Czech Republic: Staff Report for the 2018 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
26 Jun 2018
eISBN:
9781484363669
Language:
English
Keywords:
ISCR; CR; koruna; core inflation; government; headline inflation; surplus; labor productivity; housing market; debt management; foreign currency; current account; Europe; CNB favor
Download PDF (1.7 MB)

The economy has been doing very well, with high growth and the lowest unemployment rate in the EU. So far, there are no major macroeconomic imbalances.

Abstract

The economy has been doing very well, with high growth and the lowest unemployment rate in the EU. So far, there are no major macroeconomic imbalances.

Recent Developments

1. Recent growth has been strong and particularly job rich. GDP growth accelerated in the second half of 2017, reaching 4.4 percent y/y. The unemployment rate has fallen to a record low of 2.3 percent in April 2018, even with increased participation.

uA01fig01

GDP Growth and Unemployment

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Haver Analytics.

2. Macro policies have tightened moderately. The Czech National Bank (CNB) has increased the policy rate (Section A) and tightened macroprudential settings further (Section B). The overall budget surplus improved by 0.9 percent of GDP in 2017; staff estimates that fiscal policy will ease in 2018 and, in particular, 2019 (Section D).

3. Notwithstanding the strong demand in goods and labor markets, major macroeconomic imbalances have so far been avoided:

  • Growth has been broad based, without lower saving rates. All sectors contributed positively, with the contribution of services overtaking manufacturing in the second half of the year. In terms of expenditures, private consumption was strong, supported by real wage growth of 4 percent and employment growth of 1.6 percent in 2017. Investment—notably private domestic capital formation—picked up in the second half of the year (Figure 1). Household and national savings rates remain stable, at about 11 and 25 percent of GDP, respectively.

  • Inflation has so far been moderate (Figure 2). Nominal wage inflation has been very strong, averaging 8½ percent in the first quarter of the year. Labor productivity gains and decreasing margins have constrained domestic inflation thus far, while imported inflation has been negative. Headline and core inflation fell in the first quarter, but are now close to the target.

  • The current account posted a surplus in 2017 (Figure 3). The REER has appreciated by 8 percentage points from April 2017 to April 2018, but this has not dented the robust trade surplus. External debt increased in the run-up to the exit from the currency floor, driven by increased bank deposits, but has remained stable since then. The NIIP remains comfortable at −26 percent of GDP.1 Staff assesses the external position in 2017 to have been stronger than warranted by medium-term fundamentals and desirable policies, consistent with the persistent current account surplus and the EBA CA model assessment of a 7 percent undervaluation. (Annex I).

  • The fiscal position is comfortable. Staff projects overall and structural budget surpluses of 1.6 and 1.0 percent of GDP for this year; debt is estimated to have fallen to 35 percent of GDP in 2017.

Figure 1.
Figure 1.

Czech Republic: Recent Growth

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Figure 2.
Figure 2.

Czech Republic: Inflation

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Figure 3.
Figure 3.

Czech Republic: External Position and Competitiveness

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

uA01fig02

Gross Savings Rate of Households

(Percent)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Eurostat.
uA01fig03

Gross Savings

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Eurostat.

4. But supply is hitting limits (Figure 4). The working age population has fallen by 7 percent from 2009 to 2017. A significant increase in the participation rate has so far compensated for this decline. Even so, firms report hiring problems, especially of those with appropriate skills, with more than one vacancy per unemployed person.

Figure 4.
Figure 4.

Czech Republic: Capacity Constraints

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

5. And there are signs of financial vulnerabilities (Figure 6). Overall credit growth remains in line with that of nominal GDP, and the overall indebtedness of households is not high by international standards. But real estate lending has accelerated and many households continue to borrow at high multiples of incomes, associated with buoyant housing markets (Section B).

Figure 5.
Figure 5.

Czech Republic: Near-Term Growth Momentum

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Figure 6.
Figure 6.

Czech Republic: Credit Developments

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

6. A new government has not yet been formed. The ANO party won the largest share of votes in the general elections in October 2017 but fell short of a majority of seats in parliament. Discussions to form a coalition continue; the most likely scenario is a coalition with cabinet formed from representatives from the ANO and center-left CSSD parties (the two parties in the previous coalition), with a separate agreement between ANO and the communist KSCM party to ensure a majority in votes of confidence. In the meantime, administration continues under the terms of the 2018 budget.

Outlook and Risks

7. The outlook is favorable, but constrained by supply limits. Staff projects growth of 3.7 percent in 2018, gradually falling to 2.5 percent by 2023.

  • Near-term domestic growth momentum is strong. Consumer and business confidence is high, consistent with strong demand for durable goods and production equipment (Figure 5).

