IMF Says Czech Borrowing Rates Need to Increase

The Czech Central Bank needs to raise borrowing rates due to the problem of accelerating inflation, the International Monetary Fund said in its an Article IV Consultation summary published on its Web site today.

Economic performance remained strong in 2007, supported by continued robust growth of domestic demand. The current account deficit widened, but remained largely financed by inflows of direct investment. With vulnerabilities limited, the economy weathered the international financial market turmoil with minimal spillover impact. The strong economy boosted job creation while unemployment declined and capacity utilization reached record high levels. In this environment, inflation pressures mounted on account of higher domestic demand amid tightening labor markets as well as food and regulated price increases. Monetary policy was tightened in the second half of the year, although policy rates remain among the lowest in the EU.

Inflation is expected to almost double to above 5 percent, owing to food, energy and indirect tax increases, as well as demand and wage pressures. Risks of higher inflation expectations feeding into wage and price-setting remain while a slower pace of koruna appreciation could also increase inflation pressures. Shaping expectations is thus critical, especially with the planned lowering of the inflation target to 2 percent by 2010.

Directors commended the authorities on their prudent monetary policy, and supported the recent policy tightening to counter rising inflation pressures. With inflation set to rise to well above the target of 3 percent, Directors stressed the importance of ensuring that expectations remain well anchored to the inflation target through further timely monetary policy action. The appropriate pace of monetary tightening will depend, inter alia, on the degree of koruna appreciation and second-round effects of indirect tax and energy and food price increases. The planned downward shift in the inflation target to 2 percent from 2010 underscores the importance of preserving the Czech National Bank's high credibility. In this context, Directors encouraged the authorities to build further on welcome recent steps to enhance the transparency of monetary policy communication.

Given the looming population ageing problems the summary also suggests that the Czech Republic should look for a ``sustainable'' budget policy while giving the pension system a "comprehensive" overhaul.

In view of the coming challenge of population aging, Directors reiterated the importance of early and comprehensive pension and health care reforms. Along with the welcome increase in the retirement age to 65 years, complementary reforms to raise the effective retirement age and promote reliance on private pensions will also be needed. Directors welcomed the introduction of co-payments in health care as a step that should help contain excess demand pressures.

Czech Retail Sales November 2007

Czech retail sales growth slowed to an annual growth rate of 4.7 percent in November as accelerating inflation erodes spending power, and the economy slows slightly. Sales compared with an annual expansion of 7.9% percent in October, the Czech Statistical Office said today.



Inflation in the Czech Republic, which rose to an annual 5 percent in November from only 1.3 percent in January 2007, appears to be discouraging discouraged people from spending as did an outlook for government expenditure cuts and higher indirect taxes which entered into effect this month. This slowdown in retail sales, and other areas of economic activity, may allow the central bank to adopt a more "wait and see" approach about whether or not to procede with more increases in its benchmark interest rate, now at 3.5 percent.



Retail sales, including cars and motor fuels, rose by 5.9 percent from a year earlier the statistics office said. Sales and maintenance of cars jumped 8.4 percent, helped by this year's changes that have made leasing terms less favorable.

Household spending has been the main engine of gross domestic product growth - which has remained at over 6 percent for the past 10 quarters and concerns about overheating had prompted the central bank to lift what had been the European Union's lowest interest rates four times last year.

Retail sales growth may well slow this year as social spending cuts, an increased value-added tax on food and apartments and a rise in the average inflation rate bite into people's purchasing power. Inflation may well rise in 2008 to between 5 percent and 6 percent, compared with 2.8 percent in 2007, according to many estimates. The Czech central bank continues to keep the possibility of a further rate increase on the table due to concerns that the current pickup in inflation, may trigger wage demands and prevent a decline of consumer-price growth to the banks 3 percent target range.

Czech Current Account Surplus November 2007

The Czech Republic posted a surprising current-account surplus in November as import growth slowed and foreign investors doing business in the Czech Republic sent less profit home. This was the first surplus since March, and reached 1.2 billion koruna ($774 million), compared with a 13.7 billion-koruna deficit in October and a 10.9 billion-koruna gap a year ago, according to data from the central bank earlier today.

The Czech current account typically worsens in the middle of the year as foreign investors collect dividends and profit shares from local companies. Later in the year, the improving trade balance outweighs the effect of the dividend outflow. However it seems probable that higher investment income will continue to be a burden to the current account, which will almost certainly be in the red for most of 2008.

Czech Republic To Hold Fire On Euro Membership

Monetary policy experts in the Czech Republic are having second thoughts about the advisability of adopting the euro in the near future, based presumeably on the experience of those who have gone for rapid euro convergence. According to central bank board member Robert Holmanhe the Czech Republic is "not ready" to adopt the euro because giving up the koruna could cause the economy to overheat, (he has obviously been looking over his shoulder at what has been happening in the Baltics, Bulgaria, Romania etc).

