Czech Republic -- 2005 Article IV Consultation Mission, Preliminary Conclusions
May 24, 2005
1. Following a period of comparatively low growth, the past two years have been favorable for the Czech economy. Growth accelerated and inflation remained low. Last year, investment surged against the backdrop of supportive monetary policy, EU accession, and strong corporate profitability. A record-breaking expansion of exports substantially narrowed the trade deficit, and fiscal developments were positive.
2. Yet, these results should not invite complacency. Recent economic performance has not been underpinned by fundamental reform, risking an erosion of the favorable position in the face of challenges posed by rising global competition and population aging. Adverse demographic trends—more pronounced than in other OECD and Central European Countries—compounded by a tendency of older workers to exit the labor market early, are set to harm growth and fiscal sustainability. The recent acceleration of growth is exposing shortages of specialized skills, while obstacles to geographical mobility and disincentives for job search remain. The business-legal environment is still marked by uncertainty, costly delays, and inadequate protection of creditor rights. Despite welcome initial steps in some areas and efforts to develop a medium-term strategy, measures to alleviate impediments have been piecemeal, and progress in crucial areas has been slow or stalled. Medium-term prospects and convergence to EU living standards will depend on success in restoring fiscal viability, and improving labor market flexibility and the business environment. Decisive and comprehensive action has become pressing to avoid the exacerbation of imbalances and escalation of adjustment costs.
3. An expansionary and uncertain fiscal policy in the period ahead could create significant challenges for macroeconomic management. Part of the budget overperformance in 2004 can be carried over to spending in future years, although, given past experience, budget plans may not be implemented in full. Measures to achieve the 2006 fiscal target remain to be identified. Greater certainty about fiscal control and prudence is required to provide investors and the public with a sufficiently long horizon for decision-making. With upcoming elections, a clear commitment to fiscal consolidation in 2005 and 2006 would help sustain growth and low inflation.
4. In the near term, economic activity is likely to remain strong and become more balanced, with consumption offsetting a slowdown in investment. Growth is projected to stay close to 4 percent in 2005-2006. Private consumption will strengthen benefiting from rising employment and moderate wage growth. While investment will slow reflecting one-off factors in 2004, high profitability and continued FDI and infrastructure investment should support capital formation. Owing to koruna appreciation and softer external demand, export growth is projected to moderate from exceptional rates. With imports slowing in line with exports and investment, the current account balance should narrow. The government sector is expected to provide a positive stimulus in 2005. Risks to this forecast are balanced. On the downside, a slowdown in the EU, weaker employment, and faster koruna appreciation would dampen growth relative to baseline. On the upside, a larger-than-expected fiscal impulse or faster wage growth might stimulate growth in the short run at the expense of investment and competitiveness over the medium term.
5. Fiscal performance in 2004 marked a turnaround from the widening deficit trend in earlier years, but the gains could be hard to sustain. The decline in the general government deficit (excluding privatization receipts and transfers to transformation institutions) to around 3 percent of GDP reflected strong growth and the new budgetary rules allowing carryover of unspent allocations, rather than permanent expenditure measures. Moreover, there are slippages in the implementation of expenditure rationalization plans envisaged in the Convergence Program, and increases in indirect tax collections from EU harmonization will be gradually offset by lower direct tax revenues.
6. The substantial procyclical stimulus implied by the 2005 budget needs to be moderated. Current spending plans—if carried out in full—would result in an increase in the general government deficit of
1½-2 percent of GDP in 2005. While some increase in spending can be expected as EU-financed projects take off, full implementation of current expenditures could lead to inefficiency, as suggested by significant underspending last year. The ensuing rise in expenditure would make achievement of targets in 2006-07 more difficult and require a more abrupt correction in the future. A more neutral stance in 2005 and a smoother path of consolidation over 2005-07 would diminish macroeconomic risks and spread the adjustment burden. With growth above potential, this more neutral stance would require keeping the general government deficit at about the 2004 level. This would be feasible, particularly given low inflation, by containing general government spending on goods and services in line with historical growth rates (4½ percent) and National Property Fund transfers to the Transportation Fund and non-privatization net lending at 2004 levels, while maintaining EU-related spending as budgeted. Using good times to consolidate while limiting inefficient spending are sound principles for fiscal policy.
