Czech Republic: Staff Report for the 2001 Article IV Consultation

After three years of recession, the economy grew by 2.9 percent in 2000, supported by a revival of investment in primarily foreign-owned firms and a modest increase in household consumption. Against the background of a still nascent recovery, fiscal policy was expansionary in 2000, with the general government deficit (excluding privatization receipts and bank restructuring costs) increasing by nearly 1 percentage point to 4.1 percent of GDP. Executive Directors noted that flexibility in the conduct of monetary policy is key to ensuring that inflation remains under control.

Abstract

After three years of recession, the economy grew by 2.9 percent in 2000, supported by a revival of investment in primarily foreign-owned firms and a modest increase in household consumption. Against the background of a still nascent recovery, fiscal policy was expansionary in 2000, with the general government deficit (excluding privatization receipts and bank restructuring costs) increasing by nearly 1 percentage point to 4.1 percent of GDP. Executive Directors noted that flexibility in the conduct of monetary policy is key to ensuring that inflation remains under control.

I. Introduction

1. The 2001 Article IV consultation discussions with the Czech Republic were held in Prague during April 5-18, 2001.1 The mission met with Czech National Bank (CNB) Governor Tuma, outgoing Finance Minister Mertlik, several members of the CNB Board, senior officials in government ministries, the CNB, and the Czech Statistical Office, members of parliament, labor unions, financial market representatives, the European Union (EU) delegation, and senior managers in a large foreign-owned and in a large state-owned company. Mr. Jonaš (Advisor to the Executive Director) participated in the discussions. The Czech Republic had its financial sector stability assessed in a Financial Sector Assessment Program (FSAP), and FSAP missions took place in November 2000 and February 2001.

2. The Czech Republic has accepted the obligations under Article VIII, Section 2(a), 3, and 4 as of October 1, 1995, and maintains an exchange system that is free of restrictions on the making of payments and transfers for current international transactions. The Czech Republic meets the Special Data Dissemination Standard (SDDS) specifications for coverage, periodicity, and timeliness of the data (see Appendix III on statistical issues). In general, data quality is adequate for assessing the macroeconomic situation. The Czech Republic ratified the 1997 OECD Convention Against the Bribery of Foreign Public Officials in International Business Transactions on January 21, 2000, and the Convention came into force on March 21 of the same year. In March 2000, the OECD evaluated the Czech Republic’s record in implementing the Convention and concluded that legislation was missing in only one area, namely the absence of criminal responsibility of legal entities (such as corporations) for criminal acts of bribery.2

3. In concluding the 2000 Article IV consultation on July 26, 2000, Executive Directors commended the Czech authorities for the prudent and coherent set of macroeconomic policies that contributed to the economic recovery. But they noted that, for the future, policies would need to strike a balance between sustaining the recovery and achieving medium-term objectives, notably fiscal sustainability. They recommended maintaining the accommodative stance of monetary policy while inflation was still low and until the recovery was firmly established, but called for a stronger fiscal position, should the recovery gather momentum. Directors also advised accelerating the pace of structural reform, including bank privatization, legal reform, and implementing a market-oriented approach to restructuring a few large enterprises.

4. The political situation remains fragile, with the Social Democratic (CSSD) minority government continuing to rely on an agreement with the main opposition party (ODS) that the latter will refrain from casting a no-confidence vote in exchange for key parliamentary posts and policy concessions. Lower house elections are scheduled to take place in mid-2002, which makes politically sensitive reforms more difficult and popular spending plans more tempting in the near term, Mr. Tuma, formerly Deputy Governor at the CNB, was appointed as the new Governor in November 2000. During the mission, Finance Minister Mertlik resigned and was replaced by Mr. Rusnok, who previously held the post of Deputy Minister of Labor and Social Affairs.

II. Background

A. Recent Economic Developments

5. Following a recession dating back to the currency crisis in 1997, a recovery in the Czech Republic began in 1999 (Figure 1 and Table 1). Growth of real GDP registered a moderate 3.1 percent in 2000, and activity remained strong in early 2001, with industrial production and construction output in the first four months of the year rising by 10 percent and 15 percent, respectively, compared with the previous year (Figure 2). Growth has been supported by a revival of investment reflecting strong foreign direct investment (FDI), and moderate real wage growth underpinned a modest increase in household consumption. Demand from the EU led to strong export growth, but imports (primarily of investment goods) grew even faster, generating a negative contribution from the external sector.

Figure 1.
Figure 1.

Czech Republic: Developments in GDP, 1997-2000

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Sources: Czech Statistical Office; and Fund staff calculations.
Table 1.

Czech Republic: Selected Economic and Financial Indicators, 1996-2001

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Sources: Czech authorities; and staff estimates and projections.

Staff projections.

Net inflation excludes administered prices and the effects of changes in indirect taxes. Authorities’ target range for 2001.

General government operations and debt; central government guarantees. Revenues and expenditures include privatization receipts.

Includes a CZK33 billion government guarantee not included in official reported statistics.

Inflows for direct investment (equity capital and reinvested earnings) and equity securities. Includes privatization-related FDI.

Excludes privatization proceeds to be deposited in the special account for privatization-related FDI.

Figure 2.
Figure 2.

Czech Republic: Retail Trade and Industrial Production, 1998-2001

(3-month moving average, year-on-year growth in percent)

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Sources: Czech Statistical Office; and Fund staff calculations.

6. The expansion has been uneven. Vibrant, export-oriented firms with foreign participation are leading the recovery, benefiting from better organization and technology as well as access to credit and markets abroad. They are the source of high export growth (see paragraph 9), and are gradually strengthening the economy’s competitiveness. At the same time, a large number of less dynamic firms in the traditional enterprise sector are in need of restructuring and continue to face losses and overdue debt service. However, the base of growth is broadening, as an increasing number of local companies are beginning to benefit—primarily as suppliers of components—from the presence of foreign-owned companies.

