Wednesday, September 07, 2016

Euro-koruna cap may collapse already in 2016

The previous text on this topic of the Czech currency cap was posted on July 26th.

So far, I am largely unprepared for the change (also owning several stock funds denominated in other currencies, without any insurance of the Forex risks) but wealthy and money-savvy TRF readers may do better. As Reuters reported yesterday, the shorting of the EUR-CZK currency pair may be the currency trade of 2017, according to ING (and surely others).

Except that once all the people become familiar with the opportunity, events may speed up and the change may already materialize in 2016.

For an older example of the same idea, the separation of the Czech and Slovak currencies in early 1993 was also accelerated once the Slovaks began to realize that their Slovak savings may deteriorate in the case of the currency split, and that's why they moved the cash to the Czech banks and Slovak banks were running out of cash, thus forcing to do the split quickly. Czechoslovakia was only split on January 1st and the plan was to keep the currency union except that the aforementioned pressures from the self-fulfilling prophesy forced the folks to (flawlessly) separate the currencies already on February 8th, just some 37 days later.

What's going on now?

See a server with all Czech and Slovak banknotes between 1918 and 1993.

Czechoslovaks and especially Czechs have been highly conservative with their currencies and savings. The conservativeness has many implications. Unlike other post-communist countries, we have always used primarily our currency for trading, saving, loans etc. Also, the inflation rate and personal and public debt level were much lower than in Hungary but even in less extreme former communist countries.

OK, let me get to the main topic. We stayed out of the Euro and almost everyone thinks right now that it was a pretty good idea. It's possible to look at the historical continuity of the Czech crown (CZ: koruna) which goes back to feudalism. At the end of communism, the (black) market rate of the German mark was some 11 Czechoslovak crowns (CSK) per (West) Deutschmark (DEM). Via the defining 1.95583 DEM per EUR rate, this translates to 21.5 CSK per EUR.

21.5 CZK per EUR is actually still a good estimate of the true value of the crown relatively to the euro in 2016.

That's about where EURCZK could sit now if the Czech National Bank didn't ignite their "Great October Socialist Revolution" on November 7th, 2013. On that day, Mojmír Hampl, a central banker I used to agree with (and we had a friendly lunch together sometime in 2010), changed his mind, joined the supporters of the interventions who suddenly became the majority, and the Czech National Bank began to intervene.

They began to print lots of crown banknotes and buy euros to increase the Forex reserves of the Czech National Bank.

EUR jumped from CZK 25.5 to 27.5 in one day. The immediate rise was some 6 percent but the week-to-week rise was basically close to 10 percent. When the dust settled, it became clear that the bank was defending the floor at 27.00. If you look at the graph of EURCZK since 2015, you will see that 27.00 was approached from above.

Hysterical days saw the crown weaken away from the floor: on September 25th, 2015 (some China-related hysteria? I forgot what was that), EURCZK reached 27.25. On June 24th, 2016 (Friday right after the Brexit hysteria, I remember this one very well), EURCZK closed at 27.15. You may see that the crown has never weakened by more than 1% away from the 27.00 floor sometime from June 2015. Not even the Brexit hysteria was enough for such a move.

There are increasing chances that this more-than-one-percent weakening won't take place up to the exit from the cap regime. A nuclear attack on Prague or a deliberate extra weakening of the floor by the Czech National Bank are the two main risks that could change the expectation.

The Czech National Bank has announced that the interventions are temporary. There have been lots of criticisms directed against the interventions. Companies are becoming lazy, the president and many economists say. Because the old business-as-usual is enough for them, they don't innovate things etc. Moreover, the salaries began to rise rather aggressively and domestic pressures on inflation therefore re-emerged.

It's universally agreed (and backed by the trade surpluses, good economic growth etc.) that the crown is significantly stronger than the artificially defended floor at 27.00. After all, if it were weaker, it would have weakened – because no one is defending the crown against weakening right now.

There may be some volatility but it seems plausible that there are lots of transactions waiting to buy a weakened crown, so the volatility (I really mean risks of a significant weakening away from the floor) may be minimal, indeed. For those reasons, I believe that the main question is when the cap will be removed and how much the crown will strengthen.

How much

There are lots of estimates. The Reuters-ING story talks about a modest strengthening to 25.50, by six percent. However, lots of Czech and foreign analysts have different ideas about the fair rate that will be achieved. For example, Roklen24.CZ server with some Academia-affiliated economists etc., claims that by looking at the price of goods in different countries, they determined the "fair" rate as CZK 18.45 per euro – and even CZK 11.62 per USD.

The dollar figure would mean a strengthening by more than a factor of two – one USD is about 24.1 right now. The euro figure would make the crown 1.46 times stronger than it is now. I suppose that this methodology isn't accurate as a real predictor of the exchange rates and the estimates are the most extreme ones on the market.

No one really knows how far the crown should go months after the removal of the cap but the guesses are in the interval 6-30 percent or so.

The Czech economy depends on exports. Exporters obviously find a weak crown convenient. However, our exported products depend on lots of imports as well and those are cheaper when the crown is strong. For that reason, the effect of the rate on the competitiveness is much weaker than if the Czechs were producing everything themselves and I do believe that the country could still run trade surpluses with the euro at 20 crowns.

