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Public Information Notice (PIN) No.04/93
August 17, 2004
International Monetary Fund
700 19th Street, NW
Washington, D.C. 20431 USA

IMF Concludes 2004 Article IV Consultation with the Czech Republic

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2004 Article IV consultation with the Czech Republic is also available.

On August 6, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Czech Republic.1

Background

EU accession marks the formal completion of the Czech Republic's transition to a market economy. Despite a solid performance in recent years—moderate growth, low inflation, moderate public and external debt, and one of the highest per capita incomes among the accession countries—stubborn problems cloud the outlook. Growth remains sluggish compared with the other accession countries; fiscal deficits continue to drift upward, led by rising expenditures; adverse demographic trends portend unsustainable pressures on the budget; and long-term unemployment continues to rise. These trends are shared with many advanced economies. But with its lower per capita income, the Czech Republic cannot afford to delay remedial measures.

Rising growth, low inflation, and a narrowing trade deficit characterized recent performance. GDP expanded by 3.1 percent in 2003 and the first quarter of 2004, mainly supported by household consumption (reflecting rapid real wage growth and robust consumer credit expansion). Investment was also strong in 2003—driven by spending on public infrastructure—and swelled in early 2004 due to one-off influences associated with EU accession. But unemployment—particularly long-term unemployment—has risen and stands at about 8 percent. Despite strong import growth, favorable terms of trade helped narrow the trade deficit; competitiveness remains strong and the Czech Republic's share in EU markets continued to increase.

Since late 2003, inflation has been recovering from negative levels. Intense competition in the retail sector and an earlier appreciation of the koruna generated price declines during the first half of 2003. But rising consumer demand and a more recent depreciation brought a small upturn in inflation late in the year, and indirect tax increases in January and May 2004—driven in part by EU harmonization—pushed headline inflation above the bottom of the Czech National Bank's (CNB) inflation target band. However, excluding the effects of administrative measures, underlying inflation has risen only modestly, and remains below the target band.

Notwithstanding an improving trade balance, the current account deficit widened marginally to 6¼ percent of GDP in 2003. A secular decrease in the services surplus and a one-off drop in current transfers contributed. With privatization slowing and one-off Foreign Direct Investment (FDI) outflows on account of a change in ownership structure at two large foreign-owned companies, non-FDI flows were the major source of financing for the current account deficit in 2003. In early 2004, however, FDI rebounded.

Monetary conditions eased throughout 2003 owing to a cumulative 75 basis point cut in policy interest rates and a 5½ percent nominal depreciation of the koruna against the euro through January 2004. But with inflation forecasted to pick up, the inflation targeting (IT) CNB raised the repo rate by 25 basis points to 2.25 percent in late June 2004 to prevent a further decline in real interest rates. The CNB recently announced the parameters of its post-2005 IT framework, which shifts to a 3 percent point target with a tolerance band of ±1 percent, thereby ensuring continuity with the existing end-2005 target (2-4 percent).

The fiscal deficit continued to drift upward in 2003. The general government deficit—excluding privatization receipts and transfers to the Czech Consolidation Agency to cover the costs of managing bad assets—widened relative to GDP by about 1 percentage point to near 5 percent of GDP in 2003. The increase reflected mainly higher spending on subsidies, net lending, and investment. Nonetheless, public debt is still a moderate 28 percent of GDP and can be financed with ease, as the success of the recent inaugural eurobond issue illustrates.

Foreign investment has made an impressive contribution to the Czech economy. Among central European countries, the Czech Republic has attracted the largest amount of FDI on a per capita basis. Some 20 percent of the FDI stock represented privatization (mostly of banks and network utilities), with the remainder aimed at greenfield and brownfield activities. Foreign-owned firms account for more than one-third of industrial employment, nearly half of industrial output and value added, and over 70 percent of industrial exports. Foreign industrial firms are also considerably more profitable than their domestic counterparts.