7. The uneven nature of the expansion has dampened the recovery in employment Employment began to increase from the second quarter of 2000, as new job creation outweighed layoffs from enterprise restructuring; however, employment remains below the average level for 1999. The rise in employment and a drop in labor force participation reduced the unemployment rate, but only marginally from a seasonally adjusted peak of 9½ percent at end-1999 to about 8¾ percent in early 2001, a level still close to historical highs (bottom panel of Figure 3).3 This has helped restrain wage demands well within productivity growth.4 While all regions have recently experienced a drop in the unemployment rate, large regional disparities in unemployment remain, owing to the low mobility of labor. As a result, tight labor market conditions have emerged in some areas, while in many other areas, unemployed persons greatly outnumber job openings.5

Figure 3.
Figure 3.

Price and Unemployment Developments, 1997-2001

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Sources: Czech National Bank; Czech Statistical Office; and Fund staff calculations.1/ Net inflation is CPI inflation excluding administered prices and the effects of changes in indirect taxes.2/ Adjusted inflation is net inflation excluding effects of changes in food prices.

8. Absent major domestic inflationary pressures, a modest pickup of inflation has been due mostly to external factors. Consumer price inflation ended 2000 at 4 percent (12-month rate), 1.5 percentage points higher than in the previous year, owing to temporary external factors such as higher imported fuel costs and a strong U.S. dollar (see top panel of Figure 3). The recent pickup was mainly due to the rise in fuel and food prices. Domestic price pressures continued to be generally weak due to strong competition in the retail sector and moderate wage demands. Net inflation targeted by the CNB (which excludes administered prices and the impact of indirect tax changes) was 3 percent at end-2000, below the CNB’s target range of 3.5-5.5 percent, and has remained moderate so far in 2001.

9. Deteriorating terms of trade and strong imports of capital equipment led to a significant widening of the trade and external current account deficits in 2000, but this has been amply financed by FDI inflows. The current account deficit expanded from 3 percent of GDP in 1999 to 4.8 percent of GDP in 2000, as the trade deficit doubled to 6.6 percent of GDP, despite export volume growth of nearly 20 percent (Figure 4 and Table 2). Higher oil costs are estimated to have added about 1.5 percentage points of GDP to the import bill, while in volume terms, imports of capital goods and intermediate products grew strongly in 2000, with capital goods imports growing even faster in the first four months of 2001. FDI inflows continued to dominate the financial account. Incoming FDI reached 9 percent of GDP in 2000—following inflows of about 12 percent of GDP in 1999. On a net basis, though, inflows were more subdued, as a capital account liberalization measure and the narrowing of the interest rate differential between koruna- and eurodenominated assets led to a pickup in residents’ outflows. Consequently, the koruna has strengthened only modestly since early 2000 vis-à-vis the euro as well as in nominal effective terms.

Figure 4.
Figure 4.

Czech Republic: External Current Account and Trade Developments, 1997-2000

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Sources: Czech National Bank; Czech Statistical Office; and Fund staff calculations.1/ Based on quarterly national accounts data (exports and imports of goods at constant prices).
Table 2.

Czech Republic: Balance of Payments, 1997-2005

(In millions of U.S. dollars)

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Sources: Czech National Bank; and Fund staff projections.

Beginning in 1999, trade data are compiled following the revised methodology for trade statistics, according to which, only the value added during servicing of goods imported or exported for upgrades and repairs is captured in the trade statistics.

Includes privatization-related FDI.

Figures from 2001 onward exclude privatization proceeds to be deposited in the special account for privatization-related FDI.

10. Monetary conditions have been broadly constant, with a decline in real interest rates offsetting the appreciation of the koruna in real effective terms (Figures 5 and 6). Against the background of subdued underlying inflation, the CNB reduced its two-week repo rate (the key policy rate) from 5.25 percent, where it had remained since November 1999, to 5 percent in February 2001. Market interest rates tracked the cut in the policy rate (Figure 7). Still, the low interest rate environment and the pickup of economic activity have yet to be accompanied by a resumption of credit growth. Adjusted credit to the nongovernment sector declined by 0.3 percent in 2000 and was still contracting by 0.6 percent (year-on-year) at end-April 2001.6 This reflected the chilling effect on lending activity of efforts by management of newly or soon-to-be privatized large banks to consolidate loan portfolios. It is also notable that credit to households and enterprises under foreign ownership rose in 2000, in contrast to declining credit to the traditional enterprise sector. With the privatization and the restructuring process of the banking system nearing completion, modest credit growth is expected in 2001, with a further pickup thereafter. In addition, ongoing efforts to strengthen creditor rights (see paragraph 13) should help banks resume broad-based credit activities.

Figure 5.
Figure 5.

Czech Republic: Exchange Rate Indicators, 1997-2001

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Sources: Czech National Bank; and Fund staff estimates.1/ Upward movement denotes appreciation.
Figure 6.
Figure 6.

Czech Republic; Interest Rates and Monetary Conditions, 1997-2001

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Sources: Czech National Bank; and Fund staff estimates.1/ Real interest rate used is 3-month PRIBOR deflated by contemporaneous CPI inflation, REER used is PPI based (1995=100), The change in the Monetary Condition Index (MCI) is defined as two-thirds of the change in the real interest rate (in percentage point terms), and one-third of the change in the PPI-based REER (in percent).
Figure 7.
Figure 7.

Czech Republic: Selected Financial Market Indicators, 1997-2001

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Sources: Bloomberg; Czech National Bank; and Fund staff calculations.1/ Secondary market yields on government securities.2/ Difference between 4-year government bond yield and 3-month Treasury bill yield in secondary markets. Upward movements indicate a steeper yield curve.3/ One-year PRIBOR less ex-post CPI.4/ One-year PRIBOR deflated by inflation expected by selected economic sectors according to the CNB Statistical Survey.

