Czech Republic: Staff Report for the 2003 Article IV Consultation

The Czech economy has turned in a solid performance, and the medium-term prospects are good. The short-term outlook is positive, although downside risks are significant The outlook for low underlying inflation leaves scope for monetary policy to continue to support growth. The government's resolve to address the deterioration in the fiscal accounts has been commended. The challenge now is to implement the proposals and prepare for medium-term output. Redressing shortcomings of the judicial and legal systems is the top priority for structural reform.

Abstract

The Czech economy has turned in a solid performance, and the medium-term prospects are good. The short-term outlook is positive, although downside risks are significant The outlook for low underlying inflation leaves scope for monetary policy to continue to support growth. The government's resolve to address the deterioration in the fiscal accounts has been commended. The challenge now is to implement the proposals and prepare for medium-term output. Redressing shortcomings of the judicial and legal systems is the top priority for structural reform.

I. Background

1. The Czech Republic will complete the transition from central planning to EU membership in little more than a decade. Initial conditions were good—the fiscal position was healthy and external and public debt low—and stabilization occurred rapidly. But restructuring proceeded slowly and only speeded up after the 1997 currency crisis. The new momentum for structural reforms, including privatization, increased the country’s attractiveness for foreign investors and helped modernize the economy. Although it raised unemployment, it set the stage for renewed growth by the late 1990s (Figure 1).

Figure 1.
Figure 1.

Czech Republic: Macroeconomic Indicators, 1993-2002

(In percent)

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Source: IMF World Economic Outlook.

2. Recently, the economy has shown considerable resilience in the face of the global slowdown (Table 1). GDP growth slowed, but still posted a rate of 2 percent in 2002 despite serious floods. At 2.2 percent, it remained solid in the first quarter of 2003. Growth was underpinned by strong private consumption (reflecting rapid growth of wages and lending to households), rising goods exports, and a sizable fiscal stimulus. On the negative side, investment, which is geared toward prospects for final demand in Europe, slowed. Restructuring and weakening growth contributed to the upward drift of the registered unemployment rate (Figure 2).

Table 1.

Czech Republic: Selected Economic and Financial Indicators, 2000-04

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

Staff estimates and projections.

In percent of total labor force.

General government deficit excluding transfer to transformation institutions and net lending.

For 2003, data refer to growth rate from March 2002 to March 2003.

For 2003, data refer to June 1.

For 2003, data refer to April.

Excluding privatization revenues of the National Property Fund and the Czech Land Fund, the sale of shares and voting rights by local governments, and the sale of Russian debt.

Figure 2.
Figure 2.

Czech Republic: Labor Market Conditions, 1999-2003

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Sources: Czech Statistical Office; World Economic Outlook; Eurostat; and 1MK staff calculations.1/ PPP-GDP weighted average of four Central European countries (Hungary, Poland, Slovak Republic, Slovenia).2/ Seasonally adjusted.3/ Based on quarterly labor force survey data.
A01ufig01

GDP Growth, 1999-2004

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Sources: Czech Statistical Office; World Economic Outlook; Eurostat; and IMF staff estimates.1/ PPP-GDP weighted growth of Hungary, Poland, Slovak Republic, and Slovenia.

3. The export sector held up well despite a stronger koruna. Like other Central European countries (CECs), the Czech Republic has a strong record in penetrating the EU market. Geographical advantage, reinforced by growing cross-border integration of production processes, has outweighed any direct cost-competitiveness disadvantage vis-à-vis competitors from other regions. Thus, the EU’s share in exports is about 70 percent (over 80 percent including the CECs). Much of these exports is generated by foreign direct investment (FDI), which the Czech Republic has been remarkably successful in attracting. As a result, the temporary rise of the koruna against the euro from late 2001 until mid-2002 and sluggish demand in Europe slowed but did not halt export growth. Reflecting this, the trade balance improved. However, the current account deficit widened to 6½ percent of GDP on account of a large increase in reinvested earnings and transferred dividends by FDI firms (Table 2).

Table 2.

Czech Republic: Balance of Payments, 2000-04

(In millions of U.S. dollars)

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Sources: Czech National Bank; and IMF staff projections.

IMF staff projections.

A01ufig02

FDI Inflows, 1994-2002

(Average in percent of GDP)

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

A01ufig03

Exchange Rate, koruna/euro, 2002-03

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Source: Czech National Bank.

4. With a surge in FDI and other investments, the koruna came under strong upward pressure beginning in late 2001. FDI accelerated sharply owing to the privatization of the gas utility. Expectations of an appreciation precipitated other inflows as commercial banks in particular attempted to reap gains on koruna holdings by repatriating their foreign deposits and borrowing from abroad. These pressures and their likely inflation effects prompted the CNB to cut interest rates sharply and undertake some $6½ billion of sterilized intervention and off-market purchase of privatization receipts. Late in the year, after the koruna had stabilized, banks partially reversed their inflows by buying foreign debt instruments. The CNB’s sterilization operations resulted in an increase in central bank instruments on the balance sheet of banks, bringing banks’ holdings of government and CNB paper to about one-third of total assets.

