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Czech Republic

Author(s):
International Monetary Fund
Published Date:
May 2012
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CONTEXT

A. Recent Developments

1. The post-crisis recovery stalled in the second half of 2011 as exports lost momentum. The expansion since the 2009 recession was almost exclusively driven by exports, whereas domestic demand stagnated and currently stands about 7 percent below its peak. Labor market improvement has been weak and a moderate output gap remains. As export growth slowed, real GDP declined in the last two quarters of 2011, albeit marginally. As a result, GDP growth for the whole year declined to 1.7 percent from 2.7 percent in 2010.

Post-crisis Growth Performance

(Real GDP, 2008Q3=100)

2. Inflation has risen and was above the target at end-2011, despite subdued demand conditions. Inflation hovered slightly below the 2 percent target during most of 2011, but increased towards the end of the year and spiked to 3.7 percent in early 2012, buoyed by the one-off impact of the VAT adjustment and food and energy prices. Real wages increased by a modest ¼ percent in 2011, implying largely stable unit labor costs.

Main Indicators
2011Q12011Q22011Q32011Q4Latest obs.Date
Real GDP (SA, QoQ)0.50.3−0.1−0.1
Domestic Demand (SA, QoQ)−1.50.91.1−2.7
Net exports (contribution to growth, QoQ)1.8−0.5−1.12.4
Industrial production (QoQ, SA)2.20.8−0.61.5−0.5Feb-12
Inflation (same period prev. year)1.71.81.72.43.7Feb-12
Real wage (percent year-over-year)0.50.50.6−0.4
Unemployment (percent)6.96.86.66.5
Exchange Rate (CZK per EUR, eop)24.524.324.825.824.828-Mar
10 year bond yield (eop)4.13.83.03.63.528-Mar
Source: Haver
Source: Haver

3. The external current account deficit has remained contained. The combination of robust export performance and restrained imports kept the external deficit unchanged from the previous year at 3 percent of GDP in 2011. The trade surplus increased by about 1 percent of GDP. This was largely offset by an increase in the income deficit, which reflects mostly accrued profits on the existing stock of inward direct investment and reached a record 7.3 percent of GDP. Financing of the current account deficit has not been an issue, with two thirds covered by direct investment, mainly comprising retained earnings of foreign-owned firms.

4. The fiscal consolidation has continued apace. The overall deficit in 2011 is estimated at 3.8 percent of GDP, better than previous year’s 4.8 percent. The structural balance also improved by about one percentage point, mainly reflecting expenditure measures such as reductions in the central government wage bill and better targeting of social assistance. The public debt to GDP ratio at 41.5 percent at end-2011 remains manageable and attests to a strong fiscal position. Policies continue to be geared towards additional structural consolidation with a 0.8 percent of GDP improvement planned for 2012, led by a VAT adjustment and expenditure restraint.

5. Monetary conditions have been appropriately supportive of economic activity. The policy rate was cut aggressively during the 2009 crisis, and has remained at 0.75 percent since May 2010. Despite the recent spike in inflation, expectations remain well-contained, while the yield curve is consistent with a stable policy rate in the next few months. The floating exchange rate remains the main shock absorber. The koruna traded in line with the currencies of neighboring countries in 2011, albeit with lower volatility, and depreciated moderately during the fourth quarter of last year, before recovering in 2012.

Exchange Rates versus Euro

(Jan. 5, 2009=100)

6. Heightened global risk aversion has not led to dislocations in domestic markets. The sovereign risk premium increased somewhat in the second half of 2011, but remained well below the highs seen during the 2009 crisis, and compares favorably with regional peers as well as most euro area countries. Reflecting the strong fiscal position, long-term government bond yields in local currency have remained below 4.5 percent even during the episode of global risk aversion in late 2011, and have averaged 3.5 percent in March.

CDS Spreads

B. Outlook and Risks

7. Economic activity is expected to remain flat in 2012 and gradually gain momentum in 2013. The projected recession in the euro area will constrain exports in 2012. Low confidence indicators, coupled with the impact of fiscal consolidation, suggest that domestic demand will remain anemic in the short run. Unemployment is expected to increase marginally, as the output gap widens somewhat. As external conditions, in particular in the euro area, improve from the second half of 2012, activity is expected to pick up, with a balanced composition. Improving external demand will be accompanied by better confidence which will underpin a moderate domestic demand recovery. Inflation is forecast to average slightly above 3 percent in 2012, but below the 2 percent target in 2013. The current account deficit will remain well-contained.

8. The main risks are spillovers from the euro area. Thanks to sound policies and strong fundamentals, the Czech economy appears well positioned to withstand most downside risks (Annex I, Risk Assessment Matrix). However, the close integration with the euro area implies a high risk of spillovers via trade and bank channels. A deeper recession in the euro area and a decline of foreign demand would further depress the export dependent economy (exports to the EU accounted for about 83 percent of all exports and 59 percent of Czech GDP in the last two years). A potential intensification of the sovereign debt crisis in Europe also entails a risk of abrupt deleveraging by (or failures in) euro area banks, which could adversely affect domestic credit conditions and the health of the banking sector at large through parent-subsidiary relationships. Other risks include commodity price shocks and the real estate market cycle.

POLICY DISCUSSIONS

Discussions centered on the appropriate policies to address medium-term fiscal challenges, to ensure financial stability amid challenging external conditions, to safeguard the successful monetary policy framework while keeping policy flexibility, and to enhance the growth potential

Box 1.The Authorities’ Policies and Past IMF Policy Recommendations

The policies implemented in 2011 were broadly consistent with previous IMF advice. In particular, significant progress in reaching medium-term fiscal targets was achieved, while the pension reform helped address longer-term challenges.

Key RecommendationsImplemented Policies
Define additional fiscal consolidation measures, including structural savings in expenditures.Laws on the unification of VAT, as well as pension, healthcare, and social benefits reforms were passed.
Maintain accommodative monetary policy in the face of economic slack.Policy rates have been maintained at historically low levels.
Pursue productivity enhancing structural reforms.The government adopted a strategy for enhancing international competiveness.
Continue to monitor risks to the banking system from credit portfolios and foreign parents.Monitoring of transactions with foreign parent banks was intensifed.

A. Fiscal Policy

9. Since the last Article IV consultation, significant progress has been made in tackling medium-term fiscal challenges and improving the structural balance. During the crisis and its aftermath, the Czech economy experienced a 2.7 percent of GDP increase in the structural fiscal deficit and a 13½ percent of GDP public debt spike from admittedly low levels. Policies since 2010 have aimed to address these developments through higher VAT and excise rates, social assistance reforms, and changes to the pension system, as well as restraint of current expenditure (Box 2). With these policies, the authorities achieved a sizable reduction of the fiscal deficit in 2011, while they remain committed to meeting the general government headline deficit target of below 3 percent of GDP in 2013, as agreed with the European Commission (EC) in the context of the Excessive Deficit Procedure (EDP). As an intermediate step towards this goal, the authorities intend to reduce the headline deficit to 3.5 percent in 2012.

10. However, the economic outlook has weakened, requiring additional measures to counter deteriorating revenue prospects. Since the 2012 budget was formulated based on a more favorable outlook, the authorities are increasingly concerned about missing the fiscal target. In order to make up for possible revenue shortfalls, they announced an expenditure freeze in late February, which would yield an improvement of 0.6 percent of GDP in the 2012 budget result. They intend to reassess the necessary amounts later in the year.

General Government Balance and Debt: 2010–13(Percent of GDP, unless otherwise noted)
2010201120122013
ActualPrelim.Staff proj.
General government balance−4.8−3.8−3.5−3.4
Structural balance−3.9−3.1−2.3−2.2
Real GDP growth (percent)2.71.70.12.1
General government debt37.641.543.945.4
Memorandum
General government balance (budget target) 1/−5.3−4.6−3.5−2.9

From the corresponding year’s budget law, except 2013, which is from the 2012 budget.

