Czech Republic: Staff Report for the 2014 Article IV Consultation
Author:
International Monetary Fund. European Dept.
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Publication Date:
02 Sep 2014
eISBN:
9781484393383
Language:
English
Keywords:
ISCR; CR; food price inflation; staff appraisal; deficit; economy; fiscal policy; central bank; current account; foreign exchange; economic recovery; Inflation; Exchange rates; Inflation targeting; Global
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Growth is gaining momentum, led by strong external demand while domestic demand is also picking up. The central bank’s foreign exchange intervention policy has helped stem deflationary pressures but inflation is still well below target. Following substantial fiscal adjustment over the past three years, an easing of the fiscal stance is underway and the new government’s medium-term fiscal plans have not yet been fully elaborated. The financial system is sound and resilient to shocks, and improvements in the regulatory and supervisory architecture are ongoing. The challenge for the authorities is to create the conditions for strong and sustainable growth while maintaining macroeconomic stability.

Abstract

Growth is gaining momentum, led by strong external demand while domestic demand is also picking up. The central bank’s foreign exchange intervention policy has helped stem deflationary pressures but inflation is still well below target. Following substantial fiscal adjustment over the past three years, an easing of the fiscal stance is underway and the new government’s medium-term fiscal plans have not yet been fully elaborated. The financial system is sound and resilient to shocks, and improvements in the regulatory and supervisory architecture are ongoing. The challenge for the authorities is to create the conditions for strong and sustainable growth while maintaining macroeconomic stability.

Context

1. The Czech economy has gained momentum, but policymakers still face challenges. Following a prolonged period of stagnation which was exacerbated by significant fiscal consolidation that went beyond what was necessary under the Excessive Deficit Procedure (EDP), the economy has turned a corner, driven by strong external demand and a pickup in domestic demand. An easing of the fiscal stance is now envisaged, although the authorities’ fiscal policy agenda is yet to be clearly elaborated. With the policy rate at the zero lower bound, the central bank’s foreign exchange intervention policy has helped stem deflationary pressures but inflation remains well below target.

2. A new pro-European, but ideologically-diverse, coalition government took office in January 2014. In contrast to the previous right-wing and euro-skeptic coalition, the new government—a coalition of the Social Democrats, a new center right party (ANO), and the Christian Democrats—is friendlier to the EU policy agenda. It already endorsed the Fiscal Compact and stated that euro adoption is a possibility before 2020, albeit not within its current mandate. However, the new government is ideologically diverse. Its overall orientation is toward more activist social welfare-enhancing policies, as evidenced by the decision to increase the minimum wage and introduce a lower VAT rate for some items, and the promise to resume full pension indexation (to a mix of inflation and wage growth). On the other hand, ANO has pledged not to increase taxes.

Background and Recent Developments

3. The Czech economy exited the recession in 2013. Notwithstanding an average annual decline of 0.9 percent in real GDP, quarter-over-quarter growth turned positive in 2013:Q2 and accelerated throughout last year. The recovery was triggered by exports (mainly of automobiles and machinery), but has been increasingly supported by domestic demand, with a strong contribution from investment in 2013:Q4. Household consumption has also buttressed the recovery, underpinned by improvements in labor income. As a result, year-over-year growth reached 2.9 percent in 2014:Q1. Moreover, high frequency indicators, such as industrial production and sentiment surveys, suggest that growth has remained strong in recent months.

A01ufig01

Real GDP and Exports

(QoQ, SAAR)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

4. The labor market is poised for a recovery. Unemployment entered a gradually declining path in 2013 on the back of gains in employment, and reached 6.6 percent (seasonally adjusted) in 2014:Q1 compared with 7.2 percent a year earlier. While these employment gains were coupled with lower hours worked per employee and declining real wages through 2013, this trend was reversed in 2014:Q1 with real wages recording a solid increase.

5. Inflation has been falling, but is still in positive territory aided by the weaker exchange rate. Headline inflation declined from its September 2012 peak of 3.4 percent to zero in June 2014, in tandem with inflation in the euro area and in regional trade partners. About two thirds of the decline was accounted for by a moderation of food and energy prices. The decline in inflation has been mitigated by the exchange rate depreciation, which had a rapid pass-through to tradables prices—non-energy goods inflation (HICP basis) increased from -0.6 percent in November 2013 to 0.7 percent in June 2014, turning positive for the first time since 2008—and helped keep inflation at an average of 0.2 percent year-over-year in the first half of 2014. Various core inflation indicators also exhibit a trend towards normalization; inflation excluding indirect tax changes and fuels reached 1 percent, its highest level since 2011. Moreover, inflation expectations, as measured by analyst surveys, have also increased following the exchange rate move.

A01ufig02

Inflation

(y-o-y, percent)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

A01ufig03

Contributions to Inflation

(y-o-y, percent)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

6. A sharp fiscal adjustment led to an exit from the EDP and kept debt levels contained, but exacerbated the recession. The adjustment was driven mainly by a compression of capital expenditure, partly due to implementation bottlenecks, while an increase in VAT rates helped boost revenue. The fiscal stance continued to improve, with the structural deficit narrowing by 1.3 percentage points of GDP on the heels of a cumulative 2.4 percentage point consolidation during 2011–12. The decline in the headline deficit, from 4.2 percent of GDP in 2012 to 1.5 percent in 2013, was even more pronounced due to one-off factors in 2012, which had elevated that year’s deficit. The European Council abrogated the EDP in June 2014.

7. Constrained by the zero lower bound, the Czech National Bank (CNB)—an inflation targeter—resorted to foreign exchange intervention to avoid deflation, consistent with Fund advice. The koruna had been strong in 2012–13, not responding significantly to the weak economy in the last few years, partly buoyed by strengthening capital flows since 2011. In November 2013, facing the zero lower bound for its policy rate and the risk of a persistent undershoot of its inflation target, the CNB decided to use the exchange rate as an additional instrument for inflation targeting and announced its commitment “to prevent excessive appreciation of the koruna below CZK27 per € by intervening in the foreign exchange market”, implying a 6 percent depreciation that was expected to bring inflation to target in the monetary policy horizon.1 The exchange rate is currently around CZK27.5 per €, and there has been no intervention in the foreign exchange market since November 2013. In the last Article IV consultation, the Fund recommended foreign exchange intervention as preferable over purely quantitative easing through purchases of domestic financial assets 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 government bonds.

A01ufig04

Exchange Rate

(koruny per euro)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

A01ufig05

Official Reserves

(EUR billion)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

8. The banking sector remains strong, but credit provision is lackluster. Banks have improved their already strong capital position reaching a capitalization ratio of 16.5 percent at end-2013 compared with 15.6 percent in 2012. Profits moderated somewhat as net interest income was compressed, but banks continue to enjoy strong asset quality, low non-performing loans, and stable and cheap local deposit funding. At the same time, credit growth was subdued at 3.0 percent, mainly due to weak demand from corporates.

