Czech Republic: Selected Issues
Author: International Monetary Fund
Publication Date:
22 May 1998
eISBN:
9781451810011
Language:
English
Keywords:
ISCR; CR; price; interest rate; economic activity; lending rate; depreciation pressure; controlling interest; nominal exchange rate; Exchange rates; Wages
Download PDF (495.5 KB)

This Selected Issues paper examines recent developments in inflation and its key determinants in the Czech Republic, with particular focus on the role of wages. A simple analytical framework is presented that relates inflation to wages, import prices, and money, and the interaction of inflation with these variables is then examined empirically in the context of a vector autoregression model. The findings confirm the critical influence of wages, exchange rate changes, and money growth. The paper also analyzes developments in the public finance.

Abstract

This Selected Issues paper examines recent developments in inflation and its key determinants in the Czech Republic, with particular focus on the role of wages. A simple analytical framework is presented that relates inflation to wages, import prices, and money, and the interaction of inflation with these variables is then examined empirically in the context of a vector autoregression model. The findings confirm the critical influence of wages, exchange rate changes, and money growth. The paper also analyzes developments in the public finance.

Czech Republic: Summary Indicators

article image
article image
Sources: Data provided by the Czech authorities; and staff estimates.

Includes central government, local authorities, National Health Fund.

Average rate in last quarter.

January-September 1997.

I. Introduction

1. After achieving early and decisive progress in stabilization and structural reform, the Czech Republic has experienced large macroeconomic imbalances in the last few years. Large capital inflows in 1994-96 complicated monetary management under a fixed exchange rate regime and stimulated domestic demand, while weak corporate governance fueled wage growth. As a result, the current account deficit widened sharply, to 7½ percent of GDP in 1996, and inflation persisted at levels higher than in the main trading partners. Real GDP growth picked up strongly in 1995 to nearly 6 percent, but slowed to about 4 percent in 1996 (Summary Indicators and Figure 1). The investment ratio rose mainly on account of infrastructural and environmental investment, while the savings ratio declined owing to the rapid growth of real wages, which eroded enterprise savings and also encouraged consumer spending on the expectation that these gains would be sustained.

Figure 1
Figure 1

CZECH REPUBLIC: SELECTED ECONOMIC INDICATORS, 1993-97

Citation: IMF Staff Country Reports 1998, 036; 10.5089/9781451810011.002.A001

Sources: Czech Statistical Office; and Fund staff estimates.

2. The external position deteriorated further in the first quarter of 1997, leading to a foreign exchange crisis in late-May 1997. Fiscal contraction, monetary tightening, increased exchange rate flexibility and strengthened foreign demand all contributed to restoring order in the foreign exchange market and to a narrowing of the external deficit in the second half of the year. However, developments in the domestic economy were on the whole disappointing in 1997.

3. Investment was almost stagnant in the first quarter, and declined as the year progressed. This kept real GDP growth to an estimated 1–1½ percent in 1997, despite a strong recovery of exports. Consumption also weakened in the second half of 1997. Extensive floods in July caused physical damage valued at 4 percent of GDP and lowered output growth by ½ percentage point. Partly as a result of the economic slowdown and further progress in restructuring, unemployment rose to 5¼ percent at end-1997, from 3½ percent a year ago.

4. The 12-month rate of inflation reached 10 percent at end-1997, up 1½ percentage points from a year ago, owing to larger increases in administered prices. “Core” inflation—which excludes administered prices and the effects of indirect tax increases—was 7½ percent, little changed from the previous year, as the effects of the koruna depreciation and of the wage deceleration roughly offset each other.

5. The pace of wage growth slowed in 1997, but remained high in relation to productivity gains (see Chapter II). Specifically, nominal wage growth in the enterprise sector decelerated by an estimated 4 percentage points to 13 percent in 1997—with a slight deceleration also between the two halves of 1997. This reflects several factors: lower enterprise profitability, rising unemployment, and a relatively low inflation rate (under 7 percent) in early 1997 when annual wage agreements were concluded. As a result of rising unit labor costs and the nominal exchange rate appreciation, enterprise profitability and external competitiveness worsened further in 1997 Q1. The subsequent decline in relative unit labor costs appears to have restored competitiveness to about its 1995 level, but data deficiencies may overstate the improvement. Growth in economy-wide nominal wages is estimated to decelerate faster—by almost ½ percentage points to 11½ percent in 1997—owing to a strict incomes policy in the budgetary sphere.

6. The current account deficit narrowed to about 6-6½ percent of GDP in 1997, with all of the improvement concentrated in the second half of the year when the deficit was about 5 percent of GDP (see Chapter VI). Exports began to grow rapidly from 1997 Q2 after five quarters of sluggish performance, mainly reflecting the recovery of economic activity in western Europe, the sharp deceleration of domestic demand, and the beneficial effect of previous foreign direct investment. The growth of imports decelerated sharply—notwithstanding a steep rise in exports with a large import component—suggesting that imports of consumer and, especially, investment goods have been compressed after having risen rapidly for several years. An import deposit scheme, in effect during April-August 1997, restrained imports of consumer goods, but probably not by much.

