Czech Republic: Summary Indicators
|Size (sq. km.):||78.8|
|Agricultural land (in percent of total area)||52|
|Population per sq. km.:||132|
|Population characteristics (1994):|
|Total population (in millions)||1034|
|Average annual rate of growth during 1990-94 (percent change):||−0.1|
|Population age structure (in percent)|
|65 and over||12.75|
|Life expectancy at birth (in years):|
|Crude birth rate (per thousand):||10.3|
|Crude death rate (per thousand):||11.4|
|Per capita income (in U.S. dollars)||3,485|
|Period average||11.1||20.8||10.0||9.1||8.7 a/|
|12-month change||12.7||18.2||10.2||7.9||8.9 a/|
|Real wages, period average||10.2||4.1||7.5||7.3||8.2|
|Unemployment, period average|
|(Percent of labor force)||3.1||2.9||3.3||3.0||2.9|
|(In percent of GDP)|
|Fiscal operations 1/|
|Excluding use of privatization revenues||0.4||0.6||−1.3||−2.0||−0.7|
|Gross debt (central government)||19.9||17.4||15.1||12.7||…|
|(12-month change in percent of beginning of period broad money)|
|Money and credit, end of period|
|Broad money||20.6||19.8||19.9||19.8||16.1 b/|
|Credit to enterprises and households||17.5||18.9||16.6||12.7||12.5 b/|
|Net foreign assets||8.1||9.5||11.2||10.6||3.3 b/|
|Interest rates 2/|
|Average lending rate||13.2||13.9||12.9||12.8||13.2|
|Average deposit rate||6.3||6.9||6.9||6.9||6.8|
|Balance of payments 3/|
|Volume change (in percent)||…||11.4||2.6||2.8||…|
|Volume change (in percent)||…||13.4||14.2||21.7||…|
|(Percent of GDP)||0.2||2.2||0.0||−3.0||…|
|Gross official reserves (End of period)||0.8||3.9||6.2||14.0||12.7|
|External debt in convertible currencies (End of period)||6.9||8.5||10.7||16.5||16.7|
|External debt service ratio in convertible currencies|
|(Percent of exports of goods and nonfactor services)||11.4||8.4||13.1||9.0||…|
|Exchange rate (period average)|
|Real effective (ULC-based)||17.3||14.7||8.8||3.8||6.2|
|GDP in nominal terms|
|(In US$ billions)||28.0||31.3||36.0||44.9||52.6 c/|
|(In Kc billions)||791||911||1,038||1,212||1,420 c/|
I INTRODUCTION AND SUMMARY
1. The Czech Republic’s current problems are a consequence of its early successes in stabilization and structural reform. In 1991–93, quick progress was made in containing inflation, rebuilding foreign reserves, and restoring confidence in economic policies; and this was followed by resumption of growth in 1994. Financial and political stability, and continued progress toward a market economy, attracted large capital inflows in 1993–95. In spite of attempts to sterilize these inflows, monetary growth was rapid and fueled a boom in domestic demand, which in turn widened the current account deficit and maintained inflation at relatively high levels. Controls on short-term capital inflows introduced in mid-1995 proved inadequate, and net inflows of capital rose further in the latter part of the year. Operating as a self-correcting market mechanism, the rising current account deficit eventually changed market perceptions about the exchange rate at end-1995; together with the adoption of a wider exchange rate band at end-February 1996, this caused a sharp decline in capital inflows.1 Even so, the effectiveness of monetary policy remains limited by the still weak governance in many of the large enterprises and the continued sensitivity of capital inflows to the interest rate.
2. Rapid increases in domestic demand and wages in relation to economic potential lie behind the sharp deterioration in the external current account (officially projected to be in deficit of 6½–7 percent of GDP in 1996 from near balance in 1994) and the persistence of relatively high inflation (8–10 percent in recent years) despite a stable exchange rate since 1991 (Chart 1 and Summary Table):
Real domestic demand grew on the average by 10 percent in 1994–95 and is expected to rise by another 10 percent in 1996, thus outpacing real GDP which itself rose by a record 5 percent in 1995. In large part, the sharp rise in domestic demand has reflected increased fixed investment, but private consumption has also been buoyant. Investment has been mainly concentrated in transportation, energy and telecommunications; investment in manufacturing has remained sluggish. Unemployment, at 3 percent of the labor force, is very low by international standards, and the housing situation severely limits geographical mobility as evidenced by an unemployment rate of ½ percent in the Prague region. An inflow of workers from neighboring transition economies has reportedly alleviated labor shortages, and has probably added about one percentage point to employment growth in recent years.2
Average nominal wages in the economy have risen well in excess of labor productivity—by 18 percent on average in 1994–95 with productivity growth of up to 2 percent in recent years—thus adding to inflationary pressures, which are more evident in the nontraded goods sector. Tight labor market conditions and management accommodation to labor demands haw contributed to the rapid wage growth. Wage controls, applied intermittently until mid-1995, were ineffective as designed and implemented. Productivity growth in the traded goods sector (especially manufacturing) has accelerated in recent years but this has not prevented a continued rise in relative unit labor costs (RULC) vis-à-vis the main trading partners. A more favorable picture emerges from the financial accounts of manufacturing enterprises, which suggest that the deteriorating trend in profitability (as indicated by a rising share of labor costs in value added) has been gradually arrested in recent years, and even reversed in 1995. Developments in relative profitability (RULC adjusted for producer prices, effectively comparing the share of labor costs in value added at home and abroad) also paint a somewhat brighter picture. The divergent movement in the RULC and the relative profitability indicators could reflect improvement in non-cost competitiveness that has allowed a steady improvement in the terms of trade; but it could also imply that Czech firms are pricing themselves out of the market. Indeed, anecdotal evidence points to substitution of domestically produced consumer durables with imported ones as the price differential has narrowed.
CHART 1czech republic ELECTED ECONOMIC INDICATORS, 1992–96
Sources: Czech Statistical Office; and official projections.
3. The rapid widening of the current account deficit is associated with strong demand for imports of consumer as well as investment goods, and a comparatively weak performance of exports. All categories of imports grew at similar rates in 1995 and in the first half of 1996, and indeed their respective shares in total imports have changed relatively little since 1993. The increased imports of investment goods in 1995–96 are mainly on account of infrastructural projects. Export performance seems unsatisfactory after taking into account import growth; a decline in the domestic value-added component of exports owing to increased use of imported intermediate inputs as local firms become more integrated with foreign suppliers; and export performance by neighboring transition economies. Besides weakening cost competitiveness, unfavorable demand conditions—very strong at home, recently weakened abroad—has been an important factor behind the relatively weak export performance.
4. Net capital inflows declined sharply to US$0.8 billion in the first half of 1996, and their composition changed, thereby alleviating pressures on monetary policy. With nondebt capital inflows relatively strong at about US$0.9 billion, this mainly reflected a short-term capital outflow and, to a lesser extent, lower medium- and long-term borrowing by banks and enterprises. A significant interest differential with abroad, expectations of a possible appreciation of the koruna, and the improved credit ratings of the Czech Republic (that enhanced the attractiveness as well as availability of foreign borrowing) were the main causes of the strong capital inflows through late 1995, while the emergence of more balanced exchange rate expectations and the CNB’s shift from a large net purchaser to a net seller of foreign exchange help explain the sharp decline in capital inflows this year.
5. The weakening of monetary control in 1994–95, owing to the large capital inflows, mainly accounts for the rapid rise in domestic demand and wages. Broad money exceeded its target in 1994 and again in 1995; in the latter year, it rose by 19½ percent against a target range of 14–17 percent, even though sterilization amounted to two thirds of end-1994 base money. The expansionary role of monetary policy appears to be confirmed by the behavior of the income velocity of broad money. Specifically, the velocity stabilized in 1994–1995 as efforts by residents to run down excess liquidity through a widening current account deficit were offset by injections of liquidity through intensifying capital inflows. A worsening of the foreign trade balance and persistence of inflation eventually prompted a tightening of monetary conditions in late June 1996, through a 3 percentage point increase in the required reserve ratio and higher central bank interest rates. As a result, the 12-month broad money growth rate at end-August was brought down to just within the CNB’s target range of 13–16 percent for 1996. The monetary tightening, and continued market interest in koruna-denominated financial instruments, occasioned a rise in the value of the koruna by 4½ percent as of early September from near parity in mid-year, reflecting market concerns about the current account deficit, the koruna subsequently weakened to about 2½ percent above parity in mid-October. Monetary management has been complicated to some extent over the past year by insolvency problems in some of the smaller banks, jointly accounting for about 5 percent of the banking system. This also triggered liquidity problems in a mid-sized bank owing to cross-shareholdings with a small failed bank where irregularities were detected.
6. In line with a long conservative tradition, the government has generally adhered to a policy of balancing the fiscal accounts with minor deviations, and has kept its net indebtedness rather low in relation to GDP. Recent cuts in discretionary spending (equivalent to ¾ percent of GDP) are expected to ensure that the State Budget remains balanced in 1996. As a result, the general government deficit (excluding use of privatization revenue) is expected to be halved to 1 percent of GDP in 1996, compared with an initial target of a balanced position. The deficit in 1996 reflects extrabudgetary operations and a negative position of health insurance funds.
7. While the major banks are reportedly financially sound, weak supervision standards in the early years of the reform allowed the emergence of insolvency problems in small banks that jointly account for about 5 percent of the banking system. Over the past year, the CNB made progress in restructuring such banks at an estimated cost of 2 percent of annual GDP.
8. Following two waves of voucher privatization during 1991–94, privatized large enterprises typically still had diffuse ownership, with their shares owned by individual shareholders, Investment Privatization Funds (IPFs), and the state (NPF). This arrangement preserved a significant role for the state in the economy, especially since the four largest banks, which also manage the most important IPFs, remained under state control despite having been partially privatized. In addition, the NPF maintained substantial (sometimes majority) stakes that gave the government effective control in about 55 major (“strategic”) industrial enterprises with a total book value of over Kc 300 billion, about 40 percent of the value of large enterprises originally slated for privatization. In this environment, even though managers of (directly or indirectly) state-controlled enterprises have been given considerable autonomy, they have typically avoided tough decisions on restructuring and labor compensation out of broader social and political concerns. However, a process of ownership consolidation that started last year was giving rise to clearly defined owners who were more eager to raise productivity and profits than the previous managers. Detailed information on this process was not available, and it seemed likely that only a minority of firms had so far experienced such changes in ownership and management. Nevertheless, a pick-up in productivity growth in 1995 may be related to this process.
II. Real Sector Developments
A. Output and expenditure
9. The recovery of economic activity that began in early 1994 strengthened during 1995, and preliminary data suggest that this was roughly sustained in the first half of 1996. Real GDP increased by 4.8 percent in 1995, and is estimated to have increased by 4.3 percent in the first half of 1996 over the same period in the previous year (Chart 2).3
CHART 2czech republic GROSS DOMESTIC PRODUCT
Source: Data provided by the Czech Statistical Office.
10. On the demand side, the main driving force behind the economic recovery was a sharp increase in investment. Fixed investment increased by about 16–17 percent during both 1994 and 1995, and the pace increased slightly—to about 18 percent—during the first half of 1996. Inventory accumulation was also a major contributory factor to growth in 1995, recording a swing of nearly 5 percent of real GDP from the previous year. However, this evidence has to be interpreted with caution because changes in stocks include statistical discrepancy and are subject to other measurement errors (Tables A1 and A2).4
11. Total consumption expenditure increased at a steady pace of about 3 percent during 1994–95, and strengthened somewhat in the first half of 1996. However, the trend in total consumption masks a divergent trend between government consumption and private consumption. While government consumption has declined progressively in the last few years, private consumption growth has been around 5–6 percent, driven by large increases in real incomes.5 With the rise in investment and consumption, imports surged., and contributed to a sharp fall in net foreign demand in both 1994 and 1995.
B. Sectoral developments
12. Limited data availability hampers the analysis of developments on the supply side. National accounts by industrial origin are only available in nominal terms (Table A3). In the absence of data on sectoral value added in real terms, attention has typically focussed on the behavior of gross output. However, developments in gross output may exaggerate the trends in value added because (i) the use of intermediate inputs may have increased in the production process (the large pickup in intermediate goods imports in 1995 would be consistent with this); and (ii) with the number of firms increasing, partly as a result of the organizational restructuring taking place since the initiation of reform, the production chain has increased. In addition, the movements in the deflator for gross production may be different from those for value added, mainly reflecting changes in the terms of trade.6 Notwithstanding these limitations, the overall trends are clear: trade and services continue to be the most dynamic sectors of the economy in the last few years, and a strong recovery is underway in industry.
13. The decline in industrial output that was associated with the introduction of the reform program and the dismantling of the CMEA trading system bottomed out in 1993 (Chart 3). The growth of gross industrial production accelerated sharply from 2 percent in 1994 to about 9 percent in 1995, and the pace has been maintained in the first half of 1996.7 The growth in output has been faster in the small scale sector. In part, this reflects the proliferation of small enterprises resulting from the breakup of existing firms.8 It is estimated that about one fifth of gross industrial output in 1995 was generated in enterprises employing fewer than 100 workers.
CHART 3czech republic DEVELOPMENTS IN INDUSTRY1/
Sources: Data provided by the Czech authorities; and staff estimates.
1/ In the monitored sector; that is, in 1990–91 and from 1995 onward, establishments with 100 employees or more and in 1992–94, establishments employing 25 or more workers.
2/ Seasonally adjusted.
14. In 1995, most branches of monitored industry (i.e., large enterprises) experienced strong growth of output, with the exception of mining, textiles, leather, and the chemicals sectors (Table A4). In general, the growth was slower in light industries. The best performing sectors were transport equipment, electrical and optical equipment, rubber and plastics, and metallurgy. The strong recovery of transport equipment and electrical equipment is particularly notable as these two sectors had suffered the steepest decline in output since the introduction of reform, mainly as a result of loss of external markets. The transport equipment sector has benefitted from considerable foreign investment and export of passenger cars, and the discovery of new export markets also has been an important factor in the recovery of the electrical equipment sector. In contrast, the stagnation of the textile sector and the continued decline of leather products reflect both a slowdown of exports and inability to compete with imports.
15. Employment in industry as a whole increased marginally in 1995, though the monitored segment continued to shed labor—but at a slower pace than in previous years—notwithstanding the sharp pickup in gross output (Tables A5 and A6).9 In the monitored segment of industry, employment fell in all branches with the exception of food processing, rubber and plastics, and electrical and optical equipment. An examination of the data at the sectoral level shows that, consistent with expectations but in sharp contrast to the experience of the early years of the reform process, labor-shedding was relatively greater in sectors that experienced slower growth of output. Reflecting these developments, there was a sharp rise in labor productivity in all branches of industry, except for leather and chemicals.
16. Throughout all branches of monitored industry, average monthly wages increased by about 16–18 percent during 1995, implying an increase in the consumer real wage of about 7–8 percent. For industry as a whole, with producer prices rising at a slower pace than consumer prices, the increase in the real product wage was higher than that in the consumer real wage. However, because of the gains in productivity, product unit labor cost (i.e., the share of labor cost in real gross output) in industry fell in 1995, for the first time since 1991. There were considerable variations in real product wages between branches of industry. In general, the increase in the real product wage tended to be lower in sectors that experienced smaller gains in productivity. In 1996, real wages have continued to increase at about 8 percent, and the decline in product unit labor cost has been reversed (Chart 4).
CHART 4czech republic WAGE AND UNIT LABOR COST DEVELOPMENTS IN INDUSTRY1/
Sources: Data provided by the Czech authorities; and staff estimates.
1/ In the monitored sector.
2/ Seasonally adjusted.
3/ Adjusted from January 1993, for reduction of employer-paid taxes on wages following introduction of direct-employee contributions for social security.
4/ Real product wage/labor productivity; that is, share of wages in output.
17. Changes in productivity and unit labor costs are sensitive to whether they are measured in terms of value added or gross production, and to the choice of the deflator. If the deflator for gross industrial production is used as a proxy for the deflator for value added in industry (the latter is not available), it suggests that during 1994–95: (i) the growth of value added in total industry was faster than in the rest of the economy; (ii) productivity in industry increased by about 7 percent annually, but declined slightly in the nonindustrial sector of the economy (aggregated together); and (iii) the rate of increase in unit labor costs in industry was one half of that in the rest of the economy. If the implicit GDP deflator is used to deflate nominal value added in industry, the changes in productivity and unit labor costs for industry are quite close to those for the rest of the economy (Table 1). Enterprise level data on the share of labor costs in nominal value added (see Section II.E) suggests that the underlying situation is likely to be closer to that indicated by the use of the gross production deflator.
|Gross production in industry at constant prices||−7.9||−5.3||2.1||9.2|
|Real value added in industry, derived using deflator for gross production||−8.1||−9.4||4.7||7.7|
|Gross production in monitored segment of industry at constant prices 1/||−14.3||−8.0||−0.4||7.2|
|Real value added in non-industrial sectors 2/||−3.8||5.5||1.3||2.9|
|Entire economy 3/||−2.6||−1.6||0.8||2.6|
|Total industry 3/||−7.9||−6.8||−2.7||0.5|
|Monitored segment of industry||−12.4||−7.1||−5.5||−2.9|
|Non-industrial sectors 3/||0.7||1.3||2.6||3.7|
|Based on gross production||–||1.6||4.9||8.6|
|Based on derived value added||−1.9||−2.8||7.6||7.1|
|Monitored segment of industry||−2.2||−1.0||5.4||10.4|
|Unit Labor Costs4/|
|Based on gross production||20.0||10.7||10.3||7.6|
|Based on derived value added||23.3||14.4||8.7||10.4|
|Monitored segment of industry||22.4||23.7||9.8||6.0|
|Share of wages in nominal value added|
18. The construction sector was buoyant in 1994 and 1995, with gross output increasing by about 8 percent each year. This mainly reflects work on a number of infrastructural projects such as construction of motorways, laying of new railway tracks for high-speed trains, the Ingolstadt-Kralupy oil pipeline, and several ecological investments aimed at emission control and reducing water pollution. Housing construction continues to be depressed; in particular, there has been a sharp fall in the number of completed dwellings in 1994–95. In the first quarter of 1996, construction output suffered because of a severe winter, but activity began to pick up from April. Unlike in industry, the share of construction output generated in large-sized enterprises increased in 1995. Consistent with this trend, employment in large enterprises has increased in the last few years though employment in the sector as a whole has stabilized. In sharp contrast to the pattern during the initial years of the reform process, average monthly wages in large construction enterprises in 1995 increased at a slower pace than in industry (Tables A7 and A8).
19. For the first time since 1990, positive growth was recorded in agriculture in 1995; gross output is estimated to have increased by 5 percent after a cumulative decline of nearly 30 percent during 1991–94. Both crop production and animal production recorded an increase (Table A9). The acreage under crop output stabilized in 1995, and yield per hectare rose for most crops (Table A10). The agriculture sector has suffered in recent years from a fall in domestic demand (associated with the liberalization of food prices), lower exports to the Slovak Republic following the dissolution of the Czechoslovak federation and the subsequent imposition of obligatory quality certification requirement by the Slovak Republic, and the elimination of producer subsidies. The recent turnaround in activity suggests that the adjustment process is nearing completion.
20. The government has been providing direct and indirect support to agriculture with the aim of changing the structure of production and stimulating investment. In 1995, budgetary subsidies to agriculture amounted to about Kc 3½ billion (0.3 percent of GDP), and were directed mainly toward afforestation; renewing orchards, hop fields, and vineyards; landscape maintenance; and animal breeding activities. To facilitate access to financial resources and stimulate investment, the government established the Agriculture and Forestry Support and Guarantee Fund in 1994. Transfers from the state budget to this fund amounted to Kc 2 billion in 1995 and Kc 3 billion in 1996. The fund provided guarantees for bank credits to farmers amounting to about Kc 4.5 billion in 1995; guarantees in 1996 are projected at Kc 5 billion.10
21. Major adjustments are taking place in property relations in the agriculture sector. Land previously under state farms is being restituted, and cooperative farms are being transformed into private cooperatives. At end-1995, ownership rights had been transferred for more than three fourths of the assets.
