## Tuesday, July 26, 2016 ... /////

### Has the Czech currency war been a "smashing success"?

I learned about the following article from a tweet by Jiří Šitler. The name means neither the supersymmetric partner of Adolf Hitler (scalar Hitler or Shitler), nor something derived from the word šit.

Instead, the meaning of the word is even more diplomatic than these two explanations – it is the name of the current Czech ambassador to Sweden. ;-) It's almost as tempting to play with that name as if someone were called Motl-Trottel. Your humble correspondent knows the ambassador to Denmark in person and met him last month but I think that Mr Šitler is only known to me in the e-form.

"Market Monetarist" Lars Christensen whom I should nominally agree with just wrote about

the smashing success of Czech monetary policy
What is it about? Well, in late 2013 – on the anniversary of the November 7th "Great October Revolution" – the Czech National Bank artificially weakened the Czech crown (our currency), printed lots of it, bought Euros to increase the exchange rate by some 6 percent relatively to the pre-intervention rate around CZK 25.5 per Euro, and promised to keep the crown weaker than CZK 27 per Euro for years (a floor). For some time, the rate was some CZK 27.5 per Euro but for a year or so, it was extremely close to the floor around CZK 27 per Euro and the Czech National Bank recently allowed the crown to fluctuate and be slightly stronger than the threshold for short periods of time.
The floor has been defended by occasional anti-crown interventions which made the Czech bank's Euro reserves grow towards EUR 70 billion, not bad for a country of our size – and the central bank should leave the regime sometime next year, an extra hurdle I will discuss. From the viewpoint of Christensen, it's been a great success. The nominal GDP growth was about 5 percent since that time (even the real one was around 4.5% near the peak months ago, the maximum in the EU) which is compatible with the promised and targeted 2% inflation rate (assuming the long-term 3% GDP growth), the unemployment rate was dropping from 7.8% in late 2013 to 5.5% now, the shared lowest rate in the EU. Everything is great. Do I agree with this rosy picture?

Well, I don't have a "completely black" picture, either, but I surely don't share Christensen's perspective through the pink glasses. This question has many layers, arguments, subtleties about what is important and what is not, neglected side effects and other sides of coins, and problems with the attribution.

OK, let me mention several subtleties neglected in the pink picture:
2. Graphs expressed in Euros and the unspectacular evolution of the nominal GDP growth in that language
3. The negative effect of the unpredictability of the monetary policy and unreadability of the manipulated markets
4. A flip side: the influence of the currency war on the Czech buyers of imported goods and tourists
5. Another flip side: the influence on the other economies
6. Difficulties expected when the intervention regime is terminated
At the end, I will mention policies I would consider wiser.

The Czech economy has grown close to 4.5% in real terms in a few recent quarters, the highest score in the EU – but the modest figure was mocked by a recent Irish number above 10%. The unemployment has clearly gone down. The unemployment rate is something that may be calculated without the knowledge of the exchange rates or monetary policies – so this looks like a "real improvement". People feel optimistic about the economy.

Our billionaire finance minister Andrej Babiš, a Slovak-born communist secret agent, loves to take credit for the numbers. This is real rubbish – even though, obviously, all governments like to take credit for the growing economies. I am sure that the intervention by the Czech National Bank has affected the numbers more markedly.

But there were other reasons for the growth. One of them was that Czechia is a net recipient of the EU funds. The net inflows correspond to some 1% of the GDP, perhaps more. For several years up to 2013, Czechia wasn't capable of getting these injections effectively. Things have improved and it was receiving them "very well" in recent 3 years or so. This money may stimulate the economic activity – perhaps with a multiplier greater than one.

It seems hard to quantify these things. But OK, let me say that I do believe that a significant part of e.g. the drop in the unemployment rate is due to the floor.

GDP things only look rosy in the crown terms

I want to emphasize that the real GDP growth rate has looked nice and so did the nominal GDP growth rate. These two are closely tied because the inflation was near zero in recent years. However, a legitimate and potentially natural way to express the GDP numbers is the nominal one in terms of the Euros or another external currency.

This picture looks natural to me especially because a significant part of our very open economy is owned by Western owners who "think" in the Euro terms, anyway. For most of them, the crown is just some provincial prank used in the intermediate calculations. They think about their profits in the Euro terms. Convert the Czech GDP from crowns to the Euros. Well, at the moment when the crown was artificially weakened, the GDP expressed in Euros dropped by the same 6%. So we may say that the GDP growth since that moment is just a matter of gradual compensation of the drop – we have just barely exceeded the nominal GDP expressed in Euros that we had in late 2013.

You might say that it's more natural not to convert the GDP to the Euros because from November 7th to November 8th, 2013, "prices were stable if expressed in crowns". But this is actually a partly wrong statement. Prices of goods in the Czech shops were stable (except that many imported products were soon made more expensive). But most of the Czech economy is actually not producing for Czech shops. Most of the Czech GDP is exported!

