The Czech National Bank in August became the first European Union central bank to tighten monetary conditions since the onset of the 2008 financial crisis and subsequent recession. The CNB raised interest rates to 0.25%, and likewise lifted the repo rate from zero.
Contrary to expectations, the koruna did not appreciate following the rate increase, but is marginally weaker. This seems to confirm that markets are in a period in which the uncovered interest rate parity – the rule implying a currency should strengthen after an interest rate increase – may not work at all. The causes of this phenomenon have serious ramifications for the likelihood of another global financial sector crisis. Dangers are mounting of activity moving into unregulated areas, which could give rise to serious upsets.
There are clear reasons for the koruna to weaken, as most analysts forecast early in the year. The koruna was overbought before the CNB ended its intervention policies.
The Bank had, since 2013, imposed a Swiss-style policy of market intervention to maintain a suitable exchange rate with the euro. It may take several years for the effect of these measures to reverse.
The koruna exchange rate is like a piece of wood floating down a narrow stream, at the bottom end of which is a large and constantly leaking inflatable balloon of water that creates a counter-stream. The unconventional policies of many central banks have created ‘inflatable balloons of liquidity’ which now impede, among other things, the movement of exchange rates.
Excess liquidity in the financial system has created a situation in which the most binding rules are those which regulate capital requirements, rather than those which create floors for unused liquidity. But this means that, despite their apparent attractiveness, many arbitrage opportunities normally exploited by the financial sector remain unused. Subsequently, potential returns on many trades are meagre compared to the costs implied by regulatory capital requirements.
One of the negative consequences of this is the disappearance of mechanisms which normally work, such as the uncovered interest rate parity. However, a more positive implication is the relative stability of the financial sector. Generally, over-liquid and well capitalised financial institutions are less prone to collapse. Even if negative developments occur in some segment of the financial sector, the ample presence of liquidity may enable the relaxation of capital roles to stabilise the system. This can be achieved more efficiently than was possible at the onset of the great recession, when banks had little liquidity and seemingly ample capital.
But the long-term impact of these conditions on financial system developments is unsettling, even if the size of any impending crisis is unlikely to approach the scale of 2008. Unregulated actors will increasingly take advantage of arbitrage opportunities that regulated financial institutions appear unwilling to exploit. This means a greater number of profitable activities will move outside the boundaries of the regulated sector. As a result, the next disturbance could emanate from a sector that few regulators either oversee or understand.
Miroslav Singer is former Governor of the Czech National Bank and a Member of the OMFIF Advisory Board. He is Director of Institutional Affairs and Chief Economist at Generali CEE Holding.