11. Fiscal policy has been expansionary. Against the background of a still nascent recovery, the general government deficit—adjusted to measure more closely its aggregate demand impact and hereafter called the “adjusted” deficit—increased by nearly 1 percentage point to 4.1 percent of GDP in 2000, imparting a fiscal stimulus (see Text Table below).7, 8 With tax revenues rising in line with nominal GDP, the increase in the deficit-to-GDP ratio reflected the rapid growth of expenditures, particularly transfers to nonfinancial enterprises, social benefits, and capital expenditures (Figure 8 and Table 3). In addition, grants to transformation institutions—primarily designed to cover bank restructuring costs—added a further 1 percentage point to the headline (unadjusted) deficit.

Figure 8.
Figure 8.

Fiscal Operations of the General Government, 1995-2001 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Sources: Czech Ministry of Finance; and Fund staff estimates.1/ Excluding privatization revenues.2/ Debt of general government and liabilities of transformation institutions. For 2001, assumes liabilities of transformation institutions are unchanged from 2000.3/ Includes a CZK 33 billion guarantee maturing in 2002 that is not included in official reported statistics. Excludes guarantees of the NPF.
Table 3.

Consolidated General Government Budget, 1998-2002 1/

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Sources: Ministry of Finance and Fund staff estimates.

Includes the State budget. State Financial Assets, National Property Fund, Czech Land Fund, Extrabudgetary funds. Social funds, and local governments.

From the authorities’ Pre-Accession Economic Program, May 2001.

Includes liabilities of the state budget. National Property Fund, Health Insurance Fund, and local governments.

Includes a CZK 33 billion guarantee due in 2002 that is not included in the MoF’s published guarantee data.

Expected government payout on guarantees. Based on the average default risk estimated by the World Bank. Excludes environmental and other guarantees of the NPF which, on a risk adjusted basis, stood at CZK 33.5 billion at end 2000.

Text Table.

Adjustments to the Ministry of Finance’s Presentation of the Fiscal Data, 1998–2001

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Sources: Ministry of Finance; and Fund staff calculations.

12. On the structural reform front, progress has been mixed. Legislative reform has continued apace, and the European Commission’s (EC’s) 2000 Regular Report noted a significant acceleration in the rate of alignment with the EU’s acquis communautaire. The Czech Republic has provisionally closed 19 of 29 negotiating chapters, and is considered to be among the front-runners toward EU accession. With the imminent privatization of Komerčni banka (KB), the last major state-owned bank, the banking sector will soon be largely foreign owned. Nevertheless, cleaning up the banks resulted in the accumulation of a very large stock of nonperforming assets in the portfolio of Konsolidačni banka (KoB), the state work-out bank, and the pace of their disposal has been slow.9 Further large-scale privatization is slated for the coming two years, concentrated in the telecom and energy sectors. The state of international markets may delay this process, however.

13. Creditor rights have been strengthened, but there remain areas of weakness.10 The amendment to the Bankruptcy Act in May 2000 has introduced some positive changes, including more equitable rules regarding the appointment and operation of the bankruptcy administrator. Nonetheless, secured creditor rights appear weakened by the requirement that 30 percent of net recoveries from enforcement of collateral lose priority and fall into the general creditor pool, contrary both to international best practice and to the incentives and goals of stimulating bank lending. Also, the possibility for the courts to dissolve the creditors’ committee without well-founded reasons effectively threatens the creditors and weakens their control over the choice and the actions of the liquidator. Moreover, enforcement of existing laws and regulations is also often unsatisfactory, introducing delays and uncertainty into the judicial process.

14. Corporate restructuring is proceeding—albeit slowly. Corporate sector financial performance has begun to improve, with the return on assets increasing significantly in the first half of 2000, while leverage ratios declined. But a large segment of the corporate sector—accounting for the bulk of bad assets that have been, or will be, transferred to KoB—continues to generate losses and remains highly indebted. Bankruptcy proceedings have been initiated against some of these enterprises, but progress is very slow. Accelerating the sale of KoB’s bad assets is expected to foster the restructuring of viable enterprises. To address some of the largest enterprises, the government introduced a Revitalization Program in 1999, under the auspices of KoB, to facilitate restructuring.11 Out of the original nine enterprises in the Program, two have been sold and privatization is advancing in a further four. However, difficulties in convincing other creditors to restructure their claims has slowed the process.

B. Prospects

15. Despite favorable dynamics in the domestic economy, the staff projects that economic growth will not accelerate substantially in 2001, owing to the deterioration in global economic conditions. A positive medium-term outlook for the economy is expected to sustain strong investment demand (largely from foreign sources) in 2001, which will continue to be the main driving force of growth. The momentum of consumption is expected to build further this year as total employment expands and real wages continue to rise modestly. With weakening demand in the EU though, export growth is expected to slow. As a result, the pace of intermediate goods imports will decline, but imports of capital equipment will remain buoyant, resulting in a negative growth contribution from the external sector. On balance, the staff expects this year’s real GDP growth rate to be around 3-3.5 percent, but with an acceleration next year if the external environment improves. Given the likely increase in potential growth that occurred as a result of past FDI, a growth rate of 3-3.5 percent this year would imply some further widening of the output gap.