Source: Czech Republic authorities; and IMF staff projections

From the corresponding year’s budget law, except 2013, which is from the 2012 budget.

Source: Czech Republic authorities; and IMF staff projections

11. Staff argued that procyclical tightening in addition to the already ambitious consolidation would unnecessarily undermine short-term growth, and recommended letting automatic stabilizers operate fully. Staff agreed on the need for further gradual structural consolidation, but argued that the Czech Republic has the fiscal space to allow automatic stabilizers to work around the baseline outlined in the medium-term budget framework. Under staff projections, the Czech Republic will still be able to meet the budget target in 2012 without further expenditure cuts. Staff recommended, and would have preferred, letting the 2012 budget be executed as is, even if this would result in missing the target. Staff also argued that, if the outlook worsens significantly, the authorities should consider re-pacing the structural consolidation. Of course, this would depend on the continuation of benign financing conditions and any changes should be clearly communicated to the public and carefully fitted into the context of the European Union (EU) commitments.

12. While mindful of staff arguments, the authorities disagreed and considered adhering to preannounced targets as necessary based on financial risks and political commitments. They argued that the fiscal multiplier is very small, given a large demand leakage to imports—a view shared by the staff. More importantly, they stressed that reducing the fiscal deficit below 3 percent in 2013 as originally agreed with EU to exit the EDP, and therefore meeting the 2012 target midway, was critically important for preserving market confidence and keeping bond yields low in a challenging environment. The authorities also noted that the current government had been elected on a platform of fiscal rectitude and the long-term sustainability of public finances, and not meeting the headline targets could be construed as going against these commitments.

13. Consolidation is set to continue in the medium term. The government policy statement of 2010 envisaged a balanced budget in 2016. In this context, the authorities are considering new additional measures in 2013 and 2014, mainly on the revenue side. These include further adjustment of the VAT rates and a personal income tax increase. Staff considered that if the defined contribution component of the pension system (the second pillar) is introduced as planned in 2013 with associated revenue shortfalls for the budget (Box 2), the unchanged nominal target defined by the EDP could imply an overly tight fiscal stance that year constituting a total structural adjustment of 0.5 percent of GDP. Authorities took notice, but noted the need to weigh the short-term impact against the longer-term benefits of instituting the second pillar, e.g. giving workers more control over their retirement plans.

Measures under consideration (2012-14)Estimates of savings

(percent of GDP)
Readjusting VAT rates0.35 - 0.45
Introducing a new PIT bracket for high incomes0.08 - 0.10
Increase in PIT rate0.30 - 0.40
Introducing a carbon tax0.05 - 0.10
Temporarily change in pension indexation formula0.30 - 0.50
Source: Authorities’ plans and estimates.
Source: Authorities’ plans and estimates.

14. The authorities are revamping the fiscal policy framework in the context of the new Stability and Growth Pact (SGP). The authorities are considering various options for a fiscal rule to be enshrined in the constitution. Staff suggested a structural fiscal balance rule for the general government with a debt brake in the form of compensatory corrections for ex post deviations from the target. Such a rule would comprehensively guide fiscal policy and be fully consistent with the new SGP (Box 3). The proposal currently under consideration by the government would serve the same broad objectives, though with additional complexity and fragmentation that could complicate an effective implementation of the rules. A fiscal council, also under consideration, would contribute to the transparency and accountability of the framework. The authorities’ strong commitment to long-term fiscal sustainability does not conflict with what is stipulated in the “Fiscal Compact”, which the Czech Republic has not signed due to legal considerations, specifically the reference to EU institutions in a treaty outside the EU framework.

Box 2.Fiscal Implications of the Pension Reform

Parametric changes in the pension system have improved its sustainability considerably. The reform adopted in 2011 increased the statutory retirement age, reduced disability pensions, curtailed the rate of progressivity in the assessment of contributions, and extended the insurance period required for accessing a full pension. These and other changes to the pay-as-you-go (PAYG) system have cut its long-term deficits from 4-5 percent to around 2 percent of GDP in 2040-60, and to less than 1 percent of GDP from 2070.

The reform will also introduce a voluntary defined-contribution “second pillar” of the pension system. For those who volunteer to participate, 3 percentage points of the current public social security contribution of 28 percent of wages will be diverted to personal accounts, implying lower budgetary revenues. Each insured person will have to add to this an additional 2 percentage points from his/her own funds. The fiscal impact of this in terms of the PAYG deficit is estimated to be CZK 10 billion in 2013 (about ¼ percent of GDP), and additional CZK 5 billion for both 2014 and 2015, although there is significant uncertainty around these estimates as they depend on behavioral assumptions.

Balance of Pension System

(Percent of GDP)

Source: Czech authorities.

Box 3.The Current Fiscal Framework of the Czech Republic and Options for a Fiscal Rule

The current fiscal framework contains several standard elements necessary for effective medium-term planning, but it also has some weaknesses. The medium-term budget framework (MTBF), which is a three-year rolling budget for the general government, is the main source of guidance for the annual budget preparation. Through the MTBF, the nominal expenditure ceilings for the central government budget and six state funds are derived. While the expenditure ceilings do not cover local governments and social security funds explicitly, local governments are usually expected to prepare a balanced budget. However, the framework has important weaknesses, notably lack of a durable fiscal anchor, weak enforcement and independent monitoring, and limited coverage.

The authorities are in the process of revamping the fiscal framework. The authorities’ ongoing discussion on the overhaul of the fiscal framework, which gained urgency from the new EC directive regarding the public finances, provides a good opportunity to introduce an effective mechanism to safeguard fiscal sustainability, to mitigate the procyclical bias of fiscal policy, and to ensure compliance with the new EC fiscal framework.

Staff views a structural balance rule with a debt brake and an escape clause as an appropriate option for the Czech Republic. This rule would help achieve the twin goals of fiscal policy by striking a balance between fiscal sustainability and cyclical flexibility. Under this rule, fiscal sustainability will be ensured through a close alignment of the mediumterm fiscal target with the ultimate objective of debt stabilization, as well as the automatic correction mechanism (debt brake) for past unanticipated deviations. The structural balance rule can also allow full operation of automatic stabilizers, and it would be fully in line with the supranational rules that the Czech Republic is committed to. While estimating the output gap in a transparent and robust manner will be the key challenge in implementing this rule, the strong institutional and analytical capacity of the Czech government would support this.

The Ministry of Finance currently considers a framework with multiple targets, all of which will be enshrined in a constitutional act. The current proposal under consideration envisages imposing separate numerical constraints for general government, central government, local government, and health insurance funds. While these rules appear to be sensible individually, there is a significant risk of a budget fragmentation, by which rules could complicate the annual budget process with mutually inconsistent targets. The complexity of the proposal would also be detrimental to the transparency and accountability of the fiscal framework.

The effective implementation of the fiscal rule will also depend on its transparency and accountability. In this regard, broader reforms are highly warranted, including to provide stronger legislative support, effective monitoring and enforcement mechanism, and clear understanding of roles and responsibilities. Specifically, a constitutional amendment to outline the principles of debt stabilization, together with an introduction of new ordinary laws that define the operational details of the fiscal rule, would confer more stability to the fiscal framework. A borrowing constraint on local government budget would be useful to make local fiscal policy fully in line with the overall national goals. A fiscal council that monitors compliance with the rule and produces independent forecasts would also contribute to greater transparency and accountability of the framework.

B. Monetary Policy

15. Historically low rates remain appropriate in the context of the forwardlooking inflation targeting framework and the negative output gap, and an easing bias may usefully complement this stance. Inflation is projected to overshoot the inflation target of 2 percent in 2012 and reach 3.5 percent. However, this is mostly due to the VAT adjustment, which is beyond monetary policy’s influence. Commodity prices are the main source of inflation in the period ahead. There are no signs of demand-side inflation pressures, and wage growth is subdued against still high unemployment. Medium-run inflation expectations have continued to converge towards the target. Staff projects that inflation will fall slightly below the target in 2013, and euro area developments and fiscal tightening highlight further downside risks. Against this background staff sees merit in shifting to an easing bias to sustain the benefits of a strongly expansionary monetary policy.

