Czech Republic: Staff Report for the 2019 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
13 Jun 2019
eISBN:
9781498319355
Language:
English
Keywords:
ISCR; CR; exchange rate; expenditure; economy; central bank; potential GDP; ML risk; financial asset; output gap; monetary management; exchange rate arrangement; Anti-money laundering and combating the financing of terrorism (AML/CFT); Fiscal stance; Income; Inflation; Global; Europe; core inflation; inflation outlook; loan-to-value ratio; household debt; consumer sentiment; Loans
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May 28, 2019

Abstract

May 28, 2019

May 28, 2019

Key Issues

The economy is doing well, but supply constraints are biting. Growth has slowed as the economy has reached capacity limits, with very low unemployment even as participation has increased. Recent wage increases have been very strong, ahead of productivity. So far, inflation remains contained. The economy continues to run a current account surplus, even though domestic absorption has picked up. But the housing market is pressured, especially in metropolitan areas.

Policies should balance risks of overheating against a faster-than-expected slowdown and aim to boost potential growth.

  • Given the uncertainty about the external environment and inflation outlook, the mission team endorses pausing increases in policy rates.

  • The central bank has implemented caps on debt-to-income, debt-service-to-income and loan-to-value ratios. These should be given some time to have effect, but might yet need to be tightened further.

  • The banking system is stable, well capitalized, and well placed to direct credit toward investment. Recent cases of money laundering (ML) in several EU countries, however, have heightened concerns about potentially illicit cross-border flows. The authorities should continue their AML/CFT efforts, especially on monitoring nonresident accounts, identifying sources of foreign funds, and enhancing data collection on real estate.

  • A neutral fiscal stance is appropriate for the near term. The focus should be on spending and revenue choices that are as friendly as possible to raising growth. Hard choices will also need to be made over social spending, such on pensions and healthcare; otherwise, policy should seek efficiency gains.

  • Maintaining convergence over the medium term will require high employment and productivity growth as the population ages and the workforce shrinks. Bottlenecks in the labor force, infrastructure, and housing are holding the economy back and need attention.

Approved By

Jörg Decressin (EUR) and Kevin Fletcher (SPR)

Discussions took place in Prague during April 29-May 14, 2019. The staff team comprised Messrs. Scott (head), Tudyka, and Harrison (EUR), and Ms. Kamali (FIN). Ms. Fernando (LEG) and Mr. Stradal (OED) attended some meetings. Messrs. Park and Smith (both EUR) assisted in the preparation of the staff report. The staff team met with Czech National Bank Governor Rusnok, CNB Vice Governor Mora, CNB Board members Holub, Dědek, and Michl, Deputy Ministers Kouba, Landa, and Koppitz, State Secretary Hrdinková, Fiscal Council Chairwoman Zamrazilová, other senior officials, and representatives from the private sector. The Czech Republic is an Article VIII country (Informational Annex: Fund Relations). Data provision is adequate for surveillance (Informational Annex: Statistical Issues).

Contents

  • RECENT DEVELOPMENTS

  • OUTLOOK AND RISKS

  • POLICY DISCUSSIONS

  • A. Monetary Policy

  • B. Credit, Real Estate, and Macroprudential Policy

  • C. Financial Sector Policies

  • D. Macro- and Structural-Fiscal Policy

  • E. Governance

  • STAFF APPRAISAL

  • BOXES

  • 1. The Importance of the Auto Sector

  • FIGURES

  • 1. Recent Growth

  • 2. Capacity Constraints

  • 3. Inflation

  • 4. External Position and Competitiveness

  • 5. Near-Term Growth Momentum

  • 6. Credit Developments

  • 7. Housing Sector

  • 8. Financial Sector Developments

  • 9. Fiscal Sector

  • 10. Structural Issues

  • TABLES

  • 1. Selected Economic Indicators, 2014–24

  • 2. Balance of Payments, 2014–24

  • 3. General Government Operations, 2014–24

  • 4. Macroeconomic Framework, 2014–24

  • 5. Financial Soundness Indicators, 2012–18

  • ANNEXES

  • I. External Sector Assessment

  • 11. Reconciling Wage and Price Inflation

  • III. Assessing Labor Market Capacity

  • IV. Risk Assessment Matrix

  • V. Public Debt Sustainability Analysis

  • VI. Implementation of the 2018 Article IV Key Recommendations

Recent Developments

1. The economy is doing well but has been running against supply limits.

  • Output decelerated in 2018, with GDP growth at 2.9 percent. Private consumption growth was strong, supported by real incomes and employment security, though it cooled somewhat in the last two quarters.1 Investment growth was also strong: year-on-year growth in gross fixed capital formation reached 8.9 percent and 18 percent for the year for the private and public sectors, respectively, the latter reflecting faster absorption of EU funds (Figure 1). Survey measures show capacity utilization well above historical averages (Figure 2).

  • The labor market tightened considerably in 2018—the number of vacancies for each unemployed worker increased by 50 percent, despite increased participation across age cohorts and across most regions; the number of underemployed workers declined further, while hours worked by part-time workers increased; and the number and share of long-term unemployed continued to decline. The participation rate increased further to 77 percent by the end of the year; notwithstanding the increase in available labor, the unemployment rate declined even further to a new record low of 2 percent in November 2018.