9. Creditworthiness remains high. Czech Republic is rated investment grade with a stable outlook. Five-year credit default swaps have been remarkably stable at around 50 basis points. Bond yields increased somewhat in the second half of 2013 in line with global trends, but have recently approached historical lows: the 10-year bond yielded an average of 1.5 percent in June.

10. The current account deficit is on a moderate narrowing trend. It remained broadly stable at 1.4 percent of GDP in 2013, as a growing income deficit balanced out the improvement in the trade balance. The improving trend of the latter is expected to continue this year supported by robust export growth, thus contributing to a narrowing of the current account deficit to 0.2 percent of GDP, a level staff assesses to be in line with fundamentals, including the ouput gap and still weak domestic demand.

11. Staff’s assessment is that the real exchange rate is broadly in line with fundamentals. Estimates based on the EBA methodology yield mixed results for the Czech Republic. Specifically, the Current Account Balance approach suggests that the current account deficit is still somewhat wider than the cyclically-adjusted norm of 0.4 percent of GDP deficit, indicating an overvaluation of about 5 percent in 2013. Benchmarked against the 2 percent of GDP deficit that would stabilize the net foreign asset position, the 2013 outturn suggests a very slight undervaluation. While the multilateral REER approach finds an 18 percent overvaluation, this appears too high in view of the current account-based assessment, and needs to be treated with caution as it may not capture factors such as an initial undervaluation, and rapid quality and productivity improvements. Other considerations also point to the absence of evident imbalances in the external position (Box 2) or of significant shortcomings in non-price competitiveness indicators (Figure 6). Overall, staff assesses the exchange rate to be in broad equilibrium, and the confidence level of this assessment has increased with the koruna now 6 percent weaker than the 2013 average.

Figure 1.
Figure 1.

Czech Republic: Macroeconomic Developments

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Sources: Haver; Eurostat; EMED; and IMF staff calculations.
Figure 2.
Figure 2.

Czech Republic: Financial Markets

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Sources: Bloomberg; Dealogic; Haver; BIS; and Global Insight.
Figure 3.
Figure 3.

Czech Republic: External Sector

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Sources: Czech Statistical Office, Czech National Bank, and IMF staff estimates.
Figure 4.
Figure 4.

Czech Republic: Evolution of Baink Credit

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Sources: Haver; CNB; and IMF staff calculations.
Figure 5.
Figure 5.

Czech Republic: Fiscal Developments and Prospects

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Sources: Haver; National Authorities; and IMF staff calculations.
Figure 6.
Figure 6.

Czech Republic: Competitiveness Indicators

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Sources: Czech Republic authorities; Haver; OECD; World Bank, Doing Business Indicators; IMF, IFS; DxTime; IMF, World Economic Outlook; and IMF staff estimates and calculations.1/ Covers the period June, 2013. Rank out of 189 countries.2/ Rank for 2013–14. Ranking out of 148 countries.

Outlook and Risks

12. Economic activity is expected to strengthen further. The projected euro area recovery, supportive fiscal and monetary policies, and substantial slack in the economy will underpin growth performance over 2014–15. Staff projects growth at 2.5 percent this year, with one third and two thirds contributions from foreign and domestic demand, respectively—the latter is expected to turn positive for the first time since 2010. Investment will be supported by higher capacity utilization, greater clarity about the economic environment, foreign direct investment inflows, and greater take-up of European Union funds, whereas consumers will benefit from gains in labor income as well as improving confidence. At the same time, strong export performance (exports are projected to grow 7 percent in real terms this year) will be underpinned by positive trends in traditional markets (mainly the euro area) and products (mainly automotive and machinery). The effects of the depreciated exchange rate and recovering demand conditions are expected to push inflation gradually toward the 2 percent target. Over the medium term, output growth is set to stabilize at around 2 percent driven by domestic demand, as the current account stabilizes around a small deficit of ½ percent of GDP.

Czech Republic: Key macroeconomic indicators, 2012-19

(in percent of GDP, unless otherwise indicated)

article image
Sources: Czech authorities, and IMF staff projections

13. Risks to the outlook are balanced. The ongoing recovery in Czech Republic’s trade partners, domestic slack, supportive macroeconomic policies, and the improving automotive cycle point to upside risks to growth. On the downside, escalation of geopolitical tensions in the region could affect exports and also create uncertainty regarding energy security (Box 3). Moreover, if the euro area recovery falters, the Czech economy will be negatively affected mainly through the trade channel. The impact would be larger if low growth turns self-reinforcing through low investment in physical and human capital (see Risk Assessment Matrix).

Authorities’ views

14. The authorities broadly agreed with the near-term outlook, medium-term prospects, and the balance of risks. Against a relatively upbeat baseline, they saw mostly externally-driven downside risks. They were somewhat concerned about re-emergence of financial stress in the euro area, possibly related to the outcomes from the Asset Quality Review and stress tests, as well as risks from potential geopolitical tensions in the region. On the whole, the authorities saw these risks as a reason to sustain or even strengthen policies that are supportive of domestic demand. Finally, they saw the need to boost potential growth as a key element for future prosperity and the convergence process.

Policy Discussions

Policies should be geared toward ensuring a sustainable recovery and macroeconomic stability, while creating the conditions for higher potential growth. Discussions thus focused on the need to adopt a comprehensive growth strategy that would encompass a growth-friendly medium-term fiscal strategy and structural reforms, with monetary policy continuing to play a stabilizing role. Such a strategy would contribute to a higher level of investment and growth.

A. Fiscal Policy

15. The authorities are committed to the medium-term objective of a 1 percent of GDP structural deficit, which will need to be embedded into a clear medium-term fiscal framework, enshrined in legislation. The Ministry of Finance has prepared an updated draft Fiscal Framework Reform (FFR) and plans to submit it to Parliament for discussion and approval later this year. The draft includes expenditure ceilings derived from the medium-term objective, a debt brake rule starting at 55 percent of GDP, and a Fiscal Council (Box 4). The proposed structural deficit rule strikes the right balance between reducing debt and creating fiscal space. It would also help eliminate the pro-cyclical bias of fiscal policy and would be consistent with EU fiscal framework requirements. While the debt brake has the potential to introduce a pro-cyclical bias, the current debt level provides an adequate buffer against this risk. Finally, an independent Fiscal Council with sufficient analytical and institutional capacity would further strengthen the fiscal framework. Staff urged the authorities to move expeditiously with the approval of the FFR to help anchor fiscal policy.

