The koruna is in sight of its fundamental equilibrium exchange rate

The Czech koruna has long been the most stable currency in the region. There are a whole range of reasons for this, from the long-running solid functioning of the Czech economy, through its relatively low debt, to the high credibility of the CNB’s monetary policy. The exchange rate of the koruna – its price relative to other currencies – can also be viewed from the perspective of theoretical macroeconomics. This field encompasses equilibrium real exchange rate models, which yield important information for all of us, and especially for policy makers. The degree of misalignment of the exchange rate – the deviation of the current real exchange rate from its estimated equilibrium level – is a very valuable piece of information for the central bank, as the exchange rate can dampen the impact of shocks to the Czech economy in certain circumstances. Above all, the real exchange rate and its position relative to the equilibrium level determines the price competitiveness of the economy. It is therefore a key parameter in the process of preparing for the future fixing of the nominal exchange rate upon entry to the monetary union (the euro area).

We have to admit openly that estimating the fundamental equilibrium real exchange rate is a complicated task surrounded by numerous uncertainties. However, central banks consider it desirable to identify this equilibrium regularly in order to support qualified monetary policy decision-making. Estimates of the equilibrium real exchange rate take into account both movements of the nominal exchange rate and the difference in price levels between the domestic and external economy.

Economic theory offers a whole range of methods for estimating the equilibrium exchange rate. We applied the two probably most frequently used approaches. The first is the BEER (behavioural equilibrium exchange rate) approach, which takes into account a set of key variables – economic fundamentals – affecting the long-run real exchange rate. They include, for example, the difference in labour productivity compared to the outside world, the trade balance, and investment that expands the production capacity of the economy, etc. The second is the FEER (fundamental equilibrium exchange rate) approach, which is based on the condition of simultaneous achievement of the internal and external equilibrium of the economy. Internal equilibrium occurs when actual and equilibrium (potential) GDP are equal, that is, when the economy is neither overheating nor cooling. External equilibrium corresponds to a sustainable current account, which mainly reflects exports and imports of goods and services.

Based on the results of the two models, we constructed a range of estimates of the equilibrium real exchange rate (see Chart 1). The figure clearly shows that, especially in 2000–2008, both the equilibrium and actual real exchange rates of the Czech currency appreciated strongly (i.e. the relevant indices decreased). The domestic economy grew much faster than the euro area economy. Our catching up with the more advanced countries was supported by massive inflows of foreign direct investment, which most often came from our main trading partners in countries to the west of us.¹ Since the onset of the global financial, economic and subsequently also European debt crisis, our country’s pace of real convergence and the parallel appreciation of both the real and equilibrium exchange rates of the koruna have almost halted for many years. In this phase, an exchange rate commitment was also adopted. During its deployment in 2013–2017, the exchange rate was used as an additional monetary policy instrument. The real exchange rate did not start to appreciate visibly again until last year. Besides a strengthening nominal exchange rate, this appreciation mainly reflects markedly higher domestic inflation compared with the euro area.

Chart 1 – Range of the equilibrium real CZK/EUR exchange rate

 
The estimates from the BEER and FEER models, and hence the above range of the equilibrium exchange rate estimates in real terms, can be converted into the nominal terms with which we are all more familiar based on assumptions regarding domestic and foreign inflation (see Chart 2). Here, too, we can observe a significant appreciation of the nominal koruna exchange rate starting in summer 2020 due to the opening of economies hit by covid shutdowns. The very strongly export-oriented Czech economy visibly benefited from this despite continuing complications in global supply chains. In addition, the nominal appreciation of the koruna has been supported since the summer of last year by relatively sharp increases in domestic interest rates to the current level of 7%, which has caused a significantly positive interest rate differential to open up.

Chart 2 – Range of the equilibrium CZK/EUR exchange rate in nominal terms

 
According to our calculations (based on the identification of current fundamentals), a temporary misalignment of the koruna exchange rate towards a stronger-than-equilibrium level was observed mainly in the second and third quarters of this year. The exchange rate component of the monetary conditions thus saw the desired tightening amid high inflation and a continuing fight by the CNB to rein it in. According to our autumn macroeconomic forecast of the nominal koruna-euro exchange rate, this restrictive effect of the real exchange rate will soon subside and the exchange rate will return close to the estimated equilibrium level in the following quarters. The results of our calculations thus cast doubt on some of the statements made by domestic and foreign financial institutions regarding sustained and strong fundamental overvaluation of the koruna and the existence of potential future depreciation pressures. In our opinion, these statements reflect business considerations and plans rather than elaborate and quantitative analyses.

Sources

Frait, J. – Komárek, L. (2001). Real Exchange Rate Trends in Transitional Countries, Warwick Economics Research Papers, Department of Economics, The University of Warwick, July 2001, No 596. http://warwick.ac.uk/fac/soc/Economics/research/papers/twerp596.pdf
Komárek, L. – Motl, M. (2012): Behaviorální a fundamentální rovnovážný měnový kurz české koruny. Politická ekonomie, 60(2), pp. 147–166.
Komárek, L. – Koprnická, K. – Král, P. (2010): Dlouhodobá reálná apreciace jako fenomén ekonomické konvergence. Politická ekonomie, 58(1), pp. 70–91.

¹ For more details on the factors of the equilibrium real appreciation of the koruna amid convergence of the Czech economy towards advanced countries, see, for example, Komárek et al. (2010).