April 6, 2017 / 5:32 PM / 3 months ago

Buoyant Czech economy lets central bank scrap crown cap

Central Bank Governor Jiri Rusnok attends a news conference in Prague, Czech Republic April 6, 2017.David W Cerny

PRAGUE (Reuters) - The Czech central bank ditched its cap on the crown's exchange rate on Thursday, letting the currency free after three years of stoking prices and growth with a policy that also attracted billions of euros in speculative capital inflows.

The upper limit of 27 crowns to the euro -- in place since 2013 -- was the cornerstone of the central bank's ultra-loose policy program designed to revive inflation.

But the export-dependent Czech economy has grown now for three years, inflation has picked up above the bank's target of 2 percent, and unemployment dropped to 3.4 percent in February -- the lowest in the European Union.

"The domestic economy has for some time been causing a rise in costs and prices," Czech National Bank Governor Jiri Rusnok said.

"Given the concurrent waning of anti-inflationary influences from abroad, it means that it is not necessary to maintain monetary conditions relaxed to the extent used to date."

The decision came when the bank's board met for a weekly non-rate setting meeting, its first scheduled opportunity to scrap the weak-crown policy since a promise to leave it in place until the end of March expired.

The crown duly rose after the cap was lifted, but the gain of 1.7 percent to 26.575 to the euro was relatively muted -- a sharp contrast to the chaotic few minutes of trading that followed the Swiss National Bank' unexpected removal of the franc's cap against the euro in early 2015.

That reflected groundwork the Czech bank had laid. It signaled last week at a regular policy meeting that the cap was near an end, told the market it would not allow big swings, and warned that large positions in the crown would limit its upside.

Investors are betting the crown will return to a firming path. A Reuters analyst poll released on Thursday and conducted before the cap was lifted but expecting it to happen forecast the currency will gain 5 percent over the next year.

Bank Says Will Tolerate Crown Moves

Rusnok said the bank would allow a large degree of volatility in the currency's exchange rate without intervening until it settled into a new trading range.

"Our level of tolerance will be very, very broad in the beginning, because it is necessary to let the exchange rate find its new level," Rusnok said.

Czech Crown coins and notes are seen in this picture illustration taken April 1, 2017.David W Cerny/Illustration

The bank did, however, reiterate it would be ready to step into the market to smooth swings it deems excessive, without giving precise guidance.

Markets are expecting volatility due to the massive positions built up by investors. Analysts have estimated speculative market positions could total anywhere from 25 billion to 60 billion euros -- which some traders and investors said may even lead to swings back to the weak side of the old cap.

Yields rose on Czech short-term bonds as some holders closed positions in the papers that have been popular with foreign investors in recent months.

Investors have been betting heavily on the exit, causing the central bank to buy an estimated 70 billion euros since 2013 to defend its cap, with more than half of that coming just in the past three months. But the market hit a lull this week after speculators expecting an earlier exit closed positions and weakened the crown somewhat.

Czech Crown coins and notes are seen in this picture illustration taken April 1, 2017.David W Cerny/Illustration

The spike in the central bank's foreign currency reserves means the bank faces potential losses from the crown's firming.

Interest Rates to Follow

Inflation hit 2.5 percent in February and the central bank sees it rising close to 3 percent later this year. It has forecast the economy to grow close to 3 percent this year and in 2018, after 2.3 percent growth last year.

Where the crown settles will determine how quickly the central bank will need to follow up by raising interest rates, which stayed at 0.05 percent on Thursday.

Rusnok said nothing was excluded but the next monetary policy meeting on May 4 could be too early to move.

A stronger crown will make imports cheaper but puts a strain on exports by making Czech goods less competitive. Czech exports are equal to 70 percent of GDP, and 65 percent of them are aimed to the euro zone, especially Germany.

Companies have however had ample warnings to get ready, and massive increase in hedging since the beginning of the year, reported by banks and firms contacted by Reuters, showed they heeded the call.

"It is no problem for us, as an exporter we are hedged. So we are OK," Radek Strouhal, chief financial officer at truck maker Tatra, told Reuters.

($1 = 0.9391 euros)

Writing by Jan Lopatka; Additional reporting by Petra Vodstrcilova; Editing by Jeremy Gaunt

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