16. The Czech National Bank (CNB) sees risks to inflation as broadly balanced and maintains a neutral bias. The consensus view of the CNB at the time of the discussions was that the current high rate of inflation and the koruna posed upside risks, while the negative output gap posed downside risks. Individual Board members saw the balance of risks in slightly different shades. Since the discussions, the koruna has appreciated and is no longer seen as an upside risk for inflation, but commodity prices have risen rapidly in the same period to emerge as a short-term inflationary factor. The authorities agreed that there are no emerging macroprudential risks associated with the low rates, as lending remains subdued across categories and asset prices remain within historical norms. The authorities reiterated the benefits of a flexible policy stance, including the possibility of further easing if downside risks intensify.

17. Given the low policy rate, staff discussed with the authorities options for unconventional policy measures in the context of disinflationary adverse scenarios. The options include a commitment to keeping policy rates low for an extended period, quantitative easing, and intervening in the foreign exchange market. Staff argued that the principal considerations in choosing among the instruments are their effectiveness and the ease of return to the standard inflation targeting framework, which served the economy very well. A systemic liquidity surplus in the banking system and already low long-term rates suggest that the first two tools are likely to be limited in effectiveness. Given the importance of the exchange rate channel for the economy, staff suggested the possible use of regular and preannounced foreign exchange interventions, in particular, in case the exchange rate fails to fully respond to negative shocks. Reserves are adequate but not high by the standard metrics and can accommodate such interventions. Unsterilized interventions can both expand the monetary base and limit currency appreciation. The authorities broadly agreed with these considerations, while noting that they saw the likelihood of such a disinflationary environment rather low.

18. The free floating exchange rate regime continues to function as a factor of support for macroeconomic stability. The exchange rate has functioned as the main absorber of external shocks, and together with limited foreign exchange mismatches, it has facilitated the implementation of an independent and effective monetary policy. Staff and the authorities agreed that the koruna exchange rate is broadly in line with its fundamentals. This is confirmed by a stable market share in world markets, a moderate current account deficit, a relative price level that is consistent with the country’s income level, as well as the estimates based on the CGER methodology (Box 4). The government has not announced a target date for euro adoption.

Box 4.External Sector Assessment

  • The koruna has continued on a long-term appreciation trend. Following the large swing in 2008-09, the koruna has sustained a moderate appreciation trend in both nominal and real terms, with fluctuations around this path coming from global risk sentiment. ULC-based real exchange rate growth has been more subdued suggesting that a large part of the appreciation is absorbed by favorable wage productivity dynamics.
  • Despite the long-term appreciation trend, Czech Republic’s price level seems to be in line with what would be expected given its income level.
  • Exports grew at a sufficient pace to keep market share stable in the last three years. Following earlier robust gains, market share of Czech exports has broadly stabilized in the last three years.
  • Persistent current account deficits have led to a deteriorating net foreign asset position. Despite consistent trade surpluses, large income transfers on the stock of direct investment lead to a moderate current account deficit. In recent years, NFA has deteriorated under the influence of current account deficits, but not at a pace or scale that would suggest competitiveness problems. In addition, NFA excluding the direct investment stocks is positive, which mitigates the vulnerabilities associated with the external position.
  • Staff estimates based on the CGER methodology suggest the koruna is broadly around equilibrium value as well.
Estimates of REER Mis alignment, 2011
Macroeconomic Balance Approach−3%
External Sustain ability Approach−5%
Equilibrium Real Exchange Rate Approach9%
Overall Assessment (Fall 2011)About 0%
Source: IMF staff estimates.
Source: IMF staff estimates.

Source: Haver, and IMF staff estimates.

Share of World Imports

(In percent of total imports)

Sources: IMF Direction of Trade Statistics

Sources: CNB and IMF staff estimates

C. Financial Sector

19. Czech banks are highly profitable and self-financed with low loan-to-deposit ratios and strong capital and liquidity buffers. The banks can comfortably satisfy current and future supervisory standards, specifically Basel III and CRD4. Non-performing loans have increased after the 2009 crisis, but remain manageable at 5.5 percent. Subdued credit growth is mostly due to prudence in both demand and supply sides of the credit market. Consumers and corporates are not overly indebted by international comparison and banks continue to expand in profitable lending activities, all of which bodes well for future deepening of the financial sector. Recent events in the euro area financial system have not changed this broad picture. Domestic credit growth increased to about 5½ percent in 2011, lending margins declined, and loan growth outpaced deposit growth, suggesting little deleveraging. Moreover, comfortable liquidity and very limited currency mismatches in final borrowers’ balance sheets suggest that the system is robust. Sharp property price falls could pose a risk, but the recent moderation of price declines and the fact that a large part of the increase in recent years is undone suggest the likelihood of such an outcome is low. An increase in new mortgage loan volumes is also supportive of the real estate market.

Key Characteristics of the Czech Banking System
2008200920102011
Number of banks37394144
of which foreign controlled30323336
Assets (percent of GDP)105.1109.5111.0117.5
of which large banks60.563.264.467.3
Client loans to deposits (percent)80.977.878.079.4
of which large banks71.366.765.668.6
Net interest income (percent of assets)2.492.512.522.53
Source: Czech National Bank
Source: Czech National Bank
Financial Soundness Indicators(percent)
200820092010Sep-11
Regulatory capital to risk-w eighted assets11.614.015.315.3
Return on equity20.726.419.718.7
Liquid assets to total assets25.827.129.430.5
Provisions to nonperforming loans57.449.747.949.4
Nonperforming loans to total gross loans2.84.65.45.5
Source: Czech National Bank
Source: Czech National Bank

20. Despite solid fundamentals, the Czech financial system is confronted with a number of risks mainly from external spillovers. With banks largely owned by euro area parent groups, the main risks to the sector stem from negative developments in the euro area, which would affect the Czech subsidiaries. The Czech banking system has a net external creditor position, which reduces the risks of rapid deleveraging1. Group-wide capital scarcity could set a higher threshold for new lending in terms of profitability and risk taking. Funneling capital and liquidity out from the Czech subsidiaries to parent group banks is another plausible scenario, but only under extreme stress and uncertainty, as the stakes in the Czech subsidiaries carry significant value on a stand-alone basis. The CNB is aware of these risks, and has tightened the reporting requirements on transactions between parents and subsidiaries. A range of stress tests run during the FSAP mission found that the system would be resilient against these key risks, using simulated shocks including a large drop in GDP (about twice the magnitude of the 2009 crisis), a protracted stagnation, and failures in parent banks. Only when a large GDP drop and parent bank failures2 are combined, does the system-wide capitalization fall below the regulatory limit—a shortfall of about 2 percent of GDP.

21. The authorities are aware of these risks, and have adequate facilities to address them. In the last few years, the CNB has strengthened macroprudential supervision by setting up a separate department and allocating more resources as a first defense against systemic risks, including external spillovers. The authorities have strengthened the liquidity provision framework since the 2009 crisis with a standing collateralized liquidity window, and stand ready to take bank-specific prudential measures, should the need arise.

22. The FSAP exercise confirmed the underlying soundness of the Czech financial system and institutional framework, but made several recommendations aimed at further improvements. Staff found the CNB to be an effective integrated supervisor overall, but highlighted the need for more intensive supervision.

It also recommended operationalizing the bank resolution framework, strengthening the macro-prudential policy framework to ensure that warning signals would be translated into policy actions quickly, and broadening the mandate of the CNB (Box 5).

23. The authorities welcomed the mission’s recommendations, and have already begun implementation in many areas. The amendments to the CNB Law broadening the CNB’s mandate have been sent to the parliament and are expected to be adopted later in 2012. Legal amendments regulating the activities of credit unions are also under preparation. The limit on banks’ exposures to parent groups are planned to be reduced from 100 percent to 50 percent of bank capital from July 2012. Work is also ongoing to strengthen the macro-prudential policy framework and stress testing.

