Rates to Test New Lows, Fiscal Deterioration Main Medium-Term Risk

GDP outlook bleaker, compounded by bad 1Q results: The Czech National Bank revised down its expectations for both GDP and inflation, and now sees an overall GDP contraction of 2.4%Y (previously -0.3%), followed by a more pronounced upturn in 2010 (+1.4%Y, up from +0.9% previously). Note that the weaker-than-expected 1Q GDP release, published after the cut-off date, introduces significant risks to the forecast: assuming an unchanged quarter-on-quarter profile, GDP growth in 2009 would be almost a full percentage point below the recently published forecast. Note also that the CNB assumes (correctly, in our view) that the car scrappage incentives are simply borrowing from future growth rather than adding to the overall level of GDP.

On the inflation side, the bank maintains that the overall macro environment remains pro-inflationary (due to lagged effects of previous FX depreciation), but the economy has clearly turned anti-inflationary, with abundant slack and weak labor markets pushing down domestic inflationary pressures. Overall, a weaker FX, a higher inflation starting point but a weaker economy imply higher inflation in 2009, but lower inflation in 2010. Also, regulated prices are expected to exert a major anti-inflationary effect in 2010, with regulated price growth turning negative for most of 2010.

Fiscal deterioration is main medium-term risk: During our conversations, it transpired that the fiscal risk is the one most currently underestimated by the markets. True, the Czech Republic continues to have low government debt (33% of GDP this year) and has run very small fiscal deficits over the recent period. However, the expected change in the deficit is dramatic, with the gap likely to widen by nearly three percentage points, to 4.3% of GDP in 2009 (and further to 5.4% in 2010), according to the central bank. We note that the European Commission has similar projections. True, the CNB assumes that some anti-cyclical fiscal easing will be put in place this year that has not been approved yet, but this assumption seems very reasonable to us. And it is unlikely that any fiscal tightening gets approved before the parliamentary elections later this year. In short, it seems as though the Czech Republic will have the most expansionary fiscal stance in 2009 in Central Europe (indeed, the only one, albeit marginally). This is good for growth, but less so for budgetary dynamics. The Czech authorities we met also appear concerned regarding fiscal deterioration elsewhere (Western Europe) and believe that the wall of government bond supply set to hit markets in the coming quarters may both crowd out private investment and make it difficult for the Czech Republic to finance its own deficit. This should continue to pressure long-term yields, we think.

More rate cuts possible, rates to test 1%; no QE in sight: Rates are already at an all-time low, and our view prior to the trip was that rates had reached a bottom. We now see risks tilted towards more near-term cuts. The 1Q GDP data were a clear downside surprise, and several on the CNB will revise down their growth outlook, we believe. Senior board members like Singer and Hampl have also signaled over recent days that the door remains open for further rate cuts. We warn that any further easing will be limited and rates are unlikely to be cut by more than a further 50bp at most (1% trough). Note that the current inflation forecast is consistent with 3M PRIBOR at 1.7% by year-end (currently 2.1%), so the bank expects further falls in interbank rates. These can come via either a drop in the liquidity premium, or a fall in base rates, or both. The central bank does seem to assume some fall in the liquidity premium, but it has already made it clear that it does not see the gap between 3M interbank rates and official rates as a sign that monetary policy is ineffective. On the contrary, it sees it as a reason to ease rates more. And given the macro backdrop, we believe that the CNB will err on the side of more rather than less easing. Importantly, we saw significant resistance to any suggestion of quantitative easing, which the CNB views suspiciously due to its potential monetary and inflationary consequences, and officials seem very skeptical as to its merits.

While further near-term easing is our new base case, we continue to think that the CNB will be the first central bank in Central Europe to start reversing the rate cuts, tightening rates in early 2010. While this is in part predicated on our ECB view (75bp of hikes next year), we also note that the CNB is the most proactive central bank in the region, and we think that it will not hesitate to start taking rates to a more neutral level if our forecast of a recovery later this year and in 2010 materializes. We therefore forecast Czech rates up to 2.25% by end-2010.

Risks to our view: CZK, wages on the upside; growth on the downside: The CNB has been highly sensitive to the exchange rate. Two months ago, senior board members were talking about rate increases to stem CZK weakness. Thus, no forecast of Czech rates is immune from risks from the FX side. We think it is unlikely that CEE currencies undergo the same sort of stress that we saw in the first quarter: we are past the worst point for growth, risk appetite has improved and investors better understand the true funding needs of the region and the degree of official support which is available. Even if an episode of risk-aversion were to take place, we think there is now a much greater understanding that the Czech Republic is in a structurally superior position to any of its CEE peers (in terms of stability of banking system, vulnerability of borrowers to FX swings, external debt profile). As a result, the koruna should remain relatively more insulated, we believe. We see CZK moving broadly sideways (with a bias to strengthen) until year-end and resuming its appreciating trend versus EUR in 2010 (24.50 by year-end).