It is a common perception that among Central and East European countries the Czech Republic has been most successful to date in moving to a market-oriented economy. Macroeconomic developments, especially as regards financial stabilization, overwhelmingly support this view. Inflation has been reduced sharply and is close to single-digit levels. Economic recovery is well under way. A robust balance of payments has made it possible to build up substantial foreign exchange reserves. A strong external position has not only overcome the need for balance of payments assistance, but has enabled the Government also to repay early the entire amount it owed to the International Monetary Fund.

It is a common perception that among Central and East European countries the Czech Republic has been most successful to date in moving to a market-oriented economy. Macroeconomic developments, especially as regards financial stabilization, overwhelmingly support this view. Inflation has been reduced sharply and is close to single-digit levels. Economic recovery is well under way. A robust balance of payments has made it possible to build up substantial foreign exchange reserves. A strong external position has not only overcome the need for balance of payments assistance, but has enabled the Government also to repay early the entire amount it owed to the International Monetary Fund.

The experience of the Czech Republic also stands out among transition economies in a number of other important aspects. The unemployment rate is the lowest in the region and also below that in many countries in Western Europe. The fiscal strains arising from the transformation program have been contained, and the government budget was in surplus in 1993 and 1994. The privatization program is virtually drawing to a close, and, with the completion of the second wave of privatization, about 80 percent of the assets in the economy are in private hands. The credit rating of the Czech Republic in the international capital market has been progressively upgraded and is much higher than that of any other transition economy.1 The Government has been remarkably successful in building and maintaining proreform consensus among the population.

These achievements are noteworthy because the transition to a market economy posed considerable challenges and because the Czech Republic had to cope with the uncertainties and disruptions associated with the dissolution of the former Czech and Slovak Federal Republic (CSFR). From a structural perspective, the former CSFR was much less prepared for reform than several other planned economies in Central and Eastern Europe: the state dominated production; market mechanisms were virtually absent; and trade was heavily oriented toward members of the former Council of Mutual Economic Assistance (CMEA). At the same time that the reform program was being launched, the external environment was deteriorating sharply, as trade with CMEA members shifted to world prices and convertible currencies and economic adjustments or crises in other CMEA countries sharply contracted the CSFR’s traditional export markets. The collapse of the CMEA and the contraction of major export markets presented the former CSFR with a need for a substantial stabilization effort. A stabilization effort was also needed to prevent changes in relative prices, once prices were liberalized, from fueling inflation.

The former CSFR achieved early success in weathering the cumulated effects of a large-scale liberalization and a severe terms of trade shock that was associated with the dismantling of the CMEA trade and payments arrangements. Of course, favorable starting macroeconomic conditions—low inflation, limited monetary overhang, and a small external debt burden (as percent of GDP)—contributed to the early success. But more important to the success was a vigorous pursuit of stabilization policies comprising a pegged exchange rate and restrictive fiscal, monetary, and incomes policies.2 The progress achieved in domestic and external stabilization came under serious threat of being undermined in the second half of 1992 and early 1993 from the uncertainties associated with the dissolution of the CSFR on January 1, 1993 and the early termination of the Czech and Slovak monetary union in February 1993. Through continuing commitment to strong stabilization policies, however, the Czech Government was able to quickly overcome the shock of political and monetary separation and to regain the confidence of the international financial markets.

This paper highlights the salient achievements in financial stabilization and the progress of structural reforms in the Czech Republic and discusses the tasks that still need to be addressed. Economic transformation is far from over. A major task is to press ahead with the restructuring of enterprises. At the same time, the authorities face new challenges in safeguarding the gains of stabilization, especially with growing capital inflows fueling monetary expansion and posing a dilemma to monetary management.

Rebuilding the External Sector

The progressive improvement in the external reserves position, especially since the termination of the monetary union with Slovakia, has been impressive by any standard. Gross official reserves at the end of December 1994 stood at $6.2 billion (about four months of imports of goods and services), compared with a low of $500 million (about 1½ weeks of imports) in February 1993. The rapid rebuilding of external balance reflects strong export performance, growing receipts from tourism, and large inflows of foreign capital.

Reorientation of Exports to Western Markets

Exports to former CMEA members fell precipitously in 1991 with the dismantling of the traditional trade and payments arrangements. But, after a sluggish start, spectacular strides have been made in reorienting exports to Western markets. The share of the European Union (EU) countries in Czech exports has jumped from 31 percent in 1990 to about 54 percent in 1994, with Germany alone accounting for one third of total exports.3 The greater access afforded by the Association Agreement with the EU in March 1992 and a trade agreement with the European Free Trade Association (EFTA) were both instrumental in helping to direct exports away from the former CMEA toward industrial countries. Exports to Western markets continued to grow strongly in 1993, despite depressed demand conditions in major export markets, and in 1994. At the same time, the Czech Republic has been successful in making inroads into new markets and redirecting certain items adversely affected by EU restrictions (e.g., on selected iron and steel products).4 These gains have more than offset the steep decline in exports to Slovakia.