Box 5.FSAP Main Findings and Recommendations

While the Czech financial institutions were found resilient to the effects of ongoing global crisis, it was also identified that several elements of the financial policy framework need strengthening.

CNB mandate. The legal setting for the CNB financial stability mandate should be strengthened. Elevating the financial stability mandate beyond a supporting element of achieving the price stability will establish a stronger accountability framework for all of these functions.

Prudential requirements. The decision of the CNB to introduce extraordinary reporting requirements of liquidity position and exposures between Czech banks and their foreign parents was a welcome development. In the event of a material deterioration in the condition of foreign parent banks, the CNB should consider deploying firm-specific prudential measures, such as increased capital and liquidity requirements, pre-approval of significant intra-group transactions, and reducing the intra-group limits.

Supervisory resources. The regulatory and supervisory framework was found generally sound. The assessment of the Basel Core Principles for Effective Banking Supervision noted that the regulation and supervision of banks has been markedly strengthened since the 2001 FSAP. A few weaknesses that were identified related mainly to inadequate resources of the CNB.

Macro-prudential policy framework. Several recommendations were made in order to strengthen the macro-prudential policy framework, particularly by formalizing the decision-making mechanism on macro-prudential policy issues.

Crisis management and bank resolution. Several elements of the crisis management and resolution framework need strengthening. In particular, the deposit insurance fund should be enlarged, its payout triggers should be clarified, and the use of public funds to provide exceptional support to banks should be further operationalized.

D. Structural Issues

24. Accelerating structural reforms is critical for boosting potential growth. Convergence of Czech per capita output towards Germany, an appropriate benchmark, has stalled in recent years. While it is difficult to distinguish this phenomenon from the cyclical factors at this stage, structural factors could also be playing a role. Earlier rapid convergence, underpinned by trade integration, technology transfer, and an inexpensive and skilled labor force, produced a competitive economy with a strong exportoriented manufacturing sector. However, as the economy nears the technology frontier and labor costs converge to Western European levels, it becomes more important to be proactive in seeking new growth areas while monitoring and addressing any growth bottlenecks.

25. Several areas emerge as the key priorities in that regard. International competitiveness surveys and OECD reports highlight cumbersome business regulations, problems with the education system and human capital, persistent rigidities in the labor market, technology and scientific infrastructure weaknesses, low quality of institutions and governance issues as the key obstacles to growth.

26. The government adopted a comprehensive reform strategy to address these challenges. It sets an ambitious goal of making the Czech economy one of the 20 most competitive economies in the world by 2020. The strategy outlines concrete plans for developing infrastructure, strengthening institutions and governance, reforming the education sector, further increasing labor market flexibility, and improving the business climate (Box 6).

27. Implementation will be a challenge. Many line ministries are involved in the strategy, and enhancing cooperation among the ministries and providing centralized monitoring would be pivotal in implementing the reform plans. The authorities also view coordination with the corporate sector as well as universities as critical for implementation.

Box 6.Structural Reform Strategy

The reform strategy adopted by the government in September 2011 calls for result-oriented reforms and empirical evaluation of government policies. To guide the reforms, the strategy authors developed concrete proposals (“scorecards”) for more than 40 projects in the nine main areas (“pillars”) of the strategy. These pillars are innovation, financial markets, labor markets, education, healthcare, macroeconomics, infrastructure, institutions, and enterprise and the market for goods and services. The scorecards set time-tables and assign responsibilities for the key reform measures. Their implementation will be monitored by the inter-ministerial Competitiveness Council.

In late 2011, the government developed a new export strategy targeting diversification of products and markets. The new strategy aims to reduce the reliance on the core European markets, and limit concentration of exports in several key products and large firms. Twelve priority markets for exports have been selected, which comprise Brazil, China, India, Iraq, Kazakhstan, Mexico, Russia, Serbia, Turkey, Ukraine, the United States, and Vietnam. In parallel, the strategy calls for strengthening the export-financing institutions to support small and medium-sized exporters.

STAFF APPRAISAL

28. Since the last Article IV consultation, significant progress has been made in tackling medium-term fiscal challenges. Staff welcomes the authorities’ resolute implementation of the pension reform, including the retirement age increase and other parametric changes to the PAYG system, which was accompanied by raising the preferred VAT rate from 2012 as an intermediate step towards the unification of the two rates in 2013. Continuation of pension, health, and tax reforms is important for securing long-term sustainability of the public sector.

29. Short-run fiscal policy needs to strike a balance between consolidation and avoiding an overly contractionary stance. Staff believes that letting automatic stabilizers operate fully in 2012 to accommodate any cyclically driven revenue shortfalls is appropriate. Moreover, if the outlook worsens significantly, the planned fiscal consolidation could be repaced as well, particularly in 2013. If the defined contribution component of the pension system (the second pillar) is introduced as planned in 2013 with associated revenue shortfalls for the budget, the unchanged nominal targets as defined by the EDP could imply an overly tight fiscal stance.

30. The government’s plan to introduce a fiscal rule is a welcome step for safeguarding long-term sustainability. Given the current manageable level of public debt and sound institutional capacity in the Czech Republic, consideration could be given to a structural balance rule for the general government, augmented with a debt brake. Such a rule would ensure fiscal sustainability while avoiding unwarranted procyclicality, and would be consistent with the new EU fiscal framework. Other types of rules, including the one currently under consideration, may achieve the same broad objectives. However, it is essential for any rule to have an appropriately wide coverage, provide clear guidance to the annual budgeting process, and be consistent with supranational rules. An independent fiscal council would foster an effective implementation of the fiscal rule.

31. Monetary policy is appropriate, although an easing bias could be considered. Consistent implementation of the inflation targeting framework continues to serve the economy well, and inflation expectations remain well-anchored. The policy rate at 0.75 percent for almost two years coupled with market expectations for a continuation of the low rates have provided needed support to the economy without excessive risk taking in any particular financial market segment. Despite some upside risks arising from commodity prices, in view of the likely downside disinflationary effects and the fiscal policy constraints, there is a case for an easing bias.

32. With the already low policy rate, it is important to have strategies for coping with the zero-bound constraint. Given the limited room for conventional monetary policy, the use of unconventional tools may need to be contemplated for scenarios of significant undershoot of the inflation target. Key criteria in deciding among the potential actions should include effectiveness against disinflationary pressures, as well as the ease of reversing them. Given the importance of the exchange rate channel for the economy, foreign exchange interventions may be considered in this regard, in particular, in case the exchange rate fails to fully respond to negative shocks.

33. The Czech financial system has proved resilient to the effects of the global crisis, but spillover risks remain elevated. Despite slow GDP growth at home and financial strains abroad, the banks show good performance, with strong capitalization, solid profits, and ample liquidity. This resilience, which has been confirmed by the FSAP stress tests, reflects to a large extent a relatively conservative structure of bank balance sheets (particularly low loan-to-deposit ratios) and relatively low indebtedness of the corporate and household sectors. Nevertheless, the financial system is facing a number of risks, particularly related to the macroeconomic and financial developments in the euro area, where the parents of major Czech banks are based.

34. The authorities’ efforts to strengthen the financial stability policy framework are encouraging. The CNB has already started to improve bank reporting requirements, to intensify monitoring of transactions between parents and subsidiaries, and to implement many of the FSAP recommendations. It would be important to implement all FSAP recommendations, particularly in the areas of bank supervision and crisis management.

35. Steady implementation of the structural reforms is critical to boost potential growth. The government’s comprehensive reform strategy is a welcome first step for improving international competitiveness. Reinvigorating the “Competition Council” is another important step in the right direction. Implementation of these plans requires sustained efforts.

36. It is recommended that the next Article IV consultation with the Czech Republic be held on the usual 12-month cycle. The Czech Republic is an Article VIII country, and its data provision is adequate for surveillance (Informational Annex).

Figure 1.Czech Republic: Macroeconomic Developments, 2007–12

Sources: HAVER, Eurostat, EMED, and IMF staff calculations.