Indicators of banking sector health continue to improve and bank lending—led by credit to households—is rebounding. The cleanup and privatization of banks in the late 1990s reduced nonperforming loans, injected new capital, and raised profitability, but for several years banks remained cautious about lending. Following the introduction of new mortgage and customer loan facilities into a largely untapped market, bank lending to households has risen at an annual rate of more than 30 percent for about two years, while lending to corporates remains stagnant.

Executive Board Assessment

Executive Directors welcomed the Czech Republic's accession to the European Union on May 1, which marks the symbolic end of the full transformation of the Czech economy into a market economy, and sets the stage for further convergence to EU income levels. They also commended the authorities for the solid economic performance over the past few years. The near-term outlook remains favorable, with growth expected to firm, based on robust exports and export-related investment.

While economic fundamentals generally remain strong, Directors emphasized the need for decisive action by the new government in key policy areas to enable the Czech economy to realize its full potential, and strengthen the foundation for a successful experience in ERM2 and the euro zone. In particular, fiscal policy implementation will need to be strengthened decisively to resist spending pressures, prepare for population aging, and cope with potential calls on government guarantees. Moreover, structural reforms need to be reinvigorated to sustain the Czech Republic's attractiveness as an investment destination, increase the flexibility of labor markets, and better tailor the education system to evolving skills demands.

Directors called for a strengthened commitment to the full implementation of the multi-year fiscal plan, the credibility of which has been weakened already in its first year. They urged the authorities to make strong efforts toward adhering to the expenditure ceilings, closing loopholes, and returning to the original nominal deficit target. To strengthen the credibility of the fiscal plan, Directors recommended a shift to a comprehensive fiscal measure—preferably the standardized European Union definition. Credibility would also be enhanced by building public support for the measures contemplated under the plan.

Looking ahead, Directors noted that considerable expenditure savings will be needed to fulfill the medium-term objective of the fiscal plan, and they urged the authorities to identify and implement the measures expeditiously. Directors cautioned against yielding to pressures for permanent expenditure increases in 2005, and urged bringing forward part of the expenditure savings needed to achieve the 2006 target. Any fiscal windfall from higher-than-expected revenues should be saved to support deficit reduction.

With the effects of population aging expected to impact public finances within 10-15 years, Directors considered that ambitious expenditure reforms will be needed to ensure long-term fiscal sustainability. They urged the authorities to expedite the reforms of the pension and health systems given the lags between the introduction of these reforms and their impact on public spending. They agreed that the reforms will need to encompass significant changes in pension system parameters, including a further rise in the retirement age and greater cost-sharing with final users of health care in order to contain demand. Timely implementation of these measures would help lower the deficit to well below Maastricht norms later in the decade in the run-up to joining the euro.

Directors underscored that reforms to strengthen the private sector and the attractiveness for foreign direct investment inflows will be key to raising longer-term growth. They welcomed the authorities' plans to resume privatization, through transparent and open procedures, and to close the National Property Fund and the Czech Consolidation Agency, and they urged them to resist pressures for additional bailouts. It will also be important to improve the business-legal environment, including through enactment of a bankruptcy law that enhances creditors' rights. Directors noted that external competitiveness measured by relative unit labor costs had improved during the past year, although by less than in several other central European countries. While the high quality of Czech labor may have helped support competitiveness, efforts should also be made to improve labor market flexibility. In this regard, Directors saw the need to further reduce non-wage labor costs and welcomed intentions to tighten the rules governing the eligibility for unemployment benefits. Efforts to improve the quality of education and training, as well as research and development activities, will also be important.

