Czech Decision To Peg Koruna To DM Carries Risks, Too

By NICHOLAS HASTINGS
AP-Dow Jones News Service

LONDON -- Linking the koruna to the Deutsche mark may cause the Czech Republic as many problems as it solves.

While the new peg might make it more difficult for speculators to attack the Czech currency and increase the country's European credentials, it leaves the central bank with a distinct dilemma if the mark starts to rise again.

'I don't think it is a remedy for their trade problem by any stretch of the imagination,' said Nigel Rendell, emerging-market strategist at HSBC James Capel in London. He added that while it's logical for the republic to tie its currency to that of the country to which it sends most of its exports, the koruna's previous peg against a currency basket which also included the dollar was 'just as reasonable.'

Nevertheless, with the Czechs following a similar proposal by Bulgaria earlier this month, analysts see this as a growing trend among central European nations as they start to jockey for admission to the European Union. One market-watcher suggested that the Romanian lei will be next in line as that nation also starts a process which will help its economy to converge with those of the E.U.

The Czech National Bank's surprise announcement Monday that it was abandoning the koruna's 7.5% fluctuation band on either side of its basket of 65% marks and 35% dollars came as the central bank appeared set to lose its battle to protect the currency against speculators.

The koruna came under attack in recent weeks as the republic's current-account gap widened to nearly 9% of gross domestic product, making the Czech currency's strength against the mark appear unsustainable. As market players sold the koruna short in hopes of covering positions at a profit, the central bank was forced to sell as much as $1 billion of foreign reserves, by some estimates, in defense.

Robin Hubbard, head of London research at Chase Investment Bank, said the koruna's problems were worsened by the dollar's strength over the last year, forcing the central bank to abandon a policy it had only adopted at the start of 1996.

The central bank's announcement Monday that it was adopting a mark-only movable target of between 17 koruna and 19.50 koruna came without explanation.

Hubbard said the new system should be more flexible and should provide the Czech currency with some protection by making the target fuzzy for speculators.

But he noted that the nation faces the risk of higher bills for servicing its dollar-denominated external debt if the U.S. currency advances further. Although the republic has been more conservative than its neighbors in amassing external loans, it still has clocked up debts that are expected to rise as far as $22.5 billion by year end.

Hubbard described the Czechs' dilemma as sitting on a fence and having to decide on which side to jump. '(They) jumped toward the Deutsche mark,' he said.

But HSBC James Capel's Rendell was concerned that Czech policymakers may have leaped the wrong way. He suggested that the central bank's decision appeared to be a case of trying to salvage something from an embarrassing episode as the bank learned that it 'can't buck the market.'

Chase's Hubbard said it was more sensible to tie the koruna to the mark than to the European Currency Unit, which is likely to face volatility ahead of European economic and monetary union.

By doing so, it also means that the country may start to mimic the economic cycles that will help lead to convergence with other countries in the E.U. The Czech Republic and other central European states are widely expected to seek membership in about five years.

But Hubbard said that for the moment, 'The change is probably more symbolic than significant' and carries the added risk of moving the wrong way.

Despite the problems posed by the U.S. currency's strength, the koruna's peg to the basket was perceived as fairly reflecting the republic's trading patterns: Well over 65% of exports go to Germany and Europe, and the rest to countries where trade is largely dollar-denominated.

Hubbard warned that now the nation faces the risk that the mark, rather than the dollar, will start to strengthen, pulling the koruna higher.

When asked to comment on the Czech decision, a Deutsche Bundesbank spokesman pointed to the importance of keeping the mark stable.

'Naturally, such a decision lies solely within a country's own sovereignty,' he said. 'But (there) is no question that the decision is a challenge for the Bundesbank because the mark is considered a stable currency and it reminds us of our commitment to keep it that way.'

Some fear that the Czechs may have chosen the wrong time to act. The dollar has shown signs of ending its two-year rally against the mark, and some feel this trend could be hastened if a French parliamentary election - the second round of which is set for June 1 - brings a Socialist government to power.

Many feel that the French left's more ambivalent support of EMU will rock relations with the other perceived lynchpin of a single currency, Germany, and possibly undermine the whole process.

If so, the German currency will escape dilution in a single currency that includes weaker E.U. monies and is likely to strengthen as a result.

But if EMU does proceed, albeit in a looser fashion, the mark is expected to come under further pressure, which could aid the koruna.

'For central Europeans, there are strong arguments for this if they ultimately want to become EMU members,' Rendell of HSBC James Capel said.

He suggested that the mark could start to play a larger part in Romanian foreign-exchange policy, and he expects the nation to adopt a formal basket - dominated by the German currency - in the next year or so.

The Czech currency showed signs of stabilizing late Tuesday. The mark rose as far as 19.80 koruna from 19.20 koruna at the opening, but fell back later in the session and was quoted late in the European day at 19.38 koruna.

Concerns about a possible devaluation of the Thai baht have hurt sentiment as well, analysts say.

Many in the market concede that the possibility does exist in Indonesia for further violence - especially if Golkar's margin of victory appears too high. They add, however, that the majority of people in the market are already looking beyond the campaign-related violence to calmer times.

'The market popped sooner than we expected, and it has been largely the foreigners coming in,' said Agnes Safford, the president-director of ABN Ambro Hoare Govett In Jakarta. 'Most think the political concerns are over, and that is why they've piled in.'

Evidence of foreign interest in the market was Thursday's strong performances by such blue chips as cigarette company PT Gudang Garam (P.GGR), up 4.2% to 10,400 rupiah; telephone operator PT Telekomunikasi Indonesia, or Telkom, (TLK), up 3.8% to 4,050 rupiah; and cement company PT Semen Gresik (P.SGK) up 6.8% to 5,900 rupiah. Foreign mutual funds target such large-capitalized stocks due to their greater liquidity.

Dealers in the market note that local investors were also active, especially in buying second-line stocks. State pension funds also were reported to be buying large-cap stocks.

And with the campaign starting to recede in investors' minds, analysts say that Indonesia's economic fundamentals will set it apart from its more financially vulnerable neighbors, such as Thailand, the Philippines and Malaysia.