## _cr04266

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---

### Executive Summary
- GDP expanded by "3.1 percent" in 2003, fueled by strong consumption and investment.
- Inflation recovered from negative levels in late 2003 and is in the lower half of the CNB target range; temporary factors should push headline inflation to "4 percent" by year-end (near the top of the CNB’s target range).
- Unemployment—particularly long-term unemployment—stands at about "8 percent".
- Current account deficit widened marginally to "6¼ percent of GDP" in 2003; forecast to narrow to "5–6 percent of GDP".
- General government deficit—excluding privatization receipts and transfers to the Czech Consolidation Agency (CKA)—increased to "5 percent of GDP" in 2003.
- Per capita income is "63 percent of the EU-15 average" on a PPP basis.
- Bank lending to households expanded at an annual rate of more than "30 percent" during the past two years; corporate lending remains stagnant.
- Foreign direct investment (FDI) large: about "20 percent" of FDI stock represented privatization; foreign 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 have annual return on equity of about "20 percent" versus "8½ percent" for domestic firms.
- Staff emphasizes stopping fiscal drift, implementing the 2004–06 fiscal plan, and accelerating structural reforms.

### Macroeconomic outlook and growth projections
- Staff projection for 2004: "3¼ percent" growth; for 2005: "about 3½ percent".
- CNB April 2004 Inflation Report baseline projection for 2004: "about 4 percent" growth.
- Outlook drivers:
  - Growth to firm modestly in 2004–05, led by rising exports and related investment.
  - Temporary factors to push inflation to "4 percent" in late 2004, then toward midpoint in H1 2005, with strengthening demand leading to rising inflation thereafter.
  - Current account deficit expected to narrow to "5–6 percent of GDP".
- Risks:
  - Downside: timing/pace of EU demand recovery; renewed euro appreciation; faster competitiveness improvements elsewhere; protracted fiscal policy uncertainty.
  - Upside: continued strong bank lending to households; more dynamic EU recovery.

### Monetary policy and exchange rate
- CNB actions and framework:
  - Repo rate raised by "¼ point" to "2¼ percent" in late June 2004.
  - Post-2005 IT framework: target of "3 percent" with a tolerance band of "±1 percent" (continuity with end-2005 target "2–4 percent").
  - CNB began selling interest on reserves; first installment sold in April 2004: "US$42 million".
  - On reserves of more than "US$26 billion", CNB earned around "US$725 million" in interest in 2003.
  - CNB intends to target inflation through ERM2 in the run-up to euro adoption.
- Staff assessment:
  - Estimated first-round inflationary effect of indirect taxes, regulated prices, and EU-related import duties: "about 1½ percentage points" in 2004 and early 2005.
  - Under no policy change, inflation projected to peak at "around 4 percent" in late 2004, moderate, then rise above the point target in 2006 if monetary conditions are not tightened.
  - Real interest rates were negative prior to the June hike; further gradual tightening is warranted, with timing and size conditioned on exchange rate developments and growth robustness.
- Exchange rate and reserves:
  - Exchange rate regime: managed floating; Koruna per U.S. dollar (July 19, 2004): "CZK 25.12 = US$1".
  - Gross international reserves: Table entries include "US$26 billion" (text reference), "US$27.0 billion" (2002), "US$28.9 billion" (2003); staff notes sales capped by interest income.

### Fiscal developments, risks, and the 2004–06 plan
- Recent fiscal aggregates (selected ratios, percent of GDP, 2001–03; change in parentheses):
  - Revenues: "36.7", "37.5", "38.9" (change "2.3").
  - Expenditures, total: "41.7", "44.2", "45.1" (change "3.5").
  - Adjusted expenditures: "39.5", "41.6", "43.9" (change "4.4").
  - Transfers: "18.9", "19.4", "19.9" (change "1.0").
  - Capital expenditure: "4.8", "5.3", "5.5" (change "0.6").
  - Adjusted deficit: "-2.8", "-4.0", "-4.9" (change "-2.2").
  - General government deficit, ESA95 basis: "-6.5", "-6.5", "-12.9".
- Fiscal risks and vulnerabilities:
  - Public debt moderate at "28 percent of GDP" (text) but rising if deficits persist.
  - Total nominal stock of guarantees: "about 20 percent of GDP".
  - Privatization revenues will soon run out; aging population will increase fiscal demands.
- 2004–06 adjustment plan and targets:
  - Authorities' targeted deficit definition (2004–06): "5.5", "4.8", "4.0".
  - Staff adjusted deficit (2004–06): "5.8", "5.2", "4.4".
  - ESA95 deficit (Convergence Programme): "5.3", "4.7", "3.8".
  - Staff projects adjusted general government deficit widening by over "1 percent of GDP to 6.1 percent of GDP in 2004".
  - Staff advocated additional savings of "½ percent of GDP" to meet original targets before GDP revision effects.
- Key fiscal recommendations:
  - Bring the deficit close to target in 2004; strictly observe expenditure ceilings.
  - Fully identify measures for 2005–06 and accelerate adjustment to avoid back-loading to 2006 (an election year).
  - Refrain from relying on one-off revenues; save any fiscal windfalls to reduce deficit-to-GDP ratio.
  - Target a structural deficit of less than "2 percent of GDP" by 2008–09.
  - Expedite pension and health reforms; authorities expect pension expenditures to remain stable at about "9 percent of GDP" for the next 10–15 years but project a "6 percentage point" increase in pension spending relative to GDP by 2050.

### Revenue measures (Box 3) and fiscal arithmetic
- 2004 revenue measures enacted/proposed:
  - EU-mandated excise increases; shifting over one-fourth of the consumption basket from preferential to standard VAT.
  - "3 percentage-point" cut in the corporate income tax (CIT) as first step from "31 to 24 percent".
  - Subsequent measures: standard VAT rate lowered from "22 to 19 percent" (in effect May 2004); shortening depreciation periods; easing income tax burden on married couples and families with children (from 2005, with parliament).
- Effects of revenue measures (percent of GDP):
  - VAT 1/: "1.1", "1.5", "1.4" (2004, 2005, 2006)
  - Excises 2/: "0.5", "0.6", "0.6"
  - Corporate income taxes: "-0.1", "-0.3", "-0.9"
    - Rate decrease 3/: "-0.1", "-0.3", "-0.5"
    - Shorter depreciation period: "0.0", "0.0", "-0.4"
  - Personal income taxes: "0.0", "-0.1", "-0.2"
  - Total 4/: "1.4", "1.6", "0.9"
- Adjusted balance paths (percent of GDP):
  - Based on old GDP 1/: "-5.2" (2003), "-5.8" (2004), "-5.2" (2005), "-4.4" (2006)
  - Effect of GDP revision 2/: "0.3", "0.3", "0.3", "0.2"
  - Adjusted balance 3/: "-4.9" (2003), "-5.5" (2004), "-4.9" (2005), "-4.2" (2006)
- Decomposition of change (percent of GDP, selected):
  - Net impact of EU accession 4/: "-1.7" (2004), "0.1" (2005), "0.2" (2006)
  - Tax measures 5/: "1.4" (2004), "0.1" (2005), "-0.6" (2006)
  - One-offs (net) 6/: "-0.7" (2004)
  - Required other adjustment 7/: "0.4" (2004), "0.3" (2005), "1.2" (2006)
- Staff recommendations from Box 3:
  - Specify permanent savings early; broaden coverage of expenditure ceilings; strictly adhere to expenditure targets; avoid post-budget spending measures.
  - Close NPF by end-2005 and assume its spending obligations within the state budget (authorities’ plan).