16. The authorities are still elaborating the timeline for reaching the medium-term fiscal objective and underlying policies. Latest official projections as published in the Convergence Programme (CP) are subject to sizeable upside risks on the revenue side, while expenditure pressures exist in several areas. Near-term policies thus carry some degree of uncertainty.

  • The fiscal stance is projected to remain neutral in 2014. On the expenditure side, the budget foresees a sharp increase in capital spending to the pre-2013 levels, while other expenditure remains broadly unchanged as a share of GDP. Possible shortfalls in capital spending would be broadly neutral due to EU financing. However, the budget includes conservative revenue projections as they are based on an older vintage of macro assumptions. All in all, the CP includes a 1.8 percent of GDP projection for the headline deficit. However, in light of strong revenue performance so far this year and consistent with staff’s baseline macroeconomic framework, as long as the approved expenditure ceilings are respected, the general government deficit is projected at 1.2 percent of GDP in 2014. This would imply a broadly neutral fiscal stance.

  • Fiscal plans for 2015 are still being elaborated. The CP includes a 2.3 percent of GDP projection for the headline deficit, although the actual target is likely to be lower. However, there is uncertainty regarding the structure of the budget and the deficit target, as the coalition partners’ priorities are still being elaborated. The government has approved a lower VAT rate for pharmaceuticals, books, and infant food, and promised to abolish the reduced pension indexation—both effective next year. Based on staff’s baseline macroeconomic framework and assuming that the expenditure allocations included in the CP are respected, the general government deficit is projected at 1.4 percent of GDP, thus implying a moderate structural easing of ½ percentage point.

  • The CP includes a structural deficit of 1.7 percent of GDP in 2017 and reiterates the government’s commitment to the medium-term deficit objective. This fiscal path implies that public debt would decline to about 42 percent of GDP by 2019, thus reinforcing Czech Republic’s strong fiscal position (Appendix II).

A01ufig06

Fiscal Stance

(in percent of GDP)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Source: IMF staff calculations.
A01ufig07

Fiscal Adjustment

(Change in fiscal balances in percent of GDP)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

17. Staff welcomed the authorities’ commitment to the medium-term deficit objective, but noted the need for more clarity regarding the fiscal targets and underlying policies. Staff noted that, pending adoption of a medium-term fiscal framework by Parliament, fiscal targets should be consistent with the medium-term objective of a 1 percent of GDP structural deficit, ensuring that the chosen fiscal path strikes a balance between sustaining the economic recovery and creating space for addressing the country’s infrastructure needs. To this end, staff supported an increase in capital spending financed by a modest increase in the structural deficit to 1¼ percent of GDP during 2014–15. Moreover, staff recommended that better-than-expected tax revenues not to be channeled to re-current spending.

18. Staff emphasized the need to improve the efficiency of capital expenditure. Higher utilization of EU funds should be the first step. Eliminating obstacles in planning and implementation of public projects without compromising governance would help in this respect. Within the envelope of a 1 percent of GDP structural deficit, increases in capital spending can also be financed through rationalizing re-current spending and stepped-up efforts to improve tax administration. In this connection, staff noted that the introduction of a new lower VAT rate was a much less efficient way to address social priorities than a more targeted measure would be, and also an unwelcome complication for tax administration.

Authorities’ views

19. The authorities reaffirmed their commitment to the medium-term fiscal objective, but not to a particular timeline to achieve it. They acknowledged upside risks to revenue that, were to materialize, would lead to a 2014 fiscal outturn better than the one projected in the CP. In fact, at end-July they revised their deficit projection to 1.5 percent of GDP. As for the medium term, the draft Fiscal Framework Reform foresees the medium-term objective of 1 percent of GDP structural deficit being reached in 2020. As of now, the authorities saw the 3 percent of GDP headline fiscal deficit threshold (i.e., the EDP limit) as the only binding requirement for fiscal policy. They noted that they would elaborate their position on the path and timeline for reaching the medium-term objective in the course of the preparation of the 2015 budget. To this end, they expected detailed discussions in the fall at which time coalition partners would have to agree on the government’s priorities. They admitted though that there were expenditure pressures in several areas, which may lead to an increase in expenditure ceilings. In particular, the authorities highlighted that the recent episode of fiscal consolidation has led to an undue compression of public investment and a resulting infrastructure deficit in several areas such as transportation and energy. They also saw benefits from a slight fiscal expansion in terms of insurance against downside macroeconomic risks. Finally, the authorities noted that the approval of the new fiscal framework by Parliament could take time, despite the government’s commitment to move expeditiously.

B. Monetary Policy

20. Under the baseline scenario, with the economic recovery gathering momentum, inflation is set to rise gradually toward the central bank’s target. While headline inflation remains very low—weighed down by administered prices (e.g., gas and electricity) and food—core measures and demand-sensitive components of inflation are generally stronger and exceed headline inflation (Box 5). Demand for durables is strengthening, suggesting that the tail risk of a self-fulfilling deflationary spiral has been averted. Labor income growth is gaining momentum, underpinning solid consumption trends. Under staff’s baseline scenario, the effects of the weaker exchange rate and recovering demand conditions are expected to push inflation gradually toward the central bank’s 2 percent target over the monetary policy horizon. Moreover, inflation expectations have increased following the exchange rate move and CNB’s stated commitment to maintain the exchange rate floor into early 2015 as an instrument for achieving the inflation objective. In fact, inflation expectations have matched the CNB’s inflation forecast for a slight overshoot of the inflation target in the first half of 2015, before moderating to 2 percent by end-2015.

21. With these considerations in mind, staff recommended that the CNB continue to focus on inflation targeting, and maintain the current supportive monetary conditions for now. There are still risks to the recovery mostly from external developments; the output gap is still sizable; and inflation remains very low, including in wage agreements. Therefore, staff suggested keeping in place the exchange rate floor for now, even though it has not been binding. However, staff recommended a return to a floating exchange rate once deflation risks recede, and the inflation forecast and inflation expectations, as well as wage developments, become entrenched around the central bank’s target. The pre-existence of a consistent monetary policy and inflation targeting framework, and a credible and transparent central bank, make the exit easier than in the case of traditional pegs. Moreover, the current monetary and exchange rate settings are consistent with broad macroeconomic equilibrium. In this context, staff recommended abolishing the exchange rate floor in one step rather than gradually. This is likely to be the first stage in the normalization of monetary policy, with interest rate hikes following in due course.

Authorities’ views

22. The authorities broadly agreed with the inflation outlook and noted their commitment to inflation targeting, while for now continuing to use the foreign exchange intervention policy as an instrument for achieving their inflation objective. They were generally satisfied with the results of the intervention policy, and noted the underlying positive trends in the inflation data, which were overshadowed by still-low headline inflation. However, relative to their pre-intervention forecasts, negative price shocks have been more pronounced, and the hoped-for overshoot of inflation relative to target—to decisively break the inertia in inflation expectations—is now unlikely. As a result of a lower inflation profile, the authorities have decided to maintain the intervention policy as an instrument for achieving their inflation objective for longer, announcing in June that the policy will be in place until at least the second quarter of 2015. Nevertheless, once the conditions for exiting from the intervention policy were in place, they would return to a floating exchange rate. In this connection, the central bank would consider exit modalities in detail in the fall of this year.

