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Czech Republic: Selected Issues

Author(s):
International Monetary Fund
Published Date:
May 1998
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IV. Monetary and Exchange Rate Policy Issues31

A. Overview

66. After several years of huge capital inflows in the context of a fixed exchange rate regime, monetary policy gained some autonomy in early 1996, when a widening current account deficit and the adoption of a wider exchange rate band reduced the attractiveness of the koruna to investors. This permitted a rise in short-term interest rates and a sharp deceleration of broad money growth, which led to an appreciating exchange rate and brought inflation to post-reform lows. But with little support from fiscal and wage policies, the current account deficit continued to widen through early 1997. The rise of the current account deficit to unsustainable levels, political uncertainty, and contagion effects from Southeast Asia weakened confidence in the koruna and eventually triggered a speculative attack that led to the adoption of managed floating in May 1997. Subsequently, policies were tightened further to support the exchange rate, albeit in a relatively unfavorable environment with continued political uncertainty and contagion effects from abroad. With the exchange rate no longer providing a clear nominal anchor, inflation targeting was introduced in 1998.

67. The environment within which monetary policy operates has thus changed drastically: Until early 1997, when investor confidence in the koruna was still strong, monetary policy was constrained by the effects of monetary tightening on external competitiveness through currency appreciation. Since the Spring of 1997, with confidence in the koruna somewhat shaken by the May crisis, contagion effects and political uncertainty, the efforts of monetary policy to maintain a stable exchange rate have been constrained by its effects on the financial position of banks and enterprises, given that ⅓ of bank loans are impaired and the indebtedness of enterprises to banks is ¾ of GDP. Although major banks have provisioned/collateralized their loans and exceed the minimum required capital adequacy ratio, their profitability weakened in 1997 (see Chapter V); moreover, several smaller banks came under pressure in 1996 while their restructuring restricted somewhat the room for maneuver for monetary policy.

68. This chapter examines the monetary policy framework, operating procedures and policy stance; exchange rate developments and, especially, the May 1997 currency crisis; developments in money, credit and interest rates; and reserve money developments and the conduct of monetary policy.

B. The Policy Framework, Operating Procedures and Policy Stance

69. The exchange rate and, to a lesser extent, broad money were used as intermediate targets from the beginning of the reform in 1991 until the May 1997 currency crisis; broad money was a supplementary target in view of the long and variable lags of monetary policy, the fragility of the money-inflation relationship.32 In the aftermath of the May crisis, the emphasis on the exchange rate target waned, and, as of 1998, monetary policy started focusing directly on the inflation target. Specifically:

  • Until early 1996, the policy framework was strict exchange rate targeting with the exchange rate of the koruna kept within ±½ percent against a currency basket.33 Owing to large (partially sterilized) capital inflows, this led to monetary growth well in excess of the announced targets (Figure 10), fueling domestic demand and inflation.

  • The wider fluctuation band of ±7½ percent adopted in February 1996, together with a growing external imbalance, reduced the attractiveness of the koruna to investors, thereby increasing somewhat the autonomy of monetary policy. This enabled the Czech National Bank (CNB) to reduce liquidity growth and raise interest rates but only to the extent permitted by persisting appreciation pressures. In this period monetary targeting was pursued more vigorously but with consideration also given, among other things, to the exchange rate, economic activity and the financial condition of enterprises and banks. Because of this multi-faceted approach and uncertainty about velocity, the CNB kept under continuous review the appropriateness of the monetary target.34

  • In the aftermath of the May 1997 turbulence and the formal replacement of exchange rate targeting by managed floating, the CNB pursued simultaneously several (unannounced) intermediate targets, including a relatively stable exchange rate vis-à-vis the DM subject to avoiding unsustainable interest rate increases; and broad money growth. In an effort to correct for the absence of a clear nominal anchor, the CNB increased its focus on inflation by announcing its own inflation objective.35

  • With the adoption of inflation targeting in 1998, disinflation became the prime objective; it is cast in a medium-term context (5½-6½ percent in 1998 and ½-5½ percent by 2000) and defined in terms of core (“net”) inflation, which excludes the effects of changes in administered prices and indirect taxes (Chapter II). To reach the inflation objective, the CNB will prepare inflation forecasts on a regular basis; deviations from the target would trigger corresponding adjustments in short-term interest—rates the operating target of the CNB. The CNB no longer targets the exchange rate, even though it considers that the current exchange rate is broadly consistent with the inflation and external objectives, and is prepared to intervene to avoid excessive fluctuations. While the inflation targeting framework has been used successfully in the disinflation process in certain industrialized countries, and the institutional and technical prerequisites would generally appear to be present in the Czech Republic, structural rigidities are more pervasive than in advanced economies and other objectives may be relatively more important. These relate in particular to the need to reduce the large external imbalance. The time path envisaged for inflation reduction—which is not as ambitious as that adopted in advanced economies—appears to reflect such considerations.

Figure 10CZECH REPUBLIC: DEVELOPMENTS IN BROAD MONEY (1992-97)

Sources: Czech National Bank; and staff calculations.

