Czech Republic: Staff Report for the 2004 Article IV Consultation

This 2004 Article IV Consultation highlights that the Czech Republic’s GDP expanded by 3.1 percent in 2003 and the first quarter of 2004, mainly supported by household consumption. Investment was also strong in 2003—driven by spending on public infrastructure—and swelled in early 2004 owing to one-off influences associated with European Union accession. The fiscal deficit continued to drift upward in 2003. The general government deficit widened relative to GDP by about 1 percentage point to nearly 5 percent of GDP in 2003.

Abstract

This 2004 Article IV Consultation highlights that the Czech Republic’s GDP expanded by 3.1 percent in 2003 and the first quarter of 2004, mainly supported by household consumption. Investment was also strong in 2003—driven by spending on public infrastructure—and swelled in early 2004 owing to one-off influences associated with European Union accession. The fiscal deficit continued to drift upward in 2003. The general government deficit widened relative to GDP by about 1 percentage point to nearly 5 percent of GDP in 2003.

I. Background

1. EU accession marks an important milestone for the Czech Republic, allowing attention to shift to the challenges of completing integration with Europe. Economic performance was solid in recent years, with moderate growth, low inflation, moderate public and external debt, and one of the highest per capita incomes among the new EU members (63 percent of the EU-15 average on a PPP basis). However, problems cloud the outlook: growth remains sluggish—particularly compared with the other central European countries (CECs)—despite relatively high investment (Box 1); government deficits continue to drift upward, led by rising expenditures; adverse demographic trends portend unsustainable pressures on the budget through higher pension and health spending; and long-term unemployment continues to rise and risks becoming entrenched. These trends are shared with many advanced economies. But with its lower per capita income, the Czech Republic cannot afford to delay remedial measures. The authorities’ intention to adopt the euro around 2009–10 provides a benchmark against which to judge efforts to meet these challenges.

2. Rising growth, low inflation, and a narrowing trade deficit characterized recent performance (Table 1 and Figures 1 and 2).

Table 1.

Czech Republic: Selected Economic and Financial Indicators, 2001-04

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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.

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.

General government deficit excluding transfer to transformation institutions and net lending. Concept targeted by the authorities.

For 2004, data refer to May.

For 2004, data refer to growth rate from March 2003 to March 2004.

For 2004, data refer to June.

Figure 1.
Figure 1.

Czech Republic and Other CECs: Economic Indicators, 1993-2003

(In percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.A001

Sources: Eurostat; IMF World Economic Outlook; and IMF staff calculations.1/ Unweighted average of Hungary, Poland, Slovak Republic, and Slovenia.
Figure 2.
Figure 2.

Czech Republic: Indicators of External Competitiveness, 2000-04

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.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, and Slovenia).
  • GDP expanded by 3.1 percent in 2003 and the first quarter of 2004. Underpinning the increase in growth—an acceleration from an annual average of less than 2 percent in 1998–2002—was a strong pickup in household consumption reflecting rapid real wage growth (due to unexpectedly low inflation) and robust consumer credit expansion. Investment was also strong in 2003—driven by spending on public infrastructure—and swelled in early 2004 due to one-off influences on private investment associated with EU accession.1 Rapid investment growth spilled over into imports, leading to a deterioration in the external sector’s contribution to growth and the current account balance in early 2004 relative to a year earlier.

uA01fig01

Contributions to GDP Growth

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.A001

Sources: CSO; and IMF staff calculations.

The Czech Growth-Investment Puzzle

The Czech Republic’s GDP growth rate lagged the other CECs by about 2 percentage points during 1995–2003. At the same time, the fixed investment-GDP ratio averaged about 4 percentage points higher. This implies that the growth payoff from investment (marginal efficiency of investment) is considerably lower in the Czech Republic than in other CECs (see table).

Several explanations may help to account for the Czech Republic’s comparatively weak growth performance: (i) a smaller drop in output at the beginning of transition and a correspondingly shallower subsequent recovery; (ii) a relatively poor business-legal environment; (iii) steeper real appreciation; and (iv) stagnant bank lending to domestic firms since the late 1990s. However, these factors would explain slow growth through lower—not higher—investment.

Relative Marginal Efficiency of Investment 1998-2003 1/2/

(In percent)

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Sources: Eurostat; and IMF staff calculations.

Annual growth in real GDP during 1998-2003 divided by average gross-fixed capital formation during 1993-98.

Relative to EU-15.

Explanations for the growth-investment “puzzle” must therefore lie elsewhere. Possibilities include:

  • With industry’s share in GDP early in transition the highest among the CECs, the production and physical capital structure inherited at the beginning of transition was likely heavily misallocated into nonviable sectors in the Czech Republic. Lax bank lending through the mid-late 1990s—brought about by the delayed restructuring and privatization of the banking sector—probably reinforced this initial structure. Low value added from the unrestructured sectors were a drag on growth; and with a still-incomplete restructuring in some sectors and a high share of industry, this effect may continue.

  • The higher share of industry suggests that the Czech capital stock was relatively large compared with more agrarian or service-based economies in the region. Replacement of depreciated capital to maintain the net capital stock would therefore absorb a larger amount of investment, but with little net increase in productive capacity.

  • Gross fixed investment by the public sector has been relatively high (some 4½ percent of GDP). A significant part (1–2 percent of GDP per year) has been devoted to the environment and does not directly contribute to growth potential. Installation of new electricity-generating capacity has absorbed about 8 percent of GDP, but the plant operates infrequently.

  • FDI-financed fixed investment in new machinery has in recent years been associated with hightech activities, but the domestic component has tended to be of a low value-added, assembly-type nature.

