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Photographer: Martin Divisek/Bloomberg
QuickTake

What Might Happen When Czechs Let Koruna Run Free: QuickTake Q&A

What Might Happen When Czechs Let Koruna Run Free: QuickTake Q&A

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Photographer: Martin Divisek/Bloomberg

The koruna is on the brink of freedom. For more than three years, the Czech Republic’s central bank has shackled its currency from rising too far against the euro, in an effort to ward off deflation. In what promises to be one of the biggest currency plays in Europe this year, investors have piled into the koruna in anticipation of booking a quick profit once policy makers end that Swiss-style limit. Now it’s just about the timing. The central bank has said it will keep its formal intervention regime in place until March 31. After that, all bets are off.

1. Is the koruna definitely headed toward a strengthening?

Many economists argue that three years of continued economic and productivity growth mean the currency is fundamentally undervalued and expect, along with investors, that the koruna should move stronger once the cap is lifted. The central bank, however, has warned that traders may struggle to find counterparties if they all attempt to close their koruna positions simultaneously and says that the currency may actually weaken. The median forecast in a Bloomberg survey last week was for the koruna to gain 3.1 percent to 26.2 per euro at the end of the year. Investors in currency derivatives are positioned for slower appreciation, with three-month euro-koruna forwards trading at 26.88.

2. What outcome does the Czech central bank want?

Policy makers have repeatedly vowed to avoid a repeat off the type of shock seen in Switzerland. There, rate setters ditched their cap on the franc without warning (shortly after saying it was a pillar of their policy), sending the currency 16 percent higher in a month and sticking unsuspecting investors with billions of euros in losses. The Czechs have made clear they will end the regime any time after the first quarter of this year and return to normal monetary policy. While they insist they won’t let the koruna appreciate too much, rate setters are ready for a period of sharp turbulence in markets after they let it float freely.

3. What’s the best guess for when it happens?

Economists overwhelmingly see the exit happening in May. The seven-member policy board can drop the koruna’s cap at one of its monetary meetings that take place every six weeks, a weekly session or an extraordinary sitting. It will be the result of a vote, so the bank won’t be able to announce anything before a decision is made. While the monetary authority has long based its communication strategy on transparency and eschews the Swiss approach, “there may be some element of surprise,” according to Czech Governor Jiri Rusnok.

4. Will the koruna be fully free?

Not necessarily. The central bank will reserve the right to start intervening again at any time it deems necessary.

5. What will the bank be looking for?

It will have to contend with the massive wall of cash parked by investors in koruna-denominated assets. Some investors may jump into the koruna after the cap falls in anticipation of more strengthening, which may push the currency stronger than policy makers see as justified. It will have to carefully calibrate whether to resume interventions to stabilize the currency while also not setting a clear target for speculators to attack.

6. How big is that wall of money?

The bank bought 47.8 billion euros ($51.5 billion) in the four years through January, an amount that eclipses the 12.8 billion euros of natural currency inflows seen in the country’s balance of payments data and one that suggests massive inflows of speculative bets. Some estimates say that has grown to as much as $65 billion by mid-March. The bank has said it’s ready to buy foreign currencies in any amounts to protect its inflation goal.

7. What happens next?

The central bank has said that it wants to return to “normal” monetary policy, and that it may raise its benchmark interest rate from the record low level of 0.05 percent. The timing of the first rate increase will depend on how the koruna settles in the immediate volatility after the cap removal. Policy makers will have to balance the anti-inflationary impact of the stronger currency and the magnitude of rate hikes to make sure they don’t tighten monetary conditions too much and bring inflation below the target again.

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