There is no reason to believe that the strong export performance resulted from enterprises selling their products at below-market prices to maintain their cash flow; the terms of trade improved in both 1993 and 1994. The initial depreciation of the exchange rate at the outset of the liberalization program created a substantial competitive cushion for Czech enterprises and helped reorient Czech trade. Although competitiveness has been steadily eroding, a cushion still remains relative to the pretransition period. This is apparent from the developments in unit labor costs in the Czech Republic relative to major trading partners, adjusted for relative producer price inflation—a rough indicator of the profitability of tradables relative to trade partners (Chart 2.1).

Chart 2.1.
Chart 2.1.

Exchange Rate Indicators

(Jan.–Sept. 1990 = 100)

Sources: Czech authorities; and IMF data and staff estimates.1Unit 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.

Studies on the scope for reorienting trade to Western markets (mostly based on the gravity model commonly used to predict trade flows) conclude that the scope for reorientation is much greater for the Czech Republic, given its larger initial dependence on CMEA markets, than for neighboring transition economies.5 Also, the commodity structure of Czech exports appears to be better suited to exploiting the increased access to the EU market than those of its neighboring transition economies. Compared with Hungary and Poland, the share of agricultural products and mineral fuels (notably, coal) in Czech exports is small. With the exception of steel, and perhaps some chemical products, access to EU markets for industrial products is largely unrestricted, while markets for agricultural products and coal are struggling with overcapacity and strict regulations. The Czech Republic also has benefited from new marketing links associated with direct foreign investment, which has led to diversification of its exports. Initially, the surge in Czech exports was confined mainly to intermediate manufactured products, but since 1993 machinery and transport equipment—most of the foreign direct investment in 1991 went into this sector—and miscellaneous manufactured articles have led the growth in exports.

Foreign Capital Inflows

Except for a brief period in late 1992 and early 1993, foreign medium-and long-term capital inflows have grown steadily. Net capital inflows amounted to the equivalent of about 12 percent of GDP in 1994, compared with 5 percent of GDP in the former CSFR in 1991. The nature of these inflows has changed markedly over the past three years. In 1991, the first year of financial stabilization, capital inflows were largely in the form of official balance of payments support from multilateral organizations and foreign bond issues by the central bank. By 1992, as the success of stabilization efforts became apparent and with the start of the privatization process, foreign private sector confidence in the Czech Republic soared; this was reflected in a surge in direct foreign investment. From 1991 to 1992, net foreign direct investment almost doubled to $1 billion. Subsequently, however, direct investment slowed as the focus of the privatization program shifted from direct sales to the distribution of vouchers, and also perhaps on account of weaker activity levels in Western Europe. The slowdown, however, has been more than offset by rapidly rising external borrowing by Czech enterprises: net borrowing rose from $340 million in 1992 to $841 million in 1993, and reached $1.4 billion in 1994. External borrowing by enterprises constituted nearly 40 percent of net capital inflows in 1994, while foreign direct investment and portfolio investment each accounted for about one fourth of the total. Since mid-1994, local governments and domestic commercial banks also have turned to raising money in international capital markets.6

To an extent, external borrowing by Czech enterprises has been influenced by the ex ante cost differential (including the cost of guarantees) between domestic loans and foreign loans,7 but the main factor responsible appears to be the limited availability of long-term credit from domestic banks. The bulk of the borrowing is long term, with maturities of more than five years. No single purpose dominates borrowing; fixed investment, acquisition of real estate, and operating costs account for around one third of total borrowing. With confidence of foreign lenders in the Czech economy growing, enterprises increasingly have been able to borrow without domestic bank guarantees. In 1993, nearly 50 percent of the foreign borrowing was guaranteed by domestic banks, but this share fell to 20 percent in 1994.

Taming Inflation

After an unexpectedly large jump of about 40 percent in the first quarter of 1991, inflation declined rapidly to less than 1 percent a month by July and remained stable until August 1992. Price increases accelerated in the last four months of 1992 and culminated in a jump of the monthly rate of inflation to 8½ percent in January 1993, following the introduction of the value-added tax (VAT). Thereafter, consumer price inflation came down rapidly and was contained at 18 percent for the 12-month period ended December 1993. Excluding the contribution of the VAT and adjustments in administered prices—estimated to be 7 percentage points and 2 percentage points, respectively—price increases in 1993 were about the same as in the previous year. There was virtually no improvement in the underlying rate of inflation in 1994; inflation for the 12-month period ended December 1994 was close to 10 percent (Table 2.1).

Table 2.1.

Selected Indicators

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Sources: The Czech authorities; and IMF staff estimates.

In 1990–91, enterprises with 100 or more employees.