  • Measurement issues associated with foreign firms may, in view of the large volume of FDI, play a role. Internal pricing practices of multinationals could understate value added from Czech sources through realization of profits at the point of final sale. Moreover, it may be difficult for multinationals to define value added from support services provided in the Czech Republic in connection with a final product (e.g., logistical services and call centers).

  • Despite solid growth, unemployment—particularly long-term unemployment—has risen and stands at about 8 percent (Figure 1). While some unemployment is likely to be cyclical and may help contain wage pressures, the sustained increase may signal emerging structural problems.

  • Inflation has risen gradually after recovering in late 2003 from negative levels. Intense competition in the retail sector (due to growing penetration by large foreign retailers) combined with an earlier appreciation of the koruna generated price declines in most consumption categories during the first half of 2003. But rising consumer demand and more recent depreciation of the koruna brought a small upturn in inflation late in the year. Indirect tax increases in January and May 2004—driven in part by EU harmonization—pushed headline inflation above the bottom of the target band beginning early in the year. However, excluding the effects of administrative measures, underlying inflation has risen only modestly, and remains below the target band.

  • Competitiveness has been improving. Falling unit labor costs in manufacturing, koruna depreciation, and recovering export prices suggest increases in profit margins and strengthened competitiveness in the manufacturing sector (Figure 2). As a result, the Czech Republic made further inroads into EU-15 markets in 2003—though by less than some other CECs.

  • Notwithstanding a narrowing trade deficit, the current account deficit widened marginally to 6¼ percent of GDP in 2003. Healthy export volume growth and favorable terms of trade narrowed the trade deficit relative to GDP. But a secular decrease in the services surplus and a one-off drop in current transfers contributed to a widening of the current account deficit in 2003. Reflecting the large stock of FDI and its high profitability, dividends and reinvested earnings accounted for nearly two-thirds of the current account deficit. But with privatization slowing and one-off FDI outflows on account of a change in ownership structure at two large foreign-owned companies, non-FDI flows were the major source of financing for the current account deficit in 2003 (Table 2). However, FDI recovered in early 2004.

uA01fig02

Inflation Developments

(In percent, year-on-year change)

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.A001

Sources: Czech National Bank; Czech Statistical Office; and Eurostat.
uA01fig03

Headline CPI and Contributions of Regulated Prices and Indirect Tax Changes to Inflation

(In percent, year-on-year change)

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.A001

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

Goods and services.

3. With inflation picking up, the CNB has recently raised interest rates to prevent a further decline in real interest rates. Inflation and inflation expectations fell to very low levels in 2003, and the inflation targeting (IT) CNB cut interest rates sharply through August 2003. This action helped elicit a modest nominal depreciation of the koruna and together resulted in a significant relaxation of monetary conditions (Figure 3). Unchanged policy interest rates combined with the gradual increase in inflation further eased monetary conditions in the first half of 2004. Subsequent to the discussions, the CNB raised the repo rate—which had previously tracked the ECB rate—by ¼ percentage point to 2¼ percent in late June 2004. The CNB has announced that its post-2005 IT framework will shift to a 3 percent point target with a tolerance band of ±1 percent, thereby ensuring continuity with the existing end-2005 target (2–4 percent).

Figure 3.
Figure 3.

Czech Republic: Monetary Policy Indicators, 2001-04

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.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/ Based on real interest rate deflated by 12-month backward-looking inflation excluding effects of indirect tax and administered price changes.4/ Ex post 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.5/ Business and total adjusted for loan write-offs and changes in classification of financial institutions.

4. Indicators of banking sector health continue to improve and bank lending to households is dynamic. The cleanup and privatization of banks (some 95 percent of assets are foreign owned) in the late 1990s reduced nonperforming loans, injected new capital, and raised profitability, but for several years banks remained cautious about lending (text table and Figure 3). However with the retail credit market largely untapped and the perceived lower credit risk of households, banks introduced new mortgage and consumer loan facilities. These new credit instruments combined with low interest rates caused bank lending to households to expand at an annual rate of more than 30 percent during the past two years, while lending to corporates remains stagnant.

Indicators of Banking Sector Size and Soundness, 2001-04

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Sources: CNB; and IMF staff calculations.
Table 3.

Czech Republic: Consolidated General Government Budget, 2000-04 1/

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Sources: Ministry of Finance; and IMF staff estimates.

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

Preliminary estimates.

Staff estimates consistent with the 2004 state budget. Revenue estimates are based on staff’s GDP projections. Expenditure estimates include the effects of post-budget spending measures.

Excluding revenues from UMTS license sales.

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

Concept targeted by the authorities.

IMF staff estimates.

Includes privatization receipts 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 2004.

5. Foreign investment has made an impressive contribution to the Czech economy. Among CECs, the Czech Republic has attracted the largest amount of FDI on a per capita basis. Some 20 percent of the FDI stock represented privatization (mostly of banks and network utilities), with the remainder aimed at greenfield and brownfield activities. About half of cumulative FDI has been channeled into services (mainly banking, retailing, transport, and communication), and the rest into industry. Foreign-owned firms account for more than onethird of industrial employment, nearly half of industrial output and value added, and over 70 percent of industrial exports. Foreign industrial firms are also considerably more profitable than their domestic counterparts, with an annual return on equity of about 20 percent (compared with 8½ percent for domestic firms).

uA01fig04

Stock of inward FDI per capita

(euros, thousands)

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.A001

Sources: National Central Banks; and WEO.

6. In contrast to the favorable conjunctural developments, the fiscal deficit continued to drift in 2003. The general government deficit—excluding privatization receipts and transfers to the Czech Consolidation Agency (CKA) to cover the costs of managing bad assets—increased in most of the past five years to reach 5 percent of GDP in 2003 (Table 3).2 Deficit increases occurred in years of both weak and strong economic growth, came despite a significant increase in revenue as a share of GDP, and therefore cannot be explained away as a cyclical phenomenon. That the problem is of a structural nature is also illustrated by the gradual upward creep of government expenditure. The expenditure drift is partly explained by high and rising entitlements, but during 2001–03 expenditures in most other categories also rose. In 2003, in particular, there was higher spending on subsidies, net lending, and investment.

