After three months of gains against the euro, the koruna is closing in on the threshold that Czech central bank Governor Miroslav Singer pledged to defend.
The currency climbed to 27.07 per euro on Tuesday, the strongest level since November 2013, when the central bank intervened to weaken the exchange rate and set the floor at about 27. It traded at 27.104 as of 2:50 p.m. in Prague on Wednesday.
Here’s a snapshot of the Czech currency market and what might happen if the koruna breaches the 27 level:
1. What’s the central bank’s currency policy?
The Czech National Bank sold 200 billion koruna in November 2013, worth about $10 billion at the time and equivalent to 5 percent of the country’s gross domestic product. The bank pledged to stop the currency from strengthening past 27 per euro as it sought to stave off deflation and buttress the economy.
Rate setters have repeatedly promised to keep the cap until at least July 2016. The CNB should only scrap it when it sees a need to raise the main interest rate from 0.05 percent and is certain it won’t need to cut it back, Vice Governor Mojmir Hampl said in a statement on the bank’s website Wednesday.
The koruna hasn’t traded at 27 since November 2013, averaging 27.5 per euro in the period.
2. Why is the koruna gaining now?
The Czech economy is rebounding. Data published last week showed first-quarter GDP grew a record 2.5 percent from the previous three months, while the May trade surplus beat analyst estimates. The recovery will continue and there’s now less chance of policy makers moving the koruna cap to a weaker level, the central bank said in minutes of its June 25 meeting.
“The gains are justified given the positive developments in the economy and the fact that the market has stopped fearing the CNB might weaken the koruna further,” Jakub Seidler, chief economist at ING Groep NV’s Prague-based unit, said by phone Tuesday.
3. How likely is 27 per euro and what would happen next?
The first test of the cap “can’t be ruled out in the coming weeks,” according to Jan Vejmelek, chief economist at Komercni Banka AS in Prague. At that point “the CNB will have to step into the market” by selling the local currency, he said. According to ING’s Seidler, the bank may start defending the limit in September or October at the latest.
Still, policy makers won’t intervene “aggressively” to weaken the koruna and will “passively buy up offered euros” to prevent the cap from being breached, Vejmelek said in a report to clients on July 3.
4. Why not ditch the cap and let the koruna strengthen?
Even though the economy’s on the mend, Czech inflation at 0.7 percent is still below the central bank’s 2 percent goal. Assuming the koruna cap stays in place, consumer-price increases will reach the target in the third quarter of next year, the latest CNB forecast shows.
“Scrapping the floor earlier would immediately tighten monetary policy and the central bank would struggle to meet its inflation target,” ING’s Seidler said. “A premature exit from the intervention regime would also cause major damage to the central bank’s reputation and future credibility.”
5. How big is the central bank’s intervention war chest?
Practically unlimited. The CNB has repeatedly said it can print the local currency and sell it in the market for as long as needed to defend the cap and meet its inflation target.