### Structural reforms and productivity / role of FDI
- Key priorities:
  - Improve business-legal environment; enhance labor market flexibility; reduce state involvement (complete privatization, close NPF and CKA).
  - Accelerate pension and health care reforms.
  - Promote FDI, especially high-tech and skill-intensive activities, to raise TFP and potential growth.
- FDI role and potential growth scenario:
  - Technology firms present/committed: Accenture, IBM, Sun Microsystems, DHL, Honeywell, Olympus, Dell (as cited).
  - Potential scenario: if TFP grew at rates similar to EU-15 catching-up countries and inputs rose similarly, Czech potential growth could increase to "3¾ percent".
  - Policy implication: sizable fiscal consolidation would help accommodate stronger fixed investment and allow some narrowing of the current account deficit.

### Financial sector, household credit risks, and vulnerabilities
- Banking sector health:
  - About "95 percent" of banking assets foreign owned after cleanup and privatization.
  - Classified credits and nonperforming loans declined between 2001 and 2004; capital adequacy remained above "14 percent".
- Credit dynamics and supervisory needs:
  - Bank lending to households expanded at an annual rate of more than "30 percent" for ~two years; lending to corporates stagnant.
  - Staff calls for improved supervisory capacity in household credit: collect data on household indebtedness, debt-servicing ability, and housing transactions; enhance stress-testing.
  - Recommendation to establish a single financial sector supervisor while avoiding disruption to oversight.
- Key vulnerabilities and indicators (selected, tables cited):
  - Classified credits (percent of total credits): "31.9" (1999), "28.9" (2000), "20.8" (2001), "15.8" (2002), "11.2" (2003), "11.2" (2004 March).
  - Short-term foreign liabilities of commercial banks (US$ billions, March-04): "5.8".
  - Total external debt (percent of GDP): "37.7" (1999), "39.4" (2000), "38.4" (2001), "36.8" (2002), "36.8" (2003), "32.9" (2004 March).

### External accounts and stress tests
- Balance of payments and external accounts (selected, US$ millions unless stated):
  - Current account balance: "2000: -2,718"; "2001: -3,273"; "2002: -4,166"; "2003: -5,570"; "2004 (projection): -5,642".
  - Exports (US$ millions): "2000: 29,052"; "2001: 33,378"; "2002: 38,319"; "2003: 48,599"; "2004: 56,928".
  - Imports (US$ millions): "2000: 32,183"; "2001: 36,446"; "2002: 40,497"; "2003: 51,058"; "2004: 59,579".
- External debt sustainability (Appendix I, Table A1):
  - Baseline: external debt stock projected near "40 percent of GDP" (Table A1 baseline: "2004: 38.4 percent"; "2009: 39.3 percent").
  - Stress scenarios: external debt-GDP ratio remains under "55 percent" in 2009 in all cases; example A2 rises to "52.2 percent" by 2009; one-time "30 percent" nominal depreciation (B5) leads to external debt up to "54.8 percent" by 2009.
- Fiscal sustainability (Appendix I, Table A2):
  - Baseline: public sector debt projected to increase to about "38 percent of GDP" by 2009 (Table A2: "2004: 26.5"; "2009 baseline: 38.4 percent").
  - Adverse country-specific scenario (A2): public debt rising to "52.7 percent" by 2009.
  - Alternate shock (A3): public debt rising to "56.4 percent" by 2009.
- Gross external financing need:
  - "2003: 19.6" (US$ billions); "2004 projection: 23.9" (US$ billions).
- Staff view: FDI expected to continue financing a significant part of the current account deficit though slowing from earlier high levels.

### Data availability, revisions, and Fund engagement
- Data timeliness:
  - Exchange rates and interest rates: published daily with no lag.
  - Gross/net international reserves: reported monthly with a one-week lag; 10-day basis with one-week lag.
  - Consumer prices, monetary aggregates, interest rates, central government fiscal accounts, foreign trade: monthly with a lag of one–four weeks.
  - GDP and balance of payments: quarterly with a lag of two–three months; main BOP components also available monthly since 2003.
- National accounts revision (Q2 2004): nominal GDP revised up by "5–8 percent" in 2000–03 to meet Eurostat requirements.
- Czech Republic observance: in observance of the Special Data Dissemination Standard (SDDS).
- Fund engagement:
  - Next Article IV consultation expected on a standard "12-month" cycle.
  - Last Article IV consultation concluded "August 22, 2003"; staff report and PIN published "January 9, 2004".
  - Quota and holdings (as of "May 31, 2004"): Quota SDR "819.30 (100.00 percent)"; Fund holdings of currency "506.91 (61.87 percent)"; Reserve position in Fund "312.40 (38.13 percent)".

### Key policy priorities and recommendations (summary)
- Fiscal:
  - Bolster credibility: keep current year’s general government deficit close to original target; identify and implement the large spending cuts required under the 2004–06 plan promptly.
  - Observe and broaden expenditure ceilings; avoid post-budget spending measures and reliance on one-offs; save fiscal windfalls to lower deficit ratios.
  - Accelerate pension and health reforms to address population aging; target structural deficit below "2 percent of GDP" by 2008–09.
- Monetary:
  - Continue measured tightening to return real interest rates to levels significantly above zero; condition size/timing on exchange rate and growth.
  - Place less emphasis on short-term exchange rate movements; target inflation through ERM2 with strong preconditions for participation.
- Structural:
  - Improve business-legal environment; enhance labor market flexibility; restart and complete privatization; enact bankruptcy law strengthening creditors’ rights.
  - Promote FDI in high-tech and skill-intensive sectors to raise TFP and potential growth.
- Financial supervision:
  - Strengthen supervisory capacity to monitor household credit risks; collect household indebtedness and housing transaction data; improve stress-testing.

*Source: IMF staff report content unit _cr04266 (Executive Summary, Sections 8, Box 3, 36, 41, and related excerpts).*

### Executive Summary ......................................................................................................

### EXECUTIVE SUMMARY

### Background
- GDP expanded by 3.1 percent in 2003, fueled by strong consumption and investment.
- Inflation has risen gradually after recovering in late 2003 from negative levels, but remains in the lower half of the target range.
- Unemployment—particularly long-term unemployment—has risen and stands at about 8 percent.
- The current account deficit widened marginally to 6¼ percent of GDP in 2003, primarily due to a secular decrease in the services surplus.
- Fiscal deficit continued to drift in 2003 and widens further in 2004.
- EU accession shifts focus to completing integration with Europe; per capita income is 63 percent of the EU-15 average on a PPP basis.
- The Czech Republic’s GDP growth rate lagged other CECs by about 2 percentage points during 1995–2003 despite a fixed investment-GDP ratio about 4 percentage points higher (Box 1: Growth-Investment Puzzle).
- Bank lending to households expanded at an annual rate of more than 30 percent during the past two years, while lending to corporates remains stagnant.
- Foreign direct investment (FDI) has been large: about 20 percent of FDI stock represented privatization; 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 have an annual return on equity of about 20 percent versus 8½ percent for domestic firms.
- General government deficit—excluding privatization receipts and transfers to the Czech Consolidation Agency (CKA)—increased to 5 percent of GDP in 2003; expenditure drift and rising entitlements are structural contributors.

### Outlook
- Growth is projected to firm modestly in 2004–05, led by rising exports and related investment.
- Temporary factors should push up inflation to 4 percent (near the top of the CNB’s target range) by year’s end, before dropping toward the midpoint of the band during the first half of 2005; thereafter, strengthening demand will lead to rising inflation.
- The current account deficit should narrow to 5–6 percent of GDP.

