Czech Republic: Staff Report for the 2003 Article IV Consultation Supplementary Information

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.

1. This supplement contains information on recent economic and policy developments in the Czech Republic that became available since the circulation of the staff report for the Article IV consultation. This information does not alter the general thrust of the staff appraisal.

I. Macroeconomic Developments

2. High-frequency indicators point to weaker but still reasonably resilient activity. Industrial production expanded by 5 percent in the second quarter (year-on-year), marginally down from 6.2 percent in the first quarter. Exports (measured in euro terms) grew by 3.7 percent (year-on-year) in the second quarter, lower than the 6.8 percent in the first quarter. Import growth also slowed (to 3.5 percent from 5.7 percent in the first quarter). Meanwhile, retail sales remained strong, growing by 7.5 percent in the year to June.

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Source: Czech Statistical Office.1/ Three-month moving average.

3. After weakening somewhat in July, the koruna held steady against the euro in early August. Since reaching its high in mid-2002, the koruna depreciated against the euro to about the same level as in early 2002.

4. Headline inflation dipped back into negative territory in July. After increasing by 0.3 percent in the year to June, consumer prices declined by 0.1 percent in July. Falling prices for food products and traded goods, including clothing and consumer durables, more than offset an increase in services prices. Producer price deflation continued as prices declined by 0.6 percent (year-on-year) in July.

A02ufig02

Exchange Rate, koruna/euro, 2002-03

Citation: IMF Staff Country Reports 2004, 002; 10.5089/9781451810073.002.A002

Source: Czech National Bank.

II. Policy Developments

5. Downward revision to its inflation projections and softer 2003 growth prospects prompted the Czech National Bank (CNB) to cut its policy interest rate by 25 basis points to 2 percent on July 31—the second 25 basis point cut since the mission. In its July Inflation Report, the CNB significantly revised downwards its inflation projections for 2003–04, to 0.7–1.4 percent—below the target band—by end-2003 and to 2.5-3.9 percent—in the lower half of the target band—by end-2004. The CNB continues to expect inflation to increase as the effect of exogenous factors shifts from disinflationary to neutral, growth recovers, and indirect taxes are raised. However, the pickup is now expected to be more subdued than envisaged in the CNB’s April forecast. Underlying the revision is a reassessment of the direct and indirect effects of indirect tax increases in 2003–04. As the CNB no longer expects the indirect tax increases to apply to restaurant and hotel services, it has revised the direct effect of the tax changes on inflation to 1 percentage point from its previous estimate of 2–2.5 percentage points. In addition, a weaker growth outlook (the CNB now expects a slower pickup in growth in 2003 and revised its projections for GDP growth from 2.3-2.9 percent to 2.1–2.9 percent) and strong competition in the retail sector make strong indirect effects unlikely. In view of these developments, staff has also updated its inflation forecast for 2003-04, revising it down by about ½ percentage points. Staff now projects inflation to pick up to just over 1.5 percent by end-2003 and further to about 4 percent by end-2004 (or to 0.6 and 3.5 percent, respectively, on an annual average basis (Table 1)).1 As staff projections for GDP growth had already been predicated on a pickup slower than previously envisaged by the authorities, they have not been revised. In light of subdued prospects for inflation throughout the forecast period, staff supports the CNB’s decision to cut its policy interest rate, lowering it to the level of the ECB’s policy rate.

6. Parliament passed to the second reading the bills that form the basis for the government’s fiscal reform proposal. While detailed discussions and resolutions on the bills are only expected in late September, the parliamentary action allows the government to incorporate the effects of the proposed changes in its draft 2004 budget. However, some proposed measures, particularly on the expenditure side, may yet prove contentious: unions have threatened protests and strikes in September over measures to contain wage increases in the public sector, the Minister of Labor and Social Affairs has suggested higher-than-proposed increases in pensions, and line ministries are seeking to spend about 30 billion koruny (about 1¼ percent of GDP) more in 2004 than the proposal’s expenditure ceiling allows.

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.

1

The updated projections also take into account revised assumptions about the global economic environment, including oil prices and exchange rates, which led to small revisions on projections for trade flows and the balance of payments.