The monetary and exchange rate policy of the Czech National Bank has undergone considerable changes in the last few years. There have been two kinds of reasons for this. First, the Czech economy itself has experienced radical changes. The first transformation stage was completed with relatively favourable results. In particular, GDP growth and the balanced budget and balance of payments led the population, and especially the political leadership of the country to the conviction that the Czech Republic had already overcome the most difficult period of its post-communist development. However, numerous signals - in particular a rapidly growing internal and external imbalance - have shown since 1995 that the optimism was excessive and insufficiently justified. Unfortunately, economic policy for the most part brushed aside those signals or reacted to them belatedly. Consequently, the central bank was basically isolated in its effort to restore balanced development.
The second group of reasons for the changes in monetary and exchange rate policy is represented by a deeper understanding of the laws of monetary development and the mastering of market-conforming instruments for controlling the currency. Administrative tools, such as limiting the volume of loans, interest rates and almost all foreign exchange regulations, have disappeared forever from the range of instruments used by the Czech National Bank. The bills of exchange trades of the Czech National Bank were also abolished gradually. Naturally, the main aim of central bank activities, i.e. ensuring the stability of the currency, remained unchanged, but what changed relatively quickly was the strategy and tools used to achieve this aim.
Until 1997, the Czech National Bank applied its monetary strategy in an intermediate targeting scheme - by regulating the growth of money supply. However, it regularly exceeded its monetary target, namely to keep the growth of the money aggregate M2 within the defined corridor. The main reason for this was a big increase in net foreign assets. At the same time, there existed a fixed exchange rate regime with the Czech koruna pegged to a DEM/USD currency basket. The obligation to keep the exchange rate within a very narrow fluctuation band gradually led to a mass inflow of capital chasing risk-free profits from the interest rate differential here. This inflow was stimulated by data on economic growth and other successes of the economy. It made possible an extensive liberalisation of the foreign exchange markets and enabled the Czech Republic to join the OECD. In 1995, capital inflow reached as much as 15% of GDP, a level unparalleled in any other country.
In an attempt to keep money supply growth within reasonable limits, the Czech National Bank was forced to sterilise the capital inflow through extensive issues of its own bills. Consequently, the central bank pursued a policy of draining excessive liquidity from the banks for several years. The portfolios of commercial banks still contain a considerable number of CNB bills, with a value corresponding to around USD 5 billion. In the interest of increasing the uncertainty of short-term investments by adding an exchange rate risk, the band for the exchange rate fluctuations of the koruna was widened considerably to 7.5% from the horizontally maintained central parity. As a result, the inflow of short-term venture capital decreased significantly, creating better conditions for coping with the subsequent currency crisis, among other things.
The internal and external imbalance intensified strongly in 1995-1997. The rise in real money income far outpaced productivity growth. The subsequent high excess of domestic demand over domestic output led to growing trade and current account deficits. These results can be denoted as extreme too - for example the current account deficit reached 8% of GDP in 1996. The introduction of a tighter monetary policy (i.e. the raising of interest rates and minimum reserve requirements in the middle of 1996) was not sufficient by itself to prevent the onset of currency turbulence.
It was the widening trade deficit in particular that led to a change in the evaluation of the Czech economy and in the views of market participants concerning the appropriateness of the koruna's exchange rate level. The negative expectations of domestic entities led to demand for foreign exchange and imported goods. This situation, reinforced by the currency crisis in the South East Asia, came to a head in May 1997. The Czech National Bank was forced to intervene directly on the foreign exchange market, spending around 15% of its foreign exchange reserves but preventing the currency from collapsing disastrously. Simultaneously, it restricted commercial bank refinancing and temporarily restricted the access of foreign entities to the domestic money market. By agreement with the Government, it then abolished the existing fluctuation band and introduced a floating exchange rate for the koruna oriented towards the Deutsche Mark.
The currency crisis in the Czech Republic has confirmed that the monetary and exchange rate policy alone cannot avert the risk of crises in cases where the economy develops in an unbalanced way, but, simultaneously, that it can save the currency from an inappropriate devaluation through timely and prompt action. The koruna exchange rate stabilised at less than 10% above the former central parity and later began to appreciate again as a consequence of the improving current account and renewed trust of foreign investors. The quick reaction of the central bank was supported in July by the adoption of a stabilisation programme by the Government, which decided to make further cuts in budget expenditure and to draft a number of legislative regulatory measures.