Figure 1.
Figure 1.

Czech Republic: Recent Growth

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Figure 2.
Figure 2.

Czech Republic: Capacity Constraints

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Real GDP Growth & Capacity Utilization

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Haver Analytics.

Unemployed-Vacancy Ratio

(Number of registered unemployed persons per vacancy)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech Statistical Office; and Haver Analytics.

These developments raise the question of whether the economy risks overheating, in terms of price pressures in labor and goods markets; in terms of external balances, through increased absorption of imports; and/or in asset markets (such as real estate).

2. Wage increases have been strong, and ahead of productivity gains. Wage increases have been substantial and broad based across sectors. Across the economy, average gross wages increased by 8 percent in 2018, with some settlements much higher. Public sector wages were increased substantially, in some cases by as much as 10 percent. However, growth in output per hour worked fell to 0 percent by end-2018, while growth in output per employee slowed to 1.5 percent in 2018 (from 2.9 percent in 2017). Consequently, unit labor costs increased by 6.5 percent in 2018. The result has been a steep increase in the labor share of income, which had fallen in recent years.

Unit Labor Cost Decomposition

(Contribution to year-on-year percent change)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Haver Analytics.

Labor Income Share

(Ratio, employee compensation/value added)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Eurostat; and IMF staff calculations.

3. But despite wage increases, headline inflation remains contained (Figure 3). Inflation has been in the range of around 2 to 2½ percent since 2017, though it climbed to 2.8 percent in April 2019. Core inflation is just over the 2 percent target.2 Estimated Philips curve models show procyclical contributions to inflation from labor costs—but also a significant role for inflation expectations, which are well-anchored at the 2 percent target (Annex II: Reconciling Wage and Price Inflation). Increases in labor costs have been accommodated by decreasing margins, which remain higher than in neighboring economies.

Figure 3.
Figure 3.

Czech Republic: Inflation

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Inflation and Wage Growth

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech Statistical Office; and Haver Analytics.

Import Costs and Profit Margins

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech Statistical Office; Eurostat; and Haver Analytics.1/ Proxied by import price index for machinery & equipment.2/ Gross operating surplus share of value added.

4. Saving rates have been fairly stable over the cycle. In 2018, gross disposable income and household saving rates increased slightly. Aggregate household net financial worth grew by 4½ percent; household debt as a share of disposable income declined slightly, to 64½ percent in 2018, and remains relatively low compared to the euro area ratio of 106 percent. Meanwhile, the fiscal position is comfortable— after a headline surplus of 0.9 percent of GDP in 2018, staff projects a surplus of 0.2 percent of GDP and debt of 31.7 percent of GDP in 2019.

Gross Savings

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Eurostat.

5. The external position remains solid, despite strong domestic demand and especially considering weakness in some major trading partners (Figure 4). The current account surplus moderated to 0.3 percent of GDP in 2018, from 1.0 percent of GDP in 2017, as both goods and services trade balances declined. This was not the result of export weakness, which might have been expected given weaknesses in foreign demand. Instead, it resulted mainly from increased absorption of imports, consistent with strong private demand.

  • Demand from trading partners softened—euro area growth slowed to 0.2 percent (quarter-on-quarter) in the last two quarters of 2018, from 0.4 percent in the first two quarters. Nevertheless, export growth was solid through the year, with export growth particularly strong in the fourth quarter.

  • Gross FDI debt and equity inflows have remained steady over the years but declined in 2018 to 3.5 percent of GDP, from 4.3 percent in 2017. There were gross portfolio debt outflows due to government bond repayments and lower borrowing by financial firms. Other investment liability flows turned negative in 2018 after FX-floor related increases in previous years. In sum, net capital inflows were 0.4 percent of GDP by the end of 2018.

  • The net international investment position improved 4.5 percentage points to -22 percent of GDP in 2018. External liabilities comprise mostly FDI (52 percent) while official reserves account for 48 percent of external assets. Gross external debt was stable nominally, and declined as a share of GDP.

Current Account

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Haver Analytics.
Figure 4.
Figure 4.

Czech Republic: External Position and Competitiveness

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

6. Further increases in the real exchange rate are to be expected. Increasing labor costs caused the ULC-based REER to appreciate by 2½ percent in 2018. Going forward, a key issue is whether strong real wage growth, along with a potentially weaker external environment, will cause net trade to worsen substantially (Outlook and Risks, ¶9–11). So far, the increase in the wage share, although steep over the past year, is consistent with convergence to levels of euro area economies. Continued capital investment, including through FDI, indicates that returns to capital remain attractive. Going forward, continued income convergence would imply ongoing real exchange rate appreciation.3

Real Effective Exchange Rates

(Index: 2013Q1 = 100)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Haver Analytics; and IMF staff calculations.

