Download Economic and Financial Stability via Exchange Rate Volatility

Economic and Financial Stability via
Exchange Rate Volatility:
The Case of the Czech Republic
Jan Frait
Economic Research and Financial Stability Department
„The Modern Role of Central Banks in Small Open Economies
June 26-27, 2009, Tbilisi, Georgia
Outline
• Rise and fall of fixed exchange rate regime
• Inflation targeting under exchange rate volatility
• Miracle of a tough live with floating
• Conclusion: Success calls for currency flexibility.
1. Fixed exchange rate period
• Fixed exchange rate era was a traditional story.
• At the outset of transition the Czechoslovak authorities opted for
a fixed exchange rate regime as the nominal anchor.
• Koruna (CZK) was pegged to a basket of five currencies in
1991, in 1993 CZK pegged to a basket with German Mark
(DEM) - weight 65% and US Dollar (USD) - weight 35%.
• Three successive devaluation steps at the end of 1990 resulted
in nearly 100 percentage decline of nominal value of Koruna
against key currencies
• After the last devaluation the CZK/USD exchange rate was set
to 28 CZK/USD (today 19,5 CZK/USK) and 18 CZK/DEM (today
eq. 13,8 CZK/DEM)
• Policy of monetary-targeting with fixed exchange rate attempted
…
1. Fixed exchange rate period
• In 1995 full liberalization of financial account, full convertibility
achieved (or mis-achieved?).
• Capital inflows combined with lax lending standards of banks
lead to excessive credit and money supply growth.
• Not surprisingly rise in the net foreign assets in the base money,
and a loss of control over the money supply.
• The Czech National Bank (CNB) responded by sterilizing
monetary effects of the capital inflows.
• Macroeconomic imbalances were accumulating while the
authorities were not willing to increase exchange rate flexibility.
1. Fixed exchange rate period
• Deteriorating macroeconomic situation caused by overly
expansionary policies was first mirrored in the worsening current
account - deficit represented more than 4% of GDP in 1995 and
nearly 8% of GDP in 1996.
• Trade balance - in 1995 the deficit in the trade balance reached
nearly 8% of GDP and 11% of GDP in 1996.
• Situation became unsustainable and the authorities were forced
to switch to a managed float on May 26, 1997 - the initial effect
was depreciation of Koruna against key currencies by
approximately 15%.
• Restrictive fiscal and monetary policies adopted.
• Sharp recession and major problems in banking sector.
• Shift to inflation targeting in 1998.
1. Fixed exchange rate period
• … and what happened then was not much traditional …
20
15
depreciation
10
5
band +/-7,5%
Feb 28.1996 - May 27.1997
0
in %
-5
band +/-0,5%
Sep 27. 1992 - Feb 2.1996
the level of ER
against the former
currency basket
(65% DEM, 35% USD)
-10
-15
appreciation
-20
-25
-30
-35
targeting of M2 and until
May 26, 1997 ER as well
inflation targeting
-40
1/91 1/92 1/93 1/94 1/95 1/96 1/97 1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09
2. Inflation targeting period
• Inflation targeting (IT) introduction was not in line with textbook
recommendations.
• IT chosen in reaction to jump in inflation expectations.
• CNB used IT initially as a tool for disinflation compatible with
flexible exchange rate in a destabilised economy.
• IT was introduced in a period of strong exogenous shocks
(Russian crisis, volatile oil and food prices, etc.).
• Major modification of the system over the years (targets, escape
clauses, communication, ER management, co-operation with
government, etc.)
• Target currently set as a „permanent“ point target with
a tolerance band for headline inflation, compared to a continuous
declining corridor for headline inflation (2002-2005) or end-year
targets for “net inflation” (till 2001).
2. Inflation targeting period
8
7
target 1998
6% +/- 0,5p.b.
(announced in
December 1997)
target 2000
4,5 +/- 1p.b.
(announced in
December 1997)
6
in %
5
start of the
target band
3-5%
4
3
target 1999
4,5 +/- 0,5p.b.
(announced in
November 1998)
end of the
target band
2-4%
0
1/98
target 2001
3% +/- 1p.b.
(announced
in April 2000)
1/99
1/00
1/01
1/02
(announced
in March 2004)
point target 2%
target band
2002-2005
(announced
in April 2001)
2
1
point target 3%
1/03
1/04
(announced
in March 2007)
1/05
1/06
1/07
1/08
1/09
• Currently a 3% target (2% from January 2010).
1/10
1/11
2. Inflation targeting period
28
1W repo rate and
1W PRIBOR 75%,
the Lombard rate
50%
in May 1997
24
20
16
12
8
4
0
1993
1994
1995
1996
1997
1998
1999
2000
2W repo rate
2001
2002
2003
discount rate
2004
2005
2006
2007
2008
2009
the Lombard rate
• Nominal interest rates were high until 1998-99;
• Disinflation process led to their fall to low levels.
2. Inflation targeting period
• Explicit application of “escape clauses” since 1999.
• Major deviations of the CZK’s exchange rate unconnected with
domestic economic fundamentals and domestic monetary policy;
• Substantial deviations of global prices of raw materials, energy
sources and other commodities;
• Marked changes in the conditions for agricultural production
having an impact on agricultural prices;
• Natural disasters or similar extraordinary events having cost and
demand impacts on prices;
• Regulated price changes deviating substantially from the normal
magnitude and changes in indirect taxes (since introduction of CPI
targeting);
• Currently the clauses are used less explicitly, except for indirect
taxes.
2. Inflation targeting period
• IT period started with excessive success – unexpected reversal
of exchange rate.
• A painful but effective tool for regaining antiinflationary credibility.
20
15
depreciation
10
5
band +/-7,5%
Feb 28.1996 - May 27.1997
the level of ER
against the former
currency basket
(65% DEM, 35% USD)
0
in %
-5
band +/-0,5%
Sep 27. 1992 - Feb 2.1996
-10
-15
appreciation
-20
-25
-30
-35
targeting of M2 and until
May 26, 1997 ER as well
inflation targeting
-40
1/91
1/92
1/93
1/94
1/95
1/96
1/97
1/98
1/99 1/00
1/01
1/02
1/03
1/04
1/05
1/06
1/07
1/08
1/09
2. Inflation targeting period
14
12
10
net inflation
targets
8
headline inflation
targets
6
4
2
0
-2
12/97
12/98
12/99
12/00
12/01
12/02
Headline inflation
12/03
12/04
12/05
12/06
12/07
12/08
Net inflation
• Achieved disinflation under the inflation targeting;
• Inflation often below the targets.
2. Inflation targeting period
Deviation of Inflation From Targets
6
4
(in p.p.)
2
0
-2
-4
-6
• The two most pronounced periods of inflation target
undershooting (and negative output gap) followed the ER
overvaluation episodes.
09:Q1
08:Q3
08:Q1
07:Q1
07:Q3
06:Q3
06:Q1
05:Q3
05:Q1
04:Q3
03:Q3
04:Q1
03:Q1
02:Q3
02:Q1
01:Q3
01:Q1
00:Q3
99:Q3
00:Q1
99:Q1
98:Q3
98:Q1
-8
2. Inflation targeting period
Inflation Expectations of Analysts
1Y- ahead expectations
4
2
0
1/00
1/01
1/02
1/03
Targets
1/04
3Y-ahead
expectations
6
In %; year-on-year
In %; year-on-year
6
1/05
1/06
1/07
Infl.expectations (shifted by 1Y)
1/08
1/09
1/10
4
2
0
1/02
1/03
1/04
1/05
Targets
1/06
1/07
1/08
1/09
1/10
1/11
1/12
Infl. expectations (shifted by 3Y)
• 1Y expectations more volatile, but in line with targets;
• 3Y expectations below the 3% target in recent years (reflection
of the CNB‘s and CZK‘s track records?);
• 3Y expectations above the new 2% target (no major change).
2. Inflation targeting period
7%
Inflation targeting
5%
3%
1%
-1%
-3%
GDP growth (y/y)
09:Q1
08:Q1
07:Q1
06:Q1
05:Q1
04:Q1
03:Q1
02:Q1
01:Q1
00:Q1
99:Q1
98:Q1
97:Q1
96:Q1
-5%
Output gap
• Frequently below potential for a long period of time;
• Role of ER appreciation in two gap-widening episodes;
• Rapid and severe impact of the world economic crisis.