Includes transactions in both convertible and nonconvertible currencies, but excludes transactions with the Slovak Republic. Transactions in nonconvertible currencies converted at prevailing cross-exchange rates.

Figures for 1990–92 are for the former CSFR. In 1993–94, includes privatization revenues provided to the Government by the National Property Fund to finance budgetary and quasi-budgetary operations.

The swift harnessing of the two price jumps was important for preventing the fueling of inflationary expectations and was achieved through tight financial policies. The underlying rate of inflation has tended to remain sticky, mainly on account of the substantial number of relative price changes that are still taking place as part of the transformation process.8 Future progress on reducing inflation is likely to be gradual because important structural rigidities remain in both goods and factor markets. These rigidities persist in part because house rents and tariffs of public utilities still remain subject to price regulation and are substantially below market prices. Rents on public housing are typically one fourth of those on private housing, which too are subject to regulation. It is estimated that full liberalization of energy prices will involve further increases of 45–50 percent for natural gas, 80–85 percent for electricity, and 15–100 percent for central heating, depending on the sort of fuel used by households. The Government’s intention currently is to liberalize gradually these remaining regulated prices over the remainder of the decade.

Output and Employment Performance

Following the introduction of reforms and on account of the external shocks, output suffered.9 The decline in economic activity was concentrated mostly in 1991. Thereafter, for the next two years, real GDP fluctuated around the low level reached in the last quarter of 1991 (Chart 2.2). Economic activity had begun to rebound in the second half of 1992, but the process was interrupted in 1993 by the uncertainties associated with the dissolution of the Czech and Slovak federation and a sharp slowdown in Czech-Slovak trade. In the absence of any further exogenous shocks, a broad-based economic recovery has been under way since early 1994. After suffering a cumulative decline of about 20 percent during 1991–93, measured real GDP is estimated to have increased by 2.6 percent in 1994.10

Chart 2.2.
Chart 2.2.

Output Developments

Sources: Czech Statistical Office; and IMF staff estimates.1Using the U.S. Bureau of the Census X-II multiplicative adjustment method.

The trend in output is dominated by industry, which accounts for about 35 percent of GDP. In 1991, all branches of industry experienced a pronounced decline in output, reflecting the relatively dominant impact of economy-wide factors. The pace of output decline during 1992–93 varied considerably across sectors, suggesting that sector-specific factors may have become increasingly important. In late 1993, the output decline in industry bottomed out in virtually all sectors. In cases where the recovery in 1994 was modest (e.g., textiles, and machinery and equipment), average annual output showed a further small decline because of carryover effects.

The decline in employment was far less pronounced, however, than the decline in economic activity. During 1991–93, the cumulative fall in employment was only 9 percent. The proliferation of small-scale activity in industry and construction—a result of both new entries and the breakup of existing firms—and rapid growth in the trade and services sectors provided a safety cushion against employment losses.11 Notwithstanding the changing pattern of labor deployment, the overall picture is one of slow economic restructuring, especially in industry. Large industrial enterprises (i.e., those employing 25 or more workers) held back on labor retrenchment and were more inclined to cut work hours than the work force in the first year of the reform.12 This is not surprising, given the uncertainties surrounding the reform process, as enterprises may have perceived that the output decline was temporary. In addition, the pressure for downsizing was small, as incomes policy contributed to a sharp decline in product unit labor costs. There was no catch-up in labor shedding in 1992–93, with output and employment declining in parallel. However, employment in industry has continued to decline in 1994, albeit slowly, despite a turnaround in output, suggesting that the behavior of enterprises is getting increasingly market oriented. The reductions in employment in industry have taken place with few closures or bankruptcies.13

A significant feature of the Czech transformation process is that the decline in employment has not been matched by rising unemployment. After peaking at 4.4 percent in early 1992, the unemployment rate declined in the following 12 months and fluctuated between 2½ percent and 3½ percent during 1993–94. It is very likely that many of those who lost their jobs took up employment in the significantly underrecorded services sector, especially in tourism-related activities that have been booming since the introduction of reform. An additional escape valve has been employment opportunities in neighboring Germany and Austria.14 But, by far the most important factor that kept unemployment down, especially in 1991, has been the withdrawal of a large number of workers of pensionable age from the labor force. The number of working pensioners, who accounted for about one tenth of the economically active population in 1990, contracted by over 40 percent in 1991, and the fall continued in the succeeding years, though at a much slower pace. The shift was to a large extent policy induced. Specifically, with a view to facilitating the employment of younger workers, the Government doubled the payroll tax applied to pension age workers at the start of 1991.15

The Government’s “active” employment policies have also served to keep unemployment down, especially since 1992. Since mid-1991, the Czech Republic has had in place special programs to promote employment, the most important of which provide grants and subsidies for long-term jobs, short-term public works type jobs, retraining schemes, and employment subsidies for high school and college graduates. In 1992, the number of persons removed from the unemployment register and placed in various active employment schemes exceeded 125,000 (equivalent to more than half of the total number of unemployed). The scope of active employment policies was narrowed in 1993, as the policymakers felt that the risk of mass unemployment had receded.

