Recent Developments

Despite the weak external environment and the further slowing of growth in Western Europe, growth in the Czech economy accelerated somewhat during the first quarter of 2003, mostly due to household consumption. In addition, exports to Western Europe continued to grow rapidly, supported by the koruna’s slight weakening against the euro. But fixed capital investment remained weak due to weak external demand and uncertainty about the timing and strength of eventual recovery.

But despite its first quarter rally, growth did not gain sufficient strength to head off a further year-on-year decline in employment and rise in unemployment. New graduates entering the labor market in June pushed the unemployment rate up to 9.9 percent. But productivity is rising briskly, and together with progress in structural reforms is creating favorable conditions for faster growth later on.

After dipping below zero in early 2003, consumer price inflation began to increase gradually, only to fall again in July to -0.1 percent year-on-year. Producer prices also continued to fall, reaching -0.6 percent year-on-year in July. The reason for such low inflation was a decline in foodstuff prices and an appreciation of the koruna against the dollar that lowered the koruna prices of imported energy.

Despite the weakness of Western demand, the Czech trade deficit is still declining. During the first half of 2003, it fell to CZK 18.1 billion, compared to CZK 22.4 billion in the first half of 2002. There are three reasons for this decline. First, both the volumes and prices of imported oil have fallen. Second, the relative weakness of investments has reduced the importation of investment goods. And third, despite weak demand in Western Europe Czech exports remain robust, particularly those of foreign controlled companies. The negative factor income balance resulting from the repatriation of the profits of foreign investors pushed the current account deficit to CZK 60.6 billion in the first half of 2003, slightly higher than CZK 59 billion of last year. This deficit is still fully covered by net foreign direct investment, which—though much less than the record CZK 207 billion in the first half of 2002–reached CZK 64.5 billion in the first half of 2003.

Based on the latest data, the near term outlook has economic activity remaining relatively robust, driven mostly by consumer demand. In June, retail sales increased by a strong 7.5 percent, supported by strongly growing real disposable incomes. June industrial production rose 6.2 percent year-on-year, and industry sales rose even higher, by 7.5 percent. Despite weakening external demand, the latest Inflation Report of the Czech National Bank (CNB) left projected GDP growth in 2003 unchanged at 2.1 - 2.9 percent. It expects a further acceleration to 2.1 - 3.8 percent in 2004, with stronger investment demand and a slowing of consumer demand.

Monetary and Exchange Rate Policy

The CNB has responded quickly to continuing weak inflation and moderate economic growth by cutting interest rates. At the end of June, it cut the repo rate by 25 points, to 2.25 percent, and again at the end of July to 2 percent. This later rate cut was a response to the postponement of EU-related tax adjustments to 2004 and the reassessment of their primary and secondary effects on inflation. It is now expected that these effects will be milder than formerly thought. Given the expected persistence of the negative output gap, the CNB does not expect a significant acceleration of inflation anytime soon. In 2004, inflation is projected to reach only the lower part of the target band.

The CNB is presently conducting its monetary policy in a framework of inflation targeting with a managed exchange rate. The CNB does not target any particular level of exchange rate, but has sometimes intervened in the forex market to correct a perceived overshooting of the koruna. It is hard to say with certainty whether the interest rate cuts or the forex interventions were the more effective tool for arresting and partly reversing the koruna appreciation. What is important is that the CNB used both instruments and succeeded in reaching its objective.

In preparation for next year’s EU entry and the eventual adoption of the euro, the CNB has begun working on its monetary policy strategy for the period between 2005 (the last year for which an inflation target has already been set) and the adoption of the euro. Inflation targeting framework has worked well in the Czech Republic, and the CNB continues to improve its functioning. This being true, there are good reasons for maintaining this framework right up until euro adoption. The CNB would consider pursuing inflation targeting even within the ERM-2 mechanism, as long as the fluctuation band used to assess the criterion of exchange rate stability is sufficiently wide. Of course, the CNB is fully aware that the existence of two nominal targets, the exchange rate and the inflation rate, could affect the clarity and credibility of monetary policy. Therefore, it does not intend to remain in the ERM-2 mechanism any longer than necessary.