2. Inflation targeting period
Variance Decomposition of GDP_GAP
Variance Decomposition of PI_GAP
50
80
40
60
30
40
20
20
10
0
0
1
2
3
4
EA_GAP
CZV_GAP
IR_REAL_GAP
5
6
7
POIL_GAP
GDP_GAP
8
9
10
ER_GAP
PI_GAP
1
2
3
4
EA_GAP
CZV_GAP
IR_REAL_GAP
5
6
7
POIL_GAP
GDP_GAP
8
9
10
ER_GAP
PI_GAP
• Exchange rate shocks explain 40 - 50 % of variability in
output gap and in the deviations of inflation from targets;
• Justifies great attention paid to these shocks by the CNB.
2. Inflation targeting period
• Summary:
•
•
•
•
•
•
•
•
•
Challenging conditions;
Regime evolving over time;
Frequent undershooting of targets (overshooting in 2007/08);
Three periods of negative output gap;
Appreciation contributing to these periods of difficulties;
Exchange rate developments impacted policy rates setting;
Inflation expectations relatively well anchored;
Low inflation enabled to keep interest rates on a low level;
Current crisis severe but the economy and financial sector in a
good shape.
3. Living with floating
• Managed float declared in 1997, de facto free float from 2002.
• Both nominal and real exchange rates exhibited long-term
appreciation trend.
• Accumulation of relatively large amount of FX reserves:
• proceeds from privatization deals,
• purchases from open market (mainly in 2001-2002),
• interest accrued in recent years.
• Huge unrealized valuation losses on FX reserves holdings and
sizeable negative own capital.
• High volatility from the onset of global financial turmoil in August
2007.
2 000
1,0%
1 800
0,9%
1 600
0,8%
1 400
0,7%
1 200
0,6%
1 000
0,5%
800
0,4%
600
0,3%
400
0,2%
200
0,1%
0
0,0%
-200
-0,1%
I.98
VII.98
I.99
VII.99
I.00
VII.00
I.01
VII.01
I.02
VII.02
I.03
VII.03
I.04
VII.04
I.05
VII.05
I.06
VII.06
I.07
VII.07
I.08
in EUR mil.
3. Living with floating
Interventions (l.h. axis)
Exchange rate volatility (r.h. axis)
• Relatively long
periods of no
interventions;
• Interventions against
appreciation only;
• February-July 1998;
October 1999-March
2000; 2001-02;
• Since 2002 no
interventions.
3. Exchange rate policy and issues
Nominal Exchange Rate (EUR; USD)
Managed floating
Inflation targeting
3rd appreciation
episode
1st appreciation
episode
2nd appreciation
episode
I.96
VII.96
I.97
VII.97
I.98
VII.98
I.99
VII.99
I.00
VII.00
I.01
VII.01
I.02
VII.02
I.03
VII.03
I.04
VII.04
I.05
VII.05
I.06
VII.06
I.07
VII.07
I.08
VII.08
I.09
42
40
38
36
34
32
30
28
26
24
22
20
18
16
14
CZK/EUR (DEM before 99)
CZK/USD
• Increased
volatility since
Feb 1996 / May
1997;
• Trend
appreciation
since 1999;
• Periods of fast
appreciation
in 1998, 200102 and 2007-08.
3. Living with floating
• The reaction of private agents to currency appreciation contributed
to the flexibility of the economy.
• The CNB was explaining that these were the global pressures
behind nominal appreciation that a small economy could not avoid.
• The public gradually accepted the idea that exchange rate is not
something that the central bank should try to manage.
• Exporters and their workers gradually adjusted to the appreciation
trend:
• The exporters factored in future development of ER into their
expectations.
• The labour unions realized that currency appreciation improves the
purchasing power of workers’ wages which helped to discipline the
wage dynamics.
3. Living with floating
• Combination of currency appreciation and low interest rates
environment helped to maintain financial stability.
• Sustained appreciation worked against the formation of overly
optimistic expectations in the corporate sector which tamed the
potential for a corporate sector credit boom.