7. The progressive widening of the current account was eventually perceived by the market as unsustainable, and resulted in a foreign exchange crisis in May 1997. Depreciation pressures on the koruna first appeared in March 1997 and built up gradually amid market concerns about the widening external deficit and the emergence of a significant fiscal imbalance. As confidence ebbed in April-May 1997, the authorities announced two policy packages that aimed at restoring balance in the State Budget and at accelerating structural reform. Nevertheless, there was a speculative attack, triggered by contagion effects from other emerging markets and the government’s public calls for a loosening of monetary policy.1 On May 27, 1997—after 10 days of unsustainable foreign exchange intervention and steep increases in interest rates—the CNB abandoned the exchange rate band for the koruna, which depreciated by over 10 percent below its (former) central parity in the framework of a managed float (see Chapter IV). During June-September, 1997, the CNB took advantage of appreciation pressures, which reflected an unwinding of speculative positions, to gradually lower interest rates and strengthen its foreign reserves. During the last quarter of 1997, political uncertainty and contagion effects from abroad contributed to depreciation pressures, which prompted temporary increases in interest rates and intervention in the foreign exchange market by the CNB. More recently, the market has reacted relatively favorably to the appointment of the new cabinet, while the intensification of the Asian crisis has had little effect on the Czech Republic. As a result, conditions in the foreign exchange market remained relatively calm as of late January 1998.

8. Overall, the capital account is estimated to have recorded a surplus of 3 percent of GDP in 1997; of this, almost one half was in the form of nondebt capital inflows. A net short-term capital outflow of about 2 percent of GDP is estimated for 1997, somewhat larger than in 1996. Total gross external debt is estimated at US$22 billion at end-1997, equivalent to about 40 percent of GDP; of this, US$7 billion was short term, equivalent to 42 percent of the banking system’s short-term foreign assets. The debt service ratio remains relatively low and the Czech Republic enjoys an investment grade sovereign rating by foreign agencies. Official reserves fell to US$9¾ billion at end-1997 (from billion a year ago), equivalent to 3½ months of current account payments and 1⅓ times the level of short-term external debt.

9. The mid-year fiscal tightening and the continued tight monetary policy stance were the main factors contributing to the external improvement. The general government deficit was contained to an estimated 2 percent of GDP in 1997, compared to a deficit of 1¼ percent of GDP in 1996, notwithstanding the impact of floods (about 1¼ percent of GDP) and lower than expected economic activity (see Chapter III). This was made possible by expenditure cuts of 2½ percent of GDP, announced in April-May, which helped improve the underlying fiscal balance (excluding flood costs) by 2½ percentage points of GDP (5 percentage points at annual rates) between the two halves of 1997.

10. Twelve-month broad money growth was kept within or below the 7-11 percent target range throughout 1997—down from almost 20 percent in mid-1996. This was associated entirely with lower capital inflows: the CNB’s net domestic assets turned from strongly contractionary until early 1996 to expansionary on account of lending related to bank restructuring and a reversal of sterilization operations through a reduction in outstanding CNB bills. Interest rates in the interbank market—and to a lesser extent the lending and deposit rates—have trended upwards since the Spring of 1997 in line with increased market uncertainty and the new policy aim of maintaining a relatively stable exchange rate of the koruna against the DM.

11. The pace of enterprise restructuring and financial sector reform has been sluggish. As a consequence of voucher privatization in 1991-94, diffuse ownership and residual state shareholdings have preserved for the state a controlling interest in major enterprises and banks, and progress toward effective privatization of these entities has been relatively slow. (According to official estimates, over 70 percent of GDP in 1997 originated in the private sector, which however is defined to include partially privatized, but still state-controlled, enterprises.) The resulting weak corporate governance—in conjunction with a relatively low unemployment rate—have contributed to rapid real wage growth. Furthermore, sluggish economic activity and high real lending rates (about 7 percent in terms of producer prices) have adversely affected the financial position of banks, and further worsened the quality of their loan portfolios. The central bank has been involved in restructuring of the small banks over the past few years through mergers, liquidations and capital injections to clean up portfolios (Chapter V). In January 1998, the government reached agreement on the sale of the state’s remaining 36 percent share in one of the four major banks. Technical preparations are being made for the sale of the state’s stake in the three other major banks.

1

The first round of expenditure cuts (1¾ percent of GDP) was announced in April; the second round of expenditure cuts (¾ percent of GDP) was announced at the peak of the crisis.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Czech Republic: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 1998: Issue 036
Publisher:
International Monetary Fund
ISBN:
9781451810011
ISSN:
1934-7685
Pages:
158
DOI:
https://doi.org/10.5089/9781451810011.002

CZECH REPUBLIC: SELECTED ECONOMIC INDICATORS, 1993-97