C. Financial Sector

23. The financial sector is sound and resilient. Czech banks, which are largely owned by euro area banking groups, are self-financed with a low system-wide loan to deposit ratio and strong capital and liquidity buffers. Profitability moderated somewhat on the back of still-weak credit growth, but still helped to further strengthen banks’ capital to above 16 percent. Recent CNB stress tests indicate that aggregate bank capitalization would remain above 13 percent, significantly better than the regulatory minimum of 8 percent, even in a severe stress scenario with a large output drop and protracted stagnation. Many Czech bank parents are going through the ECB’s comprehensive risk assessment, but their Czech subsidiaries are self-funded and net creditors vis-à-vis abroad, and should thus be relatively resilient to shocks to parents.

24. Credit growth is likely to be boosted by the recovery. Despite healthy bank balance sheets and moderate debt levels in the non-financial sector, credit growth remains subdued due to a combination of low credit demand and somewhat tighter lending standards. However, with healthy balance sheets in the financial and non-financial sectors, this is mostly expected to be a cyclical phenomenon—in fact, lending surveys suggest banks are turning cautiously optimistic, with the July lending survey showing that credit standards to corporates were eased for the first time since 2011. Approval rates for most loan categories remain high, and banks noted lack of fixed investment activity and financing from internal resources as limiting corporate credit demand, but they also saw initial signs of a recovery.

25. Improvements in regulations and the supervisory architecture are continuing. Building on last year’s progress toward implementing FSAP recommendations,2 supervisory resources have been increased for on-site inspections. Moreover, a draft law on credit unions—a small but problematic sector of credit providers—has been prepared, and would help reduce reputation risks to the financial system. The implementing law of the EU Directive on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms has been approved by Parliament, and systemic banks have already been notified of upcoming capital buffer requirements, with which they would be largely in compliance at current capital levels. Finally, work on the EU-wide initiative for unified resolution schemes and deposit insurance framework is continuing.

Authorities’ views

26. The authorities shared staff’s assessment of a healthy financial sector. They saw a domestic balance sheet recession as the main risk to the financial system, but attached to this a smaller likelihood than before. They also highlighted the ongoing follow-up on FSAP recommendations and supranational regulatory initiatives. Finally, the authorities are considering the pros and cons of opting into the euro area banking union ahead of euro adoption, and a detailed study is being prepared to be discussed in the fall.

D. Structural Policies

27. Improving the Czech Republic’s growth prospects remains a key challenge. Staff estimates current potential output growth at 1.6 percent, as the capital stock increases slowly and total factor productivity gradually recovers after several years of stagnation. While potential growth is projected to increase over the medium term due to catching up with more advanced economies, diminishing low-base effects and demographic headwinds will constrain growth to 2 percent over the medium term (Appendix I). This is well below the level necessary to facilitate convergence of Czech per capita output to the level of other advanced European economies. The employment rate is expected to remain stable, but with declining working age population, the economy would require wider sources of labor supply.3 Moreover, labor force participation of some demographic groups is low, there are skill mismatches, and investment in research and development (R&D) is low. Although such labor market constraints may not be binding at this stage, they could impede the country’s medium-term growth prospects.

A01ufig08

Potential Growth

(percent, range and average, 2013-19)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

28. Renewed structural reform momentum is needed to put the Czech Republic on a higher growth trajectory. Important steps have been taken to reduce labor market rigidities, including more flexible employment arrangements, strengthened public employment services, affordable high-quality child-care facilities, and increased rental housing availability. However, labor participation in some segments of the population—e.g., women with young children—remains low4, thus calling for targeted policies. Consideration could be given to upgrading skills and addressing skill shortages in the technical fields by education and training of less-advantaged populations (e.g., through apprenticeship programs), vocational training in close cooperation with businesses, and improved incentives in the education system to better match workforce needs. Moreover, reducing uncertainty regarding tax policies, simplifying compliance with taxation requirements, and combating corruption in line with the authorities’ 2014 National Reform Programme should help enhance the business environment. Finally, strengthening R&D, improving infrastructure, and facilitating SMEs’ expansion and better integration into the international value chain would support stronger growth.

Authorities’ views

29. The authorities agreed that this is an opportune time to undertake structural reform. They broadly shared the mission’s assessment regarding impediments to stronger growth, and also noted the lack of part-time job arrangements as a barrier for increasing female labor force participation, the need to have more cooperation between the industry and schools to address the decline in the number of students majoring in technical fields, and the importance of higher public investment. To this end, they pointed to the steps in their National Reform Programme to stimulate growth, including investment in infrastructure, strong efforts to improve the absorption capacity for EU funds, development of child care services, support for vocational education, and co-operation between schools and employers. They felt confident that all these steps in the context of an improving external environment would help boost investment and growth.

Staff Appraisal

30. The Czech economy is strengthening but continues to face challenges. The economy has emerged from the prolonged recession, growth is gaining momentum, and unemployment has been falling. The recovery was triggered by exports, but has been increasingly supported by domestic demand. Despite these positive developments, inflation is still well below target, the new government’s medium-term fiscal plans are yet to be clearly elaborated, and potential growth is well below the level necessary to facilitate convergence of Czech per capita income to the level of other advanced European economies.

31. Following a sharp fiscal consolidation over the last three years, a growth-friendly fiscal strategy along with a clear medium-term fiscal framework is needed. On account of the need to sustain the nascent recovery and improve infrastructure, an increase in capital spending financed by a slight relaxation of the fiscal stance in the near term would be appropriate. At the same time, using revenue over-performance to ratchet up re-current expenditure should be avoided. The authorities’ commitment to a medium-term objective for the structural deficit is welcome, and it will need to be backed by a clear strategy on the underlying fiscal targets and policies. In addition, the medium-term deficit objective should be cast in a medium-term fiscal framework—enshrined in legislation—that would also include a debt brake rule, and an independent Fiscal Council, thus helping anchor fiscal policy, improve policy predictability, and contain pro-cyclicality.

32. The central bank should continue to focus on inflation targeting and maintain the current supportive monetary conditions for now. The effects of the depreciated exchange rate and recovering demand conditions are expected to push inflation gradually toward the central bank’s target. At the same time, though, there are still risks to the recovery, the output gap is still sizeable, inflation remains very low, and inflation expectations are not yet well-anchored around the inflation target. These considerations argue for keeping the exchange rate floor in place for now. Nevertheless, the central bank should continue to focus on inflation targeting and return to a floating exchange rate once deflation risks recede, and the inflation forecast and inflation expectations become entrenched around the inflation target.

