## 1. Financial Market Developments Since the Removal of the Exchange Rate Floor

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### Financial market developments and recent developments
- Koruna:euro exchange floor removed in April 2017.
  - Koruna appreciated by 1½ percent on the day and by a further 1 percent subsequently.
  - Forward rates indicate markets expect appreciation of another 0.2 percent by end-year.
  - Since removal of the floor, nominal exchange rate appreciated by 2½ percent.
  - CNB’s balance sheet is smaller than in April 2017.
- Capital inflows and reserves:
  - Inflows during January–March amounted to 8 percent of GDP per month.
  - Stock of foreign exchange reserves reached around 70 percent of GDP.
- Growth, inflation, and labor market:
  - Real GDP estimated to have grown by 2.4 percent in 2016.
  - Staff estimates the output gap to be slightly positive.
  - Headline inflation at 2 percent (April); core inflation at 2.4 percent.
  - Import prices rising by 5.8 percent in February; domestic industrial producer prices growing for the first time since December 2013.
  - Unemployment reached 3.3 percent in April.
  - Wages grew by 5.3 percent in Q1:2017; minimum wage increase contributed.
  - Vacancies are high; businesses report rising labor shortages.
- Credit and real estate:
  - Private credit expanding quickly, ahead of nominal incomes for a second year.
  - Real estate activities account for around 65 percent of growth in non-financial corporate loans.
  - Mortgages strongest in household lending growth; consumer credit also expanding rapidly.
- Public finances:
  - Surplus of 0.6 percent of GDP in 2016.
  - General government debt declined to just above 37 percent of GDP.
- External sector:
  - Current account balance 1.1 percent of GDP in 2016; net exports 7.5 percent of GDP.
  - Primary income deficit 5.8 percent of GDP due to inward FDI.
  - NIIP improved to -25 percent of GDP; NIIP without official reserves at -72 percent of GDP, with 53 percentage points from FDI.
  - Staff estimates exchange rate remains moderately undervalued: undervaluation of about 4 percent (Annex I).
- External environment: broadly favorable with strong demand from trading partners and stabilizing oil prices.

### Projections and risks (baseline and comparative forecasts)
- Baseline projections:
  - Real GDP growth projected to increase to 3 percent in 2017.
  - Inflation projected to increase to 2.3 percent in 2017 (from 0.7 percent in 2016).
  - Exchange rate assumed to appreciate moderately, followed by gradual policy rate increases.
  - Inflation projected to return to target in 2019.
- Forecast comparisons (selected exact values):
  - IMF 2017: GDP 3.0; 2018: 2.4; Inflation 2017: 2.3; 2018: 1.8; Budget balance 2017: 0.4; 2018: 0.5.
  - CNB 2017: GDP 2.9; 2018: 2.8; Inflation 2017: 2.5; 2018: 2.0; Budget balance 2017: 1.1; 2018: 1.1.
  - MoF 2017: GDP 2.5; 2018: 2.5; Inflation 2017: 2.4; 2018: 1.7; Budget balance 2017: 0.4; 2018: 0.3.
- Risks (RAM):
  - Domestic: erratic exchange rate from unwinding speculative positions; uncertainty about sustainable growth rate and labor productivity amid a shrinking workforce; potential policy changes after elections.
  - External: weaker/stronger-than-expected trading-partner demand; increased protectionism; medium-term investment sensitive to EU budget changes; higher global interest rates raising returns to foreign investment.
  - RAM entries include likelihoods and policy responses (see Annex III).

### Monetary policy (CNB): actions and staff assessment
- CNB actions:
  - Removed the koruna:euro floor and resumed repo tenders to pursue 2 percent inflation target.
  - At removal (April 6), CNB ready to intervene against “excessive” exchange rate fluctuations, including “excessive appreciation”.
  - CNB indicated removal should be followed by gradual interest rate increases; negative interest rates could be used in exceptional circumstances.
  - CNB will wait for koruna to find new equilibrium before increasing interest rates.
- Staff assessment and recommendations:
  - Removal appropriate given: inflation at target, fading external deflationary pressures, real exchange rate moderately undervalued, economy slightly above capacity, tight labor markets, high credit growth.
  - Recommend gradual, data-driven interest rate increases; allow exchange rate to find its value.
  - FX intervention (FXI) caution: moderate intervention valid if market conditions disorderly, but FXI should not counter structural exchange rate moves.
  - Gradualism rationale: avoid rapid tightening that could accelerate appreciation and cause sharp output and inflation falls given policy rates near effective zero bound.
- CNB reserves and balance sheet losses:
  - Absent further interventions, a nominal annual appreciation of 3 percent would imply an annual balance sheet loss of 2 percent of GDP.
  - CNB law allows retention of up to 100 percent of any year’s surplus to replenish reserves; legislation does not provide for recapitalization in case of capital shortfalls.

### Macroprudential policy: credit, housing, and recommendations
- Credit dynamics (aggregate loan growth, end of period, y/y, 2016 figures from CNB FSR 2016):
  - Total 2016: 6.9
  - Non-financial corporations 2016: 8.5
  - Real estate activity (NACE L) 2016: 12.7
  - Households 2016: 8.2
  - Loans for house purchase 2016: 7.8
  - Consumer credit 2016: 9.7
- Observations:
  - Credit growth outpacing trend nominal incomes; lending standards loosening for households and NFCs; some recent tightening for housing loans but mortgage growth remains strong.
  - Unsecured consumer credit accelerating, raising leakage concerns if mortgage LTV recommendations tightened.
  - Apartment prices rose by 15 percent year-on-year in 2016 in residential property discussion.
  - House prices escalated quickly since 2012 in Prague and outside; price-to-income and price-to-rent ratios do not yet show unusually high levels, but data gaps exist.
  - Significant share of mortgages originated via brokers; some banks report >50 percent broker-originated mortgages.
  - Variation across banks in LTI ratios; some banks extend majority of new mortgages at LTI > 5.
- CNB toolkit and legal powers:
  - CNB has issued and tightened recommendations on maximum LTV ratios and on share of mortgages above certain LTV thresholds each quarter.
  - New consumer law requires credit providers to test loan affordability.
  - CNB lacks powers to set legally binding LTV, DTI, and DSTI limits (recommendations only).
- Staff policy recommendations:
  - Give CNB powers to limit LTV, DTI, and DSTI ratios; legislation under review should be enacted quickly without dilution.
  - If data limitations slow debt limits implementation, introduce loan-to-income limits first.
  - Complement debt limits with improved household balance-sheet data; require all credit providers to participate in and access reliable data on household debt levels and interest payments.
  - Address tax, lender, and supply-side distortions with supervisory, fiscal, and structural initiatives to support macroprudential measures.
- Authorities broadly agree on need for additional macroprudential measures and favor making LTV recommendations legally binding and endowing CNB with mandate to set DSTI and DTI limits.

### Financial policy and banking sector stability
- Banking system metrics and trends:
  - Aggregate capital ratios above requirements; leverage low; liquidity high.
  - Banks funded mainly from deposits.
  - Return on assets and return on equity high relative to CEE peers and Western Europe (ROE reached 17.9 percent; ROA 1.3 percent in 2016).
  - Non-performing loans low and decreasing; NPL ratio declined by 0.7 percentage points to 3.7 percent.
  - Loan-to-deposit ratios increasing but below 100 percent for system as a whole.
  - Maturity of deposits shortened but not excessively.
  - FX lending: foreign currency loans to households almost negligible; FX loans to non-financial corporates around 30 percent of NFC loans (almost entirely in euros).
- Risks from removal of koruna floor:
  - Capital outflows: rising share of foreign-sourced deposits could trigger deposit withdrawals; large outflows could depress government security prices affecting bank balance sheets.
  - Interest rate risk: rise in world interest rates could raise wholesale funding costs but banks predominantly deposit-funded.
  - FX exposures: corporate euro-denominated FX lending could be problematic if firms lack euro revenues.
- Prudential measures and supervision:
  - Capital conservation buffer fully implemented; countercyclical capital buffer set to 0.5 percent of risk-weighted exposure amounts (from 2017).
  - Buffers activated for five systemically-important banks.
  - Consumer credit law (late 2016) requires mortgage brokers to obtain CNB permit.
  - BRRD transposed into Czech law in 2016; CNB designated resolution authority, developing resolution plans and calibrating MREL.
- Staff recommendations:
  - Continue vigilance: bottom-up stress tests with full bank sample and 3-year horizon welcomed.
  - Increase frequency of on-site inspections (current upper limit: 3 years for large banks, up to 5 years for others).
  - Improve granular data availability (real estate and household debt).
  - Monitor rapid growth in FX lending to corporates, especially where no euro revenue hedging.
- Authorities’ views:
  - Broad agreement on risks; noted tightened capital requirements, supervisory scope to influence banks bilaterally, leverage ratio of 3 percent effective in 2020.
  - FX lending growth partly due to hedging by exporters; need for clarity from European authorities on MREL and discretion to adapt MREL locally; resolution point-of-entry to differ across banks by business model.