Restructuring and Privatization

The slow response of enterprise restructuring to the introduction of market forces and prices can be attributed to a large extent to the Government’s transformation strategy: a program of rapid privatization and leaving the task of restructuring to the private owners. Although the Czech Republic has adopted the fastest possible privatization mechanism, a certain amount of lead time is unavoidable for privatizing state enterprises, given the massive scale and coverage of the operation. During the intervening period, until new managers assume control, it is not surprising if existing managers postpone investment decisions and fundamental organizational changes.

The legal framework for enforcing financial discipline and encouraging enterprise restructuring was put in place only in April 1993. The delay in introducing the bankruptcy law was prompted by the Government’s desire to prevent bankruptcies from interfering with the privatization process itself. As the privatization program was then still ongoing, the law explicitly protects enterprises from bankruptcy proceedings until the transfer of property to new owners. This is a major reason for the relatively small number of bankruptcies thus far. Tüma (1994) notes an additional reason: in some instances, when an enterprise is large and its closure would lead to an intolerable level of regional unemployment or wipe out the windfall wealth of a large interest group, the Government has been reluctant to see bankruptcy proceedings being initiated by the major creditors and has come to the rescue of the enterprise.16 Yet another reason is that banks have not been eager to initiate bankruptcy proceedings themselves because of insufficient loan-loss provisioning for the bad loans in their portfolios.

Privatization of small enterprises was completed in 1992. Privatization of large enterprises has been implemented in two waves and has involved conventional sales to domestic and foreign investors as well as transfers of shares in enterprises to citizens through a voucher scheme. In both waves, the voucher scheme accounted for about one third of the book value of total assets privatized. The first wave was concluded in May 1993.17 The second wave effectively came to an end at mid-November 1994 with the completion of the last round of bidding in the voucher scheme; the shares were distributed to voucher holders in February 1995. With this, an estimated 80 percent of assets in the economy are in private hands.

With new owners of the privatized enterprises expected to play the main role in restructuring and strengthening corporate governance, Investment Privatization Funds (IPFs) have a key role. They hold about 65–70 percent of the shares privatized through the voucher mechanism. Following the completion of the first wave of large-scale privatization, the IPFs have been active in evaluating the situation of enterprises in their portfolios. A priority has been to initiate organizational changes and new marketing arrangements—areas in which the IPFs have ready expertise. Formulation of plans for financial and physical restructuring has proceeded more slowly, with greater focus being placed on more profitable enterprises. In part, this is because of inadequate skilled manpower at the disposal of the IPFs and that much attention was also being devoted to their participation in the second wave of privatization. A common perception, however, is that the close links of some large IPFs to banks may be slowing down the process of enterprise restructuring and that current disclosure rules do not impose sufficient market discipline on these funds. The Government is now reviewing the IPFs and commercial laws, including possible means to strengthen existing requirements for disclosure of financial results of both IPFs and companies.18

Monetary Policy and Financial Sector Reform

Since the introduction of reforms in early 1991, monetary policy has played a key role in financial stabilization of the economy. The reduction in inflation, stability of the nominal exchange rate, and the strengthening of the external reserves position attest to its success. The success is all the more impressive given the challenging environment in which policy has had to be implemented. Disruptions and uncertainties associated with systemic shocks, the short period of time since the introduction of reforms, and change in underlying behavioral relationships all made formulation of the appropriate policy stance difficult.

Monetary Policy Developments

Monetary and credit conditions in early 1991 turned out to be considerably tighter than planned, owing both to the higher-than-expected initial price jump and cautious lending behavior of banks. As the macroeconomic situation stabilized in the second half of 1991, monetary conditions were gradually eased to support economic recovery.

In the latter part of 1992 and early 1993, the conduct of monetary policy was complicated by the uncertainties associated with the dissolution of the former CSFR and the impending termination of the monetary union with Slovakia. Throughout this period, the authorities kept monetary policy on a tight leash. In the period immediately preceding and following the termination of the monetary union, monetary policy focused on eliminating the excess bank liquidity that arose from the large-scale conversion of currency holdings into bank deposits. The policy stance was eased in mid-1993, following several months of favorable external and inflation performance. In the succeeding 12 months, money expanded at a rapid pace—fueled primarily by the strengthening net foreign assets position—and the income velocity of broad money fell sharply. However, with signs of inflationary pressures building up, efforts to tighten monetary expansion were initiated in the third quarter of 1994.

