## _cr05276

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### Executive summary — Background and outlook
- Growth picked up significantly in 2004 driven by an investment and export surge related to EU entry.
- Annual growth reached almost 4½ percent in 2004.
- Strong export growth improved the external accounts; export-related investment rose in response to cross-border integration of production.
- Household consumption grew only modestly; government consumption declined; employment rose only modestly owing to ongoing restructuring.
- Fiscal deficit narrowed in 2004, but largely because of one-off factors and changes in budgetary rules.
- Adjusted general government deficit declined from above 4¾ percent in 2003 to 3¼ percent in 2004.
- Staff and the authorities shared the view that, under the baseline, growth will remain healthy in 2005–06, led by domestic demand and supported by net exports.
- Headline inflation is expected to remain low in 2005–06 as continued economic slack and moderate wage growth are likely to contain second-round effects of oil price increases.
- Risks around the baseline appear evenly balanced.
- Medium-term strategy aims to reach the EU average GDP per capita by 2013.
- Medium- and long-term challenges: continued rigidities in the labor market, weaknesses in the business-legal environment, and population aging; political timing (June 2006 elections) may complicate consensus on reforms.

### Policy discussions — Monetary policy
- Current market and official expectations suggest that inflation is likely to remain below the 3 percent target through the end of 2006.
- Uncertainties call for a cautious approach to future interest rate changes.
- CNB actions and outlook:
  - CNB reduced policy rates with a cumulative rate cut of 75 basis points in January–April 2005.
  - CNB’s main policy rate stands at 1¾ percent, 25 basis points below the ECB rate.
  - CNB and staff baseline: average CPI inflation staying below 2 percent in 2005 and rising to 2¼ percent by end-2006.
  - Headline inflation is now about 1½ percent, below the CNB target band.
  - Authorities favor awaiting effects of recent rate cuts before further moves and avoid activist attempts to hit the point target.

### Policy discussions — Fiscal policy
- Withdrawal of fiscal stimulus in 2004 was appropriate.
- Staff concern: fiscal consolidation is set to be reversed in 2005; adjustment is back-loaded to 2006–07.
- Recommended emphasis: accelerate and deepen fiscal consolidation, primarily through expenditure reforms (pensions, healthcare, benefits reform) and expenditure rationalization across budget chapters.
- Staff recommended front-loading part of the adjustment to 2005 and adopting permanent measures to meet medium-term plans.
- Staff observed that lowering the deficit by 1 percent of GDP relative to the authorities’ 2005 target would ensure credibility and contain public debt growth.
- Even if staff’s 2005 recommendations were implemented, reducing the deficit in 2006–07 would still require expenditure measures amounting to a cumulative 1⅓ percent of GDP.
- Authorities’ fiscal strategy and measures:
  - Plan aims to meet the Maastricht deficit criterion by 2008, underpinned by annual expenditure ceilings and a rolling three-year framework.
  - Reductions in corporate income taxes cumulatively amount to about ¾ percent of GDP over 2004–06.
  - Planned permanent personal income tax cuts for low- and middle-income taxpayers of about ⅓ percent of GDP in 2006.
  - Authorities judged scope for 2005 savings smaller than staff suggested due to carryover rules, election-year pressures, and cofinancing needs for EU transfers.
- Fiscal risks and contingent liabilities:
  - Large share of outstanding guarantees considered high risk; guarantees total the equivalent of 16 percent of GDP (excluding ecological guarantees).
  - If primary deficits remained at the 2002–04 average, debt could climb to 40 percent of GDP by 2010.
  - Debt projected under staff baseline to reach around 30 percent of GDP by 2010 (assuming adherence to 2005–07 plan and consolidation to bring deficit to around 2½ percent of GDP by 2010).

### Policy discussions — Structural policy
- Agreement that pace of structural reform should be accelerated to sustain growth.
- Progress made improving the business-legal environment, but more implementation required; bankruptcy legislation delayed.
- Labor market reforms implemented piecemeal; employment flat despite solid GDP growth suggests eroding labor market flexibility.
- Staff argue for a comprehensive agenda combining labor market and entitlement reforms, including changes to social benefits to reduce welfare traps and increase participation.

### Policy discussions — Financial sector
- Financial system is sound and well-positioned to withstand moderate macroeconomic shocks.
- Regulatory capital to risk-weighted assets was 12.7 percent in 2005 Q1, 4 percentage points above the required 8 percent minimum in early 2005.
- Stress testing suggests the banking system would remain well-capitalized under moderate shocks; shocks comparable to the 1997 crisis would leave about 7 percent of banks with negative capital, with recapitalization costs about ½ percent of GDP.
- Rapid household credit growth (annual rate of more than 30 percent for bank consumer and mortgage lending in recent years from a low base) poses future financial stability risks.
- Classified loans: 3⅓ percent of mortgage loans and 11 percent of consumer loans.
- Banks’ exposure to households is about 12 percent of assets.
- Staff recommendations:
  - Integrate stress-testing with bank supervision and collect detailed data on household loan portfolios and housing transaction prices.
  - Stay vigilant for signs of easing credit standards.
  - Encourage long-term savings programs and review pension fund regulations and savings subsidies.

### Market sentiment and financial indicators
- Portfolio outflows reversed in 2004 around EU accession; ample global liquidity and favorable Czech performance lowered spreads.
- Koruna: depreciated in 2003, then strengthened in 2004–early 2005; appreciation slowed recently.
- Interest rates: summer 2004 increases may have supported earlier appreciation; subsequent cuts helped break appreciation trend.
- Bond spreads: local and sovereign spreads among the narrowest in the region.
- External sector: export growth slowed from exceptional rates but remained strong; trade and current account balances narrowed; FDI inflows stable relative to GDP since early 2004.

### Demographic shock and long-term implications (key projections)
- By 2050, the elderly will account for 53 percent of the population.
- Working-age population projected to shrink by 22 percent compared with 2005.
- Budgetary spending on pensions and health care projected to rise to 22 percent of GDP by 2050 from about 14 percent in 2005.
- Debt projected to reach 100 percent of GDP by 2025 under prevailing policies.
- Intertemporal fiscal gap estimated at over 10 percent of GDP in net present value terms.
- Every two-year delay will raise the needed adjustment by ⅓ percent of GDP.
- To maintain net debt at 60 percent of GDP by 2050, a smooth adjustment targeting a primary balance or a small surplus beginning early in the next decade would be needed.
- Household financial assets are currently around 140 percent of disposable income.
- Household nonfinancial assets account for 60 percent of total assets; households need to redistribute assets into more strategic forms of long-term investment.

### Economic outlook (short term and medium term)
- Staff projects growth of 4 percent in 2005–06.
- Trade account expected to post a surplus and the current account deficit to narrow to just over 3 percent of GDP.
- Leading indicators and Q1 2005 results broadly consistent with baseline; risks evenly balanced.
- Risks to baseline:
  - Downside: slowdown in the EU, higher oil prices, weaker employment.
  - Upside: pickup in EU growth, larger-than-expected fiscal impulse, faster wage growth.
- Staff estimates potential growth at less than 4 percent in the medium term.
- Assuming gradual labor market reforms, increased participation unlikely to offset decline in working-age population.
- Total factor productivity assumed to grow in line with recent history and rates similar to EU-15 catching-up countries.
- Access to EU funds and continued FDI—especially in skill-intensive activities—support medium-term prospects.
- Sizable fiscal consolidation over the medium term needed to accommodate strong fixed investment while keeping the current account deficit below 3 percent of GDP and debt ratios sustainable.

### Fiscal framework, public financial management, and transparency
- Budgetary shortcomings: persistent underspending and carryover provisions that allow line ministries to carry over unspent allocations outside expenditure ceilings.
- Carryover rules contributed about 1 percentage point of the decline in the deficit in 2004.
- Transparency hindered by off-budget spending and delays in fiscal reporting on extrabudgetary funds (e.g., National Property Fund (NPF) spending will remain outside expenditure ceilings after NPF closure).
- Staff recommended:
  - Introduce a fiscal rule targeting a structural balance or a small surplus over the medium term (based on debt sustainability analysis).
  - Restore “teeth” to the fiscal framework, integrate extrabudgetary approvals with the state budget, extend expenditure ceilings to cover carryover spending, enhance timely reporting, and consistently use the broadest fiscal concept.
  - Expedite shift to GFSM 2001.

