Concluding Remarks of 1999 Article IV Consultation--Czech Republic
April 16, 1999
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Czech Republic—1999 Article IV Consultation Mission Concluding Statement
April 16, 1999
2. What are the causes of the current crisis? With the benefit of hindsight, it is easy to say that fiscal policy should not have been so tight in 1998 and monetary policy could have been eased sooner. The general government deficit did stay unchanged at 2 percent of GDP from 1997 to 1998. However, keeping the deficit constant in a period of recession implied a major tightening, especially once account is taken of the significant increase in administered prices. It would have been better to allow the recession induced decline in revenue to be reflected in a corresponding rise in the deficit. Monetary policy was also kept tight during most of 1998, although not without reasons. International financial markets were highly unsettled in 1998 and the CNB could not ignore the risk that contagion might affect the Czech koruna. Moreover, the CNB had just introduced a new monetary framework, and, at a time when inflation remained high, it was concerned about its credibility.
3. The roots of the current problems, however, are much deeper. Owing to weak corporate governance in banks and enterprises, the substantial capital inflows received in the mid-1990s, as well as the large concomitant increase in domestic credit, were used to support substantial real wage increases, misguided investments, and "tunneling" operations. This in turn led to an excessive growth in private consumption, an unsustainable widening of the external imbalance, and ultimately an exchange rate crisis. The macro-economic policy response in 1997—namely tightening of fiscal and mainly monetary policy—was the right one, leading to a sharp reduction in the current account deficit and inflation, but on the negative side it contributed importantly to the downturn in the economy. Meanwhile, no substantial attempt was made to address the serious structural deficiencies at the root of these problems.
4. Against the background of a deepening recession, the CNB appropriately undertook a more aggressive lowering of interest rates from the last quarter of 1998 and into 1999, with the 2-week repo rate being cut to just over 7 percent by early April, about one half the level in mid-1998. This was associated with a welcome depreciation of the exchange rate in early 1999, contributing to the easing of monetary conditions. The fiscal stance has also become somewhat less restrictive. Parliament approved a state budget for 1999 with a deficit of 2 percent of GDP (including the effect of the adjustment of income tax brackets agreed in December 1998), implying a deficit for the general government of about 3 percent of GDP.
5. While these policy actions should help stabilize the economic situation in the course of 1999, any recovery is likely to be slow. Consumer confidence can be expected to remain subdued, structural problems in enterprises will not be resolved quickly, and banks will probably remain very cautious in their lending policy as they continue to consolidate their financial position at the prospect of being privatized. Moreover, the slowdown in growth in Germany and other main trading partners will dampen demand for Czech exports. Our view is that the economy could start turning around in the second half of 1999, but we project real GDP to be flat on an annual basis at best. Net inflation on a 12-month basis would likely pick up somewhat during the second half of the year, but should remain below 4 percent for end-1999. With limited increases in administered prices, CPI inflation would be at roughly the same level. The external current account deficit should remain under 2 percent of GDP, while foreign direct investment could remain at over 4 percent of GDP. This macroeconomic outlook is broadly in line with the authorities' thinking.
6. Given the weakness of economic activity, the government should allow the automatic fiscal stabilizers to operate in 1999, and the CNB should set official short-term interest rates to the lowest level consistent with the inflation target of 3½–5½ percent for end-2000. From that standpoint, current real short-term interest rates are not high, but there may still be room for some further easing given the current situation and prospects. Following the marked depreciation of the exchange rate over the past three months, one should, however, keep a close eye on foreign exchange market developments. Some further small depreciation would not be a source of concern and could help strengthen external competitiveness, but a pronounced downward move would endanger the medium-term inflation objective. On the other hand, an appreciation would have deleterious effects on the economy, and therefore any significant upward pressures on the exchange rate should be resisted through further interest rate cuts.
7. Wage moderation would facilitate further monetary easing and also improve the external competitiveness of the economy. Therefore, the mission is concerned about the apparent slow response of wage settlements to the sharp decline in inflation. Wage increases of 13–15 percent were agreed in the government sector for 1999, and wage settlements in the private sector appear to be mainly in the range of 7–8 percent. The wage increases for the government sector—while partly understandable given the nominal wage freeze imposed in mid-1997—did, when combined with the large settlement in the railways, send a poor signal to the enterprise sector. Under these circumstances, it is essential that the government now take a firm stance in any remaining wage negotiations with state-controlled enterprises for 1999 and insist on wages in the government sector and state-controlled enterprises not exceeding anticipated inflation next year. This is very much needed to avoid that the recovery of aggregate demand be followed by a marked rise in inflation, which once more would require a monetary squeeze to re-establish some price stability ahead of EU accession.
