The Koruna and the Euro

Two interesting pieces in Bloomberg this morning, both about central bank Governor Zdenek Tuma. First there is this:

The Czech koruna's climb to a record against the euro is ``unsustainable,'' though monetary policy makers must take the currency gains into consideration when setting interest rates, central bank Governor Zdenek Tuma said.

``In the open economy of the Czech Republic, the exchange rate is important and the pass-through on inflation is relatively strong,'' Tuma said in an interview in Cape Town yesterday. ``I always warn against panic regarding exchange-rate developments, but nevertheless this is very strong appreciation'' and ``we cannot ignore it.''

The koruna is the world's best-performing currency against the euro in the past month and has risen 2.6 percent in the period. The currency's surge has prompted policy makers to put off a fourth rate increase this year even after economic growth helped push inflation in October to the highest since 2001.

The koruna was at 26.65 against the euro as of 9:33 a.m. in Prague, unchanged from Nov. 16. It reached a record 26.50 per euro on Nov. 12 and climbed to an all-time high of 18.08 against the dollar on Nov. 15. The koruna has gained 14.4 percent against the dollar this year, helping to counter the effect of record oil prices.

`Unsustainable'

``By definition this pace of appreciation is unsustainable,'' Tuma said on the sidelines of a meeting of central bankers from around the world. ``That is clear.''

The Czech 3.25 percent benchmark rate is the lowest in the European Union. Tuma said the currency's gain was one of the factors that prompted the central bank's seven-member board to keep the rate unchanged at its last meeting on Oct. 25.

The koruna's exchange rate will ``stabilize,'' Tuma said. ``The only question is whether we can expect moderate correction and some stability or just that stability at new levels.''

The central bank predicts a temporary surge in the inflation rate to as high as 5.1 percent in 2008 on one-time increases in indirect taxes and utility costs, surpassing its 3 percent target plus or minus a percentage point. It expects consumer-price growth to slow again in the next 12 months, Tuma said.

and then there is this:


Czech central bank Governor Zdenek Tuma said the country can ``afford'' to keep the koruna even if neighboring countries switch to the euro.

``The Czech economy has been growing between 5 percent and 6 percent in the past few years, this is not a failure,'' Tuma said in an interview in Cape Town yesterday. ``Because of that, I can imagine we can afford to stay outside the euro. I don't think in 1990 we expected people would trust the Czech koruna this much.''

The Czechs last year dropped a plan to adopt the euro in 2010. The country, which is committed under European Union rules to give up the koruna, has yet to set a new date. Slovenia so far is the only one of the eight former communist countries that joined the EU in 2004 to become a member of the euro region.

The Czech government of Mirek Topolanek has introduced tax changes and welfare spending cuts aimed at cutting the budget deficit below 3 percent of gross domestic product starting in 2008, and has pledged to overhaul pension and health-care programs by 2010.

`Economic Shocks'

``The decision in our case is not only to push through important reforms but also to have sufficient maneuvering room for economic shocks,'' the 47-year-old Tuma said.

To apply for the euro, countries must meet thresholds for the budget deficit, debt, inflation and long-term interest rates, and enter the exchange-rate mechanism, a minimum two-year test of currency stability.

``I wouldn't like to enter'' the exchange-rate mechanism, ``a system I don't like, then to fail to'' meet ``one of the criteria and then be trapped in the terms of'' the mechanism,'' Tuma said.

By delaying the euro, the Czechs are hoping to avoid the experience of Lithuania, whose euro bid was rejected last year because inflation was too fast. Slovakia wants to switch currencies in 2009.

Tuma said the country will eventually become a member of the 13-member euro region.

``Nobody is saying we're going to postpone it forever,'' he said. ``This is the dilemma: the more successful the country is, the less important the euro is. We are committed to the euro because it's a part of the treaty and we voted for the EU, including the euro. It's just a question of timing.''

Tuma declined to give a date by which the Czech Republic may be expected to adopt the common European currency, stressing the decision would be a ``political'' one.

Premier Topolanek said on state-run public television yesterday that adopting Europe's single currency in 2012 is ``not realistic'' because the country would have to fulfill all adoption criteria as of 2008, which is not possible without an overhaul of the pension and health-care systems.

Czech central banker Mojmir Hampl told Hospodarske Noviny newspaper today that the economy is not ready to switch currencies, and that fast adoption of the euro would increase inflation.