### Structural reforms and enterprise sector priorities
- Privatization and state asset management:
  - Confirm completion of pending privatization in the electricity sector; avoid transfers of bad assets to CKA; wind down CKA with minimum cost to taxpayers.
- Business-legal environment:
  - Introduced single standardized forms and an automatic five-day deadline for registration; one-stop-shop services remain limited.
  - Continued delays in adopting bankruptcy legislation impede closure of insolvent firms and enable asset stripping.
  - Authorities created the Business Environment Development Council and streamlined company registration.
- Labor market, social benefits, and human capital:
  - Legislation prepared to tighten benefit entitlements, encourage retraining, and increase geographical mobility; adoption delayed.
  - Disincentives to work particularly strong for younger workers with large families (unemployment rate 5 percentage points higher than in families with no children).
  - Recommendations: reform social benefits, reduce implicit tax on employment, introduce in-work benefits in certain cases, curb early retirement and disability benefit abuse, promote performance-based financing of schools and universities, and ease rent control to improve mobility.

### Financial and external position — key indicators and risks
- External and public debt ratios are moderate (below 40 percent of GDP) and broadly stable.
- Official reserves cover about 1½ times the economy’s short-term debt at remaining maturity.
- Floating exchange rate provides adjustment capacity.
- Risks to public debt sustainability and deficit financing:
  - Delays in fiscal reforms, drying up of privatization revenues, and large contingent liabilities.
- Staff suggested further analysis of currency mismatches in private sector balance sheets to identify unhedged exchange rate risk.
- Structural concerns: weaknesses in the business-legal environment (weak creditor rights, discretion of bankruptcy judges, lengthy legal procedures) risk discouraging investment.

### Data availability, quality, and SDDS observance
- Key reporting lags and frequencies:
  - Exchange rates and interest rates: reported daily with no lag.
  - Gross and net international reserves: monthly with a one-week lag; also on a 10-day basis with a one-week lag.
  - Consumer prices, reserve money, broad money, interest rates, central government fiscal accounts, and foreign trade: monthly with a lag of between one and four weeks.
  - GDP and balance of payments: quarterly with a lag of two to three months.
- Data weaknesses:
  - National accounts: underestimation of value added in small-scale private sector; large discrepancies between production and expenditure approaches.
  - Quarterly national accounts subject to nonresponse bias and lumping of expenditure categories.
  - External trade: lack of fixed base price indices for exports and imports.
  - Monetary statistics: large year-end interbank clearing account float variations.
- The Czech Republic observes the SDDS and posts statistical metadata on the Fund’s Dissemination Standards Bulletin Board.

### Key numeric projections and selected indicators (high-frequency extraction)
- Real GDP (change in percent): 2001: 2.6; 2002: 1.5; 2003: 3.2; 2004: 4.4; 2005 1/: 4.1
- CPI (year average): 2001: 4.7; 2002: 1.8; 2003: 0.1; 2004: 2.8; 2005 1/: 1.6
- Unemployment rate (survey-based, percent): 2001: 8.1; 2002: 7.3; 2003: 7.8; 2004: 8.3; 2005 1/: 7.9
- Adjusted general government deficit: 2003: above 4¾ percent; 2004: 3¼ percent.
- General government debt (percent of GDP): 2001: 17.5; 2002: 18.4; 2003: 21.7; 2004: 24.0; 2005 1/: 25.8
- Guarantees (equivalent): 16 percent of GDP (excluding ecological guarantees).
- Household financial assets: around 140 percent of disposable income.
- Household nonfinancial assets: 60 percent of total assets.
- Banking sector indicators (selected):
  - Capital adequacy ratio: 15.4 (2001); 14.3 (2002); 14.5 (2003); 12.6 (2004); Mar-05: 12.7
  - NPLs in percent of total loans: 2001: 13.4; 2002: 8.1; 2003: 4.9; 2004: 4.1; Mar-05: 4.8
  - Return on equity (percent): 2001: 16.6; 2002: 27.4; 2003: 23.8; 2004: 23.4; Mar-05: 32.1
  - Credit to private sector (percent change, eop / Apr-05): 2001: 2.1; 2002: 4.5; 2003: 8.5; 2004: 8.4; Apr-05: 11.6
- Balance of payments highlights:
  - Current account (percent of GDP): 2001: -5.4; 2002: -5.6; 2003: -6.2; 2004: -5.2; 2005 1/: -3.3
  - Exports (US$ millions): 2001: 33,378; 2002: 38,319; 2003: 48,599; 2004: 66,678; 2005 1/: 80,856
  - Imports (US$ millions): 2001: 36,446; 2002: 40,497; 2003: 51,058; 2004: 67,547; 2005 1/: 80,442

### Debt sustainability and stress-test outcomes (public and external)
- Public sector debt (percent of GDP): 2001: 17.5; 2002: 18.4; 2003: 21.7; 2004: 24.0; 2005: 25.8; projected to 31.4 by 2010 under baseline.
- Debt-stabilizing primary balance (percent of GDP): 2005 projection: -0.4
- Alternative public debt scenarios (selected peaks):
  - A1 (historical averages 2005-09): debt rises to 34.1
  - A2 (no policy change): debt rises to 39.4
  - A3 (country-specific shock in 2006): debt rises to 44.7
  - Bound tests: e.g., B2: debt up to 54.8; B6: debt up to 41.0
- Total gross external debt (percent of GDP): 2001: 36.8; 2002: 36.6; 2003: 38.5; 2004: 42.3; 2005: 37.5; projected 27.5 by 2010
- Gross external financing need (US$ billion): 2001: 15.1; 2002: 15.0; 2003: 16.8; 2004: 19.6; 2005 (Proj): 23.4; projected 2006: 27.1

### Staff appraisal — priorities and recommended actions (condensed)
- Immediate priority: accelerate fiscal consolidation and front-load part of adjustment to 2005 where feasible; specify permanent saving plans for 2006–07.
- Medium- and long-term: sustained consolidation beyond 2007 to prepare for population aging; target a structural balance or small surplus over the long term.
- Structural reform priorities:
  - Pension reform: build early political consensus; consider transitional financing from privatization receipts.
  - Healthcare: rationalize supply, create incentives for cost containment, increase user cost-sharing, transform insurers into true insurers.
  - Business-legal reforms: approve modern bankruptcy procedures and expand one-stop-shop registration.
  - Labor market: reform benefits, encourage retraining, increase geographic mobility, and remove disincentives to work.
- Financial sector surveillance: integrate stress testing with supervision; collect household loan and housing price data; maintain vigilance on credit standards.
- Monetary policy: retain inflation-targeting anchor; exercise caution on further cuts given fiscal uncertainty; maintain non-interventionist FX stance except in exceptional circumstances.
- Euro adoption: potential gains conditional on credibly reducing fiscal deficit below Maastricht limit and improving labor market flexibility; adhering to current timetable requires early agreement on required policies.

*Source: _cr05276.*

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

### _cr05276 - Executive Summary

### Background and Outlook
- Growth picked up significantly in 2004 driven by an investment and export surge related to EU entry.
- Annual growth reached almost 4½ percent in 2004.
- Strong export growth improved the external accounts; export-related investment rose in response to cross-border integration of production.
- Household consumption grew only modestly; government consumption declined; employment rose only modestly owing to ongoing restructuring.
- Fiscal deficit narrowed in 2004, but largely because of one-off factors and changes in budgetary rules.
- Adjusted general government deficit declined from above 4¾ percent in 2003 to 3¼ percent in 2004.
- Staff and the authorities shared the view that, under the baseline, growth will remain healthy in 2005–06, led by domestic demand and supported by net exports.
- Headline inflation is expected to remain low in 2005–06 as continued economic slack and moderate wage growth are likely to contain second-round effects of oil price increases.
- Risks around the baseline appear evenly balanced.
- The Czech Republic faces medium- and long-term challenges from continued rigidities in the labor market, weaknesses in the business-legal environment, and population aging; the authorities judged consensus on their reform strategy might be elusive prior to June 2006 elections.
- The medium-term strategy aims to reach the EU average GDP per capita by 2013.

### Policy Discussions

H3: Monetary policy
- Current market and official expectations suggest that inflation is likely to remain below the 3 percent target through the end of 2006.
- Uncertainties call for a cautious approach to future interest rate changes.

H3: Fiscal policy
- Withdrawal of fiscal stimulus in 2004 was appropriate.
- Staff is concerned that fiscal consolidation is set to be reversed in 2005.
- With growth remaining strong, staff emphasize accelerating and deepening fiscal consolidation, particularly given the backloading of expenditure adjustment under the authorities’ fiscal plans.
- Adjustment should come from expenditure reforms, centered on entitlement reform and expenditure rationalization in all budget chapters.
- Sustained fiscal consolidation through the medium–term—focusing on pensions, healthcare, and benefits reform—is needed to prepare for aging.

