IMF Executive Board Concludes 2010 Article IV Consultation with Czech RepublicPublic Information Notice (PIN) No. 10/36
March 2, 2010
On February 22, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Czech Republic.1
The Czech economy’s fundamentals were strong prior to the global economic and financial crisis. Nevertheless, due to its highly open nature, the economy was hit by spillover effects. A downturn in the euro area depressed exports, while investment declined due to a drop in FDI and the tightening of banks’ lending standards. Monetary and fiscal easing provided helpful stimulus, thereby cushioning the economic downturn. Between August 2008 and December 2009 the Czech National Bank cut the policy rate by 275 basis points, while automatic stabilizers and fiscal measures widened the budget deficit by 4 percent of GDP in 2009. The real output decline is estimated to be 4⅓ percent in 2009.
The recovery of the Czech economy is expected to be gradual. GDP is projected to grow by 1½ percent in 2010, supported by exports and a buildup of inventories, while fixed capital formation will remain depressed and consumer spending is expected to decline reflecting still-rising unemployment, a slowdown in wage growth, and the unwinding of fiscal stimulus. Furthermore, the adverse effects of the crisis are likely to be long lasting. A collapse in investment and slowdown in total factor productivity growth reduced dramatically the output growth rate in 2009–10, and over the medium-term growth is not expected to reach pre-crisis levels. Risks to the short-term outlook seem balanced.
The tax hikes approved as part of the 2010 budget are expected to push average headline inflation to over 1½ percent in 2010, but still below the target of 2 percent. The external position remains solid, as the drop in exports has been accompanied by an even larger fall in imports, thus improving the trade balance despite the real appreciation.
Credit to the economy has decelerated dramatically reflecting both unfavorable investment sentiment and tighter credit conditions. Household credit, however, continued its double-digit growth and mortgage lending has performed relatively well. Overall, the banking sector weathered the turmoil relatively well, owing to healthy capital and liquidity buffers, strong retail funding, and limited exposure to foreign currency risk. This helped avoid the need to implement bank recapitalization from public funds or use other exceptional measures to shore up financial sector stability.
Executive Board Assessment
The Executive Directors noted that the Czech Republic entered the crisis from a strong macroeconomic position, bolstered by integration with the EU and sound policies. However, spillover effects have taken their toll on the highly open Czech economy.
Directors viewed the authorities’ policy response to the crisis—monetary and fiscal easing—as appropriate. The external position remains robust and the real exchange rate is in line with fundamentals. The banking sector has weathered the global financial turmoil relatively well without the need for the authorities to undertake bank recapitalization or other exceptional measures to shore up financial sector stability.
Directors expected that the revival of the Czech economy would be gradual and dependent on the global recovery, supported by exports and a buildup of inventories. They considered that the supportive monetary policy stance remains appropriate for now, but should shift to tightening as the recovery gathers momentum.
Directors agreed that the main challenge for the authorities will be to reverse the recent widening of budget deficits in a sustainable manner. They viewed the 2010 budget as appropriately balancing the objectives of attaining fiscal sustainability and supporting economic recovery, and cautioned against any additional spending prior to the May general elections. The new government will need to propose a credible and durable plan for medium-term fiscal consolidation in order to achieve debt sustainability, including in light of spending pressures from population aging. The new plan should draw and expand on the recently approved Convergence Program. A number of Directors called for greater focus on expenditure reductions than in the past, including measures to improve the efficiency of public services. Directors supported the need to cut expenditures, in particular mandatory spending, as well as to expand the tax base, unify VAT rates, and improve tax administration. While Directors viewed reconsidering the Corporate Income Tax (CIT) rate as a possibility, a number of Directors did not favor raising it. It will also be crucial to tackle the longer-term fiscal challenges of pension and health care reforms, which will need a broad political consensus. Improved monitoring of budget execution will be important.
Directors considered that the adverse effects of the crisis are likely to be long lasting, and that growth is not expected to reach pre-crisis levels owing to the abating convergence process and worsening demographic trends. They called for swift implementation of growth-enhancing structural reforms to increase productivity and labor participation, and to improve the business climate.
Directors noted that capital markets development has been hampered by poorly-targeted subsidies, tax exemptions on certain savings products, and old regulations regarding private pension funds, and suggested that further measures be taken to support the smooth functioning of these markets.
Directors considered that further improvements in cost efficiency would become key for Czech banks as the economic downturn affects banking sector profitability, and encouraged the authorities to closely monitor developments. Still, Directors thought that banks' soundness, low loan-to-deposit ratio, and parent banks' commitment to the market bode well for banks’ ability to resume lending as the economic outlook improves.
Directors welcomed the strengthening of the financial supervisory and prudential framework through an array of remedial measures, and expressed support for the Czech National Bank’s continued efforts to improve and enhance the integration of macro-prudential analysis and supervision activity. Given the virtually complete foreign ownership of banks, intensive cross-border supervisory coordination remains crucial.