Given a fixed exchange rate regime, strong capital inflows are creating increasing strains on the central bank in the conduct of monetary policy. Since mid-1993, foreign capital inflows have been the sole source of increase in reserve money. Although the task of monetary control has been facilitated by strong fiscal performance and the net creditor position of the National Property Fund (NPF), the Czech National Bank (CNB) has borne the main responsibility for sterilizing capital inflows. However, the CNB has been occasionally reluctant to sterilize too aggressively through open market operations because of the high cost of such operations and increasing evidence that sterilization was becoming less effective.

Czech policymakers have made considerable progress in developing indirect instruments of monetary control. With the removal of direct ceilings on commercial bank credits by October 1992, the primary focus of monetary control shifted to auctions of refinance credit and adjustments in minimum reserve requirements. Since mid-1993, the use of refinance credit auctions has been minimal and, with growing foreign capital inflows, open market operations have become increasingly important. In 1994, the system of monetary management has been based on open market operations, changes in reserve requirements, and, mainly to signal the intended policy stance to commercial banks, adjustments of the discount rate.

Reform of the Banking Sector

The establishment of a healthy commercial banking sector has figured prominently in the transformation program of the former CSFR during 1991–92 and subsequently in the Czech Republic. The efforts to this end have included the introduction of a more effective banking regulation and supervisory regime, the establishment of an efficient payments system, and strengthening the balance sheets of the commercial banks through a combination of both centralized and decentralized approaches.

The centralized operations were aimed at non-performing loans inherited from the days of central planning or incurred on behalf of the state. The measures, which have been spread over time, have included transfers of debt out of individual banks, exchanging poor quality debt for official assets, and providing capital infusion. Excluding debt transfers where assets and matching liabilities were assumed by the Government or the Consolidation Bank (an agency initially set up specifically to clean up the balance sheets of commercial banks, but subsequently converted into a universal bank), total net contributions to banks by the authorities of the former CSFR and the Czech Republic amounted to Kč 132 billion at mid-1994 (equivalent to about 25 percent of bank credit outstanding just prior to the introduction of reforms). Receipts of privatization revenues from the NPF have been an important source for covering these costs.19

The decentralized approach requires banks to bear a major responsibility in accumulating loan-loss provisions and building up their capital base. To facilitate this task, the Government has given limited tax incentives for loan-loss provisions and issued risk classification guidelines and regulations covering credit exposures and capital adequacy. To minimize the moral hazard issues associated with the balance sheet restructuring operations and to strengthen corporate governance of banks, all the large formerly state-owned banks, with the exception of the foreign trade banks, were privatized in the first wave of voucher privatization. The state—through the NPF—retained between 37 and 53 percent of the shares, and the remainder was distributed through the voucher process. To foster competition, a liberal approach was taken to the entry of new private banks. Forty-seven new banks have emerged since the beginning of the reform process, about one half with partial or full foreign participation.

Notwithstanding the progress made in recent years, the banking system still suffers from inefficiencies and is fragile. A major deficiency is the limited maturity transformation by domestic banks, which has encouraged enterprises to borrow abroad. Domestic bank lending in recent years has been mainly short and medium term. Long-term credit (i.e., more than four years) has declined in absolute terms, and its share in total credit fell from 50 percent at the beginning of 1991 to about 30 percent at the end of 1993 and remained at this level in 1994. The reluctance of domestic banks to lend long term reflects their unwillingness to accept a significant mismatch between the maturity structure of their liabilities and assets. Bank deposits also are concentrated in short-term maturities. In 1993, 88 percent of new deposits were either in the form of demand deposits or maturities of less than one year, while total long-term deposits accounted for less than 7 percent of all deposits.20

Inefficiency in bank intermediation is also evidenced in the spread between deposit and lending rates: the average spread during 1992–94 generally has been between 6 and 8 percent. The wide spreads likely reflect the banks’ burden of carrying nonper-forming loans in their portfolios and the task of setting aside loan-loss provisions from net profits. With the recent introduction of a stricter and mandatory reporting system, about 38 percent of bank credit was reported as nonperforming at the end of December 1994, despite the support already provided for the cleaning of bank portfolios.21 The big banks are reasonably provisioned and close to conformity with international supervisory norms, but the small banks have experienced a significant deterioration in the quality of their portfolios, are undercapitalized and do not have adequate loan-loss provisions. In early 1994, three small banks were placed under the special administration of the central bank, and several more began to be closely monitored. To help deal with the situation more effectively, a number of steps were initiated: amendments were made to the banking law to strengthen the supervisory powers of the central bank, and a deposit insurance scheme that covers all banks was introduced.

Fiscal Policy and Reforms

The objective of fiscal policy has been twofold: to reduce the role of the state in the economy and to help stabilize the economy. With the former objective in mind, the Government has implemented the following measures:

  • Drastic cuts in subsidies in 1991 and keeping the level unchanged in nominal terms thereafter.

  • Reform of corporate income taxation. In 1991, the rates of tax on profits were reduced by 10–20 percentage points and the rate structure was simplified. In 1993, a single tax on profits, with a 45 percent rate, replaced three earlier business taxes. The rate was lowered to 42 percent in 1994.

