A. Recent Developments

1. The Czech economy has avoided financial volatility but remains in recession. The economy has avoided serious imbalances in the recent volatile economic environment, benefitting from strong policy frameworks and sound fundamentals. However the export-led recovery observed in 2010–11 subsided as euro area import demand slowed, and growth has noticeably underperformed trade partners and peers since the middle of 2011 mainly because of weaker domestic consumption and investment. Real GDP contracted for four quarters in a row in 2012 and recorded a 1.2 percent decline for the year with only net exports contributing positively to growth.

2. Weak private consumption is particularly prominent and only partially explained by the labor market performance. Private consumption declined by 2.7 percent in 2012. Employment growth was moderately positive reaching 0.4 percent for the year, but unemployment increased from 6.5 percent to 7.2 percent between 2011Q4 and 2012Q4 as the participation rate increased. Real wages declined by an average of 1 percent in the first three quarters with only a one-off rise in the last quarter and real gross disposable income declined by 1.3 percent in 2012. Consumers then responded by increasing their savings rate, which went up to 11.2 in 2012 from 10.0 percent in the previous year. Given healthy household balance sheets, this cautious consumer behavior is mostly attributable to increases in the VAT rates and cuts in social spending at a time when labor market has been weakening, and to prolonged uncertainty in euro area economies that are closely linked to the Czech economy.

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International Trade Trends, 2008-13

(Percent change, yoy)

Citation: IMF Staff Country Reports 2013, 242; 10.5089/9781484336069.002.A001

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Growth Performance of EU Member States, 2011Q2-2012Q4

(Percent)

Citation: IMF Staff Country Reports 2013, 242; 10.5089/9781484336069.002.A001

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Gross Disposable Income and Saving Behavior

(Percent)

Citation: IMF Staff Country Reports 2013, 242; 10.5089/9781484336069.002.A001

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3. Headline inflation was pushed above the two percent target by the effects of indirect taxes and food and energy prices in 2012. Inflation averaged 3.3 percent in 2012 mainly due to increases in the VAT rates and positive contributions from foods and fuel. Both of these effects subsided and inflation fell below the target in January 2013 and averaged 1.8 percent in the first quarter of this year. Demand side inflationary pressures have been largely absent and inflation expectations have been well-anchored. The Koruna has depreciated by about 3 percent since September 2012 and is likely to become a key inflationary factor.

4. Weak domestic demand has also narrowed the current account deficit despite slowing export demand. The external current account deficit declined to 2.4 percent of GDP in 2012 from 2.8 percent, mainly on account of an improvement of the trade balance. Income deficit, in contrast, widened due to higher accrued profits of foreign-owned firms. Non-FDI capital flows turned into a moderate outflow in 2012 after strong inflows in 2009-11. The financial account surplus in 2012 was driven by a net inflow of direct investment owing to reinvested earnings as well as a surplus on portfolio investment. These net inflows were largely offset by a net outflow of other investment, primarily due to a rise in short-term assets of monetary financial institutions abroad.

5. Pro-cyclical fiscal consolidation continued in 2012 resulting in a stronger structural fiscal position than before the crisis. The overall deficit without one-offs in 2012 was 2.5 percent of GDP, down from 3.2 percent of GDP in 2011. The structural balance improved by 1.5 percent of GDP on account of a combination of revenue measures, in particular an increase of the reduced VAT rate by 4 percentage points, and expenditure measures. Fiscal over-performance relative to the budget was largely due to under-execution of capital spending, down by 0.6 percent of GDP compared to 2011, to 3.1 percent of GDP. This fiscal consolidation, however, became a drag on economic activity at a time when the output gap widened by about 2 percentage points.

6. The central bank’s policy rate has been reduced to almost zero, but credit growth remains subdued. The Czech National Bank (CNB) continued to take a lead role in countering economic weaknesses and cut the policy rate by 70 basis points in three steps in June, October and November to 0.05 percent, and committed itself to continued low rates. Long-term money market rates also moved lower in the face of weak growth and inflation expectations. This, together with declining risk premium, made government bond yields decline to record lows. The yield on the 10-year bond stabilized around 2 percent before a moderate rise in June this year, significantly less than peers. The falling rates, however, did not translate into faster credit growth. Credit to the corporate sector and households grew only by 2.6 percent at end-2012 compared to 6.3 percent of the previous year. Increased cautiousness about economic prospects played a role in limiting both credit demand and, to a lesser extent, supply.

