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Tuesday, December 11, 2007

Inflation and Monetary Policy Problems in the Czech Republic?

by Edward Hugh: Barcelona

According to the Czech Statistics Office, the Czech consumer price increased by 0.9% in November as compared with October. The rapid rise in global food prices obviously had a strong upward effect on the consumer price level, but there may be more factors at work than meet the eye here. The year-on-year rise in consumer prices accelerated to 5.0% in November from 4.0% in October, and this is the highest year-on-year price growth experienced in the country since August 2001.

The 0.9% month-on-month increase in the consumer price level had a lot to do with the rise in the ‘food and non-alcoholic beverages‘ component, and the 4.0% increase here was the highest month-on-month price jump in this category since January 1993. This sort of price increase was recorded for majority of classes of food. The main upward pressure came from the rise in prices of bread and cereals (11.3%), and the prices of rolls and baguettes rose by 24.6% and prices of bread by 16.2%.

The prices of eggs, milk, cheese and other dairy products increased by 12.6%, 2.5%, 7.9% and 3.5%, respectively. while the prices of oils and fats rose by 9.4%, of which edible oils by 17.5%, vegetable fats by 9.7% and butter by 6.0%. Prices of vegetables grown for fruit were up by 6.7%. Prices of chocolate and chocolate-based products rose by 4.8%, confectionery without chocolate by 3.2% and confectionery products by 4.5%.

The price growth in the 'transport' component was also influenced by the increase in prices of automotive fuel by 2.9%, of which prices for diesel oil rose by 6.0% and liquefied petroleum gas by 6.2%. Oil prices hit a record high in November, above any level registered since the beginning of statistical price monitoring in 1969.

Monetary Policy In A Bind?

But moving on now beyond the details of these increases, this rise in inflation in the Czech Republic is significant since it means that the Czech central bank may need to continue raising interest rates, following a string of four increases already this year, and indeed central bank Deputy Governor Miroslav Singer has been hinting at just this possibility. The Ceska Narodni Banka's seven-member board last lifted the two- week repurchase rate by a quarter of a percentage point to 3.5% on November 29.

However, at the time of taking this decision policy makers - who target inflation at 3 percent plus or minus a percentage point - had been forecasting November inflation to come in at 3.9 percent. (The next meeting of the monetary policy board is scheduled for Dec. 19).

Singer is quoted as saying that the "sensitivities" in the bank forecast to the actual inflation registered and to the exchange rate "are more or less known, so the December debate will be substantive". ``What is evident is that the level of restriction will have to be higher, but it's not evident'' how the central bank will "achieve that'' objective using interest rates and the exchange rate.

This problem is no mean one, since it is not clear at this point whether additional increases in the interest rate will serve to slow inflation, or attract more funds which may even cause it to accelerate. A combination of rising rates and a rising koruna have made the Czech Republic an ideal "haven" for those playing the currency markets, and given the present rate raising process (and of course the new tendency on the part of the US Federal Reserve and othersto loosen interest rates) the koruna may be about to make the rapid turnaround from being a "carry" currency, to a carried one.

Indeed the koruna has been the world's best-performing currency in the second half 2007 and has risen by 10 percent against the euro since July. The currency could then keep on rising, with significant consequences from the Republic's trade balance in the medium term. Some signs that this "creeping" issue is now arriving are to be found in the October trade statistics, since the Czech trade surplus dropped to 8.6 billion koruna, compared with the 13.9 billion koruna surplus in September, but still up substantially on the 3.8 billion koruna surplus registered a year ago. The point is the rate of increase in the balance is slowing, and the balance could at some point turn negative. This is a very worrying prospect, since the Czech Republic had had the most solid looking economy in the whole EU10 group.

This issue also has broader importance, since the rise in the koruna must to some extent have limited price growth in the short term. That is without the appreciation in the koruna things would have been worse on the inflation front, and this must be taken into consideration when evaluating the consequences of any possible "unwind" at a later date. In the words of Miroslav Singer "the exchange rate is undoubtedly significantly stronger than foreseen by the October forecast, and is much higher than the koruna's trend appreciation".

Also according to Singer, the last central bank inflation report was "a signal that the level of restriction that we considered adequate" to tame prices may "prove to be insufficient" and "the resulting trajectory'' of interest rates "at this point is not clear'' In this inflation report the Czech national bank forecast that the inflation rate might rise to as much as 6 percent next year, fueled in part by one-time increases in indirect taxes. Also a growing shortage of labor may lead to demands for higher wages and prevent inflation slowing toward the bank's 3 percent target as the impact of the tax increases and rising food and oil prices wanes.

Now the Czech economy grew at an annual 6 % rate in Q3/07, with this growth being principally driven by increases in domestic demand and a continuing strong export performance. Household demand is estimated to be likely to grow at around 6% this year, and investment at around 19%, while government demand is only forecast to grow at around a 1% annual rate.

So if we look at the chart below (which was prepared by a staff economist at the Czech National Bank), we will find that according to central bank estimates Czech GDP is currently growing at roughly 1 % above its non-inflationary potential, while overall monetary conditions remain broadly neutral. That is to say, inflation is not exclusively a food and fuel price story.