• Currency appreciation was also shifting part of existing domestic
demand from nontradeables to tradeables along the long-term
trend towards higher consumption of non-tradeables, contributing
to a more balanced macroeconomic and structural dynamics.
• Households did not have any incentive to borrow in foreign
currencies which had made their balance sheets insulated from
exchange rate risk.
• Households had strong incentives to save and deposit in domestic
currency.
3. Living with floating
Deposit-to-loan ratios in selected EU countries
(%; 2008; resident loans and deposits; non-bank institutions)
FX loans in selected EU countries
(% of total loans to given sector; 2008)
140
100
90
80
70
60
50
40
30
20
10
0
120
100
80
60
LV EE HU RO LT PL BG SI SK CZ
Households
EA AT BE SE
Corporates
Source: BIS, ECB, national central banks
Note: EA = euro area. SI - data as of February 2008; BE - households
include only housing loans, corporates include all client loans excluding
housing loans.
40
20
0
CZ SK PL BGROHU SI LT EE LV
BE DE AT FR
UK SE DK
Source: ECB
Note: EA = euro area; EU = average for all EU countries.
• No FX-denominated credits of Czech households;
• Deposits of Czech banks exceed the volume of loans, no reliance
on foreign financing of credits;
• Much better situation in comparison with other CEE countries.
EA EU
3. Living with floating
• The key driver behind demand for foreign currency loans is clearly
differential between lending rates in home and foreign currency.
• Fixed exchange rate regime is what drives people to ignore the
exchange rate risk.
• The share of FX loans provided to households is the lowest in two
countries with a history of profound and sustained nominal currency
appreciation - Czech Republic and Slovakia.
• This is despite the fact that taking a loan in foreign currency if the
domestic currency appreciates is ex post „cheaper“.
• The effect might go via currency denomination of deposits currency structure of borrowing must be linked to the one of saving.
If people have long-term incentive to save in domestic currency,
they will also view as natural to borrow in it.
3. Living with floating
• Real ER appreciation (stronger than in the NMS) backed by
supply-side improvements;
• Increase in GDP price level from 41 % of EU-27 in 1997 to
some 70 % in 2008.
135
130
1999= 100
125
120
115
110
105
100
95
90
1998
1999
2000
Cz ec h Rep.
2001
2002
2003
NM S weighted av.
2004
2005
2006
CE E weighted av.
2007
3. Living with floating
• Current account in the CZ was developing quite well - surplus
of G&S trade vs. incomes deficit; with self-financed reinvested
profits no external financing needs from current account now.
• NMS: trade balance still in a deficit, deeper current account
deficit.
NMS total
6%
4%
4%
2%
2%
in % of GDP
0%
-2%
-4%
-6%
0%
-2%
-4%
-6%
Goods
Services
Transf ers
Current account
Incomes
08:Q1
07:Q1
06:Q1
05:Q1
04:Q1
-12%
03:Q1
-12%
02:Q1
-10%
01:Q1
-10%
00:Q1
-8%
99:Q1
-8%
98:Q1
in % of GDP (4Q moving av.).
Czech Republic
6%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Goods
Services
Transf ers
Current account
Incomes
3. Living with floating
Global crisis - Phase I: corrections in FX markets until Lehman
Financial market corrections 2006–2007: impact on exchange rates
• The koruna with a status
of „safe haven“ currency
(CMAX index = ratio of current stock index value to maximum value in past 60 days, lefthand scale; exchange rates as indices, 1 January 2006 = 100, right-hand scale)
remained solid in the
130
1,0
same way as in previous
125
0,9
corrections. This time
120
however a bit overacted.
0,8
115
• Negative interest rate
depreciation
0,7
110
differential motivated
105
0,6
investors to use CZK for
100
carry trades: in times of
0,5
95
corrections investors
0,4
90
unwind positions in carry
85
0,3
trades = appreciation of
I.06 IV.06 VII.06 X.06
I.07 IV.07 VII.07 X.07
I.08
financing currency
CMAX PX
CMAX BUX
CMAX WIG
CZK/EUR exchange rate
(CZK).
HUF/EUR exchange rate
PLN/EUR exchange rate
Source: Bloomberg.