Labor Share of GDP vs. Real GDP per Capita, 2017

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Eurostat, IMF Staff calculations

7. Staff assesses the external position in 2018 to have been moderately stronger than the level consistent with medium-term fundamentals and desirable policies. The EBA current account model estimates that the current account in 2018 was above the “norm” for what would be expected given desirable policies and abstracting from the cycle (Annex I: External Sector Assessment). Much of the current account gap is driven by a stronger fiscal position relative to desired medium-term levels and compared to the rest of the world, plus a large residual component. The current account gap implies appreciation of the real exchange rate to ease the surplus—in the terms of the standardized EBA ranges, the real exchange rate is moderately undervalued, by about 2–4 percent. Staff finds these estimates more plausible than those from the EBA real exchange rate models, which indicate significant overvaluation.

Inflation and House Price Contribution

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech Statistical Office; and Haver Analytics.1/ Sum of contribution of actual and imputed rents.

8. The housing market remains pressured.

  • Despite a recent deceleration, house price growth was still among the 5 highest in the EU in 2018, outpacing wage and income growth (Figure 7). In Prague, where most property transactions take place, offered prices for apartments have increased by 44 percent in the three years from 2016 to 2018. The price-to-income ratio has increased by a cumulative 12.6 percent between 2015: Q4 and 2018: Q4, after having been stable over the preceding 5 years. House price increases have also made a substantial contribution to the measure of CPI targeted by the CNB.

  • Private nonfinancial sector credit accelerated from the previous year, growing ahead of nominal incomes. This was driven primarily by mortgage credit, which continues to grow at a high rate (Figure 6). But new mortgage volumes are decreasing amid increasing lending rates and tighter macroprudential borrower recommendations. Nonfinancial corporate lending growth also increased in 2018.

Figure 5.
Figure 5.
Figure 5.

Czech Republic: Near-Term Growth Momentum

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Figure 6.
Figure 6.

Czech Republic: Credit Developments

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Figure 7.
Figure 7.

Czech Republic: Housing Sector

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

New Mortgage Volumes by Maturity

(End-of-period, NSA, Billions, Koruna)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech National Bank; and Haver Analytics.

Interest Rates by Maturity, New Mortgages

(percent, annual)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech National Bank, Haver Analytics

Outlook and Risks

9. Near-term growth momentum has slowed. Consumer sentiment declined in the second half of 2018 and manufacturing PMIs have been weak. High-frequency indicators for key trading partners such as Germany and most euro area countries have also deteriorated.

10. Growth is forecast to moderate.4 In the near term, domestic demand is expected to remain strong but slow down. Although the labor market is expected to remain tight, employment and wage growth are expected to moderate slightly after the substantial increases in 2018. External demand is expected to slow in the first half of the year and recover in the second, causing growth to moderate to 2.5 percent for 2019 and increase slightly to 2.6 percent in 2020. Over the medium term, income convergence is expected to continue, with a potential growth rate of 2½ percent through the medium term. Inflation is projected above target at 2½ percent in 2019 and to moderate to target by 2021, on the assumption of moderating increases in labor costs (partly in response to gradual policy rate increases) that can be absorbed by firms’ profit margins and low external inflation.

GDP and Consumer Price Index

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Haver; and IMF staff projections.

11. Risks to this outlook are mainly external and to the downside. The Czech economy is very open—gross exports are 80 percent of GDP, of which about two thirds is domestic value added—tightly integrated into supply chains, and highly concentrated in the auto sector (Box 1. The Importance of the Auto Sector). This makes the Czech economy highly exposed to foreign shocks (Selected Issues Paper: Sources of External Demand Spillovers).5 Such shocks could arise from a disorderly Brexit (to which the Czech Republic is more exposed than the average EU economy), especially if accompanied by significant “confidence” shocks, and further weakness in Germany.

Another concern is pressure in the housing market—house price growth remains robust despite increasing lending rates and tighter macroprudential policy. The outlook for inflation—and hence the monetary stance—is uncertain, as the outcome will depend on which of domestic inflationary and imported disinflationary pressures will dominate.

The Importance of the Auto Sector

Unlike many advanced economies, manufacturing remains a highly significant part of the economy, averaging around one quarter of value added for the past 25 years. Of this, the auto industry—both final production and parts manufacturing—represents nearly a fifth.

In terms of world production, the Czech auto industry is naturally not one of the largest producers in absolute terms, producing slightly less than 1 percent of global value added. However, at 4.9 percent of gross value added, the auto industry plays the most important role for the Czech Republic among all countries. The next most significant auto industries in domestic terms are those of other central European economies: Hungary, Germany, and the Slovak Republic.

Authorities’ Views

12. The authorities agreed broadly on the outlook and the balance of risks. The authorities expect growth to be close to 2½ percent this year, supported by strong domestic demand. Views on the outlook for 2020 differed, as the authorities are more optimistic on potential growth than staff. The CNB expects inflation to be above target this year but to converge to the inflation target, and the koruna to appreciate further. External conditions—such as economic weakness in the euro area, a disorderly Brexit, increased protectionism, and the path of the exchange rate—were viewed as the main uncertainties, tilting the balance of risks for output to the downside. In the context of their modeling framework, which differs from EBA, the CNB assesses the REER as currently being close to fairly-valued and broadly consistent with fundamentals, but agrees with staff that the real exchange rate will likely appreciate over time.