Energy and environment
22. The primary source of energy in the Czech Republic is domestically produced coal. Nuclear energy is also important and has typically accounted for about one fifth of electricity generated in recent years. Oil and natural gas resources are very limited, and so far have been imported from Russia; with the opening of the Ingolstadt-Kralupy pipeline from 1996, reliance on oil imports from Russia will fall sharply. After a cumulative decline of about 20 percent during 1991–94, mainly on account of the decline in economic activity, the domestic use of primary energy increased by about 6 percent in 1995 (Tables A11 and A12). Electricity consumption by households has increased at a rising pace in recent years, mainly reflecting greater use of electrical appliances and, possibly, proliferation of unregistered establishments in the services sector.
23. Since the beginning of the transformation process, the government has increased energy prices every year, and also curtailed subsidies. The latest rounds of adjustments in prices in 1996 include an increase in the maximum prices for central heating by 10 percent in July, and an increase in the maximum consumer prices of both electricity and gas by 15 percent in August. The structure of energy tariffs is still distorted; while the tariffs for industrial consumers are in the mid-range of low-cost OECD countries, the tariffs for residential consumers are below economic costs.11 The earlier plan was to eliminate the distortions in energy tariffs gradually through annual adjustments until 1999. However, the government is now looking into adjusting energy tariffs to market levels in one shot during 1997.
24. There has been considerable progress in environmental pollution control in recent years. A large number of new laws and legislative measures have been enacted to protect the environment. Charges and fines have been set for pollution and environmental damage, depending on the amount and kind of hazardous substances that are emitted or discharged. Annual expenditures on environmental investments have increased almost three fold during 1991–94, and amounted to 2.7 percent of GDP in 1994. Reflecting the results of these efforts, the emission of sulphur dioxide and nitrogen oxides in 1994 were about 30 percent and 50 percent, respectively, lower than in 1991. Waste water discharged into water courses also declined by 15 percent during 1991–94.
25. Excluding the step increase associated with the introduction of the VAT in January 1993, the underlying inflation rate has declined only very gradually since 1992, despite a fixed exchange rate regime. The average annual inflation rate fell from 10 percent in 1994 to 9.1 percent in 1995, and 8.7 percent in the first nine months of 1996 compared with a year ago. In general, prices of nontradables have increased at a faster pace than tradables.12 This can be attributed in part to the impact of administrative price increases, but the rapid growth of wages has been a more important contributory factor.13 However, the pattern of price increases of different commodity groups during 1995 was strikingly different from that in previous years and during the first half of 1996: prices of food, and public catering and accommodation rose at a faster rate in 1995 than in previous years, and exceeded the rate of increase in the price index for services (Table A13).
26. Price regulation currently covers about 10 percent of household consumption expenditure (or about 5 percent of GDP), and its scope is largely limited to utilities. As of end-June 1996, only 14 items were subject to price regulation. Maximum prices are administratively set for natural gas, electricity, central heating, telecommunication tariffs, railroad passenger tariffs, rents on apartments, medicines, and health services. “Substance-based” price regulations—based on inspection of cost and profits—apply in the case of water supply, producer prices of gasoline, heating oil and central heating, urban public transport, bus passenger tariffs, and postal tariffs.
27. For housing, three types of regulation apply to rents: maximum rents, economically calculated (“substance-based”) rents which cover costs and profits, and state-owned apartment rents. About 45 percent of fiats are privately owned (including cooperatives), the remainder belonging to corporations (which apply the substance-based principle in setting rents) and the state. The latter have in part been transferred to local governments. Maximum rent on state-owned apartments per square meter is specified according to the category of apartment, equipments that come with it, and location of the building.14 From 1994, a new obligatory rule for increases in rents has been introduced: the increase will be equal to the rate of inflation in the previous year, plus a further increase (ranging from 6 percent to 19 percent) that municipalities can impose depending on their size.15
28. Besides adjustments in prices of gas, electricity, and central heating noted above in paragraph 15, during 1995–96, administered prices were adjusted upwards for railroad tariffs (60 percent in 1995), telecommunication tariffs (7 percent in 1995 and 3 percent in 1996), postal charges (21 percent in 1995), rents (23 percent in 1995 and 26 percent in 1996), and transportation charges for students (300 percent in 1996). It is estimated that increases in administered prices contributed 1.7 percentage points and 2 percentage points, respectively, to total inflation in 1995 and the first nine months of 1996.
D. Wages, Employment, and Unemployment
29. Wage regulation, through a system of taxation of excessive wage increases, that had been in place from the beginning of the reform process except for a brief period in early 1993, was abolished with effect from July 1,1995. The rationale was that with privatization of enterprises mostly completed, wages ought to be determined through market forces. Another important consideration was that the effectiveness of wage regulation was limited, as the typically generous guidelines (inflation plus 5 percent allowance for productivity increase) were being taken as targets rather than as ceilings. The abolition of wage guidelines has not had any significant impact on the pace of wage increase: there is no evidence of any acceleration or slowdown.
30. In the Czech Republic, collective bargaining in the enterprise sector operates at the national level and at the enterprise level. However, the proportion of the total workforce covered by collective bargaining agreements has been falling, with the proliferation of new enterprises where employees do not belong to any trade unions. It is estimated that only 40 percent of the enterprises employing 25 or more workers are currently covered by collective bargaining agreements. In the budgetary sector, wage developments follow those in the enterprise sector, but with a lag. During 1995, average wages in the budgetary sphere rose by 17.3 percent, compared with an increase of 18.1 percent in the enterprise sector. In the first quarter of 1996, the differential was somewhat wider: the year-on-year wage growth in the enterprise sector and budgetary sphere was 18.2 percent and 15 percent, respectively.
31. The pace of wage growth in different regions of the country has tended to be influenced by the rate of unemployment. Prague, with a very low unemployment rate (0.3 percent), has experienced the highest growth in average wages—19.7 percent in during 1995, compared with the national average of 17.5 percent. At the other end of the scale, the pace of wage growth has been slowest in Northern Bohemia (15.7 percent during 1995), the region with the highest unemployment rate (4.8 percent).
32. As the economy has become more market-oriented, income inequality has increased. During the five years preceding the introduction of reform (1985–90), there was hardly any change in income distribution as measured by the coefficient of variation of the distribution of monthly average wages and salaries. Subsequently, the coefficient of variation has increased from 37.5 percent in 1991 to 57.9 percent in 1995. At the same time, the share of total household income generated by wages and salaries has fallen from 65 percent in the pre-reform period to 47 percent in 1995, while there has been a commensurate increase in the share of non-wage income (mainly entrepreneurial income).
33. Total registered employment in the Czech Republic increased by about 1 percent in 1994 and 2½ percent in 1995. It is estimated that foreign workers account for about 4 percent of the labor force, and have annually contributed up to 1 percentage point to employment growth in recent years. About 45 percent of the foreign workers (100,000 out of the estimated 220,000) do not have a work permit. According to Czech officials, an estimated 42,000 Ukrainian nationals are employed in construction, and are considered essential for the continued renovation of buildings and houses. Other skilled foreign workers from neighboring transition economies have found employment in Czech industry where bottlenecks have appeared. Another group of foreigners (including from Western countries) are employed in services—such as banking, and hotels and restaurants—primarily in the Prague region. At the same time, a substantial number of Czech workers (more than 25,000) are employed abroad. Many are legally employed in Germany, and commute daily across the border into Bavaria under a special arrangement with the latter.
E. Privatization and enterprise restructuring
34. A privatization program designed to effect a sizeable and rapid transfer of state-owned assets to the private sector has been one of the major structural initiatives of the Czech Republic. The program has included six major components, that have proceeded simultaneously: restitution of expropriated property to former- owners; the transfer of state property to municipalities; transformation into private cooperatives; auction of small businesses; conventional sales of large enterprises to domestic and foreign investors; and transfer of shares in large enterprises to citizens through the voucher scheme. Reflecting the changes in ownership through privatization and also the emergence of new private enterprises, the private sector accounted for nearly two thirds of total GDP in 1995, compared with only 17 percent in 1991, and about three fourths of the workforce were employed in enterprises with mixed-ownership (Table A14).
35. Voucher privatization was implemented in two waves in 1992–93 and 1994–95, and accounted for about one third of the book value of assets earmarked for large-scale privatization. In the first wave, 988 firms with a total book value of Kc 212 billion were offered under the voucher scheme. In the second wave, voucher privatization involved assets with a book value of Kc 155 billion in 861 enterprises. Of these enterprises, 185 were also in the first wave of voucher privatization either because they had been partially included in the first wave or their shares had remained “unsold” (i.e., not distributed). At the end of the second wave, 3.7 percent of the shares remained unsold and were held by the National Property Fund (NPF) on behalf of the State.
36. From the beginning of the privatization process till end-1995, shares of large enterprises with a book value of Kc 689 billion (about US$25 billion) were assigned to the NPF for privatization, including through the voucher scheme. At end-1995, one third of these shares, with a book value of Kc 230 billion, were still held by the NPF. The bulk (75 percent or Kc 176 billion) of these shares were in 56 “strategic” enterprises in the banking, energy, telecommunications sectors. These strategic enterprises account for about 40 percent of the book value of large enterprises originally slated for privatization, and the state currently holds, on average, an over 50 percent stake in them. The government has indicated that it intends to reduce its participation in strategic enterprises, but that a gradual approach will be followed and shares will be offered on a case-by-case basis. However, no decision on completing privatization of specific strategic companies has been reached as yet. The shares in non-strategic enterprises in the possession of the NPF—primarily remaining unsold shares from voucher privatization, and shares which were to be privatized through direct sale but in which the government-approved acquirers have lost interest—will be sold through the capital market or direct competitive tenders. Besides these unsold shares, the NPF also has in its possession some unsold state property, mainly belonging to the Czech Railways and health institutions. This property also is to be privatized, but the modalities have not yet been determined.
37. At end-1995, the cumulative income of the NPF from the sale of property and shares under the privatization program amounted to Kc 107.4 billion, of which Kc 50 billion was from the sale of shares. Privatization receipts do not constitute a part of the State Budget, but accrue to the NPF to be spent for purposes determined by law: elimination of bad debts inherited from the days of central planning;16 payments for restitution claims of former property owners; and repairing ecological damage and financing investment in environmental projects. However, during 1993–95, the State Budget did use nearly Kc 40 billion of privatization revenues to finance interest payments and other quasi-fiscal expenditures, and continues to use very small amounts for quasi-fiscal expenditures.
38. The privatization strategy chosen by the Czech Republic has resulted, in the first instance, in diffused ownership, except in the “strategic” enterprises. Of the nonfinancial enterprises, the State has a majority stake in about IS percent, 4 percent are foreign controlled, and the rest are in the private sector.17 The 350 odd Investment Privatization Funds (IPFs) as a group hold about two thirds of the shares privatized through the voucher method. However, there are limits on the holding of shares by IPFs in any particular enterprise (20 percent).18 The purpose of this limit is to ensure that there is appropriate risk diversification for the true owners who are not the IPFs but those who had entrusted their vouchers to them. Diffused ownership, together with weak requirements on disclosure, is believed to have hampered efficient corporate governance.
39. Since March 1995, when the shares of the enterprises privatized in the second wave of voucher privatization began to be traded in the Prague Stock Exchange (PSE), there has been a growing tendency toward concentration ownership rights through a redistribution of the initial structure of post-privatization owners. While this process could result in potential improvements in corporate governance, it has been accompanied by irregularities: unfair equity pricing, insufficient minority shareholder protection, and use of improper ethical standards. To address these irregularities, changes to the rules of the PSE were legislated in April 1996. The main changes include: (i) an investor buying a majority stake must offer to buy out minority shareholders at the weighted average of the company’s share price over the previous six months; (ii) an investor buying 10 percent or more of an enterprise must inform the enterprise within five days; (iii) an investor buying 95 percent of an enterprise’s shares must buy the outstanding shares if offered them; (iv) an investment fund seeking to change its status into a holding company, that will not be subject to ownership limits, must offer to buy out minority shareholders at a price based on the net asset value—shares of IPFs typically sell at a discount of 40–50 percent; (v) enterprises must publish results six-monthly; and (vi) an enterprise seeking to de-list from the stock exchange must get approval from 75 percent of its shareholders.
40. The PSE expanded very rapidly in 1995 following the completion of voucher privatization. Over 1,700 companies are currently registered with the PSE, making it the second largest European stock exchange—after the London Stock Exchange—measured by the number of registered issues. However, a large number of shares in the PSE are illiquid and there is considerable variation in information disclosure. With the aim of making the securities market more transparent to investors, in September 1995, the listed market of the PSE was divided into two parts: the Main Market and the Secondary Market, while the unlisted market was renamed as the Free Market. For admission to the Main Market the basic requirements are the following: for securities issued by banks and corporate bodies, at least Kc 200 million must be subject to public offer; investment funds and unit trust funds which issue securities must have a minimum registered capital of Kc 500 million; and reports on business operations must be reported to the PSE on a quarterly basis. For admission to the Secondary Market, the minimum amounts for public offer and registered capital are Kc 100 million and Kc 250 million, respectively, and information has to be disclosed on a semi-annual basis. At the end of 1995, there were 62 share issues and 20 bond issues in the Main Market, 6 share issues in the Secondary Market, and 1,648 share issues and 28 bond issues in the Free Market.
41. An important element of the Czech Republic’s transformation strategy was to leave the task of restructuring of enterprises to the new owners. In the initial period of transition, the pace of enterprise restructuring was slow, as regular mechanisms of corporate control of state-owned enterprises were effectively absent. Enterprise level data show that in the aggregate, there was no improvement in the financial position of enterprises during 1992–93. While many enterprises made strides in increased efficiency in materials and energy use, there was little adjustment in this regard for a large part of the enterprise sector. Little was achieved also by way of restraining labor costs. Enterprises shed labor, and this occurred to a larger extent in loss-making firms, but large wage awards more than offset the gains from lower employment. Financially weak enterprises partly financed the wage increases through decapitalization, in the form of both sales of fixed assets and investing less than depreciation.19 All of this confirmed the common perception of slow restructuring that was based on macroeconomic evidence—the slow turnaround in economic activity, the low rate of unemployment, and relatively small number of bankruptcies.
42. The resumption of output growth since 1994 has been accompanied by an improvement in the profit position of nonfinancial enterprises. The proportion of enterprises which reported making profits, and the profit rate (i.e., profits as a percent of value of current production) increased in both 1994 and 1995 (Table 2).20 This pattern was visible in all branches of the economy and in all ownership groups. In the returns for both years, the proportion of profit-making firms in that year and the increase in the proportion of profit-making firms from the previous year were higher in the non-public sector (i.e., the private and the foreign-controlled firms) than in the public sector. However, the ratios of both aggregate profits and gross operating surplus to aggregate production were higher for the public sector. This finding has to be interpreted with caution, as the profit rate derived from data on aggregate profits will not necessarily match the average of profit rates of individual enterprises in the sector. Furthermore, the profit rate for the public sector is heavily influenced by the very large profits recorded by public utilities and refineries.21 However, in several branches of manufacturing—for example, textiles, machinery, electrical equipment, and “other” manufacturing (i.e., manufacturing not classified elsewhere)—the ratios of aggregate profits and gross operating surplus to aggregate production were higher for the public sector than for the private sector.
|Percent of||Profits||Gross Operating Surplus|
|Firms in Each Sector Reporting Profits||In Percent of Current Production||In Percent of Current Production|
|1994 Reporting 2/||1995 Reporting 3/||1994 Reporting 2/||1995 Reporting 3/||1994 Reporting 2/||1995 Reporting 3/|
|Of which: Manufacturing||66.8||67.3||62.6||66.7||0.5||2.8||3.0||3.5||13.3||13.0||13.3||14.0|
|Hotels and restaurants||28.2||34.4||33.3||46.7||−19.8||−10.8||−7.1||0.2||11.9||9.8||15.0||16.6|
|Transport, storage and communications||57.3||71.8||54.5||73.0||−10.9||6.5||7.1||11.7||5.6||5.6||6.0||10.9|
43. Labor costs (basic wages plus social insurance contributions) relative to value added increased in 1994 but fell in 1995. The increase recorded in 1994 reflected primarily the trend in industry and the hotel and restaurant sector. In all other sectors of the economy, the share of labor costs in value added declined or remained broadly unchanged. In 1995, the share of labor costs fell in all sectors of the economy, with the exception of trade. The decline was more pronounced in the private and foreign-controlled enterprises (Table 3).
|1994 Reporting 2/||1995 Reporting 3/|
|Of which: Manufacturing||52.9||54.2||53.3||50.8|
|Hotels and restaurants||69.7||73.6||63.1||59.0|
|Transport, storage and communications||84.6||84.0||83.0||73.7|
44. Notwithstanding the improvements in the financial position of the enterprise sector, the considerable volume of nonperforming loans of the banking system (see Section IV) suggests that a large number of enterprises are experiencing financial difficulties. However, the number of bankruptcies have been relatively small. Since the passage of the amended bankruptcy law in April 1993, only 480 bankruptcies had taken place by mid-1996. The capacity constraints on courts to process applications as well as legal obstacles related to seizing collateral hamper initiation and declaration of bankruptcies.
III. PUBLIC FINANCE
A. Fiscal sector developments
Broad developments since 1993
45. Since the beginning of transition, the general fiscal policy goals of the central government have been to maintain a balanced budget, thereby keeping the nominal value of government debt constant, and gradually to reduce the size of the budget relative to GDP. In the staffs analysis, the general government consists of the central state budget, fiscal activities of the central government financed from the NPF and State Financial Assets (SFA, the central government’s account at the Czech National Bank, in which central budget surpluses from previous years are deposited), the budgets of the local authorities, and the operations of extrabudgetary funds and the health insurance funds.22 Revenues of the NPF—that is, privatization proceeds—and transfers from the SFA are not counted as revenues of the consolidated budget. On this basis, the general government accounts were in a small surplus in 1993, and recorded deficits of 1.3 percent of GDP and 2 percent of GDP, respectively, in 1994 and 1995.23 The 1996 budget had aimed at reversing this gradual deterioration of the fiscal position, and targeted a balanced budget without resorting to the use of NPF revenues for debt service. However, the first half of 1996 saw a general government deficit of 0.7 percent of projected annual GDP, which is not in accordance with the normal seasonal pattern which typically shows surpluses in the early part of the year. Corrective steps, mainly aimed at reducing expenditures, were initiated in the second half by both the central government and the local authorities. Nevertheless, because of extrabudgetary operations and a negative position of the health insurance funds, the consolidated deficit in 1996 is forecast to be close to 1 percent of GDP (Table A15).
46. Following substantial progress in the early years of reform, the government’s attempt at reducing the share of the budget in GDP slowed during 1993–95. General government revenues fell by between 0.5 and 1 percentage point of GDP per year, while expenditures hovered around the 50 percent of GDP mark. Typically, in each year revenue performance turned out to be better than projected in the original budget, and expenditures increased accordingly through supplementary authorizations. However, in 1996, consolidated revenues and expenditures once again are projected to fall significantly as a ratio to GDP, consistent with the authorities’ goal.
47. The 1995 budget saw a slight weakening of the government’s traditionally prudent approach to fiscal management. While the central government budget was projected to be balanced and the use of privatization revalues to finance interest payments was less than in the previous year, local authorities expected a deficit of about one percent of GDP (Tables A16 and A17).
48. The main initiatives contained in the 1995 budget were a number of tax changes, viz. a reduction in the standard rate of VAT from 23 to 22 percent, a widening of the VAT base,24 and reductions in both the corporate income tax rate and the top rate of personal income tax from 42 to 41 percent. To offset these revenue losses, excise taxes on heating oil, road use, and diesel fuel were introduced. The net revenue impact of the discretionary measures was expected to be a loss of about 0.5 percent of GDP.
49. On the expenditure side, some predictable items were not included in the official budget. In particular, the government expected to increase the minimum wage and the wages of all public employees in May 1995. In addition, cost-of-living adjustments to pension benefits were expected to be required by July. These two factors would add a further one percent of GDP to 1995 expenditures, yielding a general government deficit of 2 percent of GDP, including transfers from the NPF used for fiscal purposes. Without including the NPF transfers, the underlying deficit would be about 3 percent of GDP.