5. Faced with low expected inflation, koruna appreciation and slowing growth, the CNB eased policy rates throughout 2002 and early 2003 (Figure 3). The timing and size of the cuts were heavily influenced by the pressure on the koruna. But the moves were consistent with the inflation targeting framework, as the forecast of inflation fell well below the gradually declining target band. Behind the sharp drop in inflation were falling food prices and the pass-through of the koruna’s appreciation. Real wage growth in manufacturing is estimated to be in line with productivity growth. However, wage increases have also been strong in less productive sectors—reflecting the Balassa-Samuel son effect—keeping core inflation at about 1 percent. The interest rate cuts left the spread between the two-week repo rate and the ECB policy rate nil or negative most of the past year. The negative spread eased pressures on the currency and lowered the monetary conditions index. Although the index remains some 3—4 percent above its 2000 average, owing largely to the cumulative 10 percent real appreciation of the koruna relative to 2000, part of this increase reflects the equilibrium real appreciation.1

Figure 3.
Figure 3.

Czech Republic: Monetary Policy Indicators, 2001-03

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Sources: Czech National Bank; European Central Bank; and IMF staff estimates.1/ Weighted average of real short-term interest rate and real effective exchange rate (weights: 2/3 and 1/3, respectively).2/ Based on 1-year PRIBOR deflated by 12-month backward- and forward-looking CPI inflation, respectively.3/ Expost real interest rates are 1-year PRIBOR, deflated by 12-month CPI inflation; ex ante real interest rates are deflated by 12-month inflation expected in a survey conducted by the Czech National Bank Statistical Survey.4/ Czech National Bank. Weights based on foreign trade turnover.5/ PPI-based.
A01ufig04

Inflation Developments

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Sources: Czech National Bank; Czech Statistical Office; Eurostat.

6. The 2003 budget foresees continued lax fiscal policy. The adjusted general government deficit (excluding transfers to the Czech Consolidation Agency (CKA) to finance costs of managing bad assets) widened by about 1¼ percentage points of GDP in 2002 and is expected to rise by a further 3 percentage points this year to a record 7¼ percent of GDP (Table 3). The rise reflects mainly expenditure increases—about one-third on subsidies (excluding transfers to transformation institutions) and the rest on goods and services (mainly to establish a new layer of regional government), transfers, and investment. One-off events in 2003 also play a part.2 Thanks to sizable privatization receipts in 2002, general government debt increased only moderately over the two years.

Table 3.

Czech Republic: Consolidated General Government Budget, 2000-03 1/

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Sources: Ministry of Finance; and IMF staff estimates.

Includes the state budget, Czech Consolidation Agency, State Financial Assets, extrabudgetary funds, social security funds, and local governments.

The total amounts of revenue and expenditure differ on the GFS and the national classification due to the different treatment of issued state bond premiums.

Excluding revenues from UMTS license sales

Includes privatization revenues of the National Property Fund, the Czech Land Fund, and the sale of shares and voting rights by local governments.

Includes liabilities of the state budget, extrabudgetary funds, social security funds, and local governments. Staff estimates for 2003.

Excluding privatization revenues of the NFP and the CLF, the sale of shares and voting rights by local governments, and the sale of Russian debt.

IMF staff estimates.

Recent Fiscal Developments, 2001-03 1/

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In percent of GDP.

MoF estimates based on the 2003 budget.

Excluding proceeds from privatization and the sale of Russian debt.

Adjusted for transfers to transformation institutions to cover the costs of managing bad assets.

In 2003, includes one-off transfers of 0.5 percent of GDP.

II. Report on the Discussions

7. The discussions covered demands on policies in the face of weak activity in Europe, a growing fiscal problem, and the challenges of enhancing integration with Western Europe. In this context, the key issues were fiscal adjustment, keeping monetary policy on an even keel as prospects for inflation and euro adoption evolve, ensuring banking system soundness and efficient financial intermediation, and continuing institutional and structural reforms.

8. The authorities expected a gradual strengthening in activity during 2003 to provide an opportunity to initiate fiscal adjustment and press ahead with structural reforms.

Output growth was expected to pick up as prospects for a recovery in the EU firmed. Although Czech inflation was likely to return to rates above those in the euro area, underlying inflationary pressures were expected to remain subdued. Against the background of a severe deterioration of the fiscal accounts, starting a multi-year fiscal adjustment in 2004 was recognized to be a priority. Should downside risks to growth and inflation materialize, the appropriate response would be monetary easing, while the proposed fiscal adjustment would not be altered. On the structural side, continued privatization and institutional reform were seen to be required to strengthen growth prospects. While noting the sluggishness of bank lending to enterprises in recent years, the authorities felt that the conclusion of bank privatization, which had put virtually all bank assets in the hands of foreign-owned banks while transferring bad assets to the CKA, positioned banks to increase lending activity. Planned legal and institutional reforms were expected to strengthen the attractiveness of bank lending to enterprises. Looking further ahead, plans for adopting the euro would be formulated taking into account how quickly fiscal adjustment was accomplished and the readiness of the economy for monetary union.