### Structural reform priorities
- Long-term challenges:
  - Productivity growth has slowed; labor market mismatches increasing.
  - Workforce growth expected to decline due to demographics and limited inward migration; higher dependency ratio projected.
  - High dependence on cost-competitive manufacturing; expected real exchange rate appreciation over long term.
  - Public infrastructure coverage and quality suboptimal; production concentrated in limited manufacturing subsectors.
- Policy priorities and recommended initiatives:
  - Labor market incentives:
    - Reduce relatively high tax wedge and marginal tax disincentives to enter workforce.
    - Address low participation of women with small children via childcare support, part-time work flexibility, and tax incentives.
    - Deter early retirement; strengthen vocational training, apprenticeships, in-work and life-long learning schemes.
  - Regulatory environment:
    - Simplify and reduce complexity of regulatory procedures (planning and building permits).
    - Minimize administrative burdens for start-ups; improve predictability of regulatory environment.
  - Infrastructure, connectivity and innovation:
    - Improve EU funds absorption efficiency to address infrastructure needs.
    - Increase investment in R&D; consider well-designed tax incentives for R&D and higher co-financing shares.
- Authorities’ actions:
  - National spending on R&D stepped up; new international peer-review system for R&D spending evaluation.
  - Measures to support working parents (micro-nurseries support, shortening parental allowance drawing period, abolishing preschool facility use limits).
  - New digital literacy strategy, retraining system revisions, Work 4.0 plan to upgrade skills.
  - Transparency and speed improvements via online government services and public procurement reforms.

### Fiscal policy, outlook, and composition
- Fiscal framework and legal changes:
  - New fiscal law (January 2017) establishes independent fiscal council and independent expert committee for forecasts.
  - Fiscal rules include:
    - Structural balance rule with limit of -1 percent of GDP.
    - Debt brake rule capping general government debt net of cash reserves at 55 percent of GDP.
    - 60 percent debt:revenue limit for local government.
  - Escape clauses for severe downturns, natural disasters, or emergency provide flexibility.
- Fiscal stance and projections:
  - Mild fiscal easing in 2017 appropriate.
  - Projected surplus of 0.4 percent of GDP for 2017 implies a fiscal impulse of 0.3 percent of GDP.
  - On current policies, small surpluses projected over medium term leading to declining debt.
  - If cautious spending policies and improved tax collection persist, public debt could reach around 26 percent of GDP by 2022.
- Fiscal outlook and key statistics (selected exact figures, multiple-year series)
  - Net lending/borrowing (overall balance) (selected years): -3.9 (2012), -1.2 (2013), -1.9 (2014), -0.6 (2015), 0.6 (2016), 0.4 (2017), 0.5 (2018), 0.6 (2019), 0.5 (2020), 0.5 (2021), 0.5 (Proj. 2022).
  - Net lending/borrowing (excl. revenues from EU): -5.2 (2012), -2.5 (2013), -3.4 (2014), -2.9 (2015), 0.0 (2016), -0.5 (2017), -0.6 (2018), -0.5 (2019), -0.6 (2020), -0.3 (2021), -0.3 (Proj. 2022).
  - Primary balance: -2.8 (2012), -0.2 (2013), -0.8 (2014), 0.3 (2015), 1.4 (2016), 1.2 (2017), 1.2 (2018), 1.2 (2019), 1.1 (2020), 1.1 (2021), 1.0 (Proj. 2022).
  - Structural balance: -1.5 (2012), 0.1 (2013), -0.9 (2014), -0.6 (2015), 0.5 (2016), 0.2 (2017), 0.3 (2018), 0.4 (2019), 0.4 (2020), 0.4 (2021), 0.5 (Proj. 2022).
  - Public debt (Percent of GDP): 44.5 (2012), 44.9 (2013), 42.2 (2014), 40.3 (2015), 37.2 (2016), 35.2 (2017), 33.2 (2018), 31.2 (2019), 29.4 (2020), 27.7 (2021), 26.1 (Proj. 2022).
  - Investment (percent of GDP): 25.9 (2012), 25.1 (2013), 25.1 (2014), 26.3 (2015), 24.6 (2016), 24.9 (2017), 25.0 (2018), 25.1 (2019), 25.2 (2020), 25.5 (2021), 25.8 (Proj. 2022).
  - Staff estimate: primary balance consistent with constant debt in perpetuity (at 2016 debt ratio of 37.2 percent of GDP) = -0.6 percent of GDP.
- Long-term demands on public finances:
  - Healthcare: provider inefficiencies; Czech Republic has the third highest number of annual doctor consultations per capita in the OECD; movement toward diagnosis-related groups started but slow.
  - Pensions: pension account balance projected to be around -2 percent of GDP by 2060; with revision mechanism strictly obeyed, pension spending would increase from 8.5 percent of GDP in 2017 to 10.1 percent of GDP in 2060; if statutory retirement age capped at 65, pension spending will increase to 11.2 percent of GDP.
  - Infrastructure: below EU average; Czech Republic ranks 21st across the EU for the quality of its road network.
- Fiscal policy recommendations:
  - Prioritize raising growth potential via modestly higher investment in physical and human capital rather than sizeable short-term stimulus.
  - Use surpluses to finance infrastructure and skills, mindful of uncertainty about future revenues and EU funds availability after 2020.
  - Health: introduce means-tested co-payments; introduce soft gate-keeping measures; streamline provider networks and reduce pharmaceutical costs.
  - Pensions: agree with gradual raising of the retirement age; refrain from frequent ad hoc pension adjustments; legislate pension indexation.
  - Public investment and administration: establish unified long-horizon infrastructure plan; review framework using IMF’s PIMA tool; increase processing ability and auditing capacity.

### Public debt sustainability (Annex V): baseline, shocks, and key figures
- Executive summary:
  - Public debt declined to 37.2 percent of GDP in 2016.
  - Staff projections: public debt projected to decline to 26 percent of GDP in 5 years, assuming Convergence Program targets met and growth continues.
  - Gross financing needs projected to be 5.2 percent of GDP at the end of the projection period.
- Key statistics and projections (selected exact figures):
  - Nominal gross public debt: 36.4 (2015); 40.3 (2016); 37.2 (2017); 35.0 (2018); 33.1 (2019); 31.1 (2020); 29.4 (2021); 27.7 (2022); 26.0 (projection end).
  - Public gross financing needs: 7.3 (2015); 5.9 (2016); 4.5 (2017); 5.6 (2018); 7.3 (2019); 6.3 (2020); 4.7 (2021); 4.7 (2022); 5.2 (projection end).
  - Real GDP growth (in percent): 1.8 (2015); 4.5 (2016); 2.4 (2017); 3.0 (2018); 2.4 (2019); 2.3 (2020); 2.3 (2021); 2.3 (2022).
  - Inflation (GDP deflator, in percent): 1.4 (2015); 1.0 (2016); 1.1 (2017); 1.3 (2018); 1.6 (2019); 1.8 (2020); 1.7 (2021); 1.7 (2022).
  - Effective interest rate (in percent): 3.7 (2015); 2.7 (2016); 2.4 (2017); 2.5 (2018); 2.7 (2019); 3.1 (2020); 3.6 (2021); 3.9 (2022); 4.3 (later).
- Shock and stress tests:
  - Real GDP growth shock (1 standard deviation = 3.0 percentage point decline for 2 years) leads to public debt rising to 38.7 percent of GDP and gross financing needs to 10.8 percent of GDP by 2019; thereafter debt declines to 34.8 percent by 2022 and gross financing needs fall to 7.1 percent.
  - Interest rate shock (nominal rate increases by 367 basis points) still results in debt continuing to fall, to 29.3 percent of GDP by 2022.
  - Other shocks (including exchange rate shocks) are not as important for debt dynamics as the growth shock.
- Debt management recommendations:
  - Move from a 3-year horizon to a medium-term strategy minimizing costs for an acceptable level of risk; consider operational independence.
  - Target average debt maturity of 6 years by 2018 recommended; actual maturities have shortened to under 5 years.
  - Accept higher funding costs to avoid concentration of issuance and keep refinancing risks under control.
  - 12 percent of state debt currently exposed to foreign exchange risk; review FX risk management and hedging costs.

### External balances, competitiveness, and trade concentration (Annex I & II)
- External position and exchange rate:
  - External position moderately stronger than level consistent with medium-term fundamentals.
  - Staff evaluates REER to be moderately undervalued, likely to appreciate over the medium term; implied undervaluation about -4 percent (CA model).
  - REER model shows large overvaluation (17 percent) but staff considers this problematic; External Sustainability approach indicates moderate undervaluation by 4 percent.
  - A moderate real appreciation, especially in ULC terms, has been taking place in 2016, driven by higher wage bill and slowing productivity.
- Current account and financial account:
  - Current account surplus in 2016 reflects declining imports and slowdown of EU funds absorption.
  - External debt estimated at 75 percent of GDP in 2016, mostly long-term and concentrated in “other sector”.
  - Share of short-term debt increasing, mainly due to the increase in foreign-sourced deposits.
- Trade concentration (Annex II):
  - Exports are 80 percent of GDP.
  - More than 55 percent of exports concentrated in transportation and machinery and electrical products (combined account for more than 50 percent of total exports).
  - Between 2010 and 2015 export growth driven largely by intensive margin (higher exports of existing products to existing markets).
  - Export sophistication increasing (EXPY measure).

