Czech Republic - Economic update May 2019

Mixed economic figures

The Czech economy is going through a moderate deceleration phase, but there are several reasons to remain optimistic. The current slowdown is most visible in the manufacturing sector, which is the country’s largest sector, accounting for almost one third of GDP. The manufacturing PMI has been declining for ten consecutive months and currently stands at 46.6, the poorest result in more than six years (figure CZ). Industrial companies have felt another drop in new purchase orders and have even begun laying off employees. Moreover, prospects for automotive production – the most important subsector of Czech manufacturing – are still far from optimistic due to more general European market developments.

Figure CZ – Czech economy’s moderate deceleration phase most visible in manufacturing sector

Source: KBC Economics based on HIS Markit, CZSO

On the other hand, the situation in the construction industry has taken a positive turn – both engineering and building construction are booming thanks to new projects in the public as well as private sectors. Moreover, the first quarter was characterised by a pickup in residential construction which, until now, remained short of its performance achieved during the last recession. While the increased supply of new apartments can alleviate tension in the real estate market, the question is whether this is a new trend or just a fluctuation in a single quarter. This year, the construction industry will positively contribute to Czech economic growth, but its share in GDP is very small.

Labour market tensions not diminishing

Although the Czech economy is facing a cyclical slowdown, there has been no change in the labour market situation. The harmonised unemployment rate is close to 2%, while the vacancy rate is increasing, albeit at a much slower pace than last year. Despite poorer economic results, the Czech Republic remains the country with both the lowest unemployment rate and the highest vacancy rate within the EU at the same time. Neither lower employment in the industrial sector, nor companies’ responses to lower purchase orders, nor earlier investments in automation and robotics, have threatened this result. Even though the circumstances of the labour market have not changed significantly, wage growth could slow down a bit this year, mainly due to the expected slower public sector wage increases.

The ongoing, fairly rapid rise in wages is also reflected in inflation evolutions. After the 3% yoy peak in March (i.e. the upper limit of the Czech National Bank’s (CNB) tolerance interval), inflation fell to 2.8% in April. It is still true that more than half of the inflation rate is due to the rising cost of housing, specifically in rents and energy, which account for a quarter of the consumer basket. In the last month, inflation spurred by higher fuel prices reflecting the higher oil price on global markets. By contrast, the prices of consumer goods in stores have been only slowly rising, despite persistent strong consumer demand. This is the result of intensive competition between brick-and-mortar stores and e-shops whose revenues grow significantly every year.

The CNB has raised interest rates once again

The CNB reacted to higher inflationary pressures by raising its interest rates by another 25bps in early May. The higher inflation enabled the central bank to continue its declared path of ‘normalising’ interest rates; after ten years, the principal interest rate (the two-week repo rate) thus returns to 2%. The CNB’s latest decision relied on a new forecast, which assumes a subsequent interest rate stabilisation until the middle of next year at least. Nonetheless, the central bankers’ comments suggest that they are unwilling to commit to any other step at the moment, and that more or less nothing has been ruled out. As inflationary pressures have started to ease, and inflation is expected to return to the 2% target level within a year’s time frame, there is no need for the CNB to rush further interest rate hikes. This is particularly true since the bank finally revised its previously super-optimistic outlook for economic growth. However, the big unknown is the Czech Koruna which still refuses to strengthen as envisioned by the CNB in the long term. Therefore, it will probably be the Koruna that tips the scales when the CNB makes a decision on its next steps. However, given the weakening economy and lower inflationary pressures, we assume that there is no acute risk of any additional rate hike soon.

Financial markets are not pricing in any rate hike either. The swap curve remains inverted and envisages no rate hike over a two-year time frame. Bond yields are below the repo rate, thus responding to the persistent surplus of free liquidity in the Czech market. Markets appear to completely ignore the deteriorating public finances, which will require increased government bond issuance and accelerate the growth in public debt. In the first four months of 2019, the budget deficit reached CZK 30 billion, even though the state used CZK 20 billion from the privatisation account as an aid. With respect to the approved deficit (CZK 40 billion), there is no way the state’s current performance could be perceived as positive. The budget will have to cater for a slower growth in tax revenues as well as for an expansion in social spending.

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