  • Monetary conditions are assumed to follow the CNB’s forecast of only one policy rate increase in 2018, with more rapid tightening in 2019 and beyond. Some fiscal stimulus is expected this year and the next (Section C).

  • The external environment is also supportive: GDP growth for the euro area—the most important market for the Czech Republic—is projected to reach 2.5 percent this year (1 percentage point above previous projections). Euro area inflation is projected to remain subdued, and the policy stance of the ECB to remain accommodative.

  • Employment gains are assumed to slow considerably, but wage growth is expected to remain strong, supporting private consumption. Investment is assumed to accelerate this year as firms attempt to compensate for labor shortages. Despite supportive external demand, the contribution from net exports is expected to be negative as the import intensity of domestic demand increases (Table 1).

  • CPI inflation is expected to increase in 2018 and remain slightly above target in 2019: the recent decline in margins is expected to slow somewhat, implying that increases in labor costs are passed on to domestic inflation; the exchange rate is expected to continue to appreciate, but at a lower rate, implying less disinflationary pressure than recently.

Table 1.

Czech Republic: Selected Economic Indicators, 2013–23

(Annual percentage change, unless noted otherwise)

article image
Sources: Czech National Bank; Czech Statistical Office; Ministry of Finance; Haver Analytics, and IMF staff estimates and projections.
uA01fig04

Real GDP growth and output gap

(Percent)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Czech Statistical Office and IMF staff projections
uA01fig05

Germany and Euro Area Real GDP Growth Revisions

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: IMF, World Economic Outlook database.
uA01fig06

Profit Mark-Ups

(Annual percentage change)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Note: The mark-up is proxied here by the difference between the annual rates of change of the gross value added deflator and unit labor costs (see ECB Bulletin, December 2006)Sources: Haver Analytics; and IMF staff calculations.

8. Longer-term growth will depend on the ability of productivity to accelerate above the historical trend and compensate for the decline in labor supply. Staff estimates potential growth at 2½ percent, which, given declining employment growth, implies an increase in labor productivity growth to 2¾ percent from the historical average of 2½ percent. Given the already-high capital stock, this implies an acceleration in TFP growth.2

uA01fig07

Real Labor Productivity per Person

(GDP per total employment, year-on-year percent change)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: Eurostat

9. In addition to demand pressures, the economy potentially faces important equilibrium adjustments. Structural transformation implies increased incomes and a likely shift toward more services and away from manufacturing over the long term; in turn this implies further equilibrium real exchange rate appreciation. Separately, agglomeration effects would imply job creation predominantly in cities, raising demand for urban housing.

10. Risks to the outlook are tilted to the downside and include potential external shocks, domestic vulnerabilities, and political uncertainty (Annex II):

  • Near-term growth could be stronger than anticipated if domestic demand momentum surprises on the upside, such as from a boost to investment from faster absorption of EU funds; potential growth could be lower than assumed if the recent pick-up in labor productivity is not sustained.

  • The inflation outlook is particularly uncertain, as the outcome will depend on which of domestic inflationary and imported disinflationary pressures dominate. The prospects for domestic inflation hinge crucially on the degree to which labor productivity and firms’ markups absorb wage increases; here the risks are on the upside. Alternatively, disinflationary pressures could increase, especially if either the exchange rate or pass-through are stronger than anticipated.

  • A decline in global trade is a major risk for a small economy highly dependent on external demand, particularly from the euro area, but high concentration in auto production and integration with Germany’s production chain also make the economy vulnerable to indirect spillovers, such as from increased protectionism. Rapid wage growth could pose a risk to price competitiveness should the productivity growth disappoint. An increase in financial turbulence could see increased longer-term interest rates and exchange rate volatility.

  • Persistently high mortgage lending growth coupled with high household leverage could pose a risk to financial stability.

  • The domestic political situation remains in flux, potentially delaying structural reforms. Fiscal policy could become strongly procyclical if proposed public spending and tax changes are implemented (Annex V).

Authorities’ Views

11. The authorities broadly agreed on the outlook and the balance of risks. The authorities expect growth to be close to 4 percent this year and 3½ percent in 2019, driven mainly by strong domestic demand. They shared the view that a tighter labor market would constrain supply, but were more optimistic about productivity growth, which would be boosted by investment. The CNB expects inflation to undershoot the 2 percent target this year and converge to the target at the monetary policy horizon, and the koruna, though currently at equilibrium, to appreciate further. The exchange rate and wage growth were key sources of uncertainty; the authorities were concerned with external risks related to external demand, such as from increased protectionism.

Policy Discussions

12. The main challenge for policy is to maintain sustained and stable growth over a prolonged period—this means setting policies to avoid overheating at this stage of the cycle and boosting the potential growth rate of the economy now and over the long term. Hence, all macroeconomic policies have an important role to play in navigating the path to sustained and stable growth.

