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.
The Czech economy has recovered from the negative growth of the last two years and is experiencing a strong and balanced recovery. Households’ consumption growth has resumed and is beginning to contribute meaningfully to economic growth. With stronger growth in the euro area over the last twelve months, the external environment has been positive for Czech exports. After graduating from the EU’s Excessive Deficit Procedure, fiscal policy is no longer a drag on the economy. Private and public sector investments are picking up as demand continues to improve, and the execution of projects from EU funds has improved.
The authorities expect the real GDP to grow in the order of 2.7 - 2.9 percent this year and in the order of 2.5 - 3 percent next year. Risks to the forecast stem from the speed in EU funds absorption, a continuation of the positive consumer sentiment, disinflationary risks in the euro area, the development of global commodities prices, and geopolitical risks in Ukraine and Iraq. The unemployment rate is projected to decline from its peak of 7 percent in 2013, to 6.4 in 2014, and then 6.1 in 2015. The current account is expected to reach a surplus of 0.4 percent of GDP in 2014 (for the first time since 1993) and remain balanced in 2015.
The Czech economy has weathered last summer’s pullback of capital flows from emerging markets well. Since 2008, the current account and fiscal deficits have decreased significantly and the economy has become less reliant on foreign capital. As a result, and faced with decelerating inflation, monetary policy has continued with easing, and fiscal policy can use the acquired fiscal space to provide targeted support to the economy this year.
Monetary policy stance
The Czech National Bank (CNB) reached the zero interest rate bound in November 2012, but the economy continued to experience weakness throughout 2013, households’ consumption was weak, fiscal consolidation was ongoing and weak demand and economic uncertainty weighed negatively on investment. Inflation slowed down rapidly over 2013 towards zero, with households starting to postpone consumption as prices were falling.
Faced with the risks of a deflationary spiral, missing its inflation target, and the continued low-inflation environment in the euro area, the CNB launched foreign exchange interventions in the fall of 2013 in order to further ease monetary conditions to bring inflation to its 2 percent inflation target. The CNB adopted the commitment to intervene in the foreign exchange market to weaken the koruna so as to maintain the exchange rate close to CZK 27 to the euro. The CNB only intervened during the first few days after its announcement; the exchange rate adjusted accordingly and has been above this level without significant fluctuations. The CNB communicated that further changes to its exchange rate floor towards the greater weakening of its exchange rate would be warranted only if economic conditions and the medium-term outlook were to change significantly. The CNB is an inflation-targeting central bank and foreign exchange interventions are used only as a tool to further ease monetary conditions in order to reach the inflation target in situations when monetary policy interest rates have reached the zero bound.
The fact that inflation was still only 0.5 percent in July (well below the lower boundary of the tolerance band around the CNB’s inflation target) despite the slightly weaker exchange rate (27.8 CZK/EUR as of August 22) and in an environment where growth is picking up strongly suggests that the output gap could have been even deeper than expected and the extent of households’ savings glut even greater than anticipated. Therefore, foreign exchange interventions have been successful in averting the threat of a deflationary spiral.
The current CNB forecast sees more downside inflation risks than in the previous quarter, and inflation gradually returning to the target from its presently very low levels in the second half of 2015, as wage growth in the business sector picks up. The Bank Board therefore decided to continue using the exchange rate as a monetary policy instrument at least until 2016 (originally the beginning of 2015), on the condition that there is sufficient certainty after the exit from foreign exchange interventions that inflation would not immediately fall below its target again. The Bank Board continues to discuss the exit strategy, and exchanging views with Fund staff during the June Article IV mission was very helpful in this regard. An exit from foreign exchange intervention will not imply the appreciation of the exchange rate to the level recorded before the CNB began to intervene, as the weaker exchange rate will in the meantime pass through to the price level and other nominal variables.
Government policies
The new government took office in January 2014, aiming for more pro-growth policies and emphasizing social policy priorities, while adhering to overall budgetary responsibility.
Fiscal policy
The Czech Republic exited the EU’s Excessive Deficit Procedure this year after considerable fiscal consolidation that brought down the fiscal deficit from its peak of 5.8 percent of GDP in 2009 to 1.5 percent of GDP in 2013, primarily due to the increase in VAT rates and a reduction in public investment. The government expects the fiscal deficit to reach 1.5 percent of GDP in 2014. In 2014, the government’s fiscal policy strategy expects to utilize this newly-created fiscal space to support the domestic economy’s fragile recovery in the short term, with a neutral effect in the medium term. Government investment (mainly as a result of the increase in investment financed from EU sources) and government current spending (primarily on social benefits) are projected to pick up this year, while there are only relatively moderate discretionary tax measures planned for this year. The wage bill in the state administration was approved to increase by 2 percent this year. Tax revenues are expected to improve in 2014 on the back of the strengthening economy.
The gross government debt is expected to decline from 46.2 percent of GDP in 2012 to 46 percent of GDP in 2013, then 44 percent of GDP in 2014 (currently among the lowest in the EU). The net financial government debt is estimated at 29.9 percent of GDP in 2014. Government debt denominated in foreign currency is estimated at 14 percent of total debt (or 4.1 percent of GDP, adjusted for collateral and assets). Expenditures on interest payments remain low and yields on government bonds remain at a historical low, due to the stable debt development, the country’s economic stability, and the favorable situation on global financial markets.