H3: Structural policy
- All sides agreed the pace of structural reform should be accelerated to sustain strong growth.
- Progress has been made in improving the business-legal environment, but more is required; implementation of labor market reforms has been piecemeal.
- A virtually flat employment trend despite solid GDP growth suggests labor market flexibility may be eroding.
- Staff argue for a comprehensive agenda combining labor market and entitlement reforms.

H3: Financial sector
- The financial system is sound and well-positioned to withstand moderate macroeconomic shocks.
- Staff welcome progress in strengthening the financial system, but recommend closer integration of stress-testing with bank supervision and further improvements in data collection.

### Key Findings and Indicators
- Exports and investment surged in 2004; foreign-owned firms account for most industrial exports.
- Productivity picked up significantly due to FDI and restructuring.
- Despite solid GDP growth, employment growth has been modest and unemployment has not declined significantly.
- There appears to be a small negative output gap in 2004–05 using staff GDP projections.
- Koruna appreciation, a good harvest, and strong retail competition helped keep core inflation low in 2004.
- Trade was nearly balanced in 2004; the current account deficit narrowed substantially and was largely financed by FDI.
- New budgetary rules allowed line ministries to carry over unspent allocations to future years, contributing about 1 percentage point of the decline in the deficit.
- Tax revenues, adjusted for collection delays relating to EU accession, remained strong due to the pickup in growth and harmonization of indirect taxes with the EU.

*Source: Executive Summary as in _cr05276 - Executive Summary.*

### 8.      In line with regional trends, market sentiment on the Czech Republic remains

### _cr05276 - 8.      In line with regional trends, market sentiment on the Czech Republic remains

### Market sentiment and financial indicators
- Portfolio outflows reversed in 2004, supported by a rebalancing of investors’ portfolios following accession of CEECs into the EU.
- Ample global liquidity and favorable performance of the Czech economy helped lower spreads; long-term interest rates and sovereign bond spreads are similar or narrower than those for other CEECs.
- The koruna:
  - Depreciated in 2003, then strengthened in 2004–early 2005, in line with regional trends.
  - Appreciation has slowed recently, possibly reflecting smaller risk appetite after rejection of the EU constitution by some countries and the April cut in policy rates.
- Interest rates:
  - Interest rate increases in the summer of 2004 might have contributed to earlier appreciation.
  - Interest rate cuts appear to have helped break the appreciation trend in the region.
- Bond spreads:
  - Local currency bond spreads and international sovereign bond spreads for the Czech Republic are among the narrowest in the region.
- External sector developments (Figure 6 summary):
  - Export growth slowed from exceptional rates but remained strong.
  - Trade and current account balances narrowed significantly.
  - FDI inflows have remained stable relative to GDP since early 2004.
  - Portfolio outflows were volatile but reversed around the time of EU accession.

### Demographic shock and long-term implications (Box 2)
- Demographic projections and labor force:
  - By 2050, the elderly will account for 53 percent of the population.
  - The working-age population is projected to shrink by 22 percent compared with 2005.
- Macroeconomic effects:
  - As the active labor force shrinks, employment, consumption, investment, and total and per capita real GDP will decline.
- Fiscal and debt projections under prevailing policies:
  - Budgetary spending on pensions and health care projected to rise to 22 percent of GDP by 2050 from about 14 percent in 2005.
  - Debt projected to reach 100 percent of GDP by 2025.
  - The intertemporal fiscal gap is estimated at over 10 percent of GDP in net present value terms.
  - Every two-year delay will raise the needed adjustment by ⅓ percent of GDP.
  - To maintain net debt at 60 percent of GDP by 2050, a smooth adjustment targeting a primary balance or a small surplus beginning early in the next decade would be needed.
- Private saving and asset allocation:
  - Household financial assets are currently around 140 percent of disposable income.
  - Household nonfinancial assets account for 60 percent of total assets; households need to redistribute assets into more strategic forms of long-term investment.

### Economic outlook (2005–06 and medium term)
- Short-term (2005–06) consensus and staff projection:
  - All predict rising consumption and a deceleration of investment and exports from exceptional 2004 rates.
  - Staff projects growth of 4 percent in 2005–06.
  - Trade account expected to post a surplus and the current account deficit to narrow to just over 3 percent of GDP.
  - Leading indicators and Q1 2005 results broadly consistent with baseline; risks appear evenly balanced.
- Risks to the baseline:
  - Downside: slowdown in the EU, higher oil prices, weaker employment.
  - Upside: pickup in EU growth, larger-than-expected fiscal impulse, faster wage growth.
- Medium-term:
  - Staff estimates potential growth at less than 4 percent.
  - Assuming gradual labor market reforms, increased participation unlikely to offset decline in working-age population.
  - Total factor productivity assumed to grow in line with recent history and rates similar to EU-15 catching-up countries.
  - Access to EU funds should help upgrade infrastructure; continued FDI, especially in skill-intensive activities, supports medium-term prospects.
  - Sizable fiscal consolidation over the medium term needed to accommodate strong fixed investment while keeping the current account deficit below 3 percent of GDP and debt ratios sustainable.

### Fiscal policy, targets, and risks
- Authorities’ fiscal strategy:
  - Fiscal adjustment plan aims to reverse the trend toward larger primary deficits over the past six years and meet the Maastricht deficit criterion by 2008.
  - Plan underpinned by annual expenditure ceilings and a rolling three-year fiscal framework.
  - Reductions in corporate income taxes cumulatively amounting to about ¾ percent of GDP over 2004–06.
  - Planned permanent personal income tax cuts for low- and middle-income taxpayers of about ⅓ percent of GDP in 2006.
  - Further adjustment needs to rely on expenditure reductions; spending reform measures identified but not yet approved.
- Staff assessment and projections:
  - Under staff baseline (assuming adherence to 2005–07 plan and consolidation to bring deficit to around 2½ percent of GDP by 2010), public debt projected to reach around 30 percent of GDP by 2010.
  - Achieving structural balance by 2015 and a smooth adjustment path up to 2010 and thereafter is needed to maintain a sustainable debt ratio in the face of aging pressures.
  - A large share of outstanding guarantees is considered high risk; guarantees total the equivalent of 16 percent of GDP (excluding ecological guarantees).
  - If primary deficits remained at the 2002–04 average, debt could climb to 40 percent of GDP by 2010.
  - An immediate credibility challenge: adjustment is back-loaded to 2006–07, and significant permanent measures have not yet been approved.
- Staff recommendations for strengthening credibility:
  - Front-load part of the adjustment to 2005 and adopt permanent measures to meet medium-term plans.
  - Staff observed that lowering the deficit by 1 percent of GDP relative to the authorities’ 2005 target would ensure credibility and contain public debt growth.
  - Front-loading to 2005 would limit a procyclical fiscal stimulus and minimize inefficient spending implied by significant carryover from 2004 allocations (apart from cofinancing for EU transfers).
  - Recommendations include maintaining growth of discretionary spending on goods and services at historical rates and containing extrabudgetary fund spending financed out of privatization revenues at 2004 levels.
  - Even if staff’s 2005 recommendations were implemented, reducing the deficit in 2006–07 would still require expenditure measures amounting to a cumulative 1⅓ percent of GDP; authorities urged to specify permanent savings plans for 2006–07 soon.
- Authorities’ response and constraints:
  - Authorities agreed front-loading consolidation is desirable but judged the scope for 2005 savings smaller than staff suggested.
  - Cited reasons: systemic expenditure reform not sufficiently advanced for 2005, 2004 overperformance viewed as one-off (carryover of unspent allocations after EU entry), election-year spending pressures, increasing demand for cofinancing of EU transfers, and downward risks in VAT collections.
  - Staff cautioned that recently-proposed personal income tax cuts could undermine fiscal targets and must be offset by expenditure cuts or base-broadening measures.

