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Czech Republic: The Koruna -- A Currency Under Attack

By Zdenek Tuma

Prague, 23 May 1997 (RFE/RL) - The Czech Republic today continues strenuous efforts to protect its currency, the koruna, from devaluation. But there are no tangible signs that the pressure on the koruna will ease any time soon.

The koruna declined to its all-time low -- more than 5 percent below the central parity of the 7.5 percent fluctuation band -- in the morning of May 15. The Czech National Bank (CNB) followed with several interventions designed to defend the koruna, pushing it up 2 percent.

Several different sources say the CNB spent $100 to $400 million in its first direct interventions since February 1996. Later that day, the CNB announced that it would change its interest rates flexibly, depending on the market situation. Until then, the repo rate (applied for specific loans from the central bank to commerical banks) had been 12.4 percent.

The CNB intervened again on May 16 in the morning, after the koruna hit 4 percent below parity. The repo rate was raised 0.5 percent to 12.9 percent and helped the koruna only temporarily. The CNB raised its Lombard rate -- the ceiling of money market rates -- from 14 percent to 50 percent, after the koruna traded at 4.5 percent below parity in the afternoon.

The discount rate remained unchanged at 10.5 percent. The Lombard rate hike indicated the magnitude of CNB's commitment to stabilizing the koruna in the very short term. Various sources estimated that the interventions amounted to nearly $1 billion during the first two days. The CNB would not comment. The CNB's foreign exchange (forex) reserves stood at $11.7 billion at the end of March.

On May 19, the CNB raised the repo rate further to 45 percent, when the koruna opened at 2.8 percent below parity. The scale of the repo rate hike indirectly confirmed that the amount of forex reserves spent recently by the CNB to support the koruna has been substantial. In the following three days (May 20-22), the koruna was depreciated in the range from 2 percent to over 6 percent against the central parity as the CNB intervened several times.

Moreover, the central bank started applying administrative measures on May 22, such as a prohibited approach to lombard credit and restrictions on lending Czech currency to non-residents. Despite all effort the pressure on depreciating the koruna continues to be strong.

As a result, money market rates jumped. Over-night rates sky-rocketed to hundreds percents.

The exchange rate of the koruna was one of the key macroeconomic tools in transforming the economy. It was decided to try to maintain a fixed rate of exchange as long as possible. The exchange rate has been fixed in terms of a basket of foreign currencies. The basket currently consists of the dollar (with an approximate 35 percent weight) and the Deutschemark (approx. 65 percent).

The new Foreign Exchange Act, passed in September 1995, made the koruna convertible in accordance with Article VIII of the Articles of Agreements of the IMF. In fact, the new Act liberalizes also some restrictions of capital account transactions even further than required by the Article VIII.

Among the European countries in transition, the Czech Republic has shown the highest currency stability. Since a triple devaluation of koruna in 1990, the Czech currency has been kept stable against a basket a foreign currencies.

The stability was maintained even during the turbulent splitting of the Czechoslovak federation and during abandonment of the short-lived Czechoslovak monetary union.

During 1995, the Czech koruna was under permanent appreciation pressure due to massive net foreign capital inflow. The Czech National Bank responded by widening the koruna fluctuation band from plus or minus 0.5 percent to plus or minus 7.5 percent in February 1996. The wider band successfully introduced an element of exchange rate risk into foreign investors' calculations and weakened the short-term capital inflow.

By the end of last year, the koruna hovered about 3 percent below the central parity (appreciated against the parity), but this had been achieved without any noteworthy intervention on the part of CNB since March last year.

Since the beginning of this year, the koruna has rapidly strengthened by another two percentage points inside the appreciation portion of its fluctuation band and peaked above the 5 percent level considered by some observers as critical. The main reason for that appreciation move of the koruna exchange rate was a sudden explosion of interest of various issuers in floating koruna denominated eurobonds, primarily for retail customers.

The issues, typically in a 1-2,000 million Koruna volume and with 1-2 years to maturity, were usually sold by banks, but sometimes also by less usual agents like the Austrian government. The total volume of koruna eurobonds issued this year surpassed $1 billion. The mood changed during March and April 1997 and the exchange rate broke through the central parity in mid-April to the depreciation side of the band. A major underlying reason is permanently worsening trade balance which led to a very high current account deficit (app. the sum of trade with commodities and services) already in 1996 (8.6 percent of GDP).

The negative trend in the external sector has been accompanied by declines of industrial and construction outputs in the first quarter of 1997 and by increasing political tensions and uncertainty. There are doubts about the credibility of the present government in the public so that a reshuffling of the cabinet is expected. Under these circumstances, investors have become very cautious to enter the Czech capital market and they have even started to close their positions here. As a result, the Czech koruna has moved sharply downwards and the Czech National Bank had to intervene.

The koruna will continue to be very prone to depreciation pressures in the near future. It is possible that the situation will calm down temporarily, but attacks on the exchange rate will very likely occur again sooner or later. The current level of interest rates could strangle the economy. It is unlikely that such a high level is sustainable for more than 2-3 weeks. The koruna is likely to depreciate by 10-15 percent in next weeks or by the year's end at latest.

The Czech National Bank has two basic options now.

First, it can apply other administrative measures and try to stabilize currency. Such an attempt could succeed if there were chances for reverting negative trends in the trade balance deficits. (The trade balance figure will be released on May 26).

Second, the CNB could give up the fixed exchange rate regime and choose either a further widening of the band, or devaluation of the central parity, or a crawling band, or pure floating.

If higher interest rates persist for several months domestic demand and economic growth would be negatively affected. Economic growth will be structurally different from the past, no matter how the current exchange-rate crisis is resolved. Exports will have to be the engine of growth, with several industrial sectors gaining. Construction and domestic retail, on the other hand, will be hurt.

Zdenek Tuma is chief economist at Patria Finance, a private company located in Prague. Vladimir Kreidl and Martin Kupka form Patria Finance have also contributed to this story.