Recent Fiscal Developments, 2001-03 1/

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In percent of GDP.

Excluding privatization receipts.

Excluding receipts from privatization by the NPF, CLL, and local governments 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 abroad of 0.4 percent of GDP.

7. Fiscal policy drift has now been compounded by political uncertainty. Public support for the coalition government gradually eroded, in part due to the unpopularity of their medium-term fiscal plan with the electorate (¶19). Following a poor showing of his party in the June European Parliament elections, Prime Minister Spidla resigned, and the President asked Interior Minister Gross to form a new government. Prospects for implementing the previous government’s fiscal reform plans are uncertain.

II. Report on the Discussions

8. Discussions focused on policies to entrench macroeconomic stability and accelerate income convergence, while minimizing fiscal and financial sector risks. On the fiscal side, strengthening the credibility of fiscal policy plans was the main issue. For monetary policy, keeping inflation close to the middle of the target range in the face of several one-off influences and the diminishing slack in the economy was seen as the main challenge, while discussions about longer–term issues centered on how to improve the business-legal system, enhance financial sector supervision, and make labor markets more responsive to the changing needs of the economy.

9. The authorities believed that a gradual strengthening of activity provided an appropriate setting for fiscal adjustment envisaged under the 2004–06 plan. They considered that meeting the 2004–05 targets was within reach, owing in part to up-front tax measures. Staff cautioned on the vulnerability to policy slippages—particularly giving in to wage and pension demands—and noted that expenditure adjustment envisaged under the plan is back-loaded to a scheduled election year, and requires large spending cuts which would need to be fully identified soon. On monetary policy, staff supported the central bank’s intention to enter a tightening cycle, the first step of which has already been taken.

10. To maintain the edge the Czech Republic has had so far in attracting FDI, the authorities recognized the need for structural reforms. Therefore they intend to continue improving the efficiency and predictability of the business-legal environment, as well as enhancing labor market flexibility. Further reducing state involvement in the enterprise sector, including by restarting privatization, were seen as important by all for improving resource allocation and for shoring up the fiscal accounts.

A. Economic Outlook

11. Growth is expected to firm modestly in 2004–05, led by rising exports and related activities (Table 4). Staff and the authorities agreed that demand would likely shift from household consumption (due to slower growth of real incomes) toward exports and export-related investment on account to stronger global demand and improved external competitiveness. The CNB ‘s April 2004 Inflation Report projected growth in 2004 under the baseline scenario at about 4 percent. However, CNB Board members considered risks to the Inflation Report’s growth forecast to be weighted on the downside on account of a somewhat stronger koruna than assumed in the baseline. Staff also projects a more modest 3¼ percent growth rate owing to a faster expected deceleration of consumer demand. For 2005, staff expects the pace of expansion to increase further to about 3½ percent on the back of stronger growth of EU demand. An improving trade balance is expected to contribute to narrowing the current account deficit in 2004–05. Slack in the economy is projected to decrease but fiscal and monetary policy actions should help contain demand pressures. The moderate increase in growth is not expected to yield significant employment gains in the short term as firms continue to focus on improving productivity, and industrial restructuring at remaining state enterprises continues.

Table 4.

Czech Republic: Medium-term Macroeconomic Scenario, 2001-09

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

In percent of GDP.

12. Downside risks to near-term growth dominate. The growth forecast relies heavily on the timing and pace of recovery in EU demand. Should the expected recovery be undermined by continued reluctance of EU households to step up their spending or by renewed euro appreciation against the U.S. dollar emanating from global current account imbalances, Czech growth would be weaker in 2004–05. Moreover, faster improvements in external competitiveness elsewhere in the region could limit Czech gains in market share. Protracted uncertainty regarding the course of fiscal policy could also slow growth. On the upside, however, bank lending to households remains strong and could moderate the decline in consumer spending growth, and EU recovery may prove to be more dynamic than currently projected.

13. FDI inflows, especially in skill-intensive activities, will be pivotal to achieving faster long-term growth while containing the buildup in external debt. Continuing to draw in FDI—albeit at lower levels than previously—and moving both domestic and foreign firms up the technology ladder is the most likely conduit for accelerating total factor productivity (TFP) improvements and maintaining strong capital accumulation. Already a number of technology leaders (including Accenture, IBM, Sun Microsystems, DHL, Honeywell, Olympus, and Dell) have established or committed to operations in the Czech Republic. If TFP were to grow at rates similar to those in the EU-15 catching-up countries (Greece, Ireland, Portugal, and Spain) in the second half of the 1990s, and labor and capital inputs were to rise at rates broadly similar to those recently observed, Czech potential growth would increase to 3¾ percent. Domestic and foreign investment in high-tech machinery would be the impetus to faster TFP growth, and would raise the growth payoff to investment. A sizable fiscal consolidation would help accommodate stronger fixed investment while permitting some narrowing of the current account deficit—and hence the need for foreign saving.

Decomposition of Growth, 1995-2009 1/

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Decomposition is based on spliced GDP and investment data, as these are only available for 2000-03 on the new methodology.