Directors saw the recent move to tighten monetary policy as an appropriate response to the changing economic circumstances. With the output gap projected to narrow, and in view of the negative real interest rates, Directors expected that monetary conditions will need to tighten further to keep inflation close to target, with decisions on the size and timing of rate increases carefully taking into account demand and cost push developments. Directors agreed that the flexible exchange rate regime has served the Czech Republic well. They commended the authorities' continued policy of nonintervention in the foreign exchange market, with the interest rate instrument providing markets with coherent and transparent signals about monetary policy intentions. Looking ahead, Directors generally saw continued implementation of inflation targeting as a sound anchor for monetary policy during the pre-euro period. They welcomed the authorities' gradual approach toward monetary integration, with emphasis on the need for further up-front progress on fiscal consolidation and structural reform.

Directors welcomed the continued improvement in the broad indicators of banking sector health. They commended the authorities' improved risk analysis, but stressed the need for enhanced supervisory capacity in the area of household credit, including through the collection of relevant data and enhanced stress-testing. Directors welcomed the planned consolidation of financial sector supervision within a single institution, but cautioned that organizational changes should not distract them from effective oversight.

Directors commended the Czech Republic's commitment to transparency and standards, as evident most recently from its participation in an update of the fiscal transparency module. They also welcomed the progress made by the authorities in aligning their national accounts and financial sector statistics with European standards.


Czech Republic: Selected Economic and Financial Indicators, 2001-03


 

2001

2002

2003


Real economy (change in percent)

     

    Real GDP

2.6

1.5

3.1

    Domestic demand

3.9

3.4

4.5

    CPI (year average)

4.7

1.8

0.1

    PPI (year average)

2.9

-0.5

-0.3

    Unemployment rate (year average in percent)

     

        Survey based 1/

8.1

7.3

7.8

        Registered 1/

8.5

9.2

9.9

    Gross national savings (percent of GDP)

23.5

22.3

21.4

    Gross domestic investments (percent of GDP)

28.9

27.9

27.6

       

Public finance (percent of GDP)

     

    General government revenue

36.7

37.5

38.9

    General government expenditure 2/

41.7

44.2

45.1

    General government balance 2/

-5.0

-6.7

-6.2

        Adjusted to exclude grants to transformation
        institutions to cover costs related to
        management of bad assets

-2.8

-4.0

-4.9

        Adjusted balance excluding net lending 3/

-2.7

-3.7

-3.9

    General government debt

17.5

18.4

21.9

        Including debt of the Czech Consolidation
        Agency

22.9

25.5

27.9

       

Money and credit (end of year, percent change)

     

    Broad money

13.0

3.5

6.9

    Private sector credit (percent change, eop)

2.1

4.5

8.5

       

Interest rates (in percent)

     

    Three-month interbank rate (end-of-period)

4.7

2.6

2.1

    10-year government bond

6.3

4.9

4.1

       

Balance of payments (percent of GDP)

     

    Trade balance

-5.0

-3.0

-2.7

    Current account

-5.4

-5.6

-6.2

    Gross international reserves (US$ billion)

14.5

23.7

27.0

    Reserve cover (in months of imports of
    goods and services)

4.1

6.1

5.5

       

Fund position (as of May 31, 2004)

     

    Holdings of currency (percent of quota)

   

61.9

    Holdings of SDRs (percent of allocation)

   

n.a.

    Quota (millions of SDRs)

   

819.3

       

Exchange rate

     

    Exchange rate regime

   

Managed float

    Koruna per U.S. dollar (July 19, 2004)

   

CZK25.12=US$1

        Nominal effective exchange rate
        (2000=100)

104.4

116.1

115.6

        Real effective exchange rate (CPI-based;
        2000=100)

105.5

116.7

112.6


Sources: Czech Statistical Office; Czech National Bank; Ministry of Finance; and IMF staff projections.

1/ In percent of total labor force.
2/ Excluding privatization revenues of the National Property Fund and the Czech Land Fund, the sale of shares and voting rights by local governments, and the sale of Russian debt.
3/ General government deficit excluding transfer to transformation institutions and net lending. Concept targeted by the authorities.


1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities and this PIN summarizes the views of the Executive Board.




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