In an extraordinary monetary policy meeting held on Thursday, the Czech National Bank (CNB) exited its commitment to the currency floor. For over three years, the CNB had used exchange rates as a monetary policy tool by setting a floor of 27 for the EUR/CZK exchange rate in November 2013.
The action was not a surprise per se. Dismissing comparisons to the Swiss National Bank which exited its FX policy abruptly in January 2015, the CNB has (always) chosen to give markets clear guidance. Such transparency about the “timing” of the exit could have been costly. By settling the FX policy exit by “around mid-2017” (known as ‘soft commitment’) against a backdrop of strong economic fundamentals – including solid growth and rising inflation– generated a (possibly) undesirable consequence for the Czech Republic: a massive amount of capital inflows since the beginning of the year. The CNB had thus to heavily intervene in the forex markets to maintain the currency floor and, in turn, built up international reserves totaling 58% of the GDP in February, up from 44% in December, triple the level before the interventions began in November 2013. The CNB was clearly under pressure to keep its currency floor policy this year.
Hence, by keeping its transparency commitment, the CNB indicated during its last monetary policy committee held last week (30 March), that the exit from the FX commitment would happen any time from 1 April. It happened a few days later. As the markets expected, the EUR/CZK exchange rate appreciated, but the movement was quite limited: it gained 1.5% to reach 26.63 during the day. That said, both our valuation models and the macro aspect suggest that a strong appreciation of the currency is very unlikely as, i) the currency is already overvalued and ii) the Czech Republic is an export-driven economy and the CNB would surely intervene in the forex market to keep the CZK from rising too much – in fact, they clearly stated they would do so. Moreover, it is very likely that any speculative capital will leave the country in the very short run.