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 Policy

14. Expecting temporary factors to drive a rapid rebound in inflation during 2004—mid-2005 while underlying price pressures remained subdued, the CNB decided to keep interest rates on hold through mid-2004. The authorities and staff agreed that strong retailsector competition and unused economic capacity would limit the first-round inflationary effect of changes in indirect taxes, regulated prices, and EU-related import duties to about 1½ percentage points in 2004 and early 2005. Owing to low inflation expectations, the CNB saw little risk of significant second-round effects. Staff concurred, and added that a soft labor market could also moderate demands for real wage catch-up. However, staff saw additional sources of pent-up inflationary pressure in previous koruna depreciation, faster growth in wages relative to productivity in the nontraded sector, and rising world prices of oil and raw materials. Staff projections indicate that the realization of these price pressures later this year, combined with the effects of the administrative measures, would temporarily push up inflation to 4 percent (near the top of the CNB’s target band) by year’s end, before dropping during the first half of 2005 (Box 2). The authorities felt that the prevailing negative output gap would dampen somewhat the inflationary effect of these factors, but agreed that with the gradual closing of the output gap, inflation would begin to pick up again in the second half of 2005.

Short-Term Inflation Outlook

Staff estimated a model of Czech inflation that relates consumer prices to exchange rates, commodity prices, productivity-adjusted wages, and economic activity.1 The model also takes into account the impact of regulated prices and indirect tax changes on inflation.

The forecast of the model under the no policy change scenario, which includes the latest WEO oil-price projections and assumes constant nominal interest rates, sees year-on-year inflation peaking at around 4 percent in late 2004. Inflation is then expected to moderate as the impact of administrative price and indirect tax changes dissipates. Declining slack in the economy, together with growth in wages and commodity prices, will however exert upward pressure on inflation beginning in mid-2005. If monetary conditions are not tightened, year-on-year inflation is projected to lie well above the CNB’s point target in 2006.

uA01fig05

Headline Inflation Under No Policy Change Scenario, 2001-05

(In percent; year-on-year)

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.A001

Sources: Czech Statistical Office; and IMF staff calculations.
1 A background paper discusses the model in more detail.

15. The authorities thought that current loose monetary conditions and a gradual closing of the output gap called for a measured policy tightening to keep inflation on target over the medium term. In view of the expected closing of the output gap over the coming year and growing demand-pull inflation pressures, the CNB foresaw the need to initiate a tightening cycle to gradually return real interest rates to levels significantly above zero, with the size and timing of interest rate increases conditioned on exchange rate developments and the robustness of growth. Staff agreed that, with growth expected to rise gradually, monetary conditions were probably too loose to support the inflation target over the next one–two years. Indeed, even after the ¼ percent increase in late June, policy interest rates remain near historical lows while the depreciation of the koruna also contributes to easier monetary conditions. But staff cautioned that the speed at which the output gap closes would depend on additions to productive capacity, which may have been substantial with the near completion of several large manufacturing investments. A rising pace of potential growth would therefore moderate the size of needed future interest rate increases. Staff also cautioned that the exchange rate—while a key determinant of growth and inflation—had recently been quite volatile and the pace of equilibrium real appreciation uncertain. This suggested that less emphasis be given to short-term exchange rate movements in decision making.

16. Notwithstanding a modest reopening of the euro-area interest rate gap, the CNB expected exchange rate pressures to remain relatively balanced. The CNB considered that its ongoing agreement to convert government foreign currency receipts off market and completion of the large initial wave of nonprivatization FDI—while associated dividend outflows were continuing—would help contain the risk of future excessive appreciations. They emphasized that their recent decision to begin selling interest on reserves to limit further accumulation of reserves, although implying an appreciation bias, was not intended to influence the level of the exchange rate.3 The CNB viewed competitiveness as adequate, pointing to the rise in export growth and the improving trade balance. The staff, however, cautioned that Czech unit labor costs (ULCs)—although declining in recent years—had continued to run ahead of ULCs in several other new EU members, and Czech wages were considerably higher than those of second wave enlargement and other emerging-market countries (Figure 2 and text chart). The authorities expected competitiveness in low-productivity, labor-intensive activities to erode with time, as these activities were gradually supplanted by higher productivity ones. They felt that some slowdown in FDI was to be anticipated even with strong competitiveness, owing to the low capital intensity of higher-tech R&D and strategic services that were expected to comprise the next wave of FDI.

uA01fig06

Dollar Wages in Transition Countries, 2003

(In percent of Czech Wages)

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.A001

Source: IMF staff estimates.

17. The post-2005 inflation targeting framework provides continuity and a sound anchor for monetary policy during the pre-euro period. The CNB considered the medium-term inflation target of 3 percent as balancing the goals of inflation convergence and trend productivity catch-up. To capitalize on its acquired credibility, and to avoid a potentially disruptive regime shift, the CNB intends to target inflation through ERM2. CNB officials noted that no regime could resolve the inherent over-determinacy of the Maastricht inflation and exchange rate-stability criteria, and considered it wasteful of reserves to attempt to stabilize the koruna in the event of fluctuations unrelated to fundamentals. Staff supported this pragmatic approach to monetary policy during ERM2, and agreed that the chances of meeting simultaneously the inflation and exchange rate-stability criteria would be enhanced by realizing strong preconditions for ERM2—including credibly reducing the fiscal deficit, improving wage and price flexibility, and strengthening financial sector supervision to reduce risks of financial instability.

C. Fiscal Policy

18. The consequences of fiscal drift have so far remained manageable but the tolerance margin for policy inaction is steadily shrinking. Public debt is still moderate (28 percent of GDP) and its financing costs low.4 However, debt will increase rapidly if significant deficits continue, especially as privatization revenues will soon run out (¶30). It may also jump suddenly if a large amount of guarantees (their total nominal stock is about 20 percent of GDP)5 were to be called—in fact, public debt is already substantially higher on an ESA95 basis, mostly due to accounting for a large guarantee extended earlier that was partially called. These effects would be compounded by a rapidly aging population, which will sharply increase demands on the public purse. Large financing needs could ratchet up interest rates and crowd out private sector credit. High deficits could also derail plans to adopt the euro over the medium term by moving the Czech Republic farther away from being able to fulfill the Maastricht fiscal criteria. And finally, fiscal inaction would preclude easing the Czech Republic’s high tax burden.

