July

23 Koruna still not responding to more attractive interest rate differential Higher interest rates will eventually help koruna The koruna s exchange rate will reflect external factors in the months to come, in our view. The degree of its vulnerability to developments on global markets looks set to remain high. Domestic factors now play a much smaller role than they used to, and we think nothing is set to change here. Despite the unexpected June interest rate hike and increased expectations that the CNB Significant increase in market rate hike expectations since start of 2Q18 not helping the koruna CZK FRA 9x12 (%) 0 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Source: Bloomberg, Economic & Strategy Research, Komerční banka will continue this trend, we have seen no positive reaction by the Czech currency. The koruna will likely return to its appreciation trend, but we ll have to wait. Compared with the previous edition of our Czech Economic Outlook, in which we forecast EURCZK25 to be reached in 4Q18, we now assume that it will be reached in the middle of next year. We predict the year-end 2018 rate at EUR/CZK The surplus of the current account of the balance of payments will likely continue to generate euros for the Czech economy that will need to be exchanged into korunas on the market. A positive role will be also likely played by a higher interest rate differential, which will support portfolio investment inflows. The money market is preparing for an August hike and has priced in three hikes in a one-year horizon. We assume one hike per quarter until 3Q19 (see more in the CNB Focus section of this report). Expected path of Czech money market rates Balance of payments C/A outlook EUR/CZK long-term equilibrium exchange rate (NATREX approach) Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Jul-19 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Jul-19 Jul-12 Jan-14 Jul-15 Jan-17 Jul-18 Jan-20 PRIBOR 3M 2W REPO Current Account (% GDP) EUR/CZK Equilibrium exchange rate (NATREX) Source: CNB, Economic & Strategy Research, Komerční banka Source: CNB, Economic & Strategy Research, Komerční banka Source: CNB, Economic & Strategy Research, Komerční banka Convergence on equilibrium exchange rate level to take years We expect the koruna to continue converging on the equilibrium exchange rate level, which we see below EUR/CZK24, using the NATREX approach. However, this will likely take several years. We see an economic slowdown in the Czech Republic in the context of the recession in the US in late 2019, which would mean a temporary weakening of the Czech currency and a retreat from the equilibrium level. Risks: Sell-off pressures on CZK should intensify further Our FX outlook until the end of 2019 is fully in line with the market consensus. We expect that the koruna will be stronger over a one-year horizon and will approach EUR/CZK25. By the second half of next year, the pace of appreciation should be minimal. 31 July

24 Expected EUR/CZK exchange rate market consensus, Bloomberg (30 July 2018) 27.5 EUR/CZK Consensus KB forecast min max Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jul-19 Source: Bloomberg, Economic & Strategy Research, Komerční banka We see the risks skewed toward a weaker koruna As the koruna remains overbought, it is vulnerable. The central bank s FX commitment and intervention regime led to an increase in foreign investors speculating on CZK appreciation. This position has not yet reduced significantly and makes the koruna vulnerable at a time of increased market uncertainty. On a relatively small scale, the recent depreciation of the currency has confirmed this risk. The risk for the koruna is not only a shock in global financial markets but also an earlier or deeper economic slowdown than we expect for the turn of Conversely, a decrease in global uncertainty, accompanied by domestic interest rates rising at a faster pace than we currently expect, may lead to a faster appreciation of the koruna than in our baseline scenario. CNB intervention boosted non-resident deposits at Czech banks Received deposits and loans, nonresidents (CZKbn, lhs) 600 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Source: CNB, Economic & Strategy Research, Komerční banka CNB intervention sizes (CZKbn, rhs) Box 3: Global events drag on currencies of small open economies In the first half of the year, geopolitical risk impacted the exchange rates of CEE currencies such as koruna, zloty and forint. Risk events included new governments in Italy and Spain, strain between the coalition partners in Germany, tension around the Turkish election and, most importantly, fear of a trade war between the US and the rest of the world. These events have influenced the Czech koruna much more than the fact that, ten months since the election, the Czech government had still not secured a vote of confidence in parliament. Geopolitical events do not only influence CEE currencies. Trade war developments have raised concerns in Asia, causing a gradual depreciation of local currencies. Since the beginning of the year, nearly all Asian currencies have weakened, the Indian rupee and Indonesian rupiah most of all. 31 July

