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International Monetary Fund
Czech Republic-Article IV Consultation Discussions
Concluding Statement (Preliminary)
April 17, 2001
1. Since the mission last visited the Czech Republic in October 2000, the economic expansion has gained a broader footing, and indications for 2001 remain positive, especially from the side of investment. With a favorable macroeconomic policy mix, and a steadfast pursuit of structural reforms, the Czech Republic should be able to raise its medium-term growth rate to levels that would ensure convergence with its partners in the European Union (EU). Foreign direct investment (FDI) is raising productivity levels and laying the foundation for strong, sustainable growth. With the completion of the privatization of the last major state-owned bank and the speedy disposal of bad loans, the banking sector will be able to operate on a sounder basis in the coming years, while ongoing restructuring in the corporate sector bodes well for the resolution of its long-standing problems. In the short term, however, the global economy, to which the Czech Republic is very exposed, is experiencing a slowdown, and depending on the extent of this deceleration, the growth prospects for the region could be subdued. Adjusting to this external slowdown will require prudent economic policies in the coming period.
2. Inflation is under control, and there is no near-term threat to price stability. Hence, the mission considers that monetary policy can maintain its current accommodative stance without jeopardizing price stability, while allowing private domestic demand to gather momentum. However, the main and overwhelming concern is the deterioration in public finances. The longer-term risks of widening fiscal deficits are obvious to all. But even in the short term, the expansionary fiscal stance and its reliance on uncertain financing sources-especially in a weakening international environment-increase vulnerability to external shocks and can represent a threat to macroeconomic stability. The mission therefore urges the authorities to embark on an immediate, concerted effort to initiate fiscal consolidation, through structural reform measures that have a lasting effect on the fiscal deficit. In this regard, some recent proposals that bear substantial expenditure implications need to be examined particularly carefully.
3. Over the past year, the expansion has strengthened and broadened. The main driving forces have been exports and investment generated by foreign-owned companies, and there are signs that this buoyancy is spreading to the rest of the economy. However, the slowdown of trading-partner demand is expected to have an impact on the Czech economy. On balance, we expect that this year's growth rate will remain around 3 percent, with an acceleration next year especially if global economic conditions improve. The continuing inflows of FDI will strengthen the supply side of the economy, enhancing productivity, competitiveness, and potential growth. This, in turn, will help achieve balanced growth over the medium term, and facilitate the Czech Republic's catch-up to the EU.
4. Inflation is moderate, and is expected to remain subdued. In addition to lower imported oil prices that will tend to depress this year's inflation, wage and productivity growth and foreign exchange market developments augur well for continuing low inflation. Unemployment is declining; although employment also fell in 2000 due to ongoing restructuring in the corporate sector, recent signs suggest that this negative trend may be reversing. Nevertheless, there is likely still some excess capacity in the economy. The trade and current account deficits are expected to remain broadly unchanged this year as growing domestic demand as well as a slowdown in trading partner countries-especially Germany-balances the effect of lower oil prices. The current account deficit will be amply financed by FDI inflows.
5. The general government deficit (excluding privatization receipts) was originally envisaged to expand to 9.4 percent of GDP this year. More than half of this deficit was transfers to cover bank restructuring costs that have little effect on aggregate demand and, without these, the deficit was projected to reach nearly 4½ percent of GDP. We estimate that this policy implies a demand stimulus of about 1½ percentage points of GDP, reflecting increased public support of enterprises and greater public investment. This expansion is inconsistent with the objective of achieving medium-term fiscal sustainability, and is also unnecessary given the improved cyclical position of the economy and the accommodative stance of monetary policy. Although a stimulus of this size is unlikely to lead to overheating this year, the tendency to continually add to existing spending programs without retrenchment elsewhere will overstretch the budget to the point where fiscal policy no longer has the flexibility to inject stimulus in periods when growth is weak.
