Abstract
The Czech Republic’s strong fundamentals helped to sustain economic growth with low unemployment and underpin strides toward convergence with EU-15. Executive Directors welcomed the euro accession strategy and the sustained implementation of the Maastricht criteria, which would provide a solid foundation for euro adoption. They commended the sound financial system and prudent monetary policies and supported policy tightening to counter rising inflation pressures. Directors highlighted the need to sustain fiscal consolidation, promote labor participation, and lower structural unemployment in alleviating fiscal adjustment.
The Czech authorities would like to thank the IMF staff for another comprehensive and useful report. Salient features of this consultation include comprehensive tax and spending reforms decided by the government and the new monetary policy communication strategy adopted by the Czech National Bank (CNB).
The dialogue between the authorities and staff was constructive and candid. The joint conference on fiscal reforms, in which the public and private sectors and the academia participated, enabled an exchange of views with a broad professional audience on the staffs analytical work, which is included in the Selected Issues Paper. The involvement of experts from different areas was helpful in building consensus on fiscal reforms.
Recent macroeconomic developments
With output growth of 6 percent, the third quarter of 2007 was the 10th consecutive quarter during which real GDP grew by at least 6 percent. GDP growth is now estimated to have been 6.2 percent in 2007, considerably better than the 4.8 percent projected by staff or the 5.3 percent projected by the CNB last year.
Less positive is that annual inflation which reached 5.4 percent in December 2007, a peak since August 2001 and more than 2 percentage points above the projections made by the Fund and CNB one year ago.
The acceleration in inflation was the result of higher prices for food, alcoholic and non-alcoholic beverages, tobacco, transportation, restaurants and hotels. Rising food and energy prices worldwide make the surge in Czech inflation largely an exogenous cost-driven shock. The hike in food prices in the Czech Republic was however higher than that in neighboring countries. One factor could be that these prices were adjusted upwards in anticipation of the VAT increases that were to be implemented on January 1, 2008. The inflation outturn in January 2008 may confirm this analysis or indicate other factors that resulted in these late 2007 price increases such as higher demand pressures than those in neighboring countries or a weakening in competition. In any case, the CNB expects a further tightening of monetary policy. How much will the interest rates increase will depend on the size of the nominal exchange rate appreciation which effectively tightens monetary conditions. The most recent appreciation of the Czech Koruna overshoots the equilibrium exchange rate path estimated by the CNB.
High growth and lower unemployment have contributed to a favorable budget outcome, estimated to be a deficit of CZK 66.4 billion in 2007, or 1.9 percent of GDP. This was CZK 30 billion less than the deficit in the previous year and CZK 25 billion less than budgeted for 2007. Unused budget appropriations of CZK 79 billion were transferred to the reserve funds.
For 2008, the Ministry of Finance has projected a general government budget deficit of 2.9 percent of GDP. However, in light of the 1.9 percent fiscal deficit in the previous year, the authorities are now considering to implement fiscal measures which will ensure more balanced macroeconomic conditions.
Challenges of fiscal policy
Since the new government took office in January 2007, it has expressed its commitment to bringing public finance to the original trajectory of a declining deficit and to closing the Excessive Deficit Procedure of the EU in a credible and sustained manner. With these goals, the September 2007 Act on Stabilization of Public Finances, primarily curbs mandatory expenditures by amending 49 laws and regulations. However, the authorities are aware of the need for further expenditure cuts in order to prepare the public finances for the cost of aging. Therefore, pension and health care systems and other mandatory expenditures will be further reformed before the next election in mid-2010. This will be a politically challenging task, because the government is supported by just 100 out of the 200 members of Parliament. Moreover, the better than expected fiscal outcome in 2007 carries the risk that Parliament becomes more complacent about the need for further fiscal consolidation.
Despite the cyclical improvement in the 2007 budget outcome, long-term fiscal sustainability remains a challenging policy issue. The government remains fully engaged in the preparations for reforming the pension and health care systems.
