We thank staff for their papers and constructive approach during the mission. The Czech authorities broadly agree with the staff’s appraisal, especially with respect to the need for fiscal consolidation. The authorities welcome staff’s call for reforms in the pension and health care system. They observe that a fundamental reform in these areas requires wide political consensus.

Political background

The current caretaker government, which was set up in early 2009 after the collapse of the previous coalition government, has a limited political mandate and is therefore constrained with respect to fundamental fiscal or other reforms. The next general elections will be held in May 2010. The two major political parties have somewhat different approaches for fiscal consolidation. While the social democrats of the CSSD generally prefer tax increases, the civic democrats of the ODS favor cuts in mandatory expenditures, especially the benefits system, and increase in effectiveness of the tax system and tax collections. With respect to pension and health care system reforms, neither of the major political parties has made any strong commitment yet.

Economic background

The Czech economy has been severely hit by the global economic and financial crisis. According to preliminary data released by the Czech Statistical Office on February 12, 2010, real GDP fell by 4.3 percent y-o-y in 2009, driven mainly by a decline in external demand and investments. GDP contracted by 4.2 percent in 4Q 2009. Industrial production declined by 13.4 percent y-o-y in 2009.

The unemployment rate reached 6.8 percent in 2009. The Czech National Bank (CNB) estimates that unemployment may reach a peak of 8.9 percent in 2010/2011.

The extent of the Czech economy’s decline was similar to other Western European economies but was less severe than in some of the Eastern European economies. The Czech economy’s decline reflects its strong trade linkages to Western Europe, especially Germany.

The future course of economic growth in the Czech Republic largely depends on the growth dynamics in Western Europe. The Czech authorities expect some improvement in economic activity in 2010, with a more sustained economic rebound expected in 2011. The end of the cash-for-clunkers program in Germany and the weaker than expected economic growth in Western Europe in 4Q 2009, which suggests only a gradual and uneven recovery of foreign demand, are the main external risks to economic growth in the Czech Republic. The CNB expects GDP to grow by 1.4 percent in 2010 and by 2.1 percent in 2011. The Czech Ministry of Finance (MoF) is somewhat more optimistic as it expects GDP growth of 2.6 percent in 2011. The main drivers of GDP growth in 2010 will be net exports while household consumption will be quite week this year.

With a deficit of 6.6 percent of GDP in 2009, the fiscal position worsened significantly but remains comparable to a number of Western European countries and more favorable than in some other Eastern European countries as well as in some euro area countries.

Monetary policy and the banking sector

CPI inflation bottomed in 2009, reaching 0.2 percent in 3Q 2009. The CNB started to decrease its policy interest rates already in August 2008, from 3.75 percent to 1 percent currently. The February 2010 forecast of the CNB sees inflation returning to its new 2 percent target in the first half of 2011, suggesting that the cycle of interest rates easing may have probably ended. The main drivers of inflation in 2010 will be tax changes, a rise in regulated rents, growing gasoline prices and a modest recovery in food price growth. There are no apparent fundamental inflationary pressures in the economy at the moment, even though there is uncertainty associated with the nominal wage growth. The transmission mechanism of the monetary policy is improving and remained operational even during the crisis. The CNB did not have to rely on any truly non-conventional monetary policy measures. The measures introduced during the crisis (i.e. liquidity-providing repo operations with fixed rate, full allotment and collateralized by Czech government bonds), were used by the banks only to a very small extent. Monetary policy performed well during the crisis and retained its credibility. Inflation expectations remain anchored. The CNB regards the current level of the CZK/EUR exchange rate as broadly in line with fundamentals and believes that the trend of equilibrium real appreciation will resume in the medium to longer term. Foreign investors perceive the Czech economy as stable with a relatively low public debt level.

With respect to enhancing the integration between macro-prudential analysis and supervision analysis, the CNB established a macro-financial panel taking place before each monetary-policy meeting of the Central Bank Board. This panel gathers representatives from both the monetary policy department and the supervision and financial stability departments to discuss e.g. current macro-prudential issues and results the banking sector stress-tests.