### Monetary Policy
- With inflation forecasted to pick up, a tightening cycle has been initiated.
- The CNB raised the repo rate by ¼ point to 2¼ percent in late June 2004; this was considered an appropriate first step.
- The CNB announced that its post-2005 IT framework will shift to a 3 percent point target with a tolerance band of ±1 percent, ensuring continuity with the existing end-2005 target (2–4 percent).
- Further rate increases should be conditioned on the robustness of growth and exchange rate developments.
- Prior to the rate increase, the CNB cut interest rates sharply through August 2003 as inflation and inflation expectations fell, contributing to a significant relaxation of monetary conditions.

### Fiscal Policy
- Putting a stop to fiscal drift is a priority: rising deficits and high-risk guarantees will compound fiscal unsustainability brought on by population aging.
- Staff considers it essential to reverse the widening of the fiscal deficit and implement the 2004–06 fiscal plan.
- Key fiscal actions recommended:
  - Bring the deficit close to target in 2004.
  - Strictly observe expenditure ceilings.
  - Fully identify measures for 2005–06.
  - Accelerate adjustment to avoid back-loading it to 2006 (a scheduled election year).
- Authorities did not intend additional measures for 2004, believing tight budget execution and lower-than-planned spending by extrabudgetary funds would suffice; they saw little scope for accelerating adjustment but agreed that pension and health reforms were needed for long-term sustainability.

### Structural Issues and Reform Priorities
- Implementation of a broad structural reform agenda needs to be accelerated despite EU accession progress.
- Priorities include:
  - Improving the business-legal environment.
  - Keeping the labor market flexible.
  - Completing privatization.
- Progress was being made in most areas, but at a measured pace.
- Structural concerns highlighted in Box 1 (Growth-Investment Puzzle) include misallocated capital from transition, a relatively large capital stock requiring replacement investment with little net productivity gain, high public investment in environmental projects with limited growth payoff, low domestic value-added in some FDI-related activities, and measurement issues related to multinationals’ internal pricing.

### Financial Sector and External Position
- Banking sector indicators have improved: bank cleanup and privatization left about 95 percent of assets foreign owned; classified credits and nonperforming loans declined between 2001 and 2004; capital adequacy remained above 14 percent.
- Stock of inward FDI per capita has been large relative to peers and supported export performance; dividends and reinvested earnings accounted for nearly two-thirds of the current account deficit.
- Non-FDI flows were the major source of financing for the current account deficit in 2003, though FDI recovered in early 2004.

### Political Context
- Fiscal policy drift has been compounded by political uncertainty: following poor electoral performance in the June European Parliament elections, Prime Minister Spidla resigned and prospects for implementing the previous government’s fiscal reform plans are uncertain.

*IMF staff report: Executive Summary (2004).*

### 8.      Discussions focused on policies to entrench macroeconomic stability and

### 8.      Discussions focused on policies to entrench macroeconomic stability and accelerate income convergence, while minimizing fiscal and financial sector risks.

### Macroeconomic policy stance and objectives
- Main fiscal objective: strengthen the credibility of fiscal policy plans.
- Main monetary objective: keep inflation close to the middle of the target range amid one-off influences and diminishing slack.
- Longer-term structural priorities: improve the business-legal system, enhance financial sector supervision, and increase labor market responsiveness.
- Authorities’ view: gradual strengthening of activity provides an appropriate setting for fiscal adjustment envisaged under the 2004–06 plan.

### Economic outlook and growth projections
- Staff projection for 2004: "3¼ percent" growth, citing faster expected deceleration of consumer demand.
- CNB April 2004 Inflation Report baseline projection for 2004: "about 4 percent" growth.
- Staff projection for 2005: "about 3½ percent" growth on the back of stronger growth of EU demand.
- Contribution to narrowing current account deficit: improving trade balance in 2004–05.
- Labor market and employment: moderate increase in growth not expected to yield significant employment gains in the short term as firms focus on productivity and industrial restructuring at remaining state enterprises.
- Downside risks highlighted:
  - Dependence on timing and pace of EU demand recovery.
  - Potential renewed euro appreciation against the U.S. dollar.
  - Faster improvements in external competitiveness elsewhere in the region.
  - Protracted uncertainty regarding the course of fiscal policy.
- Upside factors:
  - Strong bank lending to households could moderate decline in consumer spending.
  - EU recovery may be more dynamic than projected.

### Role of FDI and productivity
- FDI, especially in skill-intensive activities, is pivotal to faster long-term growth while containing external debt buildup.
- Example technology leaders present or committed: Accenture, IBM, Sun Microsystems, DHL, Honeywell, Olympus, Dell.
- Potential scenario: if TFP grew at rates similar to EU-15 catching-up countries (Greece, Ireland, Portugal, Spain) in the late 1990s and labor and capital inputs rose similarly, Czech potential growth would increase to "3¾ percent".
- Policy implication: sizable fiscal consolidation would help accommodate stronger fixed investment and permit some narrowing of the current account deficit.

### Monetary policy assessment and outlook
- CNB policy through mid-2004: kept interest rates on hold expecting temporary inflation rebound through mid-2005 while underlying price pressures remained subdued.
- Estimated first-round inflationary effect of indirect taxes, regulated prices, and EU-related import duties: "about 1½ percentage points" in 2004 and early 2005.
- Staff inflation projection under no policy change: year-on-year inflation peaking at "around 4 percent" in late 2004, then moderating, with upward pressure resuming in mid-2005 and potentially lying well above the CNB’s point target in 2006 if monetary conditions are not tightened.
- Monetary policy stance: CNB intended to initiate a tightening cycle to gradually return real interest rates to levels significantly above zero, with size and timing conditioned on exchange rate developments and growth robustness.
- Staff cautions:
  - Monetary conditions likely too loose to support the inflation target over the next one–two years even after a "¼ percent" increase in late June.
  - The output gap closure speed depends on additions to productive capacity; near completion of several large manufacturing investments may raise potential growth and moderate needed interest rate increases.
  - Exchange rate volatility and uncertain pace of equilibrium real appreciation argue for less emphasis on short-term exchange rate movements in decision making.
- Exchange rate and reserves:
  - CNB began selling interest on reserves to limit further accumulation of reserves; action not intended to influence exchange rate level.
  - CNB sold first installment of interest on reserves in April 2004: "US$42 million".
  - On reserves of more than "US$26 billion", CNB earned some "US$725 million" in interest in 2003; sales will be capped by current interest income.
- Post-2005 framework: medium-term inflation target of "3 percent"; CNB intends to target inflation through ERM2 to avoid disruptive regime shift.