A. Economic Outlook

9. The short-term outlook appears reasonably positive. The authorities and staff expected recovery to begin during 2003 and to strengthen in 2004. Modest differences in the expected pace of the recovery were due to different assumptions about the external environment. Although the first quarter did bear out the perceived resiliency, a gloomier outlook for Europe has prompted staff to revise down its growth projections since the discussions—by about ¼ percentage point to 1¾ percent in 2003 and by over ½ percentage point to about 2½ percent in 2004. Nevertheless, the basic picture remains one of solid private consumption growth and strengthening exports as demand in Europe recovers. Unemployment is projected to increase only slightly. The current account deficit, mostly financed by FDI, should narrow to 5-6 percent of GDP (Table 4). Inflation should remain contained owing to a negative output gap and continuing effects from last year’s appreciation of the koruna, but should pick up during 2003 (to slightly above 2 percent by end-2003 on staffs projections) as the effects of falling food prices wane. In 2004, indirect tax changes are expected to temporarily increase inflation

Table 4.

Czech Republic: Medium-term Macroeconomic Scenario, 2000-08

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

In percent of GDP.

Projections for 2003 are based on the budget. Projections for 2004–06 are based on the MoF adjustment proposal. For 2007-08, the reduction in the general government deficit is assumed to continue at a similar pace, with the adjustment coming from the expenditure side.

Excluding transfers to transformation institutions.

Excluding net lending and transfers to transformation institutions.

Excluding privatization revenues of the NPF and CLF, the sale of shares and voting rights by the local governments, and the sale of Russian debt.

10. The balance of risks is on the downside. The possibility of prolonged weakness in Europe represents a direct risk for exports, investment, and employment, indeed, the increasing synchronization of developments in the Czech economy with cyclical conditions in Europe raises the possibility of confidence spillovers to consumption. Should these downside risks to growth materialize, inflation would likely turn out to be lower than under the baseline projection.

11. Medium-term prospects are favorable, provided that fiscal problems are tackled, institutional reforms continue, and external competitiveness is maintained. The authorities and staff agreed that, under these conditions, medium-term potential growth could rise to 3½-4 percent, despite small negative effects from a shrinking labor force. Direct and indirect effects of foreign investment (its stock was over 40 percent of GDP in 2001), cumulated benefits of structural reforms, and a flexible labor market should raise total factor productivity growth. In this scenario, external current account deficits should be about 5 percent of GDP.

Decomposition of Growth 1/

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Source: IMF staff calculations.

Capital stock data are not available. The calculations assume a capital-output ratio of 4 and a 35 percent depreciation in 1994. In the following years, the rate of depreciation is assumed to remain constant at 5.5 percent.

B. Monetary and Exchange Rate Policy

12. The 18-month outlook for inflation, which conditions monetary policy under the inflation targeting framework, was softening. The CNB’s central forecast, published in April, saw inflation rising to about 3 percent by late 2003, owing to a rebound in food prices and dissipating effects of the koruna’s appreciation. In addition, indirect tax changes before EU accession were expected to add 2-2.5 percentage points to headline inflation in 2004 and temporarily push it above the target range. While this one-off effect was not a concern to policy makers, a possible wage response was. At the time of the mission, however, sentiment in the CNB was shifting toward the view that tax effects might be smaller than originally estimated. Also, with increasing risks of a slower-than-expected recovery in the euro area, the output gap could close more slowly than previously envisaged, muting the projected price pick-up and the risks of a wage response to the tax changes. In July, the CNB lowered its estimates of the inflation impact of indirect tax changes to 1.5 percentage points and its projection for inflation in 2003-04.3

13. The CNB, who at the time of the discussions was awaiting clearer indications for inflation prospects before deciding the direction of the next interest rate change, has since moved to easing policy. While agreeing with the CNB’s approach of delaying policy moves until potential inflationary pressures were more convincingly ruled out, staff urged the authorities to move quickly to reduce rates once they were. Staff pointed to the negative output gap and risks of a weak external environment as limiting prospective inflationary pressures. Since the discussions, continued low inflation, soft first quarter growth in the EU, and a reduction in the ECB’s policy interest rates prompted the CNB to cut its policy rate by 25 basis points on June 26. Looking forward, the CNB did not intend to respond to the impact of the tax changes on inflation, but would react preemptively to any second-round wage effects—a position supported by staff.

14. The authorities and staff agreed that foreign exchange market intervention should be exceptional. The CNB explained that the sterilized intervention on several occasions during 2002 was a departure from the record of the past few years. It was, however, a response to their perception that the appreciation of the koruna since October 2001 was an overshoot. They felt that the intervention, including the off-market conversion of privatization inflows into koruna, had played a role in halting the appreciation. Staff questioned whether the simultaneous, aggressive cuts in interest rates had not in fact been the decisive factor. In this light, had the effects of sterilized intervention on the exchange rate been large or clear enough to warrant the potential costs—in terms of both possible losses for the CNB and clear communications with markets? Although the jury was still out on the relative importance of interest rate cuts and intervention in halting the appreciation, the authorities acknowledged that intervention could entail some costs: losses would accrue if short-term koruna interest rates rose above euro interest rates or the koruna appreciated. They were also concerned that the large volume of liquid CNB instruments on banks’ balance sheets could reduce their ability to control credit growth without large interest rates changes. Finally, as regards the clarity of communications with the market, while the interventions might have created room for speculation about policy in the future, most officials felt that the market understood the exceptional nature of the interventions. Indeed, the authorities intended to intervene only in exceptional circumstances, an approach that staff supported.