A. Monetary Policy

13. The CNB has moved to gradually normalize monetary conditions. The repo rate has been raised to 0.75 percent, less and slower tightening than was projected by the CNB immediately before removing the koruna floor. FX interventions have ceased. The nominal effective exchange rate has appreciated by 8 percent from the exiting the floor through to April 2018; there has been some depreciation against the euro and most other currencies since then.

uA01fig08

Exchange Rate and CNB Interventions

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Czech National Bank.
uA01fig09

CNB 3-month PRIBOR forecast

(Percent)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Czech National Bank.

14. One additional rate hike is expected this year. The CNB’s May 2018 inflation forecast was adjusted downwards, owing to lower observed inflation so far in 2018 and weaker regulated price inflation. On this basis, the CNB projects one more rate increase in 2018, followed by a series of increases in 2019.

15. Given the uncertainty about inflation, the CNB’s gradual approach to normalizing policy is appropriate. In the current situation, in which there is a risk that disinflationary pressures could increase while policy rates are still close to zero, this is the right approach.3 That said, given the strength of domestic inflation, the CNB should continue to communicate its readiness to raise rates earlier than currently projected if needed to fulfil its mandate.

16. The CNB has adopted a new FX reserves management strategy. FX reserves increased to 62 percent of 2017 GDP during the period of the koruna floor. The CNB is not planning to sell the reserves. To increase expected returns, the CNB has tranched its FX reserves: a core, currently 45 percent of FX reserves, will be invested in short-term and highly-liquid assets, and the remainder in longer-term investments with higher expected returns, including shares and mortgage-backed securities. This approach is appropriate so long as liquidity, market, and other risks are contained.

Authorities’ Views

17. The CNB favors continued gradual normalization of interest rates, seeking to avoid undue appreciation of the exchange rate that would put pressure on the tradeables sector. It assesses the risks to the inflation forecast—and consequently the interest rate path—as broadly balanced, reflecting, in particular, uncertainties about the transmission of labor costs and import prices to CPI. CNB Board members did not favor a schedule of earlier and more regular policy rate increases, noting that the regular meetings of MPC gave ample opportunity to avoid falling behind necessary policy adjustment.

B. Macroprudential Policy

18. Private credit growth is in line with nominal GDP growth, but household lending is growing more quickly. Bank lending to residents eased to 4 percent (y/y) in April, of which loans to resident non-financial corporations grew by only 1½ percent. However, loans to households increased by 7½ percent; mortgage loans to households increased by 9½ percent, off the recent peak in mid-2017 of 10½ percent, but nonetheless outpacing nominal income growth. Consumer credit also grew relatively strongly.

19. Some households are highly leveraged. The aggregate household debt-to-income (DTI) ratio has not increased further over the year, given the strong growth of disposable income. But many households continue to borrow at high loan-to-income multiples (Figure 6), associated with escalating price-to-income and price-to-rent ratios (Figure 7).

Figure 7.
Figure 7.

Czech Republic: Housing Market

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

20. The CNB has tightened macroprudential recommendations (Annex III). New, non-binding recommendations implemented in 2017: Q2 included a 90 percent LTV cap on individual loans and a 15 percent cap on the share of new loans originated with LTV ratios between 80 and 90 percent. In June 2017, the CNB recommended that banks pay extra attention to debt-to-income and debt-service-to-income ratios. Reported lending standards have subsequently tightened, and the share of new household mortgage loans with LTVs above 90 percent has declined, with many loans at around 80 percent LTV. However, concerns were expressed that this improvement may have been flattered by inflated valuations.4

21. Additional measures are needed to insure against household financial vulnerabilities. DTI ratios on new mortgages are only indirectly addressed by LTV restrictions—to safeguard household finances, the financial authority needs more comprehensive tools and access to data sufficient for a comprehensive picture of households’ finances (¶22).

  • The CNB should be given binding powers over maximum LTV, DTI, and Debt-Service-To-Income (DSTI) ratios as soon as possible.5 Debt-based measures would provide a more comprehensive assessment of financial risks than loan-based measures, and are increasingly standard in advanced economies. In the absence of legislation granting binding powers, the CNB should immediately issue recommendations over DTI and DSTI ratios, to reinforce those over LTVs and better target high leverage.

  • If such “demand side” (i.e. borrower-based) tools are not implemented, additional “supply side” measures could be considered, but these would only indirectly address the underlying problem of high household leverage. Risk weight add-ons or minimum risk weights for property exposures could provide insurance against growing real estate exposures, but a substantial increase would likely be required to make a meaningful difference to lending conditions, given that capital ratios are above regulatory requirements.6 The CNB has discretion over capital requirements under Pillar II, but it is not guaranteed that the effects would “pass through” to mortgage borrowers.