As to the modification of the tax legislation, the Lower House of Parliament already approved an increase in the rates on the excise duty on tobacco products in line with EU requirements, particularly due to the currency depreciation. As of January1, 2015, the government plans to amend the personal income tax legislation, including by increasing tax credits for children and reintroducing tax discounts for pensioners; to introduce a second, reduced VAT rate of 10 percent on drugs, books, and essential infant nutrition; and to abolish fees for prescription and outpatient treatment.
The government is committed to the medium-term structural deficit objective of 1 percent of GDP by 2020 and the headline deficit below 3 percent. In the medium term, the government expects to reach a headline fiscal deficit of 1.7 percent of GDP in 2017, and plans changes in the area of direct and indirect taxation. The government’s priority is to increase the effectiveness of tax collection and more successfully fight against tax evasion. The rationalization of expenditure and savings in the government sector’s current expenditure are also among the key priorities. The wage bill in the state administration is expected to grow by 1 percent in the medium term, and the wages of medical doctors should increase in 2015 and 2016. A larger amount of funding will be directed to the healthcare sector, as public and private spending on health care is below the OECD average. The gross fixed capital formation of the government sector is expected to be around 3 percent annually in the medium-term outlook horizon until 2017. The structural deficit is expected to deteriorate to 1.7 percent of GDP by 2017 as a result of the reduced emphasis on public sector consolidation. Government debt is projected to increase only slightly by 2017, in view of the expected recovery of GDP growth.
The government committed to adopt the Fiscal Compact of the EU. Furthermore, the government continues its work on the Constitutional Act on Fiscal Responsibility with the government’s aim of enacting it in 2015. The Act will introduce numerical fiscal rules, a debt break, and a fiscal council. Based on the agreement between the Government and the two political parties in the parliamentary opposition, the new Civil Service Act is to be approved with a view to entering into force on January 1, 2015.
Structural policies
In line with staff recommendations to increase labor force participation, a draft Act to introduce a new type of service to provide childcare was adopted by the Lower House of the Parliament. The government also aims to create suitable conditions for long-term sustainable employment, based on a targeted active employment policy and by modifying the investment incentive system to improve employers’ motivation to invest in regions with an above-average unemployment rate. The government will also start implementing measures to reduce entrepreneurs’ administrative and regulatory burden. The minimum wage should be increased annually in order to reflect the socio-economic environment and to raise it over time to 40 percent of the average wage.
The government is returning to the pre-2012 rules for the indexation of pensions to allow for its indexation based on the CPI index and real wage growth. From 2015, the average, independently paid old-age pension will increase by at least 1.8 percent annually. The main goal is to stop the decrease of the real value of pensions and to prevent the decrease of the standard of living of pensioners.
With the measures from 2011 introducing increases in the retirement age, the average period of pension payments was stabilized for the long term, in accordance with the expected future demographic development and changes in life expectancy. However, being aware of the uncertainty regarding demographic forecasts, the current government considered the possibility to implement standardized procedures of regular revisions to the retirement age increase rate.
In line with the Policy Statement of the Government, an expert committee has been established to propose changes to the current pension system with a view to bringing a long-term stable setup of the system, enhancing the sustainability of its funding, and the adequacy of the provided benefits. The Government also mandated the expert committee to submit a proposal for termination of Pillar II of the pension system on January 1, 2016.
Financial sector
The Czech banking sector remains stable and sound. Czech banks follow a traditional banking model, are well-capitalized (17.1 percent capital adequacy ratio) and continue to be some of the most profitable in the region (18.4 percent return on equity). Bank lending is predominantly financed by domestic deposits (a loan-to-deposit ratio of 74 percent, among the best in EU) and foreign exchange loans to households are virtually non-existent. Banks operate in an environment of excess liquidity. The net external position of the Czech banking sector is positive. Non-performing loans are leveling up at 6.5 percent of total loans while non-performing loan provisioning remains flat at 48 percent. Credit growth remains moderate, with growth in loans to households being low and growth in loans to the non-financial corporate sector stagnating due to weak domestic demand.
The CNB’s most recent bank stress tests again showed that the banking sector is sufficiently resilient to even very unfavorable shocks, owing to its profitable business model, and strong capital and liquidity position. The insurance sector also showed sufficient resilience to the adverse scenario on account of its large capital buffer. The pension management company sector (pillar III) remains sensitive to a rise in yields on securities holdings.
The Czech Republic transposed the EU Capital Requirements Directive (CRD IV) into Czech law as of June this year, with selected parts taking effect in 2015 and 2016, and banks are already in compliance with the new regulation. The EU Directive establishing a framework for the recovery and resolution of credit institutions and investment firms (BRRD) is expected to be transposed into Czech law in 2015. The Czech authorities continue to address the weaknesses in the non-systemic sector of credit unions, following up on the recent FSAP recommendations, by closing down unviable businesses and strengthening the regulation for the sector. In line with FSAP recommendations, the CNB also increased staff in financial sector supervision. The Czech authorities thank the Article IV team for a constructive exchange of views during its mission.