50. Despite some concerns at mid-year, the 1995 consolidated budget outturn was in line with that envisaged at the beginning of the year, recording a deficit of about 1 percent of GDP, including privatization revenues (2 percent of GDP excluding privatization revenues). The central government implemented a non-budgeted increase in public sector wages and pension benefits as expected in the middle of the year, but higher VAT, excise (especially from gasoline and cigarette purchases by German tourists), and social security revenues were sufficient to cover the additional revenue requirements. Corporate tax revenues ended the year below their originally projected level, but the shortfall was offset by the unexpectedly buoyant performance of consumption and wage-based taxes, due to higher-than-expected growth of the tax bases. Finally, despite significantly higher than expected import growth, customs duties were relatively stagnant compared with their 1994 yield, due to the reduction in the average tariff rate from the assumed rate of 4 percent to 3.6 percent. This change in the average effective tax rate was caused by reductions in the statutory tariff rates under EU Association Agreement and commitments to the World Trade Organization, and a reallocation of domestic demand towards lower-taxed goods.
51. The central government reported a surplus of Kc 7.2 billion in 199S. However, included in this figure were “revenues” of about Kc 8 billion transferred from the government’s state financial assets account with the central bank (Kc 6.4 billion, representing previous years’ surpluses) and the NPF (Kc 1.5 billion). Properly treating these as financing items, the underlying central budget actually finished 1995 virtually balanced. Despite earlier proposals from parliamentarians to spend the full 1994 central state budget surplus of Kc 10.4 billion, the government limited itself to using only part of those resources.
52. The performance of the local authorities also improved over initial projections, and on a combined basis they registered only a small deficit for the year as a whole. This was mainly due to higher than projected personal income tax receipts, as wage growth pushed more taxpayers into higher tax brackets.25 In total, revenues of the local authorities increased by some 30 percent over their budgeted level, more than offsetting an 18 percent increase in expenditures. Most of the increased expenditures were of a capital nature, reflecting the difficulty of projecting investment expenditures by local authorities at the early stages of the budgetary process.
53. Quasi-fiscal operations of extrabudgetary funds—relating to agriculture, environmental, and cultural activities—were in approximate balance in 1995, being financed by both own revenues (e.g., from pollution charges, etc.) and transfers from other budgets. Due to a lack of information at the early stages of the budgetary process, the health insurance funds had originally been assumed to run balanced budgets in 1995. However, as insurance claims were more than 10 percent higher than originally projected, the funds contributed 0.3 percentage points of GDP to the consolidated deficit (Tables A18-A20).
54. The 1996 budget adopted a similar strategy to that of the previous years, in terms of maintaining fiscal balance and lowering the tax burden. In fact, on a consolidated basis excluding privatization revenues, the budget represented a significant fiscal tightening, as reliance on NPF revenues for the purpose of making interest payments was discontinued. Both the central state budget and the consolidated budget were projected to be balanced, implying a fiscal contraction equal to 2 percent of GDP.
55. On a consolidated basis, the general government revenue to GDP ratio was projected to fall by about 1½ percentage points to about 47 percent. Revenues from corporate taxes were projected to fall as a proportion of GDP, in line with the reduction in the corporate profit tax rate from 41 percent to 39 percent. However, despite a reduction in the top marginal rate from 41 to 40 percent, personal income tax revenues were projected to remain roughly unchanged as a ratio to GDP as the share of labor in output continued to expand, and as more taxpayers entered higher rate brackets (despite some bracket indexation). The social security contribution rate was also reduced by one percentage point to 35 percent.26
56. A major change to the budget in 1996 is the allocation of revenues between the central government and the local authorities. Since 1993, revenues from the personal income tax on wages and entrepreneurial income were assigned to the local authorities,27 while corporate profits tax revenues wore assigned to the central government. With strong and continued wage growth but somewhat less buoyant profits, revenue shares had been shifting in favor of the local authorities, particularly since the profits tax base tended to recover at a dower pace than profits themselves, as enterprises made use of carry-forward provisions in the tax code. This year, 36 percent of personal income tax revenues will go to the central government, and 20 percent of corporate profit tax revenues will go to the local authorities, effecting a net transfer of Kc 6 billion (0.4 percent of GDP) to the center. This transfer is only partially offset by increased direct center-local transfers.
57. Another organizational change in the 1996 budget is the creation of a pension fund within the budget. Revenues from the pension portion of the social security wage tax (equal to 27.2 percentage points out of the 35 percent) will be deposited in this fund, which will generate surpluses if pension spending is less than revenues. If pension benefits are greater than the fund’s revenues, the deficit will be covered, implicitly, by the budget.
58. On the expenditure side, consolidated spending as a proportion of GDP was originally budgeted to fall by 3 Vi percentage points. This reduction was to be shared between current expenditures on goods and services, transfers to enterprises, capital expenditures and net lending, each of which exhibited reductions of between 0.6 and 1 percentage points. All interest payments were to be covered by the budget this year, with no recourse to NPF financing as was previously the case.
59. Indexation of pension benefits previously occurred only after the CPI had risen by at least 10 percent. As of this year, however, indexation will occur after any 5 percent increase in the CPI, increasing the frequency of revisions, and the effect thereof on expenditures. Unlike in 1995, however, the 1996 budget includes provisions for these pension adjustments.
Developments in the first half of 1996 and revised outlook
60. The fiscal outturn in the first half of 1996 was weaker than expected, taking into account the normal seasonal pattern and the annual budget target. The general government accounts excluding privatization revenues recorded a deficit of Kc 9.5 billion (0.7 percent of projected annual GDP). The state budget and the local authorities were in deficits of Kc 1 billion and Kc 3 billion, respectively, and the health insurance funds accounted for the remainder of the deficit.28
61. The weaker-than-anticipated position of the state budget arose principally on account of a shortfall of about Kc 5 billion in foreign debt repayments due to Paris Club rescheduling of debt owed by Russia, and a host of other expenditures were about Kc 2 billion higher than budgeted.29 In addition, there was a transfer payment by the government to cover a shortfall of the health insurance companies, with the understanding that this payment would be repaid later in the year, when the funds became profitable. On the revenue side, overall developments were broadly in line with expectations, but the composition was different. Collection of corporate profits tax was below initial projections, but this was offset by better-than expected performance of personal income tax and the value added tax. As for local authorities, revenue performance was lagging, because of lower non-tax revenues. Moreover, many local authorities had stepped up capital expenditures on the mistaken expectation of a superior revenue performance.
62. In response to the incipient deficit in the state budget, the authorities initiated expenditure cuts in the second half of the year with the objective of achieving a balanced budget. A two pronged approach was taken: (i) all line ministries were asked to cut expenditures across the board on all current expenditures excluding wages, social security, and expenditures on science by 5 percent and investment expenditure by 5 percent.30 Such cuts are expected to yield savings of Kc 4.7 billion; and (ii) targeted cuts of Kc 4.6 billion, mainly in areas financed from the reserve fund.31 The pattern of revenue developments in the first half is expected to hold for the year as a whole. The weakness in corporate profits tax collections is believed to reflect the effects of the new deductibility rules for bad debts that will begin to apply this year.32 On the other hand, personal income tax and value added tax collections will be strong on account of continued large increases in wages and strong consumption and investment demand. Although non-tax revenues are still projected to be in line with the budget, they now include transfers of Kc 3.3 billion and Kc 1.5 billion, respectively, from the State Financial Assets account in the CNB and the NPF. Properly treating these financing items, the underlying state budget would be in a deficit of Kc 4.8 billion (0.3 percent of GDP).
63. The local authorities have slowed down their expenditures in the second half of the year, and are also expected to achieve a balanced budget for the year as a whole. However, the position of the health insurance funds is expected to deteriorate further in the second half of the year, and arrangements have been made by the government to transfer Kc 1.4 billion from the NPF. After including these transfers, the deficit of the health insurance funds is expected to be about Kc 4 billion (0.3 percent of GDP).33 The accounts of the functional extrabudgetary funds (e.g., the funds for agriculture, environment, culture, etc.) are forecast to swing from a small surplus in the first half of the year to approximate balance at the end of the year. Miscellaneous extrabudgetary spending financed from the central government’s State Financial Assets account is projected at Kc 3.6 million. Taking into account all these spending and those financed from NPF transfers, the consolidated general government accounts are projected to show a deficit of nearly Kc 13 billion (0.9 percent of GDP) for 1996 as a whole.
64. At end-June 1996, the central government’s debt amounted to Kc 165 billion (11½ percent of GDP), compared with Kc 159 billion (17½ percent of GDP) at end-1993. In recent years, an increasing proportion of the debt has been securitized and the importance of direct credit has fallen sharply. In mid-1996, about two thirds of the debt (Kc 111 billion) was in the form of securities, while the rest was in the form of direct credits mainly from abroad. Three fourths of the securities were held by deposit money banks, 5 percent by foreign investors, and the rest by the domestic non-bank sector. In addition, outstanding loans guaranteed by the Czech Government at end-June 1996 amounted to Kc 62 billion (4 percent of GDP), almost double the amount of outstanding guarantees at the beginning of 1995. Loan guarantees increased sharply in the first half of 1996, and on account of guarantees given for the construction of railway tracks for high-speed trains (Table A21).
Proposed 1997 budget
65. The proposed budget for 1997, currently awaiting parliamentary approval, is based on the following assumptions: real GDP growth of 5 percent, average inflation of 8½–9 percent, nominal GDP increasing by 13.6 percent, average unemployment rate of 3.3 percent, average wage increase of 12.4 percent in budgetary organizations and enterprises controlled by the State, and average wage increase of 13.8 percent for the economy as a whole.
66. Based on these assumptions, a balanced state budget has been formulated. The accounts of the local authorities prepared by the Ministry of Finance are projected to be in a surplus of about Kc 2 billion. However, there are uncertainties about the budget of the local authorities on which the central government has little control; the final version of the local authorities’ budgets is prepared in January-February only after the amounts for subsidies and transfers included in the State Budget are known with certainty. The extrabudgetary funds are expected to show a small deficit, the health insurance funds are projected to be in balance, and hardly any use is envisaged of the State Financial Assets account. However, net spending from NPF resources is projected at about Kc 2½ billion (Kc 1½ billion to extrabudgetary funds, and Kc 1 billion to the health insurance funds). Taking all this into account, the consolidated budget is projected to be in a small deficit of Kc 1.3 billion (0.1 percent of projected GDP) in 1997.
67. Total revenues of the central government are projected to decline from about 34 percent of GDP in 1996 to 33 percent of projected GDP in 1997. This mainly reflects a decline in the tax revenue/GDP ratio that arises on two accounts: excise taxes are projected to fall as a ratio to GDP by 0.3 percentage points because they are mainly levied in specific terms, and the share of international trade taxes are also set to fall by 0.2 percentage points of GDP reflecting reductions in tariff rates in line with the requirement of the EU Association Agreement. Non-tax revenues from budgetary and subsidized organizations are also projected to fall in absolute terms, because the special factors for 1996 will be absent and property sales will be lower.
68. Revenues from the corporate profits tax are projected to increase in line with nominal GDP growth. Unlike in previous years, and reversing the intentions of lower rates announced before the June 1996 elections, the government has decided to keep corporate tax rates unchanged in 1997. The projection for corporate profits tax is premised on the expectation that banks and enterprises will not make use of deductions for loan write-offs to a greater extent than in 1996, and also does not take into account the effects of the recent banking crisis on the tax liabilities of affected institutions.
69. Personal income tax revenues are projected to grow slightly faster than nominal GDP. No changes in rates have been proposed, but the amounts of permitted deductions will be indexed for inflation;t he authorities’ objective is to keep taxation of wages in real terms in 1997 the same as in 1996.
70. On the expenditure side, the following categories of expendtiures are projected to fall as a ratio to GDP: “other goods and services”, current transfers to enterprises and subsidized organizations, and capital expenditures by budgetary organizations. Current subsidies to enterprises wlil be kept unchanged in nominal terms in 1997. This reflects a cut in heating subsidies which will be made possible by the 39 percent increase in heating charges that is currently under consideration. Within the framework of overall retsraint in expenditures, increases will take place in a number of priority areas: housing policy (increase of 40 percent form Kc 9.6 billion in 1996 to Kc 13.6 billion in 1997); transfers for export guarantees (up by 60 percent from Kc 1 billion to Kc 1.6 billion); expenditure on science (by 19 percent from Kc 6.2 billion to Kc 7.4 billion); investment in infrastructure—mainly railways and roads (up by 19 percent from Kc 16 billion to Kc 19 billion), and transfers to the health insurance funds representing payment for unproductive persons (up from Kc 14.6 billion to Kc 18.3 billion). A striking aspect of the expenditure plans of the 1997 Budget is that it does not include any provision for bailing out and restructuring small banks.
B. Fiscal Issues
71. The 1993 tax reform fundamentally altered the way in which government activities were financed. The focus of revenue collection was shifted from enterprise taxes to wage and consumption taxes, and the widely dispersed array of marginal tax rates was rationalized.34Chart 5 shows that the general trend away from firm-level taxation has continued through to 1995, and is expected to be further enforced in 1996. The share of wage and personal income taxes in total revenues of the consolidated budget35 increased from about 40 percent in 1993 to a projected 51 percent in 1996. Indirect taxes have shown a slight tendency to increase their share of the budget, but the shares of profit and other taxes have declined noticeably.
CHART 5czech republic COMPOSITION OF GENERAL GOVERNMENT REVENUES AND EXPENDITURES
Source: Data provided by the Czech Ministry of Finance.
72. Despite some reductions in the associated tax rates, revenues from wage and personal income taxes have increased in importance for three reasons: (i) the reductions in wage and personal income tax rates have been small; (ii) labor’s share in output has been increasing; and (iii) reductions in corporate tax rates have been more significant over the period, thereby shifting the relative weights toward labor.
73. Tax is levied on personal incomes under two schedules. Dividends, interest and related receipts are taxed at a flat 25 percent rate (which has not been changed since 1993).36 All other income, including wages, salaries, and certain capital gains, is taxed at graduated rates, starting at 15 percent. Since 1993, the top marginal rate has been reduced progressively from 43 percent to 40 percent in 1996. However, due to relatively generous exemptions and deductions, the number of individuals affected by the top rate has been small.37 In fact, an individual earning average wages in 1994 faced a marginal tax rate of 45.5 percent on gross wages, including the effect of social security and health insurance contributions.38 By 1996, this had only been reduced to 45 percent, suggesting that the revenue impact would be slight.
74. Against this small negative effect on wage and personal income taxes, high rates of wage growth and imperfect indexation have caused significant “bracket-creep”, helping to boost revenues as a share of both GDP and the budget. Finally, the reductions in the corporate tax rate, which applies more uniformly to, and thus affects a greater share of, corporate profits, have yielded proportionately larger revenue effects in the opposite direction.
75. Predicting the behavior of corporate profit tax revenues has been complicated by changes in the tax rules, as well as the rates. For example, in 1995 new rules were introduced allowing enterprises (including banks) to make deductions for certain bad loans.39 The extent to which these new deductions would be exercised, and the timing of such, were difficult to predict, and revenue estimates at mid-1995 exhibited a high degree of uncertainty. In the end, collections turned out to be near the high end of the range of mid-year expectations, suggesting that firms may take more advantage of the deductions in 1996.
76. Coupled with the developments in wages (see section II), these base changes have meant that taxable profits as a share of GDP have been at best stagnant over the period 1993–96. As the corporate tax rate has fallen, the share of total revenues derived from the corporate profits tax has thus fallen.
77. A myriad of differentiated turnover taxes was replaced by a small number of indirect taxes—in particular a VAT and a series of excise taxes—in 1993. There were predictable problems with the implementation of the new taxes, especially the VAT, which required new reporting, collection, and auditing systems. In fact, the Czech Republic has probably had as much success as any other transition economy in implementing a new VAT.40 Indirect tax revenues have contributed a relatively stable share of the budget over time, amounting to about 30 percent. Within this category, the VAT contributes roughly 55 percent, excises about one third, and customs duties a little more than 10 percent. As tariff reductions have reduced the revenue yield from the third component, the share of excise tax revenues has increased somewhat. However, the general structure of indirect tax revenues has remained relatively stable.
78. The structure of expenditure of the consolidated government sector has been somewhat more stable than the structure of revenues. Chart 5 shows that the shares of general government consumption,41 interest payments, transfers, and capital expenditure plus net lending in total spending were more or less constant. In particular, transfers to enterprises have remained virtually unchanged in nominal terms, and fallen as a ratio to GDP (Table A22). The components of public expenditure which pose the more significant long-term challenges for the government include health care services and household transfers. Recent developments regarding these items are addressed below.
79. Health expenditures: Health services are provided by both public employees—mostly in government hospitals and clinics—and private doctors and other providers. The number of private health facilities has been growing steadily since reforms were introduced, and many public employees also work privately to supplement their incomes. Health care services are financed by the central state budget, local authorities’ budgets, health insurance companies, and private payments. Revenues and expenditures of the health insurance companies are included in the consolidated general government budget, because the companies are essentially tax financed and have no meaningful discretion over the majority of pricing and service provision decisions (which are made by the Ministries of Health and Finance).
80. Health expenditures in the Czech Republic have increased sharply in recent years, from about 5.4 percent of GDP in 1992 to 8.5 percent in 1995. In 1996, such expenditures are projected to fall somewhat as a ratio to GDP to 8.2 percent. Until 1993, all health expenditures were implemented through the general government budget. From 1994, some private payments for health services have been registered, and amounted to about 11 percent of total health expenditures in 1995. Reflecting this trend, the proportion of total budgetary expenditures of the state and local authority budgets devoted to health have fallen progressively.
81. On the demand side, health insurance is provided to all Czech residents, through a system of about 26 competing non-profit health insurance funds. The largest fund is the General Insurance Company (GIC), a government body insuring approximately 65 percent of the population. The extent to which the funds meaningfully compete is limited, and such competition that does exist is not necessarily efficiency-enhancing. Individuals’ insurance “premiums” are collected in the form of a proportional wage tax. Since the tax rate is independent of the choice of insurer, consumer demand is not price sensitive. Forty percent of an individual’s tax/contribution is retained by his/her insurance company, with the remaining 60 percent directed to a central fund (managed by the GIC). This pool of money is then redistributed to insurers on the basis of need (based on number of enrolled persons, number of aged enrollees, etc). Thus, there is little incentive for insurers to reduce utilization or cost, since most of any marginal increase in expenditures is reimbursed from the central fund. The primary way in which insurers compete is by offering extra “Cadillac” coverage in order to attract more individuals, and not be improving efficiency. Further, because individuals face few if any point-of-service charges, they have little incentive to economize on utilization.
82. This insurance structure has led to rising demand and escalating costs. While the government does not provide all medical services, the public nature of the financing means that health care is properly included in the consolidated budget. A number of health insurance companies have recently run into financing troubles, and there has been a return of many individuals to the GIC, which is seen as being less risky. In the face of these developments, recent reform proposals have stressed the need to incorporate some kind of cost-sharing at the point of service, to induce consumer price responsiveness. The government is also of the opinion that the number of insurers should be consolidated, to take advantage of economies of scale, while retaining a heterogenous insurance market. However, real competition in insurance provision will only come with decentralization of the premium setting process, which may not be consistent with the government’s social and redistributive goals.
83. Household transfers: Transfers to households include old age, disability, and survivor pensions, sickness benefits,42 family benefits, unemployment benefits, general income support, and others. Pension payments made up 55 percent of total household transfers in 1995, and represented 9.1 percent of GDP. In 1996, total expenditures on family allowances (including the child benefit, parents’ allowances, etc.) fell, as these allowances became income tested, causing the share of pensions in total household transfers to increase to nearly 70 percent. Pension payments are projected to increase by more than 20 percent in nominal terms in 1996 to 9.4 percent of GDP (Table A23).
84. Since 1993, major reforms to the pension system have been underway. The main aims of the reforms are to improve the long-term financial viability of the system in the face of an ageing population structure, to rationalize the treatment of different individuals, and to remove harmful incentives that existed under the old regime by linking benefits more directly to past earnings. The government has also implemented reforms to the system of family and social benefits, targeting some components more towards less well off individuals and families. Despite recent political opposition to some of these reforms, the process appears to be continuing generally as planned.43
85. As noted earlier, the 1996 Budget saw two significant institutional changes: (i) a change in the allocation of revenues between central and local government budgets, and (ii) the introduction of a special pension fund, into which will be deposited the revenues of the pension part of the social security contributions. Under the new structure of revenue assignment, high wage growth and somewhat stagnant corporate profits over the last three years have resulted in a significant shift in revenue from the central to the local governments. Although this shift could in theory be offset by changes in intergovernmental transfers, such an offset, to the extent it exists, has not been one-for-one. This shift, as well as constraining the central government’s revenue position somewhat, has also meant that its control over local spending decisions has been be reduced over time. Thus, in 1996, revenues from the wage tax and corporate tax have been reassigned, and are shared between the two levels of government.