*Source: IMF staff report (content unit: _cr05276 - 8.      In line with regional trends, market sentiment on the Czech Republic remains).*

### 17.      The authorities shared staff concerns about longer-term budgetary pressures

### _cr05276 - 17.      The authorities shared staff concerns about longer-term budgetary pressures

### Longer-term budgetary pressures: pensions and healthcare
- Rapid rise in elderly dependency ratio and high public burden of age-related spending call for decisive reform in pensions, healthcare and social benefits (Box 2).
- Pensions
  - Despite a recent increase in the statutory retirement age and elimination of an overly generous early retirement scheme, the system remains unsustainable.
  - An expert committee has completed technical work on reform options.
  - Given little scope to increase payroll taxation, most proposals focus on changes in system parameters; some proposals consider introducing a voluntary second-pillar private pension system or a notionally defined contribution system.
  - Staff agreed on the need to increase the retirement age from its still-low level by international standards.
  - Further reforms might be needed given the large size of the expected fiscal gap.
  - In the meantime, staff suggested keeping pension indexation to the legal minimum.
- Healthcare
  - Authorities recognize the system is unsustainable because of poor incentives for cost control by providers and virtually free services for users.
  - Insurance companies do not have actuarial and control roles, but mainly channel funds from taxpayers to service providers.
  - As a result, sizable arrears have built up, and yet another bailout of health insurers is under discussion.
  - Staff emphasized that systemic reforms focusing on both the demand and supply of health services are needed to limit moral hazard and prepare for the demands of elderly care.

### Fiscal framework and medium‑term fiscal stance
- Budgetary shortcomings include persistent underspending of budgets and carryover provisions that pose risks for fiscal policy implementation.
- Expenditure ceilings weakened by carryover rules allowing spending from reserves outside the ceilings.
- Transparency hindered by off-budget spending and delays in fiscal reporting on extrabudgetary funds.
  - The National Property Fund (NPF) is expected to close at end-2005, and the accounts will be transferred to the Ministry of Finance. But spending from the NPF account will remain outside the expenditure ceilings and the budget. Transfers to the CKA financed through bonds are also treated as outside the budget.
- The finance minister intends to explore ways to strengthen budgetary rules on carryover spending to enhance fiscal discipline.
- Staff recommended introducing a fiscal rule that targeted a structural balance or a small surplus over the medium term, based on staff’s debt sustainability analysis incorporating demographic projections (Box 2).
- Authorities have not discarded stronger fiscal rules but are concentrating on meeting targets under their fiscal framework for now.

### Monetary policy assessment and outlook
- The CNB reduced policy rates after a reassessment of the inflation outlook in early 2005.
  - Cumulative rate cut of 75 basis points in January–April 2005 was considered needed because:
    - Substantial additions to productive capacity delayed the closing of the output gap.
    - A stronger-than-expected koruna appreciation led to lower import prices.
- Staff agreed with the CNB assessment; retail competition and productivity growth also helped delay inflationary pressures.
- Headline inflation is now about 1½ percent, below the CNB target band.
- CNB’s main policy rate stands at 1¾ percent, 25 basis points below the ECB rate.
- CNB and staff baseline projection: average CPI inflation staying below 2 percent in 2005 and rising to 2¼ percent by end-2006—below the 3 percent point target but within the lower half of the tolerance band.
- CNB preferences and views:
  - Structure of growth (investment and exports) and other noncyclical factors are main reasons for low demand-pull pressures.
  - Avoid an activist approach to bring inflation to the point target to prevent unnecessary interest rate volatility.
  - Await effects of recent interest rate cuts before further moves.
  - Some CNB Board members expressed doubts about sustainability of a negative interest differential with euro area rates, but prevailing view was domestic rates were at the right level given projected inflation.
  - Over a longer horizon, authorities envisage an increase of real interest rates above current levels to maintain inflation on target.
- Monetary policy complications and contingencies:
  - Uncertainties about fiscal policy and doubts about the fiscal outturn in 2005 complicate monetary decision-making.
  - CNB expected a smaller-than-budgeted expansion in 2005, maintaining a policy mix consistent with a benign inflation outlook and a narrowing external current account.
  - Outlook after the 2006 elections is more uncertain; further monetary moves would depend on evidence of continued commitment to sustain fiscal consolidation.
- Credibility of inflation targeting:
  - Post-2005 framework: a 3 percent point target with a tolerance band of ±1 percent; continuity with end-2005 target (2–4 percent).
  - Role of foreign exchange market intervention will continue to be exceptional.
  - Staff suggested Inflation Report clarify whether the forecast reflected Board or staff views; authorities acknowledged some past ambiguity and noted steps taken to shorten publication lag of Board minutes and hold periodic meetings with analysts.

### Financial sector resilience and household credit risks
- Banking sector viewed as sound and well-positioned to withstand moderate macroeconomic shocks due to past restructuring and improved risk management.
  - Regulatory capital to risk-weighted assets was 12.7 percent in 2005 Q1, 4 percentage points above the required 8 percent minimum in early 2005 (text table shows earlier levels).
  - Stress testing suggests the banking system would remain well-capitalized under moderate shocks.
  - Shocks comparable to the 1997 crisis would leave about 7 percent of banks with a negative capital, with recapitalization costs amounting to about ½ percent of GDP.
- Rapid growth of credit to households poses future financial stability risks:
  - Bank consumer and mortgage lending expanded at an annual rate of more than 30 percent in recent years (from a low base).
  - Banks’ exposure to households is about 12 percent of assets.
  - Classified loans: 3⅓ percent of mortgage loans and 11 percent of consumer loans.
  - Staff view: further increases in household liabilities would be justified by standards of more developed countries, but if financial assets do not keep pace, household liquidity and solvency could be at risk under adverse macro shocks.
  - A return of real interest rates to levels significantly above zero could be disruptive with substantial household indebtedness and high asset prices.
- Staff recommendations for supervisory and structural measures:
  - Supervisors should consider a more proactive approach by integrating stress testing of household loan quality into their work.
  - Collect data on household loan portfolio structure and prices of housing transactions.
  - Bank supervision should stay vigilant for signs of easing credit standards.
  - Population aging points to the need to encourage long-term savings programs; pension fund regulations and savings subsidies may need review as they appear to encourage medium-term savings at the expense of long-term savings.

### External position, public debt risks, and structural concerns
- External and public debt ratios are moderate (below 40 percent of GDP) and broadly stable; official reserves cover about 1½ times the economy’s short-term debt at remaining maturity.
- A floating exchange rate provides adjustment capacity for most shocks.
- Risks to public debt sustainability and deficit financing:
  - Delays in fiscal reforms.
  - Drying up of privatization revenues.
  - Large contingent liabilities.
- Staff noted further analysis of currency mismatches in private sector balance sheets—suggested by the international investment position—would help identify unhedged exchange rate risk.
- Structural policy and long-term growth:
  - Weaknesses in the business-legal environment risk discouraging future investment and holding back growth.
  - Investors cite weak creditor rights, excessive discretion of bankruptcy judges, and cumbersome and lengthy legal procedures as key problems.
  - Authorities created the Business Environment Development Council to focus on improving the business-legal system and streamlined company registration.

*Source: _cr05276 - 17.      The authorities shared staff concerns about longer-term budgetary pressures*

### introduction of single standardized forms and an automatic five-day deadline. Staff

### _cr05276 - introduction of single standardized forms and an automatic five-day deadline. Staff

### Business-legal environment and enterprise sector
- Single standardized forms and an automatic five-day deadline were introduced; staff welcomed these initiatives as crucial for lowering the cost of doing business, especially for small and medium-sized firms.
- Progress remains lagging in other areas:
  - Continued delays in adopting bankruptcy legislation are holding up the closure of insolvent firms and provide scope for asset stripping.
  - One-stop-shop services allowing combined application for commercial registry and trade licenses remain limited.
- Privatization and state involvement:
  - Privatization of Český Telecom has been reported and preparation for sale of the electricity company (CEZ) is under way.
  - Authorities confirmed plans to divest most assets from the CKA and to terminate its activities by end-2007.
  - Authorities are not planning to transfer new bad assets to CKA; any such transfer will require parliamentary approval.
  - Staff welcomed resistance to CKA bailouts of health insurance companies and underscored that state support to strategic companies should occur only within viable restructuring plans and be transparently recorded in government accounts.

### Labor market, social benefits, and human capital
- Labor market trends and proposed reforms:
  - A virtually flat employment trend despite solid GDP growth in recent years suggests labor market flexibility may be eroding.
  - Authorities attribute this to disincentives generated by the benefit system, skills mismatches, and high nonwage costs.
  - Legislation has been prepared to tighten benefit entitlements, encourage retraining, and increase geographical mobility; staff welcomed the legislation but noted delays in its adoption.
  - Staff considered that the intended effect on labor participation of the planned reduction in income taxes is likely to be limited unless accompanied by a reform of the benefits system.
- Specific concerns and measures:
  - Disincentives to work are particularly strong for younger workers with large families, among whom the unemployment rate is 5 percentage points higher than in families with no children.
  - Social benefits could be reformed to lower the implicit tax on employment and, in certain cases, introduce in-work benefits.
  - Attractive early retirement schemes and scope for abuse of disability benefits are reducing labor force participation of older workers.
  - Authorities noted elimination of a generous early retirement pension scheme and ongoing discussions to better control sickness benefits as a pathway to disability benefits.
  - Authorities proposed measures to encourage performance-based financing of schools and universities, and improve R&D cooperation with industry; staff agreed these would help preserve the Czech Republic’s attractiveness for FDI.
  - Reducing impediments to labor mobility, including through easing rent control, would also limit persistent skills mismatches.