33. The financial system is sound and resilient; continued vigilance will help sustain its health. The banking sector has strong capital and liquidity buffers, which make it resilient to shocks. Moreover, bank supervision has been enhanced by strengthening supervisory resources and legislative changes. Still, proactive supervision would be necessary along with gradual improvements in the supervisory architecture in line with the European and global initiatives.

34. Unleashing Czech Republic’s full growth potential requires renewed structural reform momentum. Implementation of structural reforms aimed at enhancing investment in physical and human capital, and improving the business environment is critical to support Czech Republic’s advancement in the international value chain and support stronger growth. Efforts to increase labor participation should continue, and greater emphasis should be placed on strengthening research and development, and upgrading skills in the technical fields.

35. It is recommended that the next Article IV consultation with the Czech Republic be held on the standard 12-month cycle.

Czech Republic—Risk Assessment Matrix1/

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The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks at the time of discussions with the authorities.

Response to Past Fund Policy Advice

Policy implementation has been broadly consistent with IMF advice with the fiscal stance being an exception.

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Competitiveness Assessment

The koruna has depreciated moderately since mid-2011 against the background of financial turmoil in the euro area. This trend has mitigated the lingering real appreciation from the 2007–08 spikes in the exchange rate, with an additional impetus from the CNB intervention in November 2013 to ease monetary conditions. While the CPI-based real exchange rate remains higher than its 2006 level, the recent favorable wage productivity dynamics has helped the Czech Republic preserve its competitive position—the real exchange rate deflated by unit labor costs in the manufacturing sector is now slightly lower than its historical average.

A01ufig09

Real Exchange Rate

(2001Q1=100)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

A01ufig10

Share of World Imports

(Percent of total imports, 2000=100)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Despite the recent exchange rate depreciation, the Czech export market share has not yet increased. Following earlier robust gains, the export market share has been broadly stagnant in the post-crisis period with some evidence of underperformance since 2011. While part of the explanation is the weak relative performance of the main Czech export market, the euro area, export performance has also lagged the one of Slovakia, which has a similar industrial structure and is oriented towards the same export markets.

Current account deficits have been largely financed by FDI inflows, the net international investment position (NIIP) has stabilized, and reserves are strong. Reflecting the high FDI stock, Czech Republic has traditionally had a large income deficit that outweighs the trade surplus to produce moderate current account deficits. However, these deficits have been largely financed by FDI flows that are underpinned by foreign earnings reinvested in the country, as well as new investments. The accumulated external deficits over the years have led to a moderate negative NIIP of about 45 percent of GDP, but the NIIP has stabilized in recent years. Excluding the FDI stock, the NIIP is positive reflecting low external indebtedness and a strong reserve position. In fact, foreign exchange reserves are well above the suggested adequacy range, providing ample cushion against external shocks.

A01ufig11

Current Account and International Investment Position

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

A01ufig12

Czech Republic: Reserves

(US$ billion)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

1/ Based on IMF Reserve Adequacy Metric.

The Czech Republic’s Links with Russia and Ukraine

Real sector links with Russia and Ukraine, except for energy imports, are limited; and direct financial links are negligible.

Czech Republic’s dependency on Russia and Ukraine is mainly through indirect supply chain links. Direct trade links are moderate. Russia is Czech Republic’s 8th largest export market with 3.2 percent of Czech exports going to Russia, and the 6th largest importer, with 5 percent of imports originating from Russia. Czech exports to Ukraine are about 1 percent of total exports and imports from Ukraine represent 0.8 percent of total. Moreover, the share of Russian value added embodied in Czech gross exports is somewhat above 5 percent only in two industries. However, final demand from Russia, in particular for automobiles produced in the Czech Republic and supplied indirectly through the German-Central European Supply Chain, is an important driver for exports, and thus lower growth in Russia could lower Czech exports.

The Czech Republic has a significant dependency on Russia and Ukraine for its energy imports. The share of Russian gas in the Czech Republic’s total gas consumption is 80 percent—the third largest share after Finland and Belarus. In addition, as the entire region is heavily dependent on energy imports from Russia, lengthy disruptions in gas supply would adversely affect production in the Czech Republic also through the impact on other countries. Nevertheless, there is scope for re-routing gas imports through other countries and, with seasonally-low demand, the Czech Republic could overcome short-lived disruptions.

Direct financial linkages are negligible. However, there is a risk of contagion through confidence effects.

There is significant reliance on tourism from Russia. The number of Russian tourists to the Czech Republic increased sharply in recent years, and now is the second largest only after the one of tourists from neighboring Germany.

The Fiscal Framework

The current fiscal framework lacks a medium-term fiscal anchor and contributes to a pro-cyclical bias. It consists of a medium-term fiscal target within the medium-term budgetary framework (MTBF) introduced in the 2004 Public Finance Reform. The MTBF is a three-year rolling framework that converts general government balance targets into expenditure ceilings, currently the only binding numerical fiscal constraint for the state budget and six state funds. In practical terms, the framework provides an effective constraint only on next year’s budget, thus lacking a proper medium-term fiscal anchor. Moreover, there is no enforcement mechanism or corrective actions and the coverage is limited to less than 60 percent of general government spending. As a result, the Czech Republic stands relatively low in the European Commission’s (EC) ranking of fiscal rule strength.

A01ufig13

Fiscal Rules Index, 2000-12 1/

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Source: European Commission.1/ Compiled by the European Commission, the Fiscal Rules Index is higher, when the numerical fiscal rules are stronger. Based on: (i) the statutory base of the rule, (ii) room for setting or revising its objectives, (iii) the body in charge of monitoring respect and enforcement of the rule, (iv) the enforcement mechanisms relating to the rule, and (v) the media visibility of the rule.

The proposed fiscal framework aims at addressing these weaknesses. It encompasses a structural balance rule, a debt brake supplemented with a debt restriction on local governments, and a deficit constraint on social security funds. The debt brake starts to apply when public debt, adjusted for the Ministry of Finance’s liquid reserves, exceeds 55 percent of GDP. The debt brake and the structural balance rule incorporate escape clauses applicable in cases of serious economic downturns, natural disasters, or emergency.

According to the debt brake, several automatic procedures would be launched when debt exceeds 55 percent of GDP. In such a case, the state budget as well as budgets of public health insurance companies and local governments must target a balance or surplus. Any new state guarantee would be provided only after a majority approval (by both Chambers of Parliament). While the debt brake has the potential to introduce a pro-cyclical bias, the current debt level provides an adequate buffer against this risk.

