## _cr0839

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### Executive Summary — Overall assessment
- The Czech economy "continues to perform well" and external vulnerabilities are "limited."
- Growth momentum sustained; economy has so far weathered recent market turmoil well.
- External debt is low and the modest current account deficit is comfortably financed by direct investment flows.
- The koruna "has appreciated sharply in recent months" but "it is estimated to be broadly in line with fundamentals."

### Growth and inflation outlook
- Growth
  - Staff projects growth to decline to about 4½ percent in 2008.
  - GDP growth likely "at close to 6 percent for the third year in a row" in 2007.
  - Hyundai expected to start a major new automobile plant in late 2008, which "could contribute nearly a percentage point to GDP growth."
- Inflation
  - Headline inflation "is set to double" due to shocks from indirect taxes and food and energy price increases.
  - Headline inflation reached 5 percent in the year to November 2007.
  - Core inflation had been around 1 percent but has risen steadily since late 2006.
  - Headline inflation is forecast to rise above 5 percent in 2008 and projected increase in inflation to 5 percent in 2008 (Executive appraisal and Risks section).
- Risks
  - Downside risks to growth stem primarily from fragility of growth in major export markets and continued high oil prices.
  - Labor supply constraints at home add to downside risks.

### Monetary policy
- "Monetary policy needs to be on a sustained tightening path."
- CNB rate changes in 2007:
  - Raised from 2 ½ percent to 3 percent in early summer 2007.
  - Then to 3 ¼ percent in August 2007.
  - Then to 3 ½ percent in November 2007.
- Interest rate differential vis-à-vis the euro area was "already at 125 basis points in May 2007."
- Real rates have turned negative; koruna appreciation—"about 5 percent since October"—contributed to tightening monetary conditions.
- Czech policy rate remains among the lowest in the EU.
- CNB credibility and enhanced policy communication (including publication of a forecast-consistent interest-rate path and voting records beginning in 2008) intended to anchor inflation expectations and facilitate transition to a 2 percent inflation target from 2010.

### Fiscal policy and medium-term challenges
- "The main medium-term policy challenge centers on achieving sustainable fiscal consolidation."
- Authorities plan to lower the deficit below the Maastricht threshold limit from 2008 onwards.
- Authorities plan to reduce the deficit from the officially projected 3.4 percent of GDP in 2007 to 2.9 percent in 2008 and to 2.3 percent of GDP by 2010, entailing a cumulative fiscal effort of about 1½ percent of GDP over the next three years.
- Staff argued the 2007 outturn was likely better than the projected 3.4 percent of GDP by over ½ percent of GDP; staff suggested a commensurately lower deficit target around 2¼ percent of GDP in 2008 if cyclical gains are saved.
- "Comprehensive pension and health care reforms, implemented early, will be essential for sustainable public finances."
- Fiscal developments in 2007:
  - General government deficit (ESA-95 basis) is likely to be below 3 percent of GDP in 2007.
  - Fiscal stance for 2007 is estimated to be expansionary, albeit modestly.
  - Memo items: Nominal GDP growth 6.3, 7.5, 9.6, 10.2 (table heading context preserved).

### Tax and welfare reform (Box 1 — impact on fiscal balance, In percent of GDP)
- Introduction of a flat rate of personal income tax at 15 percent: 2008: -0.6; 2009: -0.7; 2010: -0.8
- Phased reduction of corporate income tax from 24 percent to 19 percent by 2010: 2008: -0.2; 2009: -0.6; 2010: -0.8
- Increase in the lower VAT rate from 5 percent to 9 percent and introduction of environmental taxes: 2008: 1.0; 2009: 1.0; 2010: 0.9
- Introduction of a ceiling on social security contributions: 2008: -0.2; 2009: -0.2; 2010: -0.2
- Reduction and streamlining of social benefits, and health care reform1/: 2008: 0.5; 2009: 0.7; 2010: 0.6
- Total: 2008: 0.6; 2009: 0.2; 2010: -0.2
- Staff assessment: shift toward indirect taxes may enhance savings and investment, but package "does not fully deliver its objectives efficiently"; personal income tax cuts are "largely unnecessary and not well-targeted"; cap on social security contributions would reduce revenue efficiency.

### External sector and financing
- Current account deficit widened to around 3½ percent of GDP in 2007 from about 3 percent in 2006.
- Widening deficit largely financed by inflows of direct investment.
- Gross international reserves reached above US$ 31 billion by end-October 2007, covering over 3 months of imports and 1.2 times short-term maturing debt.
- External debt rose to around 41 percent of GDP at end-2006.
- Staff estimates underlying current account deficit in 2007 at around 3 percent of GDP; equilibrium estimate around 2½ percent of GDP.

### Financial sector and vulnerabilities
- Near-term vulnerabilities limited.
  - Public debt relatively low at around 30 percent of GDP.
  - Limited exposure to foreign currency public debt.
- Household debt—primarily mortgages—has risen rapidly; credit risks limited by low level of foreign currency borrowing and bank lending financed primarily through domestic deposits.
- Financial market liquidity remained adequate during August–December 2007 turmoil; sovereign spreads rose little.
- Yields remain the lowest in Central Europe.
- Financial stability indicators (selected)
  - Number of banks (2003–2007q3): 35, 35, 36, 37, 38.
  - Regulatory capital to risk-weighted assets (percent): 14.5, 12.6, 11.9, 11.4, 11.9.
  - Nonperforming loans (percent of total loans): 4.9, 4.1, 4.3, 3.6, 3.0.
  - Liquid assets (percent of total assets): 36.4, 33.6, 32.8, 30.4, 28.6.
  - After-tax return on average assets (percent): 1.2, 1.3, 1.4, 1.2, 1.3.
- Credit growth and housing
  - Credit to the private sector increased by 25 percent in the year to September 2007.
  - Household credit growth around 30 percent.
  - Housing prices have started to rise rapidly (index base 2002m12=100).

### Koruna and carry trades (Box 2)
- Koruna used as a funding currency for carry trades in 2007; depreciation of more than 4 percent in first half of 2007 preceded by carry activity.
- Main instruments: financial derivatives—primarily outright forwards and currency swaps—with spikes in January and June 2007.
- Appetite for koruna carry trades has since disappeared: subsequent monetary tightening and global turmoil accelerated carry-trade unwinding.
- Koruna decoupled from other low-yield currencies and again moves with CEE-4 currencies; recent appreciation could also be driven by weakening of the US dollar and withdrawal of funds from U.S. assets.

### Medium-term growth and structural challenges
- Staff projects potential growth to slow to around 4½ percent.
- Structural issues: aging pressures on public finances and labor market; tax-benefit system creates low-wage and unemployment traps; skill mismatches and regional disparities; strict employment protection regulations; slipping business competitiveness rankings.
- Labor market reform, active labor market policies, and improved tax-benefit design recommended to raise participation and reduce structural unemployment.