### Institutional quality
- Many key institutional quality indicators worsened in the last two years (indicators and source: World Bank; survey-based indicators; see Kaufmann and others (2005) in source).
- The quality of institutions in the Czech Republic is broadly in line with that in other CEECs, but below par compared with more developed EU economies and other transition economies, like the Baltics.

### Staff appraisal — macroeconomic outlook and priorities
- Near-term outlook and strengths:
  - The Czech Republic’s recent strong economic performance augurs well for its near-term outlook.
  - Substantial foreign direct investment and growing cross-border integration of production processes have helped raise GDP growth and improve the external balance.
  - Inflation has stabilized at a low level, and the sovereign risk premium has fallen.
  - Corporate and banking profitability is strong, and banks remain well-capitalized to take advantage of lending opportunities in a growing economy.
  - A skilled workforce and an open regime for trade and capital flows supports a large manufacturing and service base.
- Risks from inaction:
  - Continued inaction in key areas could prevent the economy from realizing its full potential over the medium term.
  - Attractiveness to foreign and domestic investors could be slowly undermined by continued rigidities in the labor market and the business-legal environment, and an uncertain policy setting that shortens the horizon for decision making.
  - Without an early and comprehensive response, population aging is set to slow growth and undermine the sustainability of the fiscal position.
- Immediate priority: accelerate fiscal consolidation
  - Robust growth offers the opportunity to eliminate the back-loading of adjustment in the authorities’ fiscal plan and strengthen its credibility in the face of significant long-term debt sustainability concerns.
  - Part of the adjustment can be shifted forward to 2005 by maintaining expenditure savings achieved in 2004 and using revenues from stronger-than-expected growth to build in a cyclical margin.
  - Cumulative savings needed for 2006–07 are substantial; authorities should take decisive steps to adopt the corresponding measures.
  - With elections scheduled in 2006, taking early action to secure the recommended adjustment has considerable merit.
- Medium- and long-term fiscal sustainability:
  - Continued consolidation beyond 2007 is needed to ensure fiscal sustainability in the face of population aging pressures.
  - Structural balance or a small surplus will be needed over the long term to shore up the fiscal position ahead of intensifying budget pressures from population aging.
  - Pensions: considerable progress made towards evaluating reform options; an early political consensus on reform is the next priority. Options under consideration imply significant transitional deficits and it would be prudent to set aside a substantial share of privatization revenues to finance these deficits.
  - Healthcare: arrears buildup is symptomatic of deep-rooted problems. Measures need to include rationalization of the supply of health services, incentives for providers to contain costs, greater sharing of the financial burden with final users, and transformation of health insurance companies from payment agencies into true insurers.
  - Social benefits: as part of labor market reform, restructuring entitlements is needed to reduce welfare traps, improve incentives to work, and save budget resources.

### Fiscal framework and public financial management
- Recent budgetary rules on the carryover of spending by line ministries encouraged more rational spending but unveiled weaknesses in budgeting and weakened the fiscal framework because carryover spending is outside expenditure ceilings.
- Recommended reforms to strengthen the fiscal framework:
  - Restore “teeth” to the fiscal framework for policy sustainability and credibility.
  - Integrate the budget approval process for extrabudgetary funds with the state budget.
  - Extend expenditure ceilings to cover carryover spending and extrabudgetary funds.
  - Enhance transparency by timely reporting of spending by extrabudgetary funds.
  - Consistently use as the targeted fiscal concept the broadest possible and most commonly used measure of the deficit.
  - Expedite the delayed shift to GFSM 2001, which is close to standardized European fiscal indicators.

### Structural reforms to boost growth potential
- Privatization and state asset management:
  - Confirm completion of pending privatization in the electricity sector.
  - Avoid further transfers of bad assets to the CKA to signal that there will be no new bailouts and to wind down CKA with minimum cost to taxpayers.
- Business-legal environment and insolvency:
  - Simplification of company registration should be a first step toward creating a one-stop shop for investors combining company registration and licensing.
  - Creation of modern bankruptcy procedures—pending for several years—is crucial to enable effective restructuring of poorly performing companies.
  - Authorities should pursue early approval of an amendment on bankruptcy procedures for financial institutions, still under consideration in parliament.

### Monetary policy, competitiveness, and financial sector surveillance
- Monetary policy stance:
  - With the outlook for inflation low, monetary policy can remain accommodative.
  - Reducing interest rates in the second half of 2004 and April 2005 was appropriate given the benign inflation outlook.
  - Current market and official expectations suggest that inflation is likely to remain below the 3 percent target through the end of 2006.
  - Uncertainties call for a cautious approach to future interest rate changes.
- Competitiveness:
  - Measured in terms of unit labor costs, competitiveness against trading partners has eroded over the past year, reversing gains made in 2003.
  - Other factors—including labor quality—appear to have compensated as demonstrated by the dynamism of exports and growth, but continued growth of unit labor costs relative to trading partners would be a cause for concern.
- Financial sector surveillance:
  - Rapid growth in lending to households calls for a further strengthening of financial sector surveillance.
  - Rapid credit growth exposes households to liquidity and solvency risks under adverse macroeconomic shocks and requires closer supervision in an environment of easy financial conditions.
  - In the event of higher interest rates, banks would be exposed to dual risks of rising loan defaults and declining collateral prices.
  - Vigilance requires close integration of stress testing with bank supervision, and collecting data on household’s overall financial position and prices of housing transactions.
- Communication and governance of monetary policy:
  - The low inflation is a testament to a credible monetary policy.
  - The inflation targeting framework—relying primarily on the interest rate instrument rather than foreign exchange intervention—has provided a transparent and credible foundation.
  - The CNB has taken welcome steps to improve public communications; it would be helpful to clarify in the Inflation Report the respective roles of the CNB Board and staff in the elaboration of the forecast.

### Euro adoption
- Euro adoption can bring considerable economic gains provided the right policies are in place.
- Preconditions highlighted:
  - Credibly reducing the fiscal deficit below the Maastricht limit.
  - Improving labor market flexibility to cushion economic shocks after euro adoption and maintain competitiveness.
- Adhering to the current timetable for euro adoption will require securing an early agreement on the required policies.

*Source: _cr05276 - introduction of single standardized forms and an automatic five-day deadline. Staff_*

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

### _cr05276 - 40.       The next Article IV consultation with the Czech Republic is expected to be

### Real economy and macro projections
- Real GDP (change in percent): 2001: 2.6; 2002: 1.5; 2003: 3.2; 2004: 4.4; 2005 1/: 4.1
- Domestic demand (change in percent): 2001: 4.1; 2002: 2.7; 2003: 3.4; 2004: 2.9; 2005 1/: 3.1
- CPI (year average): 2001: 4.7; 2002: 1.8; 2003: 0.1; 2004: 2.8; 2005 1/: 1.6
- PPI (year average) 2/: 2001: 2.9; 2002: -0.5; 2003: -0.3; 2004: 5.7; 2005 1/: 3.9
- Unemployment rate (in percent), survey-based 3/: 2001: 8.1; 2002: 7.3; 2003: 7.8; 2004: 8.3; 2005 1/: 7.9
- Unemployment rate (in percent), registered 3/: 2001: 8.6; 2002: 9.2; 2003: 9.9; 2004: 9.2; 2005 1/: 8.8
- Gross national savings (percent of GDP): 2001: 23.5; 2002: 22.3; 2003: 21.0; 2004: 22.4; 2005 1/: 24.8
- Gross domestic investments (percent of GDP): 2001: 28.9; 2002: 27.9; 2003: 27.1; 2004: 27.6; 2005 1/: 28.1