86. The economic effects of the introduction of the special pension fund are not immediately clear. Even if the government continues to adhere to its balanced budget goal, the need to retain any pension surplus will not constrain its ability to run a deficit on the rest of the budget. Since the pension fund will remain within the budget, the overall budget position can still be kept in balance.44
IV. MONETARY POLICY AND BANKING SECTOR ISSUES
87. In the first three years of the reform (1991–93) monetary policy was very successful in containing inflation and creating a relatively stable macroeconomic environment, despite external and domestic shocks to the economy. Thus, abstracting from one-off influences (the large scale price liberalization in 1991 and the VAT introduction in 1993) annual average inflation was contained to about 10–12 percent during that period, significantly lower than in most other transition economies. However, further progress in significantly reducing inflation has proved elusive as monetary policy came under increasing pressure from massive capital inflows in 1994–95, which were attracted in large part by expectations of koruna appreciation and a large differential between domestic and foreign interest rates. The attractiveness of the koruna was eventually reduced by market concerns about a widening current account deficit; this, together with the adoption of a wider exchange rate band for the koruna at end-February 1996, caused a sharp decline in capital inflows in 1996. Nevertheless, broad money growth continued at a rapid pace through mid-1996 as the Czech National Bank (CNB) allowed domestic credit to pick up, apparently out of concern about the effects of sharply higher interest rates on economic activity and the exchange rate. In response to a continued worsening of the foreign trade account and the persistence of inflation pressures, the CNB adopted restrictive measures in late June 1996. The monetary tightening contributed to an appreciation of the koruna from near parity at mid-year, indicating that monetary policy continued to be constrained by incipient capital inflows.
88. On the structural front, progress has been made in strengthening the financial position of the banking system, especially of the four largest (state-controlled) banks that have comfortably high capital adequacy ratios and investment grade credit-risk rating by major agencies. However, weak supervision standards in the early years of the reform have allowed the emergence of insolvency problems in a number of small banks, jointly accounting for about 5 percent of the banking system. These problems are estimated to involve considerable quasi-fiscal costs (about 2 percent of GDP) for the CNB; in September 1996, they also triggered liquidity problems in a mid-sized bank owing to cross-shareholdings with a small failed bank where irregularities were detected.
89. The following sections of this chapter discuss in greater detail the objectives and targets of monetary policy; developments in monetary and financial conditions; and structural issues related to the banking system.
B. Objectives and targets of monetary policy
90. Convergence of the Czech inflation rate to that in the EU—to be achieved gradually through a reduction in the inflation rate by one percentage point a year—has been an important, though not strictly adhered, economic objective of the authorities. The CNB has been assigned a lead role in the disinflation effort;45 fiscal policy has been generally prudent but has not actively supported monetary policy which has been constrained by large capital inflows or, more recently, appreciation pressures on the koruna.
91. With a view to anchoring price expectations and nominal magnitudes, the exchange rate of the koruna and broad money46 have been used as intermediate targets of monetary policy since the beginning of the reform in 1991. Broad money was adopted as a supplementary intermediate target given the long and variable lags of monetary policy. Targeting modalities have gradually moved from an exchange rate peg coupled with a broad money (point) target to a target range for broad money (since 1994) and a wide band around the central parity of the koruna (since end-February 1996). The exchange rate of the koruna was pegged to baskets of hard currencies, within an exchange rate band of ±½ percent, from the beginning of 1991 until end-February 1996,47 when the band was widened to ±7½ percent around the central parity. The broad money target has been set within an annual framework and not as” part of a broader medium-term disinflation strategy: that is, the current-year targets/projections for inflation and growth are set, velocity is projected, and a consistent rate of monetary expansion is derived. This methodology may impart an inflationary bias as it validates current inflation as well as overruns of past inflation and monetary targets; and it lacks a built-in mechanism to correct for past excesses. More importantly, the methodology does not take into account the repercussions of current monetary growth for future inflation, an important consideration given the long lags involved in the monetary transmission mechanism.
92. Large capital inflows (that rose from 9½ percent of GDP in 1994 to 18½ percent of GDP in 1995) gave rise to a conflict between the two intermediate targets, and to an overshooting of the broad money targets until very recently, as the CNB effectively gave precedence to the exchange rate. This reflected several factors: First, allowing a nominal appreciation of the koruna in order to discourage capital inflows was deemed undesirable by the authorities owing to concerns about external cost competitiveness. Second, in light of difficulties in estimating a demand for money, it was considered possible that the overshooting of the broad money targets was due in part to a rising demand for money.48 Third, the persistence of relatively high inflation was seen to be partly due to relative price changes, characteristic of economies in transition, and not necessarily to excessive money growth. Fourth, given the sensitivity of capital flows to the interest rate differential (various studies estimated an “offset coefficient” of about 0.3–0.6), sterilization operations have been costly for the CNB. Finally, the weak financial position of small banks, and of a number of enterprises, may have constrained monetary policy. The recent adoption of a wider band has afforded the CNB greater control over domestic financial conditions by discouraging capital inflows and allowing some trade-off between the exchange rate and the monetary target. After hovering around parity until late June 1996, the koruna appreciated by 4½ percent as of early September reflecting in part the adoption of restrictive monetary measures in June 1996 (discussed below) and absence of CNB intervention in the interbank market as greater weight was effectively given to the monetary target (Chart 6). Even though the koruna appreciation was partially reversed as of early November, it suggests that monetary policy continues to be constrained by the sensitivity of capital inflows to the interest rate differential. In addition, the effectiveness of monetary policy is limited by weaknesses in corporate governance that rendered wages relatively unresponsive to financial tightening.
CHART 6czech republic EXCHANGE RATE OF THE CZECH KORUNA AGAINST THE BASKET (1995–96) 1/
Sources: Czech National Bank; Bloomberg; and staff calculations.
1/ The basket consists of fixed amounts of DM and US$ with corresponding weights of about 65 percent and 35 percent. Official rates at the CNB fixing are used in the calculations. Decline indicates nominal appreciation.
93. Since 1992, the operating procedures of monetary policy have evolved from base money to interest rate targeting, reflecting a shifting emphasis on broad money as an intermediate target and the development of financial markets. This has occurred in four phases:
In the first phase, from the abolition of bank-specific credit ceilings in September 1992 until mid-1994, the operating target was base money (currency plus bank reserves) which, given the embryonic state of financial markets at that time, was managed mainly through the refinancing facility of the CNB.
In July 1994, the CNB switched to total bank reserves following large and unpredictable swings in the currency in circulation since 1993 that had resulted in a volatile money multiplier (Chart 7). However, the new operating target did not prevent sharp increases in interest rates (interbank interest rates more than doubled to 12½ percent) that attracted large capital inflows in the latter half of 1994. The perceived problems were compounded by errors in forecasting the demand for bank reserves owing to unanticipated end-of-year changes in the composition of deposits.49
At the beginning of 1995, the CNB switched to targeting excess bank reserves subject to an overriding upper limit on interbank interest rates. During this third phase, interest rates increases were restrained to discourage capital inflows; also, the level and volatility of excess reserves declined leading to a more stable money multiplier.50
Finally, in December 1995, interest rate targeting was formally adopted as the operating procedure—informally, this had already been the case for about a year. Under the new procedure the Board of the CNB, after considering financial and economic indicators, sets a target interest rate for the one-week interbank interest and the operating desk develops a strategy for reaching it. The target itself is not made public but the cut-off interest rate at the daily auctions is pre-announced and set somewhat below the target rate. The adoption of the interbank interest rate as the operating target reflects the growing perception that the CNB could effectively influence market interest rates which, in turn, have a strong impact on aggregate demand. This was based on the close link that has developed since 1995 between the interbank rate, which could be directly influenced by the CNB repo rate, and the interest rate on new loans.
CHART 7czech republic MONEY MULTIPLIER AND ITS DETERMINANTS
Source: Czech National Bank; and staff calculations.
1/ The shaded area represents a +/- one percent band around the corresponding period average.
C. Monetary and financial developments
Developments in broad money and domestic credit
94. Monetary developments in recent years have been greatly influenced by capital inflows as indicated by the behavior of the net foreign assets (NFA) of the banking system. The rapid growth of broad money during 1993–95—by almost 20 percent a year and well in excess of the CNB’s targets—and its deceleration to 16 percent in the twelve months to August 1996 mainly reflected movements in the banking system NFA: their contribution to broad money growth turned from large and positive (about 11 percentage points) during 1993–95 to negative during the first eight months of 1996 (positive but small in the twelve months to August 1996).51 The recent deceleration of broad money would have been larger but for a significant increase in the growth rate of the net domestic assets (NDA) of the banking system during 1996 (Chart 8).
CHART 8czech republic CONTRIBUTIONS TO BROAD AND BASE MONEY GROWTH (1993–96) 1/
Sources: Czech National Bank; and ataff estimates.
1/ In percent of broad money in the tame period of the previous year.
2/ Base money growth has been adjusted for changes in the required reserves ratio.
|Of which: credit to economy||18.9||16.6||12.7||12.3||6.6|
|Other items, net||−7.3||−5.9||−4.1||−0.6||1.0|
|Target range for broad money growth||17||12–15||14–17||13–16|
95. The behavior of the income velocity of broad money,52 in conjunction with developments in the real economy, appears to imply that monetary policy had an expansionary influence in recent years. After temporarily rising in early 1993—owing to events associated with the dissolution of the Czechoslovak federation—velocity declined rapidly through early 1994 reflecting mainly the increased attractiveness of the koruna as a store of value and structural changes that, on balance, have raised the transactions demand for money (Chart 9). The average velocity of 1.31 in 1994–95 was remarkably low, implying a significantly monetized economy: the implied broad money to GDP ratio of 76 percent is almost twice the average ratio in advanced transition economies.53 The stabilization of velocity in 1994–95 appears to have been the result of opposing, yet offsetting, factors as efforts by residents to run down excess liquidity through a widening current account deficit were offset by injections of liquidity through intensifying capital inflows.54 In the first half of 1996 velocity rebounded owing both to increased uncertainty about the exchange rate (no longer a “one-way bet”) and to the cessation of large capital inflows that until end-1995 had kept injecting liquidity into the economy.55
CHART 9czech republic DEVELOPMENTS IN BROAD MONEY (1992–96)
Sources: Czech National Bank; and staff calculations.
1/ Velocity is calculated as annualized seasonally adjusted GDP divided by seasonally adjusted end-of-period broad money.
2/ Broad money excludes the SPT deposit with the CNB.
96. The rapid rise in banking system NFA through end-1995, and their stabilization and slight decline more recently, has been associated with a large change in their distribution between the CNB and the commercial banks. Due to the large positive differential between domestic and foreign interest rates, commercial banks borrowed abroad to supplement their resources, thus assuming a large and growing net liability position vis-à-vis nonresidents, which was more than offset by the rise in the CNB’s NFA (Charts 11 and 12). The borrowed funds have been typically channeled to domestic enterprises, in the form of foreign currency denominated loans. Hence, the growing net liability position vis-à-vis nonresidents has been offset by an increasing net asset position vis-à-vis residents, the residual open position being covered off-balance sheet. This trend was temporarily reversed in February 1996, following the widening of the exchange rate band and concern among market participants as to the overvaluation of the exchange rate that may also have raised the cost of off-balance sheet cover, but has resumed since June 1996 owing to a widening of the interest rate differential and renewed confidence in the koruna.
CHART 10czech republic COMPOSITION OF BROAD MONEY
Sources: Czech National Bank; and staff calculations.
CHART 11czech republic INTEREST RATE DIFFERENTIALS
Sources: Czech National Bank; and staff calculations.
1/ Weighted average of interest rates on three-month interbank deposits in Deutsche Marks and three-month VS. T-bills.
CHART 12czech republic NET FOREIGN ASSETS IN BILLIONS OF KORUNY
Sources: Staff calculations baaed on data provided by the Czech National Bank.
1/ The foreign exchange exposure vis-a-vis non-residents is measured by the NFA of commercial banks, excluding off-balance sheet cover.
2/ The foreign exchange exposure vis-a-vis residents is measured by the difference between foreign currency loans and foreign currency deposits.
97. With the fiscal accounts broadly balanced, bank credit to the economy (enterprises and households) has been the main factor behind the rise in the banking system NDA in recent years. Its twelve-month growth rate reached 13.2 percent by end-1995 (contributing 12.7 percentage points to NDA growth) and subsequently picked up to 15.7 percent by mid-1996 as, with the cessation of large capital inflows, foreign credits were substituted by domestic bank credit. During 1995, credits were mostly short- and medium-term and the share of foreign currency denominated credits increased steadily as did direct foreign borrowing of enterprises. When direct foreign borrowing (a close substitute of domestic credit) is included, overall credit to enterprises had been expanding at about 20 percent in 1994–95 but with the cessation of massive capital inflows it decelerated to 15 percent in the twelve months to end-June 1996. In the same period, the share of foreign currency denominated credits stabilized at about 11 percent of bank credit. The maturity distribution of bank credit tilted slightly medium- towards shorter-term maturities: at mid-1996, short, medium, and long-term credits accounted respectively for 43 percent, 27 percent and 30 percent (Table A27). The sectoral distribution of bank credit has remained virtually unchanged, with industry accounting for about one third of domestic currency credits.
Developments in reserve money and conduct of monetary policy
98. Reserve money growth56 accelerated from 1 percent (which was influenced by the special factors) during 1993 to 27 percent during 1995 despite large-scale sterilization operations and efforts to directly control the inflow of foreign capital. Sterilization operations mainly accounted for the decline in the NDA of the CNB by the equivalent of 65 percent of beginning of period reserve money during 1994 and another 98 percent during 1995. The cessation of large capital inflows in early 1996 was accompanied by some reversal of these operations, as evidenced by a rise in the NDA of the CNB by 16 percent during January-August 1996 (a decline by only 28 percent during the twelve months to August 1996).
99. The volume of sterilization undertaken by the CNB in the form of sales of CNB bills, and the transfer of public sector (NPF and SPT Telecom) deposits from commercial banks to the CNB amounted to about Kc 37½ billion during 1994 and Kc 122 billion during 1995, and is estimated to have involved a cost of Kc 2 billion (¼ percent of GDP) in 1994 and Kc 6½ billion (½ percent of GDP) in 1995 (Chart 13). In addition, sterilization has been effected through increases in non-remunerated required reserves (which does not involve a direct cost for the CNB other than the opportunity cost of investing these funds in foreign assets rather than higher yielding domestic assets) and securitization of government debt to the CNB. The cessation of capital inflows in early 1996 has allowed the CNB to redeem part of the stock of outstanding CNB bills, while a further reduction was made possible by the increase in the required reserves ratio as of August 1996. Nevertheless, the sterilization cost for the CNB is expected to rise in 1996 owing to the full-year effect of sterilization operations undertaken in late 1995.57 These, along with the cost of restructuring small banks could significantly weaken the profit position of the CNB in 1996 despite significant seigniorage revenue from reserve money, including relatively high non-remunerated required reserves (Attachment II).
CHART 13czech republic COSTS OF STERILIZING CAPITAL INFLOWS
Sources: Staff calculations based OD data provided by the Czech National Bank.
1/ Comprises outstanding CNB bills, the transfer of SFP and NPF deposits to the CNB and part of required reserves.
2/ Interest rate differential times the sum of CNB bills and the transfer of deposits to the CNB.
3/ Interest rate differential times the part of required reserves related to sterilization.
|Change in required reserves||−0.5||−9.5||−5.4||−15.5||−16.4|
|Reserve Money 3/||0.6||22.2||26.5||18.2||6.3|
|Sterilization through sale of CNB|
|bills and transfer of deposits||−24.2||−33.5||−82.9||−29.6||24.6|
100. Besides sterilization operations through issuance of its own bills, the CNB has announced a series of restrictive monetary measures on two occasions during the last two years, first in June 1995 and again in June 1996:
In June 1995, the measures were triggered by concerns about inflation—which were exacerbated by the abolition of wage controls and a loosening of the fiscal policy stance—and intensifying capital inflows, including of short-term, speculative nature that seriously hampered monetary control. Accordingly, the announced measures aimed at both tightening monetary conditions through increases in required reserves and central bank interest rates and preventing an increased capital inflow from offsetting the restrictive measures by introducing controls on capital inflows. Specifically, the CNB raised the discount and lombard rates by one percentage point each to 9½ percent and 12½ percent respectively (June 1995); unified the required reserves ratio (until then 3 percent for demand and 9 percent for term-deposits) at 8½ percent, representing an effective increase by about 1 percentage point; and introduced a limit on the short-term foreign exchange position of banks vis-à-vis non residents.58 In addition, a Kc 35.9 billion deposit of the SPT Telecom, representing privatization proceeds earmarked for imports of capital equipment, was transferred to the CNB. These measures generated a significant tightening of bank liquidity and raised interbank interest rates by one percentage point which, in turn, led to a small temporary increase in lending interest rates. However, they did not prevent a large rise in reserve money in the remainder of 1995 owing to an intensification of capital inflows, despite large sales of CNB bills whose outstanding amount almost tripled during the last quarter to reach to Kc 121 billion or 12 percent of broad money.
A continued worsening of the foreign trade balance and persistence of inflation prompted another series of restrictive monetary measures in late June 1996; until then, the CNB had allowed a pickup in domestic credit expansion to compensate for the sharp decline in net capital inflows out of concern about the effects of sharply higher interest rates on economic activity and on the exchange rate.59 During the first half of 1996, monetary policy was also burdened with the rehabilitation of financially weak banks and in this context the CNB provided emergency credit of Kc 8.5 billion (Chart 14). The CNB raised the lombard rate by one percentage points to 14 percent; the discount rate by one percentage point to 10½ percent; its repo rate by ½ percentage point to 12½ percent; and the required reserves ratio by 3 percentage points to 11½ percent (non-remunerated). As a result, interbank interest rates increased by ½ percentage point in July, a cumulative increase of two percentage points since the beginning of the year, and about Kc 30 billion of bank liquidity were absorbed by the rise in the required reserves. As a result, the 12-month broad money growth rate at end-August was brought down to just below CNB’s target range of 13–16 percent for 1996. The monetary tightening, and continued market interest in koruna-denominated financial instruments, occasioned a rise in the value of the koruna by 4½ percent as of early September from near parity in mid-year; reflecting market concerns about the current account deficit, the koruna subsequently weakened to about 2½ percent above parity in mid-October. The koruna appreciation suggests that monetary policy continues to be constrained by the sensitivity of capital flows to the interest rate differential despite the rising current account deficit that has reduced the attractiveness of the koruna and the adoption of the widened exchange rate band as of end-February that has further increased exchange rate uncertainty.
CHART 14czech republic CZECH NATIONAL BANK CREDIT FACILITIES
Source: Czech National Bank.
101. Interest rate movements since early 1995 have reflected the deepening of financial markets and the changing stance of monetary policy. Interbank rates have been less volatile than in previous years (Chart 15) as the market has expanded and money management of enterprises and financial institutions has improved. Several banks have been raising funds at the interbank market and turnover more than doubled between 1994 and 1996; however, the market remains short-term with 65 percent of transactions being overnight and 28 percent having an one- or two-week maturity. The PRIBOR rose in mid-1995, when monetary policy was tightened, thus raising the interest rate differential vis-a-vis foreign rates to about 6½ percentage points (Chart 11). The rate and the differential rose further in 1996 along with the gradual tightening of policy. In two important developments since the beginning of 1995, interbank interest rates have become more closely related to interest rates on new loans although the lead time and the strength of the response are still rather tenuous; and the differential between PRIBOR and the repo rate of the CNB has been eliminated (Chart 16). In view of this, the CNB has started to manage actively its repo rate and other official rates in an effort to influence lending and deposit rates.
CHART 15czech republic OFFICIAL AND INTERBANK INTEREST RATES
Source: Czech National Bank.
CHART 16czech republic LENDING AND DEPOSIT INTEREST RATES
Source: Czech National Bank; and staff calculations.
102. Interest rates on new loans hovered around 13.2 percent in 1995 and declined in the first half of 1996 but picked up again in response to the rise of the required reserves ratio. The level of deposit interest rates remained virtually unchanged since end-1994 although the term structure flattened somewhat in response to improving inflation prospects (Chart 15). The average deposit interest rate remained lower than inflation, although less so compared to previous years (Chart 17). On the other hand, interest rates on term deposits have been positive and this must have contributed to their increased share in total deposits. An important development has been that PRIBOR, which has also been positive in real terms, has been increasingly used as a basis for setting deposit interest rates.