1/ Broad money excludes the SPT deposit with the CNB.

2/ Velocity is calculated as annualized seasonally adjusted GDP divided by seasonally adjusted end-of-period broad money.

70. The operating procedures have changed little since early 1995, when short-term interest rate targeting was adopted as the operating procedure of monetary policy: the repo rates on CNB bills are set so as to influence domestic interest rates (they are closely related to interbank rates which, within a month, affect interest rates on new loans and, to a smaller extent, deposits) and through them to limit exchange rate fluctuations and regulate domestic economic conditions. This is implemented by setting a maximum interest rate on one- and two-week repos (or a minimum interest rate in the case of reverse repos, the main instrument of injecting short-term liquidity) on CNB bills and letting the volume of repos be determined in a competitive auction. In September 1997, the CNB introduced three-month repos in an effort to lengthen the average maturity of money market instruments; to increase the attractiveness of these instruments, their interest rate has been set 30-40 basis points higher than that of two-week repos. As a rule, daily auctions are held for two-week repos and weekly for three-month ones.

71. In addition to repos, use is made of outright sales of CNB bills and, on an infrequent basis, changes in non-remunerated required reserves and transfers of deposits from commercial banks to the CNB.36 Contrary to the previous practice of massive interventions to prevent the koruna from appreciating, foreign exchange interventions have been used sparingly since the beginning of 1996 in order to avoid encouraging short-term capital flows:37 the CNB intervened on three occasions (February 1996, May 1997, and October-December 1997) in support of the koruna, while in July-August 1997 it purchased foreign exchange to prevent the koruna from appreciating to what was perceived to be an unsustainable level. The CNB has occasionally attempted to influence foreign exchange markets by “talking down” the exchange rate from levels that were perceived as unsustainable (thereby reducing the need for costly interventions). Finally, for a very brief period during the May currency crisis, banks were instructed to stop lending korunas to nonresidents; however, the restriction was not enforced strictly and did not generate a wedge between the domestic and offshore markets.38

72. The monetary policy stance has been tight since mid-1996, despite pressures from the restructuring of small banks. This is manifested in the sharp deceleration of money and credit expansion, the rise in real interest rates, and a rise of broad money velocity, as the pass-through of the depreciation and the administrative price increases were only partially accommodated. In particular:

  • In mid-1996, after capital inflows had dried up, the CNB raised interest rates and required reserves, generating a rapid deceleration of money growth from 20 percent at mid-1996 to less than 10 percent by end-1996 and below 8 percent in 1997. The increase of the interest rate differential vis-à-vis euromarkets led to a temporary appreciation of the koruna and contributed to the slowdown of 12-month inflation by 2 percentage points as of early 1997. But with inadequate support from fiscal and other macroeconomic policies, monetary tightening did not prevent a further widening of the current account imbalance.

  • In early 1997, the slowdown of GDP growth (to which the monetary tightening contributed) generated political pressures for monetary relaxation. In the context of the fiscal and structural reform policy package announced in April 1997, the CNB reduced required reserves by 2 percentage points (while encouraging banks to keep lending rates unchanged and raise deposit interest rates) and relied on sterilization operations to keep the stance of monetary policy unchanged. In the event, weak fundamentals, uncertainty about the future stance of monetary policy, and contagion effects contributed to a weakening of the koruna and set the stage for the May 1997 currency crisis.

  • After the May 1997 depreciation, monetary policy was tightened again by raising interest rates and mopping up liquidity. After an initial blip, interest rates were kept 2 percentage points above their pre-crisis level and were raised further in the last quarter of 1997 to fend off pressures on the koruna that stemmed from the turbulence in international financial markets and domestic political uncertainty. Fiscal policy was also tightened during this period.

C. Exchange Rate Developments

73. The koruna has experienced a considerable swing since mid-1996 (Figure 11): following the widening of the fluctuation band to ±7½ percent around the currency basket it first appreciated to almost 6 percent above its central parity (February 1997); then weakened rapidly as market sentiment was reversed; came under a strong speculative attack (May 1997), depreciating to 11 percent below its central parity; and has been volatile since then, falling at its trough (in November 1997) to 15 percent below its (former) parity. High interest rates—the result of an unbalanced policy configuration (heavy reliance on monetary tightening with insufficient support from fiscal and wage policies)—and lagged market response to deteriorating fundamentals lie behind the initial appreciation. Meanwhile, contagion effects from turbulence in Southeast Asia and political uncertainty at home exacerbated the depreciation pressures on, and volatility of, the koruna since the second quarter of 1997. In late January 1998, the koruna was trading at 12-15 percent below its former central parity (around CZK 19½ per DM 1), which represented a depreciation of less than 6 percent against the average rate in 1995 (still a real appreciation).

Figure 11CZECH REPUBLIC: EXCHANGE RATE AND THE TRADE BALANCE

Sources: CNB, Bloomberg, and Fund staff calculations.