Employment and Unemployment in the Czech Republic September 2007

The Czech jobless rate fell to what for the Czech Republic in recent times was the unprecedently low level of 6.2% in September (or around 5% if we use the ILO rather than the Czech MLSA methodology). This was the lowest recorded level for the Czech Republic since the new data series was introduced in January 2004, and was the result of the rapid rate of job creation which has accompanied the third consecutive year of substantial economic growth. But the rapid rate of economic growth and job creation which has been taking place in the Czech Republic is at the same time starting to give rise to fears about ensuing labour shortages and a concern that these may lead to the sort of wage-increase driven inflation we are currently seeing in some other parts of the EU10. Indeed Czech Central Bank Governor Zdenek Tuma recently explicitly warned that a shortage of available labor may fuel wage growth, and that this in turn would fuel inflation.

In an attempt to maintain inflation under some sort of control the central bank has already raised interest rates three times so far this year, and only really decided to leave it's two-week repo rate unchanged at 3.25% at the October meeting because it took the view that the administrative fiscal-tightening measures the Czech government has now started to introduce following the fiscal expansionary measures of 2006 - and which will themselves not be bereft of some inflationary consequences, since they involve raising taxes and untility prices - were likely to have an overall restraining effect on demand such that it would be both unnecessary and undesireable to further tighten monetary policy at this point in time. This, and of course the increased external risk which follows from the financial market turmoil of last August.





Despite this consideration, several members of the monetary policy committe did voice their concerns that while demand side inflationary pressures seemed reasonably benign, labor market tightening may become a major factor in the Czech situation, and the non-inflationary effect of real wage increases that the comittee in fact took was conditional on fairly optimistic assumptions regarding labour productivity growth. All-in-all there was an expectation that inflation maywell be driven up towards the upper end of the 4 percent target range sometime early next year.

"The tension on the labor market is relatively significant....pressures on wage growth can be expected...If inflation is low, relatively significant pressures on the labor market can be expected."
Zdenek Tuma, Governor of the Czech National Bank speaking in Prague last month

Increases in regulated prices have pushed headline inflation closer to the 3 percent target in 2006, but the underlying inflationary pressures have remained subdued. Lingering slack in the labor market and inflows of migrant workers kept wage inflation moderate, which, coupled with strong productivity gains, helped contain labor costs. There are no apparent signs of the second-round effects from increases in energy and other regulated prices, which, together with well anchored expectations, underscores the strong credibility of the Czech National Bank (CNB).
IMF, Executive Board Concludes 2006 Article IV Consultation with the Czech Republic, February 28 2007

Czech GDP growth - which has hovered around the 6% mark - has certainly been strong, but not excessively so, in recent years, and the problems which currently exist in the Czech republic are certainly a far cry from the overheating issues which are arising elsewhere in the EU10, and in particular in the Baltics and Bulgaria.



The Czech economy grew at exactly an annual 6 % rate in Q2/07, with this growth being principally pulled by increases in domestic demand. Household demand is estimated to be likely to grow at around 6% this year, and investment at around 19%, while government demand is only forcast to grow at around a 1% annual rate. According to central bank estimates GDP is currently growing at roughly 1 % above its noninflationary potential, while overall monetary conditions remain broadly neutral. What all this means is that the Czech economy is now moving into tricky territory, with what is known as the output gap - which is really a rule of thumb measure of how fast an economy can grow without producing inflation, since the "gap" in question is a general measure of spare capacity - having turned negative around the end of 2005, as can be seen in the chart below which was prepared by a staff economist at the Czech National Bank. So basically the Czech economy is now dependent on flows of funds, and in particular on FDI (to pay for the current account deficit) and on inward migration of workers to meet all the labour supply needs.




Nominal wage growth has accelerated up towards 8 % mark in recent months while nominal uniit labour costs are now growing at around 3 %. This - if you like - is the "productivity gap". What it means is that real wages are no longer in "anti-inflationary" mode, since the ongoing decline in unemployment (which is now evidently below the level which any reasonable estimate of NAIRU ought to give us) means that supply side pressures emmanating from the real economy have become pro-inflationary.






I have commented separately on the fiscal situation in this note, but it is evident that structural reforms in government spending are essential if Czech finances are to achieve longer term sustainability. Even making full allowance for the impact of the new fiscal reform introduced this year, the government deficit is likely to be around 2.5 % of GDP in 2008, which is a strange posture to find in an economy running a negative output gap, ie in an economy which is already expanding at a rate which on many estimates would seem to be above its real capacity. However, it should be stressed that such measures of capacity are only that, estimates. Given the ease and facility of capital and migrant labour flows in todays global economy, a judicious leveraging of such a position can allow an economy to grow at well beyond what might seem to be the normal capacity rate. But this possibility is conditional on simply this, a judicious leveraging of the available resources.