3. Living with floating
Global crisis - Phase I: corrections in FX markets until Lehman
• Between summer 2007 and summer 2008 the koruna managed to beat
any traded currency.
• Declarations of currency overvaluations relative to fundamentals was
not much efficient.
The appreciation of the koruna against traded currencies
(from the outset of turmoil till 29 July 2008, y-o-y in %)
KRW
THB
JMD
VND
ZAR
GBP
NZD
SAR
VEF
USD
HKD
LBP
CAD
RON
PHP
ARS
KWD
CLP
EGP
MYR
TWD
RUB
TRY
TND
JPY
MXN
CNY
SEK
SGD
MAD
COP
AUD
NOK
DKK
EUR
BGN
CHF
HRK
BRL
HUF
SKK
PLN
50
45
40
35
30
25
20
15
10
5
0
3. Living with floating
Global crisis - Phase II: after Lehman (September 2008-February 2009)
• Negative economic outlook for CEE countries increased the risk
aversion towards the CEE region as a whole.
• Resulting currency depreciation aggravated the situation in countries
with high share of FX loans => further increase in risk aversion and
higher roll-over risk.
Exchange rate developments
(1.1.2007=100)
Credit default swaps of selected EU countries
(5Y CDS spreads, bps)
130
700
125
600
120
115
500
110
400
105
300
100
95
200
90
100
85
0
01/07 04/07 07/07 10/07 01/08 04/08 07/08 10/08 01/09 04/09
EU average
CZ
Source: Thomson Datastream
HU
PL
SK
SE
80
01/07
05/07
09/07
CZK/EUR
01/08
05/08
PLN/EUR
Source: Reuters, Thomson Datastream
09/08
01/09
HUF/EUR
3. Living with floating
Global crisis - Phase III: post-Lehman
• Investors started to
differentiate
between countries.
• Koruna stabilized
and returned to its
long-term trend.
• High volatility
continues.
• Sharp moves on
both sides likely.
The koruna exchange rate and its volatility
38
30
36
25
34
32
20
30
15
28
26
10
24
5
22
20
3/00
0
1/01 11/01 9/02
7/03
CZK/EUR (left-hand scale)
5/04
3/05
1/06 11/06 9/07
7/08
Implied 1M volatility (right-hand scale)
Source: CNB calculation based on CNB data
Note: The dotted line shows the long-term trend.
Exchange Rate Criterion and ERM2
The future exchange rate policy – ERM II
The Eurosystem position: „ … ERM2 offers a meaningful
framework for combining nominal and real convergence
and should be seen as a useful regime on its own right …“
"That's the most important piece of evidence we've heard yet."
said the King …
"I don't believe there's an atom of meaning in it." said Alice …
"If there's no meaning in it, that saves a world of trouble,
as we needn't try to find any."
said the King.
Lewis Carroll, Alice's Adventures in Wonderland,
Chapter XII, Alice's Evidence
Concluding remarks:
Success calls for flexibility
• Fixed exchange rate in a dynamic emerging market economy is a
risky adventure.
• Success in attracting FDI inflows and speeding up GDP
convergence is likely to deliver real exchange rate appreciation.
• Resulting optimistic expectations will boost demand for credit.
• The exchange rate flexibility can then play and important role in
addressing the challenges associated with the process of real
economic catch up.
• If the authorities want to succeed with fixed exchange rate instead,
they must often accompany fixed exchange rate with some other
measures, resign on using interest policy in managing domestic
demand and still have plenty of luck.
Concluding remarks:
Success calls for flexibility
• Allowing domestic currency to appreciate over time may bring low
interest rates and low demand for loans in foreign currencies which
supports the financial stability.
• The timing of an increase in the exchange rate flexibility is of
utmost importance - in a situation of prevailing depreciation
pressures might actually lead to a flight from the national currency.
• Nominal currency appreciation is easier to achieve under floating
then via realignment under fixed exchange rate regime.
• It makes no sense to idealize floating either – it may bring more
volatility and periods of misalignment.
Thank You for Your Attention!
Contact:
Jan Frait
Economic Research & Financial
Stability Department
Czech National Bank
Na Prikope 28
CZ-11503 Prague
Tel.: +420 224 414 430
E-mail: [email protected]