This is a reason to say that "the prices of Czech products expressed in the Euros were stable from November 7th to November 8th" is closer to the truth than the similar statement in crown terms. A more accurate truth is somewhere in between. The nominal GDP expressed in the Euros really did go down after the November 7th, 2013 announcement and this way of accounting is partly legitimate. In the most natural variables – some compromise between the crowns and the Euros – there was a smaller but nonzero drop of the GDP when the interventions were announced and this drop was just being erased by the enhanced GDP growth rate we saw in the following years.

It's obvious that the intervention has winners and losers. The winners are the foreign-owned employers and exporters. They only have to pay smaller salaries (if expressed in the Euros) and it's easier to export these more cheaply produced products. On the other hand, the Czech employees but especially frequent tourists, importers, and Cosmopolitan savers who save "in crowns", were losing. The latter were surely very angry for a year or two after 2013 before they got used to the new reality.

My broader point is that when a currency is manipulated, things such as GDP expressed in terms of these manipulated currencies may be misleading and the quantification in terms of a less manipulated currency (or at least some compromise between the two) may provide us with a more faithful picture what's going on.

Currency wars are anti-market, unpredictable, manipulative

I don't want to spend too much time with this point because it should be obvious to everyone who is really pro-market. What the Czech National Bank did were interventions of the most unnatural type. Interventions distort prices. The Euro-crown exchange rate is a price of a sort and it should be determined by the free market.

During communism, the Czechoslovak crown wasn't convertible. The official rate was some "CSK 13 per dollar" or so except that no one could actually buy these dollars for that flattering rate. Foreigners could sell their dollar for CSK 13, however. They preferred to sell the dollar for some CSK 20 to the Wechselmen (controversial pioneers of new capitalism in Czechoslovakia) in jeans and leather jackets on the streets, and those sold the dollar on the "black market" for the "black market price" (="actual market price") to other people for some CSK 25 per dollar (and maybe CSK 30), basically the same rate as today (the integrated inflation rates were the same in the U.S. and Czechia for 25 years). Maybe my numbers aren't accurate – some numbers could have been confused with the German mark and "bons" (the convertible "edition" of the Czechoslovak crown) but the spirit is accurate.

It was a great victory when the markets – including the exchange rates – were liberalized. I was believing that such things would be determined by the markets forever. The manipulation of the exchange rate was a big step back from my perspective. That's how the Chinese, and not Czech, National Bank is expected to behave.

When exchange rates are manipulated, every kind of reasoning that depends on them may be flawed in some hard-to-decipher way. (For example, no one can say whether the heavily subsidized and confusing electricity industry in the USSR sector was making a profit or a loss.) Also, the possibility that the central bank may change the rate surprisingly again in the future represents an extra burden that makes the planning for the future harder.

I do believe that the exchange rates should be left to the free markets and when it's done so, the free markets are expected to adjust the exchange rates basically so that the (current or expected) trade balances of the countries (or territories using a currency) are balanced (no deficits and no surpluses). This has some issues – whether we consider just trade balance or current account (I think that the former is actually more sensible); and some extra "strength" is allowed by the markets for the currencies that are recognized global reserve currencies (because the U.S. dollar and the U.S. treasuries are partly viewed as "products" that others want to buy and use for savings, so a part of the U.S. trade deficit may be "explained" as an export of a product, the money, that was neglected when the U.S. trade deficit was computed).

Domestic losers of the intervention

As I have already mentioned, there are losers of the intervention. Those who accidentally had savings in crowns although they will need to make future expenses in other currencies, importers to Czechia, and others. Even within Czechia, the weighted total number of losers is pretty much the same as the weighted total number of winners. With the artificially weakened crown, it's easier for employers to hire. But employees are really being robbed. Many of the rosy stories only look at one side of this coin. I don't have to explain these trivialities, I think.

A major flip side clearly is that Czechia has one of the lowest nominal wages in the EU – according to some recent EU data, even the lowest ones. (I have no idea how Bulgaria and Romania may survive if their vastly lower GDP per capita is combined with higher nominal wages.) This is what you should see along with the fact that Czechia has the lowest unemployment in the EU. Thankfully, Czechia also has the 6th cheapest food in the world so the low nominal salaries translate to a much more satisfactory purchase parity.

But the manipulation changes many variables and it's a subtle question which function of these variables should be considered a faithful "index of the well-being" and whether that index was affected positively or negatively. I think that the pundits who see these policies as a clear "smashing success" are extremely naive or one-sided.

Foreign losers of the intervention

Even if you decided that the intervention against the crown is great for the bulk of the Czech economy and the Czech nation, one thing is still true: the effect of this intervention certainly has the opposite sign on the nations using other currencies – which have strengthened relatively to the crown. So even if the intervention made Czechia a better place, it makes ex-Czechia a worse place and doesn't improve the world. So it's simply not a policy that could become an example for the whole world! You can't make all currencies weaken relatively to all others.