  • Introduction of a sweeping tax reform in 1993, which included introduction of the VAT (at three rates of zero, 5, and 23 percent) and a reform of the income tax (both personal and corporate) and social security systems. A personal income tax on a progressive scale was introduced to replace the previous patchwork of taxes on the wages of large enterprises and various other forms of income. For social security, the old payroll tax of differential rates was replaced by a system where both the employer and the employee contributed.

The tax reforms of 1993 shifted the tax burden from corporate incomes onto wage incomes. Apart from reduced tax rates, additional incentives were provided to the enterprise sector through acceleration of allowed depreciation and tax credit for investment in selected equipment. The new system of VAT-cum-excises expanded the coverage of indirect taxes to services, mitigated the cascading implicit in the earlier turnover tax, and condensed the range of standard tax rates.

On the expenditure side, a number of social safety net programs were introduced in 1990. These included unemployment insurance, support of families in poverty and long-term unemployed, and cash payments to households in compensation for price liberalization. In 1994, programs of aid to low-income tenants and matching subsidies of voluntary, supplemental pension contributions in private plans were introduced. Barring these efforts, the entitlement system—especially, pensions and family allowances—continued to be as before under central planning.

The size of the fiscal balance and the extent of the government disengagement distinguish the experience of the former CSFR and the Czech Republic from that of other formerly planned economies during the initial years of transition. The government budget, as in other transition economies, came under considerable strain following the introduction of reforms. Nevertheless, the Government of the former CSFR managed to contain fiscal deficits to 2 percent of GDP in 1991 and 3½ percent of GDP in 1992. The fiscal accounts for the Czech Republic posted a small surplus in both 1993 and 1994 (Table 2.2).

Table 2.2.

Major Components of Operations of the General Government in the Former Czech and Slovak Federal Republic and the Czech Republic1

(In percent of GDP)

article image
Sources: National authorities; and IMF staff estimates.

Includes central and local governments (budgetary and extrabudgetary operations), the National Health Fund, and the extrabudgetary funds (except NPF), but excludes funds of ministries and gross operations of subsidized organizations.

Includes expenditures on goods and services, transfers to subsidized organizations, and expenditures of the National Health Fund.

Includes only privatization revenues provided to the Government by the NPF to finance budgetary and quasi-budgetary operations.

Revenue as a ratio to GDP in the former CSFR fell by about 9 percentage points during 1991.22 A part of the decline was related to the contraction of tax bases for profit tax, wage-related taxes, and domestic indirect taxes (profits, wages, and domestic consumption had all declined) that accompanied the reforms. A more important contributory factor, however, in sharp contrast to other transition economies, was the discretionary cuts in the rates for corporate income tax and turnover taxes.23 The revenue-GDP ratio stabilized in 1992, and in the Czech Republic in 1993, it rose slightly (compared with the underlying position for the Czech lands in the previous year). This development primarily reflects reversal of some of the earlier endogenous revenue losses. In particular, an increase in real wages boosted wage-related taxes (mainly social insurance contributions). This compensated for the continuing decline in corporate income tax relative to GDP, arising from both discretionary action and endogenous factors. Although real consumption grew in 1992–93, there was no improvement in the share of indirect tax revenues in GDP. This reflects deficiencies in tax administration, especially the inability to capture a significant proportion of the increase in private economic activity.

The most salient feature of the trend in government expenditure is the sharp contraction of subsidies, which fell from 16 percent in the 1990 CSFR to less than 4 percent of GDP in the 1993 Czech Republic. Most of the reduction took place in 1991, as price liberalization removed many of the subsidies implicit in the administrative price structure.24 The Czech authorities also have been successful in containing the other major components of expenditures. The ratios to GDP of current spending on goods and services and of transfers to households have been broadly maintained around 23–25 percent and 13 percent, respectively, since the introduction of the reform program. Transfer payments have been limited by the comparatively mild degree of open unemployment and by a tightening of the eligibility requirements for the new programs of unemployment benefits and compensatory income support. In addition, the benefits of traditional programs, especially child allowances and pensions, were only partially indexed to inflation on a discretionary basis, while the increase in the number of pensioners was relatively small.25 Unlike other transition countries, the Czech Republic has not had to face the pressure of debt-service payments, thanks to its low initial level of public debt.