22. Better data are needed for monitoring risks. The use of DTI and DSTI measures puts great demands on data—to accurately assess risks and to be fully sure of compliance, the CNB needs access to comprehensive household loan data.7 Better data on commercial real estate transactions would also be helpful.

23. Macroprudential measures should be supported by addressing fiscal and structural policies. Increasing house prices in major metropolitan areas reflects equilibrium adjustment, and demand has consistently outstripped supply, especially in Prague. Planning and zoning laws contribute to housing supply constraints that add to pressures on prices. Some progress has been made in streamlining procedures for building permits, but construction levels remain below pre-crisis highs (Box 1). In addition, the tax environment adds to housing demand (¶39). Without attention to such problems, the housing market is likely to remain tight.

Demand and Supply Pressures in the Housing Market

Construction activity declined after the financial crisis and has yet to recover to levels seen in 2009. The effect is particularly noticeable in Prague, for which housing completions have not kept pace with housing demand. Low numbers of housing starts imply that the problem will continue for some time. Demand has been driven mainly by migration within the country and strong demand for prime properties by foreigners; demand for investment properties is also believed to play a significant role.

uA01fig10

Construction Output

(Index, 2011=100)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Czech Statistical Office.
uA01fig11

Apartment construction and population growth in regions in year 2017

(x-axis: regions; y-axis: thousands)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: CZSO, Eurostat, CNB calculations.

Authorities’ Views

24. The CNB seeks additional borrower-based tools to complement existing measures. The authorities felt lending was cooling, both in terms of prices and volumes, indicating that LTV measures and consumer credit legislation were having desired effects. Nonetheless, they would prefer to have binding powers over LTV, DTI, and DSTI ratios. They were open to making recommendations over DTI and DSTI ratios before being granted binding powers. They noted the importance of access to detailed loan-by-loan data. They did not favor changing risk weights, as they regarded procedures as burdensome, but had pointed to discretion under Pillar II to raise capital requirements.

C. Financial Policy

25. The banking system is well capitalized, with stable funding (FSI Table, Figure 8).

  • The banking sector maintains capital above required levels.8 Average risk weights for banks using the IRB approach have been declining somewhat, but are not especially low. The leverage ratio decreased over the previous year, but mostly because of a sharp increase in holdings of central bank reserves and government bonds through the period of the koruna floor that increased total assets; tier 1 capital itself continued to increase.

  • The share of liquid assets remains relatively high, and banks are funded largely by deposits.9 Net interest margins, though slightly lower than previously, remain high, and returns are relatively high.

Figure 8.
Figure 8.

Czech Republic: Financial Sector Developments

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

26. Credit risk continues to decline. Nonperforming loans for NFCs and households have continued to decline, and those for secured consumer loans are lower than the average. Default rates are also falling, both for NFCs and households.

27. The main risk could arise from growing real estate market exposures. Recent stress tests by the CNB indicate that the banking sector is resilient overall, but risks to the banking system would increase if the share of real estate loans in total loans were to increase further and risk weights were to fall. Demand for commercial real estate has also been strong, but lending to developers has not increased significantly, as many developers are equity financed.

28. Other risks arise from FX loans and the large deposit inflows during the period of the koruna floor:

  • Foreign currency loans present a risk to unhedged firms that either do not invoice in euros or are momentarily short on euros. Much of the recent FX lending may have been driven by expectations of koruna appreciation once the floor was removed—the growth rate of FX lending has subsequently plunged to zero—but the share of foreign currency bank loans nonetheless stands at 20 percent. Some argue that FX lending a natural consequence of increased trade openness, noting that it is almost entirely to firms and mainly in euros. But the growth of FX lending has for some years exceeded that of exports, indicating that intrusive supervision is needed to monitor risks.

  • Non-resident inflows: Non-residents’ holdings of commercial bank deposits increased significantly in early 2017 and have since remained largely unchanged. Risks associated with these developments include a sudden withdrawal of foreign-sourced deposits, although this would likely be manageable. The ultimate source of the inflows is mostly unknown. Non-resident deposits, including from parent banks, should be subject to adequate customer due diligence requirements (CDD), which should be effectively supervised. Although a domestic bank may be permitted to rely on a parent bank to perform elements of the CDD measures, under international standards the ultimate responsibility for CDD measures remains with the domestic bank.

uA01fig12

Ratios of Lending to Nominal Expenditure

(In percent)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: Czech Statistical Office; Czech National Bank; and IMF staff calculations.
uA01fig13

Ratios of FX Lending to Total Lending

(In percent)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: Czech National Bank; and IMF staff calculations.
uA01fig14

Change in Received Deposits and Loans from Non-residents and Increase in Other Investment Liabilities 1/

(Cumulative, billions of koruna)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: Haver; and Czech National Bank1/ Received deposits and loans from non-residents are from the balance sheet of commercial banks. “Other investments” are from the balance of payment.
uA01fig15

Deposits and Loans from Non-residents and Banks Deposits and Loans to Central Bank

(Cumulative, billions of koruna)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Czech National Bank.