1/ The basket consists of fixed amounts of DM and US$ with corresponding weights of about 65 percent and 35 percent. Official rates at the CNB fixing are used in the calculations. Decline indicates nominal appreciation.

Koruna Appreciation and Subsequent Correction (June 1996-April 1997)

74. The appreciation of the exchange rate in late 1996 and early 1997 was driven by capital inflows attracted by the high interest rate differential vis-à-vis euromarkets (8½ percentage points)39 and a history of exchange rate stability. A surge in Eurokoruna bond issues (US$2 billion) in early 1997 contributed to the appreciation of the koruna to the extent that issuers covered their positions with domestic assets.40 The CNB did not intervene in the foreign exchange market during this period so as to avoid increases in liquidity, which would have either derailed the monetary target or necessitated costly sterilization operations; instead, it tried to guide the koruna toward parity by issuing statements that the appreciated exchange rate was inconsistent with fundamentals.

75. The deteriorating external deficit (Figure 11) did not raise market concern until February 1997. But at that time, the appreciation of the koruna to 5½ percent above parity; forecasts that the current account deficit might widen further, to 9 percent of GDP; and weakening economic activity sparked a public debate about the deteriorating cost competitiveness; there were also government calls for monetary relaxation. These factors focused markets more on fundamentals, reversed capital inflows, and induced foreign investors to switch to shorter maturities, leading to a rapid depreciation of the koruna. A fiscal retrenchment and structural reform package announced in mid-April failed to reverse market sentiment, political uncertainty increased, and by mid-May the koruna had depreciated by 8 percentage points to 3 percent below its former central parity from its peak three months earlier. Waning confidence shows up in tests of the sustainability of the exchange rate band (Annex III).

May 1997 Currency Crisis

76. Contagion from Southeast Asia (owing to rebalancing of international portfolios after the currency attacks on the Thai baht and other emerging country currencies, and expectations of higher interest rates in Japan) exacerbated the depreciation pressures and triggered an attack on the koruna in mid-May.41 The CNB resisted these pressures through foreign exchange interventions and interest rate increases but not to the extent of compromising its reserve position or the financial position of banks and enterprises. On May 27, after evidence that residents were also taking large positions against the koruna (e.g., by switching to foreign currency deposits) the CNB abolished the fluctuation margins in favor of a managed float, and allowed the koruna to depreciate to about 12 percent below the former central parity; while on May 28, the coalition government announced additional stabilization and reform measures, including further expenditure cuts of ¾ percent of GDP. (A day-to-day account of the crisis and the policy response is provided in Annex IV).

77. The floating of the koruna was decided after intervention sales of US$2 billion in the previous week and steep increases in interest rates (to 75 percent for the CNB’s two-week repo and to 35 percent for the three-month PRIBOR). The CNB did not resort to exchange controls, nor did it strictly enforce an instruction to banks (in effect during May 22-June 17) barring koruna lending to non-residents; as a result, there was no significant interest or exchange rate differential with the offshore market. The CNB temporarily borrowed from a local branch of a foreign bank42 and engaged in gold swaps (for US$1 billion in total) to keep its gross reserves at around US$10 billion; and arranged—but has not used—a one-year US$2 billion credit line with foreign banks on favorable terms (10 basis points over LIBOR) in order to demonstrate market confidence and readiness to intervene if needed. The CNB did not engage in significant forward sales of foreign exchange against the koruna, and all such contracts had matured by September 1997.

78. The handling of the currency crisis was complicated by the short (two-week) maturity of money market instruments: When the koruna came under attack, banks did not renew the repos upon maturity despite the increase of interest rates; instead, they switched to foreign assets exacerbating the pressure on the koruna. In an effort to address this problem, the CNB introduced three-month repos in September.

The Aftermath of the Currency Crisis (June 1997-January 1998)

79. For four months after the May attack, the CNB stabilized the koruna within a 6-12 percent range below its former central parity, despite renewed turbulence in Southeast Asia and extensive floods in July 1997. The CNB took advantage of appreciation pressures, which reflected an unwinding of speculative positions, to gradually lower interest rates and purchase foreign exchange to prevent an unsustainable appreciation. As a result, the three-month PRIBOR declined to ½ percent by July 1997 (2 percentage points above its pre-crisis level), while official reserves recovered to US$1114 billion at end-September (Figure 12). New euro-koruna bond issues during 1997 Q3 were further indications of strengthening market confidence.

Figure 12CZECH REPUBLIC: EXCHANGE RATE, INTEREST RATES AND FOREIGN RESERVES

Sources: CNB, REUTERS, and staff calculations.