B. Outlook and Risks

7. Economic activity is expected to be weak in 2013 and recover gradually thereafter. This pattern is similar to that projected for euro area trade partners, on whom the outlook of the Czech economy is heavily dependent. An improvement in the euro area economy will encourage Czech exports, but only starting in late 2013, and gradually improving confidence is expected to foster moderate domestic demand recovery thereafter. Prospects are for a prolonged period of modest growth with the output gap closing only gradually. Inflation is forecast to hover below the 2 percent target in 2013 and risks are to the downside. The current account deficit will remain smaller than the historical average.

8. Risks are mainly to the downside and the main risk is further deterioration of euro area growth. If growth prospects for the euro area worsen, it would discourage sentiment and delay the recovery of the already policy-constrained Czech economy (See Annex I, Risk Assessment Matrix). Lower export demand from the euro area, the market for two-thirds of Czech exports, would have a significant impact on the growth prospects. The recent disappointing export performance indicates that the economy is at the risk of being dragged deeper into recession, and the current poor growth performance, if protracted, runs the risk of translating itself into a long-term decline in potential growth due to lower investment.

9. The Czech financial system appears well positioned to withstand spillover risks. A reemergence of financial stress in the euro area, possibly due to stalled or incomplete delivery of euro area policy commitments as discussed in the Risk Assessment Matrix (Annex I), entails a risk of deleveraging by European parent banks, which would adversely affect Czech domestic credit conditions through parent-subsidiary relationship. However, the effect of such deleveraging would be limited since Czech banks are self-reliant in their funding. This soundness of the financial sector as well as good standing of balance sheets of households and the corporate sector limits the vulnerability to the euro area financial spillovers. If risks to European financial stability were to increase to extreme levels, spillovers could also take the form of confidence loss and become damaging to Czech financial stability.

A. Fiscal Policy

10. With a budget deficit projected below 3 percent of GDP in 2013, the Czech Republic should be able to exit the Excessive Deficit Procedure and complete the consolidation effort started in 2010. The total structural fiscal consolidation since 2010 has amounted to about 4.2 percent of GDP resulting in a structural deficit of 1.7 percent of GDP in 2013 (from 6 percent of GDP in 2009). Fiscal performance this year is, so far, consistent with the budget even under a moderately weaker macroeconomic environment than expected.

Czech Republic: Fiscal Stance 2009-2016

(in percent of GDP)

Source: IMF calculations and Fiscal Outlook of the Czech Republic, May 2012, Ministry of Finance.

Czech Republic: Fiscal Stance 2009-2016

(in percent of GDP)

		2009	2010	2011	2012		2013		2014		2015		2016
					IMF	Auth	IMF	Auth	IMF	Auth	IMF	Auth	IMF	Auth
Total revenue		38.9	39.1	40.0	40.3	40.1	40.4	40.4	40.3	40.2	40.2	39.5	40.1	38.9
Total expenditure		44.7	43.8	43.2	44.6	44.5	43.3	43.3	43.2	43.0	42.8	42.3	42.6	41.7
Net lending		−5.8	−4.8	−3.3	−4.4	−4.4	−2.9	−2.8	−2.9	−2.9	−2.6	−2.8	−2.4	−2.8
	excluding all one-offs	−6.1	−4.8	−3.2	−2.5	−2.3	−2.9	−2.8	−2.9	−2.9	−2.6	−2.8	−2.4	−2.8
Structural balance		−6.0	−4.9	−3.3	−1.8	−1.7	−1.7	−1.8	−1.8	−1.8	−1.8	−2.1	−1.9	−2.4
Public Debt		34.2	37.9	41.0	45.9	45.8	47.8	48.5	49.2	50.3	49.8	51.2	50.2	51.9
Nominal GDP		3,759	3,791	3,823	3,830	3,843	3,892	3,858	4,006	3,939	4,157	4,079	4,319	4,228

Source: IMF calculations and Fiscal Outlook of the Czech Republic, May 2012, Ministry of Finance.

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Czech Republic: Fiscal Stance 2009-2016

(in percent of GDP)

