Czech Republic - Economic update March 2019
Weaker growth ahead
The most recent growth figures for 2018 confirm the Czech economy is in solid shape. However, there is a growing contrast between those figures and new (soft) data released since the beginning of this year. For instance, the purchasing managers index for industry dropped to a six-year low in February. Meanwhile, according to the first official estimate, GDP grew by 0.9% qoq in the last quarter, translating into a 2.8% yoy growth rate (or 3.0% annual growth over the full year). On the demand side, growth was supported by investment and government consumption, as well as by a smaller drag from net exports (figure CZ1).
Figure CZ1 – Contributions to variation in GDP by expenditure approach (change year-on-year, in % points)
The investment boom was by no means surprising given the shortage of labour that domestic companies have been confronted with for more than two years. Higher investment activity, particularly when it comes to machinery and ICT, is a natural response, aiming to deal with labour shortages by means of new technologies. Public sector activity was also higher in an attempt to make up for the deficit in investments the past few years. Household consumption was surprisingly poor over Q4, rising by only 2.2% yoy despite solid wage and employment growth. On the supply side, economic growth was driven mainly by the manufacturing industry, namely car manufacturing and the production of electrical equipment. Trade activities and the construction sector also performed well.
Despite the strong Q4 results, we expect the Czech economy to slow in 2019 and beyond. Due to the deteriorating outlook for the European, and particularly German, economy, we expect a further economic growth deceleration and a decline in the external trade surplus. The evolution in European demand, the automotive market cycle, and tensions in the domestic labour market remain the main risks.
Inflation moving above target
Despite deteriorating business sentiment, the domestic labour market situation has not changed, in line with general regional developments. Employment rose in the last quarter of 2018, while unemployment remained at a historical (and European-wide) low. Consequently, wages grew at a brisk pace. This was lower than expected by the Czech National Bank (CNB), but it was a consequence of base effects from the previous year. While wage growth lagged behind the CNB forecast, inflation at the beginning of the year exceeded it easily. After a jump to 2.5% yoy in January, inflation reached 2.7% yoy in February. This is well above the CNB’s target and its current forecast, but still within the central bank’s tolerance band.
More than half of the current inflation is fuelled by higher housing costs, i.e. real estate, rents, energy, water and heat. More expensive services, food, and cigarettes also make a minor contribution to inflation growth. Core inflation has even reached 3% yoy, which is equal to the upper limit of the central bank’s tolerance band of ± 1% around its 2% inflation target. However, this is very likely just a temporary peak as inflation will likely come down rapidly within roughly three months, due to last year’s comparative base. In the second half of the year, the year-on-year core and headline inflation should remain close to the CNB’s target. This is particularly true if the decline in consumer demand, which started in the second half of last year, continues in 2019.
Central bank chose to wait
The CNB continues to assume that the labour market tensions, reflected in the higher wage growth, will act as a significant pro-inflation factor and facilitate a further interest rate normalisation. The CNB’s base scenario forecast does not expect any further rapid interest rate increases. However, both its alternative (sensitivity) scenarios, which are based on slower Koruna strengthening and a hard Brexit, anticipate a stringent tightening of monetary policy. Moreover, a considerable proportion of the Bank Board is in favour of rate increases. However, due to international risks and uncertainty, the Board still voted to remain on hold at the February meeting.
This year’s second monetary policy meeting takes place at the end of March, where we believe there will be another postponement in raising interest rates until international developments are clearer, and more figures are available for the domestic economy. The CNB does not need to rush given the postponement of the ECB’s normalisation process. Therefore, we are cautiously counting on one more interest rate hike this year, although it will probably only occur in the second half of the year.
Financial markets also expect one more rate hike this year. However, the bond market may start paying more attention to developments in public finances, or the public sector borrowing requirement, which, in contrast to previous years, may start to grow again. This is due primarily to the fact that the generous increase in social spending coinciding with a decelerating economy will turn the budget into a deficit. Hence this policy may require an intervention in the form of budget cuts next year. Therefore, we cannot rule out that after the successful test of a new (small) bond in euros in February, the state might offer a much larger issue of Eurobonds to foreign investors later this year. Although the money will come from a different source, the domestic budget problem will not become any easier.