The Czech National Bank said that it will try to avoid excessive volatility and prevent the Czech currency from excessive strengthening but it's not clear what it exactly means.


The "middle of the road" publicized estimates of the Czech National Bank talk about mid-2017 as the end of the cap. Some polls among economists say that according to a majority, the cap will only be removed in late 2017, see a histogram. However, the central bankers admitted that the removal could also take place in early 2017. The new main governor Jiří (George) Rusnok said that the cap may be removed even if the latest inflation rate is slightly below the 2% target but the forecasts indicate that the target would be reached soon. (The latest official inflation rate, also from today, is 0.6%, higher than before, in agreement with ČNB projections.)

And many "psychologically enhanced" analysts argue that the central bank will want to avoid excessive positions against the euro so it will probably remove the cap some 3-6 months before it is generally announced or expected. This could very well be already in 2016. So some people – like myself – could very well be late and lose lots of money (or the opportunity) again.

Today, the Czech National Bank released the new Forex reserves numbers for August 2016. In euros (which are the dominant currency in the reserves), they grew from 68.4 to 70.5 billion. You may check the countries by their Forex reserves.

With $78 billion, Czechia is the 29th strongest country according to its absolute Forex reserves. Needless to say, all the countries "above Czechia" with the exception of Switzerland and Israel are vastly more populous nations and much stronger economies. By the "Forex reserves to GDP ratio", Czechia could very well be at the very top, much like in the "reserves per capita" – over $7,500 per capita.

Just look at some funny numbers. Those $78 billion in reserves are higher than the Forex reserves of the whole Eurozone ($75 billion), more than 1/3 of the reserves of whole Germany, more than 1/2 of the whole reserves of the U.S. LOL, 1/5 of the whole Russia, 3 times greater than Austria or Belgium, 10 times greater than Greece, 25 times higher than Slovakia, 120 times Malta, and so on, and so on. The Czech National Bank Forex reserves are huge and growing.

Although they claim to have bought less than €0.5 billion in August 2016 by interventions against the crown, those claims could be due to some bizarre accounting tricks. (Oops, I am an idiot: the figure CZK 8.29 billion are interventions from July, the August ones were almost certainly much higher, as I generally expect or see in the reserves.) The growth of the Forex reserves may be speeding up. They grew by €2.1 billion in the latest month (see also The Daily Mail) and the number could be twice as much as the previous monthly change. It's totally plausible that the increase of the Euro reserves is being doubled every month as increasingly many traders are learning about the opportunity.

If that's true, the reserves could very well be €74 billion after September, €82 billion after October, €98 billion after November, and €130 billion after December. ;-) Note that the reserves were just €35 billion at the end of October 2013, days before the interventions began. The intervention regime has already doubled the reserves.

Perhaps, there's nothing wrong about these hugely growing reserves and the central bankers have made such claims. Except that there are at least three reasons why this "we don't care attitude" could be indefensible:
  • These reserves quantify some "accumulated distortion of some market quantities" and the bankers must realize, like everyone else, that if we want to return to the true market economy, the growing distortions must stop at some point and the higher the reserves are, the harder and more unpredictable the exit may become.
  • The central bankers are really "losing money of all of us". You may have asked: If all the traders will make a profit on EURCZK, who are the losers? Well, the Czech National Bank will basically be the only loser or "sponsor" of this charade. Because they have bought some €35 billion for the price of CZK 27 per euro, and the euro will only be worth e.g. CZK 24, it means that they have already made a loss of 100 billion crowns – comparable to the largest budget deficits in the Czech history – by these trades. Imagine that someone would want Hampl to repay the debt he has caused. Even 0.1% of it would be devastating for him. One may argue that this loss is "not real" in some sense except that any commercial bank that would be doing the same "buy euros, sell euros" trade would record a very real loss. The greater the reserves will become, the higher this loss will be.
  • The printing is fast but it's probably not unlimited. Assuming that they won't introduce new banknotes, they may print at most the CZK 5000 and one needs millions of those to cover the billion-of-euros purchases. The printing is done by the [state-owned] State Printing House of Precious Papers (in 6 Růžová/Pink Street – we have watched their printing presses from the nearby CERGE economics institute some years ago) and its capacity could be higher than the current needs just by a "factor not parameterically higher than one". At some moment, the demand for the crowns could simply be too high and the floor would be breached, thus forcing the central bankers to admit that their muscles are no longer enough.
So if the bets on the dropping EUR-CZK begin to get out of control, the intervention regime may very well stop well before the announced or estimated moments.

Like ING, I would probably tell you that if you have an access to Forex trading, you should probably short EURCZK soon (I decided not to use a stronger word than "soon"). With a 100-to-1 leverage, you may multiply the amount that you invest into that position by a factor of 10 when the crown strengthens by 10%. The risk is that you lose the position if the crown weakens by more than 1% for some reasons before the cap is removed or destroyed. You may try to employ a lower leverage, or delay your purchases of the crowns to the moment when the crown hypothetically weakens further etc.

The typical rates at which you may sell/buy euros on Forex servers are 27.01 and 27.03 crowns now. The value really seems extremely stable whole days. It looks like a peg – but one that has been announced not to be eternal (unlike the Swiss franc's peg to the euro which was promised to be eternal so its surrender was a surprise).

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