### Public finance (general government, percent of GDP)
- General government revenue: 2001: 36.7; 2002: 37.5; 2003: 38.6; 2004: 38.4; 2005 1/: 38.8
- General government expenditure 4/: 2001: 41.6; 2002: 44.1; 2003: 44.6; 2004: 42.5; 2005 1/: 45.1
- General government balance 4/: 2001: -5.0; 2002: -6.6; 2003: -6.0; 2004: -4.0; 2005 1/: -6.3
- Adjusted balance (to exclude grants to transformation institutions to cover costs related to management of bad assets): 2001: -2.8; 2002: -3.9; 2003: -4.8; 2004: -3.3; 2005 1/: -4.9
- Targeted: adjusted balance excluding net lending 5/: 2001: -2.6; 2002: -3.7; 2003: -3.9; 2004: -2.8; 2005 1/: -4.4
- General government debt: 2001: 17.5; 2002: 18.4; 2003: 21.7; 2004: 24.0; 2005 1/: 25.8
- Including debt of the Czech Consolidation Agency: 2001: 22.9; 2002: 25.5; 2003: 27.7; 2004: 27.8; 2005 1/: 28.4

### Fiscal composition and budgetary details (percent of GDP)
- Total revenue and grants 3/: 2001: 36.7; 2002: 37.5; 2003: 38.6; 2004: 38.4; 2005 1/: 38.8
  - Total revenue: 2001: 36.6; 2002: 37.4; 2003: 38.1; 2004: 37.5; 2005 2/: 37.1
  - Current revenue: 2001: 36.1; 2002: 37.0; 2003: 37.6; 2004: 37.1; 2005 1/: 36.6
    - Tax revenue: 2001: 33.8; 2002: 34.5; 2003: 35.0; 2004: 35.0; 2005 1/: 34.9
    - Nontax revenue: 2001: 2.4; 2002: 2.5; 2003: 2.6; 2004: 2.1; 2005 1/: 1.7
  - Capital revenue: 0.4 (2001), 0.5 (2002), 0.4 (2003), 0.4 (2004), 0.4 (2005)
  - Grants, incl. EU compensation: 0.1 (2001), 0.1 (2002), 0.5 (2003), 0.9 (2004), 1.8 (2005)
- Total expenditure and net lending 4/: 2001: 41.6; 2002: 44.1; 2003: 44.6; 2004: 42.5; 2005 1/: 45.1
  - Excl. grants to transformation institutions: 2001: 39.4; 2002: 41.5; 2003: 43.4; 2004: 41.7; 2005 1/: 43.8
  - Current expenditure: 2001: 36.7; 2002: 38.6; 2003: 38.2; 2004: 36.5; 2005 1/: 38.4
    - Goods and services: 2001: 7.9; 2002: 8.6; 2003: 8.0; 2004: 7.4; 2005 1/: 9.2
    - Interest payments: 2001: 0.9; 2002: 0.7; 2003: 0.8; 2004: 1.1; 2005 1/: 1.2
    - Transfers to households and nonfinancial enterprises: 2001: 18.7; 2002: 19.2; 2003: 19.2; 2004: 18.6; 2005 1/: 18.1
    - Transfers abroad, incl. EU: 2001: 0.1; 2002: 0.1; 2003: 0.5; 2004: 0.7; 2005 1/: 1.1
    - Subsidies: 2001: 9.0; 2002: 9.9; 2003: 9.6; 2004: 8.7; 2005 1/: 8.8
      - Subsidies excluding grants to transformation institutions 5/: 2001: 6.8; 2002: 7.3; 2003: 8.4; 2004: 8.0; 2005 1/: 7.4
      - Subsidies excluding semibudgetary organizations: 2001: 2.3; 2002: 2.4; 2003: 2.6; 2004: 2.4; 2005 1/: 3.1
  - Capital expenditure: 2001: 4.8; 2002: 5.3; 2003: 5.5; 2004: 5.6; 2005 1/: 6.2
  - Net lending (excl. privatization and the sale of Russian debt): 2001: 0.1; 2002: 0.2; 2003: 0.9; 2004: 0.3; 2005 1/: 0.5
- Overall balance 4/: 2001: -5.0; 2002: -6.6; 2003: -6.0; 2004: -4.0; 2005 1/: -6.3
- Financing highlights:
  - Privatization receipts 6/: 2001: 2.6; 2002: 5.2; 2003: 1.0; 2004: 0.5; 2005: 3.5
  - Proceeds from sale of UMTS licences: 2001: 0.1; 2002: 0.0; 2003: 0.0; 2004: 0.2; 2005: 0.0
  - Proceeds from the sale of Russian debt: 2001: 0.0; 2002: 0.8; 2003: 0.0; 2004: 0.0; 2005: 0.0
  - Net increase in financial liabilities: 2001: 2.2; 2002: 0.5; 2003: 5.1; 2004: 3.3; 2005: 2.8
- Memorandum items:
  - Grants to transformation institutions to cover costs related to management of bad assets: 2001: 2.2; 2002: 2.7; 2003: 1.2; 2004: 0.7; 2005: 1.4
  - General government debt 7/: 2001: 17.5; 2002: 18.4; 2003: 21.7; 2004: 24.0; 2005 1/: 25.8
  - General government balance, ESA95-based: 2001: -5.9; 2002: -6.9; 2003: -11.7; 2004: -3.0; 2005: -5.0

### Balance of payments and external sector
- Trade balance (percent of GDP): 2001: -5.0; 2002: -3.0; 2003: -2.7; 2004: -0.8; 2005 1/: 0.3
- Current account (percent of GDP): 2001: -5.4; 2002: -5.6; 2003: -6.2; 2004: -5.2; 2005 1/: -3.3
- Current account balance (US$ millions): 2001: -3,273; 2002: -4,166; 2003: -5,570; 2004: -5,574; 2005 1/: -4,049
- Trade balance (US$ millions): 2001: -3,068; 2002: -2,179; 2003: -2,458; 2004: -869; 2005 1/: 414
  - Exports (US$ millions): 2001: 33,378; 2002: 38,319; 2003: 48,599; 2004: 66,678; 2005 1/: 80,856
  - Imports (US$ millions): 2001: 36,446; 2002: 40,497; 2003: 51,058; 2004: 67,547; 2005 1/: 80,442
- Nonfactor services net: 2001: 1,524; 2002: 668; 2003: 469; 2004: 485; 2005 1/: 867
  - Receipts: 2001: 7,090; 2002: 7,061; 2003: 7,764; 2004: 9,666; 2005 1/: 11,671
  - Payments: 2001: 5,566; 2002: 6,393; 2003: 7,295; 2004: 9,181; 2005 1/: 10,804
- Factor income (net): 2001: -2,197; 2002: -3,532; 2003: -4,132; 2004: -5,429; 2005 1/: -6,169
- Transfers: 2001: 467; 2002: 877; 2003: 552; 2004: 239; 2005 1/: 839
- Capital account: 2001: -9; 2002: -4; 2003: -3; 2004: -545; 2005 1/: 294
- Financial account balance (US$ millions): 2001: 4,544; 2002: 10,625; 2003: 5,805; 2004: 7,040; 2005 1/: 8,076
  - Direct investment, net: 2001: 5,476; 2002: 8,276; 2003: 2,351; 2004: 3,917; 2005 1/: 8,285
  - Portfolio investment, net: 2001: 916; 2002: -1,428; 2003: -1,336; 2004: 2,421; 2005 1/: -504
  - Financial derivatives, net: 2001: -85; 2002: -131; 2003: 137; 2004: -600; 2005 1/: (not reported)
  - Other investment, net: 2001: -1,764; 2002: 3,908; 2003: 4,654; 2004: 762; 2005 1/: 295
- Errors and omissions, net: 2001: 502; 2002: 172; 2003: 225; 2004: -656; 2005 1/: 0
- Change in reserves: 2001: -1,765; 2002: -6,627; 2003: -457; 2004: -264; 2005 1/: -4,321
- Gross international reserves (US$ billion): 2001: 14.5; 2002: 23.7; 2003: 27.0; 2004: 28.4; 2005 1/: 33.3
- Reserve cover (months of imports of goods and services): 2001: 4.1; 2002: 6.1; 2003: 5.5; 2004: 4.4; 2005 1/: 4.4
- Nominal effective exchange rate (2000=100) 7/: 2001: 104.7; 2002: 115.8; 2003: 117.0; 2004: 119.4; 2005 1/: 127.9
- Real effective exchange rate (CPI-based; 2000=100) 7/: 2001: 105.7; 2002: 116.6; 2003: 114.2; 2004: 115.8; 2005 1/: 123.6