15. There was agreement that the current level of the exchange rate, judged against a broad set of indicators, was in the manageable range. The authorities felt that firms had weathered the strong koruna in 2002 with little adverse effect. Nevertheless, they welcomed the depreciation of the koruna against the euro by about 10 percent since its peak in mid-2002. As a result, cost-competitiveness indicators were back in line with those of other CECs, profits of the export sector were rising, and exports were resilient (Figure 4). Sizable greenfield foreign investment and high (and increasing) reinvested earnings reinforced the view that the Czech Republic remained competitive as an investment location. Staff concurred with these points, but noted that the 10 percent real effective appreciation since 2000 had probably exceeded that justified by estimated Balassa-Samuelson effects. Also, while cost competitiveness had come back in line with that of other CECs, it needed to be judged also against that of rising exporting countries in the rest of the world. While data comparability problems hinder direct, up-to-date comparisons with non-European emerging markets, informal indicators suggest some weakening of competitiveness against these countries. At present, however, any weakening appeared unlikely to offset the considerable geographic advantage vis-à-vis the European market.

Figure 4.
Figure 4.

Czech Republic: Indicators of External Competitiveness, 1998-2002

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Sources: Czech Statistical Office; Czech National Bank; International Financial Statistics Direction of Trade Statistics; and IMF staff calculations.1/ Relative to industrial country partners, January 2000=100.2/ Trade-weighted average of four Central European countries (Hungary, Poland, Slovak Republic, Slovenia).3/ Czech Republic, Hungary, Poland, Slovak Republic, and Slovenia.

16. The timetable for euro adoption would be based on progress in formulating a convincing medium-term fiscal adjustment program and more general indications of readiness for monetary union. The CNB believed that the risks of a soft-peg exchange rate regime counseled minimizing time spent in ERM2. They therefore intended to enter ERJVI2 only when fiscal policy was clearly on a sustainable adjustment track. The timing decision would be influenced not only by prospects for satisfying the Maastricht tests, but also by their judgment on the economy’s readiness to participate in the union. On the latter, staff noted that measures of business cycle synchronization and integration with the euro area were not as strong as in other CECs but were strengthening.

17. The authorities were hoping for greater clarity on the requirements for euro adoption before decisions on a new monetary policy framework were made. The current policy framework is based on an inflation target that expires in 2005, so decisions on a new target or framework will be needed in early 2004. Ideally these would be based on a clear view of the path and requirements of ERM2 and euro adoption. The CNB’s accumulated experience with inflation targeting and the risks to credibility in shifting to a new framework argued for continuing inflation targeting until euro adoption. The authorities and staff agreed that—as inflation would be affected by real convergence and administrated prices and tax changes for some time—the future inflation target should be calibrated to accommodate structural sources of inflation.4 Staffs calculations indicate that targeting a point in the 2/4-3 percent range with a symmetric ± percent band would do so and satisfy the Maastricht inflation criterion. The authorities viewed inflation targeting as feasible even during ERM2 if the Maastricht exchange rate stability criterion were assessed relative to a fairly wide exchange rate band. Were the exchange rate stability criterion interpreted more narrowly, the CNB indicated that it might gear monetary policy to targeting the nominal exchange rate.

C. Fiscal Policy

18. The discussions indicated a strengthened political will to address the risks to fiscal sustainability. The widening deficit, high tax burden, and mandatory and quasi-mandatory nature of 80 percent of total expenditures had established the need for adjustment. Population aging would further stress fiscal accounts beginning in 2006.5 While public debt is low (27 percent of GDP), high deficits and a drop in privatization revenues will contribute to a steep increase in coming years. Moreover, government guarantees, provided for exports, infrastructure projects, the debts of the Czech railways, and in connection with the failure of the IPB bank, amount to about 20 percent of GDP6 and are not accounted for in the debt. The medium-term goal of meeting the Maastricht deficit limit also argued for a decisive change in policy. The alternative to adjustment was grim: public debt would rise rapidly to over 50 percent of GDP under the authorities’ no-reform scenario (Appendix I), and lapses in progress toward meeting the Maastricht criteria could negatively affect investor confidence, exchange markets and interest rates.

A01ufig05

Effect of Contingent Liabilities on Public Debt 1/

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Sources: Ministry of Finance; and IMF staff calculations.1/ Including CKA’s debt. Assumes a deficit path consistent with the authorities’ no-reform scenario.2/ Assumes all guarantees are called in 10 years, one-third of which in 2003-05.

Fiscal Adjustment Proposal, 2003-06

(In percent of GDP)

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Sources: Ministry of finance; and IMF staff estimates.

Excludes privatization revenues, transfers to CKA, and net lending. Based on MoF estimates of revenues and expenditures and IMF staff GDP projections. In 2003, excludes one-off spending of about 0.7 percent of GDP.

The steep increase in the deficit in 2004 is mostly due to Ell-related revenue losses and spending increases, and the full implementation of the civil service reform that would introduce a new system of remuneration.

