Czech Republic - Economic update April 2019

Contrasting hard and soft data

Revised official GDP data reveal a slight decrease compared to the previously published data for Q4 2018. With 2.6% growth in Q4 2018 and 2.9% for the entire calendar year, the Czech economy cooled down compared to 2017 (4.5% growth) but is still performing very strongly. Apart from the slight decrease in 4Q 2018 estimated growth, more underlying data has become available. As expected, non-financial corporations maintain their strong investment appetite, clearly reacting to the scarcity of labour. As a result, investments to GDP increased again. Faster wage growth caused, however, a drop in corporate profitability. The ratio of profitability to value added dropped to 47% in 2018, still significantly above the European average. The financial sector’s profitability increased slightly to 61%.

Soft indicators like the PMIs or short-term surveys suggest that the Czech economy has been losing momentum since the beginning of this year. The drop in industrial output in January was partly compensated by a production increase in February, and orders have improved too. Yet, the latest industrial PMIs indicate a further slowdown in the largest domestic sector, representing one third of the Czech economy. The performance of the automotive industry is particularly unconvincing. On the one hand, the industry has to cope with reduced demand from most European markets while on the other, it is unable to guarantee sufficient production levels for some models to match the demand for SUVs. Overall, however, car production fell by 7.9% to 231,000 units in the first two months of 2019. Fortunately, statistics on expected new orders show no significant downturn that would indicate a recession in the sector. Recovery seems the most likely scenario in the short run. In the longer run, the main challenge for the Czech industry remains the tight labour market, as the order books continue to look promising.

The construction sector did very well in February, thanks to the positive developments in both building construction and civil engineering. Sentiment in the construction sector is distinctively positive too, while other sectors are starting to show signs of pessimism.

Czech consumers are becoming more concerned about their future financial situation and unemployment. Obviously, the reports on decelerating growth in Europe and potential threats to long-term economic developments in the Czech Republic are reaching consumers. We can therefore expect that the consumer sentiment deterioration – albeit not dramatic yet – will gradually translate into a lower willingness to spend as well as to lend.

Minimum unemployment and record vacancy rates

Unemployment remains close to the all-time low. According to harmonized data, the unemployment rate was 2% in February, while the number of vacancies continued along its upward trajectory. On average, there are currently three vacancies per unemployed person. This is, of course, an exceptional situation from both a domestic and a European perspective. Tensions in the labour market will lead to further wage increases in 2019, albeit probably slower than in 2018 due to the less generous public sector salary growth (figure CZ).

Figure CZ - Tensions on the labour market will lead to further wage increases

Source: KBC Economics based on Eurostat

Wage growth is clearly affecting headline inflation, although it is far from being the dominant inflation factor. The rising cost of housing due to more expensive real estate, higher rents, and higher energy prices are still the most inflationary factors. The energy price evolution reflects the earlier rise in electricity prices in the German market affected by environment-friendly activities in the form of emission allowance trading and the boom of green, but often inefficient, power plants. This brought year-on-year inflation to the upper limit of the Czech National Bank’s (CNB) tolerance interval (3%) in March. Nonetheless, more than half of this inflation was due to the housing costs just mentioned. They will remain the main inflation driver in the coming months, too. We expect that starting in summer, inflation will tend to fall rapidly towards the target, as the high comparative basis of the previous year kicks in. Therefore, the CNB should have no problem meeting its inflation target in the medium run.

Sit and wait policy

In light of uncertainties and risks, the CNB board decided to leave interest rates unchanged in March. Five members of the CNB board voted again for stability, while two voted to raise interest rates for the third time in a row. Therefore, the CNB’s position remains unchanged and there will be no rush to raise interest rates until there have been some clear (sufficiently positive) signals from the economy. We continue to expect the CNB to implement another interest rate increase in the second half of this year. By that time, it will be clear whether the European, and in particular the German, economy is recovering. Moreover, the extended Brexit uncertainty forces the CNB into a wait and see mode too.

Although we do not expect a rate change at the upcoming meeting in May, the event remains interesting as new CNB forecasts will be published. The CNB’s current forecast is based on the optimistic assumption of an accelerating economy and a rapid strengthening of the Czech Koruna. As the Koruna outlook plays a very important role in the rate determination, it will be interesting to see how the CNB views the exchange rate development in its new forecast. So far, the CNB has assumed that the koruna would strengthen by more than 2% to an average of 25.20 per euro in Q2 2019. For the time being, even the existing interest rate differential with the euro seems insufficient to drive such CZK appreciation considering the volume of speculative capital and the high levels of exporters’ exchange rate hedging. Moreover, financial markets do not expect the CNB to continue raising rates. The interest rate curve remains inverted. However, the entire yield curve remains far above its euro area counterpart.

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