Figure 2.Czech Republic: Inflation Developments, 2007–12

Sources: Czech Statistical Office, Czech National Bank, Haver.

Figure 3.Czech Republic: External Sector Developments, 2007–12

Sources: Czech Statisical Office, Czech National Bank, and IMF staff estimates.

Figure 4.Czech Republic: Financial Markets

Sources: Bloomberg, Haver, and the Czech National Bank.

Figure 5.Czech Republic: Bank Credit, 2005–12

Sources: CNB and IMF staff calculations.

Figure 6.Czech Republic: Fiscal Developments and Prospects

Sources: Eurostat; Bloomberg, and IMF staff estimates.

1/ Cyclically-adjusted primary balance.

Table 1.Czech Republic: Selected Economic Indicators, 2007–13
2007200820092010201120122013
Prelim.Staff Proj.
Nominal GDP (USD billions)180.5225.4196.2197.7215.3206.0213.6
Population (millions)10.310.410.510.510.510.610.6
GDP per capita (USD thousands)17,54421,71518,73918,81420,44419,51520,196
Real economy (change in percent, unless stated otherwise)
Real GDP5.73.1−4.72.71.70.12.1
Domestic demand6.62.2−5.92.0−1.0−1.41.4
Private consumption4.22.8−0.40.6−0.5−0.31.2
Investment15.51.9−20.85.9−1.6−3.72.7
Exports11.24.0−10.016.411.0−1.26.0
Imports12.82.7−11.616.07.5−3.25.7
Ouput gap (percent of potential output)3.12.8−3.6−2.5−1.9−3.5−3.2
CPI (average)2.96.31.01.51.93.51.9
PPI (average)4.14.5−3.11.35.5
Unemployment rate (in percent)5.34.46.77.36.77.07.4
Gross national savings (percent of GDP)25.426.821.622.121.521.321.8
Gross domestic investments (percent of GDP)29.828.924.025.124.523.423.7
Public finance (percent of GDP) 1/
General government revenue40.338.939.139.340.741.341.2
General government expenditure41.041.144.944.144.544.944.6
Net lending / Overall balance−0.7−2.2−5.8−4.8−3.8−3.5−3.4
Primary balance0.4−1.2−4.6−3.4−2.4−2.0−1.8
Structural balance−1.8−3.2−4.5−3.9−3.1−2.3−2.2
General government debt28.028.734.337.641.543.945.4
Money and credit (end of year, percent change)
Broad money (M3)16.113.60.21.92.7
Private sector credit26.616.10.83.05.5
Interest rates (in percent, year average)
Three-month interbank rate3.14.02.21.31.2
Ten-year government bond4.34.64.73.73.5
Balance of payments (percent of GDP)
Trade balance (goods and services)2.92.74.33.44.25.05.2
Current account balance−4.4−2.1−2.5−3.0−2.9−2.1−1.9
Gross international reserves (US$ billion)34.937.041.642.540.342.944.9
(in months of imports of goods and services)3.53.24.53.93.23.83.9
(in percent of short term debt, remaining maturity)113.5100.1131.6132.6122.8133.5135.9
Exchange rate
Nominal effective exchange rate (index, 2000 = 100)108.1121.6116.3118.7122.4n.a.n.a.
Real effective exchange rate (index, CPI-based; 2000 = 100)108.8125.5120.5122.5125.0n.a.n.a.
Sources: Czech Statistical Office; Czech National Bank; Ministry of Finance; HAVER, and IMF staff estimates and projections.

Assumes unchanged policies

Sources: Czech Statistical Office; Czech National Bank; Ministry of Finance; HAVER, and IMF staff estimates and projections.

Assumes unchanged policies

Table 2.Czech Republic: Balance of Payments, 2007–13
2007200820092010201120122013
Est.Staff proj.
(billions of US$)
Current account balance−7.9−4.8−4.8−6.0−6.3−4.4−4.0
Trade Balance2.21.74.62.85.36.06.5
Exports106.5125.199.1116.7138.5123.0127.2
Imports104.3123.494.6113.9133.2117.1120.7
Nonfactor Services2.94.43.93.93.84.34.7
Receipts17.421.919.420.923.121.323.1
Payments14.517.515.517.019.317.118.5
Factor Income (net)−12.7−10.6−13.2−13.2−15.6−14.8−15.3
Transfers−0.4−0.3−0.20.50.20.10.2
Capital account1.11.62.71.70.81.21.2
Financial account6.45.47.89.55.15.24.7
Direct investment, net9.02.32.05.04.23.32.7
Portfolio investment, net−2.70.08.68.10.40.30.3
Other Investment and Financial derivatives, net0.13.2−2.7−3.40.71.61.8
Errors and omissions1.30.2−2.6−3.1−0.60.00.0
Change in reserves 1/−0.9−2.4−3.1−2.11.0−2.0−2.0
Memorandum items:
Current account, percent of GDP−4.4−2.1−2.5−3.0−2.9−2.1−1.9
Trade balance, percent of GDP1.20.82.31.42.52.93.1
Foreign direct investment, net, percent of GDP5.01.01.02.52.01.61.3
Terms of trade (% change)0.8−1.41.4−2.5−2.3−0.50.0
Gross official reserves34.937.041.642.540.342.944.9
in months of the current year’s imports3.53.24.53.93.23.83.9
as a ratio to the short-term debt 2/114100132133123133136
as percent of GDP19162121192121
External debt, percent of GDP42.237.445.548.347.748.748.6
Sources: Czech Statistical Office; Czech National Bank; and IMF staff estimates and projections.

Changes in reserves reflect off-market conversion of large privatization receipts, EU transfers, eurobond issuance, and sales of accumulated interest.

Remaining maturity basis.

Sources: Czech Statistical Office; Czech National Bank; and IMF staff estimates and projections.

Changes in reserves reflect off-market conversion of large privatization receipts, EU transfers, eurobond issuance, and sales of accumulated interest.

Remaining maturity basis.

Table 3.Czech Republic: The Statement of Operations of General Government, 2007-14 1/(In billions of Koruny)
20072008200920102011201220132014
EstProj.
Revenue1,476.41,498.61,462.01,484.51,550.71,612.41,669.01,749.3
Taxes725.9714.4686.7688.6738.0779.6814.8857.3
Personal income tax155.9142.5136.0135.2151.3145.9151.0158.5
Corporate Income tax171.1161.8132.3127.2130.9132.3145.6152.9
VAT226.8254.8254.0258.8271.9304.6314.0331.5
Excise142.5126.1137.3138.4147.3150.9156.6164.5
Other taxes29.529.127.228.936.745.847.549.9
Social contributions576.7599.2559.7577.8587.6601.1613.7639.5
Grants38.248.877.585.691.491.094.499.1
Other revenue135.7136.2138.1132.4133.6140.8146.1153.4
Property income27.130.331.330.731.033.735.036.7
Sales of goods and services95.2102.9104.098.799.6104.0107.9113.3
Other revenue13.42.92.93.03.03.13.23.4
Expenditure1,503.11,583.51,679.71,665.21,697.01,750.91,806.91,884.2
Expense1,350.31,407.41,487.91,500.71,532.01,579.21,629.11,699.5
Compensation of employees268.6279.6292.9285.6280.0291.5301.6313.4
Use of goods and services218.7227.9238.4234.9239.4249.2257.8267.9
Interest39.839.447.451.255.061.266.271.2
Subsidies60.862.374.771.378.081.284.087.3
Grants37.036.234.132.933.534.936.137.5
Social benefits643.5675.4728.3743.5760.0791.1818.7850.7
Other expenses82.086.672.181.386.270.264.771.5
Net acquisition of nonfinancial assets152.8176.1191.8164.5165.0171.8177.7184.7
Gross Operating Balance126.191.2-25.9-16.218.733.339.949.8
Net lending/borrowing (overall balance)-26.7-85.0-217.7-180.7-146.3-138.5-137.9-134.9
Net financial transactions-26.7-85.0-217.7-180.7-146.3-138.5-137.9-134.9
Net acquisition of financial assets75.832.7-1.5-32.07.77.90.00.0
Currency and deposits76.175.3−57.8−30.1….….….….
Debt securities3.61.93.7−0.6….….….….
Loans−9.7−3.00.12.1….….….….
Equity and investment fund shares−17.3−23.2−8.80.7….….….….
Other financial assets23.1−18.361.3−4.27.77.90.00.0
Net incurrence of liabilities97.1126.8216.3145.0161.7134.7125.7126.4
Currency and deposits0.00.00.00.00.00.00.00.0
Debt securities86.778.5164.9148.0161.7134.7125.7126.4
Loans−6.70.022.05.7….….….….
Other liabilities17.148.329.3−8.7….….….….
Adjustment and statistical discrepancies 2/-5.49.20.1-3.77.6-11.7-12.1-8.5
Memorandum item:
General government debt1,023.81,104.91,282.31,417.71,579.41,714.11,839.81,966.2
Primary balance13.1−45.5−170.3−129.5−91.3−77.3−71.7−63.6
Structural balance 3/−65.6−122.3−168.5−146.3−119.7−89.5−90.9−101.6
Structural primary balance 3/−39.5−93.0−131.5−104.0−73.5−40.1−36.9−42.6
Output gap 3/113.7109.4−133.4−96.1−74.0−136.2−130.7−93.5
Sources: Ministry of Finance and IMF staff estimates and projections.