Budgetary impact of the new system of remuneration limited to 5 billion koruny, 2 percent per annum decline in employees of budgetary and semi-budgetary organizations

19. A government proposal for fiscal adjustment in 2004-06, with the weight of the measures on the expenditure side, is now before parliament. At the time of the discussions, the Ministry of Finance (MoF) had prepared a proposal to reduce the deficit from a projected 6¼ percent of GDP (without one-off spending) in 2003 to 4 percent of GDP by 2006.7 The 2004 budget would incorporate the first stage of the adjustment effort and reduce the deficit relative to GDP by about ¾ percentage point.8 Beyond narrowing the deficit, the proposal makes room for higher EU-related spending (Table 5) and gradual cuts in the corporate income tax rate from 31 percent to 24 percent (Box 1). About one-quarter of the adjustment is envisaged to come from revenue measures—mainly by shifting certain goods and services from the preferential to the regular VAT category and increasing excises. The bulk of the adjustment is thus on the expenditure side and, with the exception of savings from limiting the budgetary impact of civil service reform, distributed across many small measures. Implementation of measures requiring legislation—mainly changes to social benefits—is planned for 2004 and 2005. Since the discussions, government backing for the deficit targets and the main institutional changes has been secured, but some measures underpinning the adjustment have yet to be agreed. Parliament started discussions on the proposal on July 22.

Table 5.

Czech Republic: EU-related Fiscal Flows, 2004-06 1/

(In billions of koruny)

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Sources: Ministry of Finance; and IMF staff estimates.

Based on the Copenhagen agreement. The Ministry of Finance’s baseline is based on more conservative assumptions regarding inflows from the Structural and Cohesion Funds.

From the perspective of the budget EU payment appropriations are treated on a gross basis.

Assuming that copayments do not substitute for previously existing expenditure.

Assuming a 30 percent copayment ratio.

Assuming maximal top-off to farmers.

Assumptions on copayments are based on National Development Plan estimates.

Corporate Income Tax Rates in Selected Accession Countries

The corporate income lax (CIT) rate in the Czech Republic is high compared with other CECs. Moreover, across the region, countries with higher CIT rates are planning substantial cuts that by 2004 will put CIT rates in the 15-19 percent range. Caution is needed in interpreting the effects of these changes on countries’ competitiveness—which depends on features of the tax system other than tax rates, as well as a variety of nontax factors. Nevertheless, these developments illustrate regional pressures on tax policy.

Corporate Income Tax Rates in Selected Accession Countries

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Source: IMF country desk data.

20. Staff welcomed the proposals, especially those to rein in public spending. As the recent widening of the general government deficit was due to increasing expenditures—a trend that the authorities’ no-reform scenario saw continuing—placing most of the burden of adjustment on public spending was clearly appropriate. Permanent savings would result from many of the measures, notably cutting public employment to limit the wage bill and trimming social spending (mainly by lowering benefit levels, slowing indexation, and reducing abuse). The proposed changes to the pension system—such as increasing the retirement age to 63 years and shifting to a notionally defined contribution system—and measures to reduce the level and incidence of sickness benefits were also likely to bear significant long-term savings.

21. Spending restraint would need to be taken further to stabilize debt and meet the Maastricht 3 percent of GDP deficit limit. Some aspects of the proposed expenditure measures raised staff concerns. First, compressing operating expenditure and delaying the full implementation of civil service reform would only temporarily restrain spending. Second, questions remained as to whether the measures targeted the areas that had produced the bulk of the recent increase in expenditures. Specifically, on a GFS basis, increases in subsidies and transfers to nonfinancial enterprises had accounted for much of the widening in the deficit since 2000; it was not clear how far the proposed measures would go in reversing rises in this category. Third, further pension reform will be necessary to ease future population aging stresses. This could build on the proposed measures, including (i) allowing average benefits to fall below 40 percent of the average wage, (ii) increasing further the statutory retirement age, (iii) extending the minimum contributory period, and (iv) tightening eligibility for noncontributory periods. The authorities acknowledged these concerns. On the second point, they explained that classification problems, partly related to ongoing fiscal devolution to regions, complicated the analysis of past expenditure trends. Moreover, much of this spending appeared to occur on semibudgetary organizations such as schools and hospitals.9

Effects of the Proposed Adjustment Measures, 2004-06 1/

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Source: Ministry of Finance.

Compared to the authorities’ no-reform scenario.

Includes limiting the budgetary effect of a new system of remuneration to 5 billion koruny, and reducing the number of employees in budgetary and semi-budgetary organizations by 2 percent per annum.

Changes to construction savings subsidies.

Includes lower military spending, savings on operating expenditure, lower subsidies to businesses, and lower debt service cost.

A01ufig06

Increase in Expenditure Categories, 2000-03

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Sources: Ministry of Finance; and IMF staff estimates.1/ Without transfers to CKA.2/ Excludes one-off transfers of 0.5 percent of GDP in 2003.

22. Implementation of the program would be helped by strengthened budgetary procedures. The MoF was pressing to (i) introduce a medium-term fiscal framework with binding expenditure targets; (ii) incorporate spending by extrabudgetary funds in the responsible ministries’ expenditure ceilings and the budget procedure; and (iii) limit the issuance of new public guarantees and account for them explicitly in the budget.10 Staff supported these disciplining changes, currently under discussion in the parliament: they would help focus on the longer-term consequences of policy choices and contribute to a coherent strategy for meeting the Maastricht fiscal criteria. Also, acting on the recommendations of the fiscal ROSC update would enhance transparency and complement the reform proposal.

