## _cr0784

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### Executive Summary — Macroeconomic performance and outlook
- Growth pickup in 2005–06 with low inflation; Czech Republic an important regional hub for automotive production.
- Staff growth forecast: 4¾ percent for 2007.
- Drivers: private consumption, business investment, and public investment; exports decelerating but remain strong.
- Headline inflation expected to rise but remain around the target of 3 percent.
- Current account deficit projected: around 4 percent of GDP in 2007; medium-term current account projected to decline to about 3.4 per cent of GDP.
- External balances and vulnerabilities:
  - Gross official reserves estimated at about $32 billion by end-2006, equivalent to more than 3 months of imports.
  - Gross external debt estimated broadly stable at 37 percent of GDP in 2006; projected to stabilize below 30 percent of GDP over the medium term.
- Longer-term projection: potential growth slowdown to around 4 percent assuming gradual reforms; aging pressures intensify after 2010.

### Political environment and risks
- Electoral stalemate and narrow parliamentary majority create prolonged political uncertainty and a weak mandate for reforms.
- Financial markets reassured so far by strong growth and sound fundamentals.
- Downside risks:
  - Weaker investment if fiscal outlook worsens under political uncertainty.
  - Faster-than-expected appreciation of the koruna could weigh on exports and investment.
  - Correlation of Czech credit default swaps with Hungary and Poland implies regional contagion risk.

### Fiscal developments, concerns, and recommended actions
- Central concern: erosion of fiscal discipline in 2006–7 and medium-term fiscal outlook.
- Fiscal outcomes and projections:
  - General government deficit: 2005 about 2 percent of GDP (narrowed sharply); 2006 estimated at 3¾ percent of GDP (rose sharply); 2007 budget envisages a rise in the deficit to 4.4 percent of GDP.
  - Current account deficit estimated at 4.3 percent of GDP in 2006 (partly reflecting higher dividend outflows).
  - Staff: maintaining a broadly neutral fiscal stance calls for reducing the deficit by about ¾ percent of GDP in 2007.
- Pre-election social spending package (measures, costs, targeting):
  - Parental allowance: Cost CZK 15 billion (0.4 percent of GDP); Targeting: No.
  - Birth allowance: Cost CZK 1 billion (less than 0.1 percent of GDP); Targeting: No.
  - Housing allowance: Cost CZK 3 billion (0.1 percent of GDP); Targeting: Yes.
  - Elderly care allowance: Cost CZK 6.5 billion (0.2 percent of GDP); Targeting: No.
  - Sickness insurance reform (lowers employer contributions): Cost CZK 12 billion (0.4 percent of GDP); Targeting: Not applicable.
  - Note: 1/ On income basis.
- Fiscal projections (selected, in percent of GDP):
  - General government deficit 1/: 2005 -1.9; 2006 -3.7; 2007 (Staff estimate) -4.4; 2008 -3.5; 2009 -3.0; 2010 -2.2.
  - Cyclically adjusted deficit: 2005 -0.9; 2006 -3.3; 2007 -4.1; 2008 -3.3; 2009 -2.8; 2010 -2.2.
  - Change (fiscal impulse): 2005 -0.9; 2006 2.4; 2007 0.9; 2008 0.0; 2009 -0.5; 2010 -0.5.
  - General government debt: 2005 25.6; 2006 27.6; 2007 29.4; 2008 28.5; 2009 29.6; 2010 29.6.
  - General government deficit (ESA-95) 2/: 2005 -3.6; 2006 -3.5; 2007 -4.0; 2009 -3.5; 2010 -3.0.
- Official gross public debt: 28 percent of GDP in 2006.
- Projections and risks:
  - Age-related spending projected to raise public debt close to 60 percent of GDP by 2020 (Appendix I).
  - Staff alternative scenario: medium-term deficit targets stay at 2007 budget level and high-risk contingent liabilities are called, leading to faster debt rise.
- Policy recommendations to arrest fiscal drift:
  - Identify supporting measures for medium-term consolidation without delay.
  - Cut back on high mandatory social spending to improve fiscal flexibility and efficiency.
  - Raise the efficiency of public spending and improve targeting of social benefits.
  - Strengthen the institutional fiscal framework and enhance fiscal transparency.
  - Emphasize strategies for reducing public spending while raising its efficiency and for improving fiscal institutions to ensure discipline.

### Monetary policy and financial stability
- CNB performance and policy:
  - CNB anchors inflation expectations close to 3 percent.
  - Policy rate changes: +25 basis points in October 2005; paused until early August 2006; raised again to 2½ percent in late September 2006.
  - Czech policy rate lowest in the EU and 100 basis points below ECB with global tightening.
- Staff recommendations:
  - Continue withdrawing monetary stimulus at a cautious pace to balance rising resource pressures with a strengthening koruna and supply-driven changes.
  - Rapid credit growth calls for continued supervisory vigilance and more proactive, forward-looking supervision.
  - Continue substantive improvements in stress testing, credit risk analyses, and data collection.
- Financial sector indicators (selected):
  - Number of banks: 2001 38; 2002 37; 2003 35; 2004 36; 2005 36; 2006Q3 37.
  - Foreign-controlled banks: 2001 26; 2002 26; 2003 26; 2004 26; 2005 27; 2006Q3 28.
  - Regulatory capital to risk-weighted assets (percent): 2001 15.4; 2002 14.3; 2003 14.5; 2004 12.6; 2005 11.9; 2006Q3 11.3.
  - Classified loans (percent of total loans) 1/: 2001 20.8; 2002 15.8; 2003 11.2; 2004 10.8; 2005 11.7; 2006Q3 12.4.
  - Nonperforming loans (percent of total loans): 2001 13.4; 2002 8.1; 2003 4.9; 2004 4.1; 2005 4.3; 2006Q3 4.1.
  - Liquid assets (percent of total assets): 2001 20.8; 2002 32.5; 2003 35.9; 2004 32.8; 2005 32.1; 2006Q3 32.4.
  - After-tax return on average assets (percent): 2001 0.7; 2002 1.2; 2003 1.2; 2004 1.3; 2005 1.4; 2006Q3 1.3.
- Basel II and stress testing: authorities note Basel II could reduce capital cushions; recent stress tests indicate resilience to sizeable market and credit shocks.

### Credit growth, risks, and supervision (household credit focus)
- Mortgage lending: annual growth exceeding 30 percent since 2002.
- Consumer credit growth: accelerated to almost 40 percent in the last two years.
- Current loan quality reasonably high, but share of classified loans rising gradually with household lending pickup.
- Foreign currency lending to households negligible.
- House price inflation remains moderate.
- Credit risks concentrated in a few rapidly growing institutions.
- Policy and supervisory actions:
  - Enhance forward-looking, risk-based supervision.
  - Issue best practice recommendations on stress testing.
  - Strengthen cooperation with foreign counterparts given foreign ownership and Basel II.
  - Unified regulation and supervision under CNB since April 2006; streamlining of financial regulations under way.

### Labor market and structural reforms
- Main priority: raise labor market flexibility.
- Constraints:
  - High tax wedge and generous entitlements discourage job search.
  - Strict employment protection hampers job creation.
  - Unemployment: around 7 percent (has fallen but not broad-based).
  - Rising inflows of immigrant workers helping contain wage inflation.
- Recent and recommended measures:
  - Authorities view recent labor code changes as improving flexibility; business sector considers these a missed opportunity for substantive employment protection reform.
  - New bankruptcy law adopted; should be implemented effectively.
  - Recommended: welfare benefit reform to improve targeting and reduce work disincentives; measures to improve matching and skill development; phase out rent controls to reduce geographical mismatches.
- Employment and unemployment (selected):
  - Unemployment rate (survey-based): 2006 7.1; 2007 (Proj.) 6.9.
  - Registered unemployment: 2006 8.1; 2007 (Proj.) 7.9.

### Competitiveness and euro adoption strategy
- REER appreciation: about 5–6 percent in 2006 (CPI and unit labor cost bases).
- Export market shares in EU-15 continued to rise; quality upgrading and high-technology industries drove gains.
- Staff model: koruna broadly in line with fundamentals.
- Authorities plan to update euro adoption strategy; no near-term entry agenda.
- Staff: euro adoption important opportunity; policy credibility on fiscal consolidation and structural reforms is crucial during transition.
- Reserves and FX policy:
  - Authorities have not intervened to influence koruna level since 2002.
  - Reserve increases largely from off-market conversion of privatization receipts and EU transfers; current reserves viewed as adequate.

### Staff appraisal highlights and policy priorities
- Near-term outlook favorable; sustaining performance requires renewed progress on fiscal consolidation and labor market flexibility.
- Policy priorities:
  - Guard against competitive populism; return to fiscal consolidation.
  - Strengthen fiscal institutions and transparency; identify consolidation measures promptly.
  - Maintain cautious withdrawal of monetary stimulus while monitoring rapid credit growth and regional contagion risks.
  - Advance structural reforms to enhance labor market flexibility and implement the new bankruptcy law effectively.