Assumes unchanged policies.

Adjustments for cash-accrual differences, valuation changes and other discrepancies.

Staff estimates of output gap.

Sources: Ministry of Finance and IMF staff estimates and projections.

Assumes unchanged policies.

Adjustments for cash-accrual differences, valuation changes and other discrepancies.

Staff estimates of output gap.

Table 4.Czech Republic: The Statement of Operations of General Government 2007-14 1/(In percentage of GDP)
20072008200920102011201220132014
EstProj.
Revenue40.338.939.139.340.741.341.241.1
Taxes19.818.618.418.219.420.020.120.2
Personal income tax4.33.73.63.64.03.73.73.7
Corporate Income tax4.74.23.53.43.43.43.63.6
VAT6.26.66.86.97.17.87.87.8
Excise3.93.33.73.73.93.93.93.9
Other taxes0.80.80.70.81.01.21.21.2
Social contributions15.715.615.015.315.415.415.215.0
Grants1.01.32.12.32.42.32.32.3
Other revenue3.73.53.73.53.53.63.63.6
Property income0.70.80.80.80.80.90.90.9
Sales of goods and services2.62.72.82.62.62.72.72.7
Other revenue0.40.10.10.10.10.10.10.1
Expenditure41.041.144.944.144.544.944.644.3
Expense36.936.639.839.840.240.540.240.0
Compensation of employees7.37.37.87.67.47.57.47.4
Use of goods and services6.05.96.46.26.36.46.46.3
Interest1.11.01.31.41.41.61.61.7
Subsidies1.71.62.01.92.02.12.12.1
Grants1.00.90.90.90.90.90.90.9
Social benefits17.617.519.519.720.020.320.220.0
Other expenses2.22.31.92.22.31.81.61.7
Net acquisition of nonfinancial assets4.24.65.14.44.34.44.44.3
Gross Operating Balance3.42.4-0.7-0.40.50.91.01.2
Net lending/borrowing (overall balance)-0.7-2.2-5.8-4.8-3.8-3.5-3.4-3.2
Net financial transactions-0.7-2.2-5.8-4.8-3.8-3.5-3.4-3.2
Net acquisition of financial assets2.10.80.0-0.80.20.20.00.0
Currency and deposits2.12.0−1.5−0.8….….….
Debt securities0.10.00.10.0….….….
Loans−0.3−0.10.00.1….….….
Equity and investment fund shares−0.5−0.6−0.20.0….….….
Other financial assets0.6−0.51.6−0.10.20.20.00.0
Net incurrence of liabilities2.73.35.83.84.23.53.13.0
Currency and deposits0.00.00.00.00.00.00.00.0
Debt securities2.42.04.43.94.23.53.13.0
Loans−0.20.00.60.2….….….
Other liabilities0.51.30.8−0.2….….….
Adjustment and statistical discrepancies 2/-0.10.20.0-0.10.2-0.3-0.3-0.2
Memorandum item:
General government debt28.028.734.337.641.543.945.446.2
Primary balance0.4−1.2−4.6−3.4−2.4−2.0−1.8−1.5
Structural balance 3/−1.8−3.2−4.5−3.9−3.1−2.3−2.2−2.4
Structural primary balance 3/−1.1−2.4−3.5−2.8−1.9−1.0−0.9−1.0
Output gap 3/3.12.8−3.6−2.5−1.9−3.5−3.2−2.2
GDP at current market prices (billions of Koru3,662.63,848.43,739.23,775.23,809.33,902.94,049.84,252.6
Sources: Ministry of Finance and IMF staff estimates and projections.

Assumes unchanged policies.

Adjustments for cash-accrual differences, valuation changes and other discrepancies.

Staff estimates of output gap.

Sources: Ministry of Finance and IMF staff estimates and projections.

Assumes unchanged policies.

Adjustments for cash-accrual differences, valuation changes and other discrepancies.

Staff estimates of output gap.