25 Last year, international markets did not appear to believe that the US president would start a trade war. The South Korean won and Chinese yuan appreciated to their strongest levels since 2014 and 2015 respectively. However, South Korea and China were the first two countries affected by Trump s trade policy when in January the US introduced tariffs on solar panels and washing machines. Thus, between January and June, both currencies settled down, oscillating by ±1%, although the US continued to introduce new tariffs, including on aluminium and $50bn of Chinese goods. Even in April, when Trump considered additional tariffs of $100bn on Chinese goods, there was no major panic. Asian currencies reactions to geopolitical events ( = 100) Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 CNY/USD KRW/USD INR/USD IDR/USD TWD/USD Source: Bloomberg, Economic & Strategy Research, Komerční banka The situation changed in June. With ambiguity around tariffs remaining in the shadow of the Trump-Kim summit, Asian currencies including the yuan began to depreciate. The previously stable Chinese currency lost around 3.5% over several days. It is not easy to determine whether this was a reaction by the free-floating currency or whether the Chinese government manipulated it despite saying it wouldn t use the currency as a tool in the trade war. Other Asian currencies depreciated too, with the Indian rupee losing more than 2% and the Taiwan dollar nearly 3%. This was despite the fact that the main conflict shifted towards the West the US and EU. CEE currencies had already started depreciating in April, at which time the trade war was escalating between the US and China Since then, the Czech koruna has depreciated to an 11-month low, the zloty hit an 18-month low, and the Hungarian forint saw its weakest level in this business cycle. It seems that geopolitical events currently play a more important role in exchange rate volatility in small open economies than economic developments at home or worldwide. In our view, political developments will be the main driver of exchange rate movements in the coming months. Monika Junicke monika_junicke@kb.cz 31 July

26 EUR/CZK Technical Analysis (updated on July 27 at 4:17pm) Head of Technical Analysis Stéphanie Aymes (44) Technical Analyst Tanmay Purohit (91) Technical Analyst Natarajan Visweswaran (91) Breaches upward sloping trend support EUR/CZK has been witnessing a steady pullback after hitting the multiyear trend at 26.20/26.25 earlier in July. The pair has breached a steeper trend and is now probing the 200-day MA near Daily RSI is at a trend support however the phase of consolidation is expected to persist /26.25 will remain an important resistance. In case of violation below the 200-day MA near 25.60, EUR/CZK will head towards next supports located at and more importantly near 25.40/25.35, the ascending trend since February and the 76.4% retracement of that rebound caps near term upside. EUR/CZK, weekly chart. EUR/CZK, daily chart. Source: SG Cross Asset Research/Technical Analysis Important Disclaimer: The recommendations in the part Technical analysis is based only on analytical methods of technical analysis and may be different from the fundamental opinion of KB (or SG) presented in other part s of this documents or of other documents of KB (or SG). 31 July

27 Czech Government Bonds and the IRS Market Jakub Matějů (420) Faster growth at the short end of the curve Following the record-high issuance year-to-date, we raise our full-year forecast to CZK250bn, while next year we expect an increase to CZK260bn due to the larger volume of maturing bonds. As a result of faster-than-expected CNB tightening, we now expect a steeper path for CZGB yields and IRS than previously. That said, the yield curve s slope looks set to decline further. CZGB yields, Bloomberg generic (%) ASW spreads (bp) CZGB 10Y CZGB 5Y CZGB 2Y % % % % Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Source: Bloomberg, Economic and Strategy Research, Komerční banka -160 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Source: Bloomberg, Economic and Strategy Research, Komerční banka Czech government bond yields rose in 2Q18. This was driven by expectations of further CNB hikes, solid inflation, and strong supply at the longer end of the curve. At end-june, the 10y CZGB yield reached 2.2%, its highest level since early Meanwhile, ASW spreads for shorter maturities moved into positive territory, which further fueled demand for these bonds. Since then, the gap has closed again, though strong demand seems to be prevailing. We expect government bonds to sell like hot cakes in 3Q, as auction volumes are seasonally lower. We expect the Finance Ministry to sell CZK250bn of medium- and long-term bonds this year. Supply in 2H18: larger volume in 3Q and annually We continue to expect gross borrowing needs of CZK341bn this year, slightly (CZK10bn) below the Finance Ministry s call. The difference comes from our expectation of a lower budget deficit. Given the bonds already sold in 2Q and a relatively rich auction calendar for this summer, we raise our forecast for the total annual issuance volume this year to CZK250bn. In addition to Quarterly CZGB issuance on the primary market (CZKbn) Q Q2 Source: Finance Ministry, Economic & Strategy Research, Komerční banka * 2Q-4Q18 is KB forecast Q3 Q4 31 July