At the end of 2002, the CNB has submitted to the Government a document entitled “The Czech Republic and the Euro—a Proposed Strategy for Euro Adoption,” intended to become the basic document of the euro adoption strategy. Thereafter the Government asked the Ministry of Finance and the Ministry of Industry to collaborate with the CNB to finalize this strategy by September 30, 2003. The new document should define the strategies for participating in ERM-2 and for meeting the Maastricht exchange rate criterion. After consultations with representatives of the European Union Commission and the European Central Bank, the CNB is recommending the following:

• It is not desirable to stay in the ERM-2 for more than two years. Therefore, the Czech Republic should not join ERM-2 unless there are sufficient assurances that two years later it will be able to adopt the euro.

• It is not desirable to join the ERM-2 immediately after EU entry. Doing so would lead to the assessment of the exchange rate convergence criterion in mid 2006, but it is projected that the fiscal deficit for 2006 will still be above 3 percent (see below). This makes progress with fiscal consolidation a crucial factor for setting the time of the euro adoption. The CNB recommends continuing to pursue fiscal consolidation and structural reforms, so as to strengthen the competitiveness and efficiency of the Czech economy.

• The strategy for euro adoption to be submitted by September 30, 2003, should contain mechanisms for regularly assessing Czech compliance with the Maastricht criteria and the degree of convergence of the Czech economy with the euro zone.

Fiscal Policy

The general government deficit continued to rise in 2002 and a further significant increase to 8.6 percent of GDP (without adjusting for the cost of transfers to transformation institutions) is projected for 2003. Until now, privatization revenues and ample liquidity have kept the financing of the growing deficits from becoming a problem. Low inflation and low nominal interest rates on government borrowing have limited interest payments to about 1 percent of GDP. The relatively weak growth and the negative output gap mean that fiscal expansion does not threaten CNB’s inflation target. But the current fiscal trends are clearly unsustainable in medium and longer terms. Fund missions have repeatedly warned the authorities of the eventual risks created by the absence of fiscal consolidation; and more recently, the approach of EU entry and eventual euro adoption have become prominent topics in the public discussion about the need for fiscal reforms.

The authorities have now taken the crucial step from recognizing the problem to addressing it. In June 2003, the Government approved a public sector reform strategy which has now been submitted to Parliament. Its main objectives are (1) to reduce the general government deficit to 4 percent by 2006 (the year of the next parliamentary election); (2) to improve the efficiency of government spending and strengthen longer term budgetary discipline by introducing medium term expenditure ceilings; (3) to reduce corporate taxes and implement reforms harmonizing the Czech taxation system with the EU requirements; and (4) to increase the transparency of the public finances (see measures described in paragraph 22 of the staff report.).

One advantage of this somewhat delayed beginning of fiscal reform is that the extensive discussions of recent years, and the unmistakable deterioration of the public finances, both now ensure strong public and political support for it. The most important political question is no longer whether to undertake fiscal consolidation, but how fast it should proceed and how it can best be accomplished. Given the rapidly growing contribution of mandatory spending to the widening deficits, and given the already relatively heavy burden of taxation in the Czech Republic, the government is relying mainly on spending constraints. Naturally, such a policy is never politically easy to implement. But the government is explaining to the public that further delays of fiscal reforms will not make them go away but will make them still more painful later on.

Structural Issues

Following the completion of privatization, and the removal of most bad assets from banks’ balance sheets, the situation in the banking sector is significantly better. At the same time, the banks have become more careful about lending to companies, particularly small and medium sized enterprises, and prefer to invest in government and CNB securities instead. And most recently they have begun a rapid expansion of their lending to households. The authorities are well aware that even though household bank debt is relatively low now, its rapid growth must be monitored carefully. It is expected that the consolidation of banks’ balance sheets and the improved protection of creditors’ legal rights will lead to a revival of banks’ lending to enterprises.

Now that the privatization of banks has been completed, the authorities are focusing on completing the sale of the state’s stakes in several nonfinancial strategic companies, including Czech Telecom and Unipetrol. As the privatization process nears its end, the authorities are thinking of terminating the National Property Fund by the end of 2005, and the Czech Consolidation Agency by the end of 2007.

The authorities are closely monitoring developments in the labor market, and remain concerned about the growth of unemployment. The Czech Republic’s participation rate remains high, which suggests that there are no significant labor market rigidities. Growing unemployment can also be seen as reflecting the continuation of structural reforms under relatively weak growth conditions. But there are serious and persistent problems in the Czech labor market, including regional pockets of high unemployment; skill mismatches caused by shifts in the structure of demand for different skills; and the low regional mobility of labor due partly to rent controls. These problems have yet to be effectively addressed.