CHART 17czech republic INFLATION ADJUSTED INTEREST RATES 1
Sources: Czech National Bank; and staff calculations.
1/ Adjusted for the underlyinf CPI which is defined as the twelve-month moving average of CPI growth, excluding the effect of VAT changes.
103. The spread between lending and deposit rates has narrowed gradually from 6 percentage points in 1994 to 5.6 percentage points in the first half of 1996 but it subsequently widened again to 6 percentage points following the hike in the required reserves ratio (Chart 15). Its relatively high level60 can be accounted for by the needs for provisioning against classified loans and by the high non-remunerated required reserves.
D. Structural Issues
104. The banking system has developed rapidly since the beginning of the reform in 1991, but the process has not been balanced nor without problems, mainly related to the poor quality of the loan portfolio of banks. While the major banks were rehabilitated early on in the transition and are reported to have high capital adequacy ratios and enjoy investment grade rating by major agencies, the systematic restructuring of small, financially weak banks started only in the past year. In the summer of 1996 banking problems emerged in connection with the failure of a small bank and spill over effects on a medium-sized bank. Nevertheless, there appears to be no “systemic” risk, and the CNB has taken steps to accelerate the restructuring of small banks. After some voucher privatization in 1992, privatization has stalled with the State still holding controlling stake in the major banks.
The structure of the banking system
105. Besides the CNB, the Czech banking system comprises some 55 banks that can be placed into six groups: (i) the four major (state-controlled) banks with a combined market share of about 70 percent (ii) three specialized banks with virtually no deposit taking activities,61 (iii) 20 small majority Czech-owned banks (14 with foreign participation) most of which have come under stress from bad loans and weakening public confidence,62 (iv) 12 foreign-owned banks, (v) 10 branches of foreign banks and (vi) 6 small building societies (Table A32).
106. The four major banks are universal banks with significant stakes in enterprises, mainly through Investment Privatization Funds (IPFs) that they manage but also through securitization of loans. They all have been granted investment grade rating by major credit rating agencies, and rank among the six largest in Central and Eastern Europe.63Komercni Banka, the largest in terms of lending, spun-off from the former State Bank of Czechoslovakia in 1990 taking over most of its commercial activities. Ceska Sporitelna (Czech Savings Bank) is the second largest bank and the prime institution of mobilizing household deposits; under various names and legal forms it has been in operation since 1825. The Investicni a Postivni Banka (IPB) was created in 1993 from the merger of Investicni Banka (also a spin-off from the former State Bank of Czechoslovakia) and Postovni Banka (Postal Bank). The Ceskoslovenska Obchodni Banka (Czechoslovak Foreign Trade bank, CSOB) is the fourth largest bank; it handles mostly foreign payments transactions and operates in both the Czech Republic and the Slovak Republic.
107. The State still maintains controlling stakes in the four major banks, mainly through the National Property Fund (NPF).64 The presence of NPF representatives at the board of these banks and cross holdings, which allow representation in the board of other banks, could dilute competition. To minimize this risk, the NPF behaves as a passive owner and refrains from interfering in the day-to-day management of banks; but wields influence on their long-term strategy and dividends policy. The position of the government on these issues is formulated by the Banking Council, which includes the Minister of Finance, the Governor of the CNB, and the Chairman of the NPF. Effective privatization of the state-controlled banks stalled over the past four years as consensus about the strategy and modalities of privatization has not been reached, the main contested issues being the extent of residual state ownership and whether restructuring of the banks should precede their further privatization. The CNB maintains that there is scope for consolidating existing banks into fewer larger institutions capable of competing successfully in the European market; favors strategic partnerships with international banks which could contribute know-how and access to markets; and cautions against transferring control to industrial shareholders as this could compromise lending policies of banks and dilute competition. In October 1996, the CNB proposed to the government a long-term restructuring plan for the four big banks envisaging completion of the privatization of Komercni and IPB, and the merge of the Savings Bank with CSOB so as to create a rival to Komercni. Since then there have been conducts with foreign banks regarding the sale of the government’s stake in IPB.
108. With the exception of the “big four”, most of the other banks were established in 1991–93 (Chart 18). The rapid expansion of the small Czech-owned banks, as well as the initial lack of skilled staff and adequate supervisory framework, contributed to the accumulation of bad debts and the need for their restructuring in recent years. The number of banks declined in the course of 1995–96 as a result of shrinking number of small banks and of a tight policy of licencing new banks aimed at stopping the proliferation of small banks and encouraging potential investors to take over existing small banks.65 The two-year long moratorium on the bank licencing was ended in May 1996 and two new foreign banks were licenced.
CHART 18czech republic DISTRIBUTION OF BANKS AND BANK LENDING
Sources: Staff calculations based on data provided by the Ciech National Bank.
1/ Includes branches of foreign banks.
2/ Includes specialized banks and building societies.
109. Small banks have three distinguishing characteristics: they lack a stable source of funding, have shown a tendency to assume greater risks than other banks and provide insider loans, and in general they have been undercapitalized. The lack of a broad and stable deposit base reflects the costs of setting up a branch network as well as a reluctance on the part of depositors given that until 1994 there was no deposit insurance scheme. As a result, small banks relied initially on CNB refinancing and later on the interbank market; but as this source of financing was expensive, they tended to lend at high interest rates to high risk borrowers, a practice which later led to a disproportionate incidence of bad loans. Borrowing from the interbank market introduced an additional risk, namely maturity mismatching between interbank borrowing (typically very short-term) and lending to enterprises. This put small banks under strain when market concerns about their liquidity and solvency emerged. Following some bank failures in 1994–95, the liquidity problems of small banks became acute as deposits from non-banks were withdrawn, especially in 1996, while existing shareholders have typically reluctant to inject new capital in the banks.
Legal and regulatory framework
110. The regulation and prudential supervision of banks falls in the jurisdiction of the CNB, except for licencing (including modification and revocation of licences) which is decided jointly with the Ministry of Finance.66 Regulations on capital adequacy and large exposures have been modeled after EU directives: they stipulate a capital adequacy ratio of 8 percent by end-1996 and a maximum credit exposure to any particular client of 25 percent of the bank’s capital (230 percent for the ten largest debtors). There are also guidelines on liquidity management, limits on foreign exchange exposure, and restrictions on loans to and investments in connected persons; finally prior approval by the CNB is needed for acquiring a more than 15 percent stake in a bank (Attachment HI). The CNB conducts both on- and off-site inspections, and is empowered to impose penalties, restrict the licence, or put the bank under conservatorship in case of non-compliance.
111. New loan classification and provisioning rules were introduced in 1994 and the tax treatment of creating reserves and provisions was revised in 1995. Loans are classified in five categories according to the delay in their servicing, the debtor’s financial situation and his previous payments record. For each category banks are required to build up specified provisions and reserves (the so called risk coefficient) and may earmark part of their pre-tax income for this purpose (annual allowances for reserves and provisions). The annual rates of tax deductible allowances have been set so as to enable banks to reach the required level of provisions in five years. The new tax treatment of provisions and general reserves is only marginally more generous than the previous one due to budgetary considerations: first, the flat rate of 10 percent on classified loans that banks could allocate as tax deductible general reserves has been replaced by a graduated scale of provisions ranging from 1 to 20 percent according to the classification of the loan, effectively raising the average rate to almost 14 percent. However, annual provisions may not exceed 3 percent of total credits. Second, the rate for general reserves on standard claims was reduced from 2 percent to 1 percent but at the same time the base of calculation was extended from medium- and long-term to all standard loans, leaving the effective rate virtually unchanged.
112. A Deposit Insurance Fund, introduced in 1994, covers 80 percent of insured deposits (reduced by the depositor’s liabilities to the bank) up to a limit of Kc 100,000 (equivalent to about US$4,000 or a year’s average salary) per depositor, excluding anonymous accounts.67 This limited insurance coverage, reflecting moral hazard considerations, was abandoned in practice when the authorities considered that it was contributing to a general lack of depositor confidence in small banks. Thus, the limit has been effectively raised to Kc 4 million (equivalent to about US$150,000), with the CNB and the budget covering the—still relatively modest—losses of the Deposit Insurance Fund.
|Loan classification||Delay in servicing||Required total|
|Standard||Up to 30 days||0||1||64|
|Watch||31 to 90 days||5||1||6|
|Substandard||91 to 180 days||20||5||4|
|Doubtful||181 to 360 days||50||10||5|
|Loss||More than 360 days||100||20||21|
|Claims on entities declared bankrupt|
by a court
Quality of the bank’s loan portfolio
113. Problem or “classified” loans amount to over 35 percent of all loans (Table A28). The share of classified loans is higher in the Czech Republic than reported rates in other transition economies such as Poland and Hungary in part because Czech banks could not “inflate away” these loans through rapid credit expansion. Accounting and tax regulations have also contributed to a high level of problem loans by (i) restricting the writing-off of loss loans against provisions and (ii) requiring banks to accrue interest (and pay the corresponding taxes) even on non-serviced loans.68 The overall share of classified loans increased sharply in mid-1994, when the new classification rules were introduced, and subsequent increases can be at least partly attributed to improved external auditing and stricter CNB inspections. There is no evidence of serious arrears problems with loans granted after 1993, and indeed the share of classified loans in short-term credits has been declining.
114. Overall, banks seem to have accumulated comfortable provisions against bad loans. At end-1995, loss reserves and provisions reached 31 percent of classified loans and 54 percent of non-guaranteed classified loans.69 On a risk-weighted basis, which essentially measures the total volume of reserves that banks are required to accumulate,70 classified loans amount to about 24 percent of total loans and their share falls to 16 percent once collateralized loans are excluded.71 Excluding the Consolidation Bank, a specialized institution with State support and virtually no deposit liabilities, required provisions amounted to 12.1 percent of total credits against which banks have, so far, accumulated loss reserves and provisions equal to 11.4 percent of their total credits. In addition, they have built up comfortable general reserves as the average capital adequacy ratio of all banks reached 12.2 percent in 1995.
Spread between lending and deposit interest rates
115. Classified loans increase the cost of intermediation and weaken the competitive position of bad-loan ridden banks. Although prime borrowers are generally able to avoid paying higher interest rates (as they have the option of shifting to banks without classified loans or to foreign borrowing) the cost of provisioning would be reflected either in a higher spread between average lending and deposit rates or in lower bank profits; and eventually one would expect bad-loan ridden banks’ market share to deminish.
116. Despite some decline relative to previous years, the spread between average lending and deposit interest rates stood at 5.8 percentage points in 1995 which is about the same as in Hungary and Poland but double the level in industrial countries.72 Calculations based on 1995 revenue and expenditure of banks confirm earlier findings (SM/95/171) that provisioning for classified claims along with administrative costs are the major contributors to the spread.73 On the other hand, revenue from other activities, mainly foreign exchange and securities operations, allowed banks to decrease the spread by 2.7 percentage points. Required reserves added only ¼ of a percentage point to the spread but their contribution is expected to rise along with the increase of the required reserves ratio and could reach 0.7 percentage points in 1997.
|Current period losses||−0.4|
117. The spread and its components should be interpreted with caution: first, as the average lending interest rate is inflated by the inclusion of unpaid interest arrears, losses are correspondingly underestimated. Under plausible assumptions (no interest is received on loss loans; the recorded interest rate is lower than the average) the average interest rate is inflated by about 2 percentage points while the corresponding profit tax amounts to more than ½ percentage point of the spread. The elimination of this tax distortion would make room for higher bank profits and the build up of reserves against problem loans, which should be part of the strategy of addressing the stock aspect the problem loans. The flow aspect can only be addressed by improved governance and an effective collection process. Second, average lending and deposit rates reflect the overall effect of banks’ asset and liability management and differ from the marginal interest rates. At the margin, the spread that banks face when making lending decisions can be very different from the average spread based on the income statement. Third, the contribution of required reserves calculated above is an “average” concept which reflects the composition of the banks’ liabilities as well as the average interest rate paid on deposits. A lower share of deposits in the funding of lending operations implies a smaller contribution of required reserves to the average cost of banks. Moreover, when making decisions at the margin the spread should be evaluated at the marginal cost of funds which can be approximated by PRIBOR. This implies a contribution to the spread (at the margin) of almost one percentage point, i.e., double the estimate based on average cost calculations.74
Recent developments in bank restructuring
118. In the past two years, bank restructuring focused on small financially weak banks as the CNB intervened actively to improve their management and foster their recapitalization. Banks that could not have their capital raised were either liquidated or put under forced CNB administration and some of these were later taken over by other banks. Following liquidity problems in a high-profile medium-sized bank—triggered by the Mure of a small bank which raised public concern about the viability of small banks in general—in October 1996 the CNB announced a comprehensive consolidation program for small banks involving the cleaning of their bad loan portfolio and the restructuring of their management.
119. In contrast with the major banks, whose classified loan portfolio was cleaned up in 1991–93 in what has become known as Consolidation Program I,75 a comprehensive strategy for the restructuring of small banks, the so-called Consolidation Program II, was only developed only in 1995. Several reasons contributed to this delay: First, although most of the bad loans in the portfolio of small banks had been extended before 1994, the seriousness of the problem started to become evident only gradually as loans matured and debtors were unable to meet their obligations. Second, early identification was hampered by the absence of a uniform loan classification system: instructions issued in 1993 became obligatory in 1994 and were enforced through increasingly strict CNB inspections. In addition, financial problems in small banks were not considered to pose a systemic risk although it was gradually realized that they posed a “sub-systemic” risk that threatened small financially healthy banks.
120. The initial policy response to small bank problems was driven by events and determined on a case-by-case basis. When Banka Bohemia failed (due to fraud) in early 1994, deposit insurance did not exist but depositors were fully compensated in an effort to forestall a run on banks. A deposit insurance scheme was introduced later in that year and, on moral hazard considerations, stipulated the partial compensation of depositors. In bank failures immediately after the introduction of this scheme, depositors incurred losses due to only partial compensation, and this, in turn, contributed to a run on other smaller banks. In response, supplementary compensation was provided to depositors in all subsequent cases. This experience with runs on small banks led to the assessment that the rehabilitation of financially weak banks could not be approached in a piecemeal fashion.
121. Consolidation Program II comprises three elements: (i) evaluation of the loan portfolio of all small banks to screen out banks with negative net worth; (ii) a model for restructuring banks with a positive net worth; and (iii) extension of the deposit insurance scheme to forestall a run on banks. On the basis of external auditors’ reports and CNB inspections, two banks were liquidated at end-1995 (Ceska and AB banka), and nine banks (accounting for about 5 percent of the banking sector) were selected for restructuring in 1996.76 Moreover, in another nine banks (accounting also for 5 percent of the banking sector) arrangements were made for capital increases. Regarding the model for restructuring, preference has been given to a capital injection by existing shareholders. If this is not feasible, the bank is placed under forced administration by the CNB, its capital is reduced by the amount of losses and loss loans,77 and management is restructured to prepare the bank for sale. The third element of the program involves the adoption of legislation raising the guarantee on deposits up to Kc 4 million, well above the coverage of the Deposit Insurance Fund. In the case of liquidation, depositors are compensated (mostly with CNB contribution but occasionally with contributions by shareholders as well) and the bank’s assets are used to defray compensation costs.
122. The failure of Kreditni Banka (accounting for about 1 percent of total bank deposits) in August 1996, further weakened public confidence in small banks and precipitated liquidity problems for the medium-sized Agrobank (with 4¼ percent of deposits), thus becoming a catalyst for the measures announced in October 1996. Kreditni’s failure originated from loan losses but there were also some alleged irregularities related to the transfer of funds to a subsidiary of Motoinvest, a holding company and major shareholder in both Kreditni and Agrobanks. These cross-shareholdings raised market concerns of possible irregularities in Agrobanka and in early September major banks stopped lending to it. This created a serious liquidity problem for Agrobanka due to its heavy reliance on interbank borrowing. To restore public confidence, the CNB placed the bank under temporary administration; extended the deposit guarantee of up to Kc 4 million to all its depositors; arranged for temporary lines of credit up to Kc 6 billion from other banks; and put pressure on Motoinvest to divest from the banking sector.
123. To strengthen the financial position of small banks, the CNB announced in October 1996 a scheme whereby banks could sell non-performing loans to Ceska Financni SRO, a state-run institution administered by the Consolidation Bank and funded by the National Property Fund with about Kc 14 billion. The scheme would be open to virtually all small Czech-owned banks (accounting for about 9 percent of the banking sector) on an optional basis provided that they agree to a restructuring plan. The authorities have estimated the cost of recent problems in the banking sector to about 2 percent of annual GDP, even excluding the effects of these problems on corporate tax revenue.
V. EXTERNAL SECTOR DEVELOPMENTS
124. Early success with stabilization and structural reform attracted large capital inflows into the Czech Republic in 1993–95, which fed strong import demand while maintaining pressure for both nominal and real exchange rate appreciation. Both the trade and current accounts swung from broad balance to widening deficit, as export growth proved sluggish (a cyclical downturn in key European markets during 1996 has compounded the situation), while import growth was strengthened by a series of large infrastructure investments. Capital inflows contributed to a handsome increase in the CNB’s reserves by some US$7½ billion in 1995 alone. Controls on short-term capital inflows were introduced in August 1995, but they were of limited effectiveness. In early 1996, the koruna lost some of its attractiveness—as the market began to assess the implications of the widening current account deficit, and the authorities adopted a wider exchange rate band at end-February—leading to a sharp decline in net capital inflows. Nevertheless, with the CNB having turned to a net seller of foreign exchange in 1996, from a large net purchaser in 1995, the koruna appreciated to about 4½ percent above parity as of early September 1996, before retreating somewhat by early November.
A. Current account developments
125. The current account position has moved from a surplus of 2 percent of GDP in 1993 and approximate balance in 1994 to widening deficits in 1995 and 1996. The US$1.4 billion current account deficit recorded in 1995 (equivalent to 3 percent of GDP) is expected to reach US$3.4–3.6 billion (6½–7 percent of GDP) in 1996 according to official projections.78 Underlying the deterioration in the current balance has been a rise in the trade deficit that was only partly offset by the increase in the surplus on the services account reflecting buoyant tourism receipts.79 Specifically, the trade deficit rose from about 2¼ percent of GDP in 1994 to about 8 percent of GDP in 1995, and to over 10 percent of GDP in the first half of 1996 on an annualized basis (Table A34).
126. Overall export performance in 1995, while impressive in dollar terms, was not greatly changed from 1994 as volume growth only recorded a 3 percent increase. While exports in convertible currencies, which accounted for almost 90 percent of total exports, grew by over 25 percent in dollar terms (6–7 percent in volume terms; Table 8), exports to the Slovak Republic were sluggish reflecting a depreciated Slovak koruna under the bilateral payments agreement, quality certification requirements and diversification efforts there (Tables A35-A37). The continued re-orientation of Czech exports towards European Union markets (Section C below) as well as gains from foreign investment in joint ventures such as the Automobilka Škoda vehicle assembly plant helped to sustain the growth of exports in convertible currencies. Merchandise trade with Slovakia and in nonconvertible currencies80 continued to decline as a share of the total trade of the Czech Republic; specifically, exports to Slovakia fell from 22 percent in 1993 to 16 percent in 1995 (Table A38). Since the bilateral payments agreement with Slovakia was terminated at end-September 1995, trade with that country has been included in the convertible trade accounts.
127. Spurred on by buoyant domestic demand, imports grew by over 40 percent in nominal terms (22 percent in volume terms) in 1995. The shares of consumer, investment and intermediate goods in total imports have remained remarkably stable since 1993, although there was more of a pick-up in investment goods in 1995 (Chart 19). A number of on-going, large-scale infrastructure projects—such as the Ingolstadt-Krolupy pipeline, SPT Telecom, CEZ (the electricity company), and Czech Railways—accounted for a significant share of investment-related imports and have an estimated value of up to 2 percent of GDP. Ongoing trade liberalization within the framework of the EU Association Agreement and CEFTA (the Central European Free Trade Area) is causing effective tariff rates to fall from already relatively low levels. In response to this, as well as continued real appreciation of the koruna, consumers have substituted foreign brand goods for domestically produced ones.
CHART 19czech republic TRADE VOLUME AND COMPOSITION (1993–1996)
Sources: Czech Statistical Office, Czech National Bank and Staff estimates.