### Policy recommendations and priorities
- Maintain a sustained monetary tightening path to contain inflation pressures while monitoring koruna appreciation and second-round effects.
- Preserve the originally targeted fiscal adjustment for 2008 and pursue further consolidation to achieve deficits below the Maastricht threshold.
- Implement comprehensive pension and health care reforms early; avoid unaffordable tax cuts absent such reforms.
- Prioritize expenditure rationalization and flexibility; save cyclical gains for the 2008 budget.
- Enhance transparency of monetary policy communication (publish forecast-consistent interest-rate path; publish voting records) to anchor inflation expectations and facilitate transition to a 2 percent inflation target from 2010.
- Strengthen supervisory coordination with foreign home-country supervisors given predominant foreign control of banks.

### Key macroeconomic figures and projections (selected)
- Real GDP growth (annual): 2007: 5.9; 2008 (Staff Proj.): 4.6.
- Domestic demand growth (annual): 2007: 6.6; 2008 (Staff Proj.): 4.9.
- Unemployment (survey-based): 2007: 5.5; 2008 (Proj): 4.9.
- Current account balance (percent of GDP): 2007: -3.4; 2008 (Proj): -3.5.
- Gross international reserves (US$ billion): 2007: 34.0; 2008 (Proj): 37.0.
- Total gross external debt (percent of GDP): 2007: 37.2; 2008 (Proj): 40.9; 2009 (Proj): 37.1.
- General government deficit (percent of GDP): 2007: -2.9; 2008 (Proj): -2.8.
- General government gross debt (percent of GDP): 2007: 29.5; 2008 (Proj): 28.9.
- CPI inflation (year average, percent): 2007: 3.0; 2008 (Proj): 5.4; 2009: 3.5; 2010–2012: 2.0.
- Credit to private sector (year-on-year percent change, eop): 2007: 25.9 (data refer to October 2007).
- Exchange rate as of December 13, 2007: CZK 17.978 per U.S. dollar.

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

### Executive Summary

### Executive Summary

### Overall assessment
- The Czech economy "continues to perform well" and external vulnerabilities are "limited."
- Growth momentum has been sustained and the economy has so far weathered the recent market turmoil well.
- External debt is low and the modest current account deficit is comfortably financed by direct investment flows.
- The koruna "has appreciated sharply in recent months" but "it is estimated to be broadly in line with fundamentals."

### Growth and inflation outlook
- Growth is robust but "likely to slow in 2008."
  - Staff projects growth to decline to about 4½ percent in 2008.
  - GDP growth is likely to have been sustained "at close to 6 percent for the third year in a row" in 2007.
  - Hyundai is expected to start a major new automobile plant in late 2008, which "could contribute nearly a percentage point to GDP growth."
- Inflation is expected to "rise sharply."
  - Headline inflation "is set to double" due to shocks from indirect taxes and food and energy price increases.
  - Headline inflation reached 5 percent in the year to November 2007.
  - Core inflation had been around 1 percent but has risen steadily since late 2006.
- Downside risks to growth stem primarily from external sources.

### Monetary policy
- "Monetary policy needs to be on a sustained tightening path."
  - The appropriate pace depends on the degree of koruna appreciation and second-round effects of indirect tax and energy price increases.
  - The CNB raised its policy rate in 2007 from 2 ½ percent to 3 percent in early summer, then to 3 ¼ percent in August and to 3 ½ percent in November 2007.
  - The interest rate differential vis-à-vis the euro area was "already at 125 basis points in May 2007."
  - Real rates have turned negative, but the rapid appreciation of the koruna—"about 5 percent since October"—has contributed to tightening monetary conditions.
  - The Czech policy rate remains among the lowest in the EU.
- The Czech National Bank’s high credibility, and recent steps to enhance transparency of policy communication, should help anchor inflation expectations and facilitate transition to the lower inflation target of 2 percent from 2010.

### Fiscal policy and medium-term challenges
- "The main medium-term policy challenge centers on achieving sustainable fiscal consolidation."
  - Authorities plan to lower the deficit below the Maastricht threshold limit from 2008 onwards.
  - Building on a considerably better-than-budgeted outcome in 2007, the authorities should maintain the originally targeted adjustment for 2008.
  - The recently approved tax and welfare reform package "does not sufficiently advance fiscal consolidation."
  - "Comprehensive pension and health care reforms, implemented early, will be essential for sustainable public finances."
  - "Absent such reforms, tax cuts can be ill afforded."
  - Labor market reforms could help alleviate fiscal adjustment.
- Fiscal developments in 2007:
  - General government deficit (ESA-95 basis) is likely to be below 3 percent of GDP in 2007.
  - Fiscal stance for 2007 is estimated to be expansionary, albeit modestly.
  - Memo items: Nominal GDP growth 6.3, 7.5, 9.6, 10.2 (table heading context preserved as in source table excerpt).

### External sector and external financing
- The current account deficit widened to around 3½ percent of GDP in 2007 from about 3 percent in 2006.
- The widening deficit has been largely financed by inflows of direct investment.
- Trade and services balances improved due to strong automobile and electronic sector exports, but repatriation of dividends by foreign investors offset some gains.
- Gross international reserves reached above US$ 31 billion by end-October, covering over 3 months of imports and 1.2 times short-term maturing debt.
- External debt rose to around 41 percent of GDP at end-2006.

### Financial sector and vulnerabilities
- Near-term vulnerabilities are limited.
  - Public debt is relatively low at around 30 percent of GDP.
  - Limited exposure to foreign currency public debt.
- Household debt—primarily mortgages—has risen rapidly, but credit risks are limited by the low level of foreign currency borrowing and bank lending financed primarily through domestic deposits.
- Financial market liquidity remained adequate during the August–December 2007 turmoil; sovereign spreads rose little.
- Yields remain the lowest in Central Europe.

### Policy recommendations and priorities
- Maintain a sustained monetary tightening path to contain inflation pressures while monitoring koruna appreciation and second-round effects.
- Preserve the originally targeted fiscal adjustment for 2008 and pursue further consolidation to achieve deficits below the Maastricht threshold.
- Implement comprehensive pension and health care reforms early to ensure long-term debt sustainability; avoid unaffordable tax cuts absent these reforms.
- Pursue labor market reforms to reduce structural unemployment and improve labor participation, aiding fiscal consolidation and income convergence.
- Enhance transparency of monetary policy communication to anchor inflation expectations and facilitate transition to a 2 percent inflation target from 2010.

*Executive Summary — IMF staff report on the Czech Republic (source content: _cr0839 - Executive Summary).*

### 12.      The risks to this forecast are on the downside, stemming primarily from fragility

### _cr0839 - 12.      The risks to this forecast are on the downside, stemming primarily from fragility

### Risks to the Forecast and External Vulnerabilities
- The risks to this forecast are on the downside, stemming primarily from fragility of growth in major export markets.
- No discernible spillover through credit channels from the ongoing financial market turbulence abroad has been observed so far.
- If the turmoil were to persist leading to a more pronounced slowdown in the euro area and the United States, it could adversely affect Czech exports.
- Continued high oil prices could place a further drag on growth.
- Labor supply constraints at home add to these risks.
- Stress tests suggest that external debt will remain stable over the medium term (Figure 7 and Table 6).

