Public Information Notice: IMF Concludes Article IV Consultation with Czech Republic
July 29, 1999
|Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.|
On July 21, 1999, the Executive Board concluded the Article IV consultation with the Czech Republic.1
The Czech economy slowed markedly in 1997, and fell into a severe recession in 1998. The immediate cause was the prolonged tightening of fiscal and monetary policies in response to the widening of internal and external imbalances and the resulting currency crisis in early 1997. However, serious structural deficiencies were at the root of the problems. Weak corporate governance in the state-controlled banks and in the enterprise sector resulted in the channeling of the large capital inflows received in the mid-1990s into excessive credit growth, which supported large real wage increases for employees and even more for management, misguided investments, and in some cases outright asset stripping. Tight fiscal and monetary policies--combined with favorable temporary factors--eliminated the macroeconomic imbalances, but without adequate structural changes the cost has been high in terms of economic activity.
Output contracted by 2½ percent in 1998, reflecting a large decline in domestic demand, especially fixed investment. Private consumption also declined reflecting a sharp adjustment of growth in household incomes, in part because of a surge in unemployment from 4½ percent in 1997 to 6 percent in 1998. By June 1999, the unemployment rate had reached 8½ percent. Net inflation (CPI inflation excluding goods subject to administered prices and tax effects) fell from a peak close to 8 percent in March 1998 to 1.7 percent in December and dropped further to -½ percent in June 1999. The decline in inflation reflected the tight policy stance and increasing output gap, but also favorable temporary factors, with a substantial appreciation of the exchange rate and sharp declines in the prices of imported commodities and domestic foodstuffs. Nominal wage growth also decelerated in 1998, reflecting the continued wage freeze in the government sector and some slowdown in the enterprise sector. Wage growth (average monthly earnings) in the corporate sector and industry slowed during the year from about 13 percent to 8-9 percent, owing partly to a reduction in overtime work, with wage rates thus decelerating less markedly.
The external current account deficit declined sharply to 2 percent of GDP in 1998 from 6 percent of GDP the year before, reflecting mainly the weakness of domestic demand and strong export growth, while the decline in world commodity prices also led to a 5 percent improvement in the terms of trade. However, export performance deteriorated towards the end of 1998 and into 1999, as economic activity weakened in Europe and the impact of the real exchange rate appreciation during 1998 was realized. The upward pressures on the exchange rate in 1998 were reversed in early 1999 with an 8 percent depreciation of the koruna, but upward pressures have re-emerged in recent months. Capital inflows stabilized in the second half of 1998 with a decline in interest-sensitive inflows offset by higher foreign direct investment (FDI), which continued to be very bouyant in the first half of 1999. The Czech National Bank's (CNB) foreign reserves rose to just under US$12 billion in June 1999 (equivalent to five months of imports) from US$10 billion at end-1997. With the lower current account deficit in 1998 fully financed by FDI, total external debt remained stable at US$24 billion at end-December, equivalent to 44 percent of GDP; of this, one third was short term, equivalent to 40 percent of the banking system's short-term foreign assets.
Fiscal and monetary restraint facilitated the large external adjustment but macroeconomic policies were eased towards the end of 1998 to help address the severe economic downturn. Fiscal policy remained tight in 1998, despite the severe downturn in the economy. The general government deficit remained broadly unchanged (about 2 percent of GDP in both 1997 and 1998) but the structural deficit declined from an estimated 2½ percent of GDP in 1997 to ½ percent of GDP in 1998, with the substantial increase in the output gap. The approved 1999 state budget implied a deficit of about 3 percent of GDP for the general government, which suggested a ½ percent of GDP increase in the structural deficit. Monetary policy was kept tight during the first half of 1998 to stem contagion pressures from the international financial crisis, but also reflecting political uncertainty related to the June elections and the attempt to establish the credibility of the new inflation targeting framework. However, as it became clear that inflation would stay well within the target and that the economy was in a severe recession, CNB interest rates were cut more aggressively from the last quarter of 1998 onwards--falling from 14½ percent in mid-1998 to 6½ percent by June 1999-causing monetary conditions to ease significantly.
On the structural front, the deteriorating financial condition of banks and enterprises was brought out into the open in 1998. This reflected the tight monetary conditions, which worsened the cash flow of highly indebted enterprises, with the recession compounding the problems. Furthermore, the major banks' willingness to lend was affected by the weak condition of the enterprise sector and a tightening of the legal and regulatory framework, including stricter provisioning requirements, and the planned privatization of the state-controlled banks. A large number of medium-sized and large companies have not been adequately restructured and are excessively indebted, owing to poor corporate governance and weak lending policies by the state-controlled banks. Several of these companies have been brought to the verge of collapse, and bankruptcy proceedings were initiated against some of the large industrial conglomerates in 1998. While the enterprise sector does include several well-performing firms, the available aggregate data point to low and declining basic earning power, profit margins, and returns to equity, as well as increasing indebtedness and over-reliance on short-term debt.