128. Developments so far in 1996 point to continued sluggish export performance and strong import growth. Exports in the first half of 1996 were 3½ percent higher in U.S. dollar terms (about 1 percent in volume terms) than in the corresponding period of 1995. Weak demand in the EU, and especially in Germany, was a important factor behind this development in addition to strong domestic demand (diverting exportable goods to the home market) and a weakening of the external cost competitiveness. By comparison, imports in the first half of 1996 were 11 percent higher in U.S. dollar terms (about 9 percent in volume terms) than in the corresponding period of the previous year. Imports of manufactures and machinery (SITC codes 6 and 7) were especially buoyant, while imports of intermediate goods were comparatively weak as the need for stockbuilding, which already took place in 1995, may have eased, and fewer intermediate goods were required for processing into exports which were growing more slowly (Tables A39 and A40).
129. Strong performance on the services balance, with receipts increasing by over 35 percent in 1995 benefiting from another good year for tourism, was insufficient to offset the deterioration in the merchandise trade balance. Even with further improvement in 1996 (early indications are that tourist numbers in the first half of 1996 were more than 10 percent higher than in the same period in 1995), this again will not contain the widening current account balance.
B. Capital account
130. As an early and successful reformer within Central and Eastern Europe, the Czech Republic was able to gain the confidence of foreign investors and thereby attract substantial investment inflows from 1993 onwards. The capital inflows surged in 1994 and 1995 when capital account surpluses equivalent to 9½ percent and 18¼ percent of GDP, respectively, were recorded. This boosted Czech National Bank reserves to US$14 billion at end-1995, up from US$3.8 billion at end-1993. The sharp rise in capital inflows during 1995 took mainly the form of medium- and long-term (MLT) borrowing by banks and enterprises and of foreign direct investment, both of which tripled from the previous year. The rise in the inflow of foreign direct investment reflected mainly the US$1½ billion sale of a 27 percent stake in SPT Telecom to Dutch and Swiss investors.81 MLT borrowing by enterprises was stimulated by a large interest rate differential, expectations of a koruna appreciation and improved credit ratings that enhanced the attractiveness as well as the availability of foreign credits to Czech enterprises.8283 The composition of portfolio inflows changed in 1995: after broadly similar amounts of debt and equity portfolio inflows in 1994, the equity component rose to two thirds of the total (Table 9). Short-term capital inflows, mainly by commercial banks, were very strong the first half of 1995, but the imposition of a limit on the banks’ short-term liabilities to nonresidents in August induced the banks to shift to liabilities of longer maturity (slightly over one year).
|Medium- and long-term debt, net||1,109||3,367||1,099|
|Short-term debt, net||659||971||−1,000|
|(in percent of GDP)||6.1||10.7||…|
|(in percent of GDP)||3.3||7.4||…|
131. While debt inflows in 1994 and 1995 dominated equity participation, exceeding 10 percent of GDP in 1995, the situation has been reversed in 1996.84 A change in foreign investor sentiment owing to the rising current account deficit and the widening of the exchange rate band to ±7½ percent in February 1996 (adding to exchange rate risk) resulted in a short-term capital outflow in the first half of 1996.85 As a result, the capital account surplus declined sharply to US$0.8 billion (3 percent of GDP) in the first half of 1996 (down from 10 percent a year earlier), and was entirely accounted for by nondebt capital inflows.86
132. Given the rising current account deficit, the slowdown in capital inflows and the absence of National Bank intervention in the face of a still appreciating nominal exchange rate, there has been some run down of official foreign exchange reserves so far in 1996, in sharp contrast with developments until late 1995. Gross official reserves fell by over US$1 billion during the first half of 1996 to around US$12.8 billion reflecting net intervention sales of about US$0.4 billion in the aftermath of the widening of the exchange rate band, government debt servicing, the rundown of a special SPT Telecom deposit, and valuation changes.
C. Pattern of trade and investment
133. The re-orientation of Czech trade away from former centrally planned economies toward Western Europe (and the European Union in particular) dominates the geographical composition of both exports and imports. Since 1993, the share of total exports destined for CMEA countries (including the Slovak Republic) has fallen from 37 percent to 30 percent in 1995, while the share of exports to EU markets rose from about 48 percent to 60 percent over the same period (Table A38).87 Imports from formerly planned economies followed a very similar pattern, falling some 13 percentage points to 23½ percent between 1993 and 1995.88 As the share of trade with Slovakia falls, one might expect trade patterns to be even more heavily dominated by neighboring EU countries, as Germany and Austria already account for 43 percent of exports and 36 percent of imports. Despite an increased effort to increase exports to developing countries (in Asia and Latin America in particular) that share has continued to fall.
134. The commodity composition of exports has continued to shift gradually towards higher value-added goods, with the share of manufactures and machinery89 accounting for 72.3 percent of exports in 1995, up from 69.7 percent in 1992 (Table A39). Even though the Czech Republic exports more of almost every good to market economies than formerly planned economies in absolute terms (at the one digit SITC category) there are detectable signs of Czech comparative advantage in that relatively more chemicals (SITC 5) are exported to ex-CMEA countries, while more manufactures are destined for EU/market economies. On the imports side, former planned economies continue to supply the Czech Republic with lower value-added goods (raw materials, minerals and fuels). The commodity composition of exports and imports by region in the first half of 1996 was broadly similar to the same period a year ago, but there has, nevertheless, been a small shift of exports of manufactures and machinery to the CEFTA group of countries, although this may have more to do with activity rates there (as opposed to the EU) than loss of competitiveness per se.
135. TelSource consortium partners from the Netherlands and Switzerland who had bought into SPT Telecom wore the largest single investors accounting for over half of the total foreign direct investment in 1995. Germany retains the largest stock of direct investment in the Czech Republic to date—as one might expect being the country’s largest trading partner, accounting for one third of the total—followed by Austria with one third. The three largest German investments are Automobilka Škoda (owned by Volkswagen), Linde Technoplyn Praha and Siemens Elektromotory (Table A41).
D. External debt and assets
136. The external debt of the Czech Republic has primarily been denominated in convertible currencies and of longer maturity (Table A42). Total debt in convertible currencies doubled between 1993 and 1995 to US$16.5 billion, of which US$11.5 billion was medium and long-term. Even so, this represents less than 40 percent of GDP, and debt service was relatively modest at below US$3 billion (equivalent to 9 percent of exports of goods and services) in 1995. The most significant creditor class is trade credit (which includes suppliers’ credits extended by foreign banks to Czech enterprises), and accounts for two-thirds of principal and more than half of interest payments Ming due. Meanwhile, non-convertible currency debt has been virtually eliminated. External debt service obligations are expected to rise to US$3.8 billion in 1996 (Table A43), equivalent to 13 percent of exports of goods and services; the rise is attributable to higher repayments of trade credits disbursed over the last few years.
137. On the assets side, Czech external claims against the rest of the world have also grown strongly, with convertible currency assets rising to about US$25 billion at end-1995 (Table A44). Virtually the entire increment reflected higher foreign exchange holdings of the CNB. Overall, convertible currency assets remain greater than convertible currency debt, even after adjusting for direct investment.
E. External competitiveness
138. When the Czech Republic embarked on its stabilization program in 1990, a key element in the program was an exchange rate peg which came into effect on January 1,1991. Since then, because domestic inflation has been higher than in its trading partners there has been a continued appreciation of the CPI-based real effective exchange rate (Chart 20). Despite an increase in industrial productivity in 1994–95, this did not prevent the continued weakening of external competitiveness, as measured by the rise in relative unit labor costs (RULC) which increased by 4 percent in 1995 and a further 6 percent in the first half of 1996 from a year earlier. Meanwhile, improving terms of trade limited the impact of rising unit labor costs on enterprise profitability (see Section II).
CHART 20czech republic EXCHANGE RATE INDICATORS
Sources: Data provided by the Czech authorities; IMF Information Notice System; and staff estimates.
1/ Unit labor costs in the Czech Republic relative to that in trading partner countries, adjusted for producer price inflation—a rough indicator of developments in profitability.
VI. THE EXCHANGE AND TRADE SYSTEM
139. From the beginning of 1991 until early 1996, the koruna was pegged to a basket of currencies within a narrow band (of ±½ percent). On February 29,1996 the band was widened to ±7½ percent. The nominal exchange rate has been held broadly stable during 1991–95, with most of the movements in the nominal effective rate reflecting changes in the underlying currency basket to which the koruna is pegged, as well as shifts in the relative value of major currencies. The public has had relatively free access to foreign exchange for current account transactions; a few remaining restrictions on current payments were removed following the approval of the new Foreign Exchange Act in September 1995. The Czech Republic thus accepted the obligations of Article VIII, Sections 2, 3 and 4 of the Fund Agreement on October 1, 1995.90 At the same time, the bilateral payment agreement with the Slovak Republic was ended by mutual agreement. In addition, the Czech Republic acceded to the OECD Codes of Liberalization of Capital Movements and Current Invisible Operations, and to the Declaration and Decisions on International Investment and Multinational Enterprises when it became a full OECD member in December 1995.
A. Exchange rate arrangement
140. The Czechoslovak and later Czech koruna has been pegged to a multiple currency basket since 1991. The basket first consisted of five currencies including the U.S. dollar, the Deutsche mark, the Austrian schilling, French franc and Swiss franc. Since May 3,1993 the basket has comprised two currencies:91 the U.S. dollar (with a weight of 35 percent) and the Deutsche mark (with a weight of 65 percent). The Czech National Bank (CNB) quotes daily official exchange rates against the two currencies. The National Bank also announces daily foreign exchange rates for 21 other currencies including the Slovak koruna, ECU and SDR (based on cross rates vis-à-vis the U.S. dollar). Until February 28,1996 the currency was permitted to fluctuate within a ±0.5 percent band around a central rate. Since then, the permitted fluctuation band has been widened to ±7.5 percent. The composition of the basket and the ±0.25 percent bid/offer spread remain unchanged.
B. Administration of exchange control
141. Responsibility for enforcing the Foreign Exchange Act falls to the Ministry of Finance and the CNB. In general, the Ministry of Finance exercises authority over central and local governments as well as budgetary organizations and State funds, while the CNB exercises authority over all other agents (resident or otherwise).
C. Payments agreement with the Slovak Republic
142. Following the dissolution of the Czech and Slovak Federal Republic in January 1993, the two countries introduced separate currencies in February 1993. A payment agreement was signed in February 1993, to which a protocol establishing a bilateral clearing arrangement was added. Under this arrangement all transactions were to be channeled through two clearing accounts at specified rates of exchange. The first account—the “new block”—related to transactions after the termination of the currency union on February 8,1993, and balances were denominated in “clearing ECU”. The second account—the “old block”—related to obligations incurred before the currency split, and was denominated in “clearing koruny”, with the Czech and Slovak koruny exchanging at par.
143. At the time of termination of the payment agreement at end-September 1995, the deficit of the Czech Republic exceeded the automatic credit limit of ECU 130 million by ECU 24.5 million. This excess amount was settled in early October. Three fourths of the outstanding balances in the “new block” and the “old block” was paid in convertible currency in December, and the remaining one fourth will be compensated by supplies of goods during 1996.
D. Current account transactions
144. At the time the Czech Republic joined the Fund it had a number of transitional restrictions under Article XIV, Section 2, which included: (i) exchange restrictions on invisible payments and transfers: for example, the payment of interest on koruna-denominated bonds with a maturity of less than one year, limitations on travel, education and medical treatment and remittances; and (ii) restrictions on transfers of proceeds of current payments from koruna-denominated non-resident deposits. The Czech Republic has operated a current payments system in line with the Fund’s Article VIII requirements since October 1995.
145. Foreign trading activity may be carried out by any registered enterprise or entrepreneur. Residents are required to repatriate domestic and foreign currency earnings from abroad (normally within 30 days). There are no limits on the acquisition of foreign exchange for merchandise and services imports or for repatriation of interest, profits and dividends. Import licences are required for strategic items (or items requiring public safety) including: uranium ore, coal, poisons, military materials and narcotics. An automatic licencing and tariff system is in place for specified agricultural produce, mineral fuel and oils, iron and steel. Existing trade arrangements modify the above provisions: a customs union is in effect with the Slovak Republic, and the Czech Republic offers least developed countries GSP (Generalized System of Preferences) concessions (below). Export licences are required for the purposes of health control (e.g., plant and livestock), for goods which are subject to quota or voluntary export regimes (e.g., steel and textiles), as well as certain raw materials.
E. Capital transactions
146. Capital account transactions in the Czech Republic have been significantly liberalized in 1995. Under the new Foreign Exchange Law, measures were taken to further liberalize residents’ transactions abroad, including outward foreign direct investment (for example residents’ purchase of real estate is no longer restricted). Some restrictions do remain: foreign exchange permits are required for securities transactions executed through authorized domestic agents; resident non-bank financial credits and guarantees normally require a foreign exchange permit. The extension of credits and guarantees by non-residents to residents is unrestricted. Non-resident transactions have also been liberalized, but restrictions remain in place on the acquisition of Czech real estate.
147. Part 4 of the Foreign Exchange Law includes special provisions relating to the requirements for a certain percentage of capital inflows to be backed by deposits and placed on account with Czech banks, at a rate determined by the CNB. In this way, and through emergency provisions in Part 5, the authorities retain a measure of control over capital inflows. In addition to the restrictions on capital inflows contained in the Foreign Exchange Law, the limit on net short-term borrowing by banks which came into effect on August 1, 1995 has been retained for the time being.
148. The Czech Republic has entered a number of reservations to the OECD Capital Movements Code, including the issue by residents of domestic instruments (other than shares) on foreign financial markets, as well as certain derivatives and foreign exchange operations abroad by residents. Most of these reservations are considered benign when compared with other OECD member countries. The authorities have indicated, however, that it is their intention to pursue full capital account liberalization within five years, depending on economic and other developments both domestically and abroad.
F. Trade policy developments
149. The Czech Republic is an open economy characterized by transparent trade policies and tariff bindings. The Czech Republic has ratified the Uruguay Round Agreements in December 1994. It is also an active participant in regional trading arrangements: the Central European Free Trade Area which also includes Hungary, Poland, Slovakia and Slovenia, has taken steps to implement a common external tariff and liberalize agricultural trade. Other free trade agreements have been implemented with the European Free Trade Area (EFTA) and Romania. The EU Association Agreement is in force and accession negotiations to the EU are expected in due course.
150. Tariffs in effect are at an (already low) bound level and fall into three categories: primary products (charged at 4 percent92), semi-processed goods (charged at 6 percent) and finished goods (charged at 10 percent). The simple average most-favored nation (m.f.n.) tariff rate is 8 percent93 (including agriculture), but only one-fifth of imports are actually subject to m.f.n. rates. Hitherto, the import regime has been relatively free of non-tariff barriers and export restrictions. The Czech Republic has no anti-dumping, countervailing duty or safeguards legislation in force, nor has it had recourse to such barriers. Consumer protection clauses are under active consideration in this regard. Since services play a vital role in generating export earnings, the Czech Republic has been supportive of the General Agreement on Trade in Services and is party to all key multinational agreements on intellectual property.