19. The authorities believed that their three-year adjustment plan begins to address these fiscal problems. The plan aims to achieve a deficit of 4 percent of GDP by 2006 (4.4 percent of GDP on staff’s “adjusted deficit” definition that includes nonprivatization net lending; text table), underpinned by annual expenditure ceilings and a rolling three-year fiscal framework.6 This plan is broadly consistent with the Czech Republic’s 2004 Convergence Programme.7 It combines upfront indirect tax increases with gradual expenditure reductions—focused on public sector wages, discretionary spending, and social expenditures. Despite several tax changes (mostly tax relief) not included in the budget (Box 3), measures so far in 2004 are broadly in line with the plan, but staff noted that post-budget spending decisions breach the expenditure ceiling (¶20). It is unclear whether a new government would follow the fiscal plan.

Deficit Targets of the 2004-06 Adjustment Plan 1/

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Sources: Ministry of Finance; and IMF staff projections.

In percent of GDP.

Plans formulated based on unrevised GDP.

Excluding privatization receipts, net lending, and transfers to CKA.

Excluding privatization receipts, and transfers to CKA but including nonprivatization net lending.

Based on the Czech Republic’s 2004 Convergence Programme, which adjusts the ratios for the effects of GDP revisions.

20. Staff saw the 2004–06 fiscal plan as a first step in halting––then reversing—the rise in the deficit, but expressed serious concerns regarding implementation. Under staff’s projections—which were slightly more optimistic on growth and revenues than the authorities’—the general government adjusted deficit would widen by over 1 percent of GDP to 6.1 percent of GDP in 2004 (Table 3). Without the help of GDP revisions, it would be even larger, exceeding the target by a significant margin. A drop in nontax revenues played a role in the deficit widening, but loopholes in the coverage and breaches of the expenditure ceilings also contributed. For example, expenditure ceilings exclude subsidies provided by the privatization agency (National Property Fund or NPF) and capital injections through net lending, while some extrabudgetary funds are permitted to exceed their annual expenditure ceiling by the amount of approved spending not undertaken in previous years. In addition, post-budget approval of additional transfers of ⅓ percent of GDP to compensate families and pensioners for the indirect tax hikes appeared to breach the expenditure ceiling.

21. Staff argued for bolstering the plan’s credibility by keeping this year’s general government deficit close to its original target and adjusting downward deficit targets relative to GDP in all years to account for the GDP revision. On current projections, the deficit target would be missed in the first year of the plan. Credibility would require narrowing the headline deficit to meet the original 5.8 percent of GDP target, which becomes 5½ percent of GDP after the effect of the GDP revisions (text table). This would call for additional savings of ½ percent of GDP—a cyclically well-timed tightening that should come from reining in expenditures. While the authorities did not plan additional measures, they thought that tight execution of the state budget, and lower-than-planned spending by extrabudgetary funds would make a better-than-projected fiscal outcome likely. Staff also called for adhering to the initial nominal deficit targets for 2005–06, which implies some downward revision of the targets relative to GDP on account of the changes to GDP.

Revenue Measures in 2004

The 2004 budget includes:

  • EU-mandated increases in excises and shifts of many goods and services (over one-fourth of the consumption basket) from the preferential to the standard VAT category;

  • a 3 percentage-point cut in the CIT—the first step in gradually reducing it from 31 to 24 percent.

Effects of Revenue Measures, 2004-06

(In percent of GDP)

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Sources: Ministry of Finance; and IMF staff estimates.

Net effect of shifting goods and services from the preferential to the standard VAT category; and reducing the standard VAT rate from 22 to 19 percent.

Increases in excises required by EU harmonization.

Phased decline in the corporate income tax rate from 31 to 24 percent.

The increase in the 2004 tax ratio is smaller than the effects of the revenue measures, due mostly to revenue losses from longer collection lags for VAT on imports.

Subsequent to the budget, several tax measures were legislated or proposed:

  • lowering the standard VAT rate from 22 to 19 percent while shifting more goods and services to the standard rate (in effect from May 2004);

  • shortening depreciation periods and easing the income tax burden on married couples and families with children with effect from 2005 (with parliament).

The indirect tax changes would raise revenues already in 2004, but revenue reductions from the proposed direct tax amendments would appear only in later years.

Fiscal Recommendations, 2004-06

(In percent of GDP)

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Corresponds to the deficit path targeted by the authorities’ 2004-06 fiscal plan.

Due to methodological changes, nominal GDP increased by about 5 percent.

Path assumes no change in the targeted nominal deficit compared with the plan.

Includes contributions to the EU budget; losses on customs duties and indirect taxes; direct payments and top-off to farmers; and compensation payments. Staff estimates.

Includes the effects of higher excises; a lower standard VAT rate; shifting items from the preferential to the standard VAT rate; reducing the corporate income tax rate; accelerating depreciation for certain assets; and changes to PIT.

One-offs include spending on compensation to a foreign investor in 2003 (+); shifting infrastructure investment spending from 2003 to 2004 (-); and one-off high dividend income in 2003 (-).

Residual to reach the recommended adjusted balance. Measures not yet fully identified.

22. Reducing the deficit in 2005–06 in line with the plan will require significant additional measures. The authorities thought that scope for revenue increases had largely been exhausted and further adjustment needed to rely on expenditure reductions. However, the measures underpinning cumulative savings of 1½ percent of GDP in 2005–06 were not yet fully identified. Most of the required expenditure adjustment could be back–loaded to 2006 as only modest savings were needed to meet the 2005 deficit target.8 The authorities thought these 2005 savings feasible, assuming pressures for increases in wages and pensions were resisted. Delivering the 2006 target appeared more difficult, as it required finding and implementing significant additional savings measures in a scheduled election year. The mission urged the authorities to specify their plans for permanent savings. Identifying the measures early would also make it possible to spread the expenditure cuts more evenly and bring some of the adjustment forward to 2005. Although the authorities agreed that these steps would strengthen the credibility of their deficit reduction plan, and thought that entitlements and social spending had scope for savings, work on systemic reforms was not sufficiently advanced (see below) to allow implementing measures already in 2005.