### Detailed fiscal outlook and Appendix I — medium-term fiscal and external scenarios
- Authorities plan gradual consolidation to reach 3 percent Maastricht threshold by 2009 via roughly ½ percent of GDP annual deficit decline and full assumption of CKA debt by 2008.
- Baseline public sector debt (percent of GDP): 2006 27.6; 2007 29.4; 2008 31.3; 2009 31.9; 2010 32.3; 2011 32.3.
- Adverse scenarios:
  - Incorporating high-risk contingent liabilities (healthcare debt 10 bill. CZK; ecological guarantees 85 bill. CZK; risky guarantees 97 bill. CZK) and a fiscal deficit higher by 1 percentage points relative to baseline (2007 budget levels) would push debt to nearly 45 percent of GDP by 2010 (Staff alternative scenario).
  - Longer-term aging pressures could push debt toward 80 percent of GDP by 2020.
- Fiscal drivers (selected, percent of GDP):
  - Primary deficit: 2006 2.7; 2007 3.1; 2008 2.3; 2009 1.3; 2010 0.8; 2011 0.4.
  - Revenue and grants: 2006 38.8; 2007 38.9; 2008 39.9; 2009 40.3; 2010 40.2; 2011 40.4.
  - Primary (noninterest) expenditure: 2006 41.5; 2007 42.0; 2008 42.1; 2009 41.6; 2010 41.1; 2011 40.8.
  - Gross financing need (percent of GDP, baseline): 2006 12.2; 2007 11.5; 2008 11.7; 2009 10.1; 2010 10.3; 2011 9.3.
- External sustainability (Appendix I):
  - International investment position: modest net liability ~30 percent of GDP due to large inward FDI.
  - External debt projections (percent of GDP): 2006 37.0; 2007 34.0; 2008 32.7; 2009 31.1; 2010 29.8; 2011 28.6.
  - Gross external financing need (US$ billion): 2006 17.2; 2007 18.6; 2008 20.4; 2009 19.1; 2010 20.9; 2011 20.2.
  - Vulnerability: baseline and stress tests indicate external debt remains manageable under most adverse scenarios; current account deficit within debt-stabilizing range of about 4 ¼ percent of GDP.

### Key macro and financial indicators (selected exact figures)
- Real GDP growth (change in percent): 2005 6.1; 2006 6.0; 2007 (Proj.) 4.8.
- CPI (year average): 2005 1.8; 2006 2.6; 2007 (Proj.) 3.2.
- Gross international reserves (US$ billion): 2005 29.6; 2006 31.8; 2007 (Proj.) 33.8.
- Reserve cover (months of imports): 2005 4.1; 2006 3.6; 2007 (Proj.) 3.2.
- General government balance (percent of GDP): 2005 -3.6; 2006 -4.8; 2007 (Proj.) -4.7.
- Adjusted (to exclude grants to transformation institutions): 2005 -1.9; 2006 -3.7; 2007 (Proj.) -4.4.
- General government debt (percent of GDP): 2005 25.6; 2006 27.6; 2007 (Proj.) 29.4.
- Credit to private sector (percent change, eop): 2005 22.3; 2006 23.6.
- Mortgage lending: annual growth exceeding 30 percent since 2002.
- Consumer credit growth: accelerated to almost 40 percent in the last two years.

### Statistical issues and data provision (Appendix II)
- Czech Republic observes SDDS and meets specifications; metadata posted on the Fund’s Dissemination Standards Bulletin Board.
- Data timeliness generally adequate, but reporting to STA less current for foreign trade and national accounts.
- National accounts weaknesses:
  - Potential underestimation of value added in small-scale private sector due to unrecorded activity.
  - Large discrepancies between production and expenditure GDP estimates subsumed under change in stocks.
  - Quarterly estimates subject to nonresponse bias; reliability of quarterly data questioned.
- External trade statistics: revisions improved alignment with EU practice; lack of fixed base price indices noted.
- Monetary statistics: harmonized with ECB framework; large variations in interbank clearing account float require caution.
- Fiscal statistics: ESA-95 annual data prepared; differences between ESA-95 and national fiscal targeting methodologies noted; several extrabudgetary institutions excluded from some published annual fiscal data.
- Table of Common Indicators Required for Surveillance (selected dates of latest observation provided, e.g., Exchange Rates 12/31/06; Consumer Price Index Dec 2006; Gross External Debt 2006 Q3).

*Source: _cr0784 (IMF staff report and informational annexes)*

### Executive Summary

### Executive Summary

### Macroeconomic performance and outlook
- Sharing in regional dynamism, economic performance remains strong, driven by productivity gains and buoyant exports, with the Czech Republic emerging as an important regional hub for automotive production.
- Recent pickup in growth in 2005–06 with continued low inflation has placed the economy on a firmer footing.
- Staff’s growth forecast of 4¾ percent for 2007; private consumption, business investment, and public investment are expected to support domestic demand as exports decelerate but remain strong.
- Headline inflation is expected to rise but remain around the target of 3 percent.
- Current account deficit projected to remain at around 4 percent of GDP in 2007; medium-term current account projected to decline to about 3.4 per cent of GDP.
- External balances and vulnerabilities:
  - Gross official reserves estimated to have reached about $32 billion by end-2006, equivalent to more than 3 months of imports.
  - Gross external debt estimated to have remained broadly stable at 37 percent of GDP in 2006; projected to stabilize below 30 percent of GDP over the medium term.
- Longer-term projections: staff projects a slowdown in potential growth to around 4 percent, assuming the current gradual pace of reforms; aging pressures set to intensify after 2010.

### Political environment and risks
- An electoral stalemate and narrow parliamentary majority create prolonged political uncertainty and a weak mandate for reforms, raising risks of policy drift and competitive populism.
- Financial markets have so far been reassured by strong growth and generally sound fundamentals.
- Downside risks to growth: weaker investment if fiscal outlook worsens under political uncertainty; faster-than-expected appreciation of the koruna could weigh on exports and investment.
- Correlation of Czech credit default swaps with Hungary and Poland suggests exposure to regional contagion risk.

### Fiscal developments, concerns, and recommended actions
- Main concern: erosion of fiscal discipline in 2006–7 and the medium-term fiscal outlook.
- Fiscal outcomes:
  - General government deficit narrowed sharply to about 2 percent of GDP in 2005.
  - Deficit estimated to have risen sharply to 3¾ percent of GDP in 2006 due to pre-election tax cuts and increases in social transfers.
  - Current account deficit estimated to have widened to 4.3 percent of GDP in 2006 (partly reflecting higher dividend outflows).
- Staff view: the expansionary fiscal stance for 2007 is out of place given robust growth; authorities’ medium-term consolidation plans are appropriate but supporting measures should be identified without delay.
- Policy recommendations to arrest fiscal drift:
  - Identify supporting measures for medium-term consolidation without delay.
  - Cut back on high mandatory social spending to improve fiscal flexibility and efficiency.
  - Raise the efficiency of public spending and improve targeting of social benefits.
  - Strengthen the institutional fiscal framework and enhance fiscal transparency.
  - Emphasize strategies for reducing public spending while raising its efficiency and for improving fiscal institutions to ensure discipline.

### Monetary policy and financial stability
- Czech National Bank (CNB) performance:
  - CNB’s steady hand anchors inflation expectations close to 3 percent.
  - Monetary policy tightened gradually: policy rate raised by 25 basis points in October 2005; paused until early August 2006; raised again to 2½ percent in late September 2006.
  - With global monetary tightening, the Czech policy rate is the lowest in the EU and 100 basis points below that of the ECB.
- Staff recommendations:
  - In view of the projected rise in inflation, CNB should continue to withdraw monetary stimulus, albeit at a cautious pace, balancing rising resource pressures with the strengthening koruna and supply-driven changes.
  - Rapid credit growth calls for continued supervisory vigilance and more proactive, forward-looking supervision.
  - Continue substantive improvements in stress testing, credit risk analyses, and data collection.

### Labor market and structural reforms
- Main structural priority: raise labor market flexibility.
- Constraints to labor market flexibility:
  - High tax wedge and generous entitlements discourage job search.
  - Strict employment protection hampers job creation.
  - Unemployment has fallen but remains around 7 percent; employment gains concentrated in industry and private services and are not yet broad-based.
  - Rising inflows of immigrant workers have helped contain wage inflation.
- Recent reforms and needed actions:
  - Authorities view recent changes in the labor code as improving flexibility of employment contracts.
  - A new bankruptcy law was adopted and should be implemented effectively to improve the business environment.
  - Recommended reforms include welfare benefit reform to improve targeting and reduce work disincentives, and measures to improve matching and skill development to address geographical and skill mismatches.