		2009	2010	2011	2012		2013		2014		2015		2016
					IMF	Auth	IMF	Auth	IMF	Auth	IMF	Auth	IMF	Auth
Total revenue		38.9	39.1	40.0	40.3	40.1	40.4	40.4	40.3	40.2	40.2	39.5	40.1	38.9
Total expenditure		44.7	43.8	43.2	44.6	44.5	43.3	43.3	43.2	43.0	42.8	42.3	42.6	41.7
Net lending		−5.8	−4.8	−3.3	−4.4	−4.4	−2.9	−2.8	−2.9	−2.9	−2.6	−2.8	−2.4	−2.8
	excluding all one-offs	−6.1	−4.8	−3.2	−2.5	−2.3	−2.9	−2.8	−2.9	−2.9	−2.6	−2.8	−2.4	−2.8
Structural balance		−6.0	−4.9	−3.3	−1.8	−1.7	−1.7	−1.8	−1.8	−1.8	−1.8	−2.1	−1.9	−2.4
Public Debt		34.2	37.9	41.0	45.9	45.8	47.8	48.5	49.2	50.3	49.8	51.2	50.2	51.9
Nominal GDP		3,759	3,791	3,823	3,830	3,843	3,892	3,858	4,006	3,939	4,157	4,079	4,319	4,228

Source: IMF calculations and Fiscal Outlook of the Czech Republic, May 2012, Ministry of Finance.

11. The new medium-term fiscal framework modifies previous consolidation plans and projects a relaxation in the outer years. The authorities plan to take a supportive neutral stance in 2014 and anticipate a moderately positive fiscal stance in 2015–16 in order to support growth. This medium-term stance, based mainly on revenue measures and with expenditures largely consistent with the previous plans, will be anchored in a fiscal deficit around 3 percent of GDP and will result in a structural relaxation of around 0.7 percent of GDP by 2016.

12. A structural fiscal rule has been proposed by the Ministry of Finance (MOF) to complement the Constitutional Law on Fiscal Responsibility. It consists of a structural balance rule with a balanced target to be achieved by 2021. This target is tighter than the medium-term objective agreed with the European Commission (-1 percent of GDP) and would imply a structural primary surplus of around 1.5 percent of GDP. The new framework, if approved by Parliament, will introduce, among other things, a medium-term structural anchor, a debt brake, and a fiscal council (Box 2). Given that current debt levels are close to the initial thresholds under the debt brake, transitional arrangements will have to ensure that the debt brake does not become the de facto binding fiscal rule with a pro-cyclical nature.

13. Staff considered that a neutral fiscal stance over the next few years until the economic recovery would gain strength was appropriate. This neutral stance would require avoiding future fiscal over-performance and could be followed by a moderate and gradual consolidation after 2015 with the aim of achieving a structural balance by 2021. In a severe adverse scenario, staff argued that fiscal policy should play an active role through temporary and targeted measures. In such an environment and with monetary policy constrained at the zero lower bound, fiscal policy would be more effective than under normal circumstances.¹ Going forward, recent reductions in capital spending should also be reversed including by increasing the absorption capacity of EU funds.

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Fiscal stance and growth under different multiplier assumptions

(percent of GDP)

Citation: IMF Staff Country Reports 2013, 242; 10.5089/9781484336069.002.A001

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14. The authorities agreed that a neutral fiscal stance in 2014 was appropriate but saw scope to use fiscal policy to support growth over the medium term. The authorities’ latest update of the Convergence Program targets a headline deficit of just below 3 percent of GDP for 2014–16, which given the cycle provides fiscal space to implement discretionary measures in support of the economy. They argued that the budget was relatively robust to external shocks that would, therefore, be manageable. They also thought that the risk of a severe adverse scenario had decreased.

15. The further fiscal reforms in progress to increase the efficiency of the public sector are welcome. These include an introduction of the single collection point in 2014–15 consolidating different revenue collection agencies (including revenue, customs and social security agencies), and harmonizing the revenue bases used for the personal income tax and social security contributions. At the same time, a new treasury system, introduced in 2013 in order to increase the coverage of the treasury single account, would result in more comprehensive and timely expenditure reporting.

B. Monetary Policy

16. Inflation risks are to the downside while the policy rate is technically at the zero lower bound. The CNB’s aggressive rate cuts in 2012 brought the policy rate to the zero lower bound and it was announced that this accommodative stance would be kept for an extended period. Inflation declined below the 2 percent target level starting from January 2013. Inflation is projected to remain at around 1¾ percent through 2014 as the large output gap continue to suppress demand-side inflation and the inflationary impact of VAT increases and energy prices moderate. Risks to inflation forecasts are to the downside in line with the risks to the external demand and commodity prices.

17. The CNB has identified FX interventions as the next step for monetary easing. While details of such operations have not been specified, this is a welcome step clarifying that the CNB has access to effective tools at the zero lower bound and helping keep control of inflation expectations. While CNB Board members so far see the appropriate trigger for interventions slightly differently because of different views as to the downside risks and the entry and exit costs of the operations, there is a consensus that FX interventions would be an integral part of the inflation targeting regime.