23. A stronger fiscal framework could be a useful commitment device to help future policy implementation. Staff advocated: (i) broadening the coverage of the expenditure ceilings to the widest possible range of spending items and general government units; (ii) strictly adhering to the expenditure targets even when higher revenues would finance a spending increase without endangering the deficit target; and (iii) avoiding post-budget spending measures. In response, the authorities explained that although they did not intend to formally broaden the expenditure ceilings, some loopholes would be sealed. Notably, the NPF would be closed by end-2005 and its spending obligations assumed by the state budget, bringing these expenditures under the coverage of the ceiling. The finance minister intended to propose a state budget for 2005 that observed the approved expenditure ceiling, and committed to standing firm against pressures to spend additional revenues.

24. The authorities recognized that fiscal reforms would need to continue beyond 2006 and that long-term sustainability required pension and health care reform. Staff recommended targeting a structural deficit of less than 2 percent of GDP by 2008–09. Although by itself this would not be sufficient to deal with long-term fiscal pressures from population aging, it would help keep public debt at a moderate level over the medium term. This target and policy horizon would also support the authorities’ euro adoption plans. The authorities intended to continue reducing the deficit beyond 2006, while making room to cofinance EU funds. But they recognized that a restructuring of mandatory expenditures would be necessary to sustainably reduce the deficit. In particular, health care reform could yield near-term payoffs, by reducing excess capacity and raising the financial burden on final users. A reform proposal was expected in the next few months. However, the authorities did not see the urgency regarding pension reform as they expected pension expenditures to remain stable at their current level of about 9 percent of GDP for the next 10–15 years owing to recent measures (including a gradual increase in the statutory retirement age to 63 years and tighter conditions for early retirement). But they agreed that with a projected 6 percentage point increase in pension spending relative to GDP by 2050, long-term sustainability required pension reform, and an expert group was expected to set out the main options by early 2005. Staff argued that the long lags from reforms to their impact on public spending necessitated early action. In addition, there was a risk that labor force participation by older workers may not increase as strongly as envisaged and pension spending would start rising sooner and more steeply than projected, eroding the results of previous fiscal adjustment.

D. Financial Sector Issues

25. With dynamic growth in bank lending to households, the authorities acknowledged the need for building capacity to monitor new sources of risk. The authorities recognized the importance of broadening the focus of supervision to systemic sources of risk. However, they considered vulnerabilities from lending to households to be limited owing to banks’ fairly low exposure to households (9 percent of assets), low average household indebtedness (18 percent of disposable income), and small share of classified household loans (3 percent of mortgage loans and about 10 percent of consumer loans). Staff countered that bank loans could be highly concentrated, and low average debt burdens and loan carrying costs could conceal pockets of high indebtedness and financial distress. Moreover, while the pace of consumer lending had recently slowed sharply, mortgages continued to grow very strongly (55 percent) in part due to prevailing low interest rates in fixed-then-variable rate contracts. In the event of higher interest rates, banks would be exposed to dual risks of rising loan defaults and declining collateral prices. To better gauge financial conditions of households and implications for the banking sector, staff recommended collecting data on household debt concentrations, households’ nonbank debt, indicators of debt servicing capacity (including disposable income of indebted households), and prices of housing transactions. Staff welcomed progress in developing a stress-testing framework to assess macroeconomic and financial linkages, but urged the authorities to consider credit risk scenarios where the impact of adverse macroeconomic shocks on household loan quality could differ from that on corporate loans.

26. The planned reorganization of financial supervision should aim to promote a more comprehensive oversight of the sector in the medium term. To enhance supervision of financial conglomerates, the authorities intend to establish a unified financial market supervisor by 2010. The first stage—to be completed by end-2005—will shift supervision of credit unions to the CNB, and responsibility for insurance and pension funds will move to the Securities and Exchange Commission. Subsequently, a single supervisor will be created, either within the CNB or as a separate public entity. The CNB is also reorganizing its banking oversight functions, and setting up a unit devoted to macrofinancial issues, with responsibility for preparing financial stability reports. Staff welcomed these initiatives as promoting better information flows, but cautioned that organizational changes should not distract from effective oversight. The authorities acknowledged this risk, which had prompted their decision to proceed gradually with the merger of supervisors.

E. Structural Issues

27. To minimize risks of resource misallocation, staff called for accelerating privatization and reducing state support to public companies and semi-budgetary organizations. The authorities reported that privatization had been restarted, with the recent sale of the petrochemical company (Unipetrol) and initiation of the process for Czech Telecom. However, the electricity company (CEZ) was likely to remain unsold by the time the NPF was closed. The authorities confirmed their intention to divest all assets of the Czech Consolidation Agency (CKA) and to terminate its activities by end-2007 in order to limit opportunities for future nontransparent bailouts. They also planned to require, with effect from 2006, parliamentary approval for transfers to CKA of bad assets. To limit future drains on the budget and improve allocative efficiency, staff urged that stabilizing the finances of remaining state enterprises—including the railways—be expedited, with state support granted only in the context of restructuring plans aimed at improving long-term viability.