23. Public support for the reforms was a major question. The authorities were determined to take every opportunity to explain the need for reform and to press ahead even with unpopular aspects of it. Although the public showed signs of accepting the necessity of fiscal adjustment (labor union representatives voiced their understanding to the mission), broad support for the specific proposals was not assured. Staff pointed to the danger to credibility should the proposal be watered down during the political process or implementation slip.

D. Financial Sector Issues

24. While some aftereffects of the cleanup and privatization of the banking sector persist, financial indicators had strengthened impressively. Following the large-scale transfer of non-performing loans to the CKA and the completion of bank privatization, profitability and capital adequacy ratios were strong, and the stock of nonperforming loans, adjusted for write-offs transferred to the CKA, was declining (Table 6).11 The past year and a half had seen the continuation of trends since the banking sector cleanup in the composition of banks’ balance sheets. Bank holdings of liquid government and CNB paper had continued to rise to over a third of total assets, reflecting banks’ caution in taking on risks and the 2002 sizable sterilized foreign exchange intervention. Lending to enterprises had fallen, albeit more slowly than in previous years, but lending to households had accelerated sharply.

Table 6.

Czech Republic: Financial Soundness Indicators, Credit and Depository Institutions, 1998-2003

(In percent, unless otherwise indicated)

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Source: Czech National Bank. 2/

Worst case scenario results based on CNB information, including all balance sheet items, spot operations, options, letters of credit, promissory notes and the full value of guarantees. The results are largely due to guarantees in foreign exchange issued by banks. Insufficient information was available during the mission to assess the probability of the guarantees being called, although the authorities believe it to be very low. The CNB is developing a framework for macroprudential analysis and stress testing capacity (with technical assistance from the IMF’s Monetary and Financial Systems Department). In this context of the stress testing exercise, the prudential analysis of banks’ open FX exposures and appropriate supervisory responses will be further examined.

Adjusted by the CNB to deduct Union Banka from the data series.

25. The continuing drop in bank lending to nonfinancial enterprises was viewed as part of the lingering effects of previous banking sector difficulties. Banks, recovering from large loan losses and adapting to risk management systems introduced by new foreign owners, remained highly cautious about lending to enterprises—a development typical of other post-crisis countries. In particular, the reluctance to lend to small and medium-sized enterprises reflected the perceived riskiness of these clients, heightened by inadequate protection of creditors’ rights under the existing bankruptcy law. A large part of banking system-wide assets, therefore, was held in government and central bank instruments. The authorities, while hoping to see a revival in bank lending to enterprises, emphasized that risk assessment practices were improving and the reluctance to lend to enterprises was a reflection of genuine risks. Nevertheless, they believed that the state needed to play a supportive role by changing the legal infrastructure to increase protection to creditors. Amendments to the Bankruptcy and Settlement Act to address the most obvious shortcomings and loopholes were under preparation.

26. In contrast, lending to households had accelerated sharply and discussions focused on the challenges this presented to supervisors. Banks and the authorities confirmed that the rapid increase in lending to households reflected two factors: First, a perception of acceptable risk—supported by the still-low share of household credit (21 percent of total credit in May 2003) and anecdotal evidence on so-far negligible default ratios on mortgages; and, second, households’ strong credit demand in the face of prospects for rapidly rising incomes and historically low interest rates. The authorities thought the low stock of credit to households—about 8 percent of GDP in 2002—moderated the need for prudential concerns. They considered banks’ internal risk management practices adequate to impose appropriate limits on exposure to loans secured by real estate. Staff argued that despite the low current exposure to households, the rapid change called for close monitoring of key indicators, including household indebtedness and delinquencies, housing and property prices, and banks’ aggregate and individual exposure to households, for early signs of vulnerabilities. Establishing prudential norms, such as loan-to-value rules for mortgage loans, in line with international best practices, would also help contain vulnerabilities.

A01ufig07

Credit Growth to Households, 2000-03

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Source: Czech National Bank.

27. Progress in strengthening the supervisory and regulatory framework is continuing. The authorities’ efforts were directed toward implementing prudential norms and supervisory practices on risk, improving banks’ risk management and facilitating consolidated supervision— steps identified as priorities in the 2001 FSSA (Box 2). Staff applauded these initiatives and pointed to other areas where improved supervisory capacity and measures to address institutional shortcomings were needed to safeguard banking soundness and ensure efficient financial intermediation. Recent developments in the banking sector made clear to the CNB that specific provisions should be included in the amendments to the bankruptcy law to deal with liquidation of insolvent banks. Staff also called for further improvements in the CNB’s practices for managing licensing and change of ownership processes, in enforcement powers, and in prompt corrective action practices.

E. Structural and Other Issues

28. Strengthening the institutional and legal framework remains critical for maintaining a strong record on FDI. The authorities and representatives of the private sector saw shortcomings in these areas to be the weakest link in an otherwise attractive environment for foreign and domestic investors. Shortcomings in the existing bankruptcy law (particularly regarding creditors’ rights), an overburdened judiciary, slow and nontransparent legal procedures, and inefficiencies in the operation of the Commercial Registries were considered to be important hindrances. The authorities were preparing amendments to the bankruptcy law to, inter alia, strengthen creditors’ rights, increase the capacity of administrators for bankrupt firms, and address bank liquidation issues. Banks and government officials also emphasized the importance, particularly for small-to-medium size firms, of improving transparency and timeliness of financial data, managerial flexibility, and technical capacity. Private sector initiatives, primarily focused on training and financial disclosure, were under way to improve the situation.