### Fiscal developments, risks, and the 2004–06 fiscal plan
- Recent fiscal developments (2001–03), selected ratios (in percent of GDP):
  - Revenues: "36.7", "37.5", "38.9" (change "2.3").
  - Expenditures, total: "41.7", "44.2", "45.1" (change "3.5").
  - Adjusted expenditures: "39.5", "41.6", "43.9" (change "4.4").
  - Goods and services: "7.9", "8.6", "8.1" (change "0.2").
  - Interest: "0.9", "0.7", "0.8" (change "-0.1").
  - Subsidies: "6.8", "7.3", "8.6" (change "1.7").
    - Of which: to semibudgetary organizations: "2.3", "2.4", "2.7" (change "0.4").
  - Transfers: "18.9", "19.4", "19.9" (change "1.0").
  - Capital expenditure: "4.8", "5.3", "5.5" (change "0.6").
  - Net lending: "0.1", "0.3", "1.0" (change "0.9").
  - Adjusted deficit: "-2.8", "-4.0", "-4.9" (change "-2.2").
  - Memorandum: Transfers to transformation institutions: "2.2", "2.7", "1.2".
  - General government deficit, ESA95 basis: "-6.5", "-6.5", "-12.9".
- Note on ESA95 and cash basis: staff continues to use the cash-based concept when discussing fiscal policy; ESA-based reporting is less timely and frequent.
- Fiscal risks and vulnerabilities:
  - Public debt moderate at "28 percent of GDP", but will increase rapidly if significant deficits continue.
  - Total nominal stock of guarantees: "about 20 percent of GDP"; a large calling of guarantees could sharply raise public debt.
  - Privatization revenues will soon run out; aging population will increase future fiscal demands.
  - Large financing needs could ratchet up interest rates and crowd out private credit; high deficits could impede euro adoption by complicating meeting Maastricht fiscal criteria.
- 2004–06 adjustment plan:
  - Aim: achieve a deficit of "4 percent of GDP by 2006" (staff’s “adjusted deficit” definition: "4.4 percent of GDP" in 2006).
  - Plan features: annual expenditure ceilings, rolling three-year fiscal framework, up-front indirect tax increases, gradual expenditure reductions focused on public sector wages, discretionary spending, and social expenditures.
  - Plan consistency: broadly consistent with the Czech Republic’s 2004 Convergence Programme.
  - Implementation concerns:
    - Staff projects general government adjusted deficit would widen by over "1 percent of GDP to 6.1 percent of GDP in 2004".
    - Post-budget decisions have breached expenditure ceilings (e.g., additional transfers of "⅓ percent of GDP" to compensate families and pensioners appear to breach ceiling).
    - Expenditure ceilings exclude subsidies by the National Property Fund (NPF) and capital injections through net lending; extrabudgetary funds may exceed annual ceilings by approved but previously unspent amounts.
  - Staff recommendation: keep this year’s general government deficit close to original target and adjust deficit targets downward relative to GDP in all years to account for GDP revision.
  - Specific fiscal arithmetic and targets:
    - Authorities' targeted definition (2004–06): "5.5", "4.8", "4.0".
    - Adjusted deficit (staff definitions): "5.8", "5.2", "4.4".
    - ESA95 deficit (Convergence Programme basis): "5.3", "4.7", "3.8".
    - After GDP revisions, initial 2004 target becomes "5½ percent of GDP" (text notes this follows the GDP revision which lowers deficit ratios by about "⅓ percentage point" in 2004–06).
    - Staff argued for additional savings of "½ percent of GDP" to narrow the headline deficit to meet the original "5.8 percent of GDP" target before GDP revision effects.
- Credibility and implementation conditionality:
  - Credible consolidation requires fully identified spending cuts soon, especially because expenditure adjustment is back-loaded to a scheduled election year.
  - Staff called for adhering to initial nominal deficit targets for 2005–06, implying downward revisions of targets relative to GDP because of GDP changes.
  - Uncertainty whether a new government would follow the fiscal plan.

### Key policy recommendations and priorities
- Fiscal:
  - Bolster plan credibility by keeping the current year’s general government deficit close to its original target.
  - Adjust deficit targets downward relative to GDP in all years to account for GDP revision.
  - Identify and implement the large spending cuts required under the 2004–06 plan promptly, focusing on public sector wages, discretionary spending, and social expenditures.
  - Refrain from policy slippages, especially yielding to wage and pension demands that would erode consolidation.
  - Rein in expenditures rather than rely on one-off or nonrepeatable revenues.
- Monetary:
  - Initiate a measured tightening cycle to return real interest rates to levels significantly above zero, with timing and size conditioned on exchange rate and growth developments.
  - Place less emphasis on short-term exchange rate movements given volatility and uncertainty about equilibrium appreciation.
  - Target inflation through ERM2 in the run-up to euro adoption while ensuring strong preconditions for ERM2 (reduced fiscal deficit, improved wage and price flexibility, strengthened financial supervision).
- Structural:
  - Continue improving the efficiency and predictability of the business-legal environment.
  - Enhance labor market flexibility.
  - Reduce state involvement in the enterprise sector, including restarting privatization, to improve resource allocation and shore up fiscal accounts.
  - Promote FDI, particularly in high-tech and skill-intensive activities, to raise TFP and potential growth.

*Source: _cr04266 - 8.      Discussions focused on policies to entrench macroeconomic stability and accelerate income convergence, while minimizing fiscal and financial sector risks.*

### Box 3. Revenue Measures in 2004

### Box 3. Revenue Measures in 2004

### Revenue measures enacted and proposed
- 2004 budget includes:
  - EU-mandated increases in excises and shifts of many goods and services (over one-fourth of the consumption basket) from the preferential to the standard VAT category.
  - a 3 percentage-point cut in the CIT—the first step in gradually reducing it from 31 to 24 percent.
- Subsequent to the budget, several tax measures were legislated or proposed:
  - lowering the standard VAT rate from 22 to 19 percent while shifting more goods and services to the standard rate (in effect from May 2004);
  - shortening depreciation periods and easing the income tax burden on married couples and families with children with effect from 2005 (with parliament).
- Timing and fiscal impact:
  - The indirect tax changes would raise revenues already in 2004.
  - Revenue reductions from the proposed direct tax amendments would appear only in later years.

### Effects of Revenue Measures (In percent of GDP)
- Effects of Revenue Measures, 2004-06 (rows correspond to 2004, 2005, 2006)
  - VAT 1/: 1.1, 1.5, 1.4
  - Excises 2/: 0.5, 0.6, 0.6
  - Corporate income taxes: -0.1, -0.3, -0.9
    - Rate decrease 3/: -0.1, -0.3, -0.5
    - Shorter depreciation period: 0.0, 0.0, -0.4
  - Personal income taxes: 0.0, -0.1, -0.2
  - Total 4/: 1.4, 1.6, 0.9

- Notes on the numeric entries:
  - 1/ Net effect of shifting goods and services from the preferential to the standard VAT category; and reducing the standard VAT rate from 22 to 19 percent.
  - 2/ Increases in excises required by EU harmonization.
  - 3/ Phased decline in the corporate income tax rate from 31 to 24 percent.
  - 4/ The increase in the 2004 tax ratio is smaller than the effects of the revenue measures, due mostly to revenue losses from longer collection lags for VAT on imports.
- Sources: Ministry of Finance; and IMF staff estimates.

### Fiscal balances, adjustments, and decomposition (In percent of GDP)
- Adjusted balance paths:
  - Adjusted balance based on old GDP 1/: -5.2 (2003), -5.8 (2004), -5.2 (2005), -4.4 (2006)
  - Effect of GDP revision 2/: 0.3 (2003), 0.3 (2004), 0.3 (2005), 0.2 (2006)
  - Adjusted balance 3/: -4.9 (2003), -5.5 (2004), -4.9 (2005), -4.2 (2006)
  - Change: -0.6 (2004), 0.6 (2005), 0.8 (2006)
- Decomposition (of the change):
  - Net impact of EU accession 4/: -1.7 (2004), 0.1 (2005), 0.2 (2006)
  - Tax measures 5/: 1.4 (2004), 0.1 (2005), -0.6 (2006)
  - One-offs (net) 6/: -0.7 (2004)
  - Required other adjustment 7/: 0.4 (2004), 0.3 (2005), 1.2 (2006)

- Notes:
  - 1/ Corresponds to the deficit path targeted by the authorities' 2004-06 fiscal plan.
  - 2/ Due to methodological changes, nominal GDP increased by about 5 percent.
  - 3/ Path assumes no change in the targeted nominal deficit compared with the plan.
  - 4/ Includes contributions to the EU budget; losses on customs duties and indirect taxes; direct payments and top-off to farmers; and compensation payments. Staff estimates.
  - 5/ Includes the effects of higher excises; a lower standard VAT rate; shifting items from the preferential to the standard VAT rate; reducing the corporate income tax rate; accelerating depreciation for certain assets; and changes to PIT.
  - 6/ One-offs include spending on compensation to a foreign investor in 2003 (+); shifting infrastructure investment spending from 2003 to 2004 (-); and one-off high dividend income in 2003 (-).
  - 7/ Residual to reach the recommended adjusted balance. Measures not yet fully identified.