### Inflation Outlook and Monetary Policy Implications
- Inflation is set to rise sharply against a backdrop of demand and wage pressures as well as rising food and energy prices and increases in indirect taxes.
- Headline inflation is forecast to rise above 5 percent in 2008, well above the upper margin of the Czech National Bank’s tolerance band around the target of 3 percent, mainly on account of the first round effects of increases in VAT and excises.
- Core inflation is also expected to rise in the face of a positive output gap and a tight labor market.
- Risk: a rapid doubling of headline inflation could feed into inflation expectations with knock-on effects on wage and price setting.
- A slower pace of koruna appreciation could remove a recent significant anti-inflationary influence, placing a greater burden on monetary policy.
- With inflation projected to be above target, monetary policy would need to remain on a sustained path of tightening.
- CNB officials noted they will weigh factors such as developments in the koruna, recent evidence of weaker European growth and the stance of fiscal policy when deciding the precise pace of tightening.
- The planned downward shift in the inflation target to 2 percent from 2010 underscores the importance of preserving credibility and enhancing transparency of policy communication.
- The decision to publish a forecast-consistent interest-rate path and make public the voting records of the Executive Board meetings, beginning in 2008, is intended to enhance transparency and policy credibility.

### Koruna and Carry Trades (Box 2)
- The use of the Czech koruna as a funding currency for carry trades was an important driver of exchange rate movements in 2007.
- Low interest rates, exchange rate volatility, and increasing liquidity in local foreign exchange markets made the koruna an attractive currency for carry trades, leading to a depreciation by more than 4 percent during the first half of 2007.
- Main instruments for these transactions included financial derivatives—primarily outright forwards and currency swaps—which showed two spikes in January and June 2007 preceding net outflows from July 2007.
- Hedge funds based in London and New York were the main participants reportedly trading the koruna for Turkish lira, Hungarian forint, and Polish zloty.
- The appetite for carry trade using koruna as a funding currency has since disappeared: subsequent monetary tightening and global financial market turmoil accelerated carry-trade unwinding.
- The Czech koruna has visibly decoupled from other low-yield currencies and is again moving with CEE-4 currencies.
- Recent appreciation could also be driven by the weakening of the US dollar and withdrawal of funds from U.S. assets to economies closely integrated with the euro area.

### Medium-Term Growth Prospects and Structural Challenges
- Medium-term growth prospects hinge on deeper structural reforms.
- Aging will increase pressures on the public finances and the labor market.
- The tax-benefit system has created low-wage and unemployment traps.
- Labor supply constraints despite high long term unemployment, skill mismatches and sizable regional disparities point to low labor market flexibility, exacerbated by strict employment protection regulations (Figure 8).
- Rankings of business competitiveness have slipped, reflecting concerns regarding growing scarcity of skilled labor, slow judicial processes, and corruption.
- Rising wage pressures could erode competitiveness.
- Staff projects potential growth to slow to around 4½ percent.

### Fiscal Consolidation: Findings and Fiscal Outlook
- Durable fiscal reform remains the primary policy challenge.
- Authorities recently unveiled a tax and welfare reform package aiming to reduce excessive deficits and stabilize the medium-term budget while lowering the tax burden.
- Authorities plan to reduce the deficit from the officially projected 3.4 percent of GDP in 2007 to 2.9 percent in 2008.
- They plan to further lower the deficit to 2.3 percent of GDP by 2010, entailing a cumulative fiscal effort of about 1½ percent of GDP over the next three years.
- Authorities acknowledge underlying expenditure measures to achieve these goals are yet to be fully spelled out and pressure from coalition partners for further tax cuts remain.
- Public debt remains low and stable (Figure 9 and Table 7) owing to favorable growth and financing from privatization revenues.
- Staff argued for saving any cyclical gains for the 2008 budget:
  - Staff estimates the 2007 outturn was likely to be better than the projected 3.4 percent of GDP, absent one-off or large end-of-year spending—by over ½ percent of GDP in staff’s estimates.
  - Based on a more favorable 2007 deficit estimate, staff argued that the fiscal effort envisaged in the already approved budget would imply a commensurately lower deficit target of around 2¼ percent of GDP in 2008.
  - Attaining this target would require that additional discretionary spending—from accumulated reserves of prior years—does not offset this adjustment; automatic stabilizers should be allowed to play around this path.
- Authorities’ Convergence Program plans an annual consolidation of around ½ percent of GDP in structural terms and a medium term deficit objective of 1 percent of GDP by 2012 to meet the SGP requirements and accommodate age-related spending pressures.
- Staff stressed that the Czech Republic remains one of the few countries that has yet to start reforming its pension system despite having one of the largest fiscal gaps that need to be filled.

### The Tax and Welfare Reform Package: Key Measures (Box 1 — Impact on Fiscal Balance, In percent of GDP)
- Introduction of a flat rate of personal income tax at 15 percent (while broadening the tax base to include social security contributions and increasing tax credits): 2008: -0.6; 2009: -0.7; 2010: -0.8
- Phased reduction of corporate income tax from the current 24 percent to 19 percent by 2010: 2008: -0.2; 2009: -0.6; 2010: -0.8
- Increase in the lower VAT rate from 5 percent to 9 percent and introduction of environmental taxes: 2008: 1.0; 2009: 1.0; 2010: 0.9
- Introduction of a ceiling on social security contributions: 2008: -0.2; 2009: -0.2; 2010: -0.2
- Reduction and streamlining of social benefits, and health care reform1/: 2008: 0.5; 2009: 0.7; 2010: 0.6
- Total: 2008: 0.6; 2009: 0.2; 2010: -0.2
- Source for Box 1: Czech Ministry of Finance.
- Staff assessment: shift away from direct towards indirect taxes will likely contribute to enhanced savings and investment, but the package does not fully deliver its objectives efficiently. Personal income tax cuts are largely unnecessary and not well-targeted; marginal tax rates and disincentives to work at low wages are not effectively addressed. The cap on social security contributions would reduce revenue efficiency. The package does not address fiscal consolidation in the medium- to long-term as permanent tax cuts are offset by spending measures of a temporary nature or yet to be defined.

### Staff Recommendations and Policy Priorities
- Fiscal strategy needs to:
  - (i) strike a balance between spending and revenue measures;
  - (ii) achieve systemic reforms in pensions and healthcare; and
  - (iii) promote complementary reforms in the labor market.
- Specific policy guidance:
  - Prioritize spending measures to achieve consolidation and enhance efficiency and budgetary flexibility; without durable offsetting expenditure measures, the Czech Republic cannot afford the planned tax cuts and may have to consider tax increases.
  - On pension reform: political consensus reached on raising the retirement age to 65 years, but this is unlikely to restore pension system viability; creation of pension reserves and increased reliance on private pension savings (including a partial voluntary opt-out) are being considered.
  - In health care: introduction of co-payments is an important step; further efforts to contain costs and reduce distortions are being debated.
  - Labor market reform to lower structural unemployment and tax-benefit reform to reduce disincentives to work can ease fiscal adjustment; however, near-term prospects for changes to employment protection regulations are not optimistic.

