PRAGUE STOCK EXCHANGE DOWN 20% SINCE JANUARY 1

UNCLAS PRAGUE 000035 SIPDIS SIPDIS E.O. 12958: N/A TAGS: ECON EFIN EZ SUBJECT: PRAGUE STOCK EXCHANGE DOWN 20% SINCE JANUARY 1 REF: 07 PRAGUE 758 ¶1. SUMMARY AND COMMENT: The good news is that the Czech Republic's economic fundamentals are strong; The bad news is that the Czech Republic is also impacted by negative sentiment stemming from the subprime mortgage crisis in the U.S. that has spread to global financial markets. With key economic data in the U.S., Europe and the Czech Republic due out over the next two weeks, economists expect the instability to continue. The surprise January 22 Federal Reserve rate cut was well received and, like elsewhere in Europe, helped soften the blow for the local stock exchange. The Prague Stock Exchange is down 20% since January 1 and down 10% year-on-year. In the event of a protracted period of instability or significant economic slow down, economists believe that recently passed public finance reform shows further fiscal tightening would be possible without too much suffering, while the Central Bank is faced with a trickier situation of confronting increasing inflationary pressures. END SUMMARY AND COMMENT. ECONOMY SLOWING DESPITE STRONG FUNDAMENTALS -------------- ¶2. Econoffs met with Czech investment bank Patria Finance Chief Economist David Marek and European financial group UniCredit Chief Economist Pavel Sobisek to discuss how the Czech economy is likely to fare in the current wave of financial instability stemming from the U.S. subprime mortgage crisis. Both agree that the financial turmoil will likely continue in the coming weeks, but that Czech economic fundamentals are strong (reftel). Having said that, even before the turmoil began, the Czech economy was expected to slow this year after three consecutive years of 6% GDP growth. 2008 GDP growth is projected to decrease from 6% to 5%, inflation is expected to rise from 3% to 5.4%, and industrial production is expected to slow from 8% to 5%. ¶3. Marek, who sits on the trading floor, said there was a lot of screaming on the floor January 22 and that the negative sentiment continues. The first week in February will be an especially active week for the Czech financial market, with data from the PMI index, trade balance, and inflation expected to be released, on top of Czech Presidential elections on February 8. Sobisek shared the results of an internal research paper on the impact of a stock market crash on GDP growth rates using the Oxford Economic Forecasting model: (1) if share prices bounce back within the next four to eight weeks, the negative effects are negligible; (2) in the worse case scenario (i.e., a permanent 10% drop in global stocks),there would be a 0.8% drop in U.S. GDP growth rate, 0.6% in Japanese GDP growth, 0.5% decrease in German GDP growth in 2008. CENTRAL BANK CONUNDRUM -------------- ¶4. This month marks the ten-year anniversary of the Czech National Bank's (CNB) inflation-targeting policy. And for the first time in ten years, the CNB is simultaneously confronted with the challenge of managing rising inflationary pressure and an economic slowdown. Year-on-year inflation accelerated to 5.4% in December 2007 and is expected to reach 6% in January 2008. At the January 16 Euromoney Conference in Vienna, Austria, Czech Central Bank Governor Zdenek Tuma attributed the rise in Czech inflation to growing food and energy prices across the world and the impact of the public finance reform which raised the lower VAT rate from 5% to 9%. More importantly, Tuma characterized the rise in inflation as temporary and said he expects inflation to return to "around 3% in 12 to 18 months." He also said a U.S. recession would have little effect on the Czech banking sector. ¶5. COMMENT: Czech GDP growth is primarily attributed to FDI and exports, although domestic consumption has been rising rapidly. Approximately 70% of the companies listed on the Prague Stock Exchange are multinational corporations. For a small open economy like the Czech Republic, strong economic fundamentals alone will not be sufficient to stave off the effects of a global economic slowdown. As reported in reftel, a succession of short-lived coalition governments have pursued a pro-cyclical fiscal policy and modest reforms have only just begun. At the same time, the highly-respected Czech National Bank is in a bind and expected to further raise interest rates at their next meeting to stave off rising inflation. Therefore, the policy tools available to Czech officials to soften the impact of global financial instability or recession are limited and could finally tip the Czech economy into an economic slowdown that economists have predicted for the last two years. Graber