29. The CNB has appropriately tightened its prudential stance. The CNB has increased the capital buffer for three systemically-important banks effective from January 2017. The countercyclical capital buffer will increase to 1 percent in July 2018, compared with the current level of 0.5 percent, and to 1.25 percent in January 2019.

30. Better access to data would help the financial supervisor. Access to more granular data on real estate, individual loans, and household debt would help back supervision. The supervisor should also continue to monitor both foreign currency and nonresident exposures.

31. Progress has been made on the implementation of the Bank Recovery and Resolution Directive (BRRD). A Resolution Fund has been set up. A “single point of entry” approach has been agreed by the CNB and Single Resolution Board (SRB) for three banking groups. Decisions on MREL, including deadlines, have been made at the consolidated level, but the exact composition is not yet clear with respect to the types of instruments, subordination, and cross-holdings—decisions over “internal” MREL will follow, pending policy from the SRB.

Authorities’ Views

32. The authorities considered the banking system to be robust and generally operating with low risk. They agreed that real estate exposures presented one of the risks to credit institutions. FX lending was judged to be consistent with natural hedging strategies by firms to manage cashflow. Foreign deposits were largely sourced from parent banks prior to the exit from the FX commitment—for AML purposes, parent banks are responsible for application of Know Your Customer rules in this case, as the funds at Czech subsidiaries and branches are kept in accounts of the foreign parent financial institutions. The Czech Republic has been implementing AML/CFT measures, in line with the FATF recommendations and the EU legislation; from April 2018, supervision has been fully in line with the Joint Guidelines on Risk-based Approach to AML/CFT Supervision, issued by European supervisory authorities in November 2016.10

D. Fiscal Policy

33. Fiscal balances in 2017 outperformed expectations. The overall balance is estimated to have reached 1.6 percent of GDP in 2017, compared with 0.4 percent of GDP projected in the Convergence Programme, owing to reduced social benefit outlays and improvements in social security contributions, personal income tax revenues, and VAT collections. A primary surplus of 2.2 percent of GDP and a negative interest-growth differential drove public debt down to 35 percent of GDP.

34. Lower surpluses are expected over the medium term.

  • The overall balance is expected to be the same in 2018 as 2017, and then gradually ease to about 1 percent of GDP. Higher public sector wages and infrastructure spending will be offset by higher revenues and further gains from previously-implemented tax administration measures. This projection is based on staff’s judgment of most likely policies: it includes the expected-but-as-yet-not-approved increase in state employee compensation, but does not include other recently-proposed changes to taxes and spending (Annex V).

  • A surplus is also projected for the structural balance, but lower than previously, implying fiscal stimulus of 0.1 and 0.5 percent of GDP in 2018 and 2019, respectively. Staff calculations indicate that, were EU grants to be excluded, the structural balance would be negative in 2019 and 2020.

Czech Republic: Fiscal Stance

(In percent of GDP)

article image
Source: Czech Ministry of Finance, Czech National Bank, and Fund staff projections.

Item is net of receipts of EU Structural and Cohesion Funds.

35. Public debt is expected to decline over the medium term, but debt will rebound in the long-term if age-related expenditures are left unaddressed.

  • Staff projects general government gross debt to decline to about 33 percent in 2018. The projected budget surpluses and steady nominal growth would bring debt to around 24 percent of GDP by 2023 (Annex IV).

  • Over the long term, increased healthcare and pension expenditures and declining GDP growth would increase debt. Healthcare costs pose the biggest challenge, increasing 2 percentage points of GDP by 2050 to 9 percent, due to high costs and aging. Pensions spending would increase ¾ of a percentage point, to 9 percent of GDP in 2050.11 This combination implies that public debt would start increasing from around 2030, passing 45 percent by 2050.

uA01fig16

General Government Fiscal Balances

(Percent)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: Czech Republic Ministry of Finance; and IMF staff projections.
uA01fig17

General Government Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: Czech Republic Ministry of Finance; and IMF staff projections.

36. Fiscal policy therefore faces the challenge of avoiding procyclicality, addressing medium- and long-term spending challenges, and appropriately setting incentives to raise employment and productivity.

  • Avoiding procyclicality: Proposed expenditure and tax changes would significantly add to aggregate demand, at a time when the economy is already running above its capacity.