Table 5.Czech Republic: General Government Financial Balance Sheet, 2007–10(In billions of Koruny)
2007200820092010
Opening balanceTransactionsOEFCrosing Opening balanceTransactionsOEFCrosing Opening balanceTransactionsOEFCrosing Opening balanceTransactionsOEFCrosing Opening balance
Net worth and its changes.............
Nonfinancial assets.............
Net Financial Worth:376.6-21.3219.4574.6-94.1-222.6257.9-217.860.0100.1-177.0-9.0-85.9
Financial Assets1,469.275.8165.01,710.032.7-161.41,581.3-1.556.21,635.9-32.0-9.61,594.3
Currency and deposits317.876.11.5395.475.32.6473.3−57.80.4415.8−30.17.4393.2
Debt securities18.23.6−2.019.71.9−0.920.83.7−0.224.2−0.62.225.8
Loans60.7−9.70.651.7−3.0−8.739.90.1−0.939.02.1−5.635.5
Equity and inv. fund shares793.7−17.3215.3991.7−23.2−162.1806.4−8.859.6857.10.7−10.7847.1
Other financial assets278.823.1−50.4251.6−18.37.7241.061.3−2.6299.7−4.2−2.9292.6
Liabilities1,092.797.1-54.41,135.4126.861.21,323.4216.3-3.81,535.8145.0-0.71,680.1
Currency and deposits0.00.00.00.00.00.00.00.00.00.00.00.00.0
Debt securities790.486.7−2.3874.878.52.2955.5164.9−4.11,116.3148.0−2.61,261.7
Loans159.7−6.7−0.5152.50.00.6153.222.0−0.3174.95.7−4.1176.5
Other liabilities142.517.1−51.5108.148.358.3214.729.30.6244.6−8.76.0241.9
Memorandum items:
Net financial worth (in % of GDP)11.215.76.72.7−2.0
Financial assets (in % of GDP)43.846.741.143.837.5
Liabilities (in % of GDP)32.631.034.441.139.5
o/w foreign liabilities (%)28.4%28.4%29.4%30.3%33.8%
GDP nominal prices3,352.63,662.63,848.43,739.24,252.6
Source: Ministry of Finance
Source: Ministry of Finance
Table 6.Czech Republic: Medium-term Macroeconomic Scenario, 2007–17
20072008200920102011201220132014201520162017
Real sector(change, percent, unless stated otherwise)
Real GDP5.73.1−4.72.71.70.12.13.33.63.63.5
Private Consumption4.22.8−0.40.6−0.5−0.31.23.53.83.83.6
Public Consumption0.41.23.80.6−1.4−1.40.21.11.51.51.5
Investment15.51.9−20.85.9−1.6−3.72.73.63.93.93.9
o/w fixed investment13.24.1−11.50.1−1.2−3.12.73.63.93.93.9
contribution of inventories (percent)0.9−0.5−3.01.4−0.1−0.10.00.00.00.00.0
Exports, goods and services11.24.0−10.016.411.0−1.26.05.25.25.25.2
Imports, goods and services12.82.7−11.616.07.5−3.25.75.25.25.25.2
contribution of net exports (percent)−0.51.00.61.23.21.40.80.60.60.60.6
CPI inflation2.96.31.01.51.93.51.92.02.02.02.0
GDP deflator3.31.91.9−1.7−0.72.31.71.61.71.71.7
Unemployment (percent of labor force)5.34.46.77.36.77.07.46.96.05.55.5
Output gap 1/3.12.8−3.6−2.5−1.9−3.5−3.2−2.2−1.2−0.60.0
Gross domestic savings (in percent of GDP)25.426.821.622.121.521.321.821.921.821.821.9
Public14.413.110.010.611.812.212.212.212.312.412.5
Private11.013.711.611.59.79.19.69.69.69.49.4
Gross capital formation29.828.924.025.124.523.423.723.623.623.623.6
Public finances 2/(in percent of GDP)
Revenues40.338.939.139.340.741.341.241.141.141.141.1
Expenditures41.041.144.944.144.544.944.644.344.043.943.9
Net lending−0.7−2.2−5.8−4.8−3.8−3.5−3.4−3.2−2.9−2.8−2.8
Cyclically-adjusted deficit 1/−1.8−3.2−4.5−3.9−3.1−2.3−2.2−2.4−2.5−2.6−2.7
General government debt28.028.734.337.641.543.945.446.246.646.947.1
Balance of payments(in percent of GDP)
Current account balance−4.4−2.1−2.5−3.0−2.9−2.1−1.9−1.8−1.8−1.8−1.8
Trade balance1.20.82.31.42.52.93.13.13.13.03.0
Services balance1.61.92.02.01.82.12.22.22.32.32.3
Net factor income−7.0−4.7−6.7−6.7−7.2−7.2−7.2−7.2−7.2−7.2−7.2
Current transfers−0.2−0.1−0.10.20.10.10.10.10.10.10.1
Capital account balance0.60.71.40.80.40.60.60.60.60.60.6
Financial account balance4.23.15.45.72.82.11.91.81.81.81.8
Direct investment, net5.01.01.02.52.01.61.30.60.30.30.3
Portfolio investment, net−1.50.04.44.10.20.10.10.10.10.10.1
Other investment & derivatives, net0.01.4−1.4−1.70.30.80.81.31.71.61.6
Errors and omissions, net0.70.1−1.3−1.6−0.30.00.00.00.00.00.0
Change in reserves (− increase) 3/−0.5−1.1−1.6−1.10.5−1.0−0.9−0.9−0.9−0.8−0.8
Sources: Czech Statistical Office, Czech National Bank, Ministry of Finance, and IMF staff estimates and projections.

In percent of potential GDP.

Assumes unchanged policies. On ESA-95 basis.

Changes in reserves reflect off-market conversion of large privatization receipts, EU transfers, Eurobond sales and sales of accumulated interest.

Sources: Czech Statistical Office, Czech National Bank, Ministry of Finance, and IMF staff estimates and projections.

In percent of potential GDP.

Assumes unchanged policies. On ESA-95 basis.

Changes in reserves reflect off-market conversion of large privatization receipts, EU transfers, Eurobond sales and sales of accumulated interest.

Table 7.Czech Republic: Monetary Indicators, 2005–11(billions of koruny)
2005200620072008200920102011
Monetary Aggregates
M21992218924782641275328452994
M11087124014391545166219112042
Quasi Money905949104010961091934953
Net Domestic Assets916121615081666175018302001
Net Domestic Credit to the Government Sector991367223166225335
Domestic Credits to the Rest of the Economy1068128616281890190519622070
Net Foreign Assets107697397097510031015993
Central Bank Accounts
Currency in Circulation264295324366354358378
Net Foreign Assets725659633720770799805
Credit
Private Sector938116614511700172318091923
Corporations525635743848782780828
Households41353170885194010281095
Foreign Currency94119128157147146160
Corporations93118127156146144159
Households1111112
Deposits
Private Sector1525169519042031216222742384
Corporations448520614591611633673
Households1077117412901440155116421711
Foreign Currency158179187191185183188
Corporations92118128125118121128
Households66615866676260
Interest Rates (percent)
Discount Rate1.01.52.51.30.30.30.3
Lombard Rate3.03.54.53.32.01.81.8
Repo Rate - 2 Weeks2.02.53.52.31.00.80.8
PRIBOR - 1 Week2.02.53.62.81.30.80.8
Source: Czech National Bank.
Source: Czech National Bank.
Table 8.Czech Republic: Financial Soundness Indicators (2008–11)(in percent unless indicated otherwise)
200820092010Mar-11Jun-11Sep-11
Capital
Regulatory capital to risk-weighted assets11.614.015.315.415.715.3
Regulatory Tier 1 capital to risk-weighted assets11.112.613.913.814.414.2
Capital to assets5.56.16.56.56.86.5
Profitability
Return on assets1.11.51.31.61.31.2
Return on equity20.726.419.723.919.818.7
Interest margin to gross income65.055.863.162.564.264.3
Noninterest expenses to gross income51.242.046.844.946.446.6
Trading income to total income−4.89.54.66.94.63.8
Personnel expenses to noninterest expenses40.240.539.841.841.441.4
Liquidity
Liquid assets to total assets25.827.129.431.431.430.5
Liquid assets to short-term liabilities70.370.071.176.475.974.4
Customer deposits to total (noninterbank) loans125.6128.2129.6129.6127.7127.1
Foreign-currency-denominated loans to total loans21.821.221.620.620.221.4
Foreign-currency-denominated liabilities to total liabilities16.414.214.314.814.915.4
Sensitivity to market risk
Net open position in foreign exchange to capital3.90.50.42.30.6−0.1
Gross asset position in financial derivatives to capital98.454.043.238.038.254.7
Gross liability position in financial derivatives to capital93.950.941.235.234.548.8
Net open position in equities to capital15.78.38.18.89.39.6
Memo item
Nonperforming loans to total gross loans2.84.65.45.65.65.5
Source: Czech National Bank
Source: Czech National Bank

Annex I - Risk Assessment Matrix

Czech Republic: Risk Assessment Matrix
ShockLikelihoodExpected Impact
Intensification of euro area crisisMediumHigh Lower export demand from the euro area, the market for two thirds of all exports, will negatively affect growth in the Czech Republic. Potential disruptive deleveraging, funneling capital and liquidity out from the Czech subsidiaries, and (at the extreme) outright failures can harm the Czech financial system severely. The stock of portfolio capital is limited on account of small and less liquid asset markets, but rollovers of short-term debt of banks and corporates can become more difficult.
Gradual deleveraging by euro area banksMedium It is possible that even without an intensification of the euro area crisis, euro area parent banks will reduce cross-border lending activities.Low Czech subsidiaries are largely self-reliant in their funding and are profitable. Compared with other host countries, the impact on the Czech Republic should be smaller.
Rapid increases in commodity pricesMediumLow Well-anochored inflation expectations, the negative output gap, and labor market slack should help keep inflationary spikes from turning into sustained wage price spirals.
Sharp falls in property pricesLow Property price declines subsided for the most part, but a renewed decline is still possible, though not very likely. Unsold inventory continue to pressure prices, but mortgages are performing very well thanks to prudent LTV ratios and low interest rates.High The financial system has high exposure to the real estate market through mortgages as well as credit to developers. Widespread losses on these portfolios could lead to financial instability.
Safe-haven inflows to Czech assetsLow The low indebtedness of the Czech Republic may make Czech assets look attractive to those seeking stability. However, the real economy is so tightly linked to the euro area that financial decoupling is an unlikely prospect. In addition, the local asset markets are quite small and not very liquid.High A sharp appreciation would hurt Czech exports, and, under current demand conditions, would lead to a severe disinflationary environment.