16. With external price pressures waning, inflation will remain moderate, while the weaker external environment will preclude a reduction in the current account deficit. Slowing external demand, lower world oil prices, and under-utilized factors of production (particularly labor) are expected to moderate price pressures resulting from higher domestic demand, helping to keep headline inflation around 4 percent in 2001. The outlook for 2002 is for inflation to rise somewhat, to 4—5 percent, as the moderating influence of those factors dissipates and domestic demand gathers momentum. On the external current account, growing household consumption and a slowdown in trading partner countries are expected to balance the effect of lower oil prices, a weaker U.S. dollar, and a boom in FDI-related provision of services to foreign investors, to keep the deficit near 5 percent of GDP. The current account deficit is expected to be amply financed by FDI inflows, which could exceed US$8 billion (about 15 percent of GDP) this year if the government’s privatization plans are fully realized. Some further modest outflows of short-term capital may take place, depending on the interest rate differential between the Czech Republic and abroad, but these would not be expected to jeopardize the external position. The reserve position is expected to remain comfortable in 2001 at around four months of imports.

17. The baseline macroeconomic scenario for 2001 is subject to considerable uncertainty associated with the prospects for external demand, a principal driving force behind growth in the Czech Republic. A deeper or more protracted slowdown in Europe could result in a sharper-than-envisaged decline in export growth, and could temporarily slow incoming FDI, thereby reducing investment demand and financing of the current account deficit;12 in this case, the growth rate this year could fall somewhat below 3 percent. Nevertheless, vulnerability indicators—including external debt and international reserves ratios—and recent improvements in the structure of the real economy suggest that the Czech Republic is now more resilient than it was in the mid-1990s to cope with a temporary shock of this sort (Table 4). Should the slowdown in external demand be short-lived or its effects not fully felt in the Czech economy, though, growth in 2001 could surpass 3.5 percent.

III. Report on the Discussions

18. With the recession behind them, the Czech authorities can turn their attention fully to the task of securing EU accession at an early date. Having made virtually no progress since the mid-1990s toward the target of income convergence, the authorities are now keen to get a jump start on the process, and the discussions focused on how to achieve a steady and sustainable growth path. The two main themes were:

  • The appropriate policies to sustain and extend the recovery in private sector demand, in light of the need to put public finances on a sustainable footing and given a likely slowdown in external demand; and

  • Ways to enhance the supply side of the economy and maintain external competitiveness over the longer run in order to facilitate rapid convergence of real incomes to EU levels.

A. Fiscal Policy13

19. The 2001 general government budget implies that financing needs will increase sharply, primarily reflecting transitory items, to be covered by large privatization receipts. Costs associated with EU accession (estimated by the MoF at about 2 percent of GDP) and enterprise sector reform are budgeted to boost the adjusted fiscal deficit by some 1½ percentage points, to 5.7 percent of GDP. In addition, grants to transformation institutions to cover bank restructuring costs will add over 5 percent of GDP to the headline deficit. The authorities are relying on privatization proceeds of some 9.8 percent of GDP to cover most of the financing requirement.

20. The mission’s discussions with the authorities revealed that fiscal policy in 2001 might be more expansionary than envisaged in the budget. A more realistic assessment of tax revenue would lower revenue forecasts this year by about 1 percent of GDP relative to the budget (see Table 1).14 In addition, some risk of additional spending exists under the auspices of a government plan to boost near-term growth and reduce regional income disparities, known as the “Big Bang” plan (Box 1). A number of other factors may mitigate the headline deficit, including smaller-than-expected bank restructuring costs to be covered by the state budget this year and one-time revenue from the sale of Russian debt However, these factors do not influence the budget’s impact on aggregate demand. It is nevertheless possible that the revenue shortfalls, together with financing difficulties (see paragraph 22), could compel the government to introduce some expenditure cuts.

“Big Bang” Stimulus Plan

Minister of Industry and Trade Gregr proposed in February 2001 (after parliament approved the 2001 budgets) a plan to spend CZK 100 billion (5 percent of GDP) and CZK 165 billion (8 percent of GDP) in 2001 and 2002, respectively, with the aim of boosting GDP growth to 4 percent this year and 5-6 percent in 2002, while reducing regional income disparities. The package, known as the “Big Bang” plan, would direct spending to economically depressed regions through construction of infrastructure and housing (7¾ percent of GDP) and the restructuring of state-owned mining and metallurgy enterprises and heavily-indebted industrial firms (3½ percent of GDP). The plan relies heavily on privatization receipts as its ultimate funding source.

For 2001, at least two-thirds of planned expenditures are a repackaging of already approved programs. The additional spending is intended to be used to stabilize and restructure heavily indebted firms. The new budgetary rules introduced this year grant the government very little flexibility to increase spending levels without seeking parliamentary approval - which is unlikely to be forthcoming in the current political context.1 Moreover, implementation bottlenecks and, ultimately, a constraint on available financing from privatization receipts—offer some reassurance that additional spending will not take place this year, although intense lobbying in the run-up to next year’s general elections can be expected.

The bulk of the Plan’s increase in spending in 2002 is intended to be directed to construction of housing and transport infrastructure. The budgetary framework for 2002 embodied in the political understanding between the minority government and the largest opposition party envisages substantial fiscal consolidation and would make it very difficult to expand spending along the lines of the Big Bang Plan. However, spending controls outside of the central government State Budget are less rigorous, and there are risks of unanticipated spending, especially from privatization receipts. Therefore, the plan could result in considerable fiscal risks in 2002.

1 See the Report on the Observance of Standards and Codes—Update (SM/01/193, 6/28/01).

21. The Ministry of Finance officials were not concerned about the expansionary nature of the 2001 budget, and argued that it was unrealistic to think that lasting deficit cut measures could be introduced in the near future. From a cyclical point of view, staff considered the envisaged fiscal stimulus to be unnecessary, given the improving cyclical position of the economy and the accommodative monetary policy stance. Moreover, failing to scale back the structural deficit during cyclical upturns could reduce the availability of fiscal policy as a counter-cyclical instrument, should growth falter in the future. The staff therefore argued that the government should introduce fiscal reforms that would have a lasting effect on deficit reduction, which would not only reduce the fiscal stimulus this year, but would also attenuate the problem of medium-term fiscal sustainability stemming from the country’s demographic problem (see paragraph 24). Ministry of Finance officials saw no strong need to reduce deficits for cyclical reasons, but concurred with the staff that the medium-term fiscal outlook was worrisome. Still, they noted that fiscal reform could not commence ahead of the 2002 elections, owing to the politically sensitive nature of many of the proposed reforms.15 They argued that the increase in the fiscal deficit over the past few years reflected the recognition of hidden quasi-fiscal liabilities that they had inherited from previous governments, and hence considered it unfair that they were being criticized for them or held responsible for finding ways to reduce the resulting larger deficits. They noted, though, that reforms that would yield durable savings were being prepared so that they could be implemented after the elections.