### Financial sector and market indicators
- Short-term (ST) interest rate (one-month interbank offer rate, PRIBOR), end of period: 2001: 4.5; 2002: 2.8; 2003: 2.0; 2004: 2.5; Feb-05: 2.3
- Three-month interbank rate (in percent): 2001: 4.7; 2002: 3.5; 2003: 2.3; 2004: 2.4; 2005 1/: 2.1
- Ten-year government bond (in percent) 7/: 2001: 5.0; 2002: 4.6; 2003: 4.0; 2004: 4.3; 2005 1/: 2.7
- Capital adequacy ratio (in percent): 15.4 (2001); 14.3 (2002); 14.5 (2003); 12.6 (2004); Mar-05: 12.7
- NPLs in percent of total loans: 2001: 13.4; 2002: 8.1; 2003: 4.9; 2004: 4.1; Mar-05: 4.8
- Provisions in percent of NPLs: 2001: 60.3; 2002: 77.5; 2003: 76.7; 2004: 69.4; Mar-05: 61.0
- Return on average assets (in percent): 2001: 0.7; 2002: 1.2; 2003: 1.2; 2004: 1.3; Mar-05: 1.8
- Return on equity (in percent): 2001: 16.6; 2002: 27.4; 2003: 23.8; 2004: 23.4; Mar-05: 32.1
- Foreign currency deposits (in percent of total deposits): Apr-05: 11.4
- Domestic loans in foreign currency (in percent of total loans): Apr-05: 10.2
- Net open forex position (in percent of capital): Apr-05: 0.3
- Credit to private sector (percent change, eop / Apr-05): 2001: 2.1; 2002: 4.5; 2003: 8.5; 2004: 8.4; Apr-05: 11.6

### Medium-term macro scenario (2001–10) — selected projections and assumptions
- Projected Real GDP growth (percent): 2005: 4.1; 2006: 3.9; 2007: 3.7; 2008: 3.5; 2009: 3.5; 2010: 3.5
- CPI inflation (period average, percent): 2005: 1.6; projected 2006–10: 2.0, 2.5, 3.0, 3.0, 3.0
- Gross domestic savings (percent of GDP) projection: 2005: 24.8; 2006: 25.5; 2007: 26.0; 2008: 26.2; 2009: 26.7; 2010: 26.9
- Public finances (percent of GDP) projections:
  - Revenues: 2005: 38.8; 2006: 37.6; 2007: 37.4; 2008: 37.3; 2009: 37.3; 2010: 37.2
  - Expenditures: 2005: 45.1; 2006: 41.9; 2007: 42.0; 2008: 40.2; 2009: 39.8; 2010: 39.4
  - Overall balance: 2005: -6.3; 2006: -4.2; 2007: -4.7; 2008: -2.8; 2009: -2.5; 2010: -2.2
  - Adjusted balance: 2005: -4.9; 2006: -3.9; 2007: -3.8; 2008: -2.8; 2009: -2.5; 2010: -2.2
- Public sector debt (general government gross debt, excluding CKA debt) projections: 2005: 25.8; 2006: 28.7; 2007: 28.9; 2008: 30.9; 2009: 31.3; 2010: 31.4
- Memo: Nominal GDP in billions of U.S. dollars: 2001: 55.7; 2002: 60.9; 2003: 73.8; 2004: 90.4; 2005 (Proj): 107.0

### Debt sustainability and stress tests (public sector)
- Public sector debt (percent of GDP): 2001: 17.5; 2002: 18.4; 2003: 21.7; 2004: 24.0; 2005: 25.8; projections through 2010 show increase to 31.4
- Debt-stabilizing primary balance (percent of GDP): 2005 projection: -0.4
- Identified debt-creating flows and primary deficit (percent of GDP, selected): primary deficit 2001: 1.9; 2002: 3.3; 2003: 4.1; 2004: 2.2; 2005: 3.7
- Automatic debt dynamics contributions (selected years): 2001: -0.3; 2002: -0.3; 2003: -0.5; 2004: -0.8; 2005: -0.3
- Gross financing need (percent of GDP): 2001: 18.4; 2002: 13.1; 2003: 12.2; 2004: 10.4; 2005: 11.3
- Alternative scenarios and stress test outcomes (public sector debt in percent of GDP, selected):
  - A1 (key variables at historical averages 2005-09): debt rises to 34.1 (peak shown) with debt-stabilizing primary balance: -0.1
  - A2 (no policy change): debt rises to 39.4 with debt-stabilizing primary balance: -0.7
  - A3 (country-specific shock in 2006): debt rises to 44.7 with debt-stabilizing primary balance: -0.2
  - B1–B6 (bound tests) produce higher debt paths (examples include B2: debt up to 54.8; B6: debt up to 41.0)
- Key assumption in stress tests: primary deficit, real GDP growth, and real interest rate scenarios as specified in Table 6 footnotes

### External debt sustainability and stress tests
- Total gross external debt (percent of GDP): 2001: 36.8; 2002: 36.6; 2003: 38.5; 2004: 42.3; 2005: 37.5; projected decline to 27.5 by 2010
- Debt-stabilizing non-interest current account (percent): 2000 baseline: -3.6
- Change in external debt (percent of GDP): 2001: 0.4; 2002: -2.0; 2003: -0.2; 2004: 1.9; 2005: 3.9
- Identified external debt-creating flows (percent of GDP): 2001: 1.2; 2002: -6.4; 2003: -11.6; 2004: -3.3; 2005: -3.2
- Current account deficit excluding interest payments (percent of GDP): 2001: 3.1; 2002: 3.7; 2003: 4.3; 2004: 5.0; 2005: 4.0
- Net non-debt creating capital inflows (negative, percent of GDP): 2001: -5.9; 2002: -8.4; 2003: -10.9; 2004: -2.8; 2005: -2.3
- External debt-to-exports ratio (percent): 2001: 60.2; 2002: 55.3; 2003: 59.5; 2004: 61.9; 2005: 59.3
- Gross external financing need (US$ billion): 2001: 15.1; 2002: 15.0; 2003: 16.8; 2004: 19.6; 2005 (Proj): 23.4; projected 2006: 27.1

### Key economic and market indicators (latest observations / projections)
- Real GDP growth (in percent): 2004: 4.4; 2005 (Proj): 4.1
- CPI inflation (period average): 2004: 2.8; 2005 (Proj): 1.6
- Current account balance (percent of GDP): 2004: -5.2; 2005 (Proj): -3.3
- Net FDI inflows (percent of GDP): 2004: 3.7; 2005 (Proj): 6.7
- Exports (percentage change of US$ value, GNFS) 2004: 35.5; 2005 (Proj): 25.4
- Real effective exchange rate (2000 = 100), Jan-05: 112.6
- Gross international reserves (US$ billion), projection: 33.3
- GIR in percent of ST debt at remaining maturity (RM): 2005 (Proj): 163.3
- Total gross external debt (ED) in percent of GDP (Proj): 37.5
- Gross external financing requirement (in US$ billion) 4/: 2005 (Proj): 27.1
- Public sector overall balance (percent of GDP, Proj): 2005: -6.3; primary balance (percent of GDP, Proj): -5.1
- Public sector gross debt (PSGD, percent of GDP, Proj): 2005: 25.8

### Fund relations, exchange rate arrangement, and technical assistance
- Membership status: Joined 1/01/1993; Article VIII
- Quota (SDR Million): 819.30 (100.0 percent)
  - Fund holdings of currency: 582.73 (67.78 percent)
  - Reserve position in Fund: 236.57 (28.87 percent)
- SDR Department holdings: 5.90 SDR Million
- Outstanding purchases and loans: None
- Financial arrangements: Stand-by, Approval Date 3/17/1993, Expiration 3/16/1994, Approved (SDR Million) 177.00, Drawn 70.00
- Exchange rate arrangement: Managed floating (de facto), historical notes on peg to basket and widening of band; exchange rate of the koruna to the dollar stood at CZK 24.18 per U.S. dollar on June 30, 2005
- Last Article IV consultation: Concluded August 6, 2004; staff report and PIN published August 6, 2004
- Technical assistance (1991–2005): Multiple missions across FAD, MFD, RES, and STA on VAT administration, public financial management, monetary management, banking supervision, inflation targeting, balance of payments, government finance, money and banking statistics, and implementation of GFSM 2001 (see appendix table)