*Italic: Source — IMF staff consultation text (content unit provided).*

### 23.      The staff and the authorities agreed that the koruna had remained broadly

### The staff and the authorities agreed that the koruna had remained broadly

### Exchange rate, external position, and trade performance
- The real effective exchange rate, measured by consumer prices as well as by unit labor costs, has been broadly stable over the past year.
- Staff estimates the underlying current account deficit (excluding temporary factors such as cyclical fluctuations, one-off shocks, and adjustment lags) in 2007 at around 3 percent of GDP.
- Staff estimates of the equilibrium current account deficit are around 2½ percent of GDP.
- Since the consultation discussions, the koruna has appreciated by about 5 percent against the euro by mid-December.
- Net foreign liabilities, mostly FDI, account for 30 percent of GDP and are projected to remain broadly stable.
- Trade performance:
  - Double-digit growth in exports volume.
  - Rising export market shares in both the EU and world markets.
  - Strong profitability of large exporters.
- Exchange regime classification:
  - Intervention limited since 2003 to conversion of a large one-off privatization receipt in 2005, portfolio gains, and proceeds of EU transfers.
  - CNB officials stressed the koruna is floating independently since intervention was not intended to influence the exchange rate.
  - Staff classifies the exchange system as a managed float with no predetermined path.

### Euro adoption and macro policy alignment
- The authorities have not announced a specific target date for euro adoption, pending more progress on fiscal consolidation and economic alignment with the euro area.
- The CNB’s decision to reduce the inflation target to 2 percent from 2010 will align it with the ECB’s inflation target.
- Staff view: euro adoption remains an important opportunity for reaping further gains from enhanced trade and investment opportunities and would serve as an important anchor for policy credibility, especially under more adverse economic conditions.

### Credit growth, housing, and financial stability
- Credit growth:
  - Credit to the private sector increased by 25 percent in the year to September 2007.
  - Household credit growth of around 30 percent, driven by high demand for mortgage loans, low interest environment, a VAT hike in the construction sector in 2008, and increasing household repayment capacity.
  - Enterprise credit has also accelerated, including demand by property developers.
- Credit risk:
  - Despite rapid house price growth and rising interest rates, household credit risk currently low because most loans are denominated in domestic currency and on fixed interest rate terms.
  - Credit-to-GDP ratio remains relatively low by regional standards.
- Housing prices:
  - Recently, housing prices have started to rise rapidly (series shown for Total, Residential Buildings, Non-residential Buildings; index base 2002m12=100, seasonally adjusted for 2002-06).
- Financial stability indicators (2003–07 series):
  - Number of banks: 35, 35, 36, 37, 38 (2003–2007q3).
  - Of which foreign-controlled: 26, 27, 26, 27, 28, 30 (table shows a sequence; source text lists increases—preserve as presented: 2626272830).
  - Regulatory capital to risk-weighted assets (in percent): 14.5, 12.6, 11.9, 11.4, 11.9.
  - Nonperforming loans (in percent of total loans): 4.9, 4.1, 4.3, 3.6, 3.0.
  - Liquid assets (in percent of total assets): 36.4, 33.6, 32.8, 30.4, 28.6.
  - After-tax return on average assets (in percent): 1.2, 1.3, 1.4, 1.2, 1.3.
- Other stability features:
  - Czech markets largely unscathed by recent turmoil, reflecting limited reliance on cross-border bank borrowing and virtual absence of securitization.
  - Capital adequacy ratios remained comfortably above minimum regulatory thresholds despite a slight decline in 2005-06.
  - Non-performing loan ratios have been broadly stable; loan-to-value ratios indicate banks are well collateralized.
  - Sensitivity and stress tests (limited to first-round impacts) indicate banks would be able to withstand risk of sizeable defaults without jeopardizing capital positions.
- Supervisory reforms:
  - Unified supervision introduced in 2006; from 2008 CNB will change supervisory organization from a sectoral model to a functional model.
  - Continued coordination with foreign (home country) supervisors important given predominant foreign control of banks.
  - Foreign bank branches, all operating under the single European license, accounted for 9.3 percent of total bank assets at end-2006.
  - Geographical structure of bank shareholders (as presented): Austria 40%, France 16%, Czech Republic 18%, Belgium 7%, USA 8%, Germany 3%, Other foreign 8%.

### Staff appraisal: growth, inflation, and monetary policy
- Recent macro performance:
  - Czech economy maintained momentum of rapid growth and further convergence with EU-15.
  - Economy at a fairly advanced stage of a strong cyclical upswing; a slowdown in growth is likely in 2008 but growth expected to remain solid on continued strong domestic demand and low unemployment.
- Inflation and monetary policy:
  - With inflation set to rise sharply well above the target of 3 percent, monetary policy would need to be on a sustained tightening path.
  - Projected increase in inflation to 5 percent in 2008 driven by demand and wage pressures as well as rising food and energy prices and increases in indirect taxes.
  - Risk that rapid rise in inflation gets embedded into expectations will require further timely increases in the policy rate.
  - Importance of preserving CNB’s high policy credibility, inter alia, by enhancing clarity of policy communication; recent steps to improve transparency are welcome.

### Staff appraisal: fiscal policy, consolidation, and structural reform recommendations
- General fiscal assessment:
  - The fiscal reform package passed by Parliament promotes desirable modifications: shift from taxation of income to taxation of consumption, introduction of excises on energy consumption, and planned cut in the corporate income tax rate.
  - However, the package is insufficient to advance critical fiscal consolidation in the medium term; proposed tax cuts are permanent while some offsetting spending measures are temporary and as yet undefined.
- Short-run fiscal guidance:
  - Against the recent procyclical fiscal stance, cyclical gains for the 2008 budget should be saved and the planned fiscal adjustment implemented in full.
  - A more ambitious deficit target than that implied by the budget should be feasible given the favorable outcome in 2007.
  - Tight fiscal stance is essential alongside tightening monetary policy to anchor inflation expectations and ensure a balanced policy mix.
- Medium-term consolidation targets:
  - An annual structural consolidation of at least ½ percent of GDP would help stabilize debt over the medium term and provide a safety margin in respecting the Stability and Growth Pact limit of 3 percent of GDP under more adverse cyclical conditions, and create fiscal space for accommodating age-related spending.
  - Recent changes in budgetary rules limiting rollover of unspent allocations should alleviate risks in attaining these budget targets.
- Strategy and instruments:
  - Durable consolidation calls for a strategy that sets clear fiscal priorities with adequate balance between spending and revenue measures; precedence should be given to expenditure rationalization.
  - Possible revenue and efficiency measures include raising the low VAT rate further, reducing corporate loopholes, pruning personal tax credits, and increasing environmental taxes.
- Pension and healthcare reforms:
  - Pension and healthcare reforms should be key pillars of the medium-term fiscal strategy and implemented sooner rather than later given long lags to impact.
  - Complementary reforms to raise the effective retirement age and reliance on private pensions will be needed alongside the increase in the retirement age to 65 years.
  - In health care, introduction of co-payments should help contain excess demand pressures and enhance efficiency of health care spending.
  - Early consensus on more comprehensive reforms would be vital.
- Labor market reform:
  - Labor market reform can help alleviate fiscal adjustment.
  - The recent fiscal package fails to fully offset adverse impact of pre-election increase in social benefits on incentives to work; substantially enhanced tax credits are not targeted and effects on labor supply uncertain.
  - Higher labor market participation and lower structural unemployment could be achieved through better targeted active labor market policies, less rigid regulations regarding hiring and dismissals, and an improved design of the tax-benefit system.
  - More flexible labor markets would also help position the Czech economy for smoother euro adoption.