Executive Board Assessment
Executive Directors commended the authorities for maintaining a prudent macroeconomic policy, which had allowed the Czech economy to maintain a strong external position and relatively low inflation despite the turmoil affecting other emerging markets in the past year. However, Directors observed that deep-rooted problems in the banking and enterprise sectors, which remained unaddressed, compounded by the tight policy stance, had sent the Czech economy into a severe recession. Several Directors considered that, at least with hindsight, an earlier loosening of fiscal and monetary policies, including a full use of automatic fiscal stabilizers, would have been desirable. Some other Directors, however, stressed the benefits of the authorities' clear policy stance in the midst of a crisis and the authorities' traditional preference for balanced budgets.
Directors agreed that the recent easing of fiscal and monetary policies was appropriate to revive activity and promote employment in the short term. However, they stressed that to ensure the sustainability of economic growth in the longer term, as well as to prepare for EU accession, it was crucial to address the underlying structural weaknesses in the banking and enterprise sectors.
Regarding short-term macroeconomic policies, Directors considered that, with activity depressed, it was no longer appropriate to hold the fiscal deficit to the level envisaged in the 1999 budget and recommended that fiscal stabilizers be allowed to operate. Directors welcomed the easing of monetary policy by the Czech National Bank. In light of uncertainties about external competitiveness and export performance, Directors generally agreed that upward pressure on the koruna should be resisted through intervention or further cuts in interest rates to the extent that this could credibly be viewed as consistent with the medium-term inflation target. A few Directors went further and considered that some depreciation of the koruna would enhance prospects for recovery, especially as inflation was well below the authorities' target. A few other Directors, on the other hand, cautioned against undue monetary easing, so as not to rekindle inflationary expectations. More generally, Directors agreed on the importance of a clear and credible monetary policy in establishing the expectations of wage bargainers.
Directors stressed that wage moderation would facilitate monetary easing and also improve external competitiveness. They expressed concern that wage growth had been slow to respond to the lower inflation, and that wage settlements for 1999 appeared to be well in excess of expected inflation. Directors considered that the large public sector wage increases agreed for 1999 had sent a poor signal to the enterprise sector. They stressed the importance of the government's showing leadership in the 2000 wage negotiations by limiting wage increases in the public sector and state-controlled enterprises to expected inflation. Directors noted that, in the absence of wage moderation, there was a serious risk that the expected recovery of aggregate demand would be followed by a marked rise in inflation, necessitating once again a monetary squeeze to reestablish price stability ahead of EU accession. Some Directors saw possible scope for the use of catch-up clauses as a way to lower the rate of wage settlements, although some risks in this approach were also noted.
Directors urged the authorities to address the structural weaknesses in the public finances in order to ensure stability over the medium term. They stressed that, while the budget for 2000 should take account of the economic prospects for that year, it should also be cast within a comprehensive medium-term fiscal strategy to reduce the structural deficit. Directors noted that such a strategy was needed not only as part of the EU accession process, but also for purely fiscal reasons. They saw an urgent need to address mounting pressures from mandatory expenditure programs; to minimize the risks associated with the large stock of contingent liabilities and bank and enterprise restructuring costs; and to accommodate needs for additional expenditures, including on the environment and infrastructure. Given these factors, the medium-term fiscal outlook was quite worrisome. Corrective measures should include reform of the tax system, for instance, by broadening the coverage of the value-added tax and harmonizing the rates around the highest one; containment of subsidies to enterprises and other transfers; and reform of the pension system through raising retirement ages and modifying other parameters to ensure its long-term viability.
Directors urged the authorities to accelerate restructuring and privatization in the banking and enterprise sectors, and welcomed the announcement of the timetable for selling the remaining state-controlled banks and a plan for restructuring the enterprise sector. Directors noted the importance of accelerated divestment of strategic nonfinancial enterprises and of the state's remaining stakes in many smaller companies. Directors considered that the enterprise revitalization plan should be targeted to a limited number of enterprises with good prospects for long-term viability. However, they saw this initiative as only one of the needed measures, and stressed the need for the agency responsible for the revitalization plan to be fully independent, and for the plan to be implemented as envisaged. Directors emphasized that the government should refrain from providing additional subsidies to the enterprise sector. Some Directors stressed the fundamental need not merely to change the ownership of financial institutions and enterprises, but to raise their efficiency and competition, while others stressed the vital contribution of small-and medium-sized enterprises established by the private sector. Directors also stressed the need to support bank privatization with an additional strengthening of the regulatory and supervisory environment, including in the capital market area.
Directors noted that the restructuring of the enterprise and banking sectors also required speeding up the preparation of an effective foreclosure and bankruptcy system. More generally, they observed that far-reaching reforms to the legal and institutional framework and improved enforcement of existing laws regulating economic activity were indispensable to ensure proper business incentives and to provide an attractive environment for continued foreign investment.