### Capital inflows and financial sector balance sheet linkages (Annex VII)
- From November 2013 to March 2017, reserves increased by CZK 2,072 bn.
  - Around 80 percent of this increase can be accounted for via the financial account.
  - Approximately 40 percent of the increase can be accounted for via net inflows in the form of “Other investments”.
  - Foreign inflows of “Other investments” increased by CZK 1,018 bn.
  - Domestic outflows decreased by CZK 42 bn.
- Financial sector balance sheet linkages:
  - Accumulative inflow of “Other investments” matched with increase in “Loans and deposits of non-residents” on liability side of Czech banks.
  - Increase in bank liabilities to non-residents associated with increase in bank deposits with the central bank.
  - Increase in foreign reserves on central bank asset side associated with increase in deposits of commercial banks at the central bank.

### Risk Assessment Matrix (selected entries, Annex III)
- Retreat from cross-border integration:
  - Likelihood: High; Time horizon: Short to Medium Term; Expected impact: Medium; Policy response: A temporary easing bias would be appropriate.
- Policy and geopolitical uncertainties:
  - Likelihood: High; Time horizon: Short to medium term; Expected impact: High; Policy response: Maintain accommodative monetary conditions, while loosening fiscal stance.
- Financial conditions risk (stronger US dollar/higher rates; European bank distress):
  - Likelihood: High; Time horizon: Short Term; Expected impact: Medium/Low; Policy response: Maintain accommodative monetary conditions; Czech banking system is well capitalized, liquid, and profitable.
- Economy’s adjustment to FX floor exit:
  - Likelihood: Medium; Time horizon: Short Term; Expected impact: High; Policy response: Gradual approach in setting policy interest rates.

### Staff appraisal (summary) and procedural recommendation
- Macro context: Growth solid, unemployment low, public finances in good condition, exit from exchange rate floor smooth, banking system liquid and profitable.
- Key vulnerabilities:
  - Household financial vulnerabilities increasing (high borrowing for house purchases relative to incomes).
  - Labor shortages, especially skilled labor; medium-term growth risk due to shrinking workforce and productivity slowdown.
  - Real exchange rate moderately undervalued and likely to appreciate over the medium term.
- Principal policy prescriptions:
  - Monetary: gradual, data-guided policy rate increases; FX interventions only in cases of severe volatility.
  - Macroprudential/financial: give CNB binding powers over LTV, DTI, and DSTI ratios; monitor lending standards amid accelerating credit growth.
  - Structural: revise labor market incentives to boost labor supply and quality; invest in physical and digital infrastructure; improve regulatory environment.
  - Fiscal: prioritize investment in physical and human capital; establish unified long-horizon infrastructure plan; debt management to focus on minimizing costs and risks.
- Procedural recommendation: next Article IV consultation recommended on the standard 12-month cycle.

*Source: IMF staff report: Czech Republic (cr17168), selected excerpts.*

### 1. Financial Market Developments Since the Removal of the Exchange Rate Floor ________________ 6

### 1. Financial Market Developments Since the Removal of the Exchange Rate Floor ________________ 6

### Financial market developments
- Section title: "1. Financial Market Developments Since the Removal of the Exchange Rate Floor"
- Location in source: page 6

### The period of the koruna:Euro floor
- Section title: "2. The Period of the Koruna:Euro Floor"
- Location in source: page 7

### Inflation and capacity
- Section title: "3. Inflation and Capacity"
- Location in source: page 8

### Competitiveness
- Section title: "4. Competitiveness"
- Location in source: page 10

### Near-term growth momentum
- Section title: "5. Near-Term Growth Momentum"
- Location in source: page 11

### Credit markets
- Section title: "6. Credit Markets"
- Location in source: page 16

### Housing market
- Section title: "7. Housing Market"
- Location in source: page 19

### The economy in transition
- Section title: "8. The Economy in Transition"
- Location in source: page 23

### Demographics in the labor market
- Section title: "9. Demographics in the Labor Market"
- Location in source: page 24

### Regulation
- Section title: "10. Regulation"
- Location in source: page 27

### Infrastructure and innovation
- Section title: "11. Infrastructure and Innovation"
- Location in source: page 28

### Revenue and expenditure
- Section title: "12. Revenue and Expenditure"
- Location in source: page 33

### Health care
- Section title: "13. Health Care"
- Location in source: page 34

*Source: cr17168 - 1. Financial Market Developments Since the Removal of the Exchange Rate Floor (PDF), pages 6–40.*

### 5. Financial Soundness Indicators, 2010–16 ______________________________________________________ 41

### 5. Financial Soundness Indicators, 2010–16

### Context
- The Czech economy is doing well overall: growth is solid and income inequality is low relative to peers.1
- Employment is high and the unemployment rate low.
- After falling to zero during the past two years, CPI inflation is back toward the target level, matched by strong nominal income growth.
- Public finances are in very good condition; the banking system is liquid and profitable.
- Three policy-motivating challenges:
  - Transition from the koruna floor (CNB exchange-rate floor November 2013–April 2017): optimal interest rate path to avoid overheating and response to exchange rate volatility.
  - Credit and real estate: strong credit and real estate price growth; rising household debt with some high leverage and income multiples.
  - Long-term transition: relatively high investment share in GDP but low workforce growth and slowing productivity; expected real exchange rate appreciation challenges cost-competitive manufacturing.
- National elections scheduled for 2017 and 2018 (current government a coalition of three parties; general elections in October; presidential elections early 2018).

### Recent developments
- Koruna:euro exchange floor removed in April 2017.
  - Koruna appreciated by 1½ percent on the day and by a further 1 percent subsequently.
  - Forward rates indicate markets expect appreciation of another 0.2 percent by end-year.
  - Sovereign yield curve shifted up, more so at the short end.
  - CNB’s balance sheet is smaller than in April 2017.
- Capital inflows accelerated in the run-up to exit from the floor.
  - Inflows during January–March amounted to 8 percent of GDP per month.
  - Stock of foreign exchange reserves reached around 70 percent of GDP.
- Growth and inflation:
  - Real GDP estimated to have grown by 2.4 percent in 2016.
  - Staff estimates the output gap to be slightly positive.
  - Headline inflation at 2 percent (April); core inflation at 2.4 percent.
  - Import prices rising by 5.8 percent in February; domestic industrial producer prices growing for the first time since December 2013.
- Labor market:
  - Unemployment reached 3.3 percent in April.
  - Wages grew by 5.3 percent in Q1:2017; minimum wage increase contributed.
  - Vacancies are high; businesses report rising labor shortages.
- Credit and real estate:
  - Private credit expanding quickly, ahead of nominal incomes for a second year.
  - Real estate activities account for around 65 percent of growth in non-financial corporate loans.
  - Mortgages strongest in household lending growth; consumer credit also expanding rapidly.
- Public finances:
  - Surplus of 0.6 percent of GDP in 2016 (mainly stronger tax revenues, higher social security contributions, and capital underspending).
  - General government debt declined to just above 37 percent of GDP.
- External sector and exchange rate:
  - Current account balance 1.1 percent of GDP in 2016; net exports 7.5 percent of GDP.
  - Primary income deficit 5.8 percent of GDP due to inward FDI.
  - NIIP improved to -25 percent of GDP; NIIP without official reserves at -72 percent of GDP, with 53 percentage points from FDI.
  - Staff estimates exchange rate remains moderately undervalued: undervaluation of about 4 percent (Annex I).
  - Since removal of the floor, nominal exchange rate appreciated by 2½ percent.
- External environment broadly favorable: strong demand from trading partners; fading external deflationary pressures; oil price stabilization.

### Projections and Risks
- Baseline projections:
  - Real GDP growth projected to increase to 3 percent in 2017 (mainly domestic demand).
  - Inflation projected to increase to 2.3 percent in 2017 (from 0.7 percent in 2016).
  - Exchange rate assumed to appreciate moderately, followed by gradual policy rate increases.
  - Growth expected to decelerate in 2018 and converge to potential in medium term; inflation projected to return to target in 2019.
- Forecast comparisons (selected):
  - IMF 2017: GDP 3.0; 2018: 2.4; Inflation 2017: 2.3; 2018: 1.8; Budget balance 2017: 0.4; 2018: 0.5.
  - CNB 2017: GDP 2.9; 2018: 2.8; Inflation 2017: 2.5; 2018: 2.0; Budget balance 2017: 1.1; 2018: 1.1.
  - MoF 2017: GDP 2.5; 2018: 2.5; Inflation 2017: 2.4; 2018: 1.7; Budget balance 2017: 0.4; 2018: 0.3.
- Risks (RAM p.47): roughly balanced.
  - Domestic: erratic exchange rate from unwinding speculative positions; uncertainty about sustainable growth rate and labor productivity amid a shrinking workforce; potential policy changes after elections.
  - External: weaker/stronger-than-expected trading-partner demand; increased protectionism as downside risk; medium-term investment sensitive to EU budget changes; higher global interest rates raising returns to foreign investment.