22. Claims on expected privatization receipts have more than exhausted reasonable estimates of the amount that could be realized, raising the prospect of additional government borrowing. In view of concerns about the unsustainability of public finances, the staff advised that large one-off receipts from privatization not be used as an opportunity to increase expenditures (or reduce revenues) unduly. The authorities responded that it was appropriate to use resources generated by the privatization of industrial firms to strengthen infrastructure and to restructure the corporate sector. The staff noted that using these receipts to cover enterprises’ bad debts to banks—in the context of a well-defined restructuring plan—also met this criterion. Regarding the prospect of achieving the targeted amount of privatization this year, a significant shortfall was likely, owing to delays (primarily in the energy sector) as well as permanent shortfalls (including in the telecom sector). The staff was concerned that this could result in a large build up in debt, as spending plans for individual ministries and extrabudgetary funds had already been approved. However, the MoF saw the situation as manageable through a combination of spending cuts and postponements (including those from implementation bottlenecks), as well as some short-term bridge financing. They assured staff that privatization shortfalls would not lead to additional long-term borrowing, as parliament was unlikely to approve any such increase in debt (or government guarantees).

23. A number of uncertainties relate to fiscal policy in 2002, now in an early stage of formulation. The MoF is bound by an agreement between the ruling party and the main opposition party, which requires a state budget deficit of CZK 10 billion for 2002 (excluding the losses of KoB). This would require a substantial adjustment relative to a no-policy-change budget, on the order of 3½ percent of GDP. To this end, the MoF is proposing to cut inefficient expenditures by some 1½ percent of GDP, guided by the recommendations of the World Bank’s Public Expenditure Review. Further adjustment would require severe cuts in entitlement programs or other sensitive areas, which are likely to be difficult in the run-up to next year’s elections. Owing to the constraints on the state budget, the Big Bang plan is not expected to increase state budget expenditures. Outside the state budget, the plan calls for additional spending on the order of 3 percent of GDP in excess of this year’s level The staff responded that this would lead to a net increase in government spending and in the adjusted deficit next year, thus adding to the procyclicality of fiscal policy and likely contributing to a further widening of the current account deficit.16 However, members of the parliamentary budget committee doubted that these expenditures would be approved by parliament and predicted a very lengthy and difficult debate over the 2002 public budgets.

24. The authorities agreed with the staff that it was imperative to address the implications of the looming demographic problem well before it becomes manifest in expanding deficits later in the decade, but some difference of opinion existed about the need for an urgent response. The pay-as-you-go (PAYG) pension system is already running an annual deficit of 1 percent of GDP, and the breakeven contribution rate is 3 percentage points above the current 26 percent statutory rate. With the pension system dependency ratio expected to drop from 2 workers per pensioner in 2000 to fewer than 1.2 workers per pensioner in 2030, the staff urged the authorities to introduce necessary reforms at an early stage, given the long delays before significant payoffs can be realized. However, the authorities considered the current pension system imbalance to be due in part to low statutory retirement ages and the prevalence of early retirement, both of which are being corrected through recent reform steps. They also viewed the country’s low birth rate as providing the budget with several years of breathing space, as savings on education and child allowances and health care could more than compensate for higher old age expenditures through the end of the decade. The staff questioned whether significant savings would be realized in practice since, for example, the number of primary-age children had already declined, yet capacity in primary education had not been scaled back significantly. Within the context of a planned strengthening of the role of voluntary private schemes in the provision of pension benefits (Box 2), the authorities conceded that further changes in the basic parameters of the PAYG system would be needed to raise contributions relative to benefits.

B. Monetary and Exchange Rate Policy

25. Inflation is expected to remain moderate, creating an environment conducive to maintaining the current accommodative monetary policy stance. The CNB’s latest forecast of net inflation for end-2001 stands at 2.5 percent (within the end-year target range of 2-4 percent), and for headline inflation at 3.8 percent.17 Beyond 2001, the CNB is expecting a modest pickup of inflation, consistent with domestic demand gathering momentum—bolstered by stronger consumer spending—and a gradual elimination of the output gap. The authorities and the staff agreed on the inflation outlook, but acknowledged that the recent emergence of unfavorable trends in international oil prices could pose a risk.

26. Following 15 months of leaving the key policy interest rate unchanged, the CNB in February 2001 cut its repo rate by 25 basis points. With the koruna gradually appreciating in real effective terms in the months leading to the rate cut, the policy change reversed a gradual tightening of monetary conditions (see Figure 6 and the bottom left panel of Figure 7). Although the CNB’s action took many observers—who expected the next move to be a tightening one—by surprise, the authorities argued that a downward shift of the long end of the yield curve prior to the rate cut meant that market participants had already factored in an action by the CNB. They also noted that the CNB was ready to take an action flexibly, either tightening or loosening, as necessary. The staff agreed that in an environment of subdued inflationary prospects the rate cut was appropriate, and that, in light of uncertainty about the strength of domestic and external demand, monetary policy should remain flexible.