From 1994, the government budget is being formulated within the framework of a medium-term strategy to achieve the following objectives: reduce the expenditure-to-GDP ratio gradually to 40–42 percent by the year 2000, reduce the tax burden to levels prevailing in industrial countries, and stabilize the nominal level of public debt. As a part of the latter consideration, the objective is to achieve a balanced budget every year.26 Fiscal pressures loom ahead, however, in part because of higher expenditure claims of social benefits. It is the intention of the authorities to restore some of the erosion of pensions in real terms. In addition, both the pension system and health care will face the burden of an aging population, which, at the turn of the century, will cause the ratio of the old to young to increase. To contain these costs, the authorities have started to prepare fundamental reform measures that will address some of the shortcomings of the social security system and other elements of the social safety net. Presently, the structure of transfers is complex, with overlaps between programs. The transfer programs inherited from the days of central planning are deficient in many respects, including minimal redistributional transfers according to means of recipients, virtually no link between contributions and benefits in transfers of a social insurance nature, and almost no use of prices to allocate in-kind transfers, such as health care and education. Pension reforms are scheduled for implementation in mid-1995. Reforms of present state benefits (family allowances, compensatory income support) and general assistance are scheduled for 1996.

Tasks and Challenges Ahead

The Czech transformation process has now entered a new stage. The major tasks in this phase are to consolidate the gains of stabilization and press ahead with restructuring of enterprises. The rebound of economic activity, strong export performance, strong capital inflows in the form of enterprise borrowing abroad, and increasing nonper-forming loans in the portfolio of domestic banks suggest dualism in the industrial sector, with some firms already making necessary adjustments and doing well but others continuing to struggle through the transformation process. For enterprise restructuring to accelerate, the IPFs—the new owners of companies privatized through the voucher scheme—will have to force the pace. Making the IPFs increasingly accountable to their own shareholders through regular and timely disclosure of information would be effective in ensuring that they efficiently manage the enterprises in their portfolios.

It is doubtful that the envisaged transformation of the economy can be achieved without substantial enterprise closures. Rigidities and distortions that are still built into the economy will also need to be eliminated. Unless measures are urgently taken to improve labor mobility from areas of surplus labor to places where new jobs are being created, not only is it likely that regional unemployment from firm closures will be high but also economic growth will be stifled. A chronic shortage of housing currently constrains labor mobility. Priority, therefore, has to be given to accelerating the pace of rent decontrol and taking other measures to attract investment in housing.

Until investment and imports have picked up sufficiently, growing capital inflows are likely to continue posing a dilemma for monetary management. To help alleviate the problems created by capital flows, the authorities have already begun initiatives to eliminate the residual restrictions on external current account transactions and introduce limited additional liberalization of the capital account. The functioning of the financial system clearly needs to be improved, with much of the capital inflows reflecting insufficient maturity transformation and inefficient intermediation by the domestic banking system. Current regulations limit the room for provisioning from pretax profits and treat accrued but unpaid interest on bad loans as taxable income increase the costs of financial intermediation. Removing these distortions should lower interest rate spreads and the domestic cost of capital, thereby reducing the incentive for capital inflows.


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  • Dyba, K. and J. Svejnar, Stabilization and Transition in Czechoslovakia,in The Transition in Eastern Europe, ed. by O. Blanchard, K. Froot, and J. Sachs, Vol. 1 (Chicago: University of Chicago Press, 1994), pp. 93123.

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  • Ham, John, Jan Svejnar, and Katherine Terrell, The Czech and Slovak Labor Markets During the Transition,CERGE Working Paper (Prague: Charles University, Center for Economic Research and Graduate Education, February 1994).

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  • Ministry for the Administration of National Property and Its Privatization, Report on the Privatization Process for the Years 1989 to 1992 (Prague, 1993).

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  • Ministry of Finance, Transformation and Fiscal Policy in the Czech Republic (Prague, 1994).

  • OECD (1994a), Industry in the Czech and Slovak Republics (Paris, 1994).

  • OECD (1994b), Review of the Labour Market in the Czech Republic (unpublished report of the Employment, Labour and Social Affairs Committee, Paris, 1994).

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  • PlanEcon Report, Vol. VIII, Nos. 50–52 (Washington: December 1992).

  • Portes, Richard, Transformation Traps,The Economic Journal,Vol. 104 (September 1994), pp. 117889.

  • Shafik, Nemat, Making a Market: Mass Privatization in the Czech and Slovak Republics,Policy Research Working Paper, No. 1231 (Washington: World Bank, December 1993).

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  • Šujan, I., and M. Šujanova, The Macroeconomic Situation in the Czech Republic,Working Paper No. 46 (Prague: Charles University, Center for Economic Research and Graduate Education, April 1994).

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  • Tüma, Zdeněk, Economic Restructuring and Corporate Insolvency Procedures in the Czech Economy,paper presented at an OECD conference held in Vienna, September 28–30, 1994.

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The Czech Republic is rated BAA3 by Moody’s and BBB-plus by Standard & Poor’s. Both of these ratings have investment grade status and are just one step below an A rating.