|1991||1992 1/||1993 1/||1994 1/||1995 1/|
|(In billions of koruny, at current prices)|
|Gross capital formation||214.2||214.1||163.9||213.0||338.9|
|Gross fixed investment||165.3||225.7||241.9||311.4||390.0|
|Change in stocks||48.9||−11.6||−78.0||−98.4||−51.1|
|Net export of goods and|
|Gross domestic product||716.6||791.0||910.6||1,039.2||1,212.0|
|(In billions of koruny, at constant 1984 prices)|
|Gross capital formation||126.7||104.4||102.1||124.7||170.6|
|Gross fixed investment||112.6||122.6||113.2||132.8||154.2|
|Change in stocks||14.1||−18.2||−11.1||−8.1||16.4|
|Net export of goods and|
|Gross domestic product||432.1||404.5||400.7||411.2||431.1|
|(Share in GDP at current prices, in percent)|
|Gross capital formation||29.9||27.1||18.0||20.5||28.0|
|Gross fixed investment||23.1||28.5||26.6||30.0||32.2|
|Change in stocks||6.8||−1.5||−8.6||−9.5||−4.2|
|Net export of goods and nonfactor services||6.8||0.4||2.2||−0.4||−5.2|
|Exports of goods and services||57.5||56.6||56.7||52.5||51.1|
|Imports of goods and services||50.7||56.2||54.5||52.9||56.3|
|(Share in GDP at constant prices, in percent)|
|Gross capital formation||29.3||25.8||25.5||30.3||39.6|
|Gross fixed investment||26.1||30.3||28.3||32.3||35.8|
|Change in stocks||3.3||−4.5||−2.8||−2.0||3.8|
|Net export of goods and nonfactor services||7.0||0.1||−1.8||−6.9||−15.1|
|Exports of goods and services||55.3||63.1||68.5||66.9||68.8|
|Imports of goods and services||48.3||63.0||70.2||73.8||83.9|
|(Percentage change, at constant prices)|
|Gross capital formation||−14.9||−17.6||−2.2||22.1||36.7|
|Of which: Gross fixed investment||−17.7||8.9||−7.7||17.3||16.1|
|Exports of goods and nonfactor services||…||6.8||7.5||0.2||7.9|
|Imports of goods and nonfactor services||…||22.0||10.4||7.8||19.2|
|Gross domestic product||−14.2||−6.4||−0.9||2.6||4.8|
|(In billions of koruny, at current prices)|
|forestry, and fishing||39.9||44.8||56.3||57.6||60.5|
|Wholesale and retail trade,|
|restaurants and hotels 2/||75.1||86.6||97.6||110.9||149.9|
|Transport, storage and communication||29.1||46.2||47.6||58.6||72.6|
|Public administration, education and health||50.1||77.8||104.4||113.7||118.1|
|Community, social and personal services 3/||58.4||73.3||118.1||144.9||167.7|
|Taxes minus subsidies||98.1||99.7||106.4||112.5||124.3|
|Total GDP (at market prices)||716.6||791.0||910.6||1,037.5||1,212.0|
|(In billions of koruny, at constant prices)|
|Agriculture, hunting, forestry and fishing||31.8||…||…||…||…|
|Wholesale and retail trade, restaurants and hotels 2/||38.2||…||…||…||…|
|Transport, storage and communication||18.3||…||…||…||…|
|Public administration, education and health||39.5||…||…||…||…|
|Community, social and personal services 3/||43.9||…||…||…||…|
|Taxes minus subsidies||33.3|
|Total GDP (at market prices)||432.1||404.5||400.7||411.2||431.1|
|Mining and quarrying||−13.0||−7.1||0.4||−1.4|
|Food products and beverages||−7.6||−5.1||−1.8||4.0|
|Textiles and textile products||−14.0||−14.8||−2.3||0.5|
|Leather and leather products||−14.5||−2.2||−3.2||−10.2|
|Wood and wood products||−24.5||−17.2||1.0||2.4|
|Pulp, paper, publishing, and printing||−3.6||−8.3||19.0||1.4|
|Coke, refined petroleum products, and nuclear fuel||0.9||−8.1||8.0||7.2|
|Chemicals and chemical products||−10.0||−7.4||2.5||−1.2|
|Rubber and plastic products||−6.3||7.5||4.5||14.5|
|Nonmetallic mineral products||−6.1||−11.7||5.0||6.6|
|Basic metal and metal products||−19.2||−7.2||2.3||13.3|
|Machinery and equipment, n.e.c.||−25.6||−17.3||−5.4||9.4|
|Electrical and optical equipment||−30.7||−9.3||9.7||21.8|
|Other manufacturing, n.e.c.||−13.6||−12.7||−7.2||9.8|
|Electricity, gas, and water supply||−3.0||−5.2||−3.0||3.4|
|Industry large enterprises) 1/||−14.3||−8.0||−0.4||7.2|
|(In thousands, annual average)|
|Trade and catering||645||720||839||890|
|Transportation and communication||366||385||353||355|
|(Share in total employment, in percent)|
|Trade and catering||13.1||14.9||17.2||17.7|
|Transportation and communication||7.4||7.9||7.2||7.1|
|Trade and catering||251||212||241||161|
|Transportation and communication||311||302||292||288|
|Trade and catering||4,182||5,154||6,274||7,223|
|Transport and communication||4,602||5,672||6,807||8,238|
|Private sector 2/||5,061||5,901||6,795||7,993|
|Trade and catering||4,612||5,139||5,045||5,884||5,411||6,094||6,358||7,040||6,266||7,114||7,246||8,227||7,471||8,410|
|Transport and communication||5,158||5,675||5,597||6,529||5,855||6,661||6,772||7,884||7,035||8,156||8,202||9,552||8,775||10,023|
|Private sector 3/||5,104||5,668||5,784||6,472||5,958||6,640||6,808||7,654||7,108||7,887||8,039||8,964||8,159||9,120|
|Total gross agricultural production||−12.1||−2.3||−6.0||5.0|
|Fodder and root crops||−27.1||5.7||−9.6||2.8|
|Livestock for slaughter||0.2||−2.0||−11.6||3.9|
|(In thousands of tons)|
|(In tons per hectare)|
|Primary domestic sources||51.1||50.7||47.1||50.1|
|Other solid fuels||0.7||0.5||0.7||…|
|Other (excluding hydro–and nuclear–generated electricity)||4.9||5.0||4.6||…|
|Other primary energy imports||1.4||1.5||1.6||…|
|To Slovak Republic (all categories)||5.0||4.9||…||…|
|Change in stocks||1.5||−0.1||0.3||−0.2|
|Domestic use of primary energy||62.1||59.9||57.6||60.9|
|For electricity generation by steam (excluding hydro- and nuclear-power)||16.0||16.0||15.0||…|
|For other purposes 1/||14.8||15.8||16.0||…|
|Exports (including to Slovak Republic)||4,025||3,007||2,039||2,121|
|Goods and services||100.0||67.7||75.2||90.9||100.0|
|Goods and Services||100.0||100.0||109.1||106.3||108.5||109.8||111.9||115.7||117.8|
|Beverages and tobacco||8.6||100.0||106.3||105.0||106.1||106.8||107.4||113.9||…|
|Fuel and electricity||6.3||100.0||112.6||108.2||110.3||114.6||117.6||118.2||…|
|Services, excluding rent||14 6||100.0||109.7||104.7||109.3||112.2||112.5||119.7||…|
|Wholesale and retail trade||26.4||56.0||76.5||88.7||91.8|
|Transport, storage, and communications||3.8||18.6||40.5||38.7||53.5|
|Wholesale and retail trade||57.8||74.2||89.9||90.7||97.7|
|Transport, storage and communications||10.9||16.1||25.6||28.6||43.4|
|In billions of koruny||In percent of GDP|
|Corporate profits tax||70.9||64.5||71.1||67.3||67.8||63.0||30.8||71.7||7.8||6.2||5.9||5.6||4.8||4.4||2.2||4.4|
|Personal income tax||29.9||54.5||55.2||68.6||80.3||82.3||35.8||96.3||3.3||5.3||4.6||5.7||5.6||5.8||2.5||5.9|
|Taxes on international trade||15.2||17.4||16.5||17.4||19.0||20.3||9.4||19.6||1.7||1.7||1.4||1.4||1.3||1.4||0.7||1.2|
|Social insurance contributions||150.6||179.2||204.9||213.3||248.0||249.4||111.9||285.3||16.5||17.3||16.9||17.6||17.5||17.6||7.9||17.6|
|Other budgetary tax revenue 2/||39.1||14.7||13.5||18.0||19.5||18.4||8.0||18.7||4.3||1.4||1.1||1.5||1.4||1.3||0.6||1.1|
|On goods and services 3/||221.3||260.4||277.6||297.0||336.7||338.2||76.6||374.0||24.3||25.1||22.9||24.5||23.7||23.8||5.4||23.1|
|Balance without privatization revenues||5.1||−13.4||−23.6||−24.6||−0.4||−12.8||−9.5||−1.3||0.6||−1.3||−1.9||−2.0||—||−0.9||−0.7||−0.1|
|Use of privatization revenues 7/||7.5||18.4||13.2||15.0||2.0||4.9||2.0||2.6||0.8||1.8||1.1||1.2||0.1||0.3||0.1||0.2|
|Balance with privatization revenues||12.6||5.0||−10.4||−9.6||1.6||−7.9||−7.5||13||1.4||0.5||−0.9||−0.8||0.1||−0.6||−0.5||0.1|
|In billions of koruny||In percent of GDP|
|Corporate income tax||64.4||71.1||64.2||54.2||47.9||24.9||55.0||6.2||5.9||5.3||3.8||3.4||1.8||3.4|
|Personal income tax||5.8||6.2||8.5||28.5||30.9||14.4||35.9||0.6||0.5||0.7||2.0||2.2||1.0||2.2|
|VAT (value-added tax)||85.8||88.5||94.8||109.1||111.2||51.0||127.8||8.3||7.4||7.8||7.7||7.8||3.6||7.9|
|Social security contributions||130.0||147.1||154.3||178.9||179.9||80.8||205.5||12.5||12.3||12.7||12.6||12.7||5.7||12.7|
|Other taxes 1/||10.3||10.1||13.8||15.9||14.6||6.8||14.9||1.0||0.8||1.1||1.0||1.1||0.4||1.0|
|On goods and services||121.2||122.6||95.7||114.6||110.8||49.5||123.5||11.7||9.1||7.9||8.1||7.8||3.5||7.6|
|Wages and salaries||40.3||46.3||40.4||46.4||45.0||21.7||51.2||3.9||3.9||3.3||3.3||3.2||1.5||3.2|
|Social security benefits 3/||134.4||149.6||153.2||182.1||182.1||88.1||209.4||11.9||12.5||12.6||12.8||12.8||6.2||12.9|
|By budgetary organizations||19.7||20.5||21.4||31.0||29.4||8.2||29.8||1.9||1.7||1.8||2.2||2.1||0.6||1.8|
|Balance of central state budget||10.4||−0.4||7.2||—||—||-0.9||−||1.0||—||0.6||—||—||−0.1||—|
|Defense spending 5/||27.6||—||24.6||—||27.6||—||27.8||2.7||—||2.0||—||1.9||—||1.7|
|In billions of koruny||In percent of GDP|
|Entrepreneurial and property income||13.8||12.0||13.8||17.3||14.0||7.3||14.2||1.3||1.0||1.1||1.2||1.0||0.5||0.9|
|Budgetary and subsidized organizations||12.7||12.0||12.8||16.3||13.0||6.8||13.2||1.2||1.0||1.1||1.1||0.9||0.5||0.8|
|Fees and fines||4.2||2.5||3.3||3.9||3.5||1.7||3.6||0.4||0.2||0.3||0.3||0.2||0.1||0.2|
|On goods and services||44.4||51.5||53.1||60.1||58.1||27.1||66.1||4.3||4.3||4.4||4.2||4.1||1.9||4.1|
|Wages and salaries||8.2||8.5||9.7||12.0||10.7||4.9||12.0||0.8||0.7||0.8||0.8||0.8||0.3||0.7|
|To subsidized organizations||12.2||14.4||15.1||16.0||16.0||8.5||17.5||1.2||1.2||1.2||1.1||1.1||0.6||1.1|
|To extrabudgetary funds||2.9||—||—||—||—||—||—||0.3||—||—||—||—||—||—|
|By budgetary organization||34.0||26.6||41.7||30.8||30.8||16.0||33.3||3.3||2.2||3.4||2.2||2.2||1.1||2.1|
|To subsidized organizations||5.0||4.8||5.9||5.0||5.0||1.6||5.0||0.5||0.4||0.5||0.4||0.4||0.1||0.3|
|BALANCE OF LOCAL BUDGETS||−1.1||−9.1||−1.7||—||—||−3.1||2.3||−0.1||−0.8||−0.1||—||—||−0.2||0.1|
|In billions of koruny||In percent of GDP|
|Fund for Market Regulation||3.8||3.5||3.7||3.8||3.8||2.1||3.6||0.4||0.3||0.3||0.3||0.3||0.1||0.2|
|Current expenditure of other extrabudgetary funds||1.9||0.1||1.2||0.2||1.5||0.6||1.5||0.2||—||0.1||—||0.1||—||0.1|
|Capital expenditure of other extrabudgetary funds||0.3||1.9||1.2||2.8||1.4||0.5||1.3||—||0.2||0.1||0.2||0.1||—||0.1|
|Transfers by other extrabudgetary funds to local authorities||1.7||3.0||2.6||3.0||3.0||0.8||3.4||0.2||0.3||0.2||0.2||0.2||0.1||0.2|
|In billions of koruny||In percent of GDP|
|NATIONAL PROPERTY FUND|
|To central government||—||—||1.5||—||1.5||—||0.1||—||—||0.1||—||—||—||—|
|To local government||—||—||1.2||—||—||—||—||—||—||0.1||—||—||—||—|
|To extrabudgetary funds||1.9||1.5||1.6||2.0||2.0||2.0||1.5||0.2||0.1||0.1||0.1||0.1||0.1||0.1|
|To Health Fund||—||—||—||—||1.4||—||1.0||—||—||—||—||0.1||—||0.1|
|STATE FINANCIAL ASSETS|
|To central government||—||—||6.4||—||3.3||1.5||0.1||—||—||0.5||—||0.2||0.1||—|
|In billions of koruny||In percent of GDP|
|Transfers from government||14.3||13.5||13.5||15.3||14.6||9.3||18.3||1.1||1.1||1.1||1.1||1.0||0.7||1.9|
|Payment of claims||63.6||64.0||72.2||68.6||86.3||42.0||95.4||5.4||5.3||6.0||4.8||6.1||3.0||5.9|
|Outstanding Debt (end of period)|
|Loan Guarantees outstanding||1/1/93||1/1/94||1/1/95||1/1/96||6/30/96|
|Total subsidies 1/||38.2||38.7||27.5||28.7||28.0|
|Agriculture and foodstuffs||9.1||6.4||5.1||5.8||6.7|
|Prices and other fees||—||—||—||—||—|
|Fund fer Market Regulation 2/||3.3||1.3||0.5||0.9||1.3|
|Forestry and water||2.1||0.7||0.3||0.4||1.2|
|Bus, urban transport, and airlines||6.6||7.7||1.4||1.5||0.2|
|Other noninvestment 3/||11.2||8.2||3.4||3.7||2.6|
|Called loan guarantees||…||0.6||0.4||0.8||0.1|
|Employment of handicapped||…||0.3||0.4||0.3||0.3|
|Small business development 4/||…||1.2||1.2||1.5||1.0|
|To financial institutions 5/||…||4.5||—||—||—|
|Central investment subsidies||7.3||5.5||3.7||6.1||6.3|
|Forestry and water||…||3.0||0.7||2.6||0.2|
|Current subsidies (percent of GDP)|
|Current subsidies (percent of sectoral value added)|
|In billions of koruny||In percent of GDP|
|Budget||Rev. Proj.||Q1||Budget||Rev. Proj.||Q1|
|Sickness and maternity||16.6||18.4||20.5||22.0||6.1||1.6||1.5||1.4||1.5||0.4|
|Traditional state allowances||18.3||17.6||1.0||1.1||1.1||1.8||1.5||0.1||0.1||0.1|
|Per child allowances||12.5||12.5||1.0||1.1||1.1||1.2||1.0||0.1||0.1||0.1|
|Compensatory income support||10.6||6.0||0.5||0.6||0.6||1.0||0.5||—||—||—|
|Other state benefits 3/||0.7||1.4||1.9||1.7||0.4||0.1||0.1||0.1||0.1||—|
|Social state support||—||1.2||25.9||25.9||5.1||—||0.1||1.8||1.8||0.4|
|Per child allowances||—||—||11.1||11.3||1.9||—||—||0.8||0.8||0.1|
|Others (including housing)||—||0.2||6.6||6.3||1.4||—||—||0.4||0.4||0.1|
|Benefits provided by Local authorities||3.6||4.1||5.0||5.0||1.0||0.3||0.3||0.4||0.4||0.1|
|State policy of employment||2.6||2.4||2.7||2.7||0.6||0.3||0.2||0.2||0.2||—|
|(In billions of Koruny, end of period)|
|Net foreign assets 1/||194||209||226||251||284||276||290||269|
|Net domestic assets||651||648||662||675||728||738||764||800|
|Net credit to the economy||812||826||853||886||919||947||975||986|
|of which: in foreign currency||44||53||61||76||97||102||105||113|
|Net credit to Government||23||9||6||7||25||18||26||22|
|Net credit to Property Fund||−18||−21||−24||−4||−15||−15||−16||−17|
|Other assets, net||−167||−166||−173||−214||−201||−212||−222||−191|
|Broad money 2/3/||845||857||888||926||1,012||1,014||1,054||1,069|
|Currency outside banks||84||84||92||95||104||104||113||112|
|Time and savings deposits||388||415||435||458||499||528||541||547|
|Foreign currency deposits||61||58||58||53||60||61||69||68|
|NFA including counterpart of SPT deposit||194||209||226||285||311||299||309||286|
|Effective required reserves ratio||7.44||7.36||7.31||8.85||8.37||8.84||8.83||11.73|
|Velocity of Broad Money 5/||1.31||1.32||1.33||1.33||1.28||1.29||1.32||1.36|
|(Twelve-month change, in percent)|
|Credit to the economy||16.8||15.2||13.9||14.4||13.2||14.6||14.3||13.0|
|(Twelve-month change in percent of broad money at beginning of period)|
|Net foreign assets||11.2||10.4||8.9||10.1||10.6||7.9||7.2||3.3|
|Net domestic assets||8.8||7.1||6.8||7.0||9.1||10.5||11.5||12.4|
|Other assets, net||−5.9||−4.3||−3.4||−7.2||−4.1||−5.4||−5.4||−0.6|
|Net credit to economy||16.6||14.9||13.5||14.1||12.7||14.1||13.7||12.3|
|(In billions of koruny, end of period)|
|Net foreign assets||155||192||216||243||311||299||303||303|
|Foreign assets 1/2/||207||245||270||296||359||349||347||349|
|Net domestic credit||−10||−43||−52||−57||−108||−91||−78||−50|
|Net claims on government||−17||−43||−47||−47||−31||−45||−51||−38|
|Net claims on the economy||−5||−12||−17||−18||−16||−10||−5||2|
|CNB bills with non-banks||0||—||—||—||—||−9||−12||−6|
|Other nongovernment deposits 1/||−23||−26||−34||−38||−44||−35||−39||−38|
|Other unclassified domestic assets||12||11||15||17||25||32||44||44|
|Net claims on banks||12||12||11||8||−61||−35||−22||−14|
|Other claims on banks||1||1||2||1||2||2||7||6|
|Other deposits of banks||−13||−10||−11||−9||−8||−6||−4||−4|
|CNB bills with banks||−46||−49||−45||−51||−121||−103||−88||−83|
|Other liabilities to banks||0||—||—||—||—||—||−5||−4|
|Other net assets||2||1||−2||−3||−9||−11||−18||−15|
|of which: claims on the National Bank of Slovakia||25||25||25||26||26||26||26||26|
|Currency, incl. vault cash||96||96||105||108||119||118||129||127|
|Time deposits 1/||57.0||54.6||81.0||81.1||83.9||90.1||96.8||105.9||106.8|
|Private sector 2/||85.0||150.4||191.6||193.2||200.6||211.0||232.7||225.9||239.0|
|Time deposits 1/||10.5||44.5||64.5||79.2||85.5||90.5||98.9||104.5||109.2|
|Time deposits 1/||168.9||204.4||242.3||254.3||265.3||277.0||303.1||317.9||325.4|
|Private sector 3/||212.5||350.6||450.1||474.6||502.9||533.0||551.0||577.2||627.6|
|By branch of Industry||214.7||228.9||265.4||264.1||275.3||284.7||283.7||290.1||302.9|
|To nonindustrial activities||353.0||440.7||503.5||508.9||516.7||525.6||538.6||554.6||567.4|
|1992 2/||1993 2/||March||June||Sep.||Dec.||March||June||Sep.||Dec.||March||June|
|(In billions of koruny, end of period)|
|(In percent of total credits)|
|(In percent of total credits of the same maturity)|
|All Loans||New Loans||Deposits|
|Interbank 5/||Credits 6/||Deposits 6/|
|Discount Rate 2/||T-bills 3/|
|Date of Change|
|Category of Deposits||Jan. 1/||May||Feb.||Nov.||Feb. 2/||July||Aug.||Jury||Aug. 3/|
|Savings and time deposits||5||8||2||3||4/3||3||3||8.5||11.5|
(per annum) 4/
|Maintenance period 5/||month||month||month||month||month||fortnight||fortnight||fortnight||fortnight|
|Investicni a Postovni Banka||113||51||12.7||10.3|
|Ceska Obchodni Banka||33||22||9.1||8.4|
|Small domestic banks||20||141||773||15.1||14.3|
|Of which: Agrobanka||—||381||4.5||4.4|
|Branches of foreign banks||10||4||9||5.4||2.5|
|IPF Komercni Banky||3.4|
|AGB Investment Fund||16.7|
|Other state controlled entities||53.1||46.1||35.3||89.8||1.8||66.0||26.0|
|Ministry of Finance||19.6|
|Ministry of Agriculture||4.3||1.1||1.8|
|Restitution and Investment Fund|
|National Bank of Slovakia||24.1|
|Factor income and unrequited transfers||−18||108||473||41||420|
|(In percent of GDP)||(2.2)||(—)||(−3.0)||(…)||(−6.5)|
|Portfolio investment 3/||1,034||855||1,362||275||1,000|
|Other long term capital||816||1,109||3,367||1,099||430|
|Errors and omissions||−110||−950||595||171||200|
|Gross official reserves|
|Fund credit, net||−3||−1,117||—||—||—|
|Old Methodology||New Methodology 1/|
|Other medium- and long-term capital, net||528.4||859.5||3,227.0||3,226.9||1,005.5|
|Short-term capital, net||534.9||1,322.1||−0.2||−10.2||−1,007.8|
|Errors and omissions||−42.8||−608 2/||1,229.6 2/||1,027.7 2/||170.6|
|Change in gross|
|Factor income, net||11||—||−11|
|Unrequited transfers, net||−27||2||−16|
|Direct and portfolio investment||577||−57||−253|
|Medium- and long-term capital||—||—||—|
|Errors and omissions||−67||−686||−433|
|Other medium- and|
|Net short-term capital||—||—||—||—|
|Errors and omissions||—||—||—||—|
|(In millions of U.S. dollars)||(In percent of total)|
|Former planned economies||4,840||4,616||5,678||3,182||36.9||32.6||33.4||29.7|
|Former Soviet Union||838||885||1,026||435||6.4||6.2||6.0||4.1|
|Former planned economics||4,865||4,428||6,154||3,116||36.6||29.7||29.6||23.5|
|Former Soviet Union||1,441||1,470||2,167||1,048||10.8||9.9||10.4||7.9|
|Former Planned Countries||Market Countries||Total|
|0||Food and live animals||223||184||178||287||128||485||460||427||508||212||708||643||604||797||340|
|1||Beverages and tobacco||17||32||47||42||25||46||60||62||64||46||63||93||116||105||71|
|2||Crude materials inedible, except fuels||80||60||69||97||46||487||679||841||843||448||567||739||910||940||493|
|3||Minerals, fuels, lubricants, and related materials||129||102||176||174||85||368||430||423||504||267||497||532||602||687||352|
|4||Animal and vegetable oils, and fats||2||8||10||10||9||8||12||17||10||5||11||19||27||20||14|
|6||Manufactured goods, classified chiefly by material||437||561||528||775||466||2,399||2,677||3,186||3,945||2,258||2,836||3,238||3,720||4,721||2,724|
|7||Machinery and transport equipment||729||745||721||804||476||1,498||2,124||2,330||2,933||2,625||2,227||2,870||3,051||3,738||3,101|
|8||Miscellaneous manufactured articles||174||190||305||383||195||879||1,140||1,495||1,523||1,134||1,053||1,329||1,800||1,906||1,328|
|9||Miscellaneous transactions and commodities not classified||—||—||—||—||—||—||4||5||9||10||—||7||5||10||10|
|Former Socialist Countries||Market Countries||Total|
|0||Food and live animals||55||62||96||133||76||583||619||813||1,084||647||637||682||910||1,217||723|
|1||Beverages and tobacco||21||17||23||6||7||119||87||130||147||99||139||103||153||153||106|
|2||Crude materials inedible, except fuels||305||288||322||432||211||301||261||311||482||271||606||550||634||916||483|
|3||Minerals, fuels, lubricants, and related materials||1,504||1,164||1,148||1,606||867||103||112||229||198||155||1,607||1,276||1,378||1,802||1,022|
|4||Animal and vegetable oils, and fats||3||2||3||4||2||26||40||47||61||29||29||43||50||65||31|
|6||Manufactured goods, classified chiefly by material||210||191||253||477||259||857||1,087||1,412||2,188||1,868||1,067||1,279||1,666||2,665||2,126|
|7||Machinery and transport equipment||260||199||170||334||236||4,039||3,912||4,667||6,599||4,545||4,299||4,113||4,837||6,935||4,781|
|8||Miscellaneous manufactured articles||62||100||148||237||135||901||1,179||1,423||1,845||1,222||963||1,280||1,572||2,084||1,357|
|9||Miscellaneous transactions and commodities not classified||—||—||—||—||0||3||54||10||10||5||3||54||8||10||5|
|Agriculture, hunting, and forestry||3||2||1||8|
|Mining and quarrying||12||14||21||23|
|Electricity, gas, and water supply||9||24||87||40|
|Trade, hotels and restaurants||60||40||35||212|
|Transport, storage and communications||30||3||10||1350|
|Real estate and business activities||—||—||—||—|
|Health and social work||—||—||—||—|
|Other social and personal services||—||—||—||—|
|Food and tobacco||379||229||71||122|
|Textiles, wearing apparel, and leather||1||1||1||2|
|Wood, paper and publishing||—||—||—||—|
|Refined petroleum and chemicals||66||19||44||90|
|Basic metals and metal products||—||—||—||—|
|Machinery and equipment||40||67||292||466|
|Recycling and other manufacturing||—||—||—||—|
|Debt in convertible currencies|
|Medium- and long-term||1,936||1,835||3,557||4,565||5,284||6,494||7,806||11,504||12,168|
|Over 5 years||1,463||981||2,236||3,112||3,190||3,964||3,636||4,349||…|
|Debt in nonconvertible currencies 1/|
|Medium- and long-term||125||54||39||33||344||770||812||357||321|
|Over 5 years||109||31||—||11||—||…||…||…||…|
|Total debt 2/||6,510||4,178||7,028||8,251||7,453||9,605||12,210||17,190||17,028|
|Medium- and long-term||2,061||1,889||3,596||4,598||5,627||7,278||8,629||11,898||12,489|
|Fund repurchases 1/||—||—||1,110||—||—||—||—||—||—||—|
|Trade credits 2/||841||553||631||1,443||2,032||2,028||995||1,006||684||478|
|Trade credits 2/||57||81||139||354||434||337||284||227||171||131|
|Total debt service||1,438||1,157||2,469||2,625||3,820||3,258||2,080||2,412||1,881||1,045|
|Gross external reserves||1,739||745||1,056||2,611||3,587||6,245||8,892||17,386||17,032|
|Held by central bank||368||433||236||730||727||3,781||6,161||13,939||12,631|
|Held by other banks||1,285||205||748||1,701||2,735||2,372||2,649||2,957||3,575|
|Holding of SDRs||…||…||…||93||28||8||—||—||—|
|Other foreign assets in|
|Held by enterprises||1,104||1,598||2,089||2,422||2,884||2,652||2,589||3,053||3,544|
|Held by government institutions||433||923||1,687||1,758||1,742||1,847||1,835||1,943||1,928|
|Long-term assets of other banks||11||61||59||70||91||62||63||192||1,199|
|Direct investment abroad||…||…||…||…||160||122||143||175||362|
|Foreign assets in|
|nonconvertible currencies 1/||1,638||1,545||2,187||6,146||5,242||4,595||4,538||4,045||4,024|
|Held by central bank||45||82||15||1||—||—||—||—||—|
|Held by other banks||343||310||1,060||3,888||3,161||2||1||10||—|
|Held by enterprises||517||681||474||528||307||277||240||154||138|
|Held by government institutions||732||472||639||1,728||1,770||4,310 2/||4,297||3,880||3,885|
|Direct investment abroad||…||…||…||…||4||7||—||—||—|
|Claims on the Slovak Republic in|
nonconvertible currencies 3/
1. Inflation in the Czech Republic declined rapidly after the initial price liberalization, but further progress has remained elusive. Much of the initial success against inflation was due to a comprehensive reform program in early 1991 which coupled price liberalization with restrictive fiscal, monetary and wage policies and led to a sharp drop in the inflation rate from over SO percent in 1991 to about 11 percent in 1992. However, since then, the inflation rate has declined only very gradually to about 9 percent in 1995-1996.