8. Regarding fiscal policy, the authorities should refrain from taking discretionary measures to contain the deficit to the level envisaged in the budget for 1999, while developing policy options for addressing the structural weaknesses in the public finances to ensure stability over the medium- term. The mission estimates that, as a result of the weaker than expected economic activity, the general government deficit in 1999 would reach 4 percent of GDP (excluding potential restructuring costs and privatization revenues). While this represents a slippage relative to the approved budget, it is justified from a macroeconomic viewpoint—tax increases or expenditure containment measures would not be warranted. However, the authorities should be prepared to address any slippage in the fiscal deficit above this level because it could have a detrimental impact on the current account and complicate the task of fiscal consolidation over the medium-term.
9. As the budget is developed for 2000, fiscal policy must consider the growth prospects but must also be conceived within a framework that addresses the structural weaknesses in public finances. In this context, the mission welcomes the authorities' increased attention to enhancing fiscal transparency and their intention to provide medium-term fiscal projections. The inclusion of contingent liabilities and off-budget activities within the budgetary process is also a significant step forward. However, the authorities must go beyond these steps and develop a comprehensive and well articulated medium-term strategy. This is needed not only as part of the EU accession process, but also to address the mounting pressures from mandatory expenditure programs, risks associated with the "hidden debt" and bank and enterprise restructuring costs, and the need to make room for additional expenditures on the environment, infrastructure, and defense.
10. While the Czech Republic, unlike many of the current members of the EU, started from the enviable position of a low debt stock and a modest deficit, the medium-term fiscal prospects will be extremely unfavorable in the absence of major reforms. Preliminary mission estimates suggest that under current tax and expenditure policies (i.e. without new expenditure programs or changes in tax laws), revenue as a percent of GDP would decline somewhat faster than expenditures, causing a gradual increase in the public sector deficit and debt ratio. Once additional expenditures related to adopting the Acquis Communautaire and meeting EU directives, NATO spending targets, bank and enterprise restructuring, and the realization of contingent liabilities are taken into account, the medium-term fiscal position becomes quite worrisome, even after accounting for increased EU transfers and privatization revenues. To put public finances on a sustainable medium-term path, the government needs to undertake reform of the tax system and contain, as well as reform, expenditure programs. Measures might include incorporating some additional goods into the VAT system and harmonizing the VAT at the higher rate to increase the elasticity of revenues so that they grow in line with nominal income. The government should also continue to reduce wasteful subsidies such as those to enterprises and certainly not introduce new expenditure programs that work against the reform process such as providing new guarantees.
11. The government must also be concerned about the looming demographic time bomb that will destabilize the pension system soon after EU accession if appropriate measures are not taken before. Now is the best time to initiate changes in the pension system to make it sustainable by scheduling a further increase in the retirement age to take account of changes in life expectancy, improving the actuarial fairness of early retirement provisions, eliminating the accrual of benefits during periods when people are not in the labor force, and limiting the indexation of past earnings used to calculate pension benefits as well as pension payments solely to inflation. Further, the link between contributions and benefits should be strengthened, and consideration could be given to partially pre-funding the pension system to spread the burden of retirement financing more equally across generations and enhance fiscal discipline.
12. Lack of corporate governance, disregard of investor protection, poor lending decisions by banks, and failure to acknowledge the need to close non-viable production units have resulted in the survival of large, inefficient, and excessively indebted corporations throughout the industrial landscape. This lies at the heart of the current economic malaise. This legacy must be cleared and an efficient financial and industrial system reconstructed. Central to this endeavor is the privatization of banks. Strategic foreign investors need to be brought in to establish a sound banking culture. Above all, this must be accomplished quickly if one is to avoid a further deterioration of the banks, which would impede their ability to intermediate effectively. The government's ambitious plans are a welcome expression of its commitment to early privatization. Concrete steps to launch the process, including the issue of Information Memoranda, should be taken as quickly as possible. The government will need to have a clear idea of the quality of the assets and the value of the banks in order to assess the bids in a timely fashion. Any necessary prior measures on the part of the government to make the banks more sellable should reflect this review, so that any take-over of bad assets is done at the appraised value, and new shares for capital increases subscribed at prices that reflect the value of the banks.