27. The CNB—in formal agreement with the government as required under the new CNB Act—announced a new inflation targeting framework in April. The main changes involve: (i) the introduction of a continuous target band, rather than year-end targets; (ii) the specification of a target band not only for 2002 but also through 2005; and (iii) a switch to targeting headline inflation (Box 3). The new framework will increase the transparency of the inflation concept being targeted, while the longer horizon of the target and the specification of an intra-year band will help to better pin down short and medium-term inflation expectations. Also, the CNB officials pointed out that, with the disinflation process that had been initiated a few years ago largely completed, the targeted path of headline inflation from 3-5 percent in January 2002 to 2-4 percent at end-2005 represented the CNB’s desire to preserve hard-won disinflation gains.

28. However, there are disadvantages in the new framework as well, and its operational aspects need to be carefully examined. Unlike the existing framework, the new framework will entail no clearly specified time horizon on which the CNB will focus; instead, the focus is to be on a continuous path well into the future, which might make it difficult for the public to understand the time horizon of the CNB’s policy actions: namely, whether the CNB is aiming to keep inflation within the target band 12 months ahead, or 18 months ahead, and so on. In addition, administered price adjustments and the envisaged large indirect tax changes could make headline inflation very erratic.18 With details of the new framework yet to be announced, the staff cautioned that it would be important to give due consideration to a range of operational issues to enable the CNB to firmly establish the conduct of monetary policy under the new framework. These include: (i) how to produce and communicate to the general public the CNB’s inflation forecasts; (ii) how to develop optimal procedures concerning the communication and understanding between the CNB and the government with respect to administered price and indirect tax adjustments; and (iii) how to design and use escape clauses. The CNB officials agreed with the staff on the need to enhance accountability and preserve the CNB’s credibility—especially with regard to the proper design and use of escape clauses—and assured the staff that every effort would be made to achieve these objectives. Moreover, they explained that the CNB was planning to include in its quarterly Inflation Reports its headline inflation forecast path up to 18 months ahead as a way of signaling to the public that it would be aiming at controlling inflation more than a year ahead.

Pension System Reform: Need and Plans

The Czech pension system consists of two pillars: a mandatory pay-as-you-go (PAYG) defined benefit scheme within the state budget that is financed largely by taxation of labor, and a voluntary private scheme, which is expanding rapidly (from a very low base), owing to generous state copayments and the tax deductibility of contributions.

Total benefit expenditures of the PAYG pension system (including old age, disability, and survivors benefits) were equivalent to 9 percent of GDP in 2000, with old age pensions accounting for about 7 percentage points (similar to the level in the UK). Social security contributions to the “pension account” of the state budget equaled 8.9 percent of GDP which, together with administrative costs, resulted in a pension system deficit of about 1 percent of GDP in 2000.

The public pension system is ill equipped to cope with an expected increase in the system dependency ratio beginning later this decade. According to calculations by the Ministry of Labor and Social Affairs—and assuming an unchanged average gross replacement rate (the ratio of average old-age pension benefits to gross wages) of 45 percent and real GDP growth of 3 percent—pension payments should increase only gradually to a still-modest 13 percent of GDP by 2030; however, owing to the fall in the number of contributors per beneficiary from 2 in 2000 to fewer than 1.2 in 2030, the breakeven contribution rate on gross wages would need to rise steadily from 29 percent in 2000 (compared with a statutory rate of 26 percent) to more than 45 percent in 2030 (see figure below).

A01ufig01
Source: Ministry of Labor and Social Affairs.1/ Contribution rate needed to balance PAYG pension system revenue and expenditures. As a percent of gross wages.

The government is proposing a number of changes to the pension system that would affect primarily the structure of the system, rather than its financial stability. These changes include: (i) adding a voluntary private employer-based scheme which, together with the existing private scheme, would be expected to eventually provide pensioners with one quarter of their income; and (ii) separating the PAYG mandatory scheme from the state budget in 2002 or 2003 (however, the state budget would still be required to cover any system deficit so that, absent fundamental reforms, this would not improve the fiscal outlook).

In the near term, the government is introducing or proposing several steps that would generate some modest reduction in the PAYG system deficit. These include: (i) from July 2001, the elimination of incentives for early retirement; and (ii) a proposal to raise the minimum assessment base for calculating premiums on the self employed. Over the longer term, the government has committed to adjust the parameters of the PAYG system to shore up its financial stability, possibly within the context of a shift from a defined benefit to a notional defined-contribution scheme.

New Inflation Targeting Framework

In April 2001, the CNB announced changes to its inflation targeting framework. Under the existing framework, the CNB has an end-year target range for net inflation (i.e., headline CPI excluding administered prices and the impact of indirect tax changes) which is announced about 20 months in advance. The new framework shifts to targeting headline inflation and specifies a continuous linear and declining target band from January 2002 through end-2005. The changes were primarily motivated by the desire to increase the transparency of monetary policy and help better anchor inflation expectations. The target band for headline inflation was specified at 3-5 percent in January 2002, declining to 2-4 percent in December 2005 (Figure below). This range is consistent with the CNB’s medium-term target for net inflation of 1-3 percent announced in 1999, and is based on the assumption that the impact on headline inflation of changes in administered prices will not exceed 1.5 percentage points at any point in time. Should the effect of changes in administered prices exceed the amount assumed, the CNB intends to invoke escape clauses. The CNB has yet to announce details of the operational aspects of the new framework, including the design and use of escape clauses.

The new framework is broadly in line with practices in most other countries targeting inflation. Most countries have intra-year targets or checkpoints rather than a single end-year target (Table below), though many of them have already achieved price stability so that they have a flat target band, unlike the Czech Republic. Most emerging market countries target headline inflation, while the choice of target varies in industrial countries. Most countries with relatively low and stable inflation employ a band width of 2 percentage points or less, and some countries prefer to accompany the target band with a mid-point to help focus expectations in the middle of the targeted range. Finally, few countries include escape clauses as part of their inflation targeting framework; many countries prefer to accommodate shocks to inflation through wider bands, owing to concerns that escape clauses could undermine the credibility of monetary policy.