### Fiscal policy recommendations and assessment (2004–06)
- Main findings:
  - Reducing the deficit in 2005–06 in line with the plan will require significant additional measures.
  - Authorities considered scope for revenue increases largely exhausted and expected further adjustment to rely on expenditure reductions.
  - Measures underpinning cumulative savings of 1½ percent of GDP in 2005–06 were not yet fully identified.
  - Most required expenditure adjustment could be back–loaded to 2006, since only modest savings were needed to meet the 2005 deficit target.
  - Delivering the 2006 target appeared more difficult because it required finding and implementing significant additional savings measures in a scheduled election year.

- Staff recommendations:
  - Specify plans for permanent savings early to allow spreading expenditure cuts more evenly and bringing some adjustment forward to 2005.
  - Broaden coverage of expenditure ceilings to the widest possible range of spending items and general government units.
  - Strictly adhere to expenditure targets even when higher revenues would finance a spending increase without endangering the deficit target.
  - Avoid post-budget spending measures.
- Authorities’ response and actions:
  - Do not intend to formally broaden the expenditure ceilings, but plan to seal some loopholes (notably closing the NPF by end-2005 and assuming its spending obligations within the state budget).
  - Finance minister intended to propose a state budget for 2005 that observed the approved expenditure ceiling and committed to resisting pressures to spend additional revenues.

- Longer-term fiscal sustainability:
  - Staff recommended targeting a structural deficit of less than 2 percent of GDP by 2008–09.
  - Long-term sustainability requires pension and health care reform.
  - Authorities expected pension expenditures to remain stable at about 9 percent of GDP for the next 10–15 years owing to recent measures (including a gradual increase in the statutory retirement age to 63 years and tighter conditions for early retirement), but recognized a projected 6 percentage point increase in pension spending relative to GDP by 2050, implying the need for pension reform.
  - An expert group was expected to set out main pension reform options by early 2005.
  - Staff emphasized early action because of long lags from reforms to their impact on public spending and risks that labor force participation by older workers may not increase as envisaged.

### Cross-cutting implications and recommended fiscal behavior
- To demonstrate commitment to achieving the 2006 deficit target:
  - Required expenditure cuts should be identified expeditiously and spread more evenly.
  - Authorities should aim for an over-performance of the deficit in 2005 by saving any fiscal windfall (higher-than-expected revenues or upward revision of GDP) to reduce the deficit-to-GDP ratio.
  - Shifting part of the expenditure adjustment forward to 2005 is necessary to alleviate concerns about feasibility of the 2006 target.
  - Full and early identification of the necessary measures is critical given the substantial cumulative savings needed in 2005–06.

*Source: IMF staff report content in Box 3. Revenue Measures in 2004.*

### 36.      Recognition by the authorities that deficit reduction should continue beyond

### _cr04266 - 36.      Recognition by the authorities that deficit reduction should continue beyond

### Fiscal outlook and structural fiscal reforms
- Finding: Recognition that deficit reduction should continue beyond 2006 is welcome.
- Target: A structural deficit below 2 percent of GDP later in the decade is needed to help keep debt moderate and shore up the fiscal position ahead of intensifying budget pressures from population aging.
- Risk: Without pension and health care reforms, population aging will erode the adjustment effort.
- Policy recommendations:
  - Expedite reforms of the pension and health systems to sustain the fiscal adjustment.
  - Implement significant changes in pension system parameters, including further raising retirement ages.
  - Increase cost-sharing with final users in health care to reduce demand.
  - Formulate policy measures quickly and implement promptly because long lags from reform introduction to impact on public spending warrant early action.

### Structural reforms, privatization, and resource allocation
- Finding: Completing the backlog of structural reforms is crucial for improving the efficiency of resource allocation.
- Diagnosis: The initial misallocation of capital at the beginning of transition, reinforced through the late 1990s by lax bank lending decisions, is likely a major cause of relatively slow growth during the past decade.
- Progress: Restructuring and privatizing banks and some large state companies has helped ensure future investment decisions will be made on a market basis.
- Policy recommendations:
  - Resume privatization and close the NPF and CKA to reduce the role of the state and improve resource allocation.
  - Resist pressures for additional bailouts to prevent further increases in public debt and allocation of resources to low value-added uses.
  - Enact expeditiously a bankruptcy law that enhances creditors’ rights.
  - Streamline procedures for entries into commercial registers.

### Monetary policy, inflation outlook, and interest rates
- Finding: Underlying inflation is expected to rise gradually, implying monetary policy will need to tighten in the period ahead.
- Recent action: Keeping policy interest rates on hold through mid-2004 was appropriate given expectations of subdued underlying inflation; a recent ¼ percentage point increase in the policy rate was needed to prevent any further decline in real interest rates in the context of gradually rising underlying inflation.
- Outlook and guidance:
  - With the expected narrowing of the output gap and pickup in inflation from mid 2005, future interest rate increases will need to outpace inflation to tighten monetary conditions.
  - The size and timing of future interest rate increases should be conditioned on evidence of emerging demand-pull pressures, which—despite the expected continuing rise in growth—may be delayed by a faster expansion of potential output.

### Exchange rate regime and competitiveness
- Finding: The Czech inflation targeting framework has provided a transparent foundation for monetary policy and offers continuity through ERM2.
- Policy recommendation: The CNB should continue a nonintervention strategy during the forthcoming tightening cycle to avoid resisting koruna appreciation driven by rising domestic interest rates.
- Competitiveness: Measured in terms of unit labor costs, competitiveness against several CECs has eroded; other factors that are more difficult to quantify—including labor quality—are likely to partially compensate.

### Financial sector supervision and household credit risks
- Finding: Bank supervision should adapt to new risks from rapid growth in lending to households.
- Commendation: The CNB’s efforts at improving the analysis of risks from macrofinancial linkages are commendable.
- Gaps and needs:
  - Enhancement of supervisory capacity is needed in the area of household credit.
  - Require data on household indebtedness, debt-servicing ability, and housing transactions.
  - Establishing a single financial sector supervisor should improve information flow, but organizational changes should not distract from effective oversight.

*Source: IMF staff report content unit _cr04266 - 36.*

### 41.       The next Article IV consultation with the Czech Republic is expected to be

### _cr04266 - 41.       The next Article IV consultation with the Czech Republic is expected to be

### Timing and Fund engagement
- The next Article IV consultation with the Czech Republic is expected to be conducted under the standard 12-month cycle.
- Last Article IV consultation: concluded on August 22, 2003; staff report and PIN published on January 9, 2004.
- As of May 31, 2004: Quota SDR 819.30 (100.00 percent); Fund holdings of currency 506.91 (61.87 percent); Reserve position in Fund 312.40 (38.13 percent).
- Exchange rate regime: managed floating. Koruna per U.S. dollar (July 19, 2004): CZK 25.12 = US$1.