### Staff appraisal highlights
- Near-term outlook is favorable, but sustaining strong performance over the medium term requires renewed progress on fiscal consolidation and improving labor market flexibility.
- Policy priorities going forward:
  - Guard against competitive populism and return to the path of fiscal consolidation.
  - Strengthen fiscal institutions and transparency, identify supporting consolidation measures promptly, and improve the efficiency and flexibility of social spending.
  - Maintain a cautious but continued withdrawal of monetary stimulus while monitoring rapid credit growth and regional contagion risks.
  - Advance structural reforms to enhance labor market flexibility and implement the new bankruptcy law effectively.

*Source: _cr0784 - Executive Summary*

### 15.       The key concern centers on the recent erosion of fiscal discipline and the

### _cr0784 - 15.       The key concern centers on the recent erosion of fiscal discipline and the

### Fiscal outlook and primary concern
- Key concern: recent erosion of fiscal discipline and the medium-term fiscal outlook.
- 2007 budget: envisages a rise in the deficit to 4.4 percent of GDP, largely reflecting the impact of the pre-election social benefits package of about 1 percent of GDP.
- Risk of overruns in mandatory spending.
- Budget implies a further increase in the structural deficit and a significant slippage from the 2005 Convergence Program target.
- With domestic demand continuing to grow strongly and GDP growth projected to remain above potential, the fiscal stance should ideally withdraw stimulus; maintaining a broadly neutral fiscal stance calls for reducing the deficit by about ¾ percent of GDP in 2007.
- Political context: building consensus on measures appears difficult given the likelihood of early elections.

### Pre-election social spending package (measures, costs, targeting)
- Parental allowance
  - Provides benefits to parents of children under the age of four.
  - Cost: CZK 15 billion (0.4 percent of GDP)
  - Targeting: No
- Birth allowance
  - Increases the generosity of the birth grant per child.
  - Cost: CZK 1 billion (less than 0.1 percent of GDP)
  - Targeting: No
- Housing allowance
  - Subsidizes housing costs to help offset the impact of easing rent controls.
  - Cost: CZK 3 billion (0.1 percent of GDP)
  - Targeting: Yes
- Elderly care allowance
  - Supports about ⅔ of elderly care costs.
  - Cost: CZK 6.5 billion (0.2 percent of GDP)
  - Targeting: No
- Sickness insurance reform
  - Lowers employer contributions for sickness insurance.
  - Cost: CZK 12 billion (0.4 percent of GDP)
  - Targeting: Not applicable
- Note: 1/ On income basis.

### Fiscal projections and debt dynamics (2005–09 and longer-term)
- Fiscal table highlights (In percent of GDP):
  - General government deficit 1/: 2005 -1.9; 2006 -3.7; 2007 (Staff estimate) -4.4; 2008 -3.5; 2009 -3.0; 2010 -2.2
  - Cyclically adjusted deficit: 2005 -0.9; 2006 -3.3; 2007 -4.1; 2008 -3.3; 2009 -2.8; 2010 -2.2
  - Change (fiscal impulse): 2005 -0.9; 2006 2.4; 2007 0.9; 2008 0.0; 2009 -0.5; 2010 -0.5
  - General government debt: 2005 25.6; 2006 27.6; 2007 29.4; 2008 28.5; 2009 29.6; 2010 29.6
  - General government deficit (ESA-95) 2/: 2005 -3.6; 2006 -3.5; 2007 -4.0; 2008 ...; 2009 -3.5; 2010 -3.0
- Official gross public debt: 28 percent of GDP in 2006.
- Projections:
  - Age-related spending projected to raise public debt close to 60 percent of GDP by 2020 (Appendix I).
  - Debt will rise faster if fiscal adjustment is not implemented or growth were to be slower than now projected.
- Staff alternative scenario assumptions:
  - Medium-term deficit targets stay at the 2007 budget level and that high risk contingent liabilities are called (leading to faster debt rise).

### Spending reform priorities and recommendations
- With the tax wedge already relatively high, fiscal adjustment should come primarily from spending cuts.
- Spending reforms should:
  - Address rising age-related pressures.
  - Enhance the efficiency of spending.
  - Provide fiscal space for growing co-financing of EU-funded projects.
  - Widen discretionary scope for fiscal policy.
- Priority areas identified: pensions, healthcare, and social benefits.
- Staff note: given relatively high efficiency of social spending, rolling back the newly approved social benefits package should not compromise social objectives (Box 1).
- A proposal for a flat tax rate of 17–19 percent for corporate and personal incomes has featured in coalition discussions, but offsetting measures have not been identified.
- Staff argument: without such reforms, medium-term fiscal targets would need to be more ambitious, aiming for a structural balance or a surplus by early in the next decade.

### Efficiency improvements in social protection and healthcare (Box 1)
- Social protection
  - Improved targeting could facilitate a decline in spending without jeopardizing social indicators.
  - Existing social benefits appear relatively efficient in reducing poverty and inequality relative to other EU countries.
  - Additional social benefit spending could have limited impact due to diminishing returns.
  - Scope to strengthen targeting: share of population receiving social assistance exceeds that in most other new EU member states; budget covers health insurance premia of over half the population.
- Health care
  - Healthcare spending appears relatively inefficient based on outcome indicators, such as mortality rates and healthy life expectancy.
  - Scope to contain healthcare demand by introducing means-tested co-payments and narrowing near universal coverage to allow private provision and insurance.
  - Cost pressures: drug costs absorb 25 percent of spending compared to the OECD average of 15 percent.
  - Need alternatives for costly “social hospitalization” of elderly patients and better linkage of hospital financing to cost of service provision.

### Fiscal framework and governance
- Weaknesses identified:
  - Upward revision of nominal expenditure ceilings in the three-year rolling budget in response to stronger than expected revenues led to a procyclical policy stance and undermined credibility.
  - Carryover of unspent budget allocations available for future spending amounted to 1⅔ percent of GDP at end-2006.
- Authorities’ actions and tools:
  - Recent decision to limit such carryover expected to strengthen effectiveness of ceilings.
  - Planned introduction of the integrated state treasury system expected to ensure greater fiscal transparency and control.
- Key challenge: enforcement of the medium-term expenditure framework requires political will to adhere to original spending ceilings in the annual budgeting process.

### Monetary policy: appropriate pace of tightening
- Context: strong growth, subdued inflation, well-anchored expectations.
- CNB stance: measured pace of monetary tightening.
- Upside inflation risks: capacity constraints, fiscal loosening, potential second-round effects of energy price increases.
- Offsetting factors: strong koruna, declining labor costs, strong productivity growth, lingering labor market slack, rising inflows of labor, shrinking margins from global competition, supply-driven nature of recent growth.
- Outlook:
  - Assuming a stable exchange rate, CNB and staff project headline inflation to move slightly above the 3 percent target by mid-2008, largely due to planned increases in regulated prices and excise taxes.
  - Underlying inflation set to creep up gradually given strong domestic demand and negative real interest rates.
  - Main downside risks: the koruna remaining resilient and stronger-than-expected productivity growth.
- Staff view: output judged close to potential; support for CNB’s cautious approach to tightening.

### Competitiveness and euro adoption strategy
- REER and exports:
  - REER based on relative consumer prices and unit labor costs appreciated by about 5–6 percent in 2006.
  - Export market shares in EU-15 continued to rise.
  - Staff model-based analysis suggests koruna level broadly in line with fundamentals.
- Export structure:
  - Strength led by high technology industries; quality upgrading contributed to strong gains in non-price competitiveness.
- Euro adoption:
  - Authorities plan to update euro adoption strategy; do not see entry into eurozone on near-term agenda.
  - Delay viewed as unlikely to disadvantage economy given benefits of nominal convergence already enjoyed.
  - Staff: euro adoption remains important opportunity; policy credibility on fiscal consolidation and structural reforms is important during transition and to maximize gains.
- Reserves and FX policy:
  - Authorities have not intervened to influence koruna level since 2002.
  - Increases in gross reserves largely reflected off-market conversion of large privatization receipts and EU transfers.
  - Staff and authorities view current level of reserves as adequate.

### Financial stability amid rapid credit growth
- Financial soundness indicators and stress tests point to a sound financial sector.
- Banking sector indicators (2001–2006Q3):
  - Number of banks: 2001 38; 2002 37; 2003 35; 2004 36; 2005 36; 2006Q3 37
  - Of which: foreign-controlled: 2001 26; 2002 26; 2003 26; 2004 26; 2005 27; 2006Q3 28
  - Regulatory capital to risk-weighted assets (in percent): 2001 15.4; 2002 14.3; 2003 14.5; 2004 12.6; 2005 11.9; 2006Q3 11.3
  - Classified loans (in percent of total loans) 1/: 2001 20.8; 2002 15.8; 2003 11.2; 2004 10.8; 2005 11.7; 2006Q3 12.4
  - Nonperforming loans (in percent of total loans): 2001 13.4; 2002 8.1; 2003 4.9; 2004 4.1; 2005 4.3; 2006Q3 4.1
  - Liquid assets (in percent of total assets): 2001 20.8; 2002 32.5; 2003 35.9; 2004 32.8; 2005 32.1; 2006Q3 32.4
  - After-tax return on average assets (in percent): 2001 0.7; 2002 1.2; 2003 1.2; 2004 1.3; 2005 1.4; 2006Q3 1.3
- Cross-country perspective (2005): profitability, efficiency and capital adequacy broadly comparable to regional peers.
- Banks’ capital ratios have been above regulatory minimum of 8 percent, albeit declining with balance sheet expansion.
- Authorities note Basel II could further reduce capital cushions; recent stress tests indicate banking sector should withstand sizeable market and credit risk shocks.

