A Very Low Difference In The Performance Between CEE4 And The Broader Set Of EMEA Currencies
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GRL decomposition of trends – local is the most interesting
Over the analysed period, the global factor was responsible for CEE4 currency depreciation against the USD of between -6% for RON and -10% for CZK (Figure 3). This element of the FX movement can be explained by the upward trend in the USD index of 7% over the period. We note the muted global influence on RON relative to other currencies in the group, which could be explained by its more tightly managed FX regime that aims to reduce RON short-term volatility.
Regional factor resulted in a relatively small divergence between CEE4 currencies
FX deviation between countries
Global = most correlated
Regional = relatively small role
Local = main source of deviation
Another observation is that the role of the regional factor was relatively small, standing at between 1ppt and 2ppt. This reflects a very low difference in the performance between CEE4 and the broader set of EMEA currencies over the analysed period. In our opinion, two opposing effects have been at play. On the one hand, CEE4 economies were quite overheated before the pandemic and provided a strong anticyclical policy response in reaction to Covid, which made them vulnerable to global inflation shock. Moreover, the fallout of the conflict in Ukraine caused an aversion to CEE4 assets, which undermined their currencies. On the other hand, EU membership makes CEE4 currencies less vulnerable to global risk compared to other EMEA currencies.
Lastly, the local (country-specific) component was the main source of divergence in FX dynamics of CEE4 currencies. In the case of CZK, it made a positive 12ppt contribution, for PLN and RON it was responsible for a moderate -2ppt, but for HUF it knocked off 13ppt versus the dollar. Importantly, comparing the post March 2020 performance versus USD with the dynamics prior to the Covid outbreak, CZK has remained the strongest of the group, while HUF remained the weakest. That leads us to believe, that Covid was a global factor that pushed all currencies in the same direction, but at the same time made the local differences more visible and acute.
Interpretation – making economic sense of domestic factors
March Our view is that the divergent trends in the local component of CEE4 exchange rates are related to differences in macroeconomic fundamentals as well as the increased role of these fundamentals for FX markets in times of elevated economic uncertainty. This is illustrated by Figure 4, in which we collate a set of structural indicators relevant to understanding FX market developments.
In our opinion, the arguments behind the relative strength of CZK are twofold. First, the Czech Republic is the most developed economy, both in terms of GDP per capita and the quality of institutions. It is the only CEE4 country classified by the IMF as an Advanced Economy rather than Emerging Economy. Second, the medium-term fundamentals of the Czech Republic are relatively sound. The international investment position and public debt are at sustainable levels, whereas inflation, albeit currently high, is forecast to return to target by 2025. For these reasons the Czech Republic has the highest credit rating among CEE4 economies and domestic fundamentals have been exerting a steady upward pressure on the value of CZK since the outbreak of Covid.
When considering more forward-looking fundamentals, while having the lowest GDP growth rate in the group, the Czech Republic is somewhat insulated from potential external activity and current account shocks, among others thanks to the lowest share of the EU in exports (71%). The vulnerability of the current account from the imports side due to growth in energy prices seems not too high, given the moderate share of imports in the local energy mix. Also, there is lower evident dependence on the availability of EU funds, which is more of the case for the rest of the CEE4 group. Looking at the capital flows, there could have been an effect of hot capital inflows, as real estate prices seem to have been growing at elevated rates in recent years, meaning vulnerability of a reversal in the case of an economic downturn. Fluctuations in the CZK FX rate are not too relevant to the government given the low share of FX-denominated government debt (8%) and the declining non-resident share in gross public debt (30%). The local fundamentals for the relatively weak HUF are different and, in most cases, the opposite to the CZK. High levels of public and net foreign debt combined with fiscal and current account deficits6 potentially raise concerns about medium-term sustainability, especially in an environment of rising interest rates. This is reflected in the relatively low level of credit ratings issued by international credit agencies combined with a negative rating outlook. Apart from the above stock-flow issues, there are signals of inflation expectations de-anchoring, which is reflected in relatively high consensus inflation forecasts. Even though in the short-term upward inflation surprises usually lead to nominal FX appreciation, especially if they are accompanied by monetary policy tightening expectations, in the medium and long-term, high and persistent domestic inflation requires exchange rate depreciation to restore international price competitiveness. Our view is that for HUF, the latter channel dominated in 2022. Looking ahead, the risks of negative surprises on Hungary’s economic activity and finances are elevated, given the high dependence on the EU in terms of exports and financing (EU funds expected to be available for Hungary by 2027 are equivalent to almost 35% of its 2021 GDP, and are subject to political discussions), as well elevated dependence on non-EU energy imports. Also, Hungary has enjoyed even stronger capital inflow in the real estate market, meaning vulnerability to reversal. Local fundamentals of PLN and RON are sometimes closer to those for CZK and in other cases more similar to HUF Figure 4 also illustrates that the local fundamentals of PLN and RON, the mid-performers in terms of FX, are sometimes closer to those for CZK (eg, public debt) and in other cases more similar to HUF (eg, international investment position, sovereign ratings and outlook). Consensus forecasts for inflation in Poland and Romania in 2025 are slightly lower than in Hungary, but they are still above inflation targets of 2.5%. For these reasons, the impact of the local factor on PLN and RON has been broadly neutral. It can be added that for RON some of the market pressure on the FX market, related to Romania’s vulnerable fiscal and external positions as well as risky growth profile, could have been offset by the managed FX regime, which allows officials to protect the leu7. Moreover, Romania is the least dependent on energy commodity imports among CEE4 countries. From a forward-looking perspective, the mid-performers are facing challenges, such as Romania’s large twin deficit and therefore exposure to global downturn or Poland’s tensions with the EU and proximity to adverse geopolitical reality in the region. But at the same time, Romania’s lower energy import dependency and less hot real estate market, as well as Poland’s solid GDP growth trend and relatively stable structure of CA deficit8 could serve as mitigating factors.
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