CZECH CROWN'S RECORD STRENGTH WORRIES CENTRAL BANK

C O N F I D E N T I A L SECTION 01 OF 03 PRAGUE 000501 SIPDIS E.O. 12958: DECL: 07/30/2018 TAGS: ECON EFIN ETRD EINV PGOV EZ SUBJECT: CZECH CROWN'S RECORD STRENGTH WORRIES CENTRAL BANK AND EXPORTERS REF: A. PRAGUE 326 ¶B. PRAGUE 1201 ¶C. PRAGUE 973 Classified By: A/Polec Counselor Martina Strong for reasons 1.4b & d ¶1. (C) Summary and Comment. The Czech Crown hit new all-time highs of CZK 22.87/Euro on July 21 and of CZK 14.45/USD on July 22. Having gained more than 17 percent against the Euro and more than 25 percent against the USD since last year, the Crown has become the fastest appreciating currency in the world. The continued strengthening of the Crown has begun to threaten certain sectors of the Czech economy, including tourism and export-oriented industries. On the other hand, the strong Crown has kept inflation in check by cushioning the country against the rising energy prices and by keeping prices of imports low. ¶2. (C) The Czech National Bank (CNB) Chairman Zdenek Tuma sent a strong signal last week that the CNB may consider lowering the interest rates if the Crown continues to appreciate. His statement sent the Crown tumbling down, but it is unclear whether this effect would only be short-lived and would be sufficient to help the affected sectors. In response to the rising Crown, Czech exporters have also renewed their calls for a speedy Euro adoption and for lowering interest rates. Prime Minister Topolanek,s government, under pressure from the euro-skeptical wing of the ruling Civic Democrats (ODS),has so far resisted setting a date certain for the adoption of the Euro, arguing that the government must first adopt its reform agenda. Most analysts and the CNB expect a correction in the Czech exchange rate, and this correction could help Topolanek,s government continue along its present course. End Summary and Comment. Czech Crown Setting Records -------------- ¶3. (SBU) Boosted by strong economic fundamentals and its safe-haven status, the strengthening Crown defied the CNB and analysts, expectations of an early 2008 downward correction and continued to scale record levels, gaining more than 17 percent against the Euro and more than 25 percent against the USD since last year. On July 21-22, the Crown broke all previous records, trading at CZK 22.87/Euro and at CZK 14.45/USD. Analysts attribute the Crown,s steep rise to: (a) the slump of the U.S. dollar; (b) investors, confidence about Central European - and especially Czech - economies, 
which have continued to grow despite the global financial turmoil; and (c) currency speculation. Although most analysts expect a correction in the Crown,s exchange rate, investors have so far continued to view the Crown as a relatively safe bet. Strong Crown: The Winners and Losers -------------- ¶4. (SBU) Importers, Czech tourists vacationing abroad, and international shoppers have been the biggest beneficiaries of the rising Crown. According to press reports, wealthy Czech investors have been snapping up real estate near Czech borders or seaside properties in Florida and the Mediterranean. A recent Czech News Agency survey found that imported cars can be bought now at all-time low prices. The lower priced imports are also driving down the prices of domestically produced cars. ¶5. (SBU) On the other hand, international shipping companies have been among the hardest hit because they set their rates a year in advance at the anticipated levels of CZK 28/Euro, or 18 percent above the current CZK 23/Euro exchange rate. According to the Representative of the Transportation Union Cesmad Bohemia, many transportation companies operating on Czech-EU routes contemplate moving their businesses to Slovakia after it adopts the Euro on January 2009 to escape the strong Crown,s impact. ¶6. (SBU) Similarly, travel industry,s spokesperson Tomio Okamura, told EconOff that the country,s inbound tour operators incurred a 30-percent drop in profits in comparison with July 2007. According to Okamura, travel companies have been forced to subsidize the already sold tours this year, but if the Crown remains strong, the Czech Republic will become too expensive to compete with other secondary European destinations like Slovakia or Poland that offer a better bargain or the primary European destinations like France or Italy, now available at comparable cost. Many Prague luxury hotels are beginning to face cash flow issues because they have seen their room occupancy rate fall from the usual PRAGUE 00000501 002 OF 003 high-season rate of 75 percent down to 45 percent this summer, the American Chamber of Commerce Director told EconOff. With its recent jump from no. 49 to no. 29 on Mercer,s list of the World,s most-expensive cities, Prague is now only 4 percent cheaper than New York City and 15 percent cheaper than Milan. ¶7. (SBU) Exporters have also been negatively affected. Over the past few weeks, newspapers have been filled with stories of company closures, staffing reductions, and even moves to other countries in the region. Some analysts see the departure of low-cost producers as a necessary evil, as the Czech economy focuses on higher-end production. CNB Board Member and Executive Director Eva Zamrazilova agreed and told EconOff that if the strong Crown triggers innovation, efficiency and business restructuring, that would be a good thing for the economy. She was also not particularly concerned about a possible rise in unemployment that is at a record low of 5 percent nationally. ¶8. (SBU) The strong Crown has also impacted large Czech exporters by eating into their profits from foreign sales. For example, Skoda Spokesman Jaroslav Cerny confirmed to EconOff that Skoda Auto, the biggest Czech exporter, lost nearly 10 percent in profits year-on-year for the first half of 2008 due to the Crown,s strong