A01ufig02

Czech Inflation

(in percent)

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Table. Inflation Targeting Frameworks in a Range of Countries 1/

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Source: Schaechter, A., M. R. Stone, and M. Zelmer, 2000, “Adopting Inflation Targeting: Practical Issues for Emerging Market Countries” IMF Occasional Paper 202 (Washington: International Monetary Fund).

The information on Finland and Spain pertains to the period prior to their entry into the euro zone.

29. The authorities were not seriously concerned about a loss of external competitiveness stemming from the nominal appreciation of the koruna vis-à-vis the euro over the past several months. In their view, the exchange rate was broadly in line with its fundamentals, as evidenced by the stable market share of Czech exports to the EU during a period of nominal appreciation of the koruna (Figure 9). The competitiveness of Czech exports has benefited from FDI, which has introduced new, efficient technologies and management practices in the country. The competitiveness of the Czech economy will likely continue improving, reflecting the increasing role of foreign-owned firms (Figure 10). In light of the expectation of continued strong FDI inflows over the medium term, the authorities were willing to accommodate a gradual nominal appreciation of the koruna, resorting to foreign exchange market intervention only to moderate large fluctuations in the exchange rate. Consistent with this, the authorities explained that, should sizable privatization-related inflows occur this year or next, they would try to moderate their immediate impact on the market through a bilateral transaction between the government and the CNB.

Figure 9.
Figure 9.

Czech Republic: Regional Comparison of Export Performance and Real Effective Exchange Rates, 1994-2001

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Sources: Information Notice System; World Economic Outlook; and Fund staff estimates.1/ Based on monthly customs data (three month moving average) for Poland and Hungary. Based on quarterly national account data (exports of goods, constant prices) for the Czech Republic and the Slovak Republic.2/ Hungarian data are quarterly.
Figure 10.
Figure 10.

Czech Republic: Manufacturing Industry by Sectors, 1999-2000 1/

Citation: IMF Staff Country Reports 2001, 110; 10.5089/9781451810042.002.A001

Source: Czech Statistical Office.1/ Enterprises with 100 or more employees.2/ Foreign equity in excess of 50 percent

30. Looking further ahead, the Czech Republic’s steps toward the eventual entry into the euro zone becomes an increasingly relevant issue. Some officials cited the need for the economy to achieve a higher degree of convergence, as well as the need to improve public finances, before the country requests admission to ERM-II. They agreed with the staff that there might be a possible tension—arising from Balassa-Samuelson effects—between the ultimate inflation goal of 2–4 percent and the constraint imposed on the nominal exchange rate under ERM-II.19 They noted, though, that various uncertainties—including the extent of future capital inflows—would make it difficult to draw any definitive conclusion at this point regarding the timing of their participation in ERM-II.

31. The authorities are not currently considering issuing foreign-currency-denominated government debt, although this continues to be a future option. In the CNB’s view, which the MoF shared, ample liquidity existed in the domestic banking system that could accommodate new issues of government debt without crowding out the private sector. The relatively high premium associated with a euro bond issue, the cost of hedging the exchange rate risk, and the impact on the exchange rate were not deemed justified in the current circumstances where the proceeds would be used domestically rather than paying off obligations in foreign currency.

C. Financial Sector Stability

32. The FSAP report, presented in Prague by a combined IMF/World Bank team, was very well received by the authorities (Box 4). The authorities had no major disagreements concerning the report and expressed their desire to move speedily to adopt most of the recommendations as circumstances permit. They pointed to progress made in restructuring the banking sector as evidence of their determination to address the structural impediments and vulnerabilities in the Czech financial system. A main recommendation of the report dealt with the issue of adopting consolidated and risk-based supervision. The authorities acknowledged the need to extend supervision to financial conglomerates and to move toward risk-based supervision, but they indicated that this might be a long process. In addition, they noted their intention to address the issues of insolvency and creditor rights that had been constraining the proper functioning of the banking system.

33. Restructuring of the banking sector is nearing completion. The government has received bids on the sale of the last remaining large state-owned bank (Komercni banka), and the sale is expected to be completed this year. The parliament recently adopted a law transforming KoB from a bank to a nonbank agency, responsible primarily for asset disposal and consolidation. Although no major changes are expected in its activities, the new agency will be more limited in its ability to extend new financing to ailing enterprises. The staff noted that the transformation was an important step in the final chapter of restructuring the bank and corporate sectors if indeed the agency were to focus its efforts on disposing of bad assets, and argued that active corporate restructuring, currently limited to a handful of enterprises originally placed under the Revitalization Agency (see paragraph 36), should be kept to a minimum.

34. The legal system continues to slow the process of asset recovery. The KoB management explained that, in spite of the recent legal changes purported to facilitate sales of collateral, asset recovery through this channel was still plagued by delays due to legal challenges by debtors. They argued that because of this, pooled sales were a much faster and more efficient way of disposing of bad assets. The staff welcomed the sale of a large pool of bad assets in early 2001. Although the sales price reached only 7 percent of the original face value of about CZK 19 billion (11 percent of the value booked by KoB), the sale is likely to benefit both the KoB, by reducing the volume of its bad assets, and the Czech economy, by promoting the financial restructuring of many small and medium-sized enterprises. The staff therefore argued that further pooled sales should be sought, along with all other methods available to the KoB, to achieve quick asset recovery. The managers of KoB indicated that scope remained for further pooled sales. However, they noted that the strategy of pooled sales was not uncontroversial within the government and they did not exclude that it could be politically difficult to implement20 The authorities and the staff agreed that a successful workout program would require further improvements in the legal framework, such as insolvency, that would expedite enterprise restructuring and would likely also imply a better price in the auction of bad assets.