  • Long-term spending: As the population ages, the demand for health care will increase— decisions will have to be made to ensure that spending is well targeted. The old-age dependency ratio, currently 28 percent, is projected to reach nearly 40 percent by 2030 and nearly 60 percent by 2050.12 Given that the Czech Republic is increasingly well-off compared to other European countries, it is likely to receive less EU funding in the next EU budget, and should accordingly plan alternative sources of finance for long-term projects.

  • Incentives: Tax policies play a major role in shaping incentives; some effectively penalize labor participation, while property taxes do not encourage good matching in the housing market.

uA01fig18

Age-Related Expenditures and Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: IMF Staff Projections

37. Tax and spending changes should be timed to avoid procyclicality. Some of the proposed spending increases—for example, more resources for education and investment—are justified, especially given the need to boost productivity. But they could significantly add to demand if not phased in gradually. For example, if proposed tax changes were implemented later this year, the fiscal stimulus would amount to about 1 percent of GDP in 2019.

Czech Republic: Fiscal Stance with Income Tax Reform

(In percent of GDP)

article image
Source: Czech Ministry of Finance, Czech National Bank, and Fund staff projections.

Item is net of receipts of EU Structural and Cohesion Funds.

38. Staff advises healthcare and retirement age measures to address long-term challenges from demographics:

  • By increasing health spending efficiency: Cost efficiency of hospitals is low; the authorities are implementing reforms to improve the efficiency and transparency of hospital financing, but progress is slow. The system could benefit from more use of performance indicators. The number of annual doctor consultations per capita is the third highest in the OECD— strengthening the role of primary care through gate-keeping and re-introducing co-payments, for example, would deter overconsumption of health care resources.

  • By establishing an automatic link between state pension eligibility and life expectancy: The statutory retirement age is currently around 63 years; it is increasing, but will be capped at 65 years in 2030, with government approval required for subsequent adjustments to ensure that a maximum of a quarter of expected life is spent in retirement. Staff recommends establishing an automatic link between the statutory retirement age and life expectancy, to boost labor and supply and growth, in addition to supporting the public finances.13

39. Staff recommends a comprehensive review of taxes and spending to provide the right incentives for best use of resources. Tax rates should be consolidated to keep the system simple and avoid leakages—for example, the proposed changes to VAT would increase complexity and undermine efficiency, without clear gains. Particular issues that deserve attention include:

  • Labor taxes. Staff estimates that reducing disincentives for women as second earners to work— such as the non-working spouse benefit—could increase female labor force participation; the savings could be directed toward increased provision of public childcare facilities. Gains from improved tax administration should be prioritized toward reducing the high labor tax wedge, by lowering social security contributions.

  • Property taxes. Revenue from property taxation overall is low, suggesting potential to raise more revenue and reduce distortionary taxation. Staff encourages moving toward recurrent taxes, rather than transaction taxes, including formalizing more uniform value-based property taxation.14 Introducing a tax-deferral system in which tax obligations accrue to a deferred-tax asset liquidated at point of sale could help alleviate concerns about asset-rich, cashflow-poor households. Mortgage interest deductibility encourages households to take on debt to own a property and should be eliminated on a steady and predictable schedule.15

  • Public infrastructure spending. Both the stock of public capital and the quality of infrastructure are gauged to be low (Figure 9). Staff recommends that the authorities establish a unified and transparent plan for infrastructure over a long horizon. The absorption of EU funds has improved, but infrastructure investment could be further accelerated with less frequent changes in regulations and methodologies and increased processing capacity.16

  • Investment support should also be reviewed to see whether it is providing a good return for the economy. In practice, most grants and tax concessions are still given to large firms in manufacturing—the criteria for providing support should be redesigned to facilitate the best use of resources across the economy, and help the spread of technology and best practices.

Figure 9.
Figure 9.

Czech Republic: Fiscal Sector

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

uA01fig19

Property Income Tax, 2016

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Eurostat.

40. The debt management office has extended maturities, albeit at rates higher than a year ago. Staff welcomes these developments. Debt management should continue to pursue a strategy of minimizing costs for an acceptable level of risk over the medium term; to this end, extending the time horizon of the strategy beyond the current 3 years would be useful.17

41. The fiscal framework adopted last year has strengthened the accountability and transparency of fiscal policy and should be fully implemented. The fiscal rules were rightly aimed at limiting debt while providing space for counter-cyclical fiscal policy. The authorities should strive to make the fiscal council fully operational soon and add the fiscal law to the constitution.

Authorities’ Views

42. The authorities considered policies to be appropriate. They were aware of procyclicality, but noted that surpluses would still be maintained. They judged there to be little potential to reduce social security taxation, as it is a major source of revenues, and alternatives would yield little revenue. At the same time, they considered the effective VAT rate to be high, justifying reduced rates for some items. They did not believe the mortgage interest deductibility to play a major role in house purchase decisions and felt that there is flexibility for municipalities to gather more property tax revenues if needed. They noted that grants were directed to underdeveloped regions and to boost employment and pointed to support for SMEs through lending guarantees. Debt maturities were increasing, but constrained by weak demand for longer-term CZK-denominated assets.