BCP Readiness—Second Factual Update of Compliance with Basel Core Principles (BCPs) Covering July 2002-May 2003

The factual update of compliance with the BCPs found progress in several areas, consistent with recommendations of the 2001 FSAP/FSSA report.1

Framework for risk management

  • The CNB has issued new rules for managing credit and market risks. Banks are also required to adopt procedures for monitoring and controlling country and transfer risks.

  • The CNB has issued new rules on banks’ credit risk management, asset classification, and loan loss provisioning. Compliance is inspected through on-site examinations.

  • Banks are required to establish internal audit departments, adopt policies on market risk management, and test internal management and control systems.

  • The CNB plans to base its assessment of banks’ performance on their individual risk profiles. The assessment would feed into the customization of future supervisory activities.

Consolidated supervision

  • The CNB now monitors credit risk and market risk at a consolidated level, and amendments to the Act on Banks require banks to provide to the CNB information on all members of a consolidated financial group.

  • A memorandum of understanding (MOU) was signed among the domestic supervisory agencies, allowing consolidated supervision of banking, insurance, pension funds, and the capital market.2

  • MOUs have been signed with several supervisory agencies abroad.

Other areas

  • Efforts are underway to comply with international standards on AML/CFT.3

  • The CNB is developing a framework for macroprudential analysis and stress testing capacity (with technical assistance from the IMF’s Monetary and Financial Systems Department).

Nevertheless, some shortcomings remain.

Regarding preconditions for a well-functioning financial system:

  • Weaknesses in creditors’ rights and procedural issues may discourage lending, prompt over-collateralization and affect enforcement of financial contracts.

  • The Bankruptcy Law does not treat explicitly the special requirements of liquidation of financial institutions.

  • Bankruptcy proceedings and other judicial procedures are slow and judiciary capacity for handling financial matters is insufficient.

Regarding supervisory practices, deficiencies exist in some areas of change of control practices. Further amendments to the Act on Banks are needed for enforcement powers, operational risks, and connected or related parties transactions.

1“Czech Republic: Financial System Stability Assessment, including Reports on the Observance of Standards and Codes on the following topics: Monetary and Financial Policy Transparency; Banking Supervision; Insurance Regulation; Securities Regulation; Corporate Governance; and Payment Systems” (IMF Country Report No. 01/113, 07/01).2 After the mission, in June 2003, the MoF issued a draft proposal calling for consolidation of supervision for financial institutions/markets into one agency.3 An AML ROSC was recently undertaken. A report will be submitted to the Board (date to be decided).

29. With much of the state’s holdings of enterprises, banks, and other assets now divested, the authorities are aiming to complete remaining privatizations and asset sales and close the associated institutions. The authorities expected the privatization of several strategic companies (including Czech Telecom and the petrochemical company Unipetrol) to be concluded in 2004-05 and indicated that the privatization of other remaining state assets might be accelerated. After the mission, the MoF proposed to partially divest state holdings in the vertically-integrated electricity company CEZ. The sale of assets taken over by the Czech Consolidation Agency in the cleanup of the banking sector was proceeding apace, with the sale of a third bundle of assets (concluded on July 7) and a further bundle to be offered for sale later this year. The authorities were searching for strategic buyers for the viable companies in which the state had acquired majority ownership. Owing to EU limits on state aid and the inability of CKA to grant loans, the authorities did not foresee CKA taking on more bad assets.

30. The recent increase in unemployment was a concern, but the authorities did not see it as an indication of significant labor market rigidities. Over the last decade, the Czech labor market had accommodated massive structural change while unemployment was moderate and participation rates were the highest among the CECs. The authorities considered the labor market flexible and attributed the recent upward creep of the registered unemployment rate mostly to temporary effects from restructuring. This was consistent with the widening gap between the registered and the survey-based unemployment rate: some of the unemployed—possibly those with outdated skills—were likely withdrawing from the labor market. The authorities thought that the regional concentration of unemployment reflected skill mismatches, low mobility, and weak labor demand in depressed regions. Staff emphasized that to prevent the emergence of a long-term problem, motivating job search, providing retraining opportunities, reducing impediments to labor mobility, and lowering nonwage labor costs should be considered even if—as in the case of easing rent controls or reducing nonwage labor costs—they involved some fiscal costs.

A01ufig08

Participation rate 1/

(in percent)

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A001

Source: Eurostat.1 Ratio of labor market participants to the 15-64 cohort.

31. The Czech Republic has completed the alignment of its customs legislation with the acquis communautaire. Efforts are underway to align policies with the acquis on common commercial policy and to coordinate positions in the World Trade Organization with the EU.

32. Work on implementing the OECD’s Anti-Bribery Convention continues. A new criminal code is under preparation and would introduce the criminal responsibility of legal persons.

III. Staff Appraisal

33. The Czech economy has turned in a solid performance over the past few years, and medium-term prospects are good. Healthy growth, low inflation, moderate (albeit growing) unemployment, a successful restructuring of the economy and impending EU membership attest to the achievements. One feature marring this picture is the recent deterioration of the public finances. But a responsible monetary policy, continuing institutional reforms and the emergence of political will to tackle the fiscal problem make for a strong medium-term outlook. And while the authorities have not articulated a strategy for euro adoption, adhering to these policy intentions will be crucial for meeting the Maastricht criteria and keeping options on the timing of euro adoption open.