80. The koruna came under renewed pressure in the last quarter of 1997 owing to political uncertainty and contagion effects, which necessitated temporary interest rate increases and intervention sales of foreign exchange. The CNB raised its two-week repo rate by a cumulative 4½ percentage points and intervened in the foreign exchange market, while allowing some further weakening of the koruna. By mid-December, the CNB had largely reversed the repo rate increases of the preceding two months, while the three-month PRIBOR was about 16½ percent (13 percentage points higher than DM interest rates). In the latter half of January 1998, the koruna was trading at around 12-15 percent below its former central parity. Given the strengthening of the U.S. dollar, this represents a less than 6 percent depreciation of the koruna against the DM since 1995, implying that had the koruna been pegged to the DM at the average 1995 level, it would have been possible to maintain the ±7½ percent band (provided that the appreciation of early 1997 was addressed via sterilized interventions).

81. In response to the higher exchange rate uncertainty since the May crisis and concerns that the koruna might weaken further, commercial banks reduced sharply their net foreign liability position by reducing their holdings of koruna-denominated instruments and holding back on credit expansion (Figure 13). Since October, banks increased rapidly their short-term foreign assets while a restriction of their net foreign liability position was abolished.43

Figure 13CZECH REPUBLIC: NET FOREIGN ASSETS

(In Billions of Koruny)

Sources: Staff calculations based on data provided by the Czech National Bank.

1/ The foreign exchange exposure vis-a-vis non-residents is measured by the NFA of commercial banks, excluding off-balance-sheet items.

2/ The foreign exchange exposure vis-a-vis residents is measured by the difference between foreign currency loans and foreign currency deposits.

D. Developments in Broad Money and Domestic Credit

82. After growing at an annual rate of almost 20 percent in each of the three preceding years, broad money44 decelerated sharply to 9 percent in 1996 and even further in 1997. The deceleration was entirely the result of a deceleration in the growth of banking system NFA: its contribution to broad money growth has turned from large and positive (about 11 percentage points) during 1993-95 to negative since mid-1996, particularly so in May 1997, when the CNB intervened in support of the koruna. The contribution of NFA picked up again in late 1997, as commercial banks built up their foreign assets in response to increasing exchange rate uncertainty (Table 9, Figure 14).

Table 9.Czech Republic—Contributions to Broad Money Growth(Percent change in relation to broad money at the beginning of the year)
19961997
19931994199519961997I-IIIII-IVIApr.-MayJune-Sep.Oct.-Dec.
M2 1/19.819.919.89.27.94.15.1-1.63.41.64.4
Of which:
Valuation effects-------0.21.3---0.20.10.8-0.20.6
NFA9.511.210.6-1.76.20.6-2.30.2-0.53.43.0
Of which:
Excluding valuation effects9.511210.6-0.92.10.7-1.6-0.2-3.23.91.5
Commercial banks-6.83.6-7.8-0.711.01.3-2.00.46.3-1.65.9
CNB16.37.618.4-0.3-9.0-0.60.4-0.6-9.55.5-4.4
NDA10.38.89.110.91.83.57.4-1.83.9-1.81.4
Domestic Credit17.614.713.39.99.45.54.42.55.5-1.02.4
Of which:
Credit to economy18.916.612.79.79.65.54.11.84.8-0.12.1
Other assets, net-7.3-5.9-4.11.0-7.6-2.03.0-4.3-1.5-0.8-1.0
Of which:
Profits (-) from exchange rate changes------0.9-5.10.10.8-0.5-3.40.6-1.8
Memorandum item:
Target range for M2 growth1712-1514-1713-167-11
Sources: Czech National Bank and staff calculations.

Excluding the SPT Telecom deposit.

Sources: Czech National Bank and staff calculations.

Excluding the SPT Telecom deposit.

Figure 14CZECH REPUBLIC: CONTRIBUTIONS TO BROAD AND BASE MONEY GROWTH (1993-97) 1/

Sources: Czech National Bank; and staff calculations.

1/ In percent of broad money in the same period of the previous year; excluding valuation effects.

2/ Base money growth has been adjusted for changes in the required reserves ratio.

83. Technical factors—namely the expansion of deposit-like instruments, valuation effects, and the removal from the monetary survey of banks whose license had been suspended—have also contributed to the deceleration of money growth, but their impact has been of a second order of magnitude and does not invalidate the general conclusion of a rapid monetary deceleration.45

84. The weakening of the koruna in 1997 prompted a shift toward foreign exchange deposits and, within local currency deposits, toward term deposits (Figure 15). Foreign exchange deposits expanded rapidly in 1997 and especially during the second week of the currency crisis, when residents were queuing to convert koruna into foreign exchange deposits (increases, net of valuation effects, were 34 percent in May and 5 percent in June 1997, raising their share in broad money to 11 percent). The shift from demand to term deposits was in response to the higher interest rates on the latter. Demand deposits made a negative contribution to M2 growth while term deposits (especially of households) accounted for most of its increase. During the currency crisis, M2 growth accelerated as (i) the structure of interest rates made it profitable to borrow from banks and place the proceeds of the loan in short-term deposits; and (ii) several enterprises stopped making payments and placed their funds in bank accounts to take advantage of the prevailing high interest rates (which exceeded penalty rates). With interest rates remaining above their pre-crisis level, the shift toward term deposits was sustained.

Figure 15CZECH REPUBLIC: COMPOSITION OF BROAD MONEY

Sources: Czech National Bank, and staff calculations.