28. Legal and bureaucratic hurdles risk discouraging future investment by engendering uncertainty and costly delays. The Czech Republic scores very highly in global surveys as an attractive destination for offshoring, and hosts many large multinational investors.9 Nonetheless, investor representatives continued to express frustration with the business-legal environment, which they considered to fall short of the high standards expected of EU members. In particular, they pointed to weak creditors’ rights, excessive discretion of bankruptcy judges, cumbersome and lengthy legal procedures, and unpredictable and time-consuming steps for processing entries into commercial registries. The authorities outlined efforts to enhance the efficiency and predictability of the legal environment, notably progress in drafting comprehensive new legislation on bankruptcy and commercial registers and in preparing standardized forms for expediting entries into the commercial registers. Staff welcomed these steps—crucial for attracting and nurturing small and medium-sized firms and for facilitating bank lending to these firms—but noted the substantial delays until enactment. Staff therefore recommended that, in the interim, amendments to existing legislation proposed by a broad cross-section of parliament, and with support from the business and banking community, be adopted.

29. Continuing structural shifts in labor demand, an aging workforce, and a larger role for labor markets in cushioning economic shocks after euro adoption will increase the premium on labor market flexibility. However, declining employment despite solid GDP growth and significant creation of new jobs in the FDI sector, and rising long-term unemployment with persistent regional differences suggest that labor market flexibility may in fact be eroding.10 The authorities saw the roots of these trends in inappropriate incentives generated by the benefit system, skill mismatches, and high nonwage labor costs, and have begun to address some of these issues. Tightening unemployment benefit eligibility for school–leavers and plans to reduce benefit withdrawal rates for those leaving unemployment targeted improving work incentives. Staff welcomed these measures but argued for a more comprehensive strategy to create an environment conducive to job-rich growth. In addition to better incentives, avoiding persistent skill-mismatch was also key. The authorities agreed that policies to ensure that school-leavers enter the labor market with sufficient and marketable skills, and to create adequate possibilities for life-long learning were particularly important and would help preserve the Czech Republic’s attractiveness for FDI. Staff noted that other measures—reducing impediments to labor mobility, including through easing rent control, upgrading transport infrastructure, reducing nonwage labor costs, and keeping labor market regulations flexible—could also help.

uA01fig07

Unemployment by Duration

(In percent)

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.A001

Sources: Czech Statistical Office; Eurostat; and IMF staff calculations.
uA01fig08

Employment and Harmonized Unemployment Rate

(In percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2004, 266; 10.5089/9781451810219.002.A001

Source: Eurostat.1/ Weighted by PPP-GDP.

30. Stalled structural reforms could prevent a pickup in growth potential and lead to a rapid buildup in public and external debt. If a less attractive investment climate and reduced FDI inflows cap potential growth at around 2½ percent, risks associated with public and external debt accumulation would increase (Appendix I). On the fiscal side, not only would slower growth make keeping to the planned adjustment path more difficult, it would also complicate bearing the fiscal costs of called guarantees. Moreover, demands for additional bailouts—including of the railways and hospitals—may arise. By pushing up interest rates, wider deficits could further slow growth. In these circumstances, public debt could increase rapidly, to over 50 percent of GDP and its servicing costs could also rise. On the external side, lower FDI would widen the current account deficit through smaller export capacity, notwithstanding a somewhat weaker koruna and slower import growth. Higher external deficits, less nondebt financing and weaker GDP growth would increase the external debt to GDP ratio to some 55 percent of GDP over the medium term.

31. With EU accession, the Czech Republic adopted the common trade policy. Bilateral trade agreements were terminated or modified to ensure EU-conformity. Most recent changes occurred in trade relations with third countries, and were expected to be neutral, with relaxation of protection in some sectors (e.g., motor vehicles) and higher tariffs and quantitative restrictions in others, especially for some food items from outside the EU.

III. Staff Appraisal

32. The performance of the Czech economy has been broadly satisfactory over the past few years and there is reason for optimism on the near-term outlook. Substantial foreign direct investment has helped raise GDP growth and improve the trade balance. Inflation—after declining sharply in recent years—is expected to stabilize at low levels over the medium term. Public and external debt have so far stayed moderate, and interest rate spreads have been low. Banking sector profitability and capital adequacy are strong, and bank lending has resumed. The upturn in the global economic environment should entrench these favorable developments in the near term.

33. Although economic fundamentals generally remain strong, continued inaction in key areas could prevent the economy from realizing its full potential. Looming fiscal unsustainability risks ratcheting up interest rates; structural reforms are needed to maintain the Czech Republic’s attractiveness to domestic and foreign investment; and labor markets and the education system should become more flexible. Implementing policies to address these problems would contribute to raising economic growth and furthering income catch-up with new EU partners, and lay the foundation for a successful experience in ERM2 and the euro zone. The Czech Republic’s position as one of the most advanced new EU members and attractions as a platform for FDI may quickly slip if its reforms do not keep pace with those of other countries.

34. The authorities’ multi-year fiscal plan provides a basis for reversing the widening of the deficit, but firm commitment to the spirit as well as the letter of the plan is needed. The credibility of the plan has been weakened by allowing the general government deficit to expand again in 2004—the first year of the plan. Measures on the spending side are needed to return the deficit to its original nominal target (which implies a small downward adjustment relative to GDP on account of the GDP revision), and the fiscal framework for future years should be strengthened by strictly adhering to the expenditure ceilings and by closing loopholes in their coverage. The government’s intention to close the National Property Fund by end-2005 will help in this regard. Deficit targets relative to GDP for 2005–06 should also be revised downward on account of the changes to GDP. Credibility of the plan would also be enhanced by choosing as the targeted fiscal concept the broadest possible and most commonly used measure of the deficit, and by projecting and discussing fiscal performance on this basis. A full shift to standardized European fiscal indicators should be expedited.