The proposed structural balance rule foresees a limit of 1 percent of GDP for the structural deficit, identical to the medium-term objective agreed between the previous government that the EC. Adoption of a structural balance rule would also be in line with the Fiscal Compact.

The proposed framework is to be implemented by a Constitutional Law and an Act on Rules of Fiscal Responsibility. The former incorporates the debt brake, Fiscal Council, and local governments’ debt rule and requires a super majority in both chambers of Parliament to be modified. The latter specifies the practical implementation of the Constitutional Act including the structural balance rule and requires a simple majority in both chambers of Parliament to be modified.

Transparency and accountability would be enhanced with the introduction of a Committee for Budgetary Forecasts and an independent Fiscal Council. The Committee would assess government forecasts and could require their revision if deemed optimistic. At the same time, more demanding and regular reporting criteria will be introduced, along with annual reports including on tax expenditures and contingent liabilities. The establishment of an independent Fiscal Council, with sufficient institutional and analytical capacity, would further enhance transparency and accountability of fiscal operations.

Inflation Developments

While headline inflation remains low, driven by administered prices (much of it energy-related) and food price inflation, positive underlying trends in a number of indicators suggest that risks of a deflationary spiral have begun to recede.

Indicators of core inflation are supported by currency weakness and economic recovery. Import prices spiked in late-2013 as a result of the exchange rate depreciation, while producer price indices of manufactured goods and market services have also been exhibiting upward trends. Inflation excluding regulated prices and fuel turned positive for the first time in five years in April 2014.

A01ufig14

Import price and exchange rate

(y-o-y percent change)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

A01ufig15

Inflation

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Source: Czech Statistical Office, Czech National Bank, Haver.
A01ufig16

PPI

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Inflation expectations are on target. Analyst forecasts have converged toward the central bank’s 2 percent inflation target for the 12-month horizon, as market participants tuned down expectations of undershooting observed last year and overshooting expectations this year.

A01ufig17

Inflation expectations

(y-o-y percent change)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Source: Czech Statistical Office, Czech National Bank, Haver.
A01ufig18

Wages in business sector

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Wages are recovering. Nominal wages in the business sector performed strongly in the first quarter of 2014 following a bout of very weak performance. While some of the strength in average wages is due to the shifting of bonuses during the calendar year, even adjusted for this effect, private sector wage dynamics seem to have turned the corner.

Table 1.

Czech Republic: Selected Economic Indicators, 2008–16

article image
Sources: Czech Statistical Office; Czech National Bank; Ministry of Finance; HAVER, and IMF staff estimates and projections.

Offer rate. 2014 entry is January-June average.

2014 entry is January-June average.

Table 2.

Czech Republic: Balance of Payments, 2008–19

article image
Sources: Czech Statistical Office; Czech National Bank; and IMF staff estimates and projections.
Table 3.

Czech Republic: The Statement of Operations of General Government, 2008–19 1/

(in billions of Koruny)

article image
Sources: Ministry of Finance and IMF staff estimates and projections.

Adjustments for cash-accrual differences, valuation changes and other discrepancies.

Table 4.

Czech Republic: The Statement of Operations of General Government, 2008–19 1/

(in percent of GDP)

article image
Sources: Ministry of Finance and IMF staff estimates and projections.

Adjustments for cash-accrual differences, valuation changes and other discrepancies.

Table 5.

Czech Republic: Medium-Term Macroeconomic Scenario, 2008–19

article image
Sources: Czech Statistical Office, Czech National Bank, Ministry of Finance, and IMF staff estimates and projections.

In percent of potential GDP.

Table 6.

Czech Republic: Financial Soundness Indicators

(in percent unless indicated otherwise)

article image
Source: Czech National Bank

Appendix I. Potential Growth

Raising Czech Republic’s potential growth faces significant challenges. After important gains in the years prior to the 2008 global financial crisis, labor productivity improved only very little during 2008–13 (Figure 1). Moreover, as the working age population (ages 15–64) is projected to decline by 0.4 percent annually during 2010–50, medium-term growth will have to rely on a bounce back of labor productivity growth and higher labor force participation.

A01ufig19

Czech Republic: Potential growth

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Figure 1.
Figure 1.

Productivity Growth and Demographic Changes in the Czech Republic

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Sources: Eurostat, World Population Prospects, and IMF Staff Calculations.

The slowdown in labor productivity may not be just cyclical. Aggregate employment declined during 2008–13 and aggregate output dropped even more, thus suggesting a possible role of labor hoarding—firms underutilizing productive employees and hence tending not to actively hire new ones—and that the slowdown in labor productivity may be cyclical. However, sectoral level data do not fully support this: e.g., the employment drop in manufacturing and real estate was larger than the output drop in the respective sector. Service sectors, such as finance and insurance, and information and communication expanded significantly, which is perhaps inconsistent with labor hoarding. Finally, sectors whose change in labor productivity seems not to be explained by labor hoarding account for more than 80 percent of the total labor force. This suggests that a slowdown in labor productivity may be more entrenched than being purely cyclical.

The Czech growth model may be facing increasing constraints. The current growth model of the Czech Republic relies on a strengthening of the economy’s position in the German-Central European Supply Chain (GCESC) by attracting FDI and relying on relatively cheap and high-skilled labor. However, this model may increasingly be facing limits, especially as the income convergence has substantially reduced unit labor cost differentials with Germany. Moreover, increased competition from other countries in the region creates additional headwinds.

Trends in total factor productivity (TFP) and unit labor costs (ULC) seem to be the main drivers of growth in countries with an income level higher than the Czech Republic’s. To assess the Czech growth potential, we analyze the experience of OECD countries with per capita income above the one of the Czech Republic.1 Figure 2 depicts the relationship between per capita GDP growth and the gap with US income level, ULC growth, TFP growth, and gross fixed capital formation. For each country, we define the time when the country’s real purchasing power2 started to exceed the Czech Republic’s 2014 level as time 0. We then compute per capita GDP over US per capita GDP and real ULC growth3 in the five years before time 0; and TFP growth and gross fixed capital formation over GDP in the five years after time 0. This analysis suggests that higher per capita real GDP growth is positively associated with: (i) a higher gap from the US income level; (ii) more moderate historical ULC growth; (iii) higher TFP growth; and (iv) higher capital formation. Moreover, strong TFP growth and moderate ULC growth seem to be the main drivers of growth.

Figure 2.
Figure 2.