28 that, we expect a further CZK10bn to be sold directly on the secondary market. Net T-Bill issuance should reach CZK26bn, which implies gross sales of CZK70bn, and CZK11bn in liquidity reserve taps. Regarding the timing, there should be a significant drop following the record-high 2Q (CZK110bn) to seasonally weaker volumes in 3Q (CZK50bn), which would still imply strong year-on-year growth. We expect the remaining CZK27bn to be issued in 4Q, which is lower than what we forecast in our previous Czech Economic Outlook. Gross borrowing needs and financing (CZKbn) 2018e 2019e MF June 2018 KB July 2018 MF June 2018 KB July 2018 Borrowing needs Budget deficit Buybacks of CZGBs Redemption of CZGBs Redemption of eurobonds Redemption of retail bonds Redemption of T-bills Redemption of other money market instruments Redemption of EIB loans Total Financing Gross T-bill issuance 7 7 Gross CZGB issuance (in auctions) min Tap sales 1 1 Gross issuance of eurobonds Gross issuance of retail bonds Tapping of financial reserve Net effect of CZGB switches Total financing Net CZGB issuance Source: Economic & Strategy Research, Komerční banka, Finance Ministry We consider new foreign bond issuance to be unlikely. Thanks to the proactive refinancing of a large bond maturing in August and strong demand at domestic primary auctions, we consider foreign bond issuance to be unlikely. We also don t expect the new EIB loan to be used for financing this year. Towards end-july, the ministry secured 77.2% of the expected total CZGB issuance for the current year, which means 58.5% of the total gross borrowing needs net of financial reserve tapping (CZK330bn). Supply in 2019: larger volume due to higher bond redemptions In 2019, the ministry will need to refinance CZK240.9bn of maturing government bonds. In additon to that, we expect CZK70bn of maturing T-Bills and a CZK50bn budget deficit, in line with the ministry s view. Total borrowing needs should thus be relatively large, probably the highest since Because of that, we expect total CZGB issuance in 2019 to reach CZK260bn, exceeding this year s figure. Net issuance should hit c.czk30bn. We have raised our CZGB yield forecast both on the short and long end of the curve. CZGB yields to rise in 2H18 and 2019 due to CNB and strong supply Based on the change in global market sentiment since May and our new call on CNB policy, we also raise our forecasts for Czech government bond yields. We expect the 10y CZGB yield to reach 2.20% towards year-end, while the shorter end looks set to increase faster to 1.5%. The main reason for the change in our forecasts are faster CNB monetary policy tightening and stronger expected growth in the 10y Bund yield. At the short end, we forecast a one-off spike in demand at year-end due to liquidity constraints related to the Resolution Fund. 31 July

29 CZGB yield forecast 3Q18f 4Q18f 1Q19f 2Q19f 3Q19f 2y CZGB yield (%) y CZGB yield (%) y CZGB ASW (bp) Source: Economic & Strategy Research, Komerční banka Next year, the CNB looks set to further tighten monetary policy (gradually by a total of 0.75pp during 2019), and we expect inflation to stay firmly above 2% in 1H. These factors should drive the bond yields higher. We also expect a gradual tightening of CZGB yields against IRS, as demand for government bonds should remain strong and net issuance should stay short of this year s figures. Consequently, we see the nominal 10y CZGB yield surpassing 2.50% during 2019, while the 2y CZGB yield should reach 1.90%. Holdings of CZK government debt, end-june 2018 Share of non-resident holders declined earlier this year Foreign inv estors 36% Foreign bond issues 10% Households 1% Other 3% Central bank 0% Monetary f inancial institutions, excl. CNB 25% Foreign holdings of CZK debt (CZK bn, LHS) Foreign holdings of CZK debt (% of local debt, RHS) 52.0% 44.0% 36.0% 28.0% Other f inancial intermediaries and f inancial auxiliaries 2% Insurance corporations and pension f unds 23% Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 2% 12.0% Source: Finance Ministry, Economic & Strategy Research, Komerční banka Source: Finance Ministry, Economic & Strategy Research, Komerční banka CZGB holding structure to stabilise Following a sharp decline in the share of foreign debtholders at the start of this year (related to dissipating year-end effects), the share of foreigner holders of CZGB stabilised at around 40%. That is a relatively low figure compared with the previous year, when foreign investors were lured by prospective gains related to the CNB ending its policy of maintain a floor for the FX rate. However, the share of foreign holders remains well above pre-intervention figures. We do not expect the share to venture too far from current levels, as CZGBs will offer attractive carry for long-term investors, all the more so if the koruna starts appreciating again. 31 July

