In May 1997 the Czech financial markets were plunged into an unprecedented crisis when a wave of speculative selling triggered severe currency turbulence. The Czech National Bank spent millions of dollars propping up the Czech koruna against attacks by both foreign and domestic investors.
When on May 15 the koruna dropped to its all-time low of 5.2% within the fluctuation band, the central bank increased its Lombard rate from 14% to an unprecedented 50%, unleashing havoc on the interbank lending market. In the wake of this move, interbank rates climbed as high as 500%. Interest rates soared to 33% and most companies found themselves in a financial situation unsustainable in the long term.
The speculative attacks can generally be explained by problems in the domestic economy: a large trade deficit, a slowing economy, rapid growth in real wages and a still-tight labour market.
Additionally, there were indications of political problems. Opinion polls showed a dramatic decline in confidence in the government, falling to 29% in May. The government's April package of measures, aimed at tackling the downturn in the economy, did not go far enough in addressing the problems of the Czech economy.
In the course of the battle to stabilize the koruna, the central bank restricted foreign banks' access to the Czech money market. The generally expected devaluation did not materialize, but on May 27, the Czech National Bank removed the +/- 7.5% fluctuation bands for the koruna and announced the currency would only be fixed daily against the Deutschmark. This step resulted in an immediate 10% drop in the value of the koruna.
The crucial change in the fixing of the koruna was accompanied by a new government stablization and recovery programme (the Second Austerity Package) introduced the next day. The government admitted having made mistakes in its economic policy and announced further spending cuts, declared its support for the central bank's restrictive monetary policy in its efforts to peg back inflation and resolved to freeze state sector wages.
The government's new plans, followed by the appointment of new ministers including a new minister of finance, passed the test on June 10, when the government narrowly won a vote of confidence in parliament. Accordingly, economic reforms look set to continue; a bill lowering corporate income tax by 4 percentage points to 35% was recently passed by parliament.
Two weeks into the application of the measures, restrictions on foreign investors' access to the Czech money market were removed, and the exchange rate has found a level not far from the former parity. Interest rates have been coming down gradually, but the market still perceives them as too high.
The decision to abandon the fluctuation band taken by the Czech National Bank has probably removed low-risk profit opportunities for foreign investors: the substantial difference in Czech and foreign interest rates, combined with the long-term stability of the koruna, had made the Czech currency one of the most profitable in the world. The new floating exchange rate will ensure that in future the koruna reflects with the true strength of the Czech economy.