Policy Discussions

13. Discussions focused on policies to facilitate the best adjustment to supply pressures and to insure against downside risks. So far, labor market pressure has not resulted in high inflation or substantial deterioration of external balances, but those risks are live, and metropolitan real estate markets remain pressured. On the other hand, external demand has fallen, and domestic confidence indicators are ebbing. Hence, there are two main sets of policy issues: (i) the right mix of policies that balances risks of overheating against a faster-than-expected slowdown; and (ii) policies to boost potential growth.

A. Monetary Policy

14. Domestic monetary conditions have tightened while the pace of global macro policy tightening slowed. The Czech National Bank (CNB) increased the policy rate to 2.0 percent in May 2019, following five 25 basis points increases in 2018. The CNB has shed its tightening bias and signaled no further policy rate increases into 2020.

Interest Rates

(Percent)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech National Bank; and Haver Analytics.

CNB 3-month PRIBOR Forecast

(Percent)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Czech National Bank.

15. A cautious approach to raising interest rates is appropriate. The inflation outlook depends on whether domestic pressures have larger effects than external dampening effects. The combination of increasing wage costs and declining labor productivity growth could put further upward pressure on prices, warranting earlier interest rate increases than currently projected. On the other hand, weaker external demand and lower energy prices could mean lower-than-expected import prices. Currently, core inflation (Eurostat) is only just above the CPI target, and expectations remain well anchored. Staff projects inflation to converge to 2 percent over the medium term, assuming rates are held constant in the near term and move to about 3 percent over the medium term. Given also the uncertainty about inflation and the external environment, a pause in policy rate changes is justified.

Authorities’ Views

16. The CNB favors a pause in interest rate hikes, given its assessment of broadly balanced risks to the inflation forecast, reflecting uncertainties about external demand and the passthrough and persistence of domestic pressures on inflation.

B. Credit, Real Estate, and Macroprudential Policy

17. Private sector credit, particularly for real estate purchases, continues to grow strongly despite tightening lending standards (Figure 6).

  • Banks tightened lending standards to the highest levels in recent years, and nominal lending rates6 increased from a historical low of 2.1 percent at end-2016 to about 2.9 percent at end-2018. However, the perceived price of new loans (the wage interest rate—interest rates deflated by realized wage inflation) is negative and has fallen further.

  • Overall non-financial sector credit growth was nearly 7 percent in 2018, with household and private non-financial corporation credit growing by 7½ and 5½ percent, respectively. The growth of lending for house purchases has decelerated, but only modestly, to 8½ percent. Consumer credit growth accelerated from just over 4 percent in 2017 to 6½ percent in 2018.

Interest Rates for New Housing Loans

(Percent)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Haver Analytics.

Household and NPISH Credit

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: ARAD database.

18. Pressures in the housing market are still apparent (Figure 7). Property price growth has moderated, but is still strong, particularly in Prague. Price-to-income and price-to-rent ratios have continued to increase, while models of affordability indicate that valuations are high.7

19. Further macroprudential recommendations have been announced that appropriately target household leverage. Although household debt overall is relatively low, some households are highly levered—in recent years, over one third of loans have been issued at 6 times income or higher, although this share has remained stable over the past year.8 Leverage is particularly high for borrowers in major metropolitan regions such as Prague.9

  • The CNB had previously recommended that banks cap LTVs on individual loans at 90 percent and issue no more than 15 percent of new loans with LTV ratios between 80 and 90 percent. By end-2018: Q2, the share of new loans with LTV ratios between 80 and 90 percent was 11 percent, down from 31 percent by end-2017: Q2, while the share of new loans with LTV ratios above 90 percent decreased slightly to 3 percent. The CNB has also restricted loan maturities.

  • Two new recommendations aimed at limiting banks’ exposure to the housing market and ensuring borrowers’ creditworthiness were announced in June 2018 and became effective as of October 2018: limits for the debt-to-income multiple of 9 and the debt-service-to-income ratio of 45 percent.

20. Macroprudential limits should be given some time to have effect but might yet need to be tightened. There are some signs that these measures are having effects, but the market remains pressured. The number of new mortgages has decreased, but house prices continue to increase, suggesting that leverage might still be elevated for some borrowers. Hence, more tightening might yet be required. Since the underlying concern is household leverage, attention should be focused on the debt-based measures.10 Note that the CNB still can only make macroprudential recommendations—the CNB should be granted legal powers of direction to facilitate fulfilment of its financial stability mandate.

New Mortgages, Housing Prices, and Macroprudential Policy

(Index: 2010 = 100)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech Statistical Office; and Czech National Bank.

21. Other policies should support macroprudential measures. Efforts are especially needed to increase housing supply. Supply of new dwellings has been slow to pick up since the financial crisis, owing in part to problems with the permit process and municipal planning. Complicated regulations govern the building permit process and impose supply-side constraints. In the Czech Republic, 21 procedures need to be undertaken to receive a building permit, compared to 12.5 across OECD countries (World Bank Doing Business Indicators). Owing to their nature, these constraints may put sustained upward pressure on property prices. Property tax revenue is very low (2017 Article IV Staff Report); most of the revenue comes from transaction taxes and few from value taxes, which reduces the incentives to move out of housing and reinforces the problems with housing supply.

