Czech National Bank to Drop CZK Floor by Mid-2017

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The Czech National Bank is poised to exit the koruna floor by mid-year.  Rising inflation and a robust economy warrant this, but policymakers have to be alert to the potential for a disruptive move lower in EUR/CZK. POLITICAL OUTLOOK

Despite the populist/nationalist governments in neighboring Hungary and Poland, the Czech Republic has been governed by a center-left coalition since elections in October 2013.  The coalition is led by center-left Czech Social Democratic Party (CSSD) with 50 seats in the 200-seat parliament.  It also contains the Christian Democrats (KDU-CSL) with 14 seats and the centrist ANO 2011 (ANO) with 47 seats.

General elections have to be held by October of this year.  No date has been announced yet.  Elections for a third of the seats in October saw the ruling coalition maintain control of the Senate.  As such, our base case is that the coalition maintains control of the lower house (and thus forms the government) this fall.

Regional elections in October 2016 saw big gains for ANO.  As such, ANO seems likely to become the largest party in the coalition, which would see its leader Andrej Babis become Prime Minister.  Babis is currently First Deputy Prime Minister as well as Finance Minister.

Indeed, recent polls show ANO with the most support at 30%, followed by the CSSD with 15% and the Communist Party third with 13%.  Polls also show support for the center-right opposition parties ODS (16 seats) and TOP 09 (26 seats) remaining below 10%.

Babis says that ANO is meant to be a movement, not a political party.  Its anti-corruption stance has clearly struck a chord with the voters.  Notably, Babis has in the past expressed opposition to euro adoption by the Czech Republic, as well as deeper integration with the EU.  However, we do not foresee a lurch to the right under ANO.

ECONOMIC OUTLOOK

The economy is recovering.  GDP growth is forecast by the IMF to accelerate modestly to 2.7% in 2017 from 2.4% in 2016, driven by both strong domestic and external demand.  The Czech National Bank is more optimistic, forecasting 2.8% growth in both 2017 and 2018.  GDP rose 1.9% y/y in Q4 vs. 1.5% in Q3, while the q/q rate picked up to 0.4% from 0.2% in Q3.  Monthly data so far in Q1 suggest a further pickup in growth.  Thanks to EU funds, Czech Ministry of Finance estimates that investment (both private and public) should be supported in 2017.

Price pressures are rising, with CPI accelerating to 2.5% y/y in February.  This is the highest rate since November 2012, and is creeping towards the top of the 1-3% target range.  Given low base effects from 2016, inflation is likely to move above the range in H1.  Core CPI and PPI measures are also accelerating.

The inflation outlook supports the case for an exit from the koruna cap this year.  Currently, the central bank’s forward guidance suggests an exit by mid-year and we see no reason to change that.  There are three central bank policy meetings left in H1:  March 30, May 4, and June 29.  We think the March 30 meeting is too soon for an exit, but either the May 4 or June 29 meeting should be seen as “live.”

Fiscal policy has remained prudent.  The Finance Ministry estimates that the budget came in at a surplus equal to 0.5% of GDP in 2016, reversing the -0.6% deficit in 2015.  It expects the budget to be in modest deficit of -0.2% of GDP in 2017, while the central bank sees a deficit equal to -1% of GDP in 2017.

The external accounts are in good shape.  The current account surplus was about 1.5% of GDP in 2016, and is expected by the IMF to narrow to around 1% in 2017 and near balance in 2018.  The central bank forecasts the surplus around 1.5% of GDP for both those years.

Foreign reserves have exploded due to the FX intervention needed to maintain the EUR/CZK floor near 27.  They rose to $111.7 bln (EUR105.4 bln) in February, up from $47.5 bln (EUR34.8 bln) in October 2013.  The floor was put into place in November 2013.  Reserves now cover 7.5 months of imports and are almost 3 times larger than its stock of short-term external debt.

INVESTMENT OUTLOOK

EUR/CZK has not really traded with the rest of EM ever since the CNB instituted the floor “near” 27 back in November 2013.  The pair has pretty much traded around 27 since mid-2015, but it did spike from time to time in response to external factors (Brexit, US elections).  We see the floor remaining in place until mid-2017.

EUR/CZK was trading near 25.75 right before the floor was established.  The pair immediately spiked and then went on to trade as high as 28.52 in January 2015 (which represented an 11% rise) before falling back to the floor by mid-2015.  If and when the floor ends, we see scope for a 10-15% drop at the very least, which would put the pair back at the February 2011 low near 23.93.  However, we see risk of an even bigger overshoot on the order of 15-20% that could put the pair back at the July 2008 low near 22.88.

Czech policymakers have warned of excessive moves in both directions when the floor is removed.  We suspect the central bank will intervene as needed to help limit these moves.  However, we do not think it will resort to negative rates.  Indeed, the removal of the floor is the first step to normalizing monetary policy.  The next step to normalizing would be to raise interest rates (likely in 2018), not cut them into negative territory.

Czech equities have continued to underperform after a poor 2016.  In 2016, MSCI Czech was -7% vs. +7% for MSCI EM.  So far this year, MSCI Czech is up 4.3% YTD and compares to up 7.4% YTD for MSCI EM.  This underperformance should ebb, as our EM Equity model has Czech Republic at a VERY OVERWEIGHT position.

Czech bonds have underperformed recently.  The yield on 10-year local currency government bonds is +24 bp YTD.  This is very close to the worst performers Hungary (+43 bp), China (+39 bp), Romania (+34 bp), and India (+34 bp).  With inflation likely to continue rising and the central bank likely to move towards normalizing policy in 2017 and 2018, we think Czech bonds will continue underperforming.

Our own sovereign ratings model shows the Czech Republic’s implied rating at AA-/Aa3/AA-.  S&P is right on target with its AA- rating, but we see upgrade potential for the A1 and A+ ratings from Moody’s and Fitch, respectively.