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

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

### _cr0839 - 40.      It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

### Growth and Domestic Demand
- Real GDP growth (annual): 2002: 1.9; 2003: 3.6; 2004: 4.5; 2005: 6.4; 2006: 6.4; 2007: 5.9; 2008 (Staff Proj.): 4.6.
- Domestic demand growth (annual): 2002: 4.0; 2003: 4.1; 2004: 3.2; 2005: 1.2; 2006: 5.7; 2007: 6.6; 2008 (Staff Proj.): 4.9.
- Contributions to growth: strong domestic demand driven by rapid consumption growth and buoyant investment in machinery and equipment; economic growth continued at a rapid pace but is expected to slow down.

### Labor Market Indicators and Pressures
- Employment annual growth and unemployment rate trends shown for 2000-07 with unemployment declining in both cyclical and structural terms.
- Unemployment measures (survey-based): 2002: 7.3; 2003: 7.8; 2004: 8.3; 2005: 7.9; 2006: 7.1; 2007: 5.5; 2008 (Proj): 4.9.
- Registered unemployment: 2002: 9.2; 2003: 9.9; 2004: 9.8; 2005: 8.9; 2006: 8.1; 2007: 6.4; 2008 (Proj): 5.8.
- Labor market signs: capacity constraints emerging in the labor market and industry; despite some inward migration, wage pressures are on the rise.
- Real wages and productivity: real wages, unit labor cost, and productivity all tracked (annual percent change) with upward wage pressures noted.

### External Sector Developments
- Current account balance (in percent of GDP): 2002: -5.5; 2003: -6.2; 2004: -5.2; 2005: -1.6; 2006: -3.1; 2007: -3.4; 2008 (Proj): -3.5.
- Trade balance (in percent of GDP): 2002: -3.0; 2003: -2.8; 2004: -0.5; 2005: 2.0; 2006: 2.1; 2007: 2.4; 2008 (Proj): 2.8.
- Merchandise export and import growth (year-on-year percent change): export growth remained strong, increasing the trade surplus.
- Net foreign direct investment continued to comfortably finance the current account deficit.
- Portfolio flows: portfolio outflows have been volatile.
- Net foreign direct investment (in percent of GDP): 2002: 11.0; 2003: 2.0; 2004: 3.6; 2005: 9.3; 2006: 3.3; 2007: 4.1; 2008 (Proj): 4.0.

### Monetary Policy and Financial Conditions
- Policy interest rates: CNB policy rates have been rising steadily since mid-2007 as the monetary policy stance tightened.
- Monetary Conditions Index (Jan 2005=100) and real interest rates series presented; a pickup in inflation has led to lower real interest rates recently.
- Real short-term interest rate indicators: ex-ante and ex-post measures based on 1-year PRIBOR and CPI-based deflators.
- Credit to the private sector (year-on-year percent change): business, households, total — rapid credit growth persists. Private sector credit (percent change, eop): 2002: 4.5; 2003: 11.8; 2004: 15.3; 2005: 20.8; 2006: 21.6; 2007: 25.9 (data refer to October for 2007).
- Financial indicators during recent financial turmoil: koruna depreciation reversed but volatility remained low; international bond spreads remained very small; limited effect on credit default swaps.
- Long-term interest rates and policy rates: policy rate converged with Euro area rate; policy rate lowest in the region; long-term rates reflected recent monetary tightening.
- Equity markets: stock market fell sharply during the recent financial turmoil.

### Fiscal Position and Public Debt
- General government revenue (percent of GDP): 2002: 39.5; 2003: 40.7; 2004: 42.2; 2005: 41.2; 2006: 40.8; 2007: 40.4; 2008 (Proj): 40.1.
- General government expenditure (percent of GDP): 2002: 46.3; 2003: 47.3; 2004: 45.1; 2005: 44.8; 2006: 43.8; 2007: 43.2; 2008 (Proj): 42.3.
- Net lending (percent of GDP): 2002: -6.8; 2003: -6.6; 2004: -2.9; 2005: -3.5; 2006: -2.9; 2007: -2.8; 2008 (Proj): -2.2.
- General government debt (percent of GDP): 2002: 28.5; 2003: 30.1; 2004: 30.4; 2005: 30.2; 2006: 30.2; 2007: 29.5; 2008 (Proj): 28.9.
- Primary balance and cyclically adjusted balances reported: Primary Balance-2002: -5.5; 2003: -5.5; 2004: -1.8; 2005: -2.4; 2006: -1.8; 2007: -1.6; 2008 (Proj): -0.9.
- Debt-stabilizing primary balance (percent of GDP) presented in public debt sustainability framework: long-run value shown as -0.6.

### External Debt and Financing Needs
- Total gross external debt (in percent of GDP): 2002: 38.1; 2003: 36.2; 2004: 35.8; 2005: 38.2; 2006: 41.3; 2007: 37.2; 2008 (Proj): 40.9; 2009 (Proj): 37.1.
- Gross external financing requirement (in US$ billion): 2002: 16.9; 2003: 19.8; 2004: 27.1; 2005: 25.3; 2006: 26.6; 2007: 34.6; 2008 (Proj): 39.6; corresponding percent of GDP: 2002: 22.5; 2003: 21.6; 2004: 24.7; 2005: 20.3; 2006: 18.7; 2007: 19.7; 2008 (Proj): 19.3.
- External debt-to-exports ratio (in percent): 2002: 59.2; 2003: 61.8; 2004: 58.8; 2005: 51.8; 2006: 53.8; 2007: 45.2; 2008 (Proj): 39.8.
- Country debt sustainability bound tests and scenario shocks illustrated: growth shock, interest rate shock, current account shock, real depreciation shock, combined shocks, and gross financing need under baseline and scenarios (figures show paths for external debt in percent of GDP).