Housing Supply

(Thousands)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech Statistical Office; and Haver Analytics.

22. Authorities should monitor risks associated with the real estate sector. The authorities’ national risk assessment and the AML/CFT assessment of the Czech Republic by MONEYVAL11 identifies the real estate sector as one of the sectors most vulnerable to misuse for money laundering activities, including for laundering of foreign proceeds. Real estate agents were identified as having a limited understanding of money laundering/terrorist financing (ML/TF) risks; the Financial Intelligence Unit (known as the Financial Analytical Unit, FAU, in the Czech Republic) has received only a few suspicious transaction reports from real estate professionals in recent years. The FAU should continue to raise awareness of ML/TF risks among real estate professionals. Staff considers that adopting a licensing regime for real estate agents and collecting better data, including on non-resident and beneficial owners of real estate assets, would help monitoring of this sector.

Authorities’ Views

23. The CNB continues to assess credit market developments. They consider a potential buildup of household credit imbalances and property market overheating as risks to financial stability. The recent slowdown in volumes of new mortgages could reflect “frontloading” before the DTI and DSTI recommendations came into effect in October 2018. That said, more time is needed to assess the effectiveness of the debt-based limits. The relevant authorities are aware of the vulnerabilities of the real estate sector and noted that they have stepped up AML/CFT training and awareness-raising efforts. In addition, there are ongoing discussions to adopt a licensing regime for real estate agents.

C. Financial Sector Policies

24. Banks are well capitalized and profitable. Banks hold over three quarters of financial sector assets, with the rest mostly held by insurance, pension, and funds companies. There are seven Other Significant Institutions in the banking sector, and five that are assessed to be systemically important. The three largest lenders are subsidiaries of EU banks. Across the system, banks are funded mostly by deposits; bank assets are mostly in loans, of which about half is directed to households.

  • Capital ratios are well above regulatory minima: the overall capital ratio increased by about 0.2 percentage points in 2018 to 18.3 percent, comfortably above the minimum level of regulatory capital of 15.4 percent for the system as a whole,12 while the Tier 1 capital ratio increased by 0.3 percentage points to 17.8 percent. The leverage ratio has also increased, and at 6.5 percent remains at a comparatively high level.

  • Banks are highly profitable, owing to high net interest margins and low impairments. Non-performing loans declined further to 3.1 percent of total gross loans in 2018.

25. Nonetheless, the continuing decline in risk weights could be increasing financial sector vulnerability. Because of favorable economic conditions and low impairments, banks’ internal risk-based models are leading to decreasing risk weights across categories. Risk weights for housing loans have fallen by one third over the past three years, to 21.9 percent—not yet low by international comparison, but nonetheless making issuing housing loans relatively “cheap” for banks in terms of required capital. That said, bank asset concentration in mortgages has remained broadly stable through the housing cycle and does not appear to be excessive.

Average Risk Weights

(Percent, IRB approach)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Czech National Bank.

Banking System Asset Concentration

(Percent)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Czech National Bank.
Figure 8.
Figure 8.

Czech Republic: Financial Sector Developments

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: IMF, FSI database; and Czech National Bank.1 Czech banks increasingly preserve additional liquidity in the form of 2-week securities repurchase agreements (repo) with the Czech National Bank. These repo loans, although highly liquid, are not included in the definition of liquid assets used above, which explains the fall in the ratio in 2017 and 2018.

26. The authorities have appropriately responded with increasing capital requirements. The counter-cyclical capital buffer, currently at 1.25 percent, will increase to 1.5 percent in July 2019 and to 1.75 percent in January 2020. (The systemic risk buffers applying to the five domestic systemically-important banks remain unchanged.)

27. The high level of foreign deposits has remained since the release of the koruna floor in April 2017, mostly because of deposits from other credit institutions (rather than direct “client” deposits). A benign explanation is that Czech yields have remained attractive as domestic interest rates have increased and those in e.g. the euro area have not. Recent cases of money laundering across Europe, however, have revealed weaknesses in AML/CFT regimes, and raise concerns about cross-border flows.

Foreign Deposit Share of Bank Liabilities

(Percent)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Haver Analytics.

28. Authorities should closely monitor foreign financial flows. Authorities should actively seek information on the sources of foreign funds, including country of origin and other movements of funds associated with non-resident accounts. This is in line with the recent comprehensive AML/CFT assessment for the Czech Republic, which recommends that authorities focus on risks associated with foreign flows to prevent financial institutions and others, such as real estate professionals and lawyers, from acting as intermediaries for the integration of foreign criminal assets into the Czech financial system.

29. Staff recommends that authorities continue to focus AML/CFT supervisory efforts on non-resident clients. AML/CFT supervision for banks is undertaken by both the CNB and FAU. AML/CFT supervisors should ensure that banks have an appropriate understanding of their customers, including of their non-resident clients (which should be subject to customer due diligence measures even when introduced by a foreign parent bank). The AML/CFT supervisors’ effectiveness at mitigating risks could be further enhanced by mobilizing existing CNB information on cross-border financial flows to complement off-site supervisory tools, and by ensuring that banks report aggregate data related to foreign customers, which should also take into account foreign beneficial owners. Authorities should apply proportionate and dissuasive sanctions for breaches in AML/CFT compliance. In view of the ongoing relevance of these issues, authorities should consider increasing resources for AML/CFT supervision.