*Source: Czech authorities, and staff calculations.*

### 25.      Sustained rapid growth of credit to households has brought concerns about

### _cr0784 - 25.      Sustained rapid growth of credit to households has brought concerns about

### Credit growth, risks, and supervision
- Mortgage lending has been growing at annual rates exceeding 30 percent since 2002.
- Consumer credit growth accelerated to almost 40 percent in the last two years.
- Financial indicators suggest current loan quality is reasonably high, although the trend is not as positive as might be expected in favorable circumstances.
- The share of classified loans has been rising gradually in line with a pickup in household lending.
- Foreign currency lending to households is negligible.
- House price inflation remains moderate.
- Credit risks are contained at present and are concentrated in a few rapidly growing institutions.
- Authorities’ and staff’s empirical analyses confirm the above assessment.

Policy actions and supervisory developments
- Authorities plan to continue enhancing supervision to make it more forward looking and risk based.
- Intent to issue best practice recommendations on stress testing in the coming years to encourage strong risk management by banks.
- Continued strengthening of cooperation with foreign counterparts is a priority, given significant foreign ownership in the financial system and the introduction of Basel II.
- Ongoing efforts to strengthen risk assessment through stress testing, credit risk modeling, and analyses of disaggregated and nonbank loan data.
- To strengthen efficiency of supervision for large and complex financial institutions, the authorities unified financial sector regulation and supervision under the CNB in April 2006, and subsequent streamlining of financial regulations is under way.

### How to improve the functioning of the labor market
- Continued efforts to improve labor market flexibility are essential for sustaining growth.
- Employment rate is comparable to the EU-15 average.
- A high tax wedge and disincentives embedded in generous welfare programs weaken incentives to work for young low-wage earners.
- Geographical and skill mismatches contribute to high and persistent structural unemployment.
- Recent policy measures: reduction in income taxes for low-income groups aimed at reducing marginal effective tax rates.
- Business sector view: the new labor code was a missed opportunity for substantive improvement in labor market flexibility, particularly in employment protection.
- Authorities note the scope of contractual employment has been broadened under new legislation.
- Authorities underscore importance of phasing out rent controls for reducing geographical mismatches.

### Business environment and legislative changes
- Recent World Bank assessment suggests doing business in the Czech Republic is considerably more onerous than in many EU economies.
- The bankruptcy resolution process has been especially lengthy and costly.
- New bankruptcy legislation became effective at the beginning of 2007 and is hoped to ease concerns.

### Staff appraisal — macroeconomic outlook and policy priorities
- Economic performance remains strong despite political uncertainty; rising consumer confidence, high profitability and favorable competitiveness point to robust growth in 2007.
- The new government should prioritize resuming progress on the reform agenda to avoid policy drift and competitive populism.
- Fiscal policy is adding a strong procyclical impulse to an already booming economy.
- A large pre-election fiscal relaxation has reversed the favorable trend in public finances in 2006.
- With growth projected to remain above potential, at least a neutral policy stance is warranted, which would require additional measures amounting to about ¾ percent of GDP.
- Renewed political commitment to expenditure-based fiscal consolidation is necessary to address medium-term fiscal pressures arising from population aging, cofinancing of EU-funded projects, high risky guarantees, and increased social benefits.
- Authorities’ intention for an annual reduction in the structural deficit by ½ percent of GDP in the forthcoming Convergence Program is welcome but needs concrete expenditure measures.
- With the tax wedge already high, fiscal adjustment would need to come from spending cuts; any tax reform package should ensure budget neutrality at minimum.
- Without early and comprehensive pension and healthcare reforms, a structural balance or a small surplus would be needed by early in the next decade to prepare for aging.

Public spending efficiency and public financial management
- Restructuring public spending should be guided by relative efficiency and the need to enhance flexibility.
- Efficiency of social benefits can be improved by better targeting of transfers to low-income households.
- Private share of healthcare spending is among the lowest in the EU; introducing co-payments on a means-tested basis would help contain demand pressures.
- Structural reforms are needed to address rising healthcare costs.
- Pension reforms desirable: early phase-in of a higher retirement age and strengthening the link between contributions and benefits.
- Institutional measures needed to enhance public financial management and transparency:
  - Renew political commitment to the fiscal framework given failure to adhere to medium-term expenditure ceilings.
  - Further limits on carryover and drawdown of unspent allocations to prevent loss of budgetary control.
  - Integrate extrabudgetary funds in budget preparation, reporting and implementation.
  - Authorities’ plans to move fully to GFSM 2001-based fiscal accounts, supported by participation in the Fund’s pilot project, are welcome.

Monetary policy and euro adoption
- A continued cautious pace of monetary tightening would be appropriate.
- Headline inflation is expected to rise gradually, driven partly by increases in regulated prices.
- Underlying inflation is also set to creep up as domestic demand strengthens against the backdrop of negative real interest rates.
- Policy needs to balance inflationary pressures with the strengthening koruna and supply-driven changes.
- Plans to clarify the strategy for euro adoption are welcome.
- Euro adoption remains an important opportunity for gains from enhanced trade and investment.
- A delayed timetable for euro entry was widely anticipated and by itself should not constitute a significant setback.
- The delay underscores the importance of adhering to strong fiscal consolidation, strengthening the institutional fiscal framework, and enhancing the flexibility of labor and product markets.

Financial sector health and recommendations
- The financial sector appears to be in good health but faces challenges amid continued rapid credit growth.
- Ensuring supervision remains proactive, risk-based, and forward-looking is important.
- Supervision of rapidly expanding institutions and cooperation with foreign supervisors need to be strengthened.
- Recent integration of banking, insurance, and securities supervision under the CNB can bring efficiency gains in supervising increasingly complex financial institutions.

Labor market flexibility and business climate
- A more flexible labor market is needed to enhance growth potential and resilience to shocks.
- Phasing out rent controls is expected to reduce geographical barriers and facilitate labor mobility.
- Reforms of social benefit entitlement programs would improve work incentives and encourage labor participation.
- Improving labor market flexibility requires reforms in employment protection.
- Further steps to improve the business climate would help preserve the Czech Republic’s attractiveness to investors.
- Legislative initiatives such as the new law to speed up the bankruptcy resolution process are welcome.

*Source: _cr0784 - 25.      Sustained rapid growth of credit to households has brought concerns about (IMF staff report).*

### 40.      It is proposed that the next Article IV consultation be held on the standard 12-month

### _cr0784 - 40.      It is proposed that the next Article IV consultation be held on the standard 12-month 

### Growth Developments (2001-06)
- Real GDP Growth: charts show Czech Republic outpacing EU-15 and CEECs in several quarters through 2006; staff note: "Growth momentum is slowing from the recent exceptional rates...but is expected to remain strong."
- Contributions to Real GDP Growth:
  - Fixed investment, Private consumption, Net exports shown as quarterly contributors (2001q1–2006q1).
  - Investment composition (2004q1–2006q3): Machinery and equipment, Residential, Construction — "investment in machinery and equipment providing a strong impetus."
- High-frequency indicators (Jan-05 to Sep-06): Industrial production, Construction output, Retail sales (quarter-on-quarter percent change) indicate slowing momentum from exceptional rates.

### Financial Indicators (2003-06)
- Exchange Rate vs. Euro (September 1, 2005=100): series for Hungary, Czech, Poland, Slovakia (Sep-05 to Dec-06) show steady appreciation of the koruna: "Strong fundamentals have supported a steady appreciation of the koruna...and low volatility."
- Exchange Rate vs. Euro Implied Volatility 1/ (In percent): Hungary, Poland, Czech (Sep-05 to Dec-06) — volatility remained low.
- Foreign Currency Bond Spreads 2/ (In percent): Hungary, Czech, Poland, Slovakia (Sep-05 to Sep-06) — international bond spreads low and stable until a recent uptick.
- Credit Default Swaps 3/ (In basis points): Hungary, Czech, Poland (Jun-03 to Sep-06) — "Credit default swaps are low but vulnerable to regional contagion."
- Notes:
  - 1/ The volatility implied by the market price of a 1-month option contract based on a theoretical pricing model.
  - 2/ Spread of 5-year euro denominated international government bond versus 5-year Bund.
  - 3/ Five-year credit default swap spreads on sovereign debt.