13. Bank privatization needs to be supported by the establishment of a strong regulatory and supervisory environment, and recent efforts in this regard in banking supervision and securities regulation are to be commended. The CNB's decision not to allow banks to deduct the value of real estate collateral from required provisions is fundamentally a sound move. It has also highlighted the legal constraints to foreclosure and other shortcomings in the civil and bankruptcy codes as well as the judicial system's limited capacity to handle such cases. The CNB needs to adhere to its plans to introduce, inter alia, consolidated supervision, capital requirements for market risk, and improvements in the bank resolution process, some of which will require revisions to the Banking Law. Securities regulation has been strengthened, including through better regulations for investment funds, and the Securities Commission has been established. However, market oversight needs to be tightened further, the Securities Commission should be de-linked from the Ministry of Finance and given powers to promulgate regulations on its own, and hundreds of illiquid shares should be delisted. These efforts need to be supplemented by upgrading of the accounting and auditing standards to international norms, including the requirement of mark-to-market accounting, so that accounting methodologies do not provide distorted incentives, allow circumvention of regulations, or help avoid full disclosure.
14. The poor state of many of the large, domestically owned industrial conglomerates has been a drag on the economy and banking sector throughout the 1990s. The mission has examined the authorities' plan for revitalizing the enterprise sector, which is now taking concrete shape. In its view, the overall objective of the revitalization program must be to advance the restructuring of the economy—not to protect more or less insolvent enterprises from the harsh adjustments required by a market economy. Therefore, it should be carefully targeted to a limited number of large enterprises that are—at least in part—viable. There should be no bailout of private owners; this would set a dangerous precedent. Most important, the reprivatization should be targeted at majority foreign strategic investors who can provide the required capital, management, and marketing expertise, and the program must be strictly time-bound. The enterprises taken over should be reprivatized in whole or in parts within 1–2 years. Enterprises, or parts of these, for which no buyers can be found within that time frame, should be liquidated. It would be disastrous for the state to be left, directly or indirectly, as the owner of unviable enterprises for any significant period of time.
15. The revitalization program, if properly implemented, will cover only a small proportion of the many large and small industrial firms in serious financial difficulties. To deal with the remaining firms, as well as to ensure that privatized banks will operate in an appropriate environment, it is essential to immediately speed up the preparation of an effective foreclosure and bankruptcy law. More generally, there is a need for far-reaching reforms to the legal and institutional framework and improving the enforcement of existing laws regulating economic activity. This stretches from ordinary regulatory and administrative activities to the judicial and court procedures, which are often cumbersome and non-transparent.
16. The program of revitalizing problem enterprises should be coupled with an accelerated divestment of non-financial strategic enterprises as well as the many stakes in smaller enterprises. This would not only improve corporate governance and efficiency required to compete in the EU, but also send a strong signal of the commitment to the privatization process. From that standpoint, it is difficult to understand the inaction of the National Property Fund; why does it keep its equity holdings in so many firms? Also, completing the process of price deregulation over the next couple of years would facilitate further privatization (e.g. the electricity company and the housing stock) and improve the allocation of resources.
17. Provided that prudent monetary and fiscal policies are continued and the structural reform process vigorously pursued, the mission believes that there should be scope for a substantial economic recovery from 2000 and relatively high rates of growth over the medium-term driven by investment and exports. Observing the need to maintain a prudent and sustainable current account deficit and converging towards EU inflation levels would imply a current account deficit of 3–4 percent of GDP, which could be covered by foreign direct investment, while inflation could be a couple of percentage points higher than in the EU, consistent with a broadly stable exchange rate vis-à-vis the euro on the basis of relatively rapid productivity growth in the tradable goods sector. Nonetheless, given the uncertainties related to the potential effects of structural changes on the real exchange rate, the authorities should refrain from any undue fixity of the nominal exchange rate.
18. Finally, the mission strongly encourages the authorities to improve their statistical base in a number of areas, including not least on the labor market and national accounts. The absence of reliable data on wage rates (in contrast to monthly earnings) in the various sectors of the economy complicates the assessment of the macro-economic outlook. The intention to publish national accounts from the supply side by June 1999 is most welcome.
19. In sum, the Czech Republic faces large challenges in the period ahead as it seeks to lay the basis for sustainable growth over the medium-term and advances preparations for EU accession down the road. The required macroeconomic and structural policies will entail difficult political choices and considerable economic and social stress in the short run, but there is no alternative in the progress from transition to convergence. While the deep-rooted structural problems in the economy should have been addressed several years ago, it is far better to press ahead this year than next. There is no time to lose.