### A. Monetary policy (CNB)
- CNB removed the koruna:euro floor and resumed repo tenders to pursue 2 percent inflation target.
  - At removal (April 6), CNB ready to intervene against “excessive” exchange rate fluctuations, including “excessive appreciation”.
  - CNB indicated removal should be followed by gradual interest rate increases; negative interest rates could be used in exceptional circumstances.
  - CNB will wait for koruna to find new equilibrium before increasing interest rates.
- Staff assessment:
  - Removal appropriate: inflation at target, fading external deflationary pressures, real exchange rate moderately undervalued, economy slightly above capacity, tight labor markets, high credit growth.
  - Recommend gradual, data-driven interest rate increases; allow exchange rate to find its value.
  - FX intervention (FXI) caution: moderate intervention could be valid if market conditions become disorderly, but FXI should not counter structural exchange rate moves.
  - Gradualism rationale: avoid rapid tightening that could accelerate appreciation and cause sharp output and inflation falls given policy rates near effective zero bound.
- CNB reserves and balance sheet losses:
  - Absent further interventions, a nominal annual appreciation of 3 percent would imply an annual balance sheet loss of 2 percent of GDP.
  - CNB has historically operated independently with negative equity; law allows up to 100 percent of any year’s surplus to be retained to replenish reserves; legislation does not provide for recapitalization in case of capital shortfalls.

### B. Macroprudential policy
- Credit dynamics:
  - Aggregate loan growth (end of period, y/y): Total 2016: 6.9; Non-financial corporations 2016: 8.5; real estate activity (NACE L) 2016: 12.7; Households 2016: 8.2; loans for house purchase 2016: 7.8; consumer credit 2016: 9.7. (Note: 2016 is March 2016; source: CNB, Financial Stability Report 2016.)
  - Credit growth outpacing trend nominal incomes; lending standards loosening for households and NFCs; some recent tightening for housing loans but mortgage growth remains strong.
  - Unsecured consumer credit accelerating, raising leakage concerns if mortgage LTV recommendations tightened.
- Housing market:
  - House prices escalated quickly since 2012 in Prague and outside; price-to-income and price-to-rent ratios do not yet show unusually high levels, but data gaps (no aggregate commercial real estate price index publicly available).
  - Household net worth rebounded since 2009 but household debt increasing rapidly.
  - Significant share of households borrowing large amounts and at high LTI ratios.
  - Construction output declined after the global financial crisis and has not recovered sufficiently; permit processes long and complex, constraining supply responsiveness.
- CNB macroprudential toolkit and recommendations:
  - CNB has issued and tightened recommendations on maximum LTV ratios and on share of mortgages above certain LTV thresholds each quarter.
  - New consumer law requires credit providers to test loan affordability.
  - CNB lacks powers to set legally binding LTV, DTI, and DSTI limits (powers currently recommendations only).
- Staff policy recommendations:
  - Give CNB powers to limit LTV, DTI, and DSTI ratios; legislation under review should be enacted quickly without dilution.
  - If data limitations slow debt limits implementation, introduce loan-to-income limits first.
  - Complement debt limits with improved household balance-sheet data; require all credit providers to participate in and access reliable data on household debt levels and interest payments (importance given mortgage brokers’ role).
  - Address tax, lender, and supply-side distortions with supervisory, fiscal, and structural initiatives to support macroprudential measures.
- Authorities broadly agree on risks and need for additional macroprudential measures; they favor making LTV recommendations legally binding and endowing CNB with mandate to set DSTI and DTI limits.

### C. Financial policy and banking sector stability
- Banking system metrics:
  - Aggregate capital ratios above requirements; leverage low; liquidity high.
  - Banks funded mainly from deposits.
  - Return on assets and especially return on equity high relative to CEE peers and Western Europe.
  - Non-performing loans low and decreasing; provisioning in line with peers.
- System-wide vulnerabilities and trends:
  - Loan-to-deposit ratios increasing but below 100 percent for system as a whole.
  - Maturity of deposits shortened but not excessively.
  - Substantial share of mortgages originated via brokers (some banks report >50 percent), potentially weakening credit checks.
  - Variation across banks in LTI ratios; some banks extend majority of new mortgages at LTI > 5.
  - FX lending: foreign currency loans to households almost negligible; FX loans to non-financial corporates around 30 percent of NFC loans (almost entirely in euros).
  - Reported banks’ aggregate net open positions have increased.
- Risks from removal of koruna floor:
  - Capital outflows: rising share of foreign-sourced deposits could trigger deposit withdrawals; large outflows could depress government security prices affecting bank balance sheets. CNB stress tests (2016) find pension funds vulnerable to government bond price falls.
  - Interest rate risk: rise in world interest rates could raise wholesale funding costs but banks predominantly deposit-funded.
  - FX exposures: corporate euro-denominated FX lending could be problematic if firms lack euro revenues.
- Prudential measures and supervision:
  - Capital conservation buffer fully implemented; countercyclical capital buffer set to 0.5 percent of risk-weighted exposure amounts (from 2017).
  - Buffers activated for five systemically-important banks.
  - Consumer credit law (late 2016) requires mortgage brokers to obtain CNB permit.
  - BRRD transposed into Czech law in 2016; CNB designated resolution authority, developing resolution plans and calibrating MREL; European-level MREL decisions important.
- Staff recommendations:
  - Continue vigilance: bottom-up stress tests with full bank sample and 3-year horizon welcomed.
  - Increase frequency of on-site inspections (current upper limit: 3 years for large banks, up to 5 years for others).
  - Improve granular data availability (real estate and household debt).
  - Monitor rapid growth in FX lending to corporates, especially where no euro revenue hedging.
- Authorities’ views:
  - Broad agreement on risks to financial stability; emphasized tightened capital requirements, supervisory scope to influence banks bilaterally, leverage ratio of 3 percent effective in 2020.
  - Noted FX lending growth partly due to hedging by exporters; highlighted need for clarity from European authorities on MREL and discretion to adapt MREL locally; resolution point-of-entry to differ across banks by business model.

### D. Structural reform
- Long-term challenges:
  - Productivity growth has slowed; labor market mismatches increasing.
  - Workforce growth expected to decline due to demographics and limited inward migration; higher dependency ratio projected.
  - High dependence on cost-competitive manufacturing; expected real exchange rate appreciation over long term.
  - Public infrastructure coverage and quality suboptimal; production concentrated in limited manufacturing subsectors.
- Policy priorities and recommended initiatives:
  - Labor market incentives:
    - Reduce relatively high tax wedge and marginal tax disincentives to enter workforce.
    - Address low participation of women with small children via childcare support, part-time work flexibility, and tax incentives.
    - Deter early retirement; strengthen vocational training, apprenticeships, in-work and life-long learning schemes.
  - Regulatory environment:
    - Simplify and reduce complexity of regulatory procedures (planning and building permits).
    - Minimize administrative burdens for start-ups; improve predictability of regulatory environment.
  - Infrastructure, connectivity and innovation:
    - Improve EU funds absorption efficiency to address infrastructure needs.
    - Increase investment in R&D; consider well-designed tax incentives for R&D and higher co-financing shares.
- Authorities’ actions and views:
  - National spending on R&D stepped up; policy aims to stabilize funding.
  - New international peer-review system for R&D spending evaluation.
  - Measures to support working parents (micro-nurseries support, shortening parental allowance drawing period, abolishing preschool facility use limits).
  - New digital literacy strategy, retraining system revisions, Work 4.0 plan to upgrade skills.
  - Transparency and speed improvements via online government services and public procurement reforms.

### E. Fiscal policy
- Fiscal framework and legal changes:
  - New fiscal law (January 2017) establishes independent fiscal council and independent expert committee for forecasts; evaluates compliance with fiscal rules and long-term sustainability.
  - Fiscal rules include:
    - Structural balance rule with limit of -1 percent of GDP.
    - Debt brake rule capping general government debt net of cash reserves at 55 percent of GDP.
    - 60 percent debt:revenue limit for local government.
  - Penalties include retention of part of shared tax revenues of non-complying local government units; stricter requirements for entities if numerical rules ineffective.
  - Framework not embedded in constitutional law; escape clauses for severe downturns, natural disasters, or emergency provide flexibility.
- Fiscal stance and projections:
  - Mild fiscal easing in 2017 appropriate.
  - Projected surplus of 0.4 percent of GDP for 2017 implies a fiscal impulse of 0.3 percent of GDP.
  - On current policies, small surpluses projected over medium term leading to declining debt.
  - If cautious spending policies and improved tax collection persist, surpluses and steady nominal growth would bring public debt to around 26 percent of GDP by 2022 (Annex V: Debt Sustainability Analysis).
  - Net debt projected to decline.