85. With the reversal of capital inflows and the policy tightening in 1996-97, the velocity of broad money46 rose to its 1994 level (Figure 10). After declining by 2 percent in the last quarter of 1995 as a result of soaring capital inflows (20 percent of quarterly GDP), velocity rebounded in the second half of 1996, as excess liquidity was run down through a widening current account deficit. With the deceleration of GDP growth and a temporary pick-up of monetary expansion, velocity declined in the first half of 1997 (but it was still 1.2 percent higher than a year earlier). The increase in the second half of 1997 relates to the running down of excess liquidity and the partial accommodation of the pass-through of the depreciation on prices.

86. Bank credit to the economy (enterprises and households) has been the main force driving the deceleration of the banking system NDA; increased government borrowing moderated the deceleration. Except for a relapse in the second quarter of 1997, the 12-month growth rate of bank credit declined from 14 percent in the first half of 1996 to 9½ percent in 1997, in line with the tightening of monetary policy and banks’ increasing caution in their lending practices; a significant part of new deposit taking was invested in low-risk bonds (including foreign bonds). The deceleration is sharper (from almost 20 percent in 1994-95 to 10 percent in 1997), if adjustment is made for direct foreign borrowing by enterprises.

87. The composition of bank credit has changed toward (a) foreign currency credits (b) adjustable interest rate credits, and (c) relatively shorter maturities. The higher share of foreign currency lending reflects increased bank borrowing from abroad and the need to hedge the increasing foreign exchange deposits. The increased share of credits at adjustable interest rates (about one half as of mid-1997) reflects the banks’ attempt to hedge their interest rate risk (transforming, in part, the interest rate risk into credit risk). Finally, the declining share of long-term credits is associated with the stalling of investment as a result of the higher interest rates and the economic slowdown.

E. Developments in Reserve Money and the Conduct of Monetary Policy

88. With monetary tightening, reserve money growth decelerated from 26 percent in 1995 to 11 percent in 1996, and -1 percent in 1997.47 In a complete reversal relative to previous years, when capital inflows were the driving force, reserve money developments were driven in 1996-97 by the decline of NFA, which more than offset a pickup in domestic credit. In particular, after three consecutive years of rapid foreign reserve growth, the NFA of the CNB declined by 8 percent of reserve money in 1996 and by another 41 percent in 1997, excluding valuation effects (Figure 14). Meanwhile, the expansion in domestic credit changed from large and negative to positive, owing to the reversal of sterilization operations out of concern about CNB profitability, lender of last resort and bank restructuring operations, and increasing credit to government (Table 10). And, owing to the greater variability of banks’ excess reserves, the money multiplier became more volatile (Figure 16).

Table 10.Czech Republic—Contributions to Reserve Money Growth(Percent change in relation to reserve money at the beginning of the year)
19961997
19931994199519961997I-IIIII-IVIApr.-MayJune-Sep.Oct.-Dec.
Reserve Money 1/0.622.226.511.3-0.95.06.4--4.0-1.6-3.4
Of which: excess reserves-7.8-8.33.1-0.9-3.6-1.80.92.01.8-2.0-5.3
NFA 2/58.387.0124.6-12.3-22.7-8.4-3.9-1.2-28.920.7-13.3
Of which:
Excluding valuation effects58.387.0124.6-7.9-41.5-7.9---3.4-42.722.7-18.1
NDA 2/-57.7-64.8-98.123.621.713.310.31.232.9-22.39.9
Domestic Credit-62.9-52.1-75.626.46.128.4-2.01.222.8-25.07.1
Government-18.8-25.0-9.5-6.24.5-10.34.11.93.6-3.02.6
Economy 3/-2.9-10.6-16.4-3.512.518.6-22.11.90.18.32.1
Banks-41.2-16.5-49.736.1-10.820.116.0-2.019.1-30.32.4
Change in required reserves-0.5-9.5-5.4-17.07.9-2.2-14.8-1.29.6-0.80.2
Other assets, net 2/5.6-3.2-17.014.27.7-12.827.11.20.53.52.5
Of which:
Profits (-) from exchange rate changes------4.4-18.80.44.0-2.2-13.82.0-4.8
Memorandum item:
Sterilization (-) through sale of CNB bills and transfer of deposits 4/-24.2-33.5-82.931.9-13.817.314.5-1.016.4-30.31.1
Sources: Czech National Bank and staff calculations.

Calculated at unchanged required reserves ratio.

Including the SPT Telecom deposit.

Mainly credits for bank rehabilitation.

The counterparts to this item are included in net claims on the economy and banks.

Sources: Czech National Bank and staff calculations.

Calculated at unchanged required reserves ratio.

Including the SPT Telecom deposit.

Mainly credits for bank rehabilitation.

The counterparts to this item are included in net claims on the economy and banks.

Figure 16CZECH REPUBLIC: MONEY MULTIPLIER AND ITS DETERMINANTS

Sources: Czech National Bank; and staff calculations.