6. There are risks that the fiscal position could be even weaker than budgeted. Based on our current macroeconomic forecast, actual tax collections are likely to fall short of budget projections. In addition, recent proposals to stimulate economic growth through accelerated government spending ("Big Bang") are worrisome. In particular, some of the proposals would not appear to have been envisaged in the preparation of the 2001 budget and, if implemented without offsetting reductions elsewhere, would further aggravate the fiscal imbalances. And with the overall financing of the government deficit already strained (see below), such proposals could jeopardize financial stability. The effect of these spending proposals on overall general government expenditure for 2002 is unclear at this stage, but any expansion of the general government deficit works against the needed reduction in the structural fiscal deficit.
7. Financing of the budget deficit relies heavily on privatization proceeds. These are one-off receipts that should be used with care. Prudent economic management suggests that temporary large receipts from privatization should not be an excuse to expand expenditure (or to reduce tax or other revenue) unduly when the medium-term sustainability of the fiscal position is in question. However, while some of these receipts are used for financing (for example, to cover the clean-up of the banking sector, which is losses from the past), substantial transfers to the housing and transport infrastructure funds will certainly be spent on construction and therefore contribute to the relaxation of fiscal discipline. Moreover, the amounts of privatization receipts envisaged-and their timing-are inherently risky. Despite rising claims on these resources, such as in recent proposals to increase public investment to boost economic growth, indications are that there are likely to be shortfalls and delays in privatization receipts in 2001. Rather than seeking temporary bridge financing, such shortfalls should preferably lead to a permanent reduction in expenditure. In sum, the availability of large privatization receipts should not be allowed to mask the underlying adverse dynamics of the fiscal position in coming years.
8. Public debt correctly measured is still only moderately high, but is expected to increase rapidly-even assuming full realization of privatization proceeds-owing to banking sector restructuring and expanding fiscal deficits. This increase in public debt risks jeopardizing the availability of credit to the dynamic corporate sector, crowding out productive private investment. In order to slow the increase in public debt, reforms are needed to reduce expenditure relative to revenue. Harmonization of indirect taxes with EU regulations will likely boost revenue, even with a reduction in the standard VAT rate. However, an even more important requirement is to cut durably the net cost of mandatory spending programs in order to mitigate budgetary pressures from long-term demographic trends. While a drop in the school-age population could yield savings in education spending, the growing number of pensioners and the rising system-dependency ratio will eventually outstrip savings from a low birth rate. Hence, changes in the basic parameters of the government-operated pay-as-you-go pension system (including further raising retirement ages and minimum years of contribution, and increasing contributions of self-employed to levels comparable to those for employees) need to be introduced so as to increase total contributions relative to benefits.
9. The mission commends the authorities for increasing the transparency of general government finances and public debt, and for improving the efficiency of the budgetary process. However, the introduction of new extrabudgetary funds represents a setback in this regard. The resulting increased fragmentation of public budgets implies that individual spending ministries and Parliament must shoulder greater responsibility for developments in overall public finances and play a more decisive role in ensuring their sustainability. But this may be unrealistic for several reasons, including their difficulty in monitoring the state of overall public finances, both current and future, on a consistent and continuous basis. It is therefore important to ensure that the Finance Ministry has financial control over the consolidated central government budget (that is, the general government budget excluding budgets of local governments), and to prevent any further fragmentation of public budgets.
Monetary and exchange rate policy
10. In an environment of reduced inflation expectations and more benign external influences on domestic inflation, we support the recent interest rate cut by the CNB and believe that the current accommodative monetary policy stance is appropriate. Indeed, the mission does not see significant inflation pressures ahead; under-utilized resources, slowing external demand, and lower world oil prices will moderate the price pressures generated by the expected increase in domestic demand. However, considerable uncertainty about the strength of both domestic and external demand remains, suggesting that the CNB should stand ready to adjust interest rates, in either direction.