Growth Factors and Per-Capita Real GDP Growth

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

The importance of TFP and ULC growth is confirmed by regression analysis. We examine the whole period between time 0—the time when each country’s real purchasing power started to exceed the 2014 level of the Czech Republic—and year 2013 and divide the period into five year intervals. Then, we conduct a pool-OLS regression analysis4 over these country-five year interval pairs, with the dependent variable being per capita real GDP growth in the five years, and the explanatory variables of the average ratio of per-capita GDP over the US per capita GDP and ULC growth in the previous five years, TFP growth and the average ratio of investment to GDP in the five years, as well as the world trade stock growth in the five years, the FDI stock growth, services share in export, and export share in GDP in the previous five years. The results of the regression analysis (Table 1) broadly support the observations made above. For example, a 1 percent increase in annual ULC growth implies a 0.1 percent decline in the annual per-capita GDP growth; while a 1 percent increase in annual TFP growth would lead to a 0.7 percent increase in annual per-capita GDP growth. Interestingly, the coefficients of the FDI stock growth, services share in export, and export share in GDP are all insignificant.5

Table 1.

Regression Results

article image
Standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1

This analysis suggests a potential GDP growth of around 2½ percent for the Czech Republic. The model-predicted per capita real GDP growth for the Czech Republic over 2014–19, based on the regression coefficients and estimations/projections for the explanatory variables is 2.6 percent (Figure 3). However, this figure could be slightly over-estimated for two reasons. First, 0.7 percentage point growth comes from the Czech Republic’s per capita GDP being on average 34 percent of the US per capita GDP in 2008–13. Such growth due to relatively low initial income level may be better seen as potential for catch up rather than as an actual projection. Second, 0.15 percentage point growth comes from negative real ULC growth during 2009–14, which, however, should be largely attributed to the 2008 global financial recession and not necessarily imply gains in competitiveness. Considering these factors, the average potential real GDP growth of 2.2 percent over 2014–19 assumed in the staff’s baseline scenario is in line with what this analysis suggests.

Figure 3.
Figure 3.

Growth Drivers During the Five Years after the Per-Capita Purchasing Power of Countries Started to Exceed the Czech Republic’s 2014 Level

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Note: 1/ Median of other advanced economies in the five years after the real purchasing power of the country started to exceed the Czech Republic’s level in 2014, or in the previous five years, depending on the variable definitions.2/ The average during 2008-13/2014-19 depending on the variable definitions. Sources: WEO, IMF Staff Calculations.

These results point to the importance of investment in research and development (R&D). R&D spending of the Czech Republic stood at 1.8 percent of GDP in 2011, significantly lower than the OECD average of 2.4 percent. The mission’s discussions with private sector representatives suggest that this could be to a large extent due to the lack of co-operation between businesses, universities, and the government; e.g., the government’s funding support tends to favor projects in the basic research and large companies which already have sufficient funding for innovation. If that is the case, there could be room for government support to strengthen R&D in the private sector, in a way that can help strengthen technology spillovers from the Germany-Central Europe Supply Chain6 to the domestic economy.

Accelerating TFP growth should also entail enhancing domestic value-added in exports. The domestic value added of Czech exports stood at around 55 percent in 2012, substantially lower than in other advanced economies. On the one hand, the low domestic content in export may reflect the fact that the Czech Republic is exporting highly sophisticated products, whose intermediate inputs tend to be produced by more than one country. On the other hand, recent OECD studies7 point out two other explanations: first, intermediate goods produced in the Czech Republic are relatively little used in Czech exports or as intermediate inputs in global production; and second, services sectors are poorly integrated into the supply chain, and the services content in Czech exports is the lowest among OECD countries. These explanations suggest room for the Czech Republic to enhance the integration of its domestic firms into the international value chain, which can be important for the TFP growth of the Czech Republic, as studies (Eaton & Kortum, 19998) show that international technology spill-over plays a large role even for the TFP growth of advanced economies.

Addressing skill mismatches in the labor market is also important. Demographic headwinds may lead to labor shortages, with segments of skill mismatch suffering most, so the resulted upward pressure in the ULC will hamper growth. The Czech Republic has done relatively poorly in aligning its fields of study with job requirements (horizontal mismatch, Figure 5). Various interlocutors of the mission pointed to potential lack of workers trained in technical fields down the road as increasingly more students choose social science as their majors, since compensation is similar or even higher, and completion of such degrees may be less challenging. Coming to the underlying causes, it has been suggested that there are insufficient incentives for the education system to shift focus on the market needs when training students, as the university funding is based on the number of students rather than on their job market performance. To this end, recent OECD analysis9 suggests a need for the Czech Republic to improve tertiary education quality, including publicizing information on labor market outcomes by field of study and education institutions, and developing accreditation criteria for tertiary education accordingly. Adopting measures to address skill mismatch and improve labor force skills will not only help contain ULC growth but also accelerate TFP growth.10

Figure 4.
Figure 4.

Domestic Value Added in Export

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Sources: World Input and Output Table, IMF Staff Calculations.
Figure 5.
Figure 5.

Fractions of Respondents Reporting Horizontal Skills Mismatch

Horizontal skills mismatch (percent)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Sources: SEO Economic Research and Randstad (2012).

Finally, it is important to further develop the services sector and enhance labor force participation. The services sector in the Czech Republic hired 60 percent of the labor force in 2013, compared with, e.g., 70 percent and 80 percent in Germany and the UK, respectively. There is evidence that services industries, which tend to hire more women, are less-developed in the Czech Republic. For example, the top five sectors in the share of female employees (namely, health and social work, education, accommodation and food services, finance and intermediation, and administrative support) in Germany belong to the services sector and hired around 30 percent of the total labor force in 2013, while the same industries hired 38 percent in the UK and only 22 percent in the Czech Republic. In the same year, only 74 percent of employed women were working in the services sector in the Czech Republic compared with 83 percent and 91 percent in Germany and the UK, respectively. This evident suggests that the less-developed state of the services sectors may have contributed to the relatively low female labor force participation, by offering fewer attractive job opportunities. Moreover, a number of studies (e.g., Dabla-Norris et al., 201311) show that a higher dependency ratio leads to a larger value-added share of the services sector in the total economy. Given the aging of the population, the services sector could perhaps play a more prominent role in the Czech Republic. Therefore, reducing domestic entry barriers in the services sectors and enhancing competition could help further develop these sectors and achieve a dual goal of enhancing women labor force participation and better preparing for the aging society.

Appendix II. Czech Republic: Debt Sustainability Analysis

Public debt has stabilized at around 46 percent of GDP, as the effect of narrowing structural deficits was counterbalanced by economic contraction in 2012–13. Provided the expenditure ceilings as specified in the Convergence Programme are respected, public debt is projected to stay on a downward path reaching 42 percent of GDP by 2019 on the back of the economic recovery and strong revenue collection. Public debt and gross financing needs are relatively resilient to isolated shocks to key variables, but a combination of shocks to real GDP growth, interest rate, exchange rate, and revenue shortfalls could lead to a significant ratcheting up of the debt level.