1/ The shaded area represents a +/- one percent band around the corresponding period average.

89. Sterilization operations, the driving force behind the evolution of NDA, took the form of sales of CNB bills and the transfer of public sector (NPF and SPT Telecom) deposits from commercial banks to the CNB and increases in non-remunerated required reserves (which do not involve a direct cost for the CNB other than the opportunity cost of investing these funds in foreign assets rather than higher yielding domestic assets). The cost of sterilization operations reflects the combined effect of the total volume of sterilization and the opportunity cost of holding low interest rate foreign assets. The volume of sterilization through CNB bills and the transfer of public sector deposits to the CNB, which had averaged CZK 157 billion in 1996, dropped to CZK 139 billion in 199748 (Figure 17). The cessation of capital inflows in early 1996 allowed the CNB to redeem part of the stock of outstanding CNB bills and a further reduction was made possible by the increase in the required reserves ratio as of August 1996.49 These sterilization operations is estimated to have cost the CNB CZK 12½ billion (0.8 percent of GDP) in 1996 and CZK 16 billion (1 percent of GDP) in 1997.50 The higher sterilization cost in 1996, along with the cost of restructuring banks and the appreciation of the exchange rate, account for most of the 1996 CNB losses of CZK 8.7 billion. For 1997, the CNB should have a surplus, as (unrealized) valuation profits from the depreciation of the koruna are likely to exceed sterilization costs and the cost of interventions in the foreign exchange market.

Figure 17CZECH REPUBLIC: COSTS OF STERILIZING CAPITAL INFLOWS

Sources: Staff calculations based on data provided by the Czech National Bank.

1/ Comprises outstanding CNB bills, the transfer of SPT and NPF deposits to the CNB and part of required reserves.

2/ Interest rate differential times the sum of CNB bills and the transfer of deposits to the CNB.

3/ Interest rate differential times the part of required reserves related to sterilization.

90. The weakening economic activity in 1997 and the support pointed to troubled banks put pressure on, but did not lead to a relaxation of, the monetary policy stance. In particular:

  • As a compromise between the government, which was pressing for monetary relaxation in response to the slowdown of economic activity, and the CNB, which wanted to maintain interest rates, the non-remunerated reserve requirement was reduced by 2 percentage points, to 9.5 percent (announced in March 1997 with effect as from May 8); and the CNB encouraged commercial banks to keep unchanged their lending interest rates and raise their deposit rates. The measure added CZK 20 billion to bank liquidity, which was offset by the import deposit scheme51 that was in place from April to August 1997, and the contractionary effect of the capital outflows. Moreover,

  • The liquidity support and rehabilitation of troubled banks showed up as emergency credits (mainly to Agrobanka); rehabilitation credits to small banks, contingent on their adopting a restructuring plan (Figure 18); and credits to Ceska Financni for the purchase of bad loans from banks participating in the CNB-sponsored restructuring program. These two factors contributed 12 percentage points to base money growth in 1997.

Figure 18CZECH REPUBLIC: CZECH NATIONAL BANK CREDIT FACILITIES

(In Billions of Koruny)

Source: Czech National Bank.

F. Interest Rates

91. The tightening of monetary policy since mid-1996 and pressures on the koruna in 1997 jolted interest rates by several percentage points over the past two years. Interbank interest rates, which are more sensitive to market conditions, were affected the most, registering a cumulative increase of 6 percentage points. They rose in three spurts: first, by 1 percentage point to 12½ percent in mid-1996, when monetary policy was tightened; they soared (especially short-term rates) during and immediately after the May 1997 currency crisis but within three months they eased to 14½ percent; after rising again sharply during the October-November turbulence in international capital markets, they eased by mid-December to about 17 percent, a further 2½ percentage point increase (Figure 19, Table A31, SM/98/30, Sup. 1, (1/30/98)). As a result, the differential between the PRIBOR and the German interest rates doubled to 13 percentage points at end-1997 from 6 percentage points two years earlier. The higher interest rate differential has contributed to the relative stability of the koruna since the May crisis.

Figure 19CZECH REPUBLIC: DEVELOPMENTS IN INTEREST RATES (1993-97)

Sources: Czech National Bank; and staff calculations.

1/ The foreign interest rate is a weighted average of corresponding interest rates in Deutsche Mark and U.S. Dollar instruments, the weights being equal to those in the currency basket.

92. The interbank money market has developed rapidly over the past few years and has become well integrated in international financial markets, as indicated by the fact that the koruna is by far the most actively traded currency in the CEE. As a result, interbank interest rates are influenced significantly by capital movements and area by hedging operations related to Eurokoruna bond issues; in particular, the decline in early 1997 of interbank interest rates with a maturity of three months or more is attributed to the surge of Eurokoruna bond issues.52 Instruments of two-week maturity account for more than 90 percent of total activity in the interbank money market, owing to the use by the CNB of two-week repos on its bills as the principal intervention instrument. This enables the CNB to have an immediate effect on interbank interest rates.53 Moreover, as the correlation between interbank rates and the rates on new credits is close and improving over time (Figure 20), this gives the CNB a good handle on bank lending interest rates.