One part of the current fiscal adjustment measures are, however, only temporary in nature, since further tax cuts are already envisioned for 2009. So without further measures, the government deficit will start to increase again in 2009. The previous government record here does not inspire excessive confidence, since fiscal gains which were achieved in 2005 were then relinquished in 2006, when fiscal policy turned expansionary, with the general government deficit having risen to something like 3.75 percent of GDP, reflecting pre-election tax cuts and increases in social transfers for pensions and health care. A large social spending package in the budget for 2007 is expected to raise mandatory spending in the coming years.

The procyclical fiscal stimulus which was implemented in 2006, at a time when the economy was set to register another year of robust growth, was untimely to say the least. In particular, the decision to increase mandatory social spending in the 2007 budget worsened the longer term fiscal position, and an opportunity was lost to consolidate fiscal gains in what were effectively the good times. The authorities have declared, however, an intention to achieve an annual reduction in the structural deficit by 0.25 percent of GDP per annum in their forthcoming Convergence Program.

Nevertheless, weaknesses have emerged in the process of implementing the medium term budgetary framework. The upward revision of the spending limits in the medium term budget during the 2006 and 2007 budget process and the abandonment of the 2005 Convergence Program targets suggests that the fiscal framework needs to be strengthened to increase fiscal discipline in good times. Given the current environment of political uncertainty, the fiscal framework takes on added importance as a disciplining device.
IMF Selected Issues, February, 2007

Certainly the current rate of growth in the Czech Republic - as elsewhere in the EU10 - is creating jobs and reducing unemployment at an unprecedented rate. In Q3 2007, total employment in the Czech Republic grew by 102,800 year-on-year and reached the highest level of employment achieved at any time over the last ten years, according to data from the Czech Statistics Office released at the end of last week. The number of employees rose by 87.3 thousand, and the number of self-employed by 17.5 thousand. The number of unemployed according to ILO methodology was down by 98.3 thousand year-on-year, the number of long-term unemployed dropped by 62.3 thousand. The general unemployment rate fell by 1.9 percentage points to the lowest level since the end of 1997 (5.2%).

The employment rate (the proportion of first (main) jobholders in the number of persons aged 15-64) reached 66.3% and was 0.9 percentage points up year-on-year. The male employment rate grew by 1.3 percentage points to 75.2%, while the employment rate of women grew by 0.5 points to 57.3%.




The seasonally adjusted average number of employed persons increased by 25.5 thousand (+0.5%) quarter-on-quarter.



The average number of unemployed according to the ILO methodology decreased by 17,900 quarter-on-quarter (seasonally adjusted). The number of unemployed fell to only 266,700 (of which 146.900 were women), and this is the lowest level of unemployed which has been registered since the end of 1997. In comparison with Q3 2006, the total number of unemployed decreased by 98,300 and has dropped by more than a quarter year-on-year (26.9%). Generally, unemployment dropped faster among persons in the young and middle productive age. Unemployment dropped more among the female population (by 53,600), especially in the five-year age group 20-24 (by 13,700). The total number of unemployed men fell by 44,700 year-on-year, most of this in the 20-24 age group (by 14,100). A majority of the unemployed (71.1%) are persons either with secondary education without GCSE (the leaving certificate) or with only basic education.







According to the Labour Force Survey results, the general unemployment rate according to the ILO methodology (derived for the 15-64 age group) reached a ten-year minimum of 5.2% in Q3 2007. Compared to Q3 2006 it decreased by 1.9 percentage points.

The different methodology use in the Labour Force Survey is what gives rise to the difference between the general unemployment rate using ILO criteria and the registered unemployment rate by provided by the Ministry of Labour and Social Affairs of the CR (MLSA CR), but it is important to note that the development trend is the same whichever rate you use. The registered unemployment rate by the MLSA CR reached 6.3% in Q3 2007 and decreased by 1.6 percentage points year-on-year.






The regional unemployment rate ranged from 2.3% in the Hl.m.Praha Region and 3.2% in the Jihočeský region to 7.9% in the Karlovarský Region and 9.0% in the Ústecký Region. The drop of unemployment showed itself in all of the regions of the CR, with the greatest declines being registered in areas with high or above average unemployment rates i.e. in the Moravskolslezský, Karlovarský and Ústecký Regions.


Much lower unemploy­ment rates are being recorded for university graduates (2.1%) and persons having full secondary education with GCSE (3.1%). A high unemployment rate continues to be observed among persons with basic education (18.8%) and an above-the-average unemployment rate (5.6%) is still in the large group of persons with secondary education without GCSE including those with vocational education.