E. Structural Policies

43. The main challenges for structural policies is to boost capacity, made harder—and more important—by demographic changes already underway (Box 2). The economy is already relatively liberalized, but some well-targeted policies could raise employment and productivity.

44. Participation of young women and older workers could increase further.

  • Although overall female labor participation is now in line with that of peers, younger women have relatively low participation (Figure 12). Lack of childcare facilities and tax disincentives are cited as causes for low participation of younger women, which is also associated with a relatively high gender pay gap. There has been a substantial increase in participation from older workers; nonetheless, the participation rates of those aged 60+ is below the highest in the EU.

  • Staff’s analysis indicates that policies aimed at increasing participation of these cohorts could slow, but not reverse, the decline in the labor force. Increasing the participation rates of women and older workers, while also linking the statutory retirement age to life expectancy, would reduce the fall in the labor force to 2 percent by 2030 (14 percent by 2050). A more ambitious scenario—including raising participation rates to EU country maxima and the retirement age to 67—could increase the labor force by 2030, but it would fall from there (Selected Issues Paper: Labor Supply).

Figure 10.
Figure 10.

Czech Republic: Demographics and Working Age Population

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: United Nations, World Population Prospects, 2017.
Figure 11.
Figure 11.

Czech Republic: Labor Force Participation Decomposition

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Figure 12.
Figure 12.

Czech Republic: Female Labor Supply

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Challenges to Boost Employment and Productivity

The demographic outlook is poor. Although the Czech population is younger than that of western Europe, it is expected to shrink in the coming years. The working-age population is projected to decrease even more— under existing policies, including legislated increases in the retirement age, staff projects labor force to decline by 5 percent by 2030 and 21 percent by 2050. (Figure 10).1/ Participation has increased over the past few years to relatively high levels (Figure 11), and participation rates for prime-age workers are already at the EU maximum levels. Additionally, average hours worked are among the highest in Europe and are unlikely to increase as incomes grow (Selected Issues Paper: Labor Supply).

Labor productivity has been middling since the crisis, but this does not appear to be linked to lack of capital or a misdirected economy. Although average labor productivity in the Czech Republic over the last 20 years was above that of advanced economies, it was below those of peers (Figure 13). Capital investment has been very high—indeed, non-ICT capital has been the largest and most consistent contributor to labor productivity growth over the past two decades. Even during the pre-crisis period, in which TFP growth reached 3 percent per year, non-ICT capital deepening averaged nearly 2 percent. The capital stock is in line with peers, including Germany. Nor is the economy obviously misdirected: aggregate labor productivity has increased with the increasing concentration in manufacturing; there is some room to improve the allocation of capital and labor across and within sectors, but no more so that peer economies (Selected Issues Paper: Labor Productivity).

Figure 13.
Figure 13.
Figure 13.

Czech Republic: Labor Productivity

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

These findings are consistent with a relatively liberalized economy with no major restrictions in labor markets, on the flow of capital, and on trade. Overall, the Czech Republic has relatively unrestricted product and labor markets, and does not suffer from trade restrictions (Figure 14).2/

Going forward, demographic shifts will likely provide an extra challenge to TFP: higher shares of older workers have been found to be associated with lower labor productivity growth rates.1/ According to UN projections, the Czech Republic will have the highest rate of increase in the share of older workers in its workforce.

1/ See United Nations World Population Projections, 2017.2/ See Aiyar, Shekhar, Christian Ebeke and Xiaobo Shao (2016), “The effect of workforce aging on European productivity”, IMF Working Paper 16/238
Figure 14.
Figure 14.

Czech Republic: Trade Restrictiveness and Sectoral Regulation

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Source: Cerdeiro, D.A. and R.J. Nam. 2018. “A multidimensional approach to trade policy indicators,” IMF Working PaperNotes: The indicators reflect no judgment as to WTO compliance of underlying measures, nor whether certain measures (such as trade defense) are an appropriate response to the actions of other countries. The “ease of starting a business” indicator is based on perceptions as part of an established IFC survey process.Sources: Tariff data are from the WTO, World Tariff Profiles; the import licensing measure is based on UNCTAD TRAINS and COMTRADE data; the average trade facilitation performance, agricultural support measure, Services Trade Restrictiveness Index (STRI), and FDI Restrictiveness Index are from the OECD; WB STRI is from the World Bank; the post-GFC indicators are from Global Trade Alert.1\ Import (export) coverage ratio, except for the case of FDI (number of measures).
uA01fig20

Labor force, index

(2015=100)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: Czech Statistical Office and IMF staff calculations.
uA01fig21

TFP level of firms in top 25 and bottom 25 percentile

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: Orbis, IMF staff estimates
uA01fig22

World Bank “Doing Business” Indicators

(rank, from 1 to 190)

Citation: IMF Staff Country Reports 2018, 187; 10.5089/9781484363669.002.A001

Sources: World Bank

45. To boost productivity, policymakers should particularly address policies that can hold back smaller and younger firms.