Figure 20CZECH REPUBLIC: AVERAGE INTEREST RATE OF NEW CREDITS AND PRIBOR

(Annual rates, in percent)

Sources: Czech National Bank.

93. The rise of interbank interest rates has pushed up interest rates on new credits by almost 3 percentage points over the past two years; by end-1997 they had reached 16 percent; (Table A30, SM/98/30, Sup. 1, (1/30/98)). Relative to producer prices this corresponds to a real lending rate of 10 percent, which is in line with interest rates in other CEE countries and countries whose currencies came under pressure in 1997. Lending interest rates differ across the various types of borrowers and the pattern has changed over time (Figure 21). In particular, foreign-controlled enterprises (which account for less than 10 percent of borrowing) tend to borrow at lower interest rates and the distribution of interest rates tends to be less dispersed; this probably reflects the better credit rating of these enterprises which also have access to foreign borrowing at lower interest rates. On the other hand, the interest rate distribution of new credits to domestic enterprises tends to be multimodal and relatively more dispersed, a reflection of greater heterogeneity across borrowers; there is no substantial difference between private and publicly controlled enterprises. An important feature of the interest rate distribution of bank credit is that 14 percent of outstanding credits earn an interest rate of 1 percent or less; mostly, these are loss loans on which the interest rate was reduced so as to protect banks from having to pay income tax on accrued interest income (Figure 22). Old mortgage loans to households which are subsidized by the state budget account for the concentration of loans in the interval of 2-3 percent interest.54

Figure 21CZECH REPUBLIC: DISTRIBUTION OF NEW LOANS BY INTEREST RATE

Sources: Czech National Bank; and staff calculations.

Figure 22.CZECH REPUBLIC: INTEREST RATE DISTRIBUTION OF TOTAL BANK LENDING

(December 1996)

Source: CNB.

94. The average real deposit rate has been negative, although less so relative to previous years; particularly negative have been interest rates on sight deposits. On the other hand, term deposits, which are more closely related to interbank interest rates, have exceeded consumer price inflation by about 3 percentage points and this must have contributed to their increasing share in total deposits (Figure 23).

Figure 23CZECH REPUBLIC: INFLATION ADJUSTED INTEREST RATES 1/

(Annual Rates in Percent)

Sources: Czech National Bank; and staff calculations.

1/ Adjusted by the twelve-month CPI growth rate.

95. With the 3 percentage point rise in required reserves in August 1996, the spread between lending and deposit interest rates increased in the second half of 1996 by almost ½ percentage point, reaching 6 percentage points; however, it fell in early 1997 on account of declining lending rates and reached 5.3 percentage points in April. After increasing to almost 6 percentage points during the currency crisis (despite the reduction of the reserve requirement by 2 percentage points), the spread declined again to 5½ percentage points and remained at that level until the end of the year. The high non-remunerated reserve requirement and credit risk (reflected in the high share of classified loans) contribute to the high spread between lending and deposit rates (See also Chapter V).

G. Stock Market

96. Contrary to the money market, which is the most developed among European transition economies and the best integrated with international financial markets, the capital market is plagued by fairly low liquidity, opaqueness, and inadequate regulation, all of which discourage investors (foreign and domestic). The Prague Stock Exchange performed poorly in 1997 (relative to the stock exchanges in neighboring Hungary and Poland), reflecting low interest on the part of foreign investors and contagion from turbulence in international financial markets. The PX50 index (which monitors the shares of the 50 largest companies by market capitalization) declined by 8 percent in koruny terms (20 percent in terms of DM) in 1997 to about half its 1994 level (Figure 24). Stock prices followed a roller coaster path during 1997: a rally earlier in the year was reversed amid growing concern about the sustainability of the exchange rate peg and reports of mismanagement in several investment firms. In the last quarter of the year stock prices were hit by the retreat of foreign investors from emerging markets (contagion from Southeast Asia), political uncertainty, and concern about continuing sluggish economic activity.

Figure 24CZECH REPUBLIC: EQUITY PRICE INDEX (PX50)

Sources: Czech National Bank, and Bloomberg news services.

Prepared by Anastassios Gagales.

An account of the authorities’ preference for exchange rate targeting can be found in SM/96/286, pp. 40-41.

The currency basket comprised fixed amounts of deutsche mark and U.S. dollars with respective weights of 65 percent and 35 percent. The composition of the basket was last changed in May 1993.

The money growth target of 8-12 percent was revised to 7-11 percent in August 1997.

As a prelude to the more formal inflation targeting, the inflation objective was reported in mid-summer 1997 to be “single digit rate” whereas in September 1997 a target of 12 percent was mentioned in the press. Both figures related to overall or headline inflation.