*Source: IMF staff report material in "5. Financial Soundness Indicators, 2010–16" (chapter content provided).*

### 14.0 percent of GDP in 2022.

### cr17168 - 14.0 percent of GDP in 2022.

### Fiscal outlook and key statistics
- Net lending/borrowing (overall balance): -3.9 (2012), -1.2 (2013), -1.9 (2014), -0.6 (2015), 0.6 (2016), 0.4 (2017), 0.5 (2018), 0.6 (2019), 0.5 (2020), 0.5 (2021), 0.5 (Proj. 2022).
- Net lending/borrowing (excl. revenues from EU): -5.2 (2012), -2.5 (2013), -3.4 (2014), -2.9 (2015), 0.0 (2016), -0.5 (2017), -0.6 (2018), -0.5 (2019), -0.6 (2020), -0.3 (2021), -0.3 (Proj. 2022).
- Primary balance: -2.8 (2012), -0.2 (2013), -0.8 (2014), 0.3 (2015), 1.4 (2016), 1.2 (2017), 1.2 (2018), 1.2 (2019), 1.1 (2020), 1.1 (2021), 1.0 (Proj. 2022).
- Structural balance: -1.5 (2012), 0.1 (2013), -0.9 (2014), -0.6 (2015), 0.5 (2016), 0.2 (2017), 0.3 (2018), 0.4 (2019), 0.4 (2020), 0.4 (2021), 0.5 (Proj. 2022).
- Public debt (Percent of GDP): 44.5 (2012), 44.9 (2013), 42.2 (2014), 40.3 (2015), 37.2 (2016), 35.2 (2017), 33.2 (2018), 31.2 (2019), 29.4 (2020), 27.7 (2021), 26.1 (Proj. 2022).
- General government revenue (percent of GDP): 40.5 (2012) ... 41.1 (Proj. 2022).
- General government expenditure (percent of GDP): 44.5 (2012) ... 40.6 (Proj. 2022).
- Investment (percent of GDP): 25.9 (2012), 25.1 (2013), 25.1 (2014), 26.3 (2015), 24.6 (2016), 24.9 (2017), 25.0 (2018), 25.1 (2019), 25.2 (2020), 25.5 (2021), 25.8 (Proj. 2022).
- Staff estimate: primary balance consistent with constant debt in perpetuity (at 2016 debt ratio of 37.2 percent of GDP) = -0.6 percent of GDP.

### Long-term demands on public finances
- Healthcare
  - Current spending: "somewhat below the EU average" and projected to increase.
  - Institutional drivers of overconsumption: lack of any co-payment for outpatient care and lack of gate-keeping; Czech Republic has the third highest number of annual doctor consultations per capita in the OECD (Figure 13).
  - Provider inefficiencies: "Cost efficiency of hospitals is low"; movement toward diagnosis-related groups has started but progress is slow.
  - Health labor structure and outcomes (from Figure 13): high number of doctor consultations per capita; very high hospital discharges (2014); number of doctors above EU average; low ratio of nurses to physicians; high share of specialists; overall remuneration of doctors remains low.
- Pensions
  - Demographic pressure: pension account balance projected to be around -2 percent of GDP by 2060 (MoF and Ageing and Sustainability Working Group projections in the 2017 Convergence Program).
  - Policy change under consideration: introduction of a statutory retirement age limit of 65 years by 2030, subject to review at 5 year intervals; bill being considered in Parliament.
  - Ministry of Labor and Social Affairs projections: with the revision mechanism strictly obeyed, pension spending would increase from 8.5 percent of GDP in 2017 to 10.1 percent of GDP in 2060; if statutory retirement age is simply capped at 65, pension spending will increase to 11.2 percent of GDP.
- Infrastructure
  - Quantity and quality: below the EU average (Figure 11); Czech Republic ranks 21st across the EU for the quality of its road network.
  - Absorption of EU funds: last year’s absorption was even lower than expected, partly due to incompatibility of environmental impact assessment with revised EU standards; frequent changes of rules and methodology within national and EU control frameworks caused shortcomings in utilization of EU funds.
  - Coordination: responsibility for infrastructure planning and implementation is distributed across seven ministries; no single ministry responsible for coordinated planning across transport, energy, connectivity.

### Fiscal policy recommendations and composition
- Overall stance
  - Given relatively low public debt ratio and interest rates at historic lows, fiscal policy should prioritize raising growth potential via modestly higher investment in physical and human capital rather than pursue sizeable short-term stimulus.
  - Surpluses could be used to finance spending on infrastructure and skills rather than necessarily to reduce debt, but fiscal stance must account for uncertainty about future revenues and availability of EU funds financing after 2020.
- Health sector policy recommendations
  - Introduce means-tested co-payments to contain excess demand and pressure on the public healthcare system.
  - Introduce soft gate-keeping measures (e.g., requirement of referral from a general physician).
  - Streamline provider networks and reduce pharmaceutical costs.
- Pensions policy recommendations
  - Staff agrees with gradual raising of the retirement age.
  - Refrain from frequent and ad hoc pension adjustments beyond what is implied by the standard indexation formula.
  - Recommend legislating pension indexation to remove uncertainty in government and household budgets.
- Tax and expenditure composition
  - Better targeting of direct taxation and social security contributions could create extra room for public investment in infrastructure and skills and reduce tax distortions affecting the labor force.
  - Consider adjustments that boost potential output and maintain competitiveness (illustrated by the staff estimate of a -0.6 percent of GDP primary balance consistent with constant debt at 2016 debt ratio).
- Public investment and administration
  - Improve coordination: establish a unified and transparent long-horizon infrastructure plan (for example, an independent agency like the UK’s National Infrastructure Commission).
  - Review the infrastructure development framework using IMF’s PIMA tool to evaluate and enhance institutions across planning, allocation, and implementation.
  - Increase processing ability and auditing capacity in public sector management to reduce holdups in public administration, including increased spending if needed.

### Debt management recommendations and risks
- Current practice and recommended horizon
  - Debt management operates with only a 3-year horizon and places high weight on shorter-term outcomes; staff recommends pursuing a strategy of minimizing costs for an acceptable level of risk over the medium term and considering suitable operational independence to achieve such a strategy.
- Maturity and refinancing risk
  - Target for average debt maturity of 6 years by 2018 is modest; actual maturities have shortened to under 5 years.
  - Recommendation: accept higher funding costs to avoid concentration of issuance within a narrow maturity range and keep refinancing risks under control; lock in low rates for longer while opportunities remain (contingent on yield curve and risk management).
- Exchange rate and FX exposure
  - 12 percent of state debt is currently exposed to foreign exchange risk.
  - Recommendation: review policies on exchange rate risk management, assessing costs of issuance in foreign currencies and costs of hedging against risks; unhedged FX exposures leave government vulnerable to volatile and possibly increasing debt servicing costs.

### Authorities’ views
- Commitment to fiscal prudence under the recently approved fiscal responsibility act.
- Recent measures to combat tax evasion and improve tax administration: introduction of electronic VAT reporting in 2016 and expansion of electronic registration of sales to more sectors.
- Authorities view 2016 and projected surpluses as positive results, while recognizing that some savings resulted from delays in implementing the investment spending plan and acknowledging need for improvements in public investment management.
- On debt management, authorities cite short-term revenue gains as evidence of successful strategy and reiterate commitment to reach an average maturity of 6 years over the medium term.

### Staff appraisal (summary)
- Macro context: Growth is solid, unemployment low, public finances in good condition, exit from the exchange rate floor smooth, banking system liquid and profitable.
- Risks and vulnerabilities:
  - Household financial vulnerabilities increasing (high borrowing for house purchases relative to incomes).
  - Labor shortages, especially skilled labor, constraining growth; growth projected: 3 percent in 2017, about 2½ percent over the medium term.
  - Main medium- to long-term risk: sustainable growth rate given shrinking workforce and required productivity gains.
  - Real exchange rate: appears moderately undervalued and likely to appreciate over the medium term; external position moderately stronger than level consistent with fundamentals and desirable policies.
- Policy prescriptions
  - Monetary: with headline inflation at target and economy slightly above capacity, decision to leave nominal exchange rate floor was timely; future policy rate adjustments should be gradual and data-guided; FX interventions only in cases of severe volatility.
  - Macroprudential/financial: CNB should be given binding powers over loan-to-value, debt-to-income, and debt-servicing-to-income ratios to address household vulnerabilities; monitor lending standards amid accelerating credit growth.
  - Structural: revise labor market incentives to boost labor supply and quality (reduce high tax wedge and marginal disincentives, especially for women with small children, and to take later retirement); address skill mismatches; invest in physical and digital infrastructure; improve regulatory environment.
  - Fiscal: prioritize investment in physical and human capital; assess public investment management and establish a unified long-horizon infrastructure plan; debt management should focus on minimizing costs and risks over the medium term and consider suitable operational independence.
- Procedural recommendation: next Article IV consultation recommended on the standard 12-month cycle.

*IMF staff report: Czech Republic (cr17168), selected excerpts.*

### Annex I. Assessment of External Balances, Competitiveness, and

### Annex I. Assessment of External Balances, Competitiveness, and the Exchange Rate

### External position and exchange rate assessment
- The external position is moderately stronger than the level consistent with medium-term fundamentals and desirable policies.
- Staff evaluates the real exchange rate to be moderately undervalued, and likely to appreciate over the medium term.
- The Czech economy remains competitive, although the real exchange rate is appreciating.
- A moderate real appreciation, especially in ULC terms, has been taking place in 2016, driven by a combination of a higher wage bill and slowing productivity.
- The nominal koruna:euro exchange rate floor that had been in place for over three years was removed in April. Financial market reaction to the removal of the floor has been muted, with the koruna appreciating by 2½ percent so far.