Although the monetary and fiscal restriction contributed to a slowdown in economic growth, it did bring about a turnaround in the macroeconomic balance. The trade and current account deficits began to decrease rapidly, and productivity and wage growth began to converge. However, the depreciation of the exchange rate and considerable inertia of inflation expectations caused the inflation rate to practically stagnate at around 9%.
Under these circumstances, the CNB Bank Board decided at the end of 1997 to change the monetary policy scheme and to adopt an inflation targeting strategy. This was not just because of the rather unsatisfactory inflation trend, but also because analyses were not showing a sufficiently reliable relationship between money supply and inflation in the conditions of the Czech Republic. This was making it difficult to successfully use a monetary policy strategy based on the regulation of an intermediate target. With the departure from the fixed exchange rate regime, the economy had lost the nominal anchor which had existed in previous years of the transformation. It was therefore necessary to look for a new anchor, in the form of a clear anti-inflationary strategy and a concrete inflation target.
The Czech National Bank declared its basic inflation target for a three-year horizon, setting a specific band for year-on-year consumer price inflation as at the end of 2000. The inflation target takes the form of a "net inflation" index, which is the CPI adjusted for changes in indirect taxes and government decisions to alter regulated prices (primarily of energy and rent). Net inflation thus covers the price movements of around 80% of all the products and services included in the CPI. Net inflation should be somewhere between 3.5% and 5.5% at the end of 2000. In the interests of influencing inflation expectations positively, the CNB also declares its short-term (yearly) targets, which are mainly for orientation and control. The central bank's operations on the money market and setting the interest rate for its two-week operations remain the main instruments of monetary policy. It continues to impose on commercial banks the obligation to keep minimum reserves amounting to 5% of their primary liabilities.
Developments in 1998 - the first year of the new monetary policy scheme - were very atypical. The consequences of inconsistent privatisation and the postponement of essential structural changes weighed heavily on the Czech economy, resulting in economic decline. The monetary and fiscal restriction brought a year-on-year decline in domestic demand of 3%-4%. The fall in world raw material and food prices, accompanied by a mild appreciation of the exchange rate of the koruna, had a major effect on domestic prices. For these reasons, the trade balance showed a marked improvement (the current account deficit for 1998 was less than 2% of GDP) and there was a fast decrease of price indices. Net inflation stood at 1.7% and CPI inflation at 6.8% at the end of 1998. Analyses show that this was due to an unrepeatable decline in import prices of about three percentage points. Consequently, we can expect that even if world prices stabilise at their current low level there will be something of an upturn in inflation by the end of the year. However, net inflation is not likely to exceed 4%, and overall CPI inflation should stay below 7%.
The CNB has reacted to the ongoing, and in particular projected, decline in inflation by cutting interest rates. It has lowered its key interest rate for two-week repo operations on the money market several times since last summer, bringing the level down from 15% to 8%. Besides this, it has eased the minimum reserve requirements, cutting them to one half of their former level. However, even these relatively radical steps have not led to any pick-up of lending activity by commercial banks. Their behaviour is being motivated more by substantially greater prudence (in view of the high volume of classified loans), and in particular by the existing lack of attractive opportunities and projects in the corporate sector, than by the level of interest rates. The existence of a pre-privatisation period, in which intensive preparations are under way to sell off the state-owned stakes in the three largest commercial banks in the Czech Republic, is also playing a role in the current excessive prudence in the granting of loans.
The current managed floating system is compatible with the inflation targeting regime. The CNB hardly ever intervenes on the foreign exchange market, and so any movement in the koruna's exchange rate is due to market forces reacting to fundamental variables in the economy. Foreign exchange interventions are not excluded a priori, of course, and they could be used in case of unexpectedly sudden changes in the exchange rate. Up to now, the exchange rate has been characterised by a certain volatility, but the intensity of this has not necessitated foreign exchange interventions. The current nominal exchange rate of the koruna is down about 7% against the Deutsche Mark compared with its level at the beginning of the economic transformation in 1991. The koruna thus remains one of the most stable currencies. Meanwhile, in view of the higher inflation in the Czech Republic compared with our main economic partners, the real exchange rate is appreciating rapidly in real terms. For example, against the Deutsche Mark the real exchange rate has firmed by 30% since 1995.
The main problem right now as regards monetary policy in the Czech Republic is the extent of its harmonisation with the Government's economic policy. Quite logically, the economic decline is prompting both the Government and the opposition political forces to exert pressure for a radical easing of the central bank's policy. However, the experience gained in the previous few years shows that growth based on fast expansion of domestic demand can only be short-lived and that it must again lead to an imbalance, a weakening of the exchange rate, and inflation. The CNB is therefore trying to create conditions for balanced and sustainable growth. But this is a longer-term process which must also be accompanied by structural and institutional changes in the economy.