Authorities’ Views

30. The authorities see the financial system as stable. Risks from residential property lending are still present, albeit somewhat lower than in 2018. The CNB is seeking legal powers to set the LTV, DTI and DSTI limits, to ensure that conditions are the same across all lenders. Authorities have been focusing on AML/CFT supervision of banks, including on non-resident accounts. Authorities emphasize the need for banks to conduct customer due diligence on all their clients, including those that have been introduced by other banks. However, they noted that the vast majority of nonresident funds in the Czech banks are deposits of their foreign holding company banks in the context of their global liquidity management. In this case, responsibility for AML/CFT procedures, including identification of the source of funds, lies with the parent bank. Authorities will continue to monitor foreign flows associated with non-resident accounts.

D. Macro- and Structural-Fiscal Policy

31. The 2018 fiscal outturn was positive, but weaker than projected. The general government balance was 0.9 percent of GDP in 2018 (0.5 percent in structural terms), 0.7 percentage points lower than projected in the November 2018 Fiscal Outlook and driven mainly by higher spending, including on investment (up by 28 percent), the government wage bill (13 percent), and intermediate consumption (10 percent). Personal income taxes and social security contributions increased by 14 and 10 percent, respectively. General government gross debt declined to 32.7 percent of GDP by the end of the year.

32. A moderate surplus is expected in 2019. Buoyant revenues, in particular personal income taxes and social contributions are expected to partly offset discretionary expenditure measures, including increases in pensions and salaries of government employees. The headline balance is projected to be 0.2 percent of GDP in 2019; the same as the structural balance and well within the 1-percent-of-GDP deficit limit from fiscal rules. This implies a moderate fiscal impulse of around 0.4 percent of GDP during 2019, driven by discretionary measures, but also productivity-enhancing investment spending related to EU structural funds absorption.

Text Table 1.

Czech Republic: Fiscal Stance

(In percent of GDP)

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

In percent of potential GDP.

Item is net of receipts of EU Structural and Cohesion Funds; In percent of potential GDP

33. The April 2019 convergence program projects a small nominal deficit in 2020, but ongoing discussions may result in a different final budget. A softening macroeconomic environment and several proposed discretionary expenditure measures will contribute to a moderately deteriorating fiscal balance. Proposed measures include an increase in the parental allowance, costing about 0.2 percent of GDP, and an increase in pensions costing about 0.1 percent of GDP.

Age-Related Expenditures and Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: IMF staff projections.

34. The Czech Republic currently has substantial fiscal space, as debt is sustainable and financing risks are low. General government gross debt is projected to decline over the medium term under the baseline and stress scenarios (Annex V—Public Debt Sustainability Analysis). But it will pick up in the longer term owing to increases in age-related expenditures.13

Fiscal Impulse and the Business Cycle

(Percent of potential GDP)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech Ministry of Finance; CNB; and IMF staff calculations.

35. In the short run, a broadly neutral fiscal stance is appropriate. Given existing pressures on demand, no further macroeconomic stimulus is warranted. However, given uncertainties around the estimates of the output gap and downside risks associated with a cooling of the external environment, a substantial tightening would be risky, and would not be helpful over the longer term if it implied sacrifices in public investment in infrastructure and skills.

36. Introducing sectoral taxes could create distortions for little in the way of revenue. Applied extensively, they could damage the attractiveness of the Czech economy as a place for foreign firms to invest.

  • Plans are underway for an extra “digital tax” to be levied on companies with annual revenues over €750 million. The proposed rate of 7 percent is notably higher than those announced by some other European countries. Staff estimates this would yield about 0.1 percent of GDP in extra revenue.14 Staff supports internationally-coordinated reform to corporate income taxes to address tax avoidance by multinational enterprises, including digital companies. But unilateral actions by countries might only succeed in harming the economy: such taxes can lead to “double taxation” and distort incentives.

  • Various proposals are currently mooted for extra taxes on bank assets or incomes. Staff sees a potential role for bank taxes for prudential reasons,15 but the proposals are for raising general revenue, and banks in the EU already make contributions to a resolution fund intended to insure against costs to the taxpayer of bank failures. Taxing bank assets in effect penalizes banks for holding capital, and the costs might be passed on to consumers.

37. Over the medium term, low public debt and funding costs offer an opportunity to raise productive capacity, albeit constrained by fiscal rules. Gross financing needs and borrowing costs are low with a maximum spread over German 10-year Bunds of 200 basis points over the past 5 years (Annex V—Public Debt Sustainability Analysis). The structural balance is to remain above the medium-term budgetary objective of -0.75 percent of GDP allowed under the rules of the Stability and Growth Pact and the -1 percent of GDP under domestic fiscal rules. Using all available fiscal space allowed under the fiscal rules could help finance measures to increase potential growth (and therefore ease later debt pressures), before long-term spending pressures from healthcare and pensions set in.