position, even though it sold 17.9 percent more cars than a year ago and increased its production by 11 percent. In 2007, with the Crown already rising, Skoda Auto still managed to raise its net profit by 44.5 percent to a record CZK 15.98 billion (approximately USD 1 billion),with a 9 percent growth in sales. It remains to be seen whether Skoda will be able to turn things around in the second half of 2008. One way Skoda is trying to mitigate the impact of the strong Crown, is by paying its domestic suppliers in Euros. It is worth noting, however, that Czech exporters have also benefited from the rising Crown because they are now paying less for their imported inputs and have been cushioned from the steep energy price increases. Government Resists Euro Adoption -------------- ¶9. (SBU) PM Topolanek,s public statements on the rising Crown have ranged from an admission that the Crown was a short-term problem to the more frequent assertions that the Crown,s appreciation was a sign of the Czech economy,s strength and of investors, confidence. PM Topolanek, whose own ODS party includes a strongly euro-skeptical wing, has so far resisted industry,s calls for a speedy adoption of the Euro to fight the run-away exchange rate. In his public statements, he has argued that those two issues are unconnected and that the country could not set a date certain for Euro adoption, without completing his government,s reform agenda first. Last week, Finance Minister Kalousek, a Christian Democrat, indicated that he would not oppose setting a Euro-adoption date, but noted that in light of the views of his colleagues in the ODS-led cabinet and the Czech National Bank, this would not be possible. (Ref B) ¶10. (C) Former Finance Minister Bohuslav Sobotka, who is currently the Chairman of the Parliament,s Budget Committee and the deputy Chairman of the opposition CSSD, told PolOff that he also considered the Crown to be overvalued, but was not overly concerned about its impact on the economy. He believed that a minor correction in the exchange rate would likely occur next month, and a more dramatic correction in 2009, after the enthusiasm over the Slovak entry into the Euro-zone dissipates. In Sobotka,s view, Euro-adoption would play a role in the Czech 2010 parliamentary elections, with the Czech business community exerting pressure on political parties to commit to a target date for Euro-adoption. His prediction has already been confirmed by his party,s chairman, Jiri Paroubek, whose recent public attacks on PM Topolanek focus on the Crown and the need to adopt the Euro. Paradoxically, in contrast to Topolanek,s right-of-center, pro-business ODS that refuses to set a target date, the left-of-center Social Democrats may in the end lead the charge for early Euro-adoption. Crown Plummets After CNB,s Verbally Intervenes -------------- - ¶11. (SBU) With the rising Crown, pressure has also been mounting on the Czech National Bank (CNB) to take steps to slow the Crown, including by cutting interest rates. Given the CNB,s focus on price stability and its inflation-targeting policy, the strong Crown was viewed as helping to lower the country,s 6.8 percent inflation (Ref A). However, as the CNB,s Eva Zamrazilova told EconOff, the record-breaking rise of the Crown defied CNB,s expectation PRAGUE 00000501 003 OF 003 of a correction in early 2008 and raised concerns that if the trend continued, the Crown,s strength would harm the economy. Consequently, on July 22, CNB Governor Zdenek Tuma announced that the CNB might cut interest rates in August in response to the appreciating Crown. This statement, considered as the CNB,s strongest in several years, immediately sent the Crown down to CZK 23.80/Euro and CZK 15.09/USD. Within two trading days, the Crown plummeted from record highs of CZK 22.99/Euro and CZK 14.45/USD to a nearly three-week low of CZK 23.80/Euro and CZK 15.09/USD. Such a rate of depreciation (3.5 percent for the Euro and 4.4 percent for the USD) has not been seen in the past five years, according to analysts. ¶12. (C) Despite the calls for lower interest rates, most analysts believe that the CNB will leave rates unchanged at the CNB Governing Board meeting on August 7. CNB,s Zamrazilova told EconOff that she and many Board Members favor keeping the rates at the current 3.75 percent, but the decision will depend on how the Crown reacts within the next two weeks. The CNB last changed the interest rates in February by raising them 25 bps. In her view, the CNB will be aiming for a gradual correction in the Crown, as opposed to a big shock. According to Zamrazilova, it may take about a year for the rising exchange rate to impact GDP growth, inflation, or wage demands. Therefore, all the negatives may not have been seen yet at the macro level. For Zamrazilova, however, one thing was certain -- for the first time in 2008, raising interest rates is no longer on the table. Comment -------------- ¶13. (C) The rapid appreciation of the Czech Crown is widening the gulf between the right-of-center Topolanek government and businesses that have suffered a decrease in profits and have called for a speedy Euro adoption. For now the government and CNB,s strategy for dealing with the overvalued Crown appears to be one of waiting for a change in the global economic situation and investors, sentiments. In this environment, the opposition,s Sobotka is probably correct in his prediction that private sector pressure on the government will mount to adopt the Euro sooner rather than later. Businesses are a critical component of Topolanek,s ODS electorate and their concerns may resonate increasingly in the run-up to the 2010 elections. Topolanek therefore has a tough balancing act ahead of him, but the generally expected correction in the Crown,s exchange rate may help him avoid dealing with the issue in the near future. Thompson-Jones