### Recent macroeconomic performance (selected indicators, 2001–04)
- Real GDP growth: 2001: 2.6; 2002: 1.5; 2003: 3.1; 2004 (staff projection): 3.3 (change in percent).
- Domestic demand: 2001: 3.9; 2002: 3.4; 2003: 4.5; 2004: 3.1.
- CPI (year average): 2001: 4.7; 2002: 1.8; 2003: 0.1; 2004: 3.2.
- Unemployment rate (survey-based, year average in percent): 2001: 8.1; 2002: 7.3; 2003: 7.8; 2004: 7.5.
- Gross national savings (percent of GDP): 2001: 23.5; 2002: 22.3; 2003: 21.4; 2004: 22.3.
- Gross domestic investment (percent of GDP): 2001: 28.9; 2002: 27.9; 2003: 27.6; 2004: 27.8.

### Public finance and fiscal balances (2001–04; percent of GDP)
- General government revenue: 2001: 36.7; 2002: 37.5; 2003: 38.9; 2004: 38.3.
- General government expenditure (excluding privatization revenues): 2001: 41.7; 2002: 44.2; 2003: 45.1; 2004: 45.3.
- General government balance: 2001: -5.0; 2002: -6.7; 2003: -6.2; 2004: -7.0.
- Adjusted balance excluding grants to transformation institutions: 2001: -2.8; 2002: -4.0; 2003: -4.9; 2004: -6.1.
- Adjusted balance excluding net lending (targeted concept): 2001: -2.7; 2002: -3.7; 2003: -3.9; 2004: -5.9.
- General government debt: 2001: 17.5; 2002: 18.4; 2003: 21.9; 2004: 26.5.
- Including debt of the Czech Consolidation Agency: 2001: 22.9; 2002: 25.5; 2003: 27.9; 2004: 31.3.

### Balance of payments and external accounts (2000–04)
- Current account balance (US$ millions): 2000: -2,718; 2001: -3,273; 2002: -4,166; 2003: -5,570; 2004 (projection): -5,642.
- Trade balance (US$ millions): 2000: -3,131; 2001: -3,068; 2002: -2,179; 2003: -2,458; 2004: -2,651.
- Exports (US$ millions): 2000: 29,052; 2001: 33,378; 2002: 38,319; 2003: 48,599; 2004: 56,928.
- Imports (US$ millions): 2000: 32,183; 2001: 36,446; 2002: 40,497; 2003: 51,058; 2004: 59,579.
- Gross international reserves (US$ billion): 2000: 14.5; 2001: 23.7; 2002: 27.0; 2003: 28.9 (Table 1 shows 2004: 28.9 in Table 1 and Table 2 projects 27.0 for 2004—staff projections noted).
- Reserve cover (months of imports of goods and services): 2001: 6.1; 2002: 5.5; 2003: 5.1.

### Monetary and financial sector indicators (2001–04)
- Broad money (end of year, percent change): 2001: 13.0; 2002: 3.5; 2003: 6.9; 2004 (May): 9.0.
- Private sector credit (percent change, eop): 2001: 2.1; 2002: 4.5; 2003: 8.5; 2004: 8.3 (growth rate from March 2003 to March 2004 for 2004).
- One-year PRIBOR (end-of-period, in percent): 2001: 4.7; 2002: 2.6; 2003: 2.1; 2004: 2.3 (Table 1 cites end-of-period; Table 5 shows June-04 value 3.0 in a different series).
- 10-year government bond yield (end period): 2001: 6.3; 2002: 4.9; 2003: 4.1; 2004: 5.0.

### Vulnerabilities and financial soundness (highlights)
- Classified credits (percent of total credits): 1999: 31.9; 2000: 28.9; 2001: 20.8; 2002: 15.8; 2003: 11.2; 2004 (March): 11.2.
- Short-term foreign liabilities of commercial banks (US$ billions, March-04): 5.8.
- Official reserves in months of imports G&NFS (March-04): 5.0.
- Total external debt (percent of GDP): 1999: 37.7; 2000: 39.4; 2001: 38.4; 2002: 36.8; 2003: 36.8; 2004 (March-04): 32.9.
- Total external debt to exports G&NFS (in percent): 1999: 68.6; 2000: 60.2; 2001: 55.3; 2002: 59.5; 2003: 61.8; 2004 (March-04): 59.6.
- Gross external financing need (in billions of U.S. dollars): 2003: 19.6; 2004 projection: 23.9.

### External debt sustainability (Appendix I, Table A1 — baseline and stress-test results)
- Baseline projection: external debt stock projected to remain relatively stable at near 40 percent of GDP (Table A1 baseline external debt: 2004: 38.4 percent; 2009: 39.3 percent).
- Current account deficit expected to narrow driven by reduction in trade deficit and increase in services surplus; FDI expected to continue to finance a significant part of the current account deficit although slowing from earlier high levels.
- In U.S. dollar terms external indebtedness is set to increase, but GDP growth and gradual koruna appreciation against the U.S. dollar should stabilize the debt-GDP ratio.
- Gross external financing need (defined as current account deficit + amortization of medium- and long-term debt + outstanding stock of short-term debt) is expected to increase in U.S. dollar terms but decline relative to GDP.
- Stress tests considered: negative shocks to the current account, GDP growth, external interest rates, a large nominal depreciation of the koruna, and a Czech-specific shock where FDI falls each year relative to baseline by US$1 billion and GDP growth is stagnant at 2½ percent (alternative scenario A2).
- Stress-test outcome: external debt-GDP ratio remains under 55 percent in 2009 in all cases (Table A1: A2 shows external debt rising to 52.2 percent by 2009; B5 one-time 30 percent nominal depreciation leads to external debt up to 54.8 percent by 2009).

### Fiscal sustainability (Appendix I, Table A2 — baseline and stress-test results)
- Baseline: assuming general government deficit reduced in line with current plans until 2007, continued deficit reduction in 2008–09, and all of CKA’s debt fully assumed by government by 2008, public debt projected to increase to about 38 percent of GDP (Table A2: public sector debt 2004: 26.5; 2009 baseline: 38.4 percent).
- Under standard adverse shocks, public debt remains below the Maastricht ceiling of 60 percent of GDP.
- Significant risks: contingent liabilities (government guarantees nearly 20 percent of GDP at end-2003).
- Country-specific risk scenario (consistent with A2 in A1): assumes substantial share of contingent liabilities called in 2006 due to weaker growth from a drop-off in FDI; under this scenario:
  - GDP growth slows to about 2½ percent.
  - Public debt could increase above 50 percent of GDP and could exceed the Maastricht limit in the case of additional adverse shocks (e.g., higher interest rates).
- Alternative fiscal scenarios in Table A2:
  - A1 (variables at historical averages in 2005–09) projects public sector debt declining to 30.2 percent by 2009.
  - A2 (primary balance under no policy change 2005–09) projects public sector debt rising to 52.7 percent by 2009.
  - A3 (country-specific shock in 2006 with reduction in GDP growth of one standard deviation) projects public sector debt rising to 56.4 percent by 2009.

### Key scenario assumptions and contributors to debt dynamics
- Drivers of external debt dynamics include: current account deficits excluding interest payments; net nondebt creating capital inflows (notably FDI); contributions from nominal interest rates, real GDP growth, and price/exchange rate changes.
- Table A1 and A2 detailed decompositions show:
  - Automatic debt dynamics and contributions from nominal interest rates and real GDP growth materially affect debt ratios.
  - Net nondebt creating capital inflows were large in earlier years (e.g., 2003 inward FDI), mitigating borrowing needs.
- Debt-stabilizing noninterest current account (long-run) and debt-stabilizing primary balance metrics are computed in the frameworks (Table A1 and A2).