Czech inflation accelerated to the fastest in 13 months in September, closing in on the central bank's target and suggesting interest rates may rise again as early as this month. Consumer prices rose an annual 2.8 percent, up from a 2.4 percent in August, according to the Czech statistics office.



Obviously a number of factors are at work in the way the Czech economy is assimilating this drop in numbers of unemployed without stoking inflation, but could one of the important details which "mark the difference" between the Czech Republic and some of its neighbours could be the fact that the Czech Republic far from losing workers on a net-basis through out-migration, has actually been acting as a magnet which attracts inward migrants in significant numbers.

The number of foreigners legally working in the Czech Republic grew by 38,000 at the end of September 2007 in comparison with December 2006, with the total rising to 223,000, and most of the newcomers arriving from either Slovakia (100,000), Ukraine (57,000) or Poland (22,000), according to statistics issued by the Labour and Social Affairs Ministry. Tens of thousands of non-Czech nationals also work in the country illegally, according to numerous estimates.

Lingering slack in the labor market has helped contain wage inflation. Despite strengthening demand for labor, suggested by rising vacancies, wage pressures have remained subdued, as rising inflows of immigrant workers have helped offset the impact of population aging on labor supply. Recent employment gains have been concentrated in industry and private services, including real estate, and do not yet appear broad-based. Unemployment has fallen, but remains around 7 percent, as continued geographical and skill mismatches have kept structural unemployment high.
IMF Selected Issues, February, 2007

Many Czech companies would be unable to operate without the foreign labour force according to HVB Bank analyst Pavel Sobisek. The share of foreign workers in the total labour force already exceeds four percent. The share of value added created by them is around 3 percent, according to Sobisek, while in some sectors, like construction and retail, the share is much higher.




So while some Czechs have left their country to work elsewhere since the turn of the century, the Czech Republic has been more than able to compensate for this by attracting workers from elsewhere. Obviously all of this is not completely problem free, in that wage pressures are nonetheless building up. But the situation is certainly strikingly better than in many other EU 10 countries. So, is there a lesson here for anyone?

Czech September 2007 Trade Surplus

The Czech Republic posted its first trade surplus in three months in September as import growth slowed and exporters stepped up sales after production was reduced during the holiday period.

According to preliminary data from the Czech Statistics Office for September 2007, exports and imports at current prices grew by 11.0% and 7.6% year-on-year respectively. The trade balance achieved a surplus of CZK 14.4 billion, which was an improvement of CZK 7.0 billion year-on-year. This figure was fuelled by a CZK 5.8 billion increase in the trade surplus in machinery and transport equipment and by a CZK 1.9 billion decrease in the trade deficit in mineral fuels, lubricants and related materials.

The surplus was 14.4 billion koruna ($771 million), which compared with a deficit of 600 million koruna in Augustr and a 7.4 billion-koruna surplus a year earlier.




Exports grew at the slowest pace since August 2006, and imports at the slowest pace since April 2006. These figures are influenced by the high base figure of September 2006 when the third highest level for 2006 was recorded. Due to appreciation of the koruna against the euro and in particular against the US dollar, external trade grew faster in euros (exports +14.3%, imports +10.8%) and in US dollars (exports +24.6%, imports +20.8%) than in korunas.



In terms of destination and origin countries, the trade surplus with EU27 states rose by CZK 66.9 billion and trade deficit with non-EU27 states increased by CZK 28.2 billion. The surplus with Slovakia increased (by CZK 22.1 billion), as it did with Germany (by CZK 13.7 billion), the United Kingdom (by CZK 11.3 billion), Poland (by CZK 7.7 billion) and France (by CZK 7.4 billion).

The deficit in trade with the Russian Federation decreased (by CZK 27.0 billion), and the trade balance with Norway improved (by CZK 9.6 billion) turning the deficit into a surplus. The trade deficit with China increased (by CZK 49.5 billion), as it did with the Netherlands (by CZK 10.4 billion), Japan (by CZK 7.1 billion) and Ireland (by CZK 4.6 billion).

The trade balance reached a surplus of CZK 14.4 billion, which was an improvement of CZK 7.0 billion when compared with September 2006. This is the highest September surplus in the history of the Czech Republic and the second highest surplus during 2007.

Czech export-oriented plants often boost production in September following shutdowns during the holiday period and before Christmas imports. The impact of surging oil prices has also been reduced by the koruna's gain against the dollar, thus keeping open the possibility that the full-year surplus will beat the record 43 billion koruna from last year.

