FX Strategy Prepare for removal of the EUR/CZK floor

Investment Research General Market Conditions 24 October 2016 FX Strategy Prepare for removal of the EUR/CZK floor The Czech National Bank (CNB) plans to exit its exchange rate floor to the euro in the second half of 2017, due to increasing inflationary pressures in the economy. Following an initial undershooting in EUR/CZK, we do not expect a sustained largescale appreciation of the CZK, as we do not expect the CNB to allow such a move after the exit. Chart 1: Czech Republic has avoided deflationary pressures Our EUR/CZK forecast is 27.0 in 1-6M and 25.5 in 12M (previously 27.1). We recommend EUR-based corporates hedge CZK payables via FX forwards and CZK receivables via risk reversal. CNB signals abandoning of EUR/CZK floor In November 2013, the CNB introduced a floor of 27 CZK to the EUR in order to avoid an appreciating currency aggravating disinflationary pressures in the economy. The decision to use the exchange rate as an additional inflation targeting instrument was taken as the normal monetary tools were increasingly seen as constrained by the zero lower bound. Since the introduction of the floor, the CNB has allowed the crown to fluctuate above the floor but has intervened by selling CZK and buying foreign currency whenever the currency strengthened relative to the EUR. The regular interventions by the central bank in the foreign exchange market have doubled FX reserve holdings to EUR73.4bn since its adoption. Nevertheless, the policy has helped the economy avoid deflationary pressures of the same magnitude as seen in the euro area (see Chart 1). However, recent communications by Czech policymakers suggest that the CNB plans to exit its exchange rate commitment in the second half of 2017. The exit is made conditional on inflation robustly reaching the target of 2%. We see several reasons why inflation should pick up in the future. Chart 2: Tighter labour market should reinforce inflation pressures Chart 3: Current and financial accounts in record surpluses The Czech economy has registered relatively strong real GDP growth relative to its main trading partners over the past three years. The robust growth performance, driven mainly by resilient household demand, has facilitated a significant fall in the unemployment rate, which now lies well below the NAIRU and indicates that the economy is operating close to or above potential. Tighter labour market conditions, pay rises and fiscal stimulus should therefore increase inflation pressures in the future, which is already indicated in the recent uptick in wage growth (see Chart 2). The strong performance of the Czech economy has not only caused wage growth to increase but also attracted large inflows of capital into the country. Bolstered by an undervalued CZK, the current account is now recording sizeable surpluses (see Chart 3). In order to prevent a breach of the floor, the central bank has undertaken FX intervention, which in turn has given rise to an acceleration of money growth, which should support inflation (see Chart 4). First Year Analyst Aila Mihr +45 45 13 78 67 amih@danskebank.dk Chief Analyst Jakob Ekholdt Christensen + 45 45 12 85 30 jakc@danskebank.dk Senior Analyst Morten Helt + 45 45 12 85 18 mohel@danskebank.dk Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com

Probable timing of the exit The CNB s exit strategy from the EUR/CZK floor is on one hand driven by its desire to keep some uncertainty in the market about the exact exit date but on the other also prepares markets in good time for the floor lifting to avoid a surprise exit as in Switzerland. In line with this, the CNB s communication on the expected time frame for the exit has been vague, stating both that the exit will not happen before Q2 17 and that it will happen in H2 17. This makes sense from the central bank s point of view, as an abrupt and unadvertised lifting of the floor would be the more favourable strategy. A very clear and firm exit date would prompt large speculative inflows and thereby make the exit more costly for the central bank in the longrun, as it accumulates more reserves to defend the floor. A similar dynamic can already be observed in the markets, as the CNB has had to step up interventions since July 2015, when the first speculation on the floor lifting began circulating (see Chart 5). FX reserves also increased markedly in September, up by EUR2.80bn to EUR73.39bn, indicating that the central bank had to step up intervention to defend the floor when markets started speculating on earlier exit plans after CNB governor Jiří Rusnok s comments about the possibility of a floor lifting with inflation even slightly below 2%. However, the CNB has repeatedly stressed that it wants to avoid a surprise exit as in Switzerland and that it does not aim to surprise the market with an earlier-than-expected floor lifting. At its latest policy meeting on 29 August, CNB policymakers reiterated their hard commitment that the EUR/CZK floor will not be abandoned before Q2 17 and that a sustainable fulfilment of the 2% inflation target is a precondition for the lifting of the floor and the return to conventional monetary policy. In our view, the central bank will not be too concerned about foreign reserve accumulation, given that the CNB s foreign reserves currently amount to a mere 43% of GDP. This is well below the level at which the SNB lifted the floor to avoid the risk of negative capital (see Chart 6). The CNB has said that it will try to limit the growth of its balance sheet but this would be strictly secondary to the aims of monetary policy. Chart 4: Accelerating money growth Chart 5: CNB FX interventions have increased Chart 7: CNB foreign reserves still modest relative to Switzerland Chart 6: Inflation projections The current hard commitment of the CNB retains the possibility of an exit as early as the beginning of Q2 17. However, we think the CNB will exit from its exchange rate commitment only in the second of half of 2017, when actual inflation is more likely to have converged to the 2% target. We also think an abrupt move before Q2 17 would hurt CNB credibility. Furthermore, even with the positive impulse from accelerating wage and money growth, inflation is expected to pick up only gradually due to continuing disinflationary pressures from import prices and reach the central bank s target in Q3 17 (see Chart 7). 2 24 October 2016 www.danskeresearch.com