2. The sharp increase in inflation at the beginning of the reform process reflected a large increase in prices of tradables as a result of the price liberalization and a series of devaluations. Since 1992, however, prices of non-tradables have risen considerably generating strong inflationary pressures. Part of this increase in non-tradable inflation can be attributed to the adjustment of administered prices towards free market prices. However, the impact of these adjustments on the CPI has been quite small—under two percentage points—due to the small weight of regulated items remaining in the CPI basket.
3. The limited impact of administered price changes on overall inflation suggests that continuing inflation has been due to other factors. This paper examines the contribution of wages and monetary growth. The results suggest that wages have had a significant impact. This probably reflects weak corporate governance in a large number of enterprises, especially those that remain under state control despite their partial privatization (see Chapter II of this report). While the paper finds only weak evidence that such wage-led inflation has been accommodated by monetary policy, this probably reflects the weakness of the statistical tests due in particular, to the short period.
B. Productivity—adjusted wages, broad money growth and inflation
4. Wages in the Czech Republic were regulated from the beginning of the transformation process—albeit with limited success—until wage controls were finally abolished in mid-1995. The controls initially led to a sharp drop in real wages, but the decline was followed by fairly rapid wage growth because wages were frequently adjusted to take account of past inflation.2 This could have been due to an attempt by workers to prevent any further erosion in real wages and, in fact, restore them to their initial levels. (Similar problems in enforcing wage controls have also been observed in other countries where increasing exemptions cause them to unravel over time.)
5. The sharp increase in wages since 1992 suggests that there may be some relationship between wage growth and inflation in the Czech economy. Some evidence of this relationship can be seen in Chart 1 which plots annual changes in inflation and wage growth adjusted for productivity within industry. From 1993 onwards, movements in these two series appear to be strongly correlated. The empirical relationship between these variables as well as monetary growth was estimated more rigorously through an error-correction model.
Chart 1Czech Republic Annual Changes in CPI Inflation and Unit Labor Costs in Industry
Source: Czech authorities
6. The underlying structural model is determined by the following three equations. All the variables except the nominal interest rate, it, are specified in logs.
7. Equation (1) shows that output, y, decreases as the real interest rate increases and increases as the real exchange rate depreciates. The variable, q, is a measure of foreign prices converted into domestic currency and p is the domestic price level. Equation (2) is the equilibrium condition for the money market. Equation (3) is an aggregate supply function; the price level p increases with output and the nominal wage, w, and decreases with the level of factor productivity, z.
These equations can be rearranged to yield
8. If there are shifts in the demand for money, the growth rate of money supply will not be as good a predictor of inflation.3 For this reason, the money variable was adjusted, for the purpose of the estimation procedure, by the trend in velocity.4
9. The estimation procedure consisted of estimating a long-run or “cointegrating” relation between the CPI and the explanatory variables and its corresponding short-run representation or “error-correction” form. In arriving at equation (4), it is assumed that wages and monetary growth are exogenous. However, there may be simultaneity problems if these variables are also influenced by price changes. Hence, the short-run estimation corrects for problems of simultaneity by using instrumental variables.5 Since it was assumed that expected prices are based on lagged prices, an autoregressive distributed lag structure was used to derive the long-run relation. In addition, the estimated reduced form model was augmented with lags to take into account the dynamics of the underlying data. All variables are seasonally adjusted.6
10. Before presenting the estimation results, an important constraint in the empirical estimation should be noted, namely the small sample period. Data on the monetary aggregate M2 is only available from 1991 (12) onwards; consequently this dictated the estimation period. The short time period coupled with structural changes in the economy, however, makes it difficult to accurately estimate the long-run behavior of these variables. Therefore, the results need to be interpreted with caution.
The estimated long-run relationship for the CPI is:7
ULC: unit labor costs
M2': M2 adjusted for trend velocity (i.e. In(M2)+In(V))
IMP: German wholesale prices converted into domestic currency.
Standard errors are in parenthesis.
The short-run equation is:
∆: first difference of the variable
ECM: error-correction term (ie. CPIt -
11. The estimation results overall suggest that unit labor costs have a significant impact on inflation, both in the long-run and the short-run equations. While some real wage flexibility was observed initially, in the more recent period covered by the estimation, wages appear to be the main determinant of inflation. The adjustment to M2 for the trend in velocity may not have captured fully the underlying changes in the demand for money due to the short estimation period; hence money has a smaller effect than unit labor costs on long-run price movements. Although neither money nor import prices meet the usual standards of statistical significance in the short-run equation, both variables are correctly signed.8 A longer estimation period may show them to be significant as well.
12. With the pegged exchange rate and a high degree of price and trade liberalization, one would expect the link from growing labor costs to inflation to work through the price of non-tradables. The correlation between changes in prices for both tradables and non-tradables and unit labor costs in Table 1 confirms this link. Contemporaneous and 3-month lagged changes in unit labor costs show the highest degree of correlation with movements in the CPI, particularly for non-tradables. Thus, higher inflation for non-tradables could be related to the rapid wage growth in the Czech economy.
|Unit Labor Costs||ULC-3||ULC-2||ULC-1||ULC|
C. Inflation and Monetary Accommodation
13. For wage-led inflation to persist, there must ultimately be accommodation by monetary expansion. The empirical relationship between monetary growth and inflation was examined using Granger-causality tests. While the presence of Granger-causality suggests statistical precedence, it says little about economic or logical causality. An attempt was made to take into account possible leads and lags between monetary growth and inflation, by predicting these variables several months ahead. For instance, the tests look at the effect of inflation on monetary growth and vice versa at one-, three-, six- and twelve-month horizons.
14. For money itself, the results of the Granger-causality tests do not provide strong evidence of statistical causation from inflation to monetary growth (Table 2).9 The tests do not support the hypothesis of monetary accommodation over the short-run. Inflation does predict monetary growth one year ahead, but this would seem too long a lag in the policy response to be credible.
|Sample Period||F-Test (p-value) 2/|
|1 month ahead||1922 (7) to 1995 (7)|
|3 month ahead||1993 (10) to 1995 (7)|
|6 month ahead||1993(1) to 1995 (7)|
|12 month ahead||1993 (6) to 1995 (7)|
15. There is stronger evidence, however, of an indirect channel of monetary accommodation, through credit expansion (from domestic and foreign sources). Chart 2 shows the breakdown of credit into its domestic and overseas components. As Chart 2a shows, the expansion in total credit primarily reflects the growth in overseas credit to enterprises. A decomposition of trends in overseas credit in the second chart shows that much of the growth in total credit from abroad was due to direct borrowing by enterprises. Four different measures of credit were tested. These include (a) credit to the non-government sector, which consists of households and enterprises; (b) overseas credit to enterprises—which includes direct borrowing by enterprises as well as borrowing from abroad intermediated by commercial banks; (c) direct borrowing by enterprises from abroad; and (d) domestic credit to enterprises.10
Chart 2Czech Republic Trends in Credit
Source: Czech authorities
1/ Total credit includes credit to enterprises and households.
2/ Other refers to borrowing from abroad intermediated by commercial banks.
16. The results of the Granger-causality tests in Table 3 suggest that inflation leads to credit accommodation through direct borrowing by enterprises from abroad. This link is statistically significant over all the horizons examined.11 The indirect credit route of monetary accommodation would also seem consistent with the information available that about one quarter of the approved foreign credits are used to finance operating costs. The tests also show that lagged inflation has considerable predictive power for domestic credit expansion to enterprises one month ahead. However, the tests are weaker for the non-government sector as a whole. The value of the test statistic is significant at the 15 percent level, one three and six months ahead. Although these results are not significant using conventionally accepted levels of significance, the dominant effect of direct borrowing by enterprises may overwhelm trends in other sources of credit expansion affecting the results.12
|Sample Period||F-Test (p-value) 2/|
|1 month ahead||1922 (7) to l995 (7)|
|Inflation—Credit to non-government||1.79|
|Inflation—Overseas credit to enterprises||1.94|
|Inflation—Direct borrowing by enterprises||2.40**|
|Inflation—Domestic credit to corporate sector||2.64*|
|3 month ahead||1993 (10) to l995 (7)|
|Inflation—Credit to non-government||1.91|
|Inflation—Overseas credit to enterprises||3.32*|
|Inflation—Direct borrowing by enterprises||2.49**|
|Inflation—Domestic credit to corporate sector||1.82|
|6 month ahead||1993 (l) to l995 (7)|
|Inflation—Credit to non-government||1.78|
|Inflation—Overseas credit to enterprises||0.83|
|Inflation—Direct borrowing by enterprises||4.41*|
|Inflation—Domestic credit to corporate sector||1.06|
|12 month ahead||1993 (6) to 1995 (7)|
|Inflation—Credit to non-government||0.61|
|Inflation—Overseas credit to enterprises||0.86|
|Inflation—Direct borrowing by enterprises||3.75*|
|Inflation—Domestic credit to corporate sector||1.63|
17. Growing capital inflows have been the main factor responsible for the rapid pace of monetary expansion in the last two years, despite the Czech National Bank’s efforts to sterilize these and with evidence that the effectiveness of sterilization is weakening. Though by no means the only factor underlying the capital inflow (and monetary expansion), the above results suggest that partial accommodation of the capital inflow also in part accommodates wage-led inflation.
D. The Evolution of Wages
18. Table 4 shows average monthly nominal wages for the economy as a whole and disaggregated across sectors. Rapid growth can be observed across virtually all sectors of the economy, though it has been highest in financial services, real estate and (surprisingly) public administration.
|1990 Dec.||1991||1992||1993||1994||1995 HI|
|(In koruny, annual average)|
|Trade and catering||2,791||3,278||4,202||5,170||6,226||6,690|
|Transportation and communication||3,438||3,900||4,598||5,740||6,793||7,596|
|Trade and catering||…||17||28||23||20||16|
|Transportation and communication||…||13||18||25||18||21|
|Annual average CPI inflation rate 3/||…||56.5||11.1||20.8||10.0||9.5|
19. To examine inter-sectoral influences in wage developments, Granger-causality tests were conducted using quarterly wage data focused on wages in public administration to see whether they influence/are influenced by wage developments in other sectors.13 Though the results should be treated with caution because of the short data series, the Granger-causality tests show that wage growth in public administration is influenced by two other sectors which have experienced fairly rapid wage increases—financial services and real estate (Table 5). Industry wage growth also appears to have an effect on public administration wages though wage increases in industry have been lower than in public administration. Conversely, wage increases in public administration affect wages in related sectors of the economy, such as education and health with a two quarter lag. For construction and transportation and communication, the evidence is of two-way influences, probably reflecting the fact that wage developments in both sectors are affected by a common third influence such as the incomes policy or wage developments in the faster growing sectors.
|1.||Public administration wage growth—education wage growth||4.36*||0.04|
|Education wage growth—public administration wage growth||2.59||0.12|
|2.||Public administration wage growth—health wage growth||4.64*||0.04|
|Health wage growth—public administration wage growth||3.91**||0.06|
|3.||Public administration wage growth—construction wage growth||4.37*||0.04|
|Construction wage growth—public administration wage growth||6.70*||0.01|
|4.||Public administration wage growth—transport and comm. wage growth||4.59*||0.04|
|Transport and comm. wage growth—public administration wage growth||7.49*||0.01|
|5.||Public administration wage growth—trade wage growth||2.83||0.11|
|Trade wage growth—public administration wage growth||0.50||0.62|
|6.||Public administration wage growth—“other” wage growth||0.72||0.51|
|“other” wage growth—public administration wage growth||0.18||0.84|
|7.||Public administration wage growth—industry wage growth||2.17||0.16|
|Industry wage growth—public administration wage growth||9.79*||0.004|
|8||Public administration wage growth—real estate wage growth||2.68||0.12|
|Real estate wage growth—public administration wage growth||4.71*||0.04|
|9||Public administration wage growth—financial services wage growth||1.70||0.23|
|Financial services wage growth—public administration wage growth||5.18*||0.03|
20. The tests thus provide only very limited evidence that wage increases in public administration have, so far, influenced other sectors of the economy other than those of closely related sectors such as health and education. However, wage increases for the period as a whole have, in fact, been quite similar across different sectors, except in the rapidly developing financial services and real estate sectors. But, even in these sectors wage increases have been converging in recent years.
21. The results of this study suggest that the rapid growth in wages that has occurred in the past few years has played an important role in generating inflationary pressures. The channel, as expected, is through the non-tradable component of the CPI which has increased much more rapidly than prices for the tradable component. The tests for monetary accommodation are somewhat weaker but suggest partial indirect accommodation of the credit expansion (from domestic and foreign sources) financing the wage increase as part of the more general problem of offsetting the effect of capital inflows on the growth of monetary aggregates.
22. In the light of these results, a reduction in inflation would be closely linked to developments in wages in the Czech Republic. The underlying cause of the problem—weak corporate governance—can be successfully addressed only through acceleration in enterprise restructuring, which will require the effective privatization of enterprises that still remain under state control. In the meantime, there is probably room for the state to exercise its ownership rights in state-controlled enterprises so as to limit wage increases. Furthermore, it would be important to contain wage growth in the government sector which acts as a signal of acceptance wage increases and has a demonstration effect on other sectors of the economy.
1. The cost of sterilizing capital inflows and restructuring small banks, notwithstanding substantial seigniorage revenue reflecting a rather high level of reserve money (equivalent to about 14 percent of GDP in 1995) are expected to weaken significantly the CNB’s profitability in 1996. This note identifies the major determinants of the CNB’s profit position and quantifies their effect. In the final section, the main concepts of this note are related, in a stylized form, to the central bank’s balance sheet and income statement.
Determinants of central bank profits
2. Central bank profits can be defined, for the purposes of this note, as seigniorage revenue minus the costs associated with (i) the conduct of monetary policy, (ii) quasi-fiscal operations, and (iii) other operations.
3. Seigniorage measures the potential revenue that the central bank can generate by investing the counterpart of reserve money (currency and reserves) at the market interest rate minus the interest paid on reserve money (zero in the case of the Czech Republic). Formally, it is given by II*= B.RB where II*, B and RB denote respectively seigniorage, reserve money and the market interest rate; the latter being approximated by the three-month PRIBOR. Seigniorage revenue thus defined has been relatively large in the Czech Republic, and is projected to rise from Kc 18 billion (1.5 percent of GDP) in 1995 to Kc 26 billion (1.8 percent of GDP) in 1996 (Chart 1 and Tables 1 and 2). This is based on the assumption that reserve money would rise by 25 percent and that the interest rate differential would rise by 2 percentage points to 8.5 percent in 1996. The high required reserves ratio (raised in August 1996 from 8.5 percent to 11.5 percent) in conjunction with the high monetization of the economy (broad money is equivalent to about three quarters of annual GDP) explain the relatively high seigniorage revenue.
CHART 1czech republic PROXIMATE DETERMINANTS OF CNB PROFITS
Source: Staff calculations.
|In percent of reserve money||In percent of GDP|
|Net profits, II||4.4||−0.1||0.6||0.0|
|Sterilization, total cost||−5.5||−8.5||−0.8||−1.3|
|Unsterilized foreign assets,|
|Lending to banks||−0.7||−0.9||−0.1||−0.1|
|Bank restructuring, -C||−1.6||−2.4||−0.2||−0.4|
|Operating costs, -0||−0.9||−1.1||−0.1||−0.2|
|Eq.(4) breakdown||Eq.(4) breakdown|
|In billion kc||In percent of GPP||In percent of reserve money||Balance 1/|
|Yield (Percent)||Revenue (Billion kc)||In billion kc||In percent of GDP||In percent of reserve money|
|Sterilized with CNB bills and deposit||114.9||−7.0||−0.6||−4.1||153.5||−12.6||−0.9||−5.9|
|Sterilized with required reserves||40.1||−2.4||−0.2||−1.4||66.9||−5.5||−0.4||−2.6|
|Claims on banks||71.0||9.2||6.5||−1.2||−0.1||−0.7||74.0||9.5||7.0||−2.0||−0.1||−0.9|
|NPF and SPT deposits||−54.5||10.9||−5.9||−54.8||12.2||−6.7|
|Other net assets (residual)||−34.7||5.8||9.6||0.8||5.7||−29.9||6.0||9.6||0.7||4.6|
|Provisions for bad claims||−2.7||−2.7||−0.2||−1.6|