The Czech banking sector proved largely resilient to the crisis. Czech banks operate in a conservative business model and have relatively healthy balance sheets. As staff pointed out, the share of foreign exchange loans is very low, banks are well capitalized and funded domestically mainly from deposits. The economic downturn is causing an increase in non-performing loans and default rates, especially loans to corporations. Nevertheless, even the most pessimistic scenarios of the CNB’s stress-tests show that the banking sector is able to withstand even a significant increase in default rates without any intervention from the government or central bank. The future course of the banks’ lending will be conditioned on the economic growth prospects both at home and in Western Europe.

With respect to the staff appraisal of the Deposit Insurance Fund (DIF), the authorities believe that the role of the DIF should be limited to a pay-box.

Fiscal policy

Fiscal policy is the main challenge for the next Czech government. During the current economic crisis, the fiscal position significantly worsened. According to the January 2010 numbers from the MoF, the overall budget deficit in 2009 reached 6.6 percent of GDP and is projected to reach 5.3 percent of GDP in 2010. Public debt increased from 30 percent of GDP in 2008 to approximately 35.2 percent of GDP in 2009. With more than 70 percent of government expenditures being mandatory and quasi-mandatory, the structural problems of public finances are obvious and existed already before the crisis. The overall budget deficit worsened during the crisis because of both automatic stabilizers and anti-crisis measures. The austerity package approved by the current government attempts to bring the deficit down in 2010. Even though the current government has a limited mandate and tenure, it tries to act responsibly and prepare the ground for the next government with respect to fiscal consolidation. The Czech Republic has been one of the first European countries to start fiscal consolidation. There was a shift from direct to indirect taxation in 2010, which is in accordance with staff’s proposal. The MoF’s long-term goal is to unify the VAT tax rate. In the medium term, it plans to move more goods from the lower tax rate to the higher tax rate. The MoF is currently working on reviewing the tax base and minimizing the occurrence of exemptions by 2011. The MoF agrees with staff that social benefits system is too generous and should be better targeted. In cooperation with the World Bank, the MoF plans to establish one collecting agency for all taxes (except of tariffs) by 2013. The MoF is also aware of the fact that more efforts should be made in improving the entrepreneurial environment and the competitiveness of the Czech economy.

The authorities believe that the government bond market is slowly recovering from the crisis. On the primary market, investors’ demand for government bonds is still strong. The MoF regards its debt management to be transparent, rooted in its publicly available debt management strategy and sees no troubles for refinancing in 2010.

On February 8, 2010, the government approved the Convergence Program – a medium-term budget plan that should lead to compliance with the fiscal Maastricht convergence criterion by 2013. The budget deficit should be reduced to 3 percent of GDP by 2013. All political parties respect this commitment and agree that without necessary fiscal consolidation measures, this goal cannot be achieved. The Convergence Program sets out the goal and sketches possible solutions to reduce the budget deficit to 3 percent by 2013. The concrete measures will need to be approved and taken by the new government. An appropriate legislative framework needs to be prepared in advance for the 2011 budget measures. The Convergence Program was sent to the European Commission.

On February 8, 2010, the government also approved its exit strategy. The consolidation of public finances and the fight against corruption are at its forefront, with a proposal to harmonize the tax base for the calculation of personal income tax and social and health insurance, to reduce wages in the public sector, confirmed doubling of the real estate tax, and other temporary changes or increases in indirect taxes and personal income tax. Additional proposed measures include improving the business environment, reducing administrative burden on companies and a wide array of concrete steps in the energy industry, housing policy, tourism, EU funds administration, transport policy, export policy, social policy, employment policy, agriculture, and environmental policy. These government proposals received mixed feedback from the political parties but could serve as a guideline for the future government.

Structural issues

The current government welcomed the reform call by staff in the pension and health care systems, though admitted that these two areas are the most sensitive issues in the Czech Republic. Their reform will require a broad political consensus. Both of these areas are largely affected by the rapidly ageing Czech population. For the pension system, a number of smaller changes have been already approved both to the pay-as-you-go system and the voluntary pension pillar. Last January, the Minister of Finance together with Minister of Labor and Social Affairs re-established the so-called Bezdek Committee for the pension reform. This advisory body should evaluate its findings from 2004-2005, based on the current economic environment and recommend the most suitable scenario and future reform steps.

With respect to the health care reform, there is no platform set up to discuss possible reform proposals yet, but all political parties envision a need for a deeper structural reform of the health care system.