The principal features of the reform program of 1991 are discussed in detail in Aghevli, Borensztein, and van der Willigen (1992). Also, see Dyba and Svejnar (1994). The reform program was of the “big bang” type. It included a number of structural measures—almost complete liberalization of prices and the exchange and trade systems, and preparation for a rapid privatization program—supported by a mutually reinforcing package of financial policies. Portes (1994) has argued that there was overemphasis on macroeconomic policy in the reform package, and that the former CSFR did not need to stabilize or would not have done if it had not devalued the koruna excessively. (In the months preceding the introduction of the reform measures, the external value of the koruna had been cut by nearly one half through several rounds of devaluation.) The impact of the main reform measures and the external shocks were, however, very uncertain and difficult to estimate ex ante. Further, as Šujan and Šujanova (1994) note, senior Czech officials believe that for the sake of macroeconomic stability and to limit the costs of the transformation, it was desirable to create the two initial cushions of a depreciated exchange rate and a cut in real wages.


The Czech Statistical Office includes the former German Democratic Republic under Germany and the EU in pre-unification and postunification years. The total export base used to derive the trade shares excludes transactions with Slovakia.


Notable new markets in 1993 included China, which absorbed 10 percent of the increase in exports.


In May 1994, the city of Prague raised $250 million through foreign bond issues. Three large Czech banks, Komercni Banka, Investicni Banka, and Československá Obchodní Banka, have obtained syndicated loans with margins of less than 100 basis points above the London interbank offered rate (LIBOR).


Taking into account the annual cost of domestic bank guarantees, typically 2–4 percent, the interest differential between domestic and foreign loans is about 2–3 percentage points.


For example, the increase in food prices (particularly of meat) in 1994 has been mainly for supply-side reasons, as farmers continue to adjust their production levels following the elimination of subsidies and rises in costs of inputs.


Factors contributing to the decline in output are discussed in Aghevli, Borensztein and van der Willigen (1992), Borensztein, Demekas, and Ostry (1992), and Čapek (1993).


Compared with Poland, the Czech Republic’s decline in activity was marginally higher—perhaps reflecting its greater reliance on CMEA markets—and the onset of recovery took one year longer. This delay in the recovery can be attributed to the impact of the dissolution of the Czech and Slovak federation.


During 1991–93, employment in construction rose cumulatively by 12.5 percent, although output in real terms in this sector in 1993 was below its prereform level, and that in trade, restaurants, and hotels increased by about 17 percent.


In 1991, employment in industrial enterprises with 25 or more workers declined by only half as much as output. Based on various measures of labor productivity, Ham, Svejnar, and Terrell (1994) have noted that hours worked in the economy declined much more steeply than employment during 1990 and 1991, but less so in 1992. A recent OECD (1994a) study also notes that most firms reacted by reducing the number of hours worked.


Since the passage of the bankruptcy law in April 1993, only about 500 bankruptcies have taken place through the end of 1994; most of these were small companies and small entrepreneurs.


Starting from a small base in 1989, the German authorities estimate that there are now close to 50,000 Czechs legally employed in Germany, most of whom commute daily across the border into Bavaria under a special arrangement.


Although a court ruling forced a repeal of the measure in late 1992, the restructuring in the age profile of the employed was an accomplished fact by then. A recent OECD (1994b) study notes that the labor participation rate of women has also fallen significantly since the introduction of reforms. This has been influenced by the difficult re-employment prospects for women out of work and by rising costs for child-care facilities combined with a persistent lack of parttime jobs.


Measures taken by the Government in this regard have typically been in the form of credit guarantees by the National Property Fund, participation in debt-equity swaps by the Consolidation Bank, and other forms of financial and restructuring arrangements with the major creditors.


For details of the Czech privatization program, see Ministry for the Administration of National Property and its Privatization (1993), PlanEcon Report (1992), and Shafik (1993).


Measures under consideration include the following requirements from publicly traded companies: issuing six-month reports, providing frequent information on the market value of portfolios, revealing the names and holdings of shareholders whose stake exceeds 5 percent, and releasing the fees or salaries of directors.


These operations are described in detail in Bélanger and others (1995).


One reason for this behavior may be that individuals, used to only short-term saving instruments available under central planning, have been slow to respond to the increasing range of longer-term bank instruments, notwithstanding the relatively higher rates of return. It is also possible that depositors wish to remain liquid to take advantage of other investment opportunities; for example, the stock market after it becomes better established.


This estimate should be interpreted with caution as it is not risk weighted. On a risk-weighted basis, 24 percent of bank credit was nonperforming at the end of December 1994.


For the “available” general government; that is, not including interindustry transfers conducted through the funds of the ministries (eliminated in 1990) and gross operations of the subsidized organizations.


Factors underlying the weakening performance of tax revenues in the various East European countries are analyzed in a recent study by Bélanger (1994).


Currently, subsidies are devoted mainly to traditional sectors, such as agriculture and mining, and to maintaining prices of central heating and public transportation at below average cost.


The number of pensioners in the Czech lands increased by about 5 percent during 1991–93, far more slowly than in Poland.