There is a three-pronged strategy for reforming the pension system. The first phase has been stabilizing the current pay-as-you-go system by parametric adjustments such as a gradual increase in the retirement age to 65. The second phase aims at improving the protection of participants in second voluntary pension schemes, making them more attractive for workers and employers alike. The third phase of the strategy is to establish a voluntary savings pillar to which people could save and direct either full or part of their contributions under the state-run pay-as-you-go first pillar system. The political debate over the strategic issues with regard to the pension system, which was reopened in June 2007, is still ongoing.
The reform of the health care system will also be undertaken in several stages. The first phase is underway and aims at reducing the cost of the system for the public finances by introducing charges for doctors' visits, prescription drugs, hospitalization, and by curtailing the cost of medicines. The budget transfers to the health care system are now temporarily frozen. A panel of independent experts, set up in June 2007, is assessing the current state of the health care system and its viability. It remains to be seen, how soon it will be politically possible to implement that committee's recommendations.
The new government continues to improve transparency of public finances and to implement other institutional reforms needed to achieve its fiscal objectives. Key among them is the closing or integration of off-budget institutions. Tax and custom administrations will be gradually integrated, as will be the collection of social security and health insurance contributions. Both measures will reduce administrative costs.
Refinements of monetary policy communications
The CNB's current inflation target of 3 percent was announced in March 2004 and took effect in January 2006. It was set marginally above the price stability level of the European Central Bank (ECB) for the euro area. The target level of 3 percent reflected specific features of a transforming economy converging towards the advanced countries. In March 2007, the CNB has announced a new inflation target of 2 percent with a tolerance band of ± 1 percent, effective January 2010.
In recent years, the Czech economy has stabilized around its steady state. Given the gradual stabilization of the structure of consumption and the completion of the main “transformation” changes in the quality of consumer goods, the extent of statistical overestimation in the measurement of inflation is expected to decline gradually. Lower measured inflation should also be fostered by the fact that the new consumer basket, used since January 2007, has increased the weight of tradable unregulated commodities, whose prices are rising only slowly or even falling in the Czech Republic over the medium term. Also, inflation expectations have been anchored just below the CNB's current target of 3 percent. In this situation, moving to a lower inflation target will help achieve the Maastricht inflation criterion.
Since the launch of its inflation targeting strategy, the CNB has gradually increased the transparency of the Bank Board's monetary policy decision-making. Beginning 2008, the CNB will publish, in numerical form, the forecast-consistent path of its policy interest rates. This step will further enhance the transparency of the CNB's inflation forecast and will give external observers a better understanding of the CNB's monetary policy. However, this forecast is not a commitment by the CNB to future evolution of rates. Developments and new information that becomes available since the preparation of the forecast can cause the actual interest rate path to deviate from the previously forecast path. Like the forecast for other main variables, this uncertainty will be illustrated in a fan chart.
The CNB has decided to release the voting results of individual Board members on interest rate decisions. This will allow observers and the general public to better identify the opinions of each Board member and thus better understand the decisions of the Board as a whole. It will also give Board members more freedom to express their views in public. Increasing the accountability of individual board members will strengthen the principle of majority in the decision-making process of the Board.
Prospects of euro adoption
As an EU member without derogation, the Czech Republic is committed to adopting the euro once the Maastricht criteria are met. Its strategy for adopting the euro anticipated the country's joining the euro area in 2009 or 2010.
The Czech authorities annually assess whether economic conditions and nominal and real convergence are sufficiently aligned with the euro area. Based on an overall assessment, the Czech government has now concluded that only some of the preconditions for benefiting from the adoption of a single currency have already been met. The main obstacle to the fulfillment of the Maastricht criteria continues to be the medium-term prospects for public finances. The still limited flexibility of the labor market and an unsatisfactory entrepreneurial business environment represent a continuing risk for the smooth performance of the Czech economy within the European monetary union.
The euro adoption date will depend on the resolution of these obstacles. The Czech government is committed to making maximum reform efforts to resolve these problems by the end of its term. Only after successfully establishing the conditions for benefiting from adopting the euro will the Czech authorities announce the targeted adoption date and enter the ERM II for the minimum required length of time.