The Czech authorities thank the Article IV and the FSAP teams for constructive exchange of views during their missions.

Economic development and outlook

Strong exports drove the economic recovery in 2010 and continued in 2011 when real GDP growth reached 1.7 percent. However, towards the end of 2011, the Czech economy entered into a mild recession in tune with similar developments in the euro area, which is the Czech Republic’s main trading partner. Fiscal consolidation and the conservative and cautious consumer behavior of Czech households contributed to the slowdown. As external demand picks up, real GDP growth should resume in 2013. For this year, the Czech authorities expect growth in the order of 0 - 0.2 percent of GDP and in the order of 1.3 - 1.9 percent in 2013, when the loss in absolute real GDP due to the crisis is expected to be recovered.

Employment creation reflects sluggish growth and the uncertainty about developments in the euro area. Unemployment may gradually rise from 6.7 percent in 2011 to 7.2 percent in 2013. This will be a drag on household consumption.

The current account deficit is projected to shrink by 0.6 percent of GDP to about 2.3 percent in both 2012 and 2013. While the trade and services account is in surplus, the income account contributes to the overall deficit mainly because of dividends on foreign direct investments paid to non-residents (of which 1/3 is reinvested in the Czech Republic). The current account deficit should remain at a sustainable level.

At the end of 2011, the net international investment position was -49 percent of GDP. Foreign direct investment liabilities of the Czech Republic accounted for 56 percent of total external liabilities. The Czech Republic’s external debt was 49.2 percent of GDP, equally divided between public and private debt.

Monetary policy and exchange rate

Credible inflation-targeting monetary policy, flexible exchange rate as well as integrated financial sector supervision within the CNB served the country well during the crisis. The CNB did not have to rely on any unconventional monetary policy measures during this crisis period.

The macro-financial panel established within the CNB to integrate monetary policy analysis, supervision and macroprudential analysis ahead of each monetary-policy meeting of the CNB Bank Board serves the policymakers well in informing them about broader financial sector developments in the economy.

Annual changes in monthly headline inflation increased from close to zero levels at the end 2009 to 3.8 percent year-on-year in March 2012. Monetary-policy-relevant inflation, i.e. inflation adjusted for the first-round effects of changes to indirect taxes, also rose slightly to 2.7 percent in March 2012 and is thus in the upper half of the tolerance band around the inflation target (i.e. 2 percent headline inflation with tolerance band of ± 1 percent).

The main sources of inflation are administered prices (mostly natural gas prices) and food prices – reflecting first-round effects of the hikes in VAT rates – as well as fuel prices and the gradual pass-through of the depreciated exchange rate to prices. However, core inflation remains slightly negative consistent with the disinflationary development of the domestic economy.

The forecast assumes that headline inflation will be just above 3 percent for most of 2012 owing to the VAT increase and will fall below the CNB target (i.e. below 2 percent) in 2013. Consistent with well-anchored inflation expectations, the CNB’s forecast expects stability of market interest rates in the near future and a modest decline thereafter, and the exchange rate to appreciate gradually against the euro from its currently weakened level.

The CNB considers the level of foreign exchange reserves as adequate, amounting to 22 percent of GDP, covering 43 percent of all external debt liabilities of domestic entities, 23 percent of total banking sector assets, and 3.6 months of imports.

Czech banking sector

The Czech banking sector proved highly resilient throughout both the U.S. subprime crisis and the euro area crisis, mainly thanks to sound fundamentals prior to the crisis. Czech banks follow a traditional banking model. Their assets do not include substantial amounts of structured products. The share of foreign-exchange denominated loans is very low. Czech banks are primarily funded from local deposits. The Czech banking sector operates in an environment of excess liquidity. During this crisis, Czech banks – which are largely subsidiaries of euro area banks – served as net creditors to their parent banks in euro area. The loan-to-deposit ratio of the Czech banking sector is 73 percent, among the lowest in the European Union. In recent years, the Czech banking sector has been the most profitable and stable in the Central and Eastern Europe, with ROE above 20 percent, and CAR around 15 percent. The share of non-performing loans in total loans is leveling up at 6.4 percent. Almost 60 percent of non-collateralized loans to households and corporations are provisioned. The largest Czech banks substantially exceed the EBA 9 percent Tier 1 ratio recommendation. There have been no signs of loan deleveraging driven by recapitalization needs of the euro area parent banks.

The FSAP’s stress tests in November-December 2011 highlighted the resilience and profitability of the Czech banking sector. Even in the scenario of a severe recession in Europe accompanied by losses of the subsidiaries on their exposures to their euro area parents, the banking sector as a whole would remain only slightly undercapitalized, potentially requiring only a small amount of fiscal resources. Even in this scenario the banks would recover these small capital losses in as soon as two years thanks to the profitable business model.