34. The short-term outlook is positive, although downside risks are significant. Growth is expected to remain resilient and gradually strengthen with the European recovery. Inflation and the current account deficit should remain subdued. However, given the Czech economy’s openness, much depends on the strength and timing of the pickup in the EU.

35. The outlook for low underlying inflation leaves scope for monetary policy to continue to support growth. This leeway is welcome in view of the plans to start a much-needed fiscal adjustment in 2004. Near-term monetary policy decisions will need to balance the immediate downside risks to growth and inflation against the likely increase in inflation as food prices recover and indirect tax adjustments are made. The experience in halting the strong appreciation of the koruna in 2002 speaks to the importance of interest rate policy in avoiding undue exchange rate pressures. While the subsequent depreciation has returned the koruna to a manageable level, the authorities should use all the scope provided by low inflation to limit further appreciation. Taking these considerations together, the decision, after the mission, to lower the policy rate was an appropriate response to weakening prospects for European recovery and softening inflation expectations.

36. Past success with inflation targeting recommends renewing the commitment to it when decisions on the post-2005 framework are made early next year. Ideally these decisions will be made against the background of greater clarity on prospects and requirements for euro adoption. Yet, even if uncertainties remain, the authorities should continue inflation targeting at least until entering ERM2. As regards the inflation target itself, a point in the range of 2½-3 percent, with a symmetric ±1 percent band, would provide room for stability of both inflation and the nominal exchange rate as the effects of real convergence on relative prices take place.’ In this framework, the role for foreign exchange market intervention should be exceptional. While the intervention in 2002 may have played a role in halting the koruna’s appreciation, interest rate adjustments were probably more important and sent clearer signals to markets consistent with the fundamentals of inflation targeting.

37. The government’s new resolve to address the three-year-long deterioration in the fiscal accounts is welcome. The intention to reduce the general government deficit to 4 percent of GDP by 2006, while cutting corporate tax rates and reprioritizing spending to accommodate EU-related demands, represents the first step in restoring public finances to good health. Given the root of the current fiscal problem—expenditure increases—and the Czech Republic’s high tax burden, the emphasis on expenditure restraint is well-placed. Many of the proposed expenditure measures, such as reforms of pensions or sickness benefits, would yield permanent savings and make the adjustment sustainable. Formulating fiscal policy plans and annual budgets within a medium-term framework would bring a welcome lengthening in the policy horizon, help build public support for key objectives, and bolster implementation of the adjustment measures. Other proposed institutional reforms—such as incorporating spending by extrabudgetary funds in the responsible ministries’ expenditure ceilings and internalizing the budgetary impact of new public guarantees and limiting their issuance—would help reduce policy implementation risk. Acting on the recommendations of the fiscal ROSC update could complement these changes.

38. The challenge now is to implement the proposals and prepare for more over the medium term. Diluting the proposals—always a risk during discussions on detailed proposals— would only push the burden of adjustment to later years. Over the medium term, additional scope for permanent savings, particularly on mandatory and quasi-mandatory spending, will need to be found, both to replace temporary measures and to prepare for population aging and move toward the Maastricht deficit limit.

39. A sound banking system requires that supervisors respond proactively to new potential risks. While broad indicators of banking system soundness are reassuring, rapidly increasing exposures to households could become a source of vulnerability. To evaluate the prudential implications of this trend, supervisors should give priority to collecting information on household indebtedness, housing and property prices, and banks’ aggregate and individual exposure to households. They should also monitor closely banks’ ability to assess the risk of this new and dynamic class of credit and adopt appropriate prudential norms for loan-to-value ratios for real estate lending. In other areas of financial supervision, progress continues, but addressing weaknesses in supervisory capabilities is an ongoing task. The CNB should work to increase the efficacy of prompt corrective action, bank licensing and change of control practices, and bolster supervisory capacity with respect to operational risks and connected or related party lending.

40. Redressing shortcomings of the judicial and legal systems is the top priority for structural reform. The forthcoming amendments to the bankruptcy law represent an opportunity to strengthen creditors’ rights, but more transparent legal procedures, more timely court decisions, and better-functioning Commercial Registries are also necessary to improve the business environment. Proceeding with privatization will also be critical, and restructuring efforts should start targeting pockets of the economy (for example, Czech Railways) where the process is at an early stage. Steps to preserve and improve labor market flexibility remain crucial for maintaining external competitiveness and adapting to shocks to the economy.

41. It is recommended that the Article IV consultation remain on the standard 12-month cycle.

Table 7.

Czech Republic: Vulnerability Indicators, 1997-2003

(In percent of GDP, unless otherwise indicated)

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Sources: Czech Statistical Office; Czech National Bank; Ministry of Finance; and IMF staff calculations.

Debt of general government and liabilities of transformation institutions.

Includes guarantees provided to CSOB on IPB balance sheet.

Adjusted to account for removal of KoB’s banking license in September 2001, exchange rate effects on foreign-currency-denominated loans, loan write-offs, and transfer of IPB loans to CKA (CNB calculations).

Deflated by CPI inflation.

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

General government and the central bank.