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.
On behalf of our authorities, we would like to thank the staff for the valuable policy discussions. The EU accession on May 1 marks the symbolic end of transition of the Czech Republic from a centrally planned to a market economy. The Czech economy is now officially recognized as a well-functioning market economy. However, this does not mean that the task of bringing the economy on a path of increasing prosperity is done. Far from it. But the nature of challenges that need to be addressed to ensure solid economic growth over the long run has changed. As the staff note, Czech policy makers now face similar challenges as policy makers in the more advanced economies.
The staff report notes that the resignation of the government of Prime Minister Spidla and the formation of new government led by the former Interior Minister Gross has increased political uncertainty and the risk of further fiscal drift. It also observes that the unpopularity of the medium-term fiscal plan with the electorate has contributed to the erosion of public support for the previous coalition government.
We would add two observations. First, it is too early to say how the previous government’s fiscal plans will be implemented under the new government. As the staff’s supplemental statement informs us, the coalition agreement includes a gradual reduction of fiscal deficit below 3 percent of GDP by 2008, supported by structural reforms, including pension and health care reform. The new government is expected to present its program to Parliament in late August. Second, voters’ opposition to fiscal reforms may have contributed to the fall of the previous government, but we would argue that this was not the most important reason. As the staff note, fiscal consolidation has not yet begun in earnest. It would not augur well for future fiscal developments if even a plan of a relatively moderate fiscal adjustment would bring down the government.
Recent developments
The latest economic data broadly confirm the picture of a moderate recovery outlined in the staff report, driven by robust domestic demand, particularly private investment demand.
Real GDP grew by 3.1 percent in the first quarter of 2004, with fixed capital formation growing by 9.5 percent and household consumption by 3.9 percent. To a large extent, the rapid growth of investment demand reflected a sharp increase in building investment prior to the May change in the VAT. The solid growth of consumer demand was supported by growth of incomes and continued widespread use of consumer and mortgage credit. Net exports and government consumption contributed negatively to real GDP growth.
In the period January-May 2004, industrial production and sales both grew by about 10 percent, driven mainly by strong export sales. However, it is interesting to note that the gap between the growth of direct export sales and domestic sales is gradually diminishing, suggesting the growing role of domestic demand in supporting output growth. It is encouraging to note that despite the relatively fast growth of domestic demand, January-May 2004 trade deficit remained broadly unchanged from the same period last year. Both export and import growth accelerated, and it is expected that the EU entry will contribute to the continuation of this trend.
Inflation continues to rise gradually. In June consumer prices rose 2.9 percent y/y, while producer prices increased by 6.2 percent. While increase in consumer prices was affected mainly by changes in indirect taxes, and rise in food and oil prices, the increase in commodity prices was the main driving force of the increase in producer prices.
The latest Ministry of Finance macroeconomic forecast projects a somewhat faster real GDP growth in 2004 and 2005, by 3.1 and 3.2 percent respectively (compared to the previous forecast of 2.8 and 3.1 percent). In contrast, the CNB has revised downwards its earlier growth projection for 2004 (made last April) from 3.8-4.2 percent to 3.6-4 percent. In 2005, it projects an acceleration of real GDP growth to 3.5-4.9 percent, driven mainly by a more robust demand in the European Union. The CNB has also revised the projected consumer price inflation somewhat downward compared to its April 2004 forecast. Inflation is now projected to be 2.2-3.6 percent in June 2005 and 2.3-3.7 percent in December 2005.
Monetary and exchange rate policy
In response to the accelerating inflation, the CNB has increased interest rates from 2 to 2.25 percent. Markets expected that further interest rate increases will follow. However, there is some uncertainty how fast and how far this increase will go. Markets are pricing a further increase of 75 basis points by the end of 2004, even though some market analysts point to muted underlying inflation and suggest that the increase could be more gradual.
In considering the arguments for a further interest rate increase, the CNB will, inter alia, take into account the fact that real interest rates are presently negative. In the absence of a large negative output gap, a prolonged period of negative interest rates may not be optimal in an economy where actual growth exceeds potential growth. Moreover, continued elevated oil prices suggest that the risk of secondary effects of these developments on inflation expectations and inflation cannot be underestimated.
On October 13, 2003, the government approved a document prepared jointly with the CNB called “Czech Republic’s euro adoption strategy.” This document stipulates that under the assumption of successful observation of the Maastricht criteria, particularly the consolidation of public budgets, and under the assumption of a sufficient degree of real convergence and progress in structural reforms, the adoption of euro could be expected in 2009-10.