### External Sector Developments (2001-06)
- Merchandise Export and Import Growth (Year-on-year percent change): Exports and imports series (2001q1–2006q1) — "Export growth remains strong..."
- Trade and Current Account Balance (percent of GDP): Trade balance and Current account balance series (2001q1–2006q1) — "the trade surplus is stable. The current account deficit widened in recent quarters..."
- Financing:
  - Net Foreign Direct Investment (2001q1–2006q1): inflows comfortably finance deficits — "but is comfortably financed by foreign direct investment inflows."
  - Net Portfolio Investment (2001q1–2006q1): portfolio outflows broadly stable in the last two years.
- Sources: Czech National Bank; Czech Statistical Office; and IMF staff estimates.

### Monetary Policy Indicators (2001-06)
- Policy Interest Rates (Jan-01 to Nov-06): CNB and ECB series — "The policy rate is rising, but is below the ECB rate."
- Monetary Conditions Index 1/ (Jan-01 to Sep-06): index (January 2000=100) — "Monetary policy stance, while tightening gradually..."
- Real Interest Rates 4/ (Jan-01 to Nov-06):
  - Ex-ante and Ex-post real rates series; ex post real interest rates are 1-year PRIBOR deflated by 12-month CPI inflation; ex ante deflated by 12-month inflation expected in a CNB survey.
  - Conclusion: "...remained accomodative until recently."
- Credit to the Private Sector 5/ (Year-on-year percent change): Business, Households, Total (Jan-01 to Nov-06) — "Household credit has been expanding rapidly in recent years."
- Notes:
  - 1/ Weighted average of real short-term interest rate and real effective exchange rate (weights: 2/3 and 1/3, respectively). January 2000=100.
  - 2/ Based on 1-year PRIBOR deflated by 12-month backward and forward-looking CPI inflation, respectively.
  - 3/ Based on interest rate deflated by 12-month backward-looking inflation excluding effects of indirect tax and administered price changes.
  - 4/ Ex post real interest rates are 1-year PRIBOR, deflated by 12-month CPI inflation; ex ante real interest rates are deflated by 12-month inflation expected in a survey conducted by the Czech National Bank Statistical Survey.
  - 5/ Business and total adjusted for loan write-offs and changes in classification of financial institutions.

### Competitiveness Indicators (2000–2006)
- Nominal and Real Exchange Rates vis-à-vis Trading Partners 1/ (2000q1=100): NEER, REER (CPI), REER (ULC) series show appreciation (increase indicates appreciation).
- Productivity and Profitability vis-à-vis Trading Partners 1/ 2/: Labor productivity and Profitability (inverse of PPI-deflated ULC) series (2000q1–2006q3) — "Despite continued appreciation of real exchange rates...and a squeeze in profitability margins, strong productivity growth and...stable wage costs have helped to maintain competitiveness...as shown by rising export market shares."
- Nominal Compensation per Employee, 2000–06 (In Euros): series for EU-15, CEECs, Czech, Candidate countries (2000–2006) — wage costs described as stable.
- Market Share in EU-15 6/ (2000q1–2006q3): rising series for Czech — "rising export market shares."
- Notes:
  - 1/ Trade weights based on 2000-03 data for exports and imports of goods. Partner countries listed in source.
  - 2/ In manufacturing. Czech data divided by data for partner countries.
  - 3/ Data corresponds to total economy.
  - 4/ Average for Hungary, Poland, the Slovak Republic, and Slovenia.
  - 5/ Average for Bulgaria and Romania.
  - 6/ EU-15 imports from the Czech Republic as a share of total imports from world, in percent.

### Selected Economic Indicators, 2002–2007 (Table 1 highlights)
- Real economy (change in percent):
  - Real GDP: 2002: 1.9; 2003: 3.6; 2004: 4.2; 2005: 6.1; 2006: 6.0; 2007 (Proj.): 4.8
  - Domestic demand: 2002: 4.0; 2003: 4.1; 2004: 2.9; 2005: 1.8; 2006: 4.9; 2007 (Proj.): 4.8
  - CPI (year average): 2002: 1.8; 2003: 0.1; 2004: 2.8; 2005: 1.8; 2006: 2.6; 2007 (Proj.): 3.2
  - PPI (year average): 2002: -0.5; 2003: -0.3; 2004: 5.7; 2005: 3.0; 2006: 1.6; 2007 (Proj.): n.a.
- Unemployment rate (in percent):
  - Survey-based 1/: 2002: 7.3; 2003: 7.8; 2004: 8.3; 2005: 7.9; 2006: 7.1; 2007 (Proj.): 6.9
  - Registered 1/: 2002: 9.2; 2003: 9.9; 2004: 9.2; 2005: 8.9; 2006: 8.1; 2007 (Proj.): 7.9
- Savings and investment (percent of GDP):
  - Gross national savings: 2002: 23.2; 2003: 21.1; 2004: 21.6; 2005: 24.4; 2006: 23.5; 2007 (Proj.): 23.8
  - Gross domestic investments: 2002: 28.7; 2003: 27.4; 2004: 27.6; 2005: 26.5; 2006: 27.8; 2007 (Proj.): 28.1
- Public finance (percent of GDP) 2/ (staff estimates for 2006 and 2007):
  - General government revenue: 2002: 36.8; 2003: 38.2; 2004: 38.0; 2005: 39.0; 2006: 38.8; 2007 (Proj.): 38.9
  - General government expenditure 3/: 2002: 43.2; 2003: 44.2; 2004: 42.0; 2005: 42.6; 2006: 43.7; 2007 (Proj.): 43.5
  - General government balance 3/: 2002: -6.5; 2003: -6.0; 2004: -4.0; 2005: -3.6; 2006: -4.8; 2007 (Proj.): -4.7
  - Adjusted (to exclude grants to transformation institutions...): 2002: -3.9; 2003: -4.8; 2004: -3.3; 2005: -1.9; 2006: -3.7; 2007 (Proj.): -4.4
  - Targeted: adjusted balance excluding net lending 4/: 2002: -3.6; 2003: -3.9; 2004: -2.7; 2005: -1.6; 2006: -3.6; 2007 (Proj.): -4.2
  - General government debt: 2002: 18.0; 2003: 21.5; 2004: 23.7; 2005: 25.6; 2006: 27.6; 2007 (Proj.): 29.4
  - Including debt of the Czech Consolidation Agency: 2002: 24.9; 2003: 27.4; 2004: 27.4; 2005: 27.0; 2006: 28.3; 2007 (Proj.): 29.8
- Money and credit (end of year, percent change):
  - Broad money 5/: 2002: 3.5; 2003: 6.9; 2004: 4.4; 2005: 8.0; 2006: 9.0; 2007 (Proj.): n.a.
  - Private sector credit (percent change, eop) 5/: 2002: -6.7; 2003: 10.4; 2004: 15.8; 2005: 22.3; 2006: 23.6; 2007 (Proj.): n.a.
- Interest rates (year average):
  - Three-month interbank rate: 2002: 3.6; 2003: 2.3; 2004: 2.4; 2005: 2.0; 2006: 2.3; 2007 (Proj.): n.a.
  - Ten-year government bond 5/: 2002: 4.9; 2003: 4.1; 2004: 4.8; 2005: 3.5; 2006: 3.8; 2007 (Proj.): n.a.
- Balance of payments (percent of GDP):
  - Trade balance: 2002: -2.9; 2003: -2.7; 2004: -1.0; 2005: 1.4; 2006: 1.4; 2007 (Proj.): 1.3
  - Current account: 2002: -5.5; 2003: -6.2; 2004: -6.0; 2005: -2.1; 2006: -4.3; 2007 (Proj.): -4.2
  - Gross international reserves (US$ billion): 2002: 23.7; 2003: 27.0; 2004: 28.4; 2005: 29.6; 2006: 31.8; 2007 (Proj.): 33.8
  - Reserve cover (in months of imports of goods and services): 2002: 6.1; 2003: 5.5; 2004: 4.4; 2005: 4.1; 2006: 3.6; 2007 (Proj.): 3.2
- Exchange rate:
  - Nominal effective exchange rate, pa (2000=100) 5/: 2002: 116.5; 2003: 116.0; 2004: 116.4; 2005: 123.5; 2006: 129.2; 2007 (Proj.): n.a.
  - Real effective exchange rate, pa (CPI-based; 2000=100) 6/: 2002: 116.7; 2003: 112.9; 2004: 113.0; 2005: 118.9; 2006: 124.3; 2007 (Proj.): n.a.
- Sources: Czech Statistical Office; Czech National Bank; Ministry of Finance; and Fund staff estimates and projections.
  - 1/ In percent of total labor force.
  - 2/ Staff estimates for 2006 and 2007.
  - 3/ Excluding privatization revenues of the National Property Fund and the Czech Land Fund, the sale of shares and voting rights by local governments, and the sale of Russian debt.
  - 4/ General government deficit excluding transfer to transformation institutions and net lending.
  - 5/ For 2006, data refer to November.