18. Staff agreed that, if a persistent and large undershooting of the inflation target is in prospect, FX interventions should be employed. As the Czech Republic is a small open economy and pass through is relatively high, FX interventions is expected to quickly help guide inflation expectations toward the target. In contrast, purely quantitative easing through purchases of domestic financial assets is less promising given the systemic liquidity surplus in the banking system, scarcity of private financial assets to purchase, and the very low long-term interest rates for the government bonds.

19. The operational aspects of possible interventions should pay due regard to transparency. For example, the use of pre-announced interventions of fixed sizes per period would be a good candidate in terms of market communication and ease of exit, while allowing sufficient flexibility to adjust as needed. The authorities agreed with the considerations of transparency and ease of exit and reiterated the commitment to the inflation targeting regime, while they remained noncommittal on any modality stressing the importance and advantages of flexibility.

20. Importantly, FX interventions should potentially be used solely as a tool of inflation targeting, not aiming at a certain exchange rate level. Staff and the authorities agreed that the exchange rate is broadly in line with fundamentals. The Fund’s new EBA methodology supports this assessment when using the current account based indicators, but diverges when using a real exchange rate based model (Box 3). Staff’s assessment is based on the observations that the real exchange rate derived from manufacturing ULC is below the 10-year average; Czech exports have largely maintained their world market share despite the weakness in the core markets; the trade balance has been positive and improving; and the country’s relative price level is consistent with its income level.

Box 3.

External Sector Assessment

• The koruna’s long-term appreciation trend appears to have moderated. The Czech econom has gone through substantial structural change in the ’00s integrating itself into German supply chain and benefitting from rapid productivity growth. These gains were the main drivers of real exchange rate appreciation without losing competitiveness. More recently, favorable wage productivity dynamics in the manufacturing sector have continued, while both nominal and real appreciation has slowed.

• Export market share has been stable in the post crisis period. Following earlier robust gains, the market share of Czech exports has broadly stabilized in the last five years.

• Current account deficit is stable at levels consistent with fundamentals. The Czech Republic has run current account deficits averaging −2.8 percent of GDP between 2008 and 2012. These deficits are mainly due to large foreign earnings associated with the stock of inward direct investment that more than outweighs the trade surplus.

• Current account deficits have been largely financed by FDI inflows. While, portfolio and other investment inflows have increased in the 2009-2011 period with signs of reversal in 2012, the traditional source of funding the current account deficit has been net FDI inflows, which covered an average of 80 percent of the current account deficit in the last five years. The FDI flows are underpinned by foreign earnings reinvested in the country, thus providing a steady source of financing. The accumulated external deficits over the years have led to a moderate negative net international investment position (NIIP) of about 50 percent of GDP, but reflecting the prevalence of FDI financing, NIIP excluding the FDI position is positive. Reserve coverage is comfortably above standard benchmarks, and reaches 147 percent of short-term debt at end-2012.

• The new EBA methodology confirms that the external balance is overall sound, but finds some overvaluation of the koruna. The panel-based current account regression has a fitted value of 1.1 percent deficit, which is moderately narrower than the 2012 cyclically-adjusted deficit of 1.9 percent. Benchmarked against the current account deficit level that would stabilize the net foreign asset position of the country, 2.2 percent, the 2012 outturn of 2.4 percent and the 2.1 percent projection by staff in 2013 suggests that there are no major imbalances. Based on a multilateral real exchange rate model, the EBA exercise shows an overvaluation of 20 percent of the koruna but this estimate needs to be treated with caution as it may not capture factors such as initial undervaluation and rapid quality and productivity improvements.

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Real Exchange Rate

(2001Q1=100)

Citation: IMF Staff Country Reports 2013, 242; 10.5089/9781484336069.002.A001

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Share of World Imports

(Percent of total imports, 2000=100)

Citation: IMF Staff Country Reports 2013, 242; 10.5089/9781484336069.002.A001

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C. Financial Sector

21. Imminent risks to financial stability appear to be contained. Czech banks, largely owned by euro area banking groups, are highly profitable and self-financed with a low system-wide loan to deposit ratio and strong capital and liquidity buffers. The banking system had a year of record profits in 2012, helping further strengthen the capitalization. However demand for credit remains weak and there are signs of increasing competition for market share especially in well-performing segments such as mortgages and large corporations. Therefore, profitability is likely to moderate as volume growth slows and margins become compressed.