### Current account, financial account, and external vulnerabilities
- The current account turned positive in 2015 and is forecast to record small, but declining, surpluses in the medium term, given assumptions of continued, albeit moderate, appreciation of the real exchange rate.
- The current account surplus in 2016 reflects declining imports, especially of investment goods due to slowdown of EU funds absorption.
- In the past three years, large surpluses in the goods balance have been almost offset by significant deficits in the primary and secondary incomes, driven by returns on large FDI stock.
- Recent movements in the financial account reflect:
  - higher appetite for koruna-denominated assets, driven by speculation on future currency appreciation, and increased foreign exchange intervention in the run up to FX floor exit;
  - inward portfolio flows accelerated by foreign demand for government securities;
  - liabilities under other investments associated primarily with a rise in short-term deposits in domestic banks;
  - an increase in reserve assets due to foreign exchange interventions.
- The external position appears comfortable:
  - External liabilities are mainly long-term, and reserves provide a cushion against possible vulnerabilities.
  - External debt, estimated at 75 percent of GDP in 2016, is mostly long-term and is concentrated in “other sector”, reflecting loans across affiliated corporations.
  - The share of short-term debt has been increasing, mainly due to the increase in foreign-sourced deposits.
  - The banking system as a whole has sufficient liquid assets to cover foreign deposits.

### Formal EBA evaluations and staff judgment on REER
- The current account gap from the CA model (1.7 percent) indicates that the external position is moderately stronger than justified by macroeconomic variables.
- The methodology points to a cyclically-adjusted current account norm of -0.7 percent, whereas the actual current account is at 1.1.
- These results imply a moderate REER undervaluation, of -4 percent.
- A policy gap of 1.4 percent suggests that Czech financial, fiscal and external policies are broadly appropriate.
- The REER model indicates a large overvaluation, of 17 percent. Staff considers this result problematic for a number of reasons:
  - the estimated overvaluation in this approach is driven by large residuals;
  - the result is at odds with the CA model and the External Sustainability approach (which indicates a moderate undervaluation, by 4 percent);
  - overvaluation would seem inconsistent with strong export performance as shown by rising market share.

### Medium-term outlook for the real exchange rate
- Staff concludes the real exchange rate is likely to appreciate over the medium term.
- Continued and gradual real exchange rate appreciation can be expected if Czech national income converges to the European mean and if concentration in manufacturing does not increase.
- Theoretical and empirical mechanisms discussed:
  - Balassa-Samuelson supply-side mechanism: higher productivity in tradeables sectors with wage equalization drives up the real exchange rate.
  - Demand-side mechanism: higher incomes generate relatively more demand for nontradeable services than tradeable goods, driving up the real exchange rate.
  - Empirical evidence (Berka and Devereux (2015) cited): robust correlations between RERs and relative GDP per capita; typically, a 1 percent increase in relative GDP per capita is associated with a 0.35–0.40 increase in the real exchange rate.

*IMF staff assessment as presented in Annex I of the mission documentation.*

### Annex II. Trade Concentration

### Export orientation and concentration
- The Czech economy is highly export oriented—exports are 80 percent of GDP, and net exports have been trending upward.
- Trade concentration is increasing.
- More than 55 percent of Czech Republic’s exports are concentrated in two sectors, transportation and machinery and electrical products, accounting for more than 50 percent of total exports.

### Intensive vs. extensive margin of export growth (2010–2016)
- Between 2010 and 2015 diversification has not been a big driver of export growth:
  - much of export growth in the Czech Republic has been driven by higher exports of existing products to existing markets (intensive margin), and product diversification in existing markets.
- Trade in neighboring countries is also highly concentrated.
- Product concentration of exports, as measured by the Herfindahl-Hirschman index at the SITC 3-digit product level, is lower than in other central European peers, with the exception of Poland.

### Export quality and sophistication
- Trade sophistication is increasing.
- The quality and sophistication of Czech exports has been increasing, captured by the export sophistication index of Rodrik et al. (EXPY) available in the WITS database.
- In this measure, the Czech economy compares relatively well to neighboring competitors.

*IMF staff findings summarized in Annex II.*

### Annex III. Risk Assessment Matrix (selected risks, likelihoods, impacts, and policy responses)

- Retreat from cross-border integration
  - Likelihood: High
  - Time horizon: Short to Medium Term
  - Expected impact: Medium — damage to global supply chains that benefit the Czech economy
  - Policy response: A temporary easing bias would be appropriate.

- Policy and geopolitical uncertainties (post-Brexit negotiations, major elections, fragmentation/security dislocation)
  - Likelihood: High
  - Time horizon: Short to medium term
  - Expected impact: High — border closures and restrictions weigh on trade
  - Policy response: Maintain accommodative monetary conditions, while loosening fiscal stance.

- Weaker-than-expected global growth (China; structurally weak growth in advanced economies)
  - Likelihood: Low/Medium
  - Time horizon: Short/Medium Term
  - Expected impact: Medium — external demand would wane, weighing on Czech exports and growth
  - Policy response: Policies supporting domestic demand, diversifying trade partners and specialization could help cushion impact.

- Financial conditions risk (stronger US dollar/higher rates; European bank distress)
  - Likelihood: High (for US dollar/rates); High (for European bank distress)
  - Time horizon: Short Term
  - Expected impact: Medium (US dollar/rates); Low (European bank distress)
  - Policy response: Maintain accommodative monetary conditions; Czech banking system is well capitalized, liquid, and profitable; banks funded mainly from domestic deposits.

- Lower energy prices
  - Likelihood: Low
  - Time horizon: Short to Medium Term
  - Expected impact: Medium — household real incomes boosted; lower production costs support growth; lower import prices temporarily lower inflation away from target
  - Policy response: Consistent monetary framework emphasizing the priority of the inflation objective.

- Economy’s adjustment to FX floor exit
  - Likelihood: Medium
  - Time horizon: Short Term
  - Expected impact: High — costs of policy errors are asymmetric; overtightening could sharply decrease output and inflation; on upside, cheaper imported goods could boost private consumption
  - Policy response: Gradual approach in setting policy interest rates, communicated through interest rate projections.

- Financial stability risks from rapid growth in lending, especially to real estate
  - Likelihood: Medium
  - Time horizon: Medium Term
  - Expected impact: Medium — some households appear overextended and vulnerable to house price, interest rate, or income shocks
  - Policy response: CNB should be given powers of direction over LTV, LTI, and (depending on data adequacy) DTI measures; fiscal and structural initiatives to support macroprudential tools.

- Stalled income convergence and structural reforms
  - Likelihood: Medium
  - Time horizon: Long Term
  - Expected impact: Medium — convergence was set back by the financial crisis; demographic outlook poor and productivity growth has stalled
  - Policy response: Measures targeting labor participation incentives; training and skills; connectivity and infrastructure; improved expenditure efficiency (notably in healthcare); improved tax compliance; reduced regulatory burdens on small firms and start-ups.

*Risk matrix entries and staff-assessed likelihoods/horizons as presented in Annex III.*

### Annex IV. Implementation of the 2016 Article IV Key Recommendations

- Monetary: Prepare for an exit from the exchange rate floor to a floating exchange rate and be ready to use other non-conventional tools.
  - Action: Implemented. The CNB removed the koruna:euro floor on April 6 and has not intervened since then. At the announcement of the floor’s removal, the CNB stated that it stands ready to intervene against “excessive” exchange rate fluctuations. The CNB stated that the removal of the floor should be followed by a gradual increase in interest rates, although negative interest rates could be used in exceptional circumstances.

- Macroprudential: Make LTV restrictions binding. Potentially use other measures (e.g. DTI).
  - Action: In progress. Legislation providing powers over the LTV, DTI and DSTI ratios is currently under review in Parliament.

- Fiscal: Legislate fiscal framework; Reduce tax avoidance; Increase public investment.
  - Actions:
    - Implemented. A new fiscal responsibility framework was adopted in January 2017.
    - Implemented. To combat tax evasion and improve tax administration, the authorities introduced electronic VAT reporting and electronic registration of sales.
    - Not yet implemented. Public investment contracted due to very low EU funds absorption. Last year’s absorption was even lower than expected (it is typically low in the first years of a programming period), in part due to the incompatibility of an environmental impact assessment with revised EU standards.

- Structural: Boost potential growth by increasing labor market participation of certain population groups, and enhancing investment in human and physical capital.
  - Action: In progress. The authorities implemented new tax and benefits instruments supporting working parents with children and measures aimed at enhancing regional labor mobility. National spending on R&D has been increased. Functioning and transparency of public administration is being further enhanced through the development of online government services.

*Status of implementation of 2016 Article IV key recommendations as reported in Annex IV.*

### Annex V.  Public Sector Debt Sustainability Analysis

### Annex V.  Public Sector Debt Sustainability Analysis

### Executive summary
- Public debt declined to 37.2 percent of GDP in 2016, driven by an improvement in the headline balance (strong revenue collection and capital underspending), favorable financing conditions, and continued economic recovery.
- Staff projections: public debt is projected to decline to 26 percent of GDP in 5 years, assuming fiscal targets in the Convergence Program are met and growth continues.
- Public debt and gross financing needs are relatively immune to interest and exchange rate shocks; a negative shock to real GDP growth would slow debt reduction.