35. To demonstrate commitment to achieving the 2006 deficit target, required expenditure cuts should be identified expeditiously and spread more evenly, resulting in an over-performance of the deficit in 2005. Yielding to pressures for permanent expenditure increases in 2005 could not only put the 2005 deficit target out of reach, but would add to large required savings in 2006 needed to further reduce the deficit while offsetting the drop–off in tax revenues. The authorities therefore should save any fiscal windfall—whether from higher-than-expected revenues or upward revision of GDP—to reduce the deficit-to-GDP ratio. But this would not eliminate the back-loading of needed expenditure adjustment. To alleviate concerns regarding the feasibility of the 2006 target, shifting forward to 2005 part of the expenditure adjustment is necessary. Nonetheless, the cumulative amount of savings that will need to be found in 2005–06 is substantial; and credible and successful adjustment requires the full and early identification of the necessary measures.

36. Recognition by the authorities that deficit reduction should continue beyond 2006 is welcome, but reforms of the pension and health systems to sustain the adjustment should be expedited. A structural deficit below 2 percent of GDP later in the decade is needed to help keep debt moderate and shore up the fiscal position ahead of intensifying budget pressures from population aging. But without pension and health care reforms, population aging will erode the adjustment effort. Significant changes in pension system parameters will be needed, including further raising retirement ages. On health care, greater cost-sharing with final users is required to reduce demand. Long lags from the introduction of these reforms to their impact on public spending warrant early action, and policy measures should be formulated quickly and implemented promptly.

37. Completing the backlog of structural reforms is crucial for improving the efficiency of resource allocation. The initial misallocation of capital at the beginning of transition was reinforced through the late 1990s by lax bank lending decisions. This misallocation is likely to have been a major cause of relatively slow growth during the past decade. Restructuring and privatizing banks and some large state companies has helped ensure that future investment decisions will be made on a market basis. The authorities’ intention to reduce the role of the state in the economy by resuming privatization and closing the NPF and CKA will improve the efficiency of resource allocation. Pressures for additional bailouts should be resisted to prevent further increases in public debt and allocation of resources to low value-added uses. In addition, improving the business-legal environment should remain an important priority. Enacting expeditiously a bankruptcy law that enhances creditors’ rights and streamlining procedures for entries into commercial registers are long overdue.

38. With underlying inflation expected to rise gradually, monetary policy will need to tighten in the period ahead. Keeping policy interest rates on hold through mid-2004 was appropriate given expectations of subdued underlying inflation. The recent ¼ percentage point increase in the policy rate was needed to prevent any further decline in real interest rates in the context of gradually rising underlying inflation. However, with the expected narrowing of the output gap and pickup in inflation from mid 2005, future interest rate increases will need to outpace inflation in order to tighten monetary conditions. The size and timing of future interest rate increases should be conditioned on evidence of emerging demand-pull pressures which—despite the expected continuing rise in growth—may well be delayed by a faster expansion of potential output.

39. The Czech inflation targeting framework has provided a transparent foundation for monetary policy and offers continuity through ERM2. By relying primarily on the interest rate instrument, rather than foreign exchange intervention, the CNB has provided coherent signals to the market about monetary policy intentions. The CNB should continue to pursue a nonintervention strategy during the forthcoming tightening cycle to avoid resisting koruna appreciation driven by rising domestic interest rates. Measured in terms of unit labor costs, competitiveness against several CECs has eroded, but other factors that are more difficult to quantify—including labor quality—are likely to partially compensate.

40. Bank supervision should adapt to the new risks from rapid growth in lending to households. The CNB’s efforts at improving the analysis of risks from macrofinancial linkages is commendable. But enhancement of supervisory capacity is needed in the area of household credit, and will require data on household indebtedness, debt-servicing ability, and housing transactions. Establishing a single financial sector supervisor should improve information flow, but organizational changes should not distract from effective oversight.

41. The next Article IV consultation with the Czech Republic is expected to be conducted under the standard 12-month cycle.

Table 5.

Czech Republic: Vulnerability Indicators, 1997-2004 1/

(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.

Starting 2000, GDP data are revised.

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 Czech National Bank.

APPENDIX I Czech Republic: External and Fiscal Sustainability

Table A1 shows the results of the external debt sustainability framework for the Czech Republic. Under the baseline macroeconomic scenario, the Czech Republic’s external debt stock is projected to remain relatively stable at near 40 percent of GDP. The current account deficit is expected to narrow, driven largely by a further reduction in the trade deficit and an increase in the surplus on the services account (reversing its earlier trend). FDI—though slowing from very high levels seen early in the decade—is expected to continue to finance a significant part of the current account deficit. While these factors will mitigate the need for new borrowing, external indebtedness (expressed in U.S. dollar terms) is set to increase significantly. However, the automatic effect of GDP growth and gradual koruna appreciation against the U.S. dollar should stabilize the debt-GDP ratio. While the annual gross external financing need (defined as the sum of the current account deficit, amortization of mediumand long-term debt, and the outstanding stock of short-term debt) is expected to increase in U.S. dollar terms, relative to GDP this ratio is expected to decline due to favorable growth and exchange rate developments.

Table A1.

Czech Republic: External Debt Sustainability Framework, 1999-2009

(In percent of GDP, unless otherwise indicated)

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Derived as [r-g-ρ(1+g) +εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r=nominal effective interest rate on external debt; ρ=change in domestic GDP deflator in U.S. dollar terms, g=real GDP growth rate, e=nominal appreciation (increase in dollar value of domestic currency), and a=share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) +εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε>0) and rising inflation (based on GDP deflator).

For projection, line includes price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both noninterest current account and nondebt inflows in percent of GDP.

Relative to baseline, FDI declines by US$1 billion and GDP growth stabilizes at 2.5 percent. Consistent with the alternative scenario in Table A2.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and both noninterest current account and nondebt inflows in percent of GDP) remain at their levels of the last projection year.