Main Findings of the Czech FSSA1

Following an acute crisis phase, the Czech financial system has undergone a fairly rapid phase of restructuring and reform. Considerable progress has been made in improving the legislative and regulatory framework. Institutional strengthening has been accompanied by enhanced prudential oversight, extensive carve-out of bad assets, privatization of large banks to foreign strategic investors, and a significant consolidation of banks and nonbank financial institutions. After the completion of the sale of the last large state bank (Komerčni banka) later this year, about 90 percent of the banking sector will be owned by strategic foreign investors.

Little residual risk appears to remain in the banking system, as the level of non-performing loans that will be left after the carve-out of bad assets appears manageable given current provisioning levels. Stress tests indicated that the Czech banking system is only moderately vulnerable to risks. The effects of market risks appear quite limited and while the banking system will still face pockets of vulnerability to credit risk, these would not appear to add up to systemic risk at present. These results are qualified, however, by being based on the current structure of bank exposures. Although banks remain currently reluctant to extend new credit to any but top quality corporate borrowers, they are under profit pressures that may prompt them to assume new kinds of market and credit risk.

Ongoing restructuring in the corporate sector bodes well for resolution of its long-standing problems. The sector’s financial performance has started to improve, and the regulatory framework affecting corporate governance has been substantially upgraded, but it has yet to be tested. There are still many enterprises that continue to generate losses and are highly leveraged. Nevertheless, most of them are probably classified debtors which have been or are in the process of being transferred to the workout institutions.

The non-banking financial sector is quite small compared to the banking sector, and its weaker segment—namely the credit unions—is not systemically important. The insurance sector is currently adequately capitalized and profitable; however, insurance supervision is weak. In the securities markets, regulation and supervision are fairly transparent, but the supervisory capacity needs to be strengthened further. Consolidation has reduced the number of pension funds, but their performance has been modest reflecting mainly their investment in low-yielding securities. Credit unions have recently experienced a major crisis, and the deposit protection agency for credit unions is facing pressures from claims. However, credit unions remain a very small part of the Czech financial system and thus they are not systemically important.

Despite improvements in the legal and regulatory framework for the Czech financial and corporate sectors, critical challenges remain. Enforcement has been unsatisfactory, and better enforcement will require a strong build up of supervisory capacity, a more proactive approach by self-regulatory organizations, and improvements in the court system. Coordination and cooperation between supervisory agencies requires urgent attention. Supervisory objectives should be strongly oriented towards monitoring the soundness of financial institutions on a consolidated and risk basis.

1 The Czech Republic—Financial System Stability Assessment, (SM/01/189).

35. The authorities have estimated the cost of cleaning up bank balance sheets at about 20 percent of 2001 GDP. About a fourth of these costs have already been incurred and the rest are expected to burden the state budget over the course of the next four years. The authorities stressed that the total clean up cost would likely change, pending the completion of the review of the loan portfolio of IPB and the conclusion of the disposal of bad assets. A large stock of nonperforming loans—as much as 25 percent of GDP, including the “ring-fenced” part to be kept on the balance sheet of banks—remains to be worked out, a considerable part of it with KoB.

36. The government’s role in corporate restructuring may expand to cover small and medium-sized enterprises (SMEs). The intention of the original Revitalization Program was to limit the government’s involvement only to selected large firms, leaving the disposition of heavily indebted SMEs in the hands of the private sector. However, the slow court system and banks’ reluctance to actively engage in corporate restructuring have resulted in many SMEs being left in limbo. Ministry of Industry and Trade officials noted that many viable SMEs could be revived if the government offered some help. This motivated them to include in the Big Bang plan a program called “exit and balance sheet,” which appears to be an expansion of the Revitalization Program to SMEs. The staff questioned the government’s ability to distinguish viable and non-viable firms correctly, and advocated pooled sales of bad debts that would let the private sector decide whether to close or revive individual debtor firms.

IV. Medium-Term Fiscal Issues

37. In the context of the Czech Republic’s Pre-accession Economic Program (PEP), the authorities prepared a medium-term fiscal framework that achieves a moderate reduction in the deficit through a combination of higher taxes and expenditure reductions (Tables 5 and 6).21 The authorities are forecasting a decline in the general government deficit (excluding privatization and grants to transformation institutions) by 1.8 percent of GDP over three years to 3.9 percent of GDP in 2004. Excluding interest payments, the amount of adjustment over the same period increases to 2.5 percentage points of GDP. General government debt is projected to rise by 10 percentage points to about 30 percent of GDP.22

Table 4.

Czech Republic: Vulnerability Indicators

(In percent of GDP, unless otherwise indicated)

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Sources: Czech Statistical Office, Czech National Bank, Ministry of Finance, and Fund staff calculations.

Debt of general government and transformation institutions; excludes government guarantees, which amounted to 14.2 percent of GDP at end 2000 and guarantees of the National Property Fund.

Deflated by net inflation.

Includes amortization of medium and long-term debt on a remaining maturity basis. Based on M&LT debt outstanding at the end of the proceeding year.

General government and the central bank.

Yield spread on a 5-year, U.S. dollar-denominated bond issued by the Czech Export Bank. This bond is quite illiquid, trading only once during February and mid-June 2001.

Table 5.

Medium-Term Fiscal Scenarios, 2001-2004

(in percent of GDP)

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Sources: Ministry of Finance; and staff calculations.
Table 6.

Czech Republic: Macroeconomic Framework, 1997-2005

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Sources: Data provided by the Czech National Bank; Czech Statistical Office; Ministry of Finance; and Fund staff projections.

External current account deficit (+).

Equal to gross domestic investment (excluding statistical discrepancy) less foreign saving.

Equal to gross national saving less net factor income and transfers from abroad.

Based on MoF data and projections, excluding grants to TIs, privatization receipts, and other net lending.