### Fund technical assistance and institutional details (1991–2004)
- Technical assistance across departments (FAD, MFD, RES, STA) for VAT administration, public financial management, monetary management and research, banking supervision, inflation targeting, money and banking statistics, balance of payments, government finance, and implementing GFSM 2001 (detailed timing and purposes listed in Appendix II).
- Membership status: Joined 1/01/1993; Article VIII.

*Source: IMF staff report content as provided in the supplied PDF content unit.*

### 1.      Data on core surveillance variables are available to the Fund regularly and with

### Data on core surveillance variables are available to the Fund regularly and with minimal lags

### Data availability and timeliness
- Exchange rates and interest rates set by the Czech National Bank (CNB): published daily with no lag.
- Gross and net international reserves: reported monthly with a one-week lag, and on a 10-day basis (with the CNB’s balance sheet) with a one-week lag.
- Consumer prices, reserve money, broad money, borrowing and lending interest rates, central government fiscal accounts, and foreign trade: reported monthly with a lag of one–four weeks.
- Final monetary survey data: available with a lag of about one month.
- GDP and balance of payments data: made available on a quarterly basis with a lag of two to three months.
- Since 2003: main balance of payment components are also available on a monthly basis.
- Annual Government Finance Statistics Yearbook data: cover all operations of the general government (including extrabudgetary funds excluded from monthly data) and are available on a timely basis.
- Monthly fiscal data in International Financial Statistics (IFS): cover central and local budget accounts and are available with a two- to three-month lag.

### Data quality, revisions, and methodological changes
- Overall assessment: Data quality is generally adequate; authorities are taking steps to eliminate deficiencies. EU accession prompted methodological changes, particularly for trade data.
- National accounts revisions (second quarter of 2004):
  - Purpose: to bring data into line with Eurostat requirements.
  - Outcome: nominal GDP revised up by 5–8 percent in 2000–03.
  - Main adjustments:
    - (i) estimate the stock and consumption of fixed capital at replacement cost;
    - (ii) calculate imputed rent on the basis of user cost;
    - (iii) estimate the effect of business units not included in the business register.
  - Scope: both real and nominal data at the annual and quarterly frequencies were revised.
- Intra-EU trade data changes with EU entry:
  - Intra-EU trade accounts for about 80 percent of the total.
  - Data will be derived from surveys rather than customs information.
  - Large firms and some small- and medium-sized companies will be surveyed monthly.
  - Expected consequences: some nonresponse; a break in the trade data (no overlapping period where both methodologies are used); longer lags in release (25 days compared with 16 days earlier).
  - Continued weakness: unavailability of price indices for exports and imports with a fixed base; indices currently presented on the basis of the same month of the previous year.
- Monetary statistics:
  - Monetary survey data provided to the European Department are generally adequate for policy purposes despite some differences with IFS presentation.
  - Large variations in the interbank clearing account float, especially at year-end, require caution in interpreting monetary developments; CNB has worked to identify causes and adjust the data.
  - In 2002, the CNB implemented the European Central Bank (ECB) framework for monetary data and initiated reporting of monetary accounts that meet the IFS as well as the ECB requirements.
  - The same set of accounts forms the basis of monetary statistics published in the CNB’s bulletins and on the website, effectively harmonizing with monetary statistics published in IFS.

### Dissemination standards and data access
- The Czech Republic is in observance of the Special Data Dissemination Standard (SDDS) and meets the SDDS specifications.
- Statistical metadata are posted on the Fund’s Dissemination Standards Bulletin Board.
- Czech economic data can be obtained from the following websites (as listed in the source):
  - Czech Statistical Office
  - Czech National Bank
  - Czech Ministry of Finance
  - IMF SDDS country page for CZE

### Core statistical indicators (as of July 21, 2004) — timing and reporting patterns
- Date of latest observation (selected):
  - Exchange Rates: 7/21/04
  - International Reserves: 6/30/04
  - Central Bank Balance Sheet: 7/10/04
  - Reserve/Base Money: 7/10/04
  - Broad Money: 5/31/04
  - Interest Rates: 7/21/04
  - Consumer Price Index: 6/04
  - Exports/Imports: 5/04
  - Current Account Balance: Q1 2004
  - External Debt/Debt Service: Q1 2004
  - Central Government Balance: 5/04
  - GDP: Q1 2004
- Frequency of data: ranges from Daily (Exchange Rates, Interest Rates) to Monthly, 10 days, and Quarterly depending on series.
- Mode of reporting: Internet for most series; confidentiality: No.
- Sources of updates: CNB, CSO (Czech Statistical Office), MoF (Ministry of Finance) as indicated in the source.

### Recent policy and economic developments (Statement by the IMF Staff Representative, August 6, 2004; IMF PIN, August 17, 2004)
- Political/government developments:
  - A new government, identical in composition to the previous coalition, was formed in early August 2004, headed by former Interior Minister Gross.
  - The government holds 101 of the 200 parliamentary seats.
  - Coalition agreement priorities through the 2006 elections include:
    - gradually reducing the fiscal deficit to below 3 percent of GDP by 2008;
    - adopting the euro by no later than 2010;
    - preparing reforms of the pension and health care systems;
    - reducing work disincentives in social benefits;
    - supporting families and the establishment of small- and medium-sized enterprises.
- Monetary policy outlook (CNB July inflation report):
  - CNB forecasts economic growth for 2004 at 3.6–4.0 percent (down marginally from its April prediction).
  - CNB forecasts for 2005: 3.5–4.9 percent (up by ¼ percentage point from its previous forecast).
  - The CNB sees current inflation rising more slowly than previously forecast and left interest rates unchanged at its most recent monetary policy meeting.
- Fiscal projections and budget:
  - Ministry of Finance (MoF) revised its fiscal projections for 2004: updated forecast shows an adjusted general government deficit of about 5¾ percent of GDP, about ¼ percentage points narrower than MoF estimates at the time of the discussions (mostly on account of higher projected nontax revenues).
  - This revised deficit is about ¼ percentage points higher than the authorities’ original target (based on revised GDP).
  - For 2005, MoF prepared a draft budget consistent with the deficit target of the medium-term fiscal plan; discussions to resume when the new government is fully installed.
- Macroeconomic performance (PIN summary):
  - GDP expanded by 3.1 percent in 2003 and the first quarter of 2004, mainly supported by household consumption and investment (including public infrastructure and EU accession–related one-offs).
  - 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.
  - Inflation: since late 2003 inflation has been recovering from negative levels; indirect tax increases in January and May 2004 pushed headline inflation above the bottom of the CNB’s inflation target band, while underlying inflation remains below the target band.
  - Current account: notwithstanding an improving trade balance, the current account deficit widened marginally to 6¼ percent of GDP in 2003. Contributing factors included a secular decrease in the services surplus and a one-off drop in current transfers. With privatization slowing and one-off FDI outflows related to ownership changes at two large foreign-owned companies, non-FDI flows were the major source of financing for the current account deficit.

*Source: _cr04266 — IMF staff report excerpts, Statement by the IMF Staff Representative (August 6, 2004), and Public Information Notice No.04/93 (August 17, 2004)._*

### 2003. In early 2004, however, FDI rebounded.

### _cr04266 - 2003. In early 2004, however, FDI rebounded.

### Monetary conditions and policy framework
- 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.
- 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 announced the post-2005 IT framework: target of 3 percent point with a tolerance band of ±1 percent, ensuring continuity with the existing end-2005 target (2-4 percent).
- Directors saw the recent move to tighten monetary policy as appropriate; they expected monetary conditions to tighten further to keep inflation close to target, with decisions on size and timing of rate increases to take demand and cost-push developments into account.
- The flexible exchange rate regime and a policy of nonintervention in the foreign exchange market were commended; interest rates provide coherent and transparent signals about monetary intentions.
- As part of the euro adoption strategy, under assumptions of Maastricht criteria observance and sufficient real convergence, adoption of the euro could be expected in 2009-10. The CNB recommended the shortest possible ERM2 stay to minimize risks.