II- THE IMPACT OF THE INTRODUCTION OF THE EURO ON THE ECONOMY AND CURRENCY OF THE CZECH REPUBLIC
The creation of EMU has given rise to an economically stronger and more competitive whole than what used to be represented by the mere sum of the eleven national economies of the member states. This intensified competition vis-à-vis the outside world, including the Czech Republic, will affect all sectors of the economy and will be felt both by industry and by the banking sector. This is the main factor that will influence relations with all countries outside the Union. However, it will not start operating instantly, but will take effect gradually.
The Czech Republic's economic and trade relations are focused on the states of the European Union, to where roughly two thirds of our foreign trade is directed. Local businesses are thus well acquainted with the conditions of keen competition. A number of them have managed to adjust to this; others have not. But the main thing to bear in mind is that from this viewpoint the creation of EMU will not by itself lead to any sharp change and thus to any disastrous impact on the Czech economy. Competition will simply gradually get keener.
Since 1. January of this year, the euro has become a reserve currency, a transaction currency and an accounting unit for businesses in the Czech Republic as well. The central bank has already converted its Deutsche-mark foreign exchange reserves (representing around two thirds of its total forex reserves) to the euro.
As stated above, the Deutsche mark used to be the reference currency for the koruna, i.e. the currency whose exchange rate against the koruna was the basis for fixing the exchange rates of other national currencies. The anchoring to a single currency made the transition to the euro as the new reference currency much simpler, as it was actually a mere formal calculation exercise in view of the fixed exchange rates within EMU. The CNB's exchange rate list contains the euro currency unit, with the currencies of the eleven countries grouped in EMU given as calculated rates for information only. The latter have been kept in the appendix to the exchange rate list for the public's benefit, as people are familiar with certain exchange rates and continue to make cash payments in the national currencies of EU member states.
The CNB has been using the euro in transactions with its partners in EMU from the outset. Commercial banks have adapted to the requirements of their partners when carrying out cashless transactions. They are offering clients free conversion of foreign-currency accounts to the new common European currency. However, it is difficult to evaluate so far to what extent bank customers are actually making use of this possibility.
An important factor in the euro's impact on the koruna exchange rate will be the interest rate differential, which will vary in dependence on the changes to interest rates announced by the European Central Bank and the Czech National Bank. The present level of the ECB's basic interest rate is below the average level of the former interest rates of the individual central banks of the Euroregion, but the interest differential has decreased significantly owing to the considerable lowering of repo rates in the Czech Republic in the course of last year and at the beginning of this year. A stable common European currency may have a positive impact on the Czech economy, as it is no longer possible for there to be an individual devaluation movement of the currency in any country of the "Eleven" which would bring short-term disadvantages in trade relations with that country.
One can only speculate on the further influence of the common European currency on monetary development in the Czech Republic. The koruna is one of the most traded currencies (if not the most traded) in the Central and East European region. The disappearance of ten currencies from the market coupled with the interest of financial institutions in interest-rate and foreign-exchange arbitrage may strengthen demand for trading in other currencies, including the koruna. The exchange rate of the koruna would then be even more sensitive to fluctuations on the international foreign exchange markets.
For the reasons stated above, it can be assumed that the influence of the common European currency on surrounding countries will be felt gradually and over longer periods. The Czech Republic will be outside the EMU zone and so the koruna too will remain outside the Eurozone for a number of years. To become a serious candidate for acceptance into the monetary union, the Czech Republic must make every effort to achieve at least partial convergence of its economic performance with that usual in the EU. Only on the basis of such a shift, accompanied by a certain adjustment of price levels and relative prices, will it be possible to guarantee the ability to maintain the koruna's exchange rate within a suitably wide band against the common European currency and to push inflation and long-term interest rates down to values close to the requirements of the Maastricht Treaty.
It is natural that the issues of an optimum exchange rate regime are being discussed both within the CNB and among economists and analysts on the financial markets. However, the possibility of introducing any form of fixed regime (crawling band etc.) for the exchange rate does not seem topical at present. For one thing the current volatility of the koruna's exchange rate is still relatively high, and above all the adoption of a fixed regime calls for subordinating not only the monetary policy, but also the fiscal and income policy of the state to the requirements of such a system. In the present situation, this requirement seems difficult to fulfil in the economic and political conditions of the Czech Republic.