### Balance of Payments and Reserves
- Current account balance (US$ millions): 2002: -4,264; 2003: -5,785; 2004: -5,738; 2005: -2,024; 2006: -4,440; 2007: -6,002; 2008 (Est./Proj): -7,189.
- Trade balance (US$ millions): 2002: -2,239; 2003: -2,519; 2004: -530; 2005: 252; 2006: 229; 2007: 794; 2008 (Est./Proj): 2,515.
- Exports (US$ millions): 2002: 38,469; 2003: 48,700; 2004: 67,239; 2005: 77,973; 2006: 95,739; 2007: 115,128; 2008 (Est./Proj): 128,157.
- Imports (US$ millions): 2002: 40,709; 2003: 51,222; 2004: 67,768; 2005: 75,454; 2006: 99,213; 2007: 113,878; 2008 (Est./Proj): 115,193.
- Gross international reserves (US$ billion): 2002: 23.7; 2003: 27.0; 2004: 28.4; 2005: 29.6; 2006: 31.5; 2007: 34.0; 2008 (Proj): 37.0.
- Reserve cover (in months of imports of goods and services): 2002: 6.1; 2003: 5.5; 2004: 4.5; 2005: 4.1; 2006: 3.6; 2007: 2.9; 2008 (Proj): 2.6.

### Medium-term Macroeconomic Scenario and Projections (2002–2012)
- Key baseline assumptions (selected):
  - Real GDP growth (in percent): 2008: 4.6; 2009: 5.2; 2010: 4.3; 2011: 4.0; 2012: 3.9.
  - CPI inflation (year average, in percent): 2007: 3.0; 2008 (Proj): 5.4; 2009: 3.5; 2010: 2.0; 2011: 2.0; 2012: 2.0.
  - Exports growth (US$ value, percent): 2007: 17.1; 2008 (Proj): 20.5; 2009: 33.4 (Table 2 shows Est./Proj series).
  - Imports growth (US$ value, percent): 2007: 13.0; 2008 (Proj): 11.5; projections through 2012 provided.
- Scenario notes: Hyundai expected to start a major new automobile plant in late 2008 which could contribute nearly a percentage point to GDP growth; volatility in staff’s medium-term projections reflects this and trade-balance effects.

### Public Debt Sustainability Framework (2002–2012) — Selected Items
- Public sector (general government) debt (percent of GDP): baseline path from 2002: 28.5 to 2007: 29.5; projections 2008: 28.9; 2009: 28.4; 2010: 28.5; 2011: 28.7; 2012: 29.0.
- Change in public sector debt (percent of GDP): 2002: 3.4; 2003: 1.6; 2004: 0.3; 2005: -0.1; 2006: -0.1; 2007: -0.6; 2008 (Proj): -0.6.
- Identified debt-creating flows, primary deficit, automatic debt dynamics, contributions from interest rate/growth differential, privatization receipts, and residuals are presented with numeric values for 2002–2012.
- Gross financing need (percent of GDP): 2002: 21.5; 2003: 21.1; 2004: 15.6; 2005: 11.4; 2006: 10.9; 2007: 10.2; 2008 (Proj): 10.0.

### Selected Vulnerability Indicators (Latest observations and trends)
- Real GDP growth (in percent): 2007: 5.9 (Proj).
- CPI inflation (period average, in percent): 2007: 3.0 (Proj).
- Short-term (ST) interest rate (in percent, three-month PRIBOR, average): Oct-07: 3.6.
- Exchange rate NC/US$ (end of period): Oct-07: 18.7.
- Gross international reserves (US$ billion): Sep-07: 34.0 (Proj).
- Total gross external debt (in percent of GDP): 2007: 37.2; 2008 (Proj): 40.9; 2009 (Proj): 37.1.
- Public sector overall balance (percent of GDP): 2007: -2.9; 2008 (Proj): -2.8.
- Public sector gross debt (percent of GDP): 2007: 29.5; 2008 (Proj): 28.9.
- Financial sector indicators (Sep-07): Capital adequacy ratio: 11.9; NPLs in percent of total loans: 3.0; Return on average assets (Sep-07): 1.3; Return on equity (Sep-07): 23.1.
- Credit to private sector (percent change): Oct-07: 25.9.

*INTERNATIONAL MONETARY FUND — Staff Report for the 2007 Article IV Consultation—Informational Annexes, Prepared by the European Department, January 7, 2008.*

### Appendix I. Czech Republic: Fund Relations

### Appendix I. Czech Republic: Fund Relations (As of October 31, 2007)

### I. Membership and Quota
- Joined: 1/01/1993; Article VIII
- Quota: 819.30 SDR Million (100.0 percent)
- Fund holdings of currency: 765.09 SDR Million (93.38 percent)
- Reserve position in Fund: 54.21 SDR Million (6.62 percent)

### II. SDR Department
- Holdings: 12.41 SDR Million (N/A percent)

### III. Outstanding Purchases and Loans
- None

### IV. Financial Arrangements
- Stand-by
  - Approval Date: 3/17/1993
  - Expiration Date: 3/16/1994
  - Approved (SDR Million): 177.00
  - Drawn (SDR Million): 70.00

### V. Projected Obligations to Fund
- None

### VI. Exchange Rate Arrangement
- Currency: Czech koruna (created on February 8, 1993)
- Historical arrangements:
  - May 3, 1993 to May 27, 1997: pegged to basket of two currencies: deutsche mark (65 percent) and U.S. dollar (35 percent)
  - February 28, 1996: exchange rate band widened from ±0.5 percent to ±7.5 percent around the central rate
  - May 27, 1997: managed floating introduced
- Current classification: managed floating with no predetermined path for the exchange rate
- CNB interventions: Since 2002, the CNB has not engaged in direct interventions in the foreign exchange market
- Influences on international reserves: off-market purchases of large privatization receipts and EU transfers and the sales of the accumulated interest
- Exchange rate as of December 13, 2007: CZK 17.978 per U.S. dollar
- Article VIII obligations: accepted; exchange system free of restrictions on payments and transfers for current international transactions
- Exchange restrictions maintained for security reasons based on UN Security Council Resolutions and Council of the European Union Regulations; notified to the Fund under Executive Board Decision No. 144-(52/51)

### VII. Last Article IV Consultation
- Concluded: February 21, 2007
- Staff report and PIN published: February 28, 2007

### VIII. Technical Assistance (Selected 1991–2005 activities)
- FAD (selected entries)
  - Dec. 1991–Sept. 1993; March 1993; September 1993; November 1993; January 1994; July 1994; May 1995; June 1995; June–July 1999 — Regular and follow-up visits on VAT administration and public financial management; Medium-term fiscal framework
- MFD (selected entries)
  - February 1992; June 1992; July 1992; December 1992 and February 1993; December 1992 and February 1993; November 1993; April 1994; January 1995; May 1995; May 1995; May 1996; April 1997; February–June 1999; June 1999 — Monetary management and research, foreign exchange operations, banking supervision, long-term resident expert in banking supervision, bond issuance and monetary management, monetary operations, banking system reform, inflation targeting, integrated financial sector supervision (with WB)
- RES
  - September 1999; June–August 2000; February–March 2005 — Inflation targeting (financed by MFD)
- STA (selected entries)
  - May 1993; February 1994; April 1994; November 1994; January–February 1999; May 2002; February 2003; November 2006 — Money and banking statistics, balance of payments, government finance, monetary and financial statistics, Implementing GFSM 2001, GFSM 2001 Pilot Project