### Balance of Payments, 2002–2007 (Table 2 highlights)
- Current account balance (US$ million): 2002: -4,264; 2003: -5,785; 2004: -6,512; 2005: -2,574; 2006: -6,029; 2007 (Proj.): -6,850
- Trade balance (US$ million): 2002: -2,239; 2003: -2,519; 2004: -1,047; 2005: 1,735; 2006: 1,911; 2007 (Proj.): 2,082
  - Exports (US$ million): 2002: 3,846; 2003: 4,948; 2004: 8,701; 2005: 16,723; 2006: 9,782; 2007 (Proj.): 6,596? (table cell formatting indicates series)
  - Imports (US$ million): 2002: 4,070; 2003: 9,512; 2004: 8,627; 2005: 8,676; 2006: 5,309; 2007 (Proj.): 4,672? (table cell formatting indicates series)
- Nonfactor services net: 2002: 643; 2003: 470; 2004: 481; 2005: 1,811; 2006: 600; 2007 (Proj.): 792
  - Receipts and Payments listed in table.
- Factor income (net): 2002: -3,579; 2003: -4,285; 2004: -6,139; 2005: -5,940; 2006: -8,318; 2007 (Proj.): -9,203
- Capital account, Financial account and components:
  - Capital account: 2002: -4; 2003: -3; 2004: -596; 2005: 211; 2006: 622; 2007 (Proj.): 1,195
  - Financial account balance: 2002: 1,061; 2003: 756; 2004: 620; 2005: 728; 2006: 2,615; 2007 (Proj.): 6,747; 6,850 (table lists multiple numbers across columns)
  - Direct investment, net: 2002: 828; 2003: 218; 2004: 1,814; 2005: 3,941; 2006: 1,013; 2007 (Proj.): 1,325; 2,635; 6,685 (table formatting shows several entries)
- Change in reserves 3/ (US$ million): 2002: -661; 2003: 2, -441? ; 2004: -261; 2005: -3879; 2006: -2,140; 2007 (Proj.): -1,195
- Memorandum items:
  - Current account (in percent of GDP): 2002: -5.5; 2003: -6.2; 2004: -6.0; 2005: -2.1; 2006: -4.3; 2007 (Proj.): -4.2
  - Trade balance (in percent of GDP): 2002: -3.0; 2003: -2.8; 2004: -1.0; 2005: 1.4; 2006: 1.4; 2007 (Proj.): 1.3
  - Net foreign direct investment (in percent of GDP): 2002: 11.0; 2003: 2.0; 2004: 3.6; 2005: 8.2; 2006: 3.7; 2007 (Proj.): 3.5
  - Gross official reserves (in months of the following year's imports of goods and services): 2002: 5.7; 2003: 4.6; 2004: 4.2; 2005: 3.6; 2006: 3.3; 2007 (Proj.): 3.0
  - Reserve ratio to short-term debt by remaining maturity: 2002: 1.8; 2003: 1.5; 2004: 1.2; 2005: 1.3; 2006: 1.3; 2007 (Proj.): 1.3
  - Terms of trade 2/: 2002: 3.1; 2003: 0.4; 2004: 0.3; 2005: -1.8; 2006: -1.7; 2007 (Proj.): -0.1
- Sources: Czech National Bank; and IMF staff projections.
  - 1/ IMF staff estimates or projections.
  - 2/ Goods and services.
  - 3/ Changes in reserves reflect off-market conversion of large privatization receipts and EU transfers and sales of accumulated interest.

### Consolidated General Government Budget, 2002–07 (Table 3 highlights)
- Total revenue and grants (percent of GDP): 2002: 36.8; 2003: 38.2; 2004: 38.0; 2005: 39.0; 2006: 38.8; 2007 (Proj.): 38.9
  - Total revenue: 2002: 36.7; 2003: 37.8; 2004: 37.1; 2005: 38.0; 2006: 37.4; 2007 (Proj.): 36.8
  - Current revenue and components (tax, nontax) listed with exact series (see table).
  - Grants, incl. EU compensation: 2002: 0.1; 2003: 0.5; 2004: 0.9; 2005: 1.1; 2006: 1.4; 2007 (Proj.): 2.1
- Total expenditure and net lending (percent of GDP): 2002: 43.2; 2003: 44.2; 2004: 42.0; 2005: 42.6; 2006: 43.7; 2007 (Proj.): 43.5
  - Excluding grants to transformation institutions: 2002: 40.6; 2003: 43.0; 2004: 41.3; 2005: 41.0; 2006: 42.5; 2007 (Proj.): 43.3
  - Current expenditure: 2002: 37.8; 2003: 37.9; 2004: 36.1; 2005: 36.7; 2006: 37.1; 2007 (Proj.): 36.6
  - Capital expenditure: 2002: 5.2; 2003: 5.5; 2004: 5.6; 2005: 5.7; 2006: 6.5; 2007 (Proj.): 6.7
- Overall balance 4/: 2002: -6.5; 2003: -6.0; 2004: -4.0; 2005: -3.6; 2006: -4.8; 2007 (Proj.): -4.6
  - Adjusted to exclude grants to transformation institutions to cover costs related to management of bad assets: 2002: -3.9; 2003: -4.8; 2004: -3.3; 2005: -1.9; 2006: -3.7; 2007 (Proj.): -4.4
  - Cyclically adjusted balance: 2002: -2.1; 2003: -3.1; 2004: -1.8; 2005: -0.9; 2006: -3.4; 2007 (Proj.): -4.2
  - Targeted: adjusted balance excluding net lending: 2002: -3.6; 2003: -3.9; 2004: -2.7; 2005: -1.6; 2006: -3.6; 2007 (Proj.): -4.2
- Financing 5/:
  - Privatization receipts 6/: 2002: 5.1; 2003: 1.0; 2004: 0.5; 2005: 3.6; 2006: 0.2; 2007 (Proj.): 1.0
  - Net increase in financial liabilities: 2002: 0.5; 2003: 5.0; 2004: 3.3; 2005: 0.0; 2006: 4.7; 2007 (Proj.): 3.7
- Memorandum:
  - Grants to transformation institutions to cover costs related to management of bad assets: 2002: 2.6; 2003: 1.2; 2004: 0.7; 2005: 1.6; 2006: 1.1; 2007 (Proj.): 0.2
  - General government debt 7/: 2002: 18.0; 2003: 21.5; 2004: 23.7; 2005: 25.6; 2006: 27.6; 2007 (Proj.): 29.4
  - Including debt of the Czech Consolidation Agency: 2002: 24.9; 2003: 27.4; 2004: 27.4; 2005: 27.0; 2006: 28.3; 2007 (Proj.): 29.8
  - General government balance, ESA95-based: 2002: -6.9; 2003: -6.7; 2004: -2.9; 2005: -3.6; 2006: -3.5; 2007 (Proj.): -4.0
  - General government debt, ESA95-based: 2002: 28.8; 2003: 32.6; 2004: 32.7; 2005: 31.2; 2006: n.a.; 2007 (Proj.): n.a.
- Sources: Ministry of Finance and Fund staff estimates.
  - 1/ Consolidated coverage listed in source.
  - 2/ Preliminary estimates based on staff's GDP projections. Expenditure estimates exclude the effects of carryover spending.
  - 3/ Excluding revenues from UMTS licence sales.
  - 4/ Excluding privatization revenues of the National Property Fund, the Czech Land Fund, and the sale of shares and voting rights by the local governments.
  - 5/ IMF staff estimates.
  - 6/ Includes privatization receipts of the National Property Fund, the Czech Land Fund, and the sale of shares and voting rights by local governments.
  - 7/ Includes liabilities of the state budget, extrabudgetary funds, social security funds, and local governments.

### Medium-term Macroeconomic Scenario, 2002–2011 (Table 4 highlights)
- Real GDP (percent growth): 2002: 1.9; 2003: 3.6; 2004: 4.2; 2005: 6.1; 2006: 6.0; 2007 (Proj.): 4.8; 2008 (Proj.): 4.3; 2009 (Proj.): 5.0; 2010 (Proj.): 4.3; 2011 (Proj.): 4.0
- Consumption and Investment growth series provided through 2011 with exact annual figures (see table).
- CPI inflation: 2002: 1.8; 2003: 0.1; 2004: 2.8; 2005: 1.8; 2006: 2.6; 2007–2011 projections: 3.0 (2007–2011 show 3.0 for most years)
- Gross domestic savings and gross capital formation (percent of GDP): series 2002–2011 provided.
- Public finances: Revenues, expenditures, overall and adjusted balances, debt series 2002–2011 provided (exact values in table).
- Balance of payments: Current account balance (percent of GDP) 2002: -5.5; 2003: -6.2; 2004: -6.0; 2005: -2.1; 2006: -4.3; projections show narrowing to -3.3 to -3.4 by 2011.
- Memo note: "Hyundai has recently started a major new automobile plant, which is expected to come on stream in late 2008. The economic effects of the Hyundai plant are difficult to estimate at this stage, but they are likely to be analogous to those of the Toyota Peugeot Citroën Automobile (TPCA) plant in 2005–06. These considerations explain the volatility in staff’s medium-term projections for GDP growth and trade balance."

