The Causes, Solution and Consequences of the 1997 Monetary Crisis

n  Situation of the Czech economy before the crisis

n  The 1997 monetary crisis – why did it happen?

n  The crisis development

n  Consequences of the crisis

n  Different crisis explanations

n  Presentation availability: in „Study materials“ at is.muni.cz

                              Czech economy in the middle of the 90´s

n  satisfactory stage of the economic reform

n  most basic reform steps were made

n  solid economic growth

n  low  unemployment rate

n  good future view of macro aggregates

                              Czech economy in the middle of the 90´s

                              Czech economy in the middle of the 90´s

                               The 1997 crisis – why did it happen?

n  several causes (factors)

n  all of them „worked“ together

n  direct relationship between the external imbalance and the Czech koruna exchange rate

n  4 main causes: excessive domestic demand, exchange rate regime, short-term foreign capital
influx, monetary policy

                  1. Overheating of the Czech economy → excessive domestic demand

n  1994-1996 one of the fastest economic growths in Europe

n  excessive domestic demand (theory of „transformation wage pillow“)

n  insufficient domestic supply

n  imports as a natural valve of this imbalance

n  huge current account deficits

n  pressure on the CZK depreciation

                                          BP development

                                      2. Exchange rate regime

n  fixed exchange rate regime since the beginning of the transition process

n  central parity at 28 CZK/1 USD with +- 0,5% fluctuation zone

n  undervalued CZK as another „transformation pillow“

n  good anti-inflation instrument

n  but: real exchange rate problem

n  question of „crawling peg“ implementation

                                      Real CZK exchange rate

n  R[D/F] = E[D/F] . P[F]/P[D ]where:

n  R[D/F]…real exchange rate domestic/foreign currency

n  E[D/F]…nominal exchange rate domestic/foreign currency

n  P[F]…foreign price level, P[D]…domestic price level

n  if R > 1, domestic goods relatively cheaper → to acquire 1 foreign cage of goods you have to
offer more than 1 domestic cage of goods

n  if R < 1, foreign goods relatively cheaper → to acquire 1 foreign cage of goods you have to
offer less than 1 domestic cage of goods



                                      Real CZK exchange rate

                              3. Influx of short-term foreign capital

n  problem of co-existence of fixed exchange rate regime and liberalized capital flows

n  minimal exchange rate risk for foreign capital

n  positive interest-rate differential (Czech real interest rates higher than in other transition
countries)

n  increasing ratio of short-term capital on the financial account

n  virtually no problem with current account deficits – CA def. covered by FA surpluses

n  but: dangerous structure of BP

                                          BP development

                             4. Monetary policy of Czech National Bank

n  restrictive monetary policy in the early 90´s – main goal – decrease inflation

n  since 1993 – slightly expansionistic – main goal – economic growth

n  1995 – full liberalization of capital flows – since that – increase of short-term capital influx

n  February 1996 – widening of fluctuation zone of CZK to +-7,5% - the goal to raise the exchange
rate risk

n  bond-sales to eliminate the excessive growth of monetary base

n  crowding-out effect of bond-sales – another growth of interest rates, and another influx of
short-term capital

n  in 1996 – the need of restriction – middle 1996 – CNB increased the minimal required reserves
rate, and basic interest rates



                              Monetary policy of Czech National Bank

n   1996 monetary restriction as the brake of economic growth

n   slower economic growth – impulse for short-term foreign capital to „cast away“

                                     Development of the crisis

n  wrong prediction of macroeconomic aggregates for 1997

n  April 1997 – state budget deficit (the new phenomenon)

n  first „parcel of economic measures“ – cut of SB expenditures by cca 25 billion CZK (cca 5% of
total expenditures)

n  inner conflicts in the minority government – political destabilization

n  beginning monetary crisis in Southeast Asia

                                     Development of the crisis

n  first attack on the CZK: 15th May 1997

n  foreign short-term capital started to reflux

n  Czech National Bank tried to keep the CZK exchange rate

n  unequal „battle“ between the speculates and Czech National Bank

                                          BP development

                            Most important facts of the 2 crisis weeks

                                CZK exchange rate during the crisis

                            Main variables before and after the crisis

                                    Consequences of the crisis

short-term consequences:

n  personal changes in the minority government

n  governmental breakdown in autumn 1997

n  sharp devaluation of CZK, change of ER regime

mid-term consequences:

n  premature parliamentary elections in 1998

n  changes in monetary policy

n  economic recession in 1997 and 1998

n  constant unemployment growth since the end of 1997

                               The two different crisis explanations

n   Oldřich Dědek – vice governor of CNB

n   Václav Klaus – premier in 1997, current president of the Czech Rep.