Structural Balance and Fiscal Rules

(Percent of potential GDP)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: IMF staff projections.

38. Fiscal and macro-structural policies should aim to boost productivity and labor supply.

Boosting productivity

  • Public investment has been above the EU average over the past 20 years. Nevertheless, firms cite problems with public infrastructure, such as roads, railways and ports. Investment in R&D is below Euro Area and EU averages. The government has published an Innovation Strategy for the Czech Republic 2019–2030, which recognizes many of these issues. Focus should now lie on its swift and efficient implementation.

  • Coordination and collaboration across ministries and the layers of central, regional, and municipal bodies should be improved to increase the efficiency of public services and shorten approval times for construction permits, thus easing housing supply pressures.16

  • Upskilling of existing labor would provide workers with improved skillsets to meet future demand for higher-skilled employment. At a time when unemployment is so low, funds for direct job subsidies (unless for disadvantaged groups such as the disabled) would be better directed toward training the workforce— lifelong learning programs and vocational training to adapt and improve worker skills can increase productivity and innovation and help alleviate labor market pressures.17

Participation in Adult Learning, 2018

(percent of population, ages 25–64)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Eurostat

Boosting labor

  • A long-term immigration strategy—currently under discussion—that also addresses bottlenecks in processing applications would make it easier for firms to fill vacancies.

  • Participation rates have reached historical highs (Annex III), but some groups are underrepresented, in particular women. Higher female labor force participation could be achieved by increasing the number of childcare facilities.18

  • Currently, labor laws allow overtime work only “due to serious operational reasons”. Relaxing regulations that do not allow overtime work to be used in the regular planning process of employers could ease labor market pressures.19

  • Personal indebtedness can be a significant impediment to employment, disincentivizing both workers to join to the formal labor market to avoid salary seizures and employers to hire workers to avoid having to deal with the administrative burden of complying with creditors’ request. The number of people affected by enforcement orders is significant, particularly in rural regions and for low-skilled persons. A “discharge amendment” to the Insolvency Act, which takes effect in June 2019, aims to make insolvency relief easier—this is a welcome step; its effectiveness should be reviewed to see if there has been progress in reducing the numbers of those in debt traps.

39. While exploiting opportunities to boost growth, long-term fiscal spending pressures from an aging society should also be addressed early.

  • Recent pension changes20 improve replacement rates but worsen the long-term sustainability of the pension system. The increase in the retirement age will be capped at 65 in 2030. It should be linked to life expectancy instead of the current periodic review of the retirement age. The government is expected to issue a report on the pension system in 2019.

  • Increasing health spending efficiency could free up resources for higher spending on education, upskilling and reskilling of the labor force, and innovation.21

  • Revenues from property taxes are noticeably low in comparison to other countries. Taxation should be focused more on value-based property taxes. The additional revenue could be used for growth and productivity-enhancing programs.

Public Expenditure on Health, 2017

(percent of GDP)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Eurostat

Public Expenditure on Education, 2017

(percent of GDP)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: Eurostat
Figure 9.
Figure 9.

Czech Republic: Fiscal Sector

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Sources: Czech Republic Ministry of Finance; Bloomberg; and IMF staff calculations.
Figure 10.
Figure 10.

Czech Republic: Structural Issues

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Authorities’ Views

40. The authorities reiterated their commitment to fiscal discipline, citing long-term debt sustainability problems. They agreed that the fiscal stance will be procyclical in 2020, but pointed to the softening macroeconomic environment, while arguing that supply constraints and fiscal rules impose limits on further spending. They acknowledged the need for coordination across government bodies and strategic plans and cited the recently-published Innovation Strategy as an important step toward boosting the supply side of the economy. They recognized the need for boosting workforce participation and skills, pointing to efforts to improve certification of qualifications in support of life-long learning and significant improvements in the provision of childcare facilities, albeit limited by a lack of qualified personnel. They expressed concerns that valuation-based property taxation could potentially penalize low income households with limited ability to pay.

Property Income Tax, 2017

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 160; 10.5089/9781498319355.002.A002

Source: OECD.

E. Governance

41. The Czech Republic has demonstrated its commitment to improve and put in place measures and good practices which could help combat foreign bribery. Staff’s assessment is based on a summary of the OECD Working Group on Bribery in International Business Transaction (WGB) Phase 4 Report on the Czech Republic in June 2017.22 The Report noted that the authorities have put in place a number of useful measures and good practices that could help facilitate enforcement actions, including effective use of mutual legal assistance requests to detect foreign bribery cases; successful use of non-financial evidence to obtain convictions; establishment of joint investigation teams to pursue transnational investigations; and the recent establishment of centralized registries for bank accounts, beneficial ownership information of legal persons and arrangements, and contracts.

