Do not let the CNB surprise you again. The koruna is weaker than it should be
FX intervention surprised many people, though the CNB voted on it repeatedly in 2013. Now, the CNB is repeating the koruna cap will remain for some time but is temporary. FX market offers good opportunities to hedge euro revenues in 2015-2016 at rate above 27 EUR/CZK in order not to be surprised again when CNB abolishes the FX cap. Fixed FX has three important disadvantages against floating - it creates macroeconomic disbalances, the post-crisis adjustment is slower and fixed FX is costly.
The euro-koruna is trading in the range of 27.30-27.70 more than four months, after it was kicked there by the large FX intervention. We offer hedging strategies KIKO for exporters and Bonus KIKO for importers for the time of range-bound EUR/CZK, i.e. the rest of 2014. What about next year, will the CNB keep the euro-koruna bounded forever? Even after the CNB’s reasons for interventions, i.e. recession and the threat of deflation, are gone? It is not good to bet on this. The CNB says to keep the FX rate above 27 till at least early-2015 but not forever.
Many people were surprised and upset by FX intervention, though the CNB Board voted on it several times during 2013. Regardless you agree or disagree with the CNB’s policy, it would be pitiful to experience another ugly surprise and the second round of losses when the CNB cuts-off the FX anchor. Nowadays, the markets offer opportunities to lock-into forward FX rates well above 27 for 2015-16 and relatively inexpensive hedging using FX options. It will be very tough call to guess when exactly the CNB Board votes the end of interventions. It is better to be ready and hedged in advance than to be wise behind.
The CNB has not fixed the euro-koruna forever because of multiple experience from other countries that artificially stable FX rate has temporarily advantages but also 3 big disadvantages in the long-term:
i) It creates more often macro-economic imbalances and consequent crises;
ii) Macroeconomic adjustment after crises is slower;
iii) Keeping the FX rates stable is expensive.
ARTIFICIALLY STABLE FX RATES CREATE IMBALANCES AND CRISES
FX rates are not moving without reasons but reflect multiple flows from foreign trade to transfers and investments. Search for balanced FX rate by the markets is neverending process. When to process is switchedoff, by FX interventions and euro-adoption, the drivers of the move do not switch-off. The pressures, not compensated by FX moves, create macroeconomic imbalances. Once imbalances create a crisis, long-cumulated advantages of fixed FX rate are gone quickly in both cases that FX anchor survives or breaksdown.
PAINFUL ADJUSTMENT AFTER CRISES
When the FX fix breaks down after a long time, it is financial earthquake. The Czech Republic had such an ugly experience in 1997. When FX fix survives despite the crisis, ‘Chinese water torture’ follows. Nowadays, this is seen in the Eurozone – the largest set of fixed exchange rates – has helped to create large macroeconomic imbalances inside the zone. Despite the crisis, fixed FX survived. Fortunately, there was no financial earthquake, which would come in the case of the Eurozone break-up. Yet, the Chinese water torture is painful.
Peripheral European countries had to go through long and deep economic downturn and catastrophic increase in unemployment to get their price competitiveness in line with the non-price competitiveness. External imbalances of Peripheral Europe are disappeared even without floating FX rates but the process lasts painfully long. If the Czech Republic needs to go through internal devaluation, the economic performance would be even bleaker than it has been since 2008.
ARTIFICIALLY STABLE FX IS EXPENSIVE
It is expensive to keep FX rate stable and it is not only about the volume of FX intervention and the impact on CNB’s bottom line or about how much a particular country has to send into the European Stability Mechanism. It is also about reaction of people to real or expected costs of keeping FX rate stable. One example is from Germany. European economy would perform better if Germans spend more and their wages grow faster, it is a common opinion. The European Commission has recently issued a report with warning to Germany that its weak domestic demand is not only a problem for imbalanced Europe but low investments can be a big problem for German competitiveness in the long-term. Why Germans do not spend and invest more? One reason is their rationality regarding to the euro.
Imagine your kids or relatives take frequently large debts. Once they have problems to service the debts they come to you and ask for help. Would you help them? Maybe yes. Maybe no. But having this in mind, would you buy a new fancy car or chalet in the mountains or would you save more to potentially cover their debt problems? In the discussion on euro-crisis almost everybody internally assumes that Germany is a creditor of the last resort in the euro project. Everybody, including Germans. Remember that when ECB Chief Draghi camen up with OTM program in summer 2012, it was against opinion of German Bundes Bank and many suits at German Constitutional Court.