Current inflation still stands well below the 2% target level and has actually decreased from 0.6% in August to 0.5% in September. If anything, the risk is that the central bank might move its exit date further out into the future towards the end of 2017, if domestic inflation should remain subdued and continue to disappoint on the downside. However, the closer we move towards the actual exit event, the less forward guidance or communication we are likely to get from the side of the CNB about the planned floor lifting in order to suppress market speculation. Therefore, it is important to watch Czech inflation developments. CZK expected to appreciate moderately after exit The big question is what level the CZK would move to once the floor is removed. Certainly, forward markets have started to price in a significant move over the past few months, although prices have stabilised since Rusnok reiterated during the monetary policy meeting on 29 August that there is no scenario of an early exit in Q1 17. Twelve-month forwards currently trade at 26.6 (see Chart 8). What is the fundamental value of the CZK? A simple method to estimate the fundamental value of the currency is to look at the real effective exchange rate (REER), which is the weighted average of a currency against its main trading partners, adjusted for inflation. The CZK s current REER is 14.6 percentage points below its long-run trend, pointing to a substantial appreciation of the exchange rate once the floor is lifted (see Chart 9). The significant undervaluation of the CZK according to our estimate is supported by the record-high current account surpluses. However, should domestic inflation pick up to 2%, the higher inflation differential between the Czech economy and its main trading partners in the euro area should further limit the CZK rise following the exit. This is also in line with the IMF s fair value estimate from a recent study, which finds an undervaluation of 10% when using a REER methodology. However, it puts more weight on a current account methodology, which points to a more moderate CZK undervaluation of 4%. We think that the fair value is somewhere in between, i.e. around 6-8% below the current spot, implying a fair value of the CZK between 24.8 and 25.5. What will happen to the CZK after the floor is lifted? Both the positioning of the market as well as the timing of the exit from the exchange rate floor will be decisive for the magnitude of the EUR/CZK move. The CNB has stressed that it will not allow a sharp appreciation of the CZK once the floor is removed and intervene to stabilise large exchange rate swings even after exiting the floor, although it will not reveal any intervention levels. Hence, although the CNB has stated that its preferred exit from the floor would be in a one-off move, it may only allow a more gradual exit with more than one step. Furthermore, the option market is currently already pointing towards a stronger CZK after the floor lifting (see Chart 10). This anticipation might lead to a more muted reaction in the exchange rate after the event. However, we might still see a large market reaction only in the short run after the exit event, with EUR/CZK falling below 25. Chart 8: EUR/CZK spot and forward rates Chart 9: Moderate CZK undervaluation relative to the long-run trend Chart 10: Option market still biased for EUR/CZK downside Chart 11: Forecast overview 28.5 28.0 27.5 27.0 26.5 26.0 EUR/CZK DB forecast Forward Cons. forecast 25.5 Oct/14 Jun/15 Mar/16 Nov/16 Jul/17 1M 3M 6M 12M DB forecast 27.00 27.00 27.00 25.50 Forward 27.02 26.92 26.86 26.66 Cons. forecast 27.02 26.96 26.80 26.04 Source: Danske Bank 3 24 October 2016 www.danskeresearch.com

All in all, after an initial undershooting, we do not expect a sustained large-scale appreciation of the CZK similar to that experience by the Swiss franc once the floor to the EUR is lifted. We project EUR/CZK will trade higher, close to the fair value of 25.5, which would constitute an appreciation of 6% (we do not think the central bank would allow a bigger appreciation by say 8%, as this could put too much downward pressure on inflation). Hedging implications Hedge CZK payables via FX forwards We expect EUR/CZK to decline considerably once the CNB abandons the EUR/CZK floor in the second half of 2017. Therefore, we recommend EUR-based corporate clients hedge CZK payables to increase the hedge ratio and duration on CZK hedges via FX forwards. EUR/CZK forwards with longer dated maturities have already moved to the left and, in our view, are likely to fall further once the floor is removed. However, FX forwards up to the two-year tenor currently trade above the range of 24.80-25.50 at which we expect EUR/CZK to stabilise once the floor is abandoned and above our 12M forecast of 25.5. Hence, we see good value in locking CZK payables for the coming years via FX forwards. Hedge CZK receivables via risk reversal We recommend EUR-based corporates hedging CZK receivables maintain a relatively low hedge ratio. We recommend hedging CZK receivables via risk reversal, which benefits from the skewed option market, where EUR/CZK put options are expensive relative to similar EUR/CZK call options. Chart 12: FX forwards up to 2 year above 25.50 29.00 28.50 28.00 27.50 27.00 26.50 26.00 25.50 25.00 24.50 24.00 EUR/CZK Forward Expected range after floor: 24.80-25.50 Chart 13: Risk reversal attractive for EUR/CZK buyers 4 24 October 2016 www.danskeresearch.com

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