The koruna's appreciation against the euro has lifted prices near the level of those in countries that have been European Union members longer, Holman wrote in a commentary in Mlada Fronta Dnes newspaper today. Losing the ability to allow the the koruna to appreciate would be reflected in a quickening pace of inflation, he said. This may not be exactly the situation, but he is scratching in the right area, and loss of control over monetary policy - as we are seeing now in the cases of Ireland and Spain - can create special "overheating" problems, which when corrected may produce a mini boom-bust type cycle.

``We would have to live with European interest rates that would undoubtedly be too low with regard to higher domestic inflation,'' Holman said in the article. ``Our economy would overheat, which could have fatal consequences.''

This is basically what appears to have happened in the cases of Ireland and Spain with their domestic housing booms based on long periods of negative real interest rates. Holman said that once the Czech Republic enters the so-called exchange-rate mechanism - which basically offers a pre-entry test of currency stability before the switch, a commitment will have to be made to limit the koruna gains, and this could well lead to an acceleration in price growth which would not be appropriate to the low interest environment. I think Holman has a strong point here, and I think it is one which did not receive sufficient thought before Spain and Ireland were admitted - since they were always liable to have a lengthy period of rapid catch-up growth where a rising currency would have been more appropriate.

"A country that is only going through a process of real economic convergence with the euro zone cannot fulfill the low- inflation and currency-stability criteria at the same time,'' Holman wrote. He also added that once the Czech Republic gives up its own currency all ``economic shocks'' will be transmitted to unemployment and inflation. "That is not a good alternative for our employees and consumers....It's better to have a domestic currency with a flexible exchange rate."

Of course we could call this learning by doing, but I would say better late than never. For a day by day insight into the kind of mess that can result from not heeding Holman's warning can be found by following events on this blog about Spain, and starting particularly with this post.

The Czech koruna rose to a record against the euro for a second consecutive day yesterday as investors bet the central bank will raise the European Union's lowest interest rates to stem accelerating inflation.



The koruna, the best emerging-market performer this year, gained versus 14 of the 17 most-traded currencies as a report yesterday showed Czech inflation accelerated to 5.4 percent in December, exceeding the central bank's target for a second month. Policy makers now seem set to lift the key benchmark rate at some point in the not too distant future, possibly in February.

Annual inflation last month accelerated to the fastest since August 2001.




The koruna was also underpinned by a larger-than-expected trade surplus, which widened in November from the previous month as imports grew at the slowest pace in 19 months. The surplus was at 11.3 billion koruna ($641 million) compared with 8.6 billion koruna in October, according to the statistics office data released today.

Czech Trade Surplus November 2007

The Czech trade surplus widened in November from October as imports grew at the slowest pace in 19 months. The surplus widened to 11.3 billion koruna ($641 million) from 8.6 billion koruna in October and 5 billion koruna a year ago, the Prague-based statistics office said today.



Czechia probably posted a record trade surplus for the third year in a row in 2007 on the back of mounting demand from European Union countries for Czech goods.

Exports increased 11 percent from November to 233.9 billion koruna, the lowest growth rate since August 2006. Imports grew 8.2 percent to 222.6 billion koruna.




The cumulative positive balance for the January-November period amounted to 87.2 billion koruna, a 43.7 billion-koruna increase from a year ago.

Czech Inflation December 2007

Czech inflation accelerated in December above the central bank's target for a second month, increasing pressure on policy makers to raise the benchmark interest rate as early as next month. The inflation rate rose to 5.4 percent from 5 percent in November, the highest since August 2001, the Prague-based statistics office said today.



Food prices were 1.8 percent higher in the month and 11.2 percent more than in December 2006, compared with a monthly 4 percent increase in November. Automotive fuel prices grew a monthly 0.8 percent, less than the 2.9 percent rate in November.

The central bank is weighing whether the inflation pickup from rising food and fuel costs and higher taxes justifies an increase in borrowing costs or whether the koruna's 10.2 percent advance against the euro in six months will quell inflation. The bank projected an inflation rate of 3.9 percent for last month.

The koruna advanced to 25.996 per euro by 1 p.m. in Prague from 26.057 yesterday, trading near a record high.


Inflation topped the upper end of the central bank's target of 3 percent plus or minus one percentage point for a second month. The benchmark two-week repurchase rate of 3.5 percent remains the European Union's lowest even after four increases last year.

The inflation rate may breach 6 percent in January, reflecting an increase in the lower valued-added tax rate to 9 percent from 5 percent, growing energy and state-controlled prices, a higher excise tax on cigarettes and the introduction of health-care regulatory fees and green taxes, economists said.

Monetary-policy makers hope that once temporary influences fade away, annual price growth will return to the targeted level starting from 2009. This hope may not be fulfilled should workers start demanding compensation for accelerated inflation at a time when unemployment is the lowest in a decade. It may also thwart the central bank's view that inflation will slow again this year and return to below 4 percent in early 2009.