Czech Republic - Economic update

Lowering expectations

Slowly but surely, the Czech economy is reaching its limits in terms of capacity. This is reflected, inter alia, in the performance of the country’s largest sector - industry - which has been heavily affected by the changes in the automotive industry over the last three months. The year-on-year rate of production reached 2.5% in September, and even -0.9% when cleared off the impact of the differing numbers of working days. However, production in the automotive industry has been falling for two months and new orders don’t suggest a change in sight in the months to come. The fundamental factors include not only the six-year cycle of growth in demand for new cars, but also the new emission limits that have made the automotive statistics of the whole of Europe more obscure. Before the new regulation came into effect, cars that received short-term registrations were produced in huge quantities; the question is, what to do with them now. In any case, the automotive industry is unlikely to provide any other impetus, so its contribution to economic growth will remain rather marginal in the time until the end of this year. The only sector on a steeply rising trajectory is the construction industry, which is riding on a wave of new orders from the private and public sectors in the field of building construction as well as civil engineering. There is no boom in housing construction at present, but the demand for new housing is likely to be decreasing due to higher interest rates and stricter mortgage rules combined with record-breaking real estate prices. This is also indicated by consumer confidence surveys - although confidence remains very high, the interest in new housing (as well as car) purchases fell considerably in the last quarter.

The PMI (Purchasing Managers’ Index) results have also shown signs of slowing down in recent months. While it remains above the neutral 50 threshold, it fell to a two-year low in October. The result of new orders was particularly unfavourable which indicates a limited potential for further growth in the sector. On the other hand, the growth of orders has remained solid in the construction industry although, similarly to the industry, the sector has also reached its limits when it comes to a lack of staff as is confirmed by the number of vacancies available in the market. A record-breaking unemployment rate and a record-high vacancy rate constitute obstacles to the further growth of the Czech economy, prompting faster job growth while encouraging a restructuring of the economy at the same time. They have become a catalyst for previously postponed investments in automation and robotization of manufacturing and even some services. They have probably been the main driver of the current investment activities of companies, which started at the beginning of last year.

Although the labour market continues to tighten, there are still no significant inflationary pressures from the demand or cost side. The main inflation driver remains housing, which mirrors all-time high real estate prices, rents and even energy in the recent months. Food or fuel has had a secondary impact on inflation this year. Therefore, inflation remains slightly above the CNB’s target and essentially in line with its forecasts. We expect inflation to keep close to the current level for the rest of this year. At the beginning of next year, inflation may rise slightly as a result of further energy price growth but it should still remain within the central bank’s tolerance band. That is why we do not expect the CNB to continue the truly activist policy it has been executing this year.

Fifth interest rate increase this year

At the November meeting, the CNB raised its main interest rate for the fifth time this year to 1.75%. The deposit - discount - rate used by banks for 1-day deposits of their liquidity was raised at the same time, namely to 0.75%. Since the end of the exchange rate commitment in April last year, the central bank has increased its rates seven times, bringing them to the 2009 level. The CNB was motivated to take this step not only due to the performance of the economy, or the fact that it was viable, but also because the koruna remains significantly weaker than the CNB model suggests.

At the November meeting, the CNB decided on a new forecast that again assumes an acceleration in the Czech economy and a significant strengthening of the CZK. According to the central bank, the koruna should strengthen from the current CZK 25.85 per euro to CZK 25.10 per euro, i.e. by three percent at the beginning of the year. By the end of the year, the koruna should gain another three percent to the euro. With respect to the amount of free speculative capital, we believe this is a strong assumption that may remain unfulfilled just like the expectations for the last six months (figure CZ1). Therefore, contrasting with the CNB’s forecast, we think the central bank could raise its interest rates once more at the very beginning of 2019. This would further increase the interest rate differential to euro rates (from the current 215 bps) by another 25 points. That might bring on the ceasefire the Governor had announced at the November session already.

Figure CZ1 – CNB’s outlook for the CZK probably too strong (CZK per EUR, 3 month average)

Source: KBC Economic Research based on CNB and own forecasts