This is equivalent to a 100 percent reserve requirement. Two notable cases are the transfer in 1995 of a SPT Telecom foreign exchange deposit (US$1.33 billion) related to the payment by a Dutch-Swiss consortium for a 27 percent stake in the company and the transfer in 1994-95 of NPF deposits. At the peak, these two deposits amounted to 7 percent of broad money.

Since December 1997 the CNB started releasing, with a two month lag, information on its foreign exchange market interventions.

Such restrictions are difficult to enforce and can prove costly if they raise the risk premium on the currency. However, they are a useful second-best instrument in periods of extreme turmoil. They are akin to automatic circuit breakers in stock exchanges.

Government bonds became more attractive to foreign investors in 1997 with the abolition of their tax-exempt status for residents, a measure that raised the gross return for domestic investors and the net one for foreign ones.

Eurokoruna bond issues did not affect the exchange rate to the extent that they were (i) not covered with domestic assets or (ii) used to cover existing asset positions of the issuer in koruny (these had already put pressure for appreciation at the time the koruny claim was created).

Contagion affected the koruna more than the currencies of other neighboring transition economies because of the greater openness and globalization of the Czech economy, and political uncertainty, which by coincidence happened to increase each time there was turmoil in international financial markets. Several indicators of external vulnerability for the Czech economy were not significantly different from those for neighboring transition economies but were definitely better than those in Southeast Asian countries (Chapter VI).

The DM 1 billion loan from the local branch of Commerz bank was contracted on May 31, 1997 and was recorded in the CNB’s balance sheet on June 1. The loan, which was paid off in September, did not affect net foreign assets as it was recorded as a foreign liability.

The restriction, introduced in August 1995 to discourage capital inflows, stipulated that short-term foreign liabilities or banks toward nonresidents may not exceed their corresponding claims by more than 30 percent, or in any case CZK 500 million. This restriction reportedly became ineffective as banks were able to evade it through legal means.

Broad money includes deposits of several extrabudgetary organizations, accounting for about 3¾ percent of broad money at end-1996; it excludes short-term securities held by nonbanks, which amounted to 3 percent of broad money at end-1996; it excludes bank bonds and mortgage bonds; it also excludes the counterpart of the SPT Telecom deposit with the CNB related to the US$1.33 billion payment by a Dutch-Swiss consortium for a 27 percent stake in SPT (the deposit was used up in November 1997). End-of-year broad money figures are adjusted for temporary swings in the float.

Deposit-like instruments with a maturity of less than one year (CNB bills, Treasury-bills and National Property Fund bills held by nonbanks) amount to about 3 percent of broad money; their inclusion in broad money would have raised its growth rate by ½ percentage point. Valuation effects of exchange rate changes have contributed 0.2 percentage point to the deceleration of broad money growth in 1996 but have added 1.2 percentage points to broad money growth since May 1997. Finally, the removal of banks whose license had been suspended from the monetary survey (as of January 1997) contributed another 0.6 percentage point reduction in broad money growth.

Velocity is defined as annualized quarterly real GDP times the quarterly average of CPI over end-of-quarter broad money. All variables are adjusted for seasonality.

The rate of change is calculated at constant required reserves ratio using the beginning of period required reserves ratio as a reference point.

During the May 1997 currency crisis banks did not renew their repos of CNB bills, causing the volume of sterilization to decline to CZK 125 billion. In the third quarter it picked up to CZK 160 billion.

The total volume of sterilization (including through required reserves) dropped by less: from CZK 224 billion in 1996 to CZK 213 billion in 1997 or, respectively, from 103 percent to 89 percent of reserve money. The cost in relation to GDP was, respectively, 1⅓ percent and 1½ percent.

Cost calculations were based on the assumption that the yield on NFA equals the weighted average interest rate on three-month interbank deposits in Frankfurt and the three-month Treasury-bill rate in the United States, while the interest rate on CNB bills and on deposits by SPT Telecom and NPF equals the three-month PRIBOR (Prague Interbank Offered Rate).

The import deposit scheme (April-August 1997) was administered by the Consolidation Bank. It involved a six-month deposit equal to 20 percent of the value of imports; it applied to selected consumer goods and foodstuff amounting to about 30 percent of all imports and yielded CZK 10.5 billion in blocked deposits; of this amount half was on-lent to enterprises while the remaining part was deposited with the CNB and appeared as higher excess reserves of banks (thus lowering the money multiplier and raising base money). Upon its dismantling, CZK 10.5 billion was returned to importers.

In addition to the interbank market, issuers of Eurokoruna bonds have also used government securities to hedge their exchange rate risk. These securities became more attractive to nonresidents in 1997 with the introduction of a 25 percent withholding tax (from which nonresidents are exempt). In 1996-97 T-bills accounted for the bulk of trading in the money market. Nonresidents may not hold CNB bills.

When the maturities of the instruments are short, the discrepancy between the average and the current interest rate is small. Thus, a change in current money market conditions raises quickly the average interest rate which, being closely related to the cost of funding, transmits the change to the interest rate on new credits.

These loans were extended prior to 1989 and carry fixed interest rates, ranging from 0.7 percent to 2.5 percent.

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