Macroeconomic outlook

After an average growth of 6.4 percent during the period 2005–2007, growth in 2008 isestimated to have declined to around 4 percent. In 2009, the highly open Czech economy is set to slow down further due to the deteriorating outlook in its main trading partners.

In its January outlook update, the Czech Ministry of Finance revised the October forecast for output growth in 2009 from 3.7 percent to 1.4 percent. This is in line with the January 2009 Interim Forecast of the European Commission which anticipates growth of 1.7 percent. However, both outlooks point to downside risks.

Macroeconomic forecasts and their risk assessments are currently fraught with unprecedented uncertainty. Continuous revisions to the global and Euro zone economic outlook make it difficult to assess the impact of exogenous variables on the Czech economy. Weakening external demand will weigh on export and investment activities despite the current depreciation of the Czech koruna. Weaker business activity will slow down employment growth, which in turn will moderate domestic demand. The consensus forecast for 2009 has dropped from 4.4 percent in August 2008 to 0.3 percent in the January 2009 survey.

Policy challenges

The Czech Republic has entered the current global crisis without significant macroeconomic imbalances and with a sound financial system. Nevertheless, macroeconomic management is facing significant challenges because of uncertainty about the economic contraction in main trading partners. The authorities are aware that the Czech economy is heavily dependent on exports, concentrated in a few sectors and towards a few countries. Therefore, in the short term, domestic demand should be boosted with fiscal stimulus measures, while in the medium to long term, structural reforms to improve the competitiveness and flexibility of the economy will make the economy more resilient to adverse external shocks. National policy choices of a small open economy have a limited impact on the current global conditions. In a small open economy, demand-stimulating measures, significantly leak to external economies. Therefore, the Czech authorities support a coordinated international approach in reversing the current global slowdown.

On December 2, 2008, the Czech Government announced its “Strategy of Preparedness and Growth Acceleration” to mitigate risks related to the global financial crisis. Early this year, the National Economic Council was established to identify measures to minimize the impact of the unfavorable external cyclical conditions, while preserving long-term objectives. A comprehensive set of structural reforms is well-identified to improve the economy and will be implemented when a broader political consensus across ruling and opposition political parties can be reached on the detailed nature and sequence of particular reforms.

(i) Public finances and fiscal stimulus

The general government deficit has been reduced from 2.7 percent of GDP in 2006 to 1 percent in 2007. For 2008, this deficit was broadly stable at 1.2 percent, despite less favorable economic growth, thanks to the beneficial effects of the January 2008 fiscal measures.

The 2009 budget, adopted last October, targeted a deficit of 1.6 percent of GDP. However, as automatic stabilizers will be allowed full play, and because of the fiscal stimulus plan, the deficit is now expected to be at 3 percent. Assuming adherence to the spending ceilings outlined in the medium-term budget, the deficit should be 2.9 percent of GDP in 2010 and 2.5 percent in 2011.

As part of the European Economic Recovery Plan, the Czech government announced the following stimulus measures, equivalent to about 1 percent of GDP:

• Cuts in employees’ social security contributions with a net budget cost of CZK 18.4 billion;

• CZK 14.4 billion contribution to construction and modernization of infrastructure within the State Fund of Transport and Infrastructure;

• Increase of salaries in the government sector by CZK 2.7 billion following a decrease in public sector salaries in real terms in 2008;

• Increase of capital of the Czech Export Bank (CEB) and other export promoting institutions by some CZK 2 billion;

• Increase in the capital of Supporting Guarantee Agricultural and Forestry Fund by CZK 0.3 billion;

• CZK 0.6 billion investment incentives for technology centre projects;

• CZK 0.5 billion for environment related projects, which are co-financed by EU Funds.

The government is determined to cut, in 2009, expenses for CZK 15 billion, or 0.4 percent of GDP. If approved by the parliament, these cuts will create budget room to absorb the cost of additional structural measures to boost the domestic economy.

Resources from EU funds are expected to have an expansionary effect, without affecting the general government balance.

(ii) Financial sector resilience

It is important to assess each country on its own merits and to avoid associating a country with the problems in the region when this is not justified. The Czech Republic has managed to avoid contagion from the financial turmoil. The main financial institutions remain sound, well-capitalized and profitable. A comfortable level of local currency deposits shields these institutions from liquidity strains and provides them with stable financing at reasonable costs compared to other volatile external sources.

Although the Czech financial sector is not immune to the global financial crisis, its healthy conditions have helped avoid financial distress. The Czech financial system was comprehensively restructured and consolidated during the last decade. An independent central bank conducted successfully monetary policy aimed toward maintaining price stability. Financial regulation and supervision, covering the entire financial sector, was the responsibility of the central bank which encouraged sound financial practices. This setting has enabled domestic interest rates to be lower than in the eurozone, making foreign currency loans not attractive for households and corporate borrowers.

The strengths of the Czech financial system, which is mainly foreign owned, are: (i) growth opportunities in traditional banking and their reasonable profitability, (ii) negligible share of structured credits, not exceeding 1 percent of total assets, and (iii) stable funding by local deposits rather than by foreign funds. In the Czech Republic, the deposit to loan ratio is double the average ratio in the original members of the European Union.

The Staff Report concludes that “concerns about the health of the banking sector have intensified. Temporary withdrawals by depositors, contributing to a further tightening in liquidity conditions…”. This was most likely a temporary episode stemming from neighboring countries announcing more generous deposit insurance schemes. After the alignment of the deposits guarantee scheme with the EU agreement in mid-October 2008, covering 100 percent of deposits up to euro 50,000, withdrawal of deposits stopped. The staff have also expressed concern about the high off-balance sheet liabilities. The Czech authorities remain vigilant and monitor these developments. They would appreciate it if the staff could provide a more detailed analysis and comparison with similar economies.

The staff caution against the quick and significant reduction of exposures of foreign banks in the region. We would like to draw attention to the difference between a parent bank withdrawing existing funds and not extending new financing. Subsidiaries of foreign banks, with funding from local sources, as is mainly the case in the Czech Republic, are in a more stable condition than subsidiaries and branches that rely on foreign currency funding from the parent bank. In addition, the allocation of liquidity by a subsidiary to its foreign parent bank is constrained by the prudential regulation limiting risk concentration on counterpart to 20 percent of own capital. Nonetheless, the CNB monitors the situation of the main financial institutions daily in order to react without delay if appropriate. The banking law might be amended to strengthen the supervisory system as needed.

(iii) Euro adoption prospects

The Czech authorities annually assess the extent to which economic conditions, in particular, nominal and real convergence, are sufficiently aligned with the euro area. The Czech Republic has been improving its sustainable macroeconomic convergence with the euro area in all traditional indicators. Also, the government’s financial position is no longer a barrier to fulfilling the Maastricht criteria, now that the excessive deficit procedure has been terminated. Since the one-off inflationary effect that caused a temporary hike in inflation in 2008 has subsided, inflation in 2009 is expected to allow fulfillment of the price stability criterion. The criterion on long-term interest rates has been and will continue to be fulfilled.

The Czech Republic does not participate in ERM II and, thus, does not fulfill the exchange rate criterion. In addition, the present global financial crisis has increased the volatility of the exchange rate, so fulfillment of the exchange rate criterion within ERM II could be difficult and costly. Given the current assessment and the uncertain near-term outlook, the Ministry of Finance and the CNB have recommended that the government should not set a target date for adopting the Euro.