### IX. Implementation of HIPC Initiative
- Not Applicable

### X. Safeguards Assessments
- Not Applicable

### XI. Statistical Issues — Overview and Data Practices
- SDDS subscription: April 1998; metadata and annual observance report for 2006 posted on Fund’s DSBB
- Reporting timeliness and frequency (high-level):
  - Exchange rates and interest rates: reported daily with no lag
  - Gross and net international reserves: monthly with a one-week lag; 10-day basis (with CNB balance sheet) with a one-week lag
  - Consumer prices, reserve money, broad money, borrowing and lending interest rates, central government fiscal accounts, foreign trade: 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: quarterly with a lag of two to three months
  - Since 2003: main components of balance of payments also available monthly
  - Annual government finance statistics: cover all operations of general government, available on a timely basis
  - Monthly fiscal data in IFS: cover state budget accounts and available with a two- to three-month lag
- Identified data weaknesses and measures:
  - National accounts:
    - Value added in small-scale private sector likely underestimated due to underdeveloped data collection and unrecorded activity (tax evasion)
    - Large discrepancies between GDP estimates by production and expenditure methods are subsumed under change in stocks
    - Quarterly national accounts derived from quarterly enterprise reports and surveys subject to bias from nonresponse and lumping of expenditure categories; large quarter-to-quarter swings hamper business cycle analysis
  - External trade statistics:
    - Revisions have aligned export data processing with EU practice
    - Continued weakness: unavailability of fixed base price indices for exports and imports; indices presented on basis of same month of previous year
  - Monetary statistics:
    - Monetary survey data generally adequate
    - Large variations in interbank clearing account float, especially at year-end, require caution; CNB has made major efforts to identify causes and adjust data
    - 2002: CNB implemented ECB framework for collecting, compiling, and reporting monetary data to meet EU conventions; IFS monetary accounts based on ECB framework; harmonized with CNB bulletins though presentation differs somewhat
  - Fiscal statistics:
    - Annual fiscal data on ESA-95 basis prepared by Czech Statistical Office
    - Quarterly non-financial accounts compiled; quarterly financial accounts being prepared
    - Ministry of Finance uses ESA-95 methodology for Convergence Program targets; ESA-95 differs from national fiscal targeting methodology in institutional coverage and inclusion of financial transactions and accrual items
    - Ministry of Finance participated in IMF pilot project to transition to GFSM 2001 methodologies

### XII. Table of Common Indicators Required for Surveillance (As of December 17, 2007) — Selected entries with dates and frequencies
- Exchange Rates
  - Date of Latest Observation: 12/15/07
  - Date Received: 12/15/07
  - Frequency of Data: D
  - Frequency of Reporting: D
  - Frequency of Publication: D
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities
  - Date of Latest Observation: Nov. 2007
  - Date Received: 12/10/07
  - Frequency of Data: D
  - Frequency of Reporting: M
  - Frequency of Publication: M
- Reserve/Base Money
  - Date of Latest Observation: 9/01/07
  - Date Received: 9/11/07
  - Frequency of Data: 10 days
  - Frequency of Reporting: 10 days
  - Frequency of Publication: 10 days
- Broad Money
  - Date of Latest Observation: Sept. 2007
  - Date Received: 12/11/07
  - Frequency of Data: M
  - Frequency of Reporting: M
  - Frequency of Publication: M
- Central Bank Balance Sheet
  - Date of Latest Observation: 9/01/07
  - Date Received: 9/11/07
  - Frequency of Data: 10 days
  - Frequency of Reporting: 10 days
  - Frequency of Publication: 10 days
- Consolidated Balance Sheet of the Banking System
  - Date of Latest Observation: Sept. 2007
  - Date Received: 12/11/07
  - Frequency of Data: M
  - Frequency of Reporting: M
  - Frequency of Publication: M
- Interest Rates
  - Date of Latest Observation: Oct. 2007
  - Date Received: 11/16/07
  - Frequency of Data: D
  - Frequency of Reporting: D
  - Frequency of Publication: D
- Consumer Price Index
  - Date of Latest Observation: Nov. 2007
  - Date Received: 12/11/07
  - 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: Jul. 2007
  - Date Received: Sep 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: Jul. 2007
  - Date Received: Sep 2007
  - Frequency of Data: A
  - Frequency of Reporting: A
  - Frequency of Publication: A
- External Current Account Balance
  - Date of Latest Observation: 2007 Q2
  - Date Received: Aug 2007
  - Frequency of Data: Q
  - Frequency of Reporting: Q
  - Frequency of Publication: Q
- Exports and Imports of Goods and Services
  - Date of Latest Observation: Sept. 2007
  - Date Received: Dec 2007
  - Frequency of Data: M
  - Frequency of Reporting: M
  - Frequency of Publication: M
- GDP/GNP
  - Date of Latest Observation: 2007 Q3
  - Date Received: Dec 2007
  - Frequency of Data: Q
  - Frequency of Reporting: Q
  - Frequency of Publication: Q
- Gross External Debt
  - Date of Latest Observation: 2007 Q2
  - Date Received: Sep 2007
  - Frequency of Data: Q
  - Frequency of Reporting: Q
  - Frequency of Publication: Q

(Note: footnotes in original table clarify coverage and definitions, including inclusion of reserve assets pledged or net derivative positions, and frequency codes: D, W, M, Q, A, I, NA.)

### XIII. Statement by Willy Kiekens and Stanislav Polak (January 23, 2008) — Selected macroeconomic findings and outlook
- Acknowledgement: Authorities thanked IMF staff for comprehensive report; highlighted comprehensive tax and spending reforms and new CNB monetary policy communication strategy
- Dialogue: Constructive and candid; joint conference on fiscal reforms helped build consensus
- Recent macroeconomic developments:
  - Output growth: third quarter of 2007 saw output growth of 6 percent; this was the 10th consecutive quarter with real GDP growth of at least 6 percent
  - GDP growth estimate for 2007: 6.2 percent (staff projection was 4.8 percent; CNB projection last year was 5.3 percent)
  - Annual inflation: reached 5.4 percent in December 2007 (a peak since August 2001 and more than 2 percentage points above projections made by the Fund and CNB one year ago)
- Inflation drivers:
  - Higher prices for food, alcoholic and non-alcoholic beverages, tobacco, transportation, restaurants and hotels
  - Worldwide food and energy price rises characterized as largely an exogenous cost-driven shock
  - Czech food price hike higher than neighboring countries; possible factor: prices adjusted upwards in anticipation of VAT increases to be implemented on January 1, 2008
  - Alternative explanations noted: higher demand pressures or weakening in competition
- Monetary policy implications:
  - CNB expects further tightening of monetary policy
  - Magnitude of interest rate increases will depend on size of nominal exchange rate appreciation that tightens monetary conditions
  - Recent appreciation of the Czech Koruna overshoots the equilibrium exchange rate path estimated by the CNB
- Fiscal outcome and outlook:
  - 2007 general government deficit estimated at CZK 66.4 billion, or 1.9 percent of GDP
  - Deficit was CZK 30 billion less than the deficit in the previous year and CZK 25 billion less than budgeted for 2007
  - Unused budget appropriations of CZK 79 billion were transferred to reserve funds