22. The Czech financial system has proved resilient to the effects of the global crisis and weak domestic economy. The most recent stress test indicated that the capitalization of the sector as a whole would remain around 11 percent, significantly better than the regulatory minimum of 8 percent, even in a severe stress scenario with a large drop in GDP and protracted stagnation—a cumulative contraction of about 7 percentage points over a three-year horizon—and with partial impairment of the sector’s exposure to European countries whose government debt exceeds 60 percent of GDP. Given the strong capital and funding positions, the banks would comfortably abide by the upcoming Basel III and CRD IV standards.

23. The main risk for the Czech banking system is a protracted or deeper recession that would harm asset quality. Although existing capital and liquidity buffers are expected to keep the system resilient, supervisory activities should proactively ensure that provisions are adequate and buffers remain strong in the face of potential further economic weakening. Another property price decline due to a protracted or deeper recession would pose a risk to the financial system that has relatively high exposure to the real estate market (see Annex I, Risk Assessment Matrix). This, however, should be tempered by the limited run-up in prices in the boom period and prudent loan to value ratios. The authorities agreed with these risk assessments, but noted that the risks are two-sided for the real estate market given the historically low interest rates. Staff and the authorities agreed that the credit union sector comprise a non-systemic risk that nonetheless needs to be addressed. To this end, the CNB has prepared a proposal, which incorporates FSAP advice and introduces a size limit for credit unions.

24. Improvements of the financial stability framework would help safeguard the Czech financial system against a wider range of risks. The authorities have made welcome efforts to implement the recommendations made by the Fund’s FSAP Update in December 2011, including lowering regulatory limits on exposures to parent banks, strengthening cooperation between the Ministry of Finance and the CNB, and raising the role and profile of the CNB’s macroprudential policies. It is important to adopt the draft proposal on the regulation of credit unions, which is a small segment in the financial system but with higher-than-average risks. Other FSAP suggestions for improvement were in the areas of bank resolution and deposit insurance, where recent European-wide initiatives to harmonize tools and policies have taken precedence and would need to be implemented once finalized as EU Directives. In this regard, the authorities recognize the importance of the Single Supervisory Mechanism, but do not opt to enter at this stage. Staff noted it would still be important to strengthen the cooperation with home supervisors, which would become the ECB in most cases, and make preparations for a more integrated European financial policy framework.

D. Structural Issues

25. Moving up the value added chain is important for the Czech economy to stay competitive. Convergence of Czech per capita output to other advanced European economies has stalled in recent years. At the same time, the increasing degree of openness to trade in tandem with evolving regional trade supply chains has played an important role for the growth of the Czech economy. As the study on “the German-Central European Supply Chain” suggests, the future prospect of the economy, therefore, hinges on how the export sector maintains and strengthens its competitiveness and broadens domestic value added. A key factor is to raise the share of knowledge intensive industries in exports by shifting to more technologically sophisticated products. In this regard, policies that enhance investment in research and development are important.

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Income Convergence

(GDP per capita relative to Germany, in percent)

Citation: IMF Staff Country Reports 2013, 242; 10.5089/9781484336069.002.A001

Sources: OECD

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26. Investment in both physical and human capital is critical to enhance future growth potential. Enhancing private investment especially FDI is critical for future growth. In this regard, reducing uncertainty by improving the legal framework for formation, restructuring and liquidation of firms and minimizing administrative costs could significantly contribute to a better business environment. At the same time, developing and maintaining a highly capable and skilled workforce is essential for attracting more knowledge intensive industries as well as increasing labor productivity. Improving education especially at the tertiary level and vocational training has vital importance.

27. Higher labor participation, labor market flexibility, and active labor policies are important to increase potential growth and avoid long-term negative impact of unemployment. While employment is expected to be stable, with a declining share of productive age population, the economy requires wider sources of labor supply. Policies to enable labor market flexibility such as definite-term employment have been implemented. For some segments of the workforce where labor market participation is low such as woman with young children, targeted policies such as public support for childcare could be effective. In order to avoid long-term negative impact of unemployment, active labor market policies providing information, counseling and retraining are important.

Box 4.

Women’s Labor Force Participation

Women’s labor force participation is significantly below the OECD average and the underperformance is more pronounced for women in the 15-24 age group, where those with young children represent a large share.

The government places great importance on the work-life balance especially of women with young children, and is taking such initiatives as to give tax incentives for employers who provide childcare for their employees as well as to give tax discounts for childcare expenses to parents. The government also intends to expand the availability of childcare to children as early as at the age of 6 month to provide greater opportunities for women to participate in the labor force.

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Labor Force Participation by Women in OECD

(Percent of the population 15-24 years old)

Citation: IMF Staff Country Reports 2013, 242; 10.5089/9781484336069.002.A001

Source: OECD

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