### Baseline and realism of projections
- Fiscal stance and balances:
  - Structural surplus of 0.5 percent in 2016 is expected to relax to a structural surplus of 0.2 percent in 2017, with subsequent tightening.
  - Headline balance maintaining surpluses of 0.5 percent of GDP is projected over the medium term.
  - Short-term relaxation driven mostly by increased government consumption (higher compensation of employees) and higher social benefits payments.
- Growth and inflation:
  - Real GDP projected slightly above potential at 3.0 percent in 2017.
  - Inflation projected to increase to 2.3 percent in 2017 and then settle at the 2 percent target by 2019.
- Debt outlook:
  - Debt declines from 37 percent of GDP in 2016 to 26 percent in 2022 under the baseline.
  - The ratio declines in 2017 despite a slightly relaxed fiscal stance because nominal GDP growth and the primary surplus are projected to exceed the contribution of interest payments.
  - Gross financing needs projected to be 5.2 percent of GDP at the end of the projection period.

### Shock and stress tests
- Real GDP growth shock:
  - A 1 standard deviation shock to real GDP growth (3.0 percentage point decline) for 2 years, with attendant impacts on primary balance, inflation, and real interest rate, causes:
    - Public debt to rise to 38.7 percent of GDP and gross financing needs to increase to 10.8 percent of GDP by 2019.
    - Thereafter, public debt declines to 34.8 percent of GDP and gross financing needs fall to 7.1 percent of GDP by 2022.
  - Calibration note: the shock is calibrated using historical real GDP growth data from 2007–2016. Every 1 percent point decline in real GDP growth is assumed to reduce inflation by 0.25 percentage points while non-interest revenues and non-interest expenditures are assumed constant.
- Interest rate shock:
  - An interest rate shock in which the nominal rate increases by 367 basis points (the difference between the maximum real interest rate over the last 10 years and the average real interest rate over the projection period) still results in debt continuing to fall, to 29.3 percent of GDP by 2022.
- Other shocks:
  - Other shocks (including exchange rate shocks) are not as important for debt dynamics as the growth shock.

### Key statistics and projections (selected exact figures)
- Nominal gross public debt: 36.4 (2015); 40.3 (2016); 37.2 (2017); 35.0 (2018); 33.1 (2019); 31.1 (2020); 29.4 (2021); 27.7 (2022); 26.0 (projection end).
- Public gross financing needs: 7.3 (2015); 5.9 (2016); 4.5 (2017); 5.6 (2018); 7.3 (2019); 6.3 (2020); 4.7 (2021); 4.7 (2022); 5.2 (projection end).
- Real GDP growth (in percent): 1.8 (2015); 4.5 (2016); 2.4 (2017); 3.0 (2018); 2.4 (2019); 2.3 (2020); 2.3 (2021); 2.3 (2022).
- Inflation (GDP deflator, in percent): 1.4 (2015); 1.0 (2016); 1.1 (2017); 1.3 (2018); 1.6 (2019); 1.8 (2020); 1.7 (2021); 1.7 (2022).
- Nominal GDP growth (in percent): 3.2 (2015); 5.6 (2016); 3.5 (2017); 4.3 (2018); 4.0 (2019); 4.1 (2020); 4.0 (2021); 4.1 (2022).
- Effective interest rate (in percent, defined as interest payments divided by debt stock at end of previous year): 3.7 (2015); 2.7 (2016); 2.4 (2017); 2.5 (2018); 2.7 (2019); 3.1 (2020); 3.6 (2021); 3.9 (2022); 4.3 (later).
- Cumulative change in gross public sector debt (2015–2022): -11.3.
- Identified debt-creating flows cumulative (2015–2022): -8.3.
- Primary deficit (annual and cumulative): 1.8 (2015); -0.4 (2016); -1.4 (2017); -1.2 (2018); -1.2 (2019); -1.2 (2020); -1.1 (2021); -1.1 (2022); cumulative -6.8.
- Primary (noninterest) revenue and grants: 39.2 (2015); 41.3 (2016); 40.3 (2017); 40.7 (2018); 40.9 (2019); 40.9 (2020); 41.0 (2021); 40.9 (2022); cumulative 45.4.
- Primary (noninterest) expenditure: 41.0 (2015); 40.9 (2016); 38.9 (2017); 39.5 (2018); 39.8 (2019); 39.7 (2020); 39.8 (2021); 39.9 (2022); cumulative 38.6.
- Automatic debt dynamics contribution (cumulative 2015–2022): -1.5.
  - Real interest rate contribution (selected): 1.3 (2015); 1.3 (2016); 1.4 (2017); 0.4 (2018); 0.3 (2019); 0.4 (2020); 0.6 (2021); 0.6 (2022); 0.7 (later); cumulative 3.0.
  - Real GDP growth contribution (selected): -0.5 (2015); -1.8 (2016); -0.9 (2017); -1.1 (2018); -0.8 (2019); -0.7 (2020); -0.7 (2021); -0.7 (2022); -0.6 (later); cumulative -4.5.
- Residual, including asset changes (cumulative 2015–2022): -3.0.

### Scenarios and alternative projections (high-level)
- Baseline scenario assumptions (selected exact values):
  - Real GDP growth: 3.0 (2017), 2.4 (2018), 2.3 (2019–2022).
  - Inflation: 1.3 (2017), 1.6 (2018), 1.8 (2019), 1.7 (2020–2022).
  - Primary Balance: 1.2 (2017–2019), 1.1 (2020), 1.1 (2021), 1.0 (2022).
  - Effective interest rate: 2.5 (2017), 2.7 (2018), 3.1 (2019), 3.6 (2020), 3.9 (2021), 4.3 (2022).
- Historical scenario (selected exact values):
  - Real GDP growth: 3.0 (2017), 1.6 (2018–2022).
  - Primary Balance: 1.2 (2017), -1.3 (2018–2022).
- Constant primary balance scenario:
  - Primary Balance fixed at 1.2 (2017–2022).
- Real GDP growth alternative listed: 3.0 (2017), -0.6 (2018), -0.7 (2019), 2.3 (2020), 2.3 (2021), 2.3 (2022).

### Composition of public debt and financing structure (selected)
- Gross nominal public debt shares and composition displayed across 2015–2022 projection (by maturity and by currency), indicating majority medium and long-term maturity and dominance of local currency-denominated debt in projections.

*Source: IMF staff.*

### Annex VII. Capital Inflows and the Balance Sheet of the Financial

### Annex VII. Capital Inflows and the Balance Sheet of the Financial Sector

### Overview
- Historically, most inward capital flows to the Czech economy have happened via the financial account.
- Recently, those inflows have accelerated.
- On the Czech liability side, this has resulted in an increase of foreigners’ holdings of commercial bank deposits and government securities.
- On the Czech asset side, this has caused an increase in the official reserves held by the central bank.
- The increase in reserves has been associated with an increase in the monetary base (the balancing item to official reserves) on the central bank balance sheet.
- The balance sheet of Czech commercial banks has expanded concurrently with these developments.

### Balance of Payments: contributions to change in reserves
- The balance of payments identity expresses changes in reserves as the sum of:
  - (i) the current account,
  - (ii) the capital account,
  - (iii) (minus) the financial account,
  - (iv) errors and omissions.
- From November 2013 to March 2017, reserves increased by CZK 2,072 bn.
- Using the identity above, around 80 percent of the increase in reserves of CZK 2,072 bn from November 2013 to March 2017 can be accounted for via the financial account.
- Decomposing the financial account into sub-components:
  - Approximately 40 percent of the increase can be accounted for via net inflows in the form of “Other investments”.
- The net inflows of “Other investment” were driven by inflows rather than outflows:
  - Over the period, foreign inflows increased by CZK 1,018 bn.
  - Domestic outflows only decreased by CZK 42 bn.

### Financial sector balance sheet linkages
- “Other investments” in the financial account includes loans, currency, and deposits.
- The accumulative inflow of “Other investments” is matched with the accumulative increase in “Loans and deposits of non-residents” on the liability side of Czech banks.
- A substantial part of the increase (around 40%) in the reserves can be accounted for via inflows of “Other investments” in the financial account.
- The increase in “Loans and deposits to non-residents” has primarily been coming from “Other credit institutions” rather than from clients.
- The increase in bank liabilities to non-residents has been associated with an increase in bank deposits with the central bank:
  - The increase in “Received loans and deposits” has been associated with a rise in banks’ deposits with the central bank.
  - This linkage is potentially explained by banks exchanging foreign currency received from non-residents to deposits with the central bank.
- On the central bank’s balance sheet, the increase in foreign reserves on the asset side has been associated with an increase in deposits of commercial banks at the central bank on the liability side.

### Key statistics and exact figures cited
- Increase in reserves from November 2013 to March 2017: CZK 2,072 bn.
- Share accounted for by the financial account: around 80 percent.
- Share of reserve increase accounted for via net inflows of “Other investments”: approximately 40 percent.
- Increase in foreign inflows of “Other investments” over the period: CZK 1,018 bn.
- Change in domestic outflows over the period: decrease of CZK 42 bn.