*Appendix I. Czech Republic: Fund Relations (As of October 31, 2007) — IMF staff document excerpts*

### 2.9 percent of GDP. However, in light of the 1.9 percent fiscal deficit in the previous year,

### 2.9 percent of GDP. However, in light of the 1.9 percent fiscal deficit in the previous year,

### Challenges of fiscal policy
- New government (took office in January 2007) committed to bringing public finance to the original trajectory of a declining deficit and to closing the Excessive Deficit Procedure of the EU in a credible and sustained manner.
- September 2007 Act on Stabilization of Public Finances curbs mandatory expenditures by amending 49 laws and regulations.
- Authorities recognize the need for further expenditure cuts to prepare public finances for the cost of aging; pension and health care systems and other mandatory expenditures will be further reformed before the next election in mid-2010.
- Political constraints: government supported by just 100 out of the 200 members of Parliament; better-than-expected 2007 fiscal outcome risks complacency in Parliament about further fiscal consolidation.
- Despite cyclical improvement in 2007 budget outcome, long-term fiscal sustainability remains a challenging policy issue.

### Pension system reform (three-pronged strategy)
- Phase 1: Stabilize the current pay-as-you-go system by parametric adjustments such as a gradual increase in the retirement age to 65.
- Phase 2: Improve protection of participants in second voluntary pension schemes, making them more attractive for workers and employers.
- Phase 3: Establish a voluntary savings pillar to which people could save and direct either full or part of their contributions under the state-run pay-as-you-go first pillar system.
- Political debate reopened in June 2007 and is still ongoing.

### Health care reform
- Multi-stage reform: first phase aims at reducing cost for public finances by introducing charges for doctors' visits, prescription drugs, hospitalization, and by curtailing the cost of medicines.
- Budget transfers to the health care system are temporarily frozen.
- A panel of independent experts, set up in June 2007, is assessing the current state and viability of the health care system; timing of political implementation of recommendations remains uncertain.
- Introduction of co-payments in health care welcomed as a step to contain excess demand pressures.

### Institutional and administrative reforms to support fiscal objectives
- Improving transparency of public finances; closing or integrating off-budget institutions.
- Gradual integration of tax and custom administrations and of the collection of social security and health insurance contributions to reduce administrative costs.

### Refinements of monetary policy communications (Czech National Bank - CNB)
- CNB current inflation target of 3 percent announced in March 2004, effective January 2006; new target of 2 percent with a tolerance band of ± 1 percent announced in March 2007, effective January 2010.
- Rationale: transforming economy features and convergence; new consumer basket (used since January 2007) increases weight of tradable unregulated commodities, contributing to lower measured inflation over the medium term.
- Since launch of inflation targeting, CNB increased transparency of Bank Board decision-making.
- Beginning 2008, CNB will publish, in numerical form, the forecast-consistent path of its policy interest rates—enhances transparency but is not a commitment; uncertainty illustrated in a fan chart.
- CNB decided to release voting results of individual Board members on interest rate decisions to increase accountability and clarify Board views.

### Prospects of euro adoption
- As an EU member without derogation, the Czech Republic is committed to adopting the euro once the Maastricht criteria are met; strategy anticipated joining the euro area in 2009 or 2010.
- Government assessment: only some preconditions for benefiting from euro adoption have been met.
- Main obstacle: medium-term prospects for public finances.
- Additional risks: limited flexibility of the labor market and an unsatisfactory entrepreneurial business environment.
- Government committed to maximum reform efforts by the end of its term; will announce targeted adoption date and enter ERM II only after establishing conditions for benefiting from euro adoption.

### PIN: Background, outlook, and Executive Board assessment (selected highlights)
- On January 23, 2008, the Executive Board of the IMF concluded the Article IV consultation with the Czech Republic.
- 2007: economic performance remained strong, supported by robust growth of domestic demand; current account deficit widened but was largely financed by inflows of direct investment.
- Inflation pressures mounted owing to higher domestic demand, tightening labor markets, and food and regulated price increases; monetary policy tightened in the second half of the year.
- Growth projected to remain favorable but to slow as consumption boom decelerates and euro area growth weakens; domestic demand to remain primary driver as fixed investment rises.
- Risks to growth mainly on the downside: fragility in major export markets and continued euro appreciation.
- Inflation expected to almost double to above 5 percent owing to food, energy and indirect tax increases, as well as demand and wage pressures.
- Fiscal: strong 2007 outturn; starting 2008 government implementing fiscal reform (flat tax on personal income, lower corporate income taxes, offset with VAT and excise increases, tightening of wage bill and social benefits); general government deficit budgeted at 2.9 percent of GDP for 2008.
- Medium-term fiscal targets: structural deficit planned to be 2.3 percent of GDP in 2010 and 1 percent of GDP by 2012.
- Executive Directors recommended saving cyclical revenue gains and fully implementing the underlying fiscal adjustment planned in the 2008 budget to achieve an appreciably better-than-budgeted deficit.
- Directors welcomed tax-regime modifications (shift from direct to indirect taxation) but noted further measures needed for fiscal consolidation, stressing durable expenditure measures and balanced spending/revenue choices.
- Labor market: directors called for targeted active labor market policies, easing hiring/dismissal regulations, and improving tax-benefit design to enhance incentives to work and lower structural unemployment.
- Financial sector: system generally sound; authorities encouraged to ensure household credit risks do not build up amid rising interest rates and house prices; enhanced coordination with foreign supervisors and integration of supervisory functions recommended.

### Key statistics (as presented)
- General government deficit budgeted at 2.9 percent of GDP in 2008.
- Authorities plan to lower the structural deficit to 2.3 percent of GDP in 2010 and to 1 percent of GDP by 2012.
- Retirement age increase to 65.
- New CNB inflation target of 2 percent with a tolerance band of ± 1 percent, effective January 2010.
- Inflation expected to almost double to above 5 percent (2008 outlook).
- IMF Executive Board concluded Article IV consultation on January 23, 2008.
- Public Information Notice (PIN) No. 08/08; FOR IMMEDIATE RELEASE January 29, 2007.

*Public Information Notice (PIN) No. 08/08*

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