What all this means is that the Czech economy is now moving into tricky territory, with what is known as the output gap - which is really a rule of thumb measure of how fast an economy can grow without producing inflation, since the "gap" in question is a general measure of spare capacity - having turned negative around the end of 2005. So basically the Czech economy is now dependent on inward flows to maintain stability, flows of both funds, in particular of FDI, to pay for the current account deficit, and inward migration flows of workers to meet the growing labour supply needs.

Labour Shortages?

The lowest unemployment rate for 10 years and a record number of vacant jobs, created by economic growth of more than 6 percent over nine quarters now, are increasing the chances that the growing demands for rising salaries will be met. Czech real wages rose at the same 5% pace in the third quarter as it had done over the preceding three months.

The average gross monthly annual growth, adjusted for inflation, rose 5 percent, while the average nominal wage grew 7.6 percent to 21,470 koruna, led by strong wages pressure in the private sector.

Among private businesses, the monthly salary grew be 7.6 percent, to 21,612 koruna, while salaries for state employee advanced 7.5 percent in the July- September period from a year earlier, to 20,952 koruna. That translates into a 4.9 percent real increase. The largest Czech trade union is now calling for an average 8 percent salary increase next year to cushion workers against measures in the pipeline like increases in value-added tax and cuts in social spending, which will are both likely to undermine purchasing power. The November inflation data will only add more grist to their mill.

Now all of this is still comparatively tame when we look at what is happening elsewhere in the EU10 (the Baltics, Bulgaria, Romania for example), but it is still important that the Czech central bank get this under control now, before things get really out of hand.

The relative position of labour has improved steadily as unemployment falls to decade lows month after month and businesses increasingly have difficulty finding people to hire. Indeed Czech Central Bank Governor Zdenek Tuma has been quite explicit in saying he expects a shortage of labor to fuel wage growth, and hence drive inflation up even more.

"The tension on the labor market is relatively significant'" and `"pressures on wage growth can be expected" told a conference in Prague back in October.

Czechia, however, has one big advantage over many of its East European neighbours in that it has had a positive policy of encouraging migrant workers in place for some time now, and the number of foreigners in the Czech Republic has been rising steadily. Indeed over 34,000 foreigners went to live in the Czech Republic in the first six months of this year, and this compares with 25,000 in the second half of 2006, according to data fromthe Czech Statistical Office.

Data from the Czech police indicate that there were a total of 356,014 foreigners living in the Czech Republic in the first half of this year, compared to 321,456 at the end of 2006. This means that about 34,600 foreigners have arrived in the Czech Republic to stay permanently or temporarily over the past six months. The number of non-nationals living and working in the Czech Republic is still very low when compared with Western European averages, but the figure is rising, and the change in the country's evolution in this sense is very significant. While at the end of 2005 foreigners accounted for 2.5 percent of the Czech Republic's population, by mid 2007 this share had risen to 3.5 percent.

The largest group of foreigners staying in the Czech Republic are Ukrainians. In the first half of 2007, there were 115,000 Ukrainians with permanent residence or temporary stay permits, while three years ago there were 70,500. Ukrainians are also the second largest group of employees who come from abroad, although the largest number are over-the-border workers from neighbouring Slovakia (100,000). In the first half of this year, almost 49,000 Ukrainians were working legally in the Czech Republic legally, but to this should be added many thousands more who are undoubtedly working in the country illegally. (Incidentally, it should be noted that this outflow of Ukrainians to countries across Eastern and Western Europe - and in particular of course to Russia - is now producing large pressure inside the Ukraine labour market, with unemployment dropping steadily, inflation hitting 15.4% in November, and wages and salaries rising at 20% plus a year. So there is not a bottomless pit here anywhere).

Ukrainians also form the biggest group of foreigners with residence permits in Slovakia but, compared to the Czech Republic, their number is low. In the first half of this year, only 630 Ukrainians received residence permits in Slovakia. Again this comparison gives us some idea of just how far out in from on the migrant labour flow question the Czech Republic actually is. All of these countries are suffering the corrosive effect of long run low fertility, and if they are to continue to grow at the rate they are doing they will need to find the labour supply from somewhere.

To give us some idea of just how complex all of this is, it is worth noting that the third largest group of non-nationals working in Czechia come from Poland (22,000) a country with its own labour supply problem (following the mass exodus to the UK and Ireland), where labour ministry officials recently visited India to scour the terrain for construction workers, and where as a short term "urgent" measure convicts have even been released from prison to help build the local highways.

And Poland is not the only EU10 country to start looking farther afield to meet the long term needs which arise from its population shortfall, Skoda has now begun to recruit workers from Vietnam for its factories in the Czech Republic as it struggles with the local labour shortage. Long queues outside the Czech consulate in Hanoi have now become an almost daily sight, provoking some controversy (and even allegations of corruption) both in Vietnam and in the Czech Republic.

This is not the first time that workers from Vietnam have moved to the Czech Republic. When the country was under communist rule as Czechoslovakia, Vietnam, also under communist control, and Cuba sent workers in return for arms and heavy engineering goods. Many of these Vietnamese stayed in Czechoslovakia after the overthrow of communism in 1989 and set up small businesses. Now the Vietnamese are the third-largest migrant worker group in the Czech Republic, behind Ukrainians and Slovaks.

Many Czech companies would now be unable to operate without the foreign labour force, according to HVB Bank analyst Pavel Sobisek. The share of foreign workers in the total labour force already exceeds four percent, and the share of value added created by them is around 3 percent, according to Sobisek. In some sectors, like construction and retail, the share is much higher.