### Inflation and interest rate outlook
- Inflation developments:
  - CPI (year average) 2001–2003: 4.7, 1.8, 0.1
  - June consumer prices rose 2.9 percent y/y; producer prices increased by 6.2 percent (January–May 2004 references).
- Interest rates:
  - Three-month interbank rate (end-of-period) 2001–2003: 4.7, 2.6, 2.1
  - CNB increased interest rates from 2 to 2.25 percent; markets price a further increase of 75 basis points by end-2004.
- Real interest rates noted as presently negative; CNB will consider output gap and inflation risks (including elevated oil prices) in further rate decisions.

### Fiscal developments and sustainability
- General government fiscal drift:
  - General government balance (percent of GDP) 2001–2003: -5.0, -6.7, -6.2
  - Adjusted to exclude grants to transformation institutions and transfers to cover management of bad assets: -2.8, -4.0, -4.9
  - Adjusted balance excluding net lending 2001–2003: -2.7, -3.7, -3.9
  - General government revenue (percent of GDP) 2001–2003: 36.7, 37.5, 38.9
  - General government expenditure (percent of GDP) 2001–2003: 41.7, 44.2, 45.1
  - General government debt 2001–2003: 17.5, 18.4, 21.9
  - Including debt of the Czech Consolidation Agency: 22.9, 25.5, 27.9
- The general government deficit—excluding privatization receipts and transfers to the Czech Consolidation Agency—widened by about 1 percentage point to near 5 percent of GDP in 2003. Increase mainly reflected higher spending on subsidies, net lending, and investment.
- Public debt remains moderate at 28 percent of GDP (text) and can be financed with ease; recent inaugural eurobond issue cited.
- Staff and Directors’ recommendations:
  - Strengthen implementation and credibility of the multi-year fiscal plan; adherence to expenditure ceilings; close loopholes; return to original nominal deficit target.
  - Shift to a comprehensive fiscal measure—preferably the standardized European Union definition.
  - Build public support for measures under the plan.
  - Identify and implement expenditure savings expeditiously; avoid permanent expenditure increases in 2005; bring forward part of expenditure savings needed to achieve the 2006 target.
  - Any fiscal windfall from higher-than-expected revenues should be saved to support deficit reduction.
  - Accelerate pension and health system reforms (including further rise in retirement age and greater cost-sharing with final users of health care) to address population aging and ensure long-term fiscal sustainability.

### External sector and foreign direct investment (FDI)
- Foreign investment contribution:
  - Czech Republic attracted the largest amount of FDI on a per capita basis among central European countries.
  - Some 20 percent of the FDI stock represented privatization (mostly of banks and network utilities); 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,
    - over 70 percent of industrial exports.
  - Foreign industrial firms are considerably more profitable than domestic counterparts.
- Balance of payments indicators 2001–2003:
  - Trade balance: -5.0, -3.0, -2.7 (percent of GDP)
  - Current account: -5.4, -5.6, -6.2 (percent of GDP)
  - Gross international reserves (US$ billion): 14.5, 23.7, 27.0
  - Reserve cover (in months of imports): 4.1, 6.1, 5.5
- Exchange rate:
  - Exchange rate regime: Managed float
  - Koruna per U.S. dollar (July 19, 2004): CZK 25.12 =US$1
  - Nominal effective exchange rate (2000=100) 2001–2003: 104.4, 116.1, 115.6
  - Real effective exchange rate (CPI-based; 2000=100) 2001–2003: 105.5, 116.7, 112.6

### Banking sector, credit, and financial supervision
- Banking health improved after late-1990s cleanup and privatization: nonperforming loans reduced, new capital injected, profitability raised.
- Bank lending behavior:
  - Banks were cautious for several years; following introduction of mortgage and customer loan facilities, bank lending to households rose at an annual rate of more than 30 percent for about two years.
  - Lending to corporates remains stagnant.
- Directors’ supervisory recommendations:
  - Enhance supervisory capacity in household credit area, including collection of relevant data and enhanced stress-testing.
  - Proceed with planned consolidation of financial sector supervision within a single institution but ensure organizational changes do not distract from effective oversight.
- Money and credit indicators (end of year, percent change) 2001–2003:
  - Broad money: 13.0, 3.5, 6.9
  - Private sector credit (percent change, eop): 2.1, 4.5, 8.5
- Interest rate yields:
  - 10-year government bond 2001–2003: 6.3, 4.9, 4.1

### Growth, labor market, and structural reforms
- Growth and demand:
  - Real GDP (change in percent) 2001–2003: 2.6, 1.5, 3.1
  - Domestic demand 2001–2003: 3.9, 3.4, 4.5
  - Real GDP grew by 3.1 percent in Q1 2004; fixed capital formation grew by 9.5 percent and household consumption by 3.9 percent (Q1 2004).
  - Ministry of Finance macro forecast: real GDP growth in 2004 and 2005 of 3.1 and 3.2 percent respectively.
  - CNB revised its April 2004 growth projection for 2004 to 3.6-4 percent; projects 2005 growth of 3.5-4.9 percent.
- Labor market:
  - Unemployment rate (survey based, percent of total labor force) 2001–2003: 8.1, 7.3, 7.8
  - Registered unemployment 2001–2003: 8.5, 9.2, 9.9
  - Directors identified high unemployment and rising long-term unemployment as serious structural problems.
  - Recommended reforms: increase labor market flexibility, reduce non-wage labor costs, tighten eligibility for unemployment benefits, and improve education and training to match evolving skills demands.
- Structural reform priorities:
  - Reinvigorate privatization through transparent and open procedures; close the National Property Fund and the Czech Consolidation Agency; resist pressures for additional bailouts.
  - Improve business-legal environment, including enactment of a bankruptcy law that enhances creditors’ rights.
  - Improve quality of education, training, and research and development activities.

### Executive Board Assessment and policy recommendations
- Executive Directors welcomed EU accession (May 1) and commended solid recent economic performance; near-term outlook favorable with growth expected to firm based on robust exports and export-related investment.
- Key Director recommendations:
  - Decisive fiscal policy implementation to resist spending pressures, prepare for population aging, and cope with potential calls on government guarantees.
  - Strengthen credibility and implementation of the multi-year fiscal plan; prefer EU-standard fiscal measures; build public support.
  - Implement ambitious expenditure reforms (pension and health) promptly to address aging effects expected to impact public finances within 10-15 years.
  - Continue inflation targeting as a sound anchor pre-euro; gradual approach to monetary integration with emphasis on fiscal consolidation and structural reform.
  - Strengthen private sector attractiveness for FDI, improve labor market flexibility, and tailor education to skills demand.
  - Enhance financial sector supervision and data collection for household credit stress-testing.

### Selected economic and financial indicators (highlights from table)
- Real GDP: 2001 2.6; 2002 1.5; 2003 3.1
- CPI (year average): 2001 4.7; 2002 1.8; 2003 0.1
- Gross national savings (percent of GDP): 2001 23.5; 2002 22.3; 2003 21.4
- Gross domestic investments (percent of GDP): 2001 28.9; 2002 27.9; 2003 27.6
- Gross international reserves (US$ billion): 2001 14.5; 2002 23.7; 2003 27.0

*IMF staff report and Executive Board discussion on the Czech Republic (2004).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04266.pdf_