Baseline and Realism of Projections

The baseline scenario assumes a structural relaxation from a deficit of 0.6 percent of GDP in 2012 to 1.2 percent in 2015 with structural balances staying close to a 1 percent of GDP deficit over the medium term. It is underpinned by the following assumptions:

  • Expenditure ceilings: The baseline assumes that the expenditure ceilings set forth in medium term budget framework for the 2014–17 period will be respected. The small structural relaxation is mostly due to the increase in the capital expenditures from 2.8 percent of GDP in 2013 to 3.6 percent in 2015.

  • Growth and inflation: Underpinned by a recovery in domestic demand and exports, real GDP is projected to increase by 2.5 percent in 2014 and 2015, with medium-term growth converging close to 2 percent. The inflation rate is forecast to converge to the 2 percent target by end-2015.

The outlook for the fiscal path is benign under the baseline. Staff projects that the debt-to-GDP ratio will decrease from 46 percent in 2013 to 44.4 percent in 2014–15, before starting to steadily decline to 42.3 percent in 2019. The temporary stabilization in 2015 at 44.4 percent in part reflects the scheduled government structural stimulus to aid the nascent recovery. Gross financing needs are projected to stay below 9 percent of GDP throughout the projection period.

Shock and Stress Tests

A combination of macro-fiscal shocks is the main risk to debt sustainability. Assuming that shocks to real GDP growth, the primary balance, the real exchange rate and the real interest rate would occur simultaneously, public debt would increase sharply and stabilize around 62 percent of GDP. Gross financing needs would also climb to 14 percent of GDP in 2019.

A01ufig20

Czech Republic: Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(in percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Source: IMF staff.1/ Public sector is defined as general government.2/ Based on available data.3/ EMBIG.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r - π(1+g) - g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
A01ufig21

Czech Republic: Public DSA – Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2014, 256; 10.5089/9781484393383.002.A001

Source: IMF staff.
1

As a result, the de facto exchange rate arrangement has been reclassified from free floating to other managed, effective November 7, 2013.

2

See Annex II of the Staff Report for the 2013 Article IV Consultation.

3

Working age population is projected to decline by 0.36 percent per annum during 2010-50, while total population is projected to grow by 0.15 percent per annum over the same period (based on the medium fertility scenario in UN’s World Population Prospects: The 2012 Revision).

4

Overall labor force participation is around 73 percent, which is above the OECD average, and the authorities’ 2011 reform strategy aims at 75 percent by 2020.

1

These countries include (the years in the parentheses are the time when each country’s per-capita GDP in PPP US$ deflated by the US GDP deflator started to exceed the Czech Republic’s 2014 level): Australia (1989), Austria (1987), Belgium (1989), Canada (1989), Denmark (1985), Finland (1997), France (1989), Germany (1989), Greece (2003), Iceland (1986), Ireland (1997), Israel (2000), Italy (1991), Japan (1988), Korea (2007), Luxembourg (1976), Netherlands (1988), New Zealand (2003), Norway (1976), Slovenia (2006), Spain (1999), Sweden (1988), Switzerland (1969), United Kingdom (1995), and the United States (1976).

2

Real purchasing power is defined as per-capita GDP in PPP US$ deflated by the US GDP deflator.

3

Real ULC is defined as ULC in manufacturing in US$ deflated by the US GDP deflator.

4

We choose not to do a panel analysis because of a small sample size. The regression results are robust to various specifications. If we drop FDI stock growth, we will have around 80 observations, and results are largely unchanged.

5

This may not be driven by the small sample size, as the simple regression of per-capita real GDP growth on FDI stock growth is also insignificant.

6

Largely due to the participation in the GCESC, data suggest that the export sophistication (measured using the method developed by Hatzichronoglou, T. (1997) “Revision of the high-technology sector and product classification”, OECD Science, Technology and Industry Working Papers, 1997/02, OECD Publishing.) of the Czech Republic was higher than most advanced economies with similar or smaller population sizes in 2012, with notable exceptions of Ireland and Switzerland. This implies a large potential for technology spill-over in the Czech Republic.

7

OECD economic surveys: Czech Republic. March, 2014.

8

Eaton, J. and Kortum, S. (1999) “International technology diffusion: theory and measurement”, International Economic Review 40, 537-570.

9

OECD economic surveys: Czech Republic. March, 2014.

10

There are two reasons for this: first, we do not control for quality of labor when estimating the TFP, and strengthening the labor skill naturally increases the TFP as defined in the current context. Second, highly-skilled labor force can increase the capacity for firms to absorb new technologies, and hence facilitate technology spill-over.

11

Dabla-Norris, E., Thomas, A., Garcia-Verdu, R. and Chen, Y. (2013) “Benchmarking structural transformation across the world”, IMF Working Paper.

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Cover IMF Staff Country Reports
Czech Republic: Staff Report for the 2014 Article IV Consultation
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2014: Issue 256
Publisher:
International Monetary Fund
ISBN:
9781484393383
ISSN:
1934-7685
Pages:
61
DOI:
https://doi.org/10.5089/9781484393383.002

Real GDP and Exports

(QoQ, SAAR)

Inflation

(y-o-y, percent)

Contributions to Inflation

(y-o-y, percent)

Exchange Rate

(koruny per euro)

Official Reserves

(EUR billion)
Figure 1.

Czech Republic: Macroeconomic Developments
Figure 2.

Czech Republic: Financial Markets
Figure 3.

Czech Republic: External Sector
Figure 4.

Czech Republic: Evolution of Baink Credit
Figure 5.

Czech Republic: Fiscal Developments and Prospects
Figure 6.

Czech Republic: Competitiveness Indicators

Fiscal Stance

(in percent of GDP)

Fiscal Adjustment

(Change in fiscal balances in percent of GDP)

Potential Growth

(percent, range and average, 2013-19)

Real Exchange Rate

(2001Q1=100)

Share of World Imports

(Percent of total imports, 2000=100)

Current Account and International Investment Position

Czech Republic: Reserves

(US$ billion)

Fiscal Rules Index, 2000-12 1/

Import price and exchange rate

(y-o-y percent change)

Inflation

PPI

Inflation expectations

(y-o-y percent change)

Wages in business sector

Czech Republic: Potential growth
Figure 1.

Productivity Growth and Demographic Changes in the Czech Republic
Figure 2.

Growth Factors and Per-Capita Real GDP Growth
Figure 3.

Growth Drivers During the Five Years after the Per-Capita Purchasing Power of Countries Started to Exceed the Czech Republic’s 2014 Level
Figure 4.

Domestic Value Added in Export
Figure 5.

Fractions of Respondents Reporting Horizontal Skills Mismatch

Horizontal skills mismatch (percent)

Czech Republic: Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(in percent of GDP unless otherwise indicated)

Czech Republic: Public DSA – Composition of Public Debt and Alternative Scenarios