Czech Producer Price Index September 2007

In September 2007, according to data from the Czech Statistical Office, and as compared with August 2007, prices of agricultural and industrial producers, construction work and market services grew by 4.3%, 0.1%, 0.5% and 0.9%, respectively.

In comparison to September 2006, prices of agricultural and industrial producers, construction work and market services were higher by 18.1%, 4.0%, 3.8% and 1.6%, respectively.

Agricultural producer prices grew by 4.3% in total. Prices of crop products grew by 5.9%, higher were prices of fruit (+25.1%), cereals (+10.5%) and oil seeds (+9.0%). Prices of potatoes and vegetables fell by 24.6% and 3.3%, respectively. Prices of animal products increased by 2.6% due to higher prices of eggs (+14.7%), poultry (+3.8%), milk (+2.8%) and pigs for slaughter (+1.2%).

Prices of industrial producers increased by 0.1% in September 2007 (-0.1% in August). The most significant increase of prices was recorded in ‘coke, refined petroleum products’ up 2.9% (-3.8% in August). The prices of ‘food products, beverages and tobacco’ were up by 0.7% (+1.2% in August). Prices went down in ‘chemicals, chemical products and man-made fibres’ by 1.0% and in ‘basic metals, fabricated metal products’ by 0.4%.

Construction work prices grew by 0.5%, construction material input prices fell by 0.6%.

Prices of market services in the business sphere grew by 0.9% due to 1.6% price increase in ‘real estate, renting and business services’ (prices of advertising services were up by 11.1%).

The prices charged by industrial producers were up by 4.0% in September 2007 (+3.7% in August). This increase was particularly influenced by higher prices for ‘electrical energy, gas, steam and water” (+7.5%). In addition, the price level for ‘basic metals, fabricated metal products’ was up significantly - by 5.7% (+6.9% in August). Prices for ‘food products, beverages and tobacco’ went up by 4.4% (+4.0% in August). Construction work prices were higher by 3.8% (+3.6% in August), construction material input prices grew by 5.3% (+5.9% in August)

Prices of market services in the business sphere were higher by 1.6% in total (+1.0% in August). Prices of ‘real estate, renting and business services’ (higher prices of advertising services by 6.0%) and ‘freight transport and storage services’ grew by 2.5% and 3.3%, respectively.

Obviously the increase in industrial producer prices is to some extent conditioed by energy prices, but the steady upward movement since the start of the year is unmistakeable.

Retail Sales August 2007

In August, according to data from the Czech Statistical Office, seasonally adjusted sales in ‘retail trade except of motor vehicles and motorcycles’ increased by 0.3% month-on-month at constant prices. The year-on-year increase was 7.2%, not seasonally adjusted sales 6.9%. The growth of sales of food, beverages and tobacco accelerated to 5.4%, non-food goods on the contrary recorded this year’s lowest increase of 7.9%. Seasonally adjusted sales in hotels and restaurants increased by 0.7% month-on-month in August, not seasonally adjusted sales increased by 1.8% year-on-year.





Seasonally adjusted sales in retail trade (CZ-NACE 52) increased by 0.3% month-on-month at constant prices in August, of which non-food goods by 0.5% while prices of food, beverages and tobacco stagnated. The growth of the trend component by 0.5% followed up on the trend from the previous four months and was 0.1 p.p. lower compared to the average of the last 12 months.


Year-on-year, after seasonal and working day adjustments (August 2007 and 2006 had the same number of working days), sales in retail trade increased by 7.2% at constant prices. Not seasonally adjusted sales grew by 6.9% which was the third lowest growth from the beginning of the year owing most to the sale of non-food goods that this year recorded the smallest increase (7.9%) in August. Conversely, food, beverages and tobacco recorded the second highest growth (5.4%).

Almost 30% contribution to the total growth had non-specialised stores with food, beverages and tobacco predominating and a 23% contribution had specialised stores with other non-food goods. The fastest sale growth occurred in, in terms of share little significant, retail sale via Internet or mail order houses (16.6%). A two digit growth was recorded also in stores with textiles, clothing and footwear and right below 10% ranged the year-on-year sale growth in stores with pharmaceutical and medical goods, cosmetic and toilet articles. (Table 3)

Broken down by size group of enterprises, the biggest growth of sales occurred in enterprises with 50 to 99 employees (+11.1%). Enterprises with 100+ employees reported a growth by 7.9%, with 0 to 19 employees by 5.9% and with 20 to 49 employees by 5.0%.