Regarding the successful functioning within the ERM2 framework, the document emphasizes the need for a sufficient alignment of the Czech economy with the euro area in real and financial sectors, as well as further progress in structural reforms and increased flexibility of labor market. However, even if these conditions are met, the CNB does not consider participation in the ERM2 as risk-free. In order to minimize there risks, it has recommended the shortest possible stay.
As part of the strategy of the euro adoption, the CNB has clarified the monetary policy framework for the period 2005-2010. The CNB has decided that in the period after 2005 when the present policy strategy expires, it will continue to implement an inflation targeting framework. Specifically, the CNB will aim at keeping inflation at 3 percent plus/minus 1 percentage point. The CNB thinks that this objective is sufficiently ambitious to allow stabilization of inflation at a level that would allow it to meet the Maastricht inflation criterion, but at the same time, it takes into account the specific needs of the converging economy.
Fiscal policy
Fiscal policy remains the most difficult challenge. While some progress has been achieved in addressing the deterioration in public finance, it is clear that the measures implemented thus far are not sufficient to ensure a long-term sustainability of public finance.
In recent years, there has been a continued increase in general government deficits. This deterioration has continued even as real GDP growth doubled in 2003 compared with 2002. This clearly suggests that the budget deficits are mainly of a structural and not cyclical nature. To a large extent, increasing budget deficits reflect the rapid growth of mandatory spending. However, the deterioration of public finance also reflects transformation-related costs and the costs related to the EU accession. In recognition of the unsustainable trends in public finance, the government has approved in June 2003 a reform of public finance. Expenditure and revenue measures are supposed to reduce the general government deficit to below 4 percent of GDP in 2006.
It is encouraging to note that the reform measures adopted thus far have already brought some positive -though limited- results. Tightening of eligibility for sickness benefits contributed to a decline of these benefits in January-May 2004 by CZK 2.7 billion relative to the same period of the previous year. In contrast, other categories of social spending where no reform has been implemented continued to grow in 2004. The number of public sector employees has been reduced by over 9000, and total wage spending has remained largely unchanged, despite the increase in average salary by 9 percent.
The staff welcomed the adopted measures, but at the same time, have raised valid concerns. First, the staff note the insufficient coverage and enforcement of expenditure ceiling. Second, the upward revision of the GDP level means that budget deficit targets in terms of GDP could be met with higher nominal deficits. The staff call for adhering to original nominal targets. Third, the staff note that significant additional measures – mainly expenditure reduction - will be required to reduce the deficits in 2005-06 as originally planned. However, delivering spending cuts as the election scheduled for 2006 approaches could be difficult.
The Minister of Finance remains committed to keep the public finance reform on track, enforce the spending ceilings, and avoid using any potential excess revenues to increase budget spending, as prescribed by the budgetary rules. Moreover, it should be noted that fiscal policy of the new government will have to be guided by the May 2004 convergence program.
From the longer-term perspective, it is now widely recognized by the political representatives and the public that a more fundamental reform of public finance will be needed to ensure their long-term sustainability. New demographic projections released by the Czech Statistical Office at the end of 2003 point to significant medium- and long-term pension and health care spending pressures. To address this problem, all parliamentary parties have established a commission of experts to formulate alternative proposals for pension reforms. Similarly, work is underway on a comprehensive reform of the health care system. However, legislative steps are unlikely before the next election.
Structural issues
The staff has correctly identified high unemployment as another serious problem that needs to be tackled urgently. Not only does unemployment remain high, but also the share of the long-term unemployed is increasing, suggesting serious problems hampering the efficient functioning of the labor market. Reform of the labor market is desirable for several reasons: (1) to stimulate employment and increase economic growth that would also support faster reduction of fiscal deficit; (2) to prevent the creation of a large number of difficult-to-employ persons; and (3) to increase the flexibility of the economy and to prepare it better for euro adoption.
It is encouraging that recently, the growth of unemployment has stopped and the unemployment rate has even declined from 10.2 to 9.9 percent. Nevertheless, the main problems of the Czech labor market –skill and regional mismatch exacerbated by disincentives for some categories of unemployed to search more actively for jobs– are structural and cannot be addressed by higher growth.
These mismatches and disincentives require different policy responses and can bring positive results with different time lags. Reducing disincentives to search for jobs can bring the fastest results. In autumn, tighter rules for unemployment support should come into force. Persons unemployed for more than one year will be required to participate in public works to remain eligible for social benefits. Reducing regional mismatches would require a deregulation of rents, thus stimulating the housing market. This, too, can bring relatively quick results. As for skills mismatches, this could take more time to address, because it requires far-reaching changes in the education system.