The resilience of the Czech banking sector to severe stress was also confirmed by the most recent February 2012 stress tests by the CNB. The capitalization of the entire sector would remain above the regulatory minimum of 8 percent even in a significantly adverse stress scenario combining negative developments in the domestic and external economy and renewed uncertainty in financial markets caused by an escalation of the debt crisis in the indebted euro area countries.

Since 2009, there is close cooperation between the CNB, the Ministry of Finance and the Deposit Insurance Fund.

FSAP update

The Czech authorities welcome the positive assessment of the Czech regulatory and supervisory framework. They acknowledge the extensive work done by the assessment team, who delivered very well elaborated documents. Generally, the CNB appreciates the recognition of the resilience and stability of the Czech financial system as well as the statement that compliance with the Basel Core Principles for Effective Banking Supervision has improved markedly since the previous assessment and after the integration of the supervision of the whole financial sector into the CNB. The CNB values the recommendations provided by the FSAP team and works closely with the Ministry of Finance on following-up on these recommendations.

Fiscal policy

The Czech Republic was one of the first European countries to start fiscal consolidation in 2010. The fiscal deficit trajectory is to reach 3.0 percent of GDP in 2012; 2.9 percent in 2013 and 1.9 in 2014. This will bring the general government deficit below 3 percent of GDP by 2013 as required by the EU Excessive Deficit Procedure (EDP). The budget should be balanced by 2016.

Given the low public debt ratio (gross general government debt in 2011 was 41.2 percent of GDP, among the lowest in the EU), the medium-term budget objective for the Czech Republic under the Stability and Growth Pact is a structural deficit not exceeding 1 percent of GDP. This objective is likely to be reached by 2016.

The general government deficit improved significantly during the last 3 years and reached 3.1 percent of GDP in 2011. The bulk of the measures in 2011 consisted of expenditure cuts, particularly of reduction in salaries of public sector employees (excluding teachers and doctors), reduction of selected social benefits and non-mandatory current expenditures. With fiscal revenues weakening due to the slowdown, additional measures are needed to reach a deficit of 3.0 percent of GDP in 2012. To this end, the government intends to freeze the budget expenditures by CZK 23.6 billion. The expenditures of the Ministry of Education are expected to be cut by the least, in order to keep the focus on education, science and R&D intact. Also, the government adjusted the value added tax rates since January 2012. The reduced rate was increased by 4 percentage points from 10 percent to 14 percent.

Although the staff recommends allowing the automatic stabilizers to operate and to re-pace the planned fiscal consolidation if economic outlook worsens significantly, the government’s preferred fiscal policy stance is maintaining the trajectory of fiscal consolidation even in temporary unfavorable economic conditions.

The trust of the market in the continuation of the fiscal consolidation is reflected in low funding costs for the public debt. Government bond yields have been decoupling downwards from its regional peers since the beginning of 2011. Standard & Poor’s upgraded the credit rating of Czech Republic in August 2011 by two notches to AA- (stable outlook) based on the authorities’ strong commitment to fiscal consolidation and a prudently managed economy.

On April 11, 2012, the government approved a set of measures to secure the implementation of the planned fiscal consolidation. The expenditure measures include rationalization of the public administration, cuts in renewable energy subsidies, or temporary lowering of indexation of pensions for the next three years. The revenue measures include a VAT hike by 1 percentage point for both rates to 21 percent and 15 percent for the next three years, a 1 percentage point increase in PIT for all income segments, a 7 percentage points additional PIT surcharge for high-income earners, tax hikes on tobacco, introduction of tax on non-sparkling wine and a carbon tax, cancellation of oil tax subsidy for agriculture producers, a 1 percentage point increase in tax on real estate transfers, and the inclusion of the revenues of the state-owned forestry to the general budget.

In order to smooth the impact of the fiscal consolidation on economic growth, the government intends to come up with a package of growth-enhancing measures by mid May. These could include more effective drawing of EU funds, lowering the administrative burden for businesses, promotion of exports, support for innovations and more effective use of state assets.

On April 11, 2012, the government outlined its plans for a constitutional fiscal responsibility act to be adopted by the end of 2012. The act will (i) establish an independent fiscal council which would assess the fiscal impact of new legislation, conduct debt-sustainability analysis and monitor and evaluate how governments meet their fiscal goals, (ii) introduce a debt ceiling and a list of measures to be initiated when the debt approaches the ceiling, (iii) introduce fiscal rules for all levels of the government, including municipalities.

On April 25, 2012, the government coined the consolidation path and the changes to fiscal institutions as approved on April 11, 2012 into its Convergence program for the period 2011-2015. The Convergence program is submitted to the European Commission and the Council as a fulfillment of the commitments stemming from the European semester.

Structural reforms