11. The mission supports the shift to the new inflation targeting framework recently agreed between the CNB and the government-including the shift to targeting headline inflation. The new framework will increase the transparency of the inflation concept being targeted, while the longer horizon of the target and the specification of an intra-year band will help better pin down short and medium-term inflation expectations. However, the new framework is operationally more complex and, as a result, the CNB will have to redouble its efforts to enhance its accountability, making use of its regular press releases, inflation reports, and active dialogue with the private sector, market participants, and the media. In addition, there are several operational issues that the CNB needs to carefully consider so that it can firmly establish the conduct of monetary policy under the new framework. These include: (i) the best way to produce and communicate to the general public the CNB's inflation forecasts; (ii) the communication and understanding between the CNB and the government with respect to administered price and indirect tax adjustments; and (iii) the design and use of escape clauses, which can potentially cloud the transparency and accountability of the inflation-targeting framework.
12. It is the mission's view that the current level of the koruna does not pose a threat to external competitiveness. Indeed, the EU-market share of Czech exports has increased during a period when the koruna strengthened. This is due in large part to FDI, which has helped enhance competitiveness of export-oriented firms through the introduction of efficient management practices and new technologies. Under these circumstances, the mission supports the CNB's policy to limit its foreign exchange market intervention only to cases where disorderly market conditions might develop.
Financial sector stability
13. Over the past few months, the IMF and World Bank staff conducted an in-depth assessment of the structure and stability of the Czech financial system as part of the work of the two organizations on financial sector issues. The assessment concluded that the resilience of the Czech financial system to macroeconomic shocks and structural weaknesses has strengthened considerably. The prudential and legislative framework for the financial sector has been improved, bad assets of the banking system have been-or are in the process of being-carved-out, the privatization of large banks to foreign strategic investors is near completion, and a significant consolidation of banks and non-bank financial institutions has taken place. The level of non-performing loans that will be left in the banking system after the carve-out of bad assets appears manageable given current provisioning levels. This bodes well for the future of the financial sector, and should eventually lead to the resumption of credit growth to the private sector. However, in the short term, the larger banks are likely to remain reluctant to expand lending significantly while the ownership changes are being absorbed.
14. The priority now is to complete the bank restructuring and privatization as soon as possible. The clean-up of bank balance sheets represents a large cost to the budget (estimated at about 20 percent of GDP, including costs already incurred), and has resulted in a transfer of risks from commercial banks to the government. A large stock of non-performing loans-as much as 25 percent of GDP, including the ring-fenced part to be kept on the balance sheet of banks-remains to be worked out, a considerable part of it with Konsolidacni banka (KoB). Despite its low sales price, the recent disposal of a first pool of bad assets by KoB was a success, and recognizes that the private sector is best placed to spur the restructuring of potentially viable enterprises. Where possible, further pool sales should be sought, and KoB should continue to dispose of bad assets through all methods available to it. A successful workout program necessitates improvements in the parts of the legal framework that have fallen behind, such as insolvency. This is essential in order to expedite enterprise restructuring, and will likely also imply a better price in the auction of bad assets. Meanwhile, the state's involvement in industrial restructuring should remain limited to the few existing complicated and sensitive cases.
Observance of international standards
15. In recent years, the Czech Republic made substantial progress in upgrading its practices in economic and financial areas to high international standards, spurred in part by the ongoing harmonization with EU laws and regulations. In the financial sector, the transparency of the CNB's monetary policy framework displays a high level of observance of international good practice, and the regulatory and supervisory framework has been strengthened. Our recent assessment shows, however, that there is room for further improvement. In financial sector supervision, the interlocking ownership structures, the IPB collapse, and the failure of the credit union sector clearly point to the need for a supervisory framework that closely monitors and oversees all financial institutions and all members of a financial group. Introducing consolidated, risk-based supervision of financial groups should be a priority. In addition, coordination and cooperation between supervisory agencies should be strengthened to enable more effective monitoring of the activities of integrated firms and markets. Outside of bank supervision, the other supervisory agencies often lack sufficient legal and operational independence and face difficulties recruiting and retaining qualified personnel.
Legal and regulatory framework
16. The legal and regulatory framework has improved, but there remain areas of weakness. In particular, creditor rights remain weak, requiring further amendments of the collateral and insolvency regimes. Enforcement of existing laws and regulations is also often unsatisfactory, introducing delays and uncertainty into the judicial process. Better enforcement will require a strong build-up of supervisory capacity, a more proactive approach by self-regulatory organizations, and improvements in the court system.