I. Overview

1. In the context of the 1999 Article IV consultation discussions, the mission explored in some depth issues relating to the enterprise sector and corporate governance, financial sector performance and restructuring, and medium-term fiscal prospects in the Czech Republic. These issues all play a prominent role at the current conjuncture of the Czech transition process, and the Fund staffs analysis and assessment was summarized in the staff report. The background work is presented in greater detail in this paper—admittedly, it remains rather tentative given the complexity of the issues, and further analysis is required in all areas.

2. Chapter II discusses issues relating to the enterprise sector and corporate governance. This includes an overview and assessment of enterprise performance along with a discussion of the concept of corporate governance and its application in the Czech Republic, including how corporate governance practices compare in an international context. The chapter finds that the enterprise sector has performed relatively poorly in recent years compared to that of other advanced transition economies, and it attributes this in large part to weak corporate governance. In particular, the weak corporate governance has been the result of the ownership structure arising from the voucher privatization program, with strategic investors established in only about one-third of the enterprises, incentive problems surrounding the investment privatization funds, and the ownership of these funds by the major commercial banks. Further, these problems have been exacerbated by an inadequate bankruptcy process preventing the required exit of unviable enterprises. While the regulatory framework has been strengthened considerably over the last couple of years, there remains an urgent need to strengthen enforcement of existing laws and regulations, including not least the regulatory and judicial process starting with the bankruptcy framework.

3. Chapter III discusses issues related to financial sector performance and restructuring. The chapter takes stock of banking sector developments and performance and reviews financial policy and supervisory challenges, including the definition of policies for bank privatization and the appropriate prudential framework. The study finds that there are notable weaknesses in the areas of capital, asset quality, and profitability in the major banks. These problems can be traced to the structures established during the pre-transition period and early transition phase with inadequate or poor privatization of the large banks and many enterprises. The recent weak financial performance of the state-controlled banks reflects the need to provision for or write-off the large stock of non-performing loans, but also a high cost structure and increasing competition from more efficient banks for prime customers. Also, the external environment has deteriorated with the ongoing recession. The structural weaknesses in the bank and enterprise sectors have contributed importantly to the recent dramatic slow down in credit growth and have dampened the effectiveness of the credit channel of monetary policy transmission. Significant progress has been made over the last year in bank privatization with the sale of two of the state-controlled banks, but privatization of the remaining two—which are the largest of the banks—is complicated by their very poor loan portfolio. The optimal strategy needs to consider not only the fiscal cost, but also the cost of time and need to avoid a further deterioration of the banks and the financial intermediation process. Also, the regulatory and supervisory framework for banks has been strengthened markedly over the last year, but further changes are needed to fully comply with EU directives and to strengthen some aspects of banking supervision, notably relating to market risk and consolidated supervision. Further, accounting standards should be enhanced and capital market oversight improved.

4. Chapter IV provides medium-term fiscal projections and discusses their policy implications. The fiscal situation has been deteriorating in recent years, and while part of this is due to the downturn in the economy such that automatic fiscal stabilizers should be allowed to operate, the structural problems in the budget and new spending pressures raise concern about the medium-term outlook for the public finances. Even under possibly optimistic macroeconomic assumptions, projections based on current programs and policies suggest that the fiscal position would develop in a manner inconsistent with maintaining macroeconomic stability and EU accession requirements. Also, there are numerous additional fiscal challenges arising over the medium term, including EU accession related spending on the environment, infrastructure, etc., realization of the large stock of contingent liabilities, potential bank and enterprise restructuring costs, and further down the road the social security system as the population ages. Further, there are risks related not only to the macroeconomic environment, but also potential difficulties in containing discretionary expenditure programs. These additional pressures and risks could render fiscal developments unsustainable. While EU accession would also be associated with fiscal benefits in the form of transfers from the union—and hardly on its own undermine the fiscal situation—fiscal adjustment will inevitably be required, and a medium-term program to consolidate the public finances should be developed as soon as possible. The chapter presents a fiscal reform scenario consistent with the staffs medium-term, structural reform based macroeconomic framework, based on both revenue and expenditure measures and reform. The suggested measures include increasing indirect taxes consistent with EU harmonization and curtailing enterprise subsidies as well as social transfers through reform of mandatory programs.