Annex II - Debt Sustainability Analysis

Figure 1.Czech Republic: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Sources: International Monetary Fund, country desk data, and staff estimates.

1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ Permanent ¼ standard deviation shocks applied to real interest rate, growth rate, and primary balance.

3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2010, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Table 1.Czech Republic: Public Sector Debt Sustainability Framework, 2007–2017(In percent of GDP, unless otherwise indicated)
ActualProjections
20072008200920102011201220132014201520162017Debt-stabilizing primary balance 9/
Baseline: Public sector debt 1/28.028.734.337.641.543.945.446.246.646.947.1-0.2
o/w foreign-currency denominated2.64.05.66.77.47.98.18.38.38.48.4
Change in public sector debt−0.30.85.63.33.92.51.50.80.40.20.2
Identified debt-creating flows (4+7+12)−0.51.15.75.64.13.12.31.10.70.60.6
Primary deficit−0.41.24.63.42.42.01.81.51.21.11.0
Revenue and grants40.338.939.139.340.741.341.241.141.141.141.1
Primary (noninterest) expenditure40.040.143.742.843.143.343.042.642.342.242.1
Automatic debt dynamics 2/−1.8−0.11.71.41.20.60.0−0.5−0.6−0.6−0.6
Contribution from interest rate/growth differential 3/−1.3−0.32.11.01.10.60.0−0.5−0.6−0.6−0.6
Of which contribution from real interest rate0.20.50.72.01.70.60.90.90.91.01.0
Of which contribution from real GDP growth−1.5−0.81.4−0.9−0.60.0−0.9−1.4−1.6−1.6−1.6
Contribution from exchange rate depreciation 4/−0.50.2−0.40.40.1
Other identified debt-creating flows1.70.0−0.60.80.50.50.50.10.10.20.2
Privatization receipts (negative)−0.3−0.60.00.00.00.00.00.00.00.00.0
Recognition of implicit or contingent liabilities0.20.20.20.30.30.30.30.30.30.30.3
Other (specify, e.g. bank recapitalization)1.80.4−0.80.50.20.20.2−0.3−0.3−0.2−0.2
Residual, including asset changes (2-3) 5/0.1−0.3−0.1−2.4−0.2−0.6−0.8−0.3−0.3−0.4−0.4
Public sector debt-to-revenue ratio 1/69.373.787.795.5101.9106.3110.2112.4113.5114.0114.4
Gross financing need 6/4.86.610.49.39.79.69.49.18.88.68.4
in billions of U.S. dollars8.714.820.318.420.919.720.120.220.220.520.6
Scenario with key variables at their historical averages 7/43.946.248.550.953.255.60.2
Scenario with no policy change (constant primary balance) in 2012–201743.946.347.648.749.850.9-0.3
Key Macroeconomic and Fiscal Assumptions Underlying Baseline
Real GDP growth (in percent)5.73.1−4.72.71.70.12.13.33.63.63.5
Average nominal interest rate on public debt (in percent) 8/4.23.94.34.03.93.93.93.93.93.94.0
Average real interest rate (nominal rate minus change in GDP deflator, in percent)0.91.92.35.74.61.52.22.22.22.22.2
Nominal appreciation (increase in US dollar value of local currency, in percent)16.5−7.49.2−6.2−1.7
Inflation rate (GDP deflator, in percent)3.31.91.9−1.7−0.72.31.71.61.71.71.7
Growth of real primary spending (deflated by GDP deflator, in percent)3.33.53.70.62.50.61.32.52.83.43.4
Primary deficit−0.41.24.63.42.42.01.81.51.21.11.0

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - π(1+g) - g + αε(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - π(1+g) - g + αε(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Figure 2.Czech Republic: External Debt Sustainability: Bound Tests 1/2/

(External debt in percent of GDP)

Sources: International Monetary Fund, Country desk data, and staff estimates.

1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.

3/ Permanent ¼ standard deviation shocks applied to real interest rate, growth rate, and current account balance.

4/ One-time real depreciation of 30 percent occurs in 2012.

Table 2.Czech Republic: External Debt Sustainability Framework, 2007–2017(In percent of GDP, unless otherwise indicated)
ActualProjections
20072008200920102011201220132014201520162017Debt-stabilizing primary balance 6/
Baseline: External debt42.237.445.548.347.748.748.648.949.349.650.30.4
Change in external debt3.6−4.98.12.8−0.51.0−0.10.30.40.30.7
Identified external debt-creating flows (4+8+9)−5.5−6.46.70.0−3.00.4−0.4−0.5−0.3−0.3−0.3
Current account deficit, excluding interest payments3.00.81.62.22.21.10.40.00.1−0.2−0.3
Deficit in balance of goods and services−2.9−2.7−4.3−3.4−4.2−5.0−5.2−5.3−5.3−5.3−5.3
Exports68.665.260.569.675.170.170.471.973.074.275.2
Imports65.862.556.166.270.965.165.266.567.768.969.8
Net non-debt creating capital inflows (negative)−3.0−0.2−1.4−2.6−2.0−1.7−1.3−0.7−0.4−0.3−0.3
Automatic debt dynamics 1/−5.5−7.16.40.5−3.21.00.50.20.00.30.3
Contribution from nominal interest rate1.41.30.90.80.71.11.51.71.72.02.0
Contribution from real GDP growth−1.8−1.02.0−1.2−0.7−0.1−1.0−1.6−1.7−1.7−1.7
Contribution from price and exchange rate changes 2/−5.0−7.43.60.9−3.2
Residual, incl. change in gross foreign assets (2-3) 3/9.11.61.52.72.50.60.30.80.70.61.0
External debt-to-exports ratio (in percent)61.557.375.369.363.669.569.068.067.466.866.9
Gross external financing need (in billions of US dollars) 4/29.537.140.837.638.241.037.739.541.243.144.9
in percent of GDP16.316.420.819.017.819.917.617.918.018.118.3
Scenario with key variables at their historical averages 5/48.744.440.236.332.629.1-5.8
Key Macroeconomic Assumptions Underlying Baseline
Real GDP growth (in percent)5.73.1−4.72.71.70.12.13.33.63.63.5
GDP deflator in US dollars (change in percent)15.021.2−8.7−1.97.1−4.41.60.20.20.2−0.8
Nominal external interest rate (in percent)4.43.92.01.81.62.13.13.63.74.24.2
Growth of exports (US dollar terms, in percent)24.218.6−19.316.017.5−10.74.25.65.55.54.2
Growth of imports (US dollar terms, in percent)25.018.7−21.918.916.6−12.13.85.65.75.64.2
Current account balance, excluding interest payments−3.0−0.8−1.6−2.2−2.2−1.1−0.40.0−0.10.20.3
Net non-debt creating capital inflows3.00.21.42.62.01.71.30.70.40.30.3
B. Bound Tests
B1. Nominal interest rate is at historical average plus one standard deviation48.748.949.550.250.851.90.7
B2. Real GDP growth is at historical average minus one standard deviations48.749.450.551.752.954.61.3
B3. Non-interest current account is at historical average minus one standard deviations48.749.450.551.752.954.50.4
B4. Combination of B1-B3 using 1/2 standard deviation shocks48.749.550.852.253.555.41.1
B5. One time 30 percent real depreciation in 200648.771.071.572.072.573.60.5

Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, ε = nominal appreciation (increase in dollar value of domestic currency), and α = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, ε = nominal appreciation (increase in dollar value of domestic currency), and α = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

1The BIS statistics indicate that foreign banks have a small net creditor position vis-a-vis the Czech banks of about 3% of Czech banks’ balance sheet. However, this arises mainly from a limited geographic coverage.
2The Czech banks have exposures to their parents equivalent to about half of their capital. Stress tests were run using an assumption of system-wide write-offs of 40 percent on these exposures.

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