*Annex VII. Capital Inflows and the Balance Sheet of the Financial Sector — cr17168*

### 2.4 percent in 2016, but is expected to pick up to almost 3 percent this year and next, with the

### cr17168 - 2.4 percent in 2016, but is expected to pick up to almost 3 percent this year and next, with the

### Growth outlook and external sector
- Real GDP growth was 2.4 percent in 2016.
- Growth is expected to pick up to almost 3 percent this year and next, with the growth rate marginally above the estimated potential output growth.
- Growth drivers:
  - Robust household consumption reflecting consumers’ optimism in an environment of record low unemployment, rising labor force participation, and growing wages.
  - Renewed growth in gross capital formation underpinned by an increased drawdown of EU funds.
  - Ongoing recovery in main trading partners: Germany, Slovakia, and Poland.
- External sector risks:
  - Positive contribution of net exports to economic growth is projected to dissipate as the koruna appreciates and domestic demand accelerates, boosting imports.

### Labor market
- Unemployment rate (Eurostat methodology) dropped in April to 3.2 percent, the lowest in the European Union and less than half of the EU average.
- Employment growth reached 1.8 percent in 2016, the fastest pace since 2008, and is expected to grow 1.1 percent in 2017.
- Labor force participation climbed close to 75 percent after stagnating around 71 percent in 2005 – 2013.
- Participation rate is expected to increase further in the next several years due to demographic developments, gradual rise in the statutory retirement age, and policy measures (labor mobility support, incentives for families with children to work, earlier return to work for mothers).

### Inflation and monetary policy
- Inflation picked up to slightly above the CNB’s two percent target recently, but remains within the tolerance band of one percentage point above and below the target after more than three years near the zero bound.
- Latest inflation reading in May was 2.4 percent year-on-year, slightly below the CNB’s expectation.
- CNB forecasts inflation to stay in the upper half of the tolerance band for most of this year and to return to the target in late 2017 or early 2018.
- Monetary policy actions:
  - CNB discontinued the exchange rate commitment on April 6, 2017, after almost 3½ years, as a first step toward gradual return of overall monetary conditions to normal with interest rates as the main policy instrument.
  - Monetary policy rate has been at “technical zero” (+0.05 percent) since November 2012.
  - CNB assumes inflation will stay in the upper half of the tolerance band and return to the target early next year; consistent with this forecast is an increase in domestic market interest rates in the third quarter of 2017 and later also in 2018.
  - Bank Board assesses risks to the inflation forecast at the monetary policy horizon as being slightly inflationary.
- Key uncertainties:
  - Path of the exchange rate in the next few quarters reflecting past exporter hedging and closing of koruna positions by financial investors.
  - High degree of economic openness implies significant pass-through from exchange rate changes to domestic prices.
  - Authorities prefer gradualism in tightening monetary conditions; they view analytical support for some simulation results in the Selected Issues Paper as weak due to missing model verification and scenario construction details.

### Fiscal outcomes, tax collection, and fiscal framework
- General government recorded a fiscal surplus of 0.6 percent of GDP in the prior year, the best result in the history of the Czech Republic.
- Drivers of improved fiscal outcome:
  - Increase in tax revenues and social security contributions reflecting better tax collection and continued solid economic growth.
  - Drop in government investments co-financed with EU funds related to the beginning of a new EU funds programming period.
- Indirect tax revenue rose by 5.4 percent in 2016 relative to the previous year.
- Social security contributions and personal income tax revenues rose by over 6 percent mainly due to higher wages and salaries and an increase in the minimum wage by 7.6 percent.
- Expenditures and investments:
  - General government expenditures decreased by 2.2 percentage points in 2016 to 39.9 percent of GDP.
  - Nominal investments dropped by almost 33 percent due to slow transition to the new 2014–2020 EU funds programming period.
  - Excluding a one-off outlay for leasing military aircraft in 2015, purely Czech government financed investments increased by 3.5 percent year-on-year in 2016.
  - General government expenditures on final consumption grew by 3.9 percent year-on-year in 2016.
- Fiscal framework reforms:
  - New legislation on budgetary responsibility enacted in February 2017 anchors the fiscal framework in line with EU standards for central and local governments.
  - Majority of senators filed a complaint in March 2017 to the Constitutional Court concerning provisions relating to new fiscal rules for local governments; decision expected later this year and will not affect remaining provisions including expenditure frameworks for the state budget and state funds.
- Debt and medium-term outlook:
  - General government debt is likely to continue its downward path to 36 percent of GDP in 2017 and below 33 percent in 2020, with projected small general government budget surpluses and low refinancing rates in the forecast horizon.
- Pension reform:
  - Legislative amendment limiting statutory retirement age at 65 years by 2030 has been approved by both Chambers of the Parliament and remains to be signed by the President to become effective.
  - Amendment establishes procedure for regular revision of the retirement age in five-year intervals to adjust to life expectancy.

### Tax administration and VAT measures
- VAT policy and anti-evasion:
  - Introduction of electronic VAT reporting enabled pairing individual input and output transactions across entities, effectively eliminating fraudulent invoices; budgetary impact for 2016 surpassed original expectations.
  - Act on Evidence of Sales legislated in 2016 to prevent concealment of taxable income.
    - First phase (restaurant and accommodation services) launched December 1, 2016.
    - Second phase (retail and wholesale sectors) commenced March 1, 2017.
    - March 2018: liberal professions, including doctors, lawyers and accountants and entrepreneurs in transport and agriculture will fall in scope.
    - Final phase to commence in June 2018 and will apply to select trade and manufacturing activities.
  - Sectoral reverse charge mechanism on specific goods and services was broadened to the maximum allowable extent in 2016, transferring VAT declaration and payment obligation from supplier to customer to fight “missing trader frauds”.

### Macroprudential policies and financial stability
- Financial sector soundness indicators (2016):
  - Banks’ return on equity reached 17.9 percent.
  - Return on assets was 1.3 percent.
  - Non-performing loans ratio declined by 0.7 percentage points to 3.7 percent.
- Prudential tools and buffers:
  - Countercyclical capital buffer (CCyB) set at 0.5 percent of total risk exposures located in the Czech Republic since January 2017.
  - On May 25, 2017, CNB decided to increase the CCyB to 1 percent with effect from July 2018.
  - CNB applies a systemic risk buffer; after the 2016 review the number of systemically important banks rose from four to five and the buffer was increased for two banks effective January 2017.
  - CNB stands ready to increase the CCyB further if credit growth remains high, lending standards ease, and systemic risks relating to residential property financing grow.
- Residential property risks and borrower protection:
  - Apartment prices rose by 15 percent year-on-year in 2016 and appear mildly overvalued on several metrics.
  - CNB issued a recommended loan-to-value (LTV) limit in 2016 currently at 90 percent, with an additional limitation that loans with LTV in the 80 – 90 percent range not exceed 15 percent of total extended loans.
  - CNB extended the scope of its recommendation on provision of mortgage loans further in 2017.
  - All credit providers including non-bank ones should monitor debt-to-income (DTI) and debt-service-to-income (DSTI) ratios and set internal limits.
  - Authorities submitted a legislative proposal (approved by the Czech Government in January 2017) to give the CNB powers to set binding LTV, DTI, DSTI limits; the amendment is set to be discussed by the Parliament.
  - CNB will continue increasing intensity of microprudential supervision of provisioning of secured and unsecured retail loans by credit institutions, including management of intermediary distribution networks.

### Public investment, governance, and structural policies
- Public finance governance:
  - Government adopted a legislative proposal on management and control of public finance in December 2016 outlining principles and rules for verification mechanisms at all levels of public administration.
  - Act on Contracts Registry effective July 2016 obliges state and public institutions, local governments and state-owned enterprises to publish new contracts exceeding CZK 50,000 (approximately USD 2,000) within 30 days of their conclusion.
- E-government and administrative reforms:
  - Project “Initiative 202020” aims to improve e-government and rank the Czech Republic among the top 20 countries in quality and scope of e-government by the end of 2020.
- R&D and education reforms:
  - Reforms to governance of the R&D system pursued; new evaluation methodology approved February 2017 to strengthen funding allocation mechanisms for basic and applied research and facilitate stronger links between academia and businesses.
  - Amendments to the Education Act adopted March 2016 extending compulsory education to the last year of pre-school education starting September 2017 and ensuring younger children are entitled to a place in a kindergarten to improve labor force participation opportunities for parents.

### Political context and final remarks
- Political calendar:
  - Regular parliamentary elections scheduled for mid-October; voting system is proportionate and traditionally produces coalition governments with six to seven parties realistically likely to be represented in the new Parliament’s Lower Chamber.
  - Presidential elections scheduled for early 2018 but unlikely to significantly alter economic policies given limited presidential prerogatives.
- Political stability has reinforced good economic outcomes and sharp turns in economic policies are unlikely.
- Final remarks:
  - Czech authorities appreciate staff’s constructive policy engagement regarding introduction, implementation, and exit from the use of the exchange rate as a monetary policy instrument; authorities will carefully assess the policy advice.

*IMF Staff Report excerpt (cr17168).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17168.pdf_