7. Budget overperformance in 2004 and robust growth also highlight the need for revising down fiscal targets under the Convergence Program. Revenues from stronger-than-expected growth should be used to build in a cyclical margin for a possible downturn in future rather than to increase spending. In the same vein, any further reduction in tax rates needs to be compensated by tax base broadening measures to ensure revenue neutrality. With current growth likely to be above potential and a more relaxed monetary stance, a sharp fiscal stimulus could create inflationary pressures as the policies are transmitted through the economy over the next 12-18 month horizon. As future sources of privatization revenues dry up, the risk of crowding out will increase as government borrowing would need to pick up. The possibility that large guarantees—previously considered to be low-risk—will be called, suggests the need for a more cautious fiscal policy. An immediate task for the government is to design a 2006 budget based on conservative parameters, consistent with tightened targets that reflect high growth.
8. Stepping up fiscal efforts over the medium term would also help deal with population aging. Under current policies, debt is projected to reach 100 percent of GDP by 2020, and each year of delayed consolidation is estimated to incur extra costs of about ⅓ percentage point of GDP for restoring a sustainable fiscal position. Budget balance or a small surplus is needed starting early in the next decade to create budgetary room for dealing with aging. This requires structural reforms in key spending areas:
• Pensions: The considerable progress made towards evaluating the options for pension reform is welcome. Early political consensus on reform is the next priority given the long lags in realizing reform benefits. Most options under consideration imply significant transitional deficits, and it would be prudent at a minimum to put aside the larger-than-planned privatization revenues in 2005 to finance these deficits. In the meantime, pension indexation needs to be maintained at the legal minimum.
• Health care: The arrears build-up is symptomatic of deep-rooted problems in the health care system. Without substantive reform, budgetary transfers to bail out the health insurance companies would be wasteful. Measures need to include a rationalization of the supply of health services, incentives for providers to contain costs, and greater sharing of the financial burden with final users. The transfer of hospital management to regional governments is likely to improve efficiency, but risks jeopardizing their finances.
• Social benefits: As part of labor market reform (see paragraph 17), an early restructuring of entitlements is needed to reduce inactivity traps, improve incentives to work, and save budget resources. Entitlement reform should also aim to enhance budget flexibility.
9. Institutional weaknesses and the complexity of tasks in the fiscal area require strengthening the overall fiscal framework. New budgetary rules which encouraged more rational spending by ministries and led to significant underspending underscored weaknesses in budgeting. Improved budgeting and expenditure management through treasury development would save resources. On fiscal rules, the new carryover regulations further weaken the role of expenditure ceilings. These need to be strengthened by expanding coverage to extra-budgetary funds and making intertemporal spending transfers consistent with the discipline intended in the fiscal framework. More broadly, a fiscal rule targeting structural balance or surplus over the medium term (consistent with the Stability and Growth Pact) would be appropriate, especially in view of the looming age-related pressures. A stronger fiscal rule for regional governments to limit debt build-up is needed as more responsibilities are devolved to regions. The use of numerous deficit definitions is obfuscating public communication of fiscal developments. The credibility of the fiscal framework would be enhanced by using a consistent set of deficit definitions, preferably based on GFSM 2001/ESA 95 definitions, and we welcome progress made towards this goal by the Ministry of Finance. Fiscal statistics should also adequately reflect the risks associated with guarantees and long-term commitments under Public-Private Partnerships programs.
Monetary and Exchange Rate Policy
10. Inflationary pressures remain subdued, as evidenced by weak second-round effects of increases in indirect taxes and regulated prices in 2004. An auspicious combination of koruna appreciation, good harvest, and strong productivity improvements kept core inflation low in 2004. A reassessment of the inflation outlook in early 2005 led the Czech National Bank to appropriately reverse the 2004 interest rate increase, and cut policy rates further in late April. Headline inflation is now below 2 percent, close to the lower bound of the CNB target band.
11. Inflation is expected to remain low. Although growth is above potential (4 percent compared to 3½ percent), there seems to be more slack in the economy than previously anticipated and structural changes such as intensifying retail competition and productivity improvements delay the onset of inflationary pressures. The substantial appreciation of the koruna is still exerting disinflationary pressures, although the final pass-through to prices is uncertain. Wages have been growing moderately, and combined with productivity increases, have resulted in only a modest increase in average unit labor costs. This trend is expected to continue in 2005. A baseline projection with average CPI inflation staying below 2 percent in 2005, and rising to 2½ percent by end-2006—well within the CNB tolerance band—seems reasonable. Risks to this forecast stem mainly from intensifying wage pressures and significant deviations of the koruna from baseline, and are broadly balanced. A neutral bias for the remainder of 2005 thus seems appropriate.