  • Staff analysis shows that the productivity of better-performing firms is increasing healthily. But productivity in the lower tail of firms has stalled. These firms tend to be smaller, younger, and more leveraged.18

  • Factors that can present particular difficulties for smaller and younger firms include: a complex regulatory environment, with multiple layers across central, regional, and municipal governments; inconsistent application of regulations; and the structure of tax incentives and subsidies. Survey indicators suggest regulatory and planning complexity, administrative burdens, and inconsistent enforcement are significant problems. (Selected Issues Paper: Labor Productivity)

46. Government itself can contribute to the environment in which firms operate, such as public infrastructure and life-long learning.

  • Infrastructure quality is assessed to be worse than in other advanced European economies.19 A single plan for public infrastructure, coordinated across all branches of government, would be an important contribution.

  • Participation in adult learning is at the OECD average,20 but the framework for life-long learning should be enhanced further, given the demands of an aging workforce that will be retiring later in life. It is important to ensure equal access to adult learning across regions and the coordination of schemes across government.21

47. Government can also raise the efficiency with which it provides its own services, with potentially large spillover effects to the rest of the economy. Staff recommends measures to increase processing and auditing capacity, to reduce holdups in public administration. Increasing digitalization of government services could help address fragmentation in public administration. A good example comes from initiatives currently underway to bundle all information concerning planning applications into a single “e-binder” that is shared across all agencies responsible for planning approval. This could facilitate parallel processing of applications, in turn speeding up the planning process and reducing pressures on supply, especially in the real estate market. Such initiatives in “e-government” are welcome and to be encouraged more broadly.

Authorities’ Views

48. The authorities agreed with the importance of boosting capacity. They pointed to several recently-implemented measures. The new amendment to the Building Act simplifies the conditions for starting construction and accelerates building permit proceedings. A National Investment Plan is expected by the end of June. Education funding has been changed to improve the quality of regional education. Additionally, vocational training reform aims to increase coordination with businesses and improving the skills matching. New measures to aid child care include an increase in child-related tax deductions, introduction of one week of paternity leave, and a guaranteed placement in nursery schools for children aged four and older. The efficiency of public administration would be helped by the extension of electronic procurement.

Staff Appraisal

49. The economy has been doing very well, but supply constraints are biting. So far, there are no major imbalances, and the economy is expected to continue to perform strongly. But the working age population is shrinking and aging, and old-age dependency ratios are set to increase sharply.

50. The real exchange rate appears to remain undervalued, and likely to appreciate over the medium term. Since moving off the koruna floor early last year, the exchange rate has appreciated steadily. But the external position remains stronger than warranted by medium-term fundamentals. The projected gradual monetary tightening should help to address this.

51. The gradual approach to normalizing monetary conditions should continue, given uncertainty about the inflation outlook. The CNB should continue to communicate its readiness to raise rates earlier than currently projected if needed to fulfil its mandate.

52. More measures are needed to insure against financial vulnerabilities. Some households are highly leveraged. The best response would be limits on DTI and DSTI ratios, to complement those already in place on LTV ratios. That said, macroprudential tools do not remove the need for strong microprudential supervision, nor can they fix underlying problems caused by insufficient supply and tax policies that boost demand for real estate.

53. Fiscal policy should avoid procyclicality, address long-run spending issues, and set incentives for the best use of resources. Some proposals—such as extra spending on education and infrastructure—could boost productivity, but care is needed that they do not add to the pressure the economy is already experiencing to meet demand. Challenges to the budget will increase over the longer term as the population ages. Taxes and spending should be reviewed, particularly grants and tax concessions, tax expenditures that can affect incentives to work, property taxation, and the proposed changes to personal income tax and VAT.

54. Structural policies can contribute by facilitating higher productivity. To this end, a single plan for public infrastructure, an enhanced framework for life-long learning, and easier planning processes would be important contributions.

55. It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

Table 2.

Czech Republic: Balance of Payments, 2013–23

(Percent of GDP)

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

Czech Republic: General Government Operations, 2013–23

(Percent of GDP)

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

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

In percent of potential GDP.

Table 4.

Czech Republic: Macroeconomic Framework, 2013–23

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

In percent of potential GDP.