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

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

### _cr05276 - 41.      Data on core surveillance variables are available to the Fund regularly and with

### Data availability and timeliness
- Exchange rates and interest rates, set by the Czech National Bank (CNB), are reported daily with no lag.
- Gross and net international reserves:
  - Reported monthly with a one-week lag.
  - Also reported 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 between one and 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:
  - The main components of the balance of payments are also available monthly.
- Annual Government Finance Statistics Yearbook:
  - Covers all operations of the general government, including extrabudgetary funds excluded from the monthly data; annual data are available on a timely basis.
- Monthly fiscal data published in International Financial Statistics (IFS):
  - Cover central and local budget accounts and are available with a two- to three-month lag.
- Table of common indicators (as of June 22, 2005) — selected reporting frequencies and latest observations:
  - Exchange Rates: Date of latest observation 6/19/05; Date received 6/19/05; Frequency D.
  - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation 5/31/05; Date received 6/07/05; Frequency of data D; Frequency of reporting M; Frequency of publication M.
  - Reserve/Base Money: Date of latest observation 5/01/05; Date received 5/11/05; Frequency 10 days.
  - Broad Money: Date of latest observation 4/28/05; Date received 5/10/05; Frequency M.
  - Central Bank Balance Sheet: Date of latest observation 5/01/05; Date received 5/11/05; Frequency 10 days.
  - Consolidated Balance Sheet of the Banking System: Date of latest observation Apr 2005; Date received 5/24/05; Frequency M.
  - Interest Rates: Date of latest observation 6/19/09; Date received 6/19/05; Frequency D.
  - Consumer Price Index: Date of latest observation May 2005; Date received 6/08/05; Frequency M.
  - Revenue, Expenditure, Balance and Composition of Financing – General Government: Date of latest observation Dec 2004; Date received Jan 2005; Frequency A.
  - Revenue, Expenditure, Balance and Composition of Financing – Central Government: Date of latest observation Dec 2004; Date received Jan 2005; Frequency A.
  - Stocks of Central Government and Central Government-Guaranteed Debt: Date of latest observation Dec 2004; Date received Jan 2005; Frequency A.
  - External Current Account Balance: Date of latest observation 2005 Q1; Date received June 2005; Frequency Q.
  - Exports and Imports of Goods and Services: Date of latest observation Apr 2005; Date received 5/24/05; Frequency M.
  - GDP/GNP: Date of latest observation 2005 Q1; Date received June 2005; Frequency Q.
  - Gross External Debt: Date of latest observation 2005 Q1; Date received June 2005; Frequency Q.

### Data quality, deficiencies, and ongoing improvements
- Overall: Data quality is generally adequate, but specific weaknesses remain; authorities are taking measures to improve data accuracy.
- National accounts:
  - Value added in the small-scale private sector is likely to be underestimated due to underdeveloped data collection mechanisms and unrecorded activity from tax evasion.
  - Discrepancies between GDP estimates based on the production method and the expenditure method are large and are subsumed under change in stocks.
  - Quarterly national accounts:
    - Derived from quarterly reports of enterprises and surveys.
    - Subject to bias because of nonresponse (quarterly reporting is not mandatory) and lumping of several expenditure categories in particular quarters by respondents.
    - Large swings in individual components of spending and overall GDP quarter to quarter raise questions about quarterly data reliability.
- External trade statistics:
  - Revisions to export data processing procedures recently brought statistics close to EU practice.
  - Continued weakness: unavailability of fixed base price indices for exports and imports; indices are 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.
  - Large variations in the interbank clearing account float, especially at year-end, require caution in interpreting monetary developments.
  - The CNB has worked to identify causes of these variations and adjust the data.
  - In 2002, the CNB implemented the ECB’s framework for collecting, compiling, and reporting monetary data to meet EU statistical conventions.
  - Data published in IFS are based on monetary accounts derived from the ECB’s framework; the CNB’s bulletins and website use the same set of accounts, effectively harmonizing with IFS (presentation in IFS differs somewhat from the CNB’s).
- Fiscal statistics:
  - Annual fiscal data on an ESA-95 basis have been prepared by the Czech Statistical Office.
  - Quarterly data for non-financial accounts have been compiled; quarterly financial accounts will be prepared by 2006.
  - The Ministry of Finance uses the ESA-95 methodology for the Convergence Program targets.
  - ESA-95 differs from the national fiscal targeting methodology in coverage of institutions (e.g., the CKA is included in central government under ESA definition) and inclusion of financial transactions and other accrual items (e.g., called guarantees).

### SDDS observance
- 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.

### Executive Board assessment — macroeconomic findings, risks, and policy recommendations
- Macroeconomic performance and outlook:
  - GDP expanded by 4.4 percent in 2004; net exports gradually replaced investment as the main source of growth.
  - Household consumption grew only modestly; unemployment remained at about 8 percent, with more than half long-term.
  - Underlying inflation on average remained below 2 percent; headline inflation about 1½ percent, below the CNB target band.
  - Trade deficit narrowed to less than 1 percent of GDP in 2004, turning into a surplus in 2005 Q1.
  - Current account deficit declined to 5¼ percent of GDP in 2004.
  - FDI rebounded to 3⅔ of GDP.
  - Monetary conditions tightened during 2004: cumulative 50 basis point increase in policy interest rates in summer 2004 and a 6 percent nominal appreciation of the koruna against the euro during the year.
  - CNB reduced the main policy rate by cumulative 75 basis points to 1¾ percent by April 2005.
  - General government deficit—excluding privatization receipts and transfers to the Czech Consolidation Agency (CKA)—narrowed by about 1¾ percentage point to near 3¼ percent of GDP in 2004.
  - Public debt at a moderate 24 percent of GDP.
  - Bank lending to households rose at an annual rate of 20–30 percent for about three years; lending to households outpaced lending to corporates.
- Main risks and structural challenges:
  - Growth potential constrained by impediments to geographical mobility of workers, skills mismatches, and weaknesses in the business-legal environment.
  - Adverse demographic trends and population aging pose risks to fiscal sustainability.
  - Primary fiscal deficits are large; delays in health care reform and repeated bailouts of health insurance companies increase moral hazard and contingent liabilities.
  - Rapid increase in household credit requires continued supervisory vigilance.
  - Slow reforms of bankruptcy procedures hinder restructuring of poorly performing enterprises.
- Policy recommendations and priorities:
  - Fiscal policy and medium-term consolidation:
    - Advance the pace of deficit reduction and implement in full the reforms under the medium-term fiscal adjustment plan.
    - Approve quickly expenditure-reducing measures identified for 2006 and beyond to achieve medium-term fiscal targets and bolster plan credibility.
    - Strengthen the fiscal framework to address institutional weaknesses and contain fiscal drift:
      - Integrate budget approval process for extrabudgetary activities with that for the state budget.
      - Extend expenditure ceilings to cover carryover spending and extrabudgetary activities.
      - Timely reporting of spending from extrabudgetary funds.
      - Shift to a comprehensive fiscal definition—preferably the standardized European Union definition.
    - Undertake ambitious expenditure reforms to offset adverse effects of population aging; build political consensus for pension reform.
    - Create incentives for containing health care costs and greater burden-sharing with final users.
  - Monetary and exchange rate policy:
    - Continue to use the inflation-targeting framework as anchor for inflationary expectations.
    - Recent interest rate cuts were supported given the benign inflation outlook; absence of demand pressures justifies an accommodative monetary stance.
    - Exercise caution on further interest rate cuts given uncertainties about fiscal policy.
    - Maintain CNB policy of non-intervention in the foreign exchange market and use interest rate instrument to achieve price stability.
    - Further improve public communication of monetary policy decisions.
  - Financial sector supervision and household debt:
    - Maintain supervisory vigilance given rapid household credit growth; improve collection of data on household loan portfolios and evaluation of household loan quality.
    - Promote policies that encourage long-term savings to prepare for aging and transfer of financial risks from public sector to households.
  - Labor market and structural reforms:
    - Increase labor market flexibility to address decline in active labor market participants and to cushion shocks post-euro adoption.
    - Speed up adoption of legislation to tighten benefit entitlements, encourage retraining, and increase geographical mobility.
    - Reform social benefit system to reduce disincentives to work and increase labor force participation.
    - Improve quality of education, research and development activities.
  - Structural and enterprise reform:
    - Bolster the role of the private sector to raise productivity and long-term growth.
    - Resume and accelerate privatization where appropriate.
    - Swiftly approve new bankruptcy legislation to facilitate enterprise restructuring.
  - Euro adoption considerations:
    - Euro adoption can bring gains provided appropriate economic flexibility and right policies are in place.
    - Adhering to current timetable for euro adoption requires early agreement on, and building public support for, sustainable fiscal consolidation and structural reforms.

*Source: IMF staff report and Public Information Notice (PIN) summarizing the 2005 Article IV consultation with the Czech Republic (as contained in _cr05276)._*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05276.pdf_