12. The inflation-targeting framework has gained well-deserved credibility, helping anchor low inflationary expectations. Shortening the publication lag of CNB Board minutes and periodic meetings of the CNB Board and staff with analysts, have enhanced transparency and communications with the public. These measures should help improve market understanding of CNB's objectives and minimize surprises in the face of inflation deviations from the baseline forecast. Clarifying in the Inflation Report whose views such forecast reflects would further enhance monetary policy transparency.
Financial Sector Issues
13. Past restructuring, improved risk management, and recent strong growth have strengthened banks. The share of nonperforming loans in bank portfolios continued to decline in 2004, while capital ratios remained adequate and profitability increased. Stress-testing by the authorities suggests the banking system is sound and resilient to macroeconomic shocks.
14. The overall exposure of banks to the household sector is low, but rapid growth of household credit calls for further strengthening of supervision and monitoring capacity. Bank supervision should continue to stay vigilant to any signs of banks easing credit standards in an environment of low interest rates and intensifying competition, and encourage greater use of household credit reports in the loan approval process. Close integration of stress-testing and supervisory activities is key to ensure proactive supervision. Collection of additional data on the concentration of household debt, debt-servicing capacity, and nonbank lending is needed to refine stress tests further. Analysis of currency mismatches in private sector balance sheets would help identify the extent of unhedged exchange-rate risk. With the likely transfer of greater responsibility for healthcare spending and retirement from the public sector to individuals, households will need to build up and manage their financial assets. This requires reviewing and removing any policy distortions that discourage pension and other forms of long-term saving, such as possible over-regulation of private pension plans and generous subsidies for other savings; promoting the development of modern financial instruments to support this saving, and improving households' financial education.
15. Continued reduction of direct state involvement in the enterprise sector is needed to improve allocative efficiency and supply-side responsiveness. Recent privatizations, including that of Český Telecom, will contribute to better resource allocation, which should be enhanced by the pending privatization in the electricity sector. Avoiding further transfers of bad assets to the Czech Consolidation Agency (CKA) and strictly limiting the number of strategic enterprises excluded from their standard recovery process, are essential to signal that there will be no new bailouts and wind down CKA with a minimum cost to taxpayers. State support to strategic companies needs to take place only in the context of viable restructuring plans and be transparently recorded in government accounts.
16. While recent improvements in commercial registration are welcome, stalled reforms in other areas of the business-legal environment continue to hamper growth. Company registration is being simplified through the introduction of single standardized forms and an automatic five-day deadline, and speedy implementation of the new law is a priority. A new draft law on bankruptcy would strengthen creditor rights and help preserve the healthy parts of insolvent firms. Continued delays in the adoption of this law and failure to introduce a bridging amendment have real economic costs. Approval of an amendment on bankruptcy procedures for financial institutions, still under consideration in parliament, would send a positive signal to investors and should not be delayed. Progress made towards the establishment of a one-stop shop for trade licensing is welcome, and unifying registration and licensing procedures should be the next step. Tax codes are becoming increasingly complex, imposing additional administrative costs, particularly for SMEs. Simplification of these codes and tax administration procedures would improve the business environment. Continuing to draw in FDI and encouraging firms to move up the technology ladder remain a key conduit for sustaining productivity improvements and capital accumulation.
17. Boosting the economy's growth potential—important for improving living standards and reducing pressures on public finances—also requires more labor market flexibility. Improving employment opportunities for older workers calls for a comprehensive approach: making early retirement less attractive, strengthening incentives to continue working beyond the statutory retirement age, and enhancing control of entitlement to disability benefits and re-employment opportunities for beneficiaries who can work. The current system of taxes and benefits is reducing incentives for job search for younger workers as well, particularly for low-income earners and individuals with large families, and it should be reformed to lower the implicit tax on employment and, in certain cases, introduce in-work benefits. Measures to encourage requalification, recognizing company training more on par with formal education, and performance-based financing of schools and universities are important steps to strengthen competitiveness. Further policy changes should aim at reducing skill mismatches and enhancing geographical mobility. Greater cooperation between the business community and educational institutions will increase the likelihood of graduating students with necessary skills. Rent liberalization should help geographical mobility, and we encourage speedy approval of the new Rent Bill.
18. We support the authorities' euro adoption plans, which underscore the urgency of the policy agenda. Euro adoption can bring gains for trade and growth provided supporting policies are strong. With monetary policy focused on the inflation target and structural reform likely to bring benefits with a lag, a clear commitment to fiscal consolidation is a precondition for ERMII participation.
We thank the authorities for close cooperation, stimulating discussions, and their hospitality.