30 CZK IRS trend (%) Y CZK IRS 5Y CZK IRS 2Y CZK IRS Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Source: Bloomberg, Economic & Strategy Research, Komerční banka Revised call on CNB monetary policy results in a higher trajectory of CZK IRS. CZK interest rate swaps: yield curve flattening set to continue Our new views on CNB monetary policy imply a higher trajectory for CZK interest rate swaps. In our new forecast we expect the 10y IRS to reach 2.20% by year-end. This stems from strong fundamentals (inflation significantly above 2% and solid inflation expectations) and rising EUR swaps (SG forecasts 10y EUR IRS at 1.25% towards end-2018). Also, the shorter end of yield curve looks set to rise on the back of further policy tightening from the CNB. CZK IRS outlook (%) 3Q18f 4Q18f 1Q19f 2Q19f 3Q19f 2y 1,80 2,00 2,25 2,40 2,55 5y 2,00 2,20 2,40 2,50 2,60 10y 2,05 2,20 2,40 2,50 2,60 Source: Economic & Strategy Research, Komerční banka We expect the short and long ends of the curve to move in parallel through year-end, but we expect the curve to flatten next year. We assume a recession in the US to first affect the long end of the Czech government bond yield curve, while the short end should remain anchored by rising, and then stable, CNB rates. 31 July

31 Banking Sector David Kocourek (420) Interest rates on rise From October, stricter CNB mortgage recommendations will come into force. All mortgage applicants will need to have a loan-to-value (LTV) ratio of less than 90%, a debt-to-income ratio of less than 9, and a debt-service-to-income ratio of less than 45%. This follows the introduction last year for mortgages with LTV between 80% and 90%. Published estimates 2 show that one-third of applicants will not qualify for mortgages under the new rules. This estimate has become our new baseline for household real estate loans. We forecast a qoq decline in real estate loans in 4Q, followed by milder qoq growth next year. However, we see decline in tthe last quarter being offset by the frontloading of applications in 3Q this year. Household loan activity is being stimulated by low interest rates, rising wages across economic sectors and, most importantly, positive economic expectations. These factors are expected to fade next year, which in turn will slow the household loan market. This year and next, we expect corporate lending to see similar dynamics as last year. It is being supported by investment loans, which will likely remain the growth driver in the next year despite the slowdown in investment activity. Bank loans and deposits (% yoy) 2Q18 3Q18 4Q18 1Q19 2Q19 3Q19 4Q19 1Q Bank loans Total Households - real estate loans Households - consumer loans Corporate loans Deposits Total Households Non-financial corporations Others Ratios Loans/GDP Deposits/GDP Loans/deposits Interest rates Real estate loans Consumer loans Corporate loans Share of NPL Real estate loans Consumer loans Corporate loans Source: CNB, CZSO, Macrobond, Economic & Strategy Research, Komerční banka Interest rates for commercial loans will be affected by the expected monetary policy tightening described elsewhere in this report. Increases in rates for real estate loans are set to be limited 2 Česká spořitelna published this estimate which was confirmed by other banks, see e.g July

32 by sluggish demand due to the new regulations and tough competition in the market. Similarly, weak demand for loans mainly in the industrial sector will likely limit the increase in rates here. The rise in rates for consumer loans will reflect, among other things, the increasing level of risk attached to such loans over the forecast horizon. 31 July

33 Key Economic Indicators Macroeconomic indicators long-term outlook GDP real, % Inflation average, % Current account % of GDP M PRIBOR average, % EUR/CZK average USD/CZK average Source: CZSO, CNB, Macrobond, Economic & Strategy Research, Komerční banka, SG Economic Research Note: KB forecasts are in blue FX & interest-rate outlook 30-Jul-2018 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 EUR/CZK end of period USD/EUR end of period CZK/USD end of period M PRIBOR end of period Y IRS end of period Source: CZSO, CNB, Macrobond, Economic & Strategy Research, Komerční banka, SG Economic Research Note: KB forecasts are in blue Monthly macroeconomic data Inflation (CPI) %, mom Inflation (CPI) %, yoy Producer prices (PPI) %, mom Producer prices (PPI) %, yoy Unemployment rate % (MLSA) Industrial sales %, yoy, c.p n.a. Industrial production %, yoy, c.p n.a. Construction output %, yoy, c.p n.a. Retail sales %, yoy, c.p n.a. External trade CZK bn (national met.) n.a. Current account CZK bn n.a. Financial account CZK bn n.a. M2 growth %, yoy n.a. State budget CZK bn (YTD cum.) PRIBOR 3M %, average EUR/CZK average USD/CZK average Source: CZSO, CNB, MF, MLSA, Macrobond, Economic & Strategy Research, Komerční banka 31 July

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