### Selected Vulnerability Indicators (Table 5 highlights, latest observation Dec-06 / Sep-06 / Nov-06 as indicated)
- Key macro indicators:
  - Real GDP growth (in percent): 2000: 3.6; 2001: 2.5; 2002: 1.9; 2003: 3.6; 2004: 4.2; 2005: 6.1; 2006: 6.0Proj
  - CPI inflation (period average, in percent): 2000: 4.0; 2001: 4.7; 2002: 1.8; 2003: 0.1; 2004: 2.8; 2005: 1.8; 2006: 2.6Proj
  - Short-term (ST) interest rate (in percent) 2/ (one-month interbank offer rate, PRIBOR, eop): 2000: 5.3; 2001: 4.8; 2002: 2.7; 2003: 2.0; 2004: 2.5; 2005: 2.1; Dec-06: 2.5
  - EMBI secondary market spread (bps, end of period) 3/: Dec-06: 14.7; 14.2; 20.2 noted (Czech Republic not included in EMBI index).
  - Exchange rate NC/US$ (end of period): Dec-06: 20.9
- External sector:
  - Exchange rate regime: Managed floating
  - Current account balance (percent of GDP): series and projection: -4.3Proj (latest projection)
  - Net FDI inflows (percent of GDP): 2000: 8.7; 2001: 8.9; 2002: 11.0; 2003: 2.0; 2004: 3.6; 2005: 8.2; 2006: 3.7; 2007 (Proj.): 3.5
  - Exports (percentage change of US$ value, GNFS): 2000: 7.7; 2001: 13.0; 2002: 12.5; 2003: 24.0; 2004: 36.2; 2005: 15.7; 2006: 21.5Proj
  - Real effective exchange rate (2000=100): Oct-06: 132.4
  - Gross international reserves (GIR) in US$ billion: 2006 (Proj): 31.8; 2007 (Proj): 33.8
  - GIR in percent of ST debt at remaining maturity (RM): 2006 (Proj): 132.7; 2007 (Proj): 130.2
  - Total gross external debt (ED) in percent of GDP: 2006: 36.8; 2007 (Proj): 37.0
  - ST external debt (original maturity, in percent of total ED): 2006: 31.4; 2007 (Proj): 31.5
  - ED of domestic private sector (in percent of total ED): 2006: 79.7; 2007 (Proj): 79.4
  - Total gross external debt in percent of exports of GNFS: 2006: 51.4; 2007 (Proj): 48.3
  - Gross external financing requirement (in US$ billion) 4/: 2006 (Proj): 24.0; 2007 (Proj): 23.6
- Public sector:
  - Overall balance (percent of GDP): series shows 2006: -3.6; 2007 (Proj.): -4.8Proj
  - Primary balance (percent of GDP): 2006: -1.1; 2007 (Proj.): -2.7Proj
  - Gross PS financing requirement (in percent of GDP): 2006: 8.2; 2007 (Proj.): 12.2Proj
  - Public sector gross debt (PSGD, in percent of GDP): 2006: 27.6; 2007 (Proj.): 27.6? (table shows 27.6 as projection)
  - Public sector net debt (in percent of GDP): 2006: 22.1; 2007 (Proj.): 23.4Proj
- Financial sector (Sep-06 / Nov-06 observations):
  - Capital adequacy ratio (in percent): Sep-06: 11.3
  - NPLs in percent of total loans: Sep-06: 4.1
  - Provisions in percent of NPLs: Sep-06: 62.2
  - Return on average assets (in percent): Sep-06: 1.3
  - Return on equity (in percent): Sep-06: 23.8
  - FX deposits held by residents (in percent of total deposits): Nov-06: 9.2
  - FX loans to residents (in percent of total loans): Nov-06: 9.9
  - Credit to private sector (percent change): Nov-06: 17.0
- Memo item:
  - Nominal GDP in billions of U.S. dollars: 2000: 60.2; 2001: 56.7; 2002: 61.8; 2003: 75.3; 2004: 91.4; 2005: 108.2; 2006 (Proj.): 124.3
- Notes:
  - 1/ Staff estimates, projections, or latest available observations as indicated in the last column.
  - 2/ One-month interbank offer rate (PRIBOR), eop.
  - 3/ The Czech Republic is not included in the EMBI index.
  - 4/ Current account deficit, amortization of medium and long term debt, plus short-term debt by remaining maturity.
  - 5/ Public sector covers: general government. The deficit measure excludes privatization revenues but includes transfers to CKA. The debt measure excludes CKA debt.
  - 6/ Based on averages for the last five years for the relevant variables (i.e., growth, interest rates).
  - 7/ Overall balance plus debt amortization.
  - 8/ Financial sector includes: commercial banks.
  - 9/ A ratio of net profit to average assets.
  - 10/ A ratio of net profit to average capital.

*Source: IMF staff estimates, Czech Statistical Office, Czech National Bank, Ministry of Finance, and tables and figures contained in the document.*

### Appendix I. Czech Republic: Medium-Term Fiscal and External Outlook

### Appendix I. Czech Republic: Medium-Term Fiscal and External Outlook

### Fiscal Sustainability — Findings and Projections
- Authorities plan gradual fiscal consolidation to reach the 3 percent Maastricht threshold by 2009, with the general government deficit declining by around ½ percent of GDP annually and full assumption of Czech Consolidation Agency’s (CKA) debt by the government by 2008. Repayments of risky guarantees by installments is also assumed.
- Under the baseline scenario (fiscal consolidation implemented):
  - The stock of government debt is projected to stay below 35 percent of GDP.
  - Public sector debt (baseline, percent of GDP): 2006: 27.6; 2007: 29.4; 2008: 31.3; 2009: 31.9; 2010: 32.3; 2011: 32.3.
- Under standard adverse shock scenarios to growth, interest rate, and exchange rate, public debt remains sustainable in the medium term and below the Maastricht ceiling of 60 percent of GDP (see Table A1 and Figure A1).
- Risks and alternative scenarios:
  - Recent evidence of waning commitment to fiscal reform could worsen medium-term debt dynamics.
  - A pre-election social benefits package would cost in excess of 1½ percent of GDP over 2007-08.
  - Consolidation measures to achieve the medium-term deficit target were not identified at the time of the report.
  - Government guarantees stood at 14 percent of GDP at end-2005 (excluding ecological guarantees associated with environmental cleanup of privatized companies and CKA guarantees).
  - Aside from a large bank guarantee (arbitration pending), outstanding guarantees of about 3 percent of GDP are considered high risk.
  - A sizable debt in the health insurance companies remains.
  - Incorporating high-risk contingent liabilities (healthcare debt 10 bill. CZK; ecological guarantees 85 bill. CZK; risky guarantees 97 bill. CZK) and assuming a fiscal deficit higher by 1 percentage points relative to baseline (in line with 2007 budget levels), debt would reach nearly 45 percent of GDP by 2010 (Staff alternative scenario).
- Longer-term projection:
  - Aging pressures project debt levels to reach 80 percent of GDP by 2020.

### Fiscal Sustainability — Detailed Indicators and Drivers
- Key projected fiscal indicators (selected):
  - Primary deficit (percent of GDP): 2006: 2.7; 2007: 3.1; 2008: 2.3; 2009: 1.3; 2010: 0.8; 2011: 0.4.
  - Revenue and grants (percent of GDP): 2006: 38.8; 2007: 38.9; 2008: 39.9; 2009: 40.3; 2010: 40.2; 2011: 40.4.
  - Primary (noninterest) expenditure (percent of GDP): 2006: 41.5; 2007: 42.0; 2008: 42.1; 2009: 41.6; 2010: 41.1; 2011: 40.8.
  - Automatic debt dynamics contribution (percent of GDP): 2006: -0.6; 2007: -0.6; 2008: -0.4; 2009: -0.7; 2010: -0.4; 2011: -0.4.
  - Gross financing need (percent of GDP, baseline): 2006: 12.2; 2007: 11.5; 2008: 11.7; 2009: 10.1; 2010: 10.3; 2011: 9.3.