It's a classic currency war – one central bank trying to help its economy for the price of hurting others. It's simply not a way to make the world a better place. Czechia is small enough which is why almost no one gave a damn – the harm has been distributed over many producers (especially competitors of the Czech companies) in the whole world and the "harm per capita" outside Czechia is too small for the non-Czechs to complain (and perhaps even too small to learn about the existence of our country). But the life of the companies in the whole world outside Czechia was made a bit harder – exactly the mirror image of the "easier life" that the intervention brought to the companies in Czechia. If the EU, WTO, and other organizations were careful, they would try to give a hard time to the Czech National Bank, just like when China was criticized for artificially weakening its currency. We're a smaller nation but by the character and intensity of the step (per capita), the Czech National Bank has done the same thing.

How to leave the regime

The policy is supposed to be temporary. First guesses used to be that the floor should have been abandoned in mid 2016 – now. The deadline has been postponed a few times and the current estimates say that sometime in 2017, the intervention regime should be left. It's expected that crown should quickly return to its more natural exchange rate and – according to most analysts – strengthen by 10 percent or so (5 to 20 but no one really knows).

If you sell the leveraged-100 EURCZK contracts at 27.02 crowns per Euro sometime in late 2016 (bet on the crown and against the Euro), you risk losing everything you invested if the crown weakens to 27.29 or so. Chances are that it won't and the path will only be towards strengthening. With the leverage of 100-to-1, a 10 percent of strengthening of the crown should increase the price of your position by a factor of ten. Is there something wrong about this calculation? This looks like a cheap way to earn lots of money, right? ;-) Will the Czech National Bank add some additional chaotic weakening before it leaves the intervention regime? I hope that they're not reading my blog right now. But yes, if I were an adviser, I would probably recommend them to make some clever chaos before the exit.

But it's rather likely that the chaos won't be done and (even though I can't insure you) I surely recommend the TRF readers with forex accounts to bet on the strength of the Czech crown because in the coming year or so, the potential for strengthening seems to vastly exceed the potential for weakening. The new governor of the central bank Jiří Rusnok has already mentioned that the wages seem to be rising again so the policy is no longer needed etc. (I think that he and other central bankers know that there are many other ways to explain why the policy isn't needed and wasn't needed.) Please bet millions of dollars on the crown, earn tens of millions of dollars, and send me a few percent of the profit for the good tip.

So there will be some winners (hopefully you) and losers when the regime is being left. Also, the rosy numbers will partly get reversed. I think it's unavoidable that when the crown strengthens by 10% again, the nominal GDP in Czech crowns will go down a bit, just like it went up after the crown was weakened. I believe that the people who praise this intervention regime should have been more patient. They should only evaluate the "smashing success" of the intervention after both parts (and the manipulation) are over!

Similarly, the Swiss National Bank was artificially weakening the Swiss franc as well (the Swiss franc is getting a boost similar to the U.S. dollar because of its being another important reserve currency) and when it was basically forced to quit this increasingly ludicrous and unsustainable charade, it started to agree that the manipulation has been a charade. Are you really sure that the Czech case will be different?

Better alternatives

The Czech National Bank primarily targets inflation, saying that it should be close to 2%. The interest rates were already basically zero and couldn't drop further but the inflation was below 2%. (It was way above 2% in some previous years but on that side of the target, the central bankers usually don't seem to care – a biased attitude.) OK, I agree that when a central bank says that it wants to keep the value of the money such that the inflation rate is 2%, it should actually try to fulfill this commitment – in order to keep its credibility and make the people's and corporation's planning more reliable.

How?

I think that all the alternatives are actually better. They should have bought the Czech government bonds (quantitative easing), Czech corporate bonds (enhanced quantitative easing), and perhaps – most originally – the basket of the stocks traded on the Prague Stock Exchange, in ratios matching the daily volumes of the stocks, or according to some other "fair formula" that minimally distorts the relative prices. Inflated prices of bonds and stocks would also weaken the value of the crown, made some people richer and more capable of spending money, and that would be better than a manipulation of the exchange rates whose primary purpose should be to keep trade balances between countries at healthy (nearly neutral) levels.

In my opinion, it would be a good idea to try some innovative policies to anchor and predetermine the value of the crown – and reduce the potential for unnecessary, harmful shocks at the same moment. Effectively, the currency could be "backed" by a mixture of bonds, stocks, and other things in ratios that would make things smoother – but otherwise this peg would be analogous to (but much more sophisticated than) the gold standard in the past. But these policies should never try to "beat" the forex markets or other markets that are deciding about very important relative prices.

Relative prices, including the exchange rate – that basically quickly change the ratios of wages in two countries – should better be determined by the free markets because they play an important role in the allocation of capital and labor. For this reason and others, I can't agree that a currency war may be called a "smashing success".