42. The WGB recommended that authorities strengthen their efforts to detect, investigate and prosecute foreign bribery. It emphasized that authorities should prioritize efforts to pursue foreign bribery cases, taking into account the export-oriented nature of the Czech economy, which includes high-risk sectors for bribery such as machinery and defense materials and destination of exports to high-risk countries for corruption, and noting the lack of convictions in such cases. The WGB noted that the authorities should ensure the availability of adequate analytical resources to investigate foreign bribery and strengthen the independence of the prosecution and enhance whistleblower protections. Further guidance (e.g., jurisprudence, additional practical information) on the exemption related to “justly required efforts” under the Act on Criminal Liability of Legal Entities should be provided. Authorities should also make better use of AML/CFT framework to detect incidences of foreign bribery, including by encouraging designated non-financial businesses and professions (DNFBPs)—e.g. real estate agents, gambling companies, tax advisors and legal professionals—to submit suspicious transaction reports. Staff agrees with these recommendations and urges the authorities to move forward to implement them.

43. Strengthening the AML/CFT framework can help address laundering of proceeds of foreign acts of corruption. The AML/CFT assessment report by MONEYVAL and the 2016 National Risk Assessment identified corruption as one the main proceed-generating crimes, including concerns that the Czech Republic has been used to launder foreign proceeds of corruption. In line with the risks identified, it recommended that further analysis be undertaken in relation to the laundering of foreign proceeds, including through fictitious entrepreneurships and real estate business. It recognized that authorities have achieved a considerable number of ML convictions; however, there is a need to devote greater resources to large-scale and complex ML prosecutions; these should be more closely aligned with key ML risks. The report recognized the establishment of a Register of Beneficial Owners and recommended that measures be put in place to ensure that basic and beneficial ownership information is adequate, accurate and current. Authorities should continue to strengthen the supervisory framework for financial institutions and DNFBPs, including applying dissuasive and proportional sanctions for AML/CFT breaches. Finally, it recognized that authorities have pro-actively engaged in relation to foreign requests for international cooperation.

Authorities’ Views

44. The authorities are working to implement the recommendations of the WGB report and AML/CFT assessment report. Authorities acknowledged the IMF’s initiative to address supply side issues of corruption and noted that they had volunteered to be part of this assessment. The Czech Republic will be presenting its Phase 4 two-year written follow-up report on progress implementing the WGB’s recommendation at the WGB Plenary in June 2019, following which the report will be published. Authorities are working to implement the EU’s 5th AML Directive, which will include strengthening the Register of Beneficial Ownership (e.g. introduce sanctions for lack of compliance).

Staff Appraisal

45. The economy is doing well but is up against capacity constraints. There are no major imbalances, but growth is expected to slow as supply pressures bite.

46. The real exchange rate is moderately undervalued, and likely to appreciate over the medium term. The REER has appreciated steadily since 2016, but the external position in 2018 was nonetheless moderately stronger than the level consistent with fundamentals and medium-term policies. The current account balance is expected to converge to a small deficit over the medium term, supported by household income growth and small fiscal deficits.

47. The current policy mix is appropriate. Staff favors holding policy conditions as present, with a bias to raising policy interest rates rather than tightening the fiscal stance if inflation pressures were to continue, which would be more consistent with gradual exchange rate appreciation. Macroprudential measures can help insure that households do not take on too much debt. But they should be complemented with measures to enhance housing supply. If external conditions were to be substantially worse than expected, the first response would be to ease policy rates and allow automatic fiscal stabilizers to work; if shocks are persistent, there is ample space for discretionary fiscal easing.

48. Over the longer term, a durable and coordinated policy agenda that facilitates higher productivity is crucial for staying on a path of increasing living standards. Coordination across government—among ministries, and across the layers of central, regional, and municipal bodies— needs improvement, so that plans are implemented effectively and bottlenecks in labor supply, housing, and infrastructure are addressed.

49. The focus for fiscal policy should be on spending and revenue choices that are as friendly as possible to raising growth. The obvious—albeit constrained by the fiscal rules—would be investment in public goods that boosts productive potential, especially given that public debt, already low, will decrease further over the next few years and the costs of funding such investment are still low. This investment includes not just major physical structures—roads, for example—but resources such as child care and “intangibles” such as education and digital access. Hard choices will also need to be made over social spending ahead of further population aging; otherwise, policy should seek efficiency gains. Targeting extra taxes at particular sectors risks distorting economic incentives for potentially little return in revenues.

50. The banking system is stable, well capitalized, and well placed to direct credit toward investment. Recent cases of money laundering (ML) in several EU countries, however, have revealed weaknesses in AML/CFT regimes across Europe, heightening concerns about cross-border flows. The authorities should continue their AML/CFT efforts, monitoring financial flows coming into and going out of the Czech Republic, especially those associated with non-resident accounts, and identifying sources of foreign funds. The authorities should also continue to monitor ML risks associated with the real estate sector, including by enhancing data collection on non-residents and beneficial owners.

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

Table 1.

Czech Republic: Selected Economic Indicators, 2014–24

(Annual percent change, unless otherwise indicated)

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Sources: Czech National Bank; Czech Statistical Office; Ministry of Finance; Haver Analytics, and IMF staff estimates and projections.
Table 2.

Czech Republic: Balance of Payments, 2014–24

(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, 2014–24

(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, 2014–24

(Annual percent change, unless otherwise indicated)

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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.