### Policy Implications and Recommendations (implied by risks and projections)
- Maintain commitment to the planned fiscal consolidation to keep public debt on the baseline path below 35 percent of GDP.
- Identify and implement consolidation measures sufficient to offset pre-election and other fiscal slippages (pre-election package costs exceed 1½ percent of GDP over 2007-08).
- Address and mitigate high-risk contingent liabilities:
  - Quantify and, where appropriate, recognize healthcare debt and ecological and risky guarantees (staff alternative scenario quantifications: healthcare debt 10 bill. CZK; ecological guarantees 85 bill. CZK; risky guarantees 97 bill. CZK).
  - Monitor large bank guarantee cases (including arbitration exposure).
- Prepare policies to offset longer-term aging pressures that could push debt toward 80 percent of GDP by 2020.

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### External Sustainability — Findings and Projections
- Recent external developments are favorable:
  - Exceptionally strong export performance led to a trade balance surplus and a significantly narrowed current account deficit.
  - International investment position shows a modest net liability position equal to around 30 percent of GDP, reflecting a large stock of inward FDI.
  - Robust FDI inflows, exchange rate appreciation, and real GDP growth provided room to run a current account deficit without increasing external debt.
- External vulnerability and stress-test results:
  - External sustainability does not appear to be a significant concern over the medium term.
  - Vulnerability analysis suggests the current account deficit is well within the debt-stabilizing range of about 4 ¼ percent of GDP (Table A2).
  - Even under adverse conditions with a growth slowdown and a decline in FDI, external debt remains below 30 percent of GDP in 2011.
  - Bound tests indicate a largely manageable external debt ratio at around 40 percent of GDP under combined shocks from higher interest rate, lower growth and a worsened current account.
- External debt projections (selected):
  - External debt (percent of GDP): 2006: 37.0; 2007: 34.0; 2008: 32.7; 2009: 31.1; 2010: 29.8; 2011: 28.6.
  - Change in external debt (percent of GDP): 2006: -3.0; 2007: -1.4; 2008: -1.6; 2009: -1.3; 2010: -1.2.
  - Gross external financing need (in billions of U.S. dollars): 2006: 17.2; 2007: 18.6; 2008: 20.4; 2009: 19.1; 2010: 20.9; 2011: 20.2.
  - External debt-to-exports ratio (percent): 2006: 48.3; 2007: 43.0; 2008: 40.3; 2009: 37.5; 2010: 35.1; 2011: 33.2.

### External Stress Scenarios and Key Macroeconomic Assumptions
- Alternative and stress scenarios (Table A2 highlights):
  - A1 (Key variables at historical averages in 2007-11) projects external debt ratios declining toward the high 20s percent of GDP.
  - A2 (Country-specific shock in 2007 with reduction in GDP growth and FDI) still keeps external debt in the low-to-mid 30s percent of GDP by 2011.
  - B1–B6 bound tests (nominal interest, real GDP growth, dollar deflator, current account, combined shocks, one-time 30 percent nominal depreciation) show external debt ratios rising in stressed cases but generally remaining manageable versus historical thresholds.
- Key macro assumptions underlying baseline (selected):
  - Real GDP growth (percent): 2006: 6.0; 2007: 4.8; 2008: 4.3; 2009: 5.0; 2010: 4.3; 2011: 4.0.
  - GDP deflator in US dollars (change, percent): 2006: 8.3; 2007: 6.2; 2008: 9.9; 2009: 7.2; 2010: 9.5; 2011: 3.0.
  - Nominal external interest rate (percent): projected around 3.9–3.6 over projections.

### External Policy Implications
- Continue policies supporting robust FDI inflows and export performance to maintain external debt sustainability.
- Monitor external financing needs (gross external financing need in billions of U.S. dollars projected above) and ensure adequate access to stable capital inflows.
- Maintain buffers against combined shocks (interest rate, growth, and current account shocks) given bound-test outcomes showing higher debt ratios under stressed scenarios.

*Source: Appendix I. Czech Republic: Medium-Term Fiscal and External Outlook (Staff Report for the 2006 Article IV Consultation—Informational Annexes).*

### Appendix II. Czech Republic: Statistical Issues

### Appendix II. Czech Republic: Statistical Issues

### Data provision to the Fund
- 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.
- While availability of economic data is timely, reporting to STA is less current, especially for foreign trade and the national accounts.

### Data quality and ongoing improvements
- Overall data quality is generally adequate, and the authorities are taking measures to improve data accuracy.
- The Ministry of Finance is participating in the Fund’s pilot project to transition to GFSM 2001.
- The CNB implemented the European Central Bank’s (ECB) framework for collecting, compiling, and reporting monetary data in 2002; data published in IFS are based on monetary accounts derived from the ECB’s framework.

### National accounts
- National accounts data are subject to certain weaknesses:
  - Value added in the small-scale private sector is likely to be underestimated due to underdeveloped data collection mechanisms and a significant proportion of unrecorded activity stemming 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 estimates are derived from quarterly reports of enterprises and surveys and are subject to bias because of nonresponse (quarterly reporting is not mandatory while annual reporting of bookkeeping accounts is mandatory).
  - Lumping of several expenditure categories in particular quarters by respondents and large swings in individual components of spending and overall GDP quarter to quarter bring into question the reliability of the quarterly data.

### External trade statistics
- Revisions to procedures for processing export data have brought external trade statistics close to EU practice.
- A continued weakness is the 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 the end of the year, require caution in interpreting monetary developments; the CNB has made a major effort to identify causes and adjust the data.
- The set of monetary accounts used for IFS and those published in the CNB’s bulletins and on the website are effectively harmonized, although presentation in IFS differs somewhat from the CNB’s.

### Fiscal and government finance statistics
- Annual fiscal data on an ESA-95 basis has been prepared by the Czech Statistical Office.
- Quarterly data for non-financial accounts have been compiled and quarterly financial accounts are being prepared.
- The Ministry of Finance uses the ESA-95 methodology for the Convergence Program targets. ESA-95 differs from the national fiscal targeting methodology in terms of coverage of institutions (for example, the CKA is included in the central government under ESA definition) and the basis of recording due to inclusion of accrued financial transactions and other accrual items (for example, called guarantees).
- Annual data published in the Government Finance Statistics Yearbook cover operations of the general government, excluding “semibudgetary” organizations and a number of state extrabudgetary institutions and special funds. The most important excluded institutions include:
  - the Czech Consolidation Agency and its subsidiaries,
  - the Czech Collection Company,
  - the Railway Infrastructure administration,
  - the Public-Private-Partnership Centre,
  - public universities.
- Monthly fiscal data published in International Financial Statistics (IFS) cover state budget accounts.

### Table of Common Indicators Required for Surveillance (selected items, as of January 22, 2007)
- Exchange Rates: Date of latest observation 12/31/06; Date received 1/8/07; Frequency of data M; Frequency of reporting M; Frequency of publication M.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation 11/31/06; Date received 12/07/06; Frequency of data D; Frequency of reporting M; Frequency of publication M.
- Reserve/Base Money: Date of latest observation 12/01/06; Date received 12/11/06; Frequency of data 10 days; Frequency of reporting 10 days; Frequency of publication 10 days.
- Broad Money: Date of latest observation 11/30/06; Date received 12/27/06; Frequency of data M; Frequency of reporting M; Frequency of publication M.
- Central Bank Balance Sheet: Date of latest observation 11/30/06; Date received 12/27/06; Frequency of data M; Frequency of reporting M; Frequency of publication M.
- Consolidated Balance Sheet of the Banking System: Date of latest observation Nov 2006; Date received 12/15/06; Frequency of data M; Frequency of reporting M; Frequency of publication M.
- Interest Rates: Date of latest observation 12/31/06; Date received 1/10/07; Frequency of data M; Frequency of reporting M; Frequency of publication M.
- Consumer Price Index: Date of latest observation Dec 2006; Date received 1/07; Frequency of data M; Frequency of reporting M; Frequency of publication M.
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Date of latest observation Dec 2006; Date received Jan 2007; Frequency of data A; Frequency of reporting A; Frequency of publication A.
- Revenue, Expenditure, Balance and Composition of Financing – Central Government: Date of latest observation Dec 2006; Date received Jan 2007; Frequency of data A; Frequency of reporting A; Frequency of publication A.
- Stocks of Central Government and Central Government-Guaranteed Debt: Date of latest observation Sep 2006; Date received Jan 2007; Frequency of data A; Frequency of reporting A; Frequency of publication A.
- External Current Account Balance: Date of latest observation 2006 Q3; Date received Dec 2006; Frequency of data Q; Frequency of reporting Q; Frequency of publication Q.
- Exports and Imports of Goods and Services: Date of latest observation Oct 2006; Date received 11/24/06; Frequency of data M; Frequency of reporting M; Frequency of publication M.
- GDP/GNP: Date of latest observation 2006 Q3; Date received Dec 2006; Frequency of data Q; Frequency of reporting Q; Frequency of publication Q.
- Gross External Debt: Date of latest observation 2006 Q3; Date received Dec 2006; Frequency of data Q; Frequency of reporting Q; Frequency of publication Q.

*Source: Appendix II. Czech Republic: Statistical Issues*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr0784.pdf_