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.


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.

On August 22, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Czech Republic.1


The Czech Republic will have completed the transition from central planning to European Union (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. Structural reforms, including privatization, got new momentum afterwards and increased the country’s attractiveness for foreign investors, helped modernize the economy, and set the stage for renewed growth by the late 1990s.

Recently, the economy has shown considerable resilience in the face of the global slowdown. 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.

The export sector held up well despite a stronger koruna. Like other Central European countries, 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. 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 foreign direct investors.

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 this 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 Czech National Bank (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 sheets of banks, bringing banks’ holdings of government and CNB paper to about one-third of their total assets.

Faced with low expected inflation, koruna appreciation and slowing growth, the CNB eased policy rates throughout 2002 and early 2003. The timing and size of the cuts were heavily influenced by the upward pressure on the koruna. But the moves were consistent with the inflation targeting framework, as the forecasts 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, keeping core inflation at about 1 percent. The interest rate cuts had left the spread between the two-week repo rate and the European Central Bank policy rate nil or negative over most of the past year. The negative spread eased pressures on the currency and lowered the monetary conditions index.

The 2003 budget foresees continued lax fiscal policy. The adjusted general government deficit (excluding transfers to the Czech Consolidation Agency 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. The rise reflects mainly expenditure increases, but one-off events in 2003 also play a part. Thanks to sizable privatization receipts in 2002, general government debt increased only moderately over the two years.

Executive Board Assessment

Executive Directors commended the authorities for the Czech economy’s solid performance, attested to by healthy growth, low inflation, moderate (albeit growing) unemployment, successful economic restructuring, and approaching EU membership. They welcomed the recent referendum results in favor of EU accession. Directors regretted the deterioration of the public finances in the past few years, but welcomed plans to correct it. They emphasized that, in addition to responsible monetary policy and continuing institutional reforms, tackling the fiscal deficit is a precondition for a strong medium-term outlook, meeting the Maastricht criteria, and keeping options on the timing of euro adoption open.

Directors noted that the prospects for a strong recovery of the Czech economy were linked to those for Europe as a whole. The current account deficit was substantial, but needed to be seen against the backdrop of sizable reinvested profits from foreign direct investment. In light of the sizable output gap and the lagged effects of the koruna appreciation on prices, Directors expected inflation to remain low.

In these circumstances, Directors supported the decision to lower the policy interest rate in response to expectations of slower growth in Europe and softening inflation expectations at home. More generally, they commended the authorities on their proactive interest rate cuts since early 2002, which had contributed appropriately to halting and then reversing the appreciation of the koruna.

Directors recommended continuing the successful policy of inflation targeting when decisions on the post-2005 framework are made early next year. They recommended that the target be chosen with a view to providing room for low inflation and a broadly stable nominal exchange rate as the effects of real convergence on relative prices take place. Directors supported the authorities’ intention to intervene in the foreign exchange market only in exceptional circumstances.

Directors welcomed the government’s commitment to address the deterioration in the fiscal accounts by reducing the general government deficit to 4 percent of GDP by 2006, while cutting corporate income tax rates and reprioritizing spending to accommodate EU-related demands. Directors supported the emphasis on expenditure restraint, particularly on measures that yield permanent savings, as well as the intention to formulate fiscal policy plans and annual budgets within a forward-looking medium-term framework. Directors considered that other proposed institutional reforms—such as incorporating spending by extrabudgetary funds in the ministries’ expenditure ceilings, and internalizing the budgetary impact of new public guarantees—would help reduce policy implementation risk. They urged the authorities to act on the recommendations of the fiscal Report on the Observance of Standards and Codes (ROSC) to complement these changes.

Directors emphasized that the challenge now will be to implement the fiscal adjustment proposals and to strengthen consolidation efforts. In this context, additional scope for permanent savings, particularly on mandatory and quasi-mandatory spending, will need to be identified to replace temporary measures, prepare for population aging, and move toward the Maastricht deficit limit.

While the broad indicators of banking system soundness are reassuring, Directors encouraged bank supervisors to respond proactively to new potential risks so as to maintain that soundness. Rapidly increasing exposures to households could become a source of vulnerability. To evaluate the prudential implications of this trend, bank 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 banks’ ability to assess the risks of this dynamic class of credit and adopt appropriate prudential norms for loan-to-value ratios for real estate lending. Directors welcomed efforts to continue to strengthen supervisory policies and practices. Directors also urged the authorities to press ahead with institutional and legal changes, especially with respect to creditor rights. This should help stimulate bank lending to enterprises, which remains sluggish.

Directors emphasized that continued progress with structural reforms remains essential for strong medium-term prospects; and redressing shortcomings in the judicial and legal system should be given top priority. Legal procedures should be more transparent and decisions more timely, and the functioning of the Commercial Registries needs to be improved. Directors urged the authorities to renew their commitment to measures that would promote mobility and flexibility in the labor market, which would complement their intention to press ahead with privatization and restructuring. They noted that a strong regulatory structure could help ensure that public monopolies would not be replaced in the privatization process by de facto private monopolies.

Directors commended the authorities’ efforts to comply with international standards on AML/CFT and looked forward to the issuance of the ROSC AML module.

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF’s assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

Czech Republic: Selected Economic and Financial Indicators, 2000-02

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

In percent of total labor force.

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.


Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities.