## _cr09122

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---

### Staff appraisal and summary — key findings
- Growth and near-term outlook
  - Growth projected at 1½ percent in 2009, down from average growth of 6 percent during 2005-2007.
  - Downside risks: tighter credit conditions and a deeper recession in the eurozone.
- Inflation and monetary policy
  - Inflation likely to fall below CNB target of 3 percent; projected to reach 2½ percent in 2009.
  - Recent policy rate cuts appropriate; anchoring expectations to new target of 2 percent from January 2010 is important.
- External position and exchange rate
  - Export competitiveness adequate; external position remained strong.
  - Modest current account deficit expected to be financed by direct investment inflows.
  - Staff view: the koruna broadly in line with fundamentals and consistent with external stability.
- Financial sector vulnerabilities
  - Interbank liquidity tightened; government bond market trading froze temporarily in October 2008.
  - Large foreign-bank presence with exposures to emerging Europe raises uncertainty about lending cutbacks.
  - Credit risk, especially corporate, rose significantly.
- Policy stance and fiscal space
  - Fiscal position strengthened; authorities committed to nominal expenditure ceilings.
  - Allowing automatic stabilizers to operate fully in 2009 implies a deficit of about 2½ percent of GDP (versus budgeted 1.6 percent of GDP).
  - Room exists for temporary, well-targeted discretionary fiscal stimulus under a more adverse scenario.

### Introduction — context and mission
- Mission details
  - Report based on discussions in Prague during November 13-24, 2008.
  - Mission team: Mr. Subhash Thakur (head), Ms. Sònia Muñoz (EUR), Ms. Li Lian Ong (MCM), Ms. Anita Tuladhar (FAD); Messrs. Willy Kiekens (Executive Director) and Stanislav Polak (Senior Advisor) also joined.
  - Meetings with Minister of Finance Miroslav Kalousek, CNB Governor Zdeněk Tůma, senior officials, Parliament, financial and business sectors, academia, and media.
- Political and institutional backdrop
  - Three-party center-right coalition since January 2007 with very thin majority; elections in 2010.
  - Czech Republic assumes rotating EU Presidency from France in January 2009.
- Exchange regime
  - Classified as an independent float (Informational Annex).
  - Accepted obligations of Article VIII, Sections 2, 3, and 4; maintains exchange system free of restrictions on payments and transfers for current international transactions.

### The setting — macroeconomic developments 2006–08
- Growth dynamics and demand composition
  - Growth slowed to 4 percent of GDP in 2008 led by domestic demand, especially private consumption.
  - High oil and food prices and increase in VAT reduced household real disposable incomes.
  - Tight labor market and falling export profit margins (strong koruna) held back fixed investment.
  - Gathering recession in advanced economies began to slow growth in Q4 2008; output gap remained positive though capacity constraints eased.
- Inflation developments
  - Headline inflation accelerated above 6 percent in 2008, driven by oil and food prices, higher indirect taxes and demand pressures.
  - Regulated prices and indirect taxes accounted for more than 60 percent of the rise in inflation.
  - Inflation began to decline since September 2008 after fall in global commodity prices.
- Monetary policy actions and interest rates
  - CNB raised policy rate by a total of 125 basis points to 3¾ percent through 2007 and February 2008.
  - CNB cut policy rate by 25 basis points in August 2008, 75 basis points in early November 2008, and 50 basis points in mid-December 2008 to 2¼ percent.
  - Koruna strengthened by 12 percent through July 2008, keeping monetary conditions tight.

### Financial markets and banking sector — pressures and policy responses
- Banking system structure and risks
  - Foreign ownership of banking assets: 97 percent.
  - Off-balance sheet liabilities: derivatives >80 percent of total and equivalent to 3 times on-balance-sheet assets; assets under custody 10 percent of total; commitments/guarantees/pledges equivalent to one-fifth of on-balance-sheet assets.
  - Temporary depositor withdrawals in mid-2008 tightened liquidity; exposures to sub-prime securities and structured products appear insignificant.
- Deposit insurance adjustments
  - Mid-October 2008: deposit guarantee raised to 100 percent of deposits up to € 50,000 (from 90 percent up to € 25,000).
- Interbank market and central bank measures
  - Interbank market tightened; PRIBOR rose and term spreads widened.
  - CNB introduced two-week repo facility in October 2008 and a three-month repo facility in November 2008; widened collateral and aggressive rate cuts aimed at easing interbank conditions.
  - Government shifted to issuing floating rate treasury bonds; some liquidity returned.
- Government bond market and liquidity
  - Trading in government bond market virtually stopped in mid-October 2008; planned issuances cancelled.
  - Government and private sector able to issue foreign-currency bonds, though issuance fell recently.
- Equity market and credit risk
  - Equity market fell sharply in late 2008; credit risk, especially corporate, rose significantly.

### External position and balance-sheet indicators
- Current account and financing
  - Current account deficit narrowed to 1.8 percent of GDP in 2007; widened to 2.3 percent of GDP in Q3 2008 due to declining exports and large dividend outflow.
  - Financing comfortably provided by direct investment inflows.
- External debt and reserves
  - External debt at 43 percent of GDP at end-2007.
  - Short-term debt rose to $23 billion.
  - International reserves rose modestly to $34 billions, covering about 3 months of imports.
- External issuance
  - Corporate and financial sector external bond issuance activity declined in late 2008.

### Policy recommendations and medium-term priorities
- Monetary policy
  - Further easing appropriate; anchor expectations to 2 percent target from January 2010.
  - Support interbank market via liquidity facilities and widened acceptable collateral.
- Financial stability measures
  - Maintain and expand measures to improve liquidity and market functioning; widen collateral range; enhance government bond market transparency.
  - Vigilant supervision; monitor contingent liabilities; implement daily liquidity monitoring and systemic assessment frameworks.
  - Apply Pillar II of Basel II as soon as possible; calibrate Deposit Insurance Fund for transparency and credibility.
  - Proactive collaboration with home-country authorities of foreign subsidiaries and consider formal private-sector arrangements.
- Fiscal policy
  - Support growth while mindful of financing constraints and medium-term goals.
  - Allow automatic stabilizers to operate fully in 2009: staff estimate deficit about 2½ percent of GDP (versus budgeted 1.6 percent of GDP).
  - Room for temporary, well-targeted discretionary stimulus under adverse scenario; avoid permanent tax cuts.
  - Faster implementation of EU-funded projects to boost demand while safeguarding long-run fiscal position.
- Structural reforms
  - Restore reform momentum to raise potential growth and create fiscal space for demographic transition through greater efficiency in public spending.
  - Recent health and parametric pension reforms to reduce fiscal pressures and increase labor force participation.
  - Reform tax-benefit system and labor market to improve work incentives; reforms should reinforce each other.

### Fiscal position has strengthened — recent measures and outlook
- Fiscal outcomes and projections
  - General government deficit (ESA-95) narrowed to 1 percent of GDP in 2007.
  - Authorities project a deficit of 1¼ percent of GDP for 2008.
  - Staff projects a deficit of 1½ percent of GDP for 2009 (implying a small fiscal stimulus).
- Fiscal reform package (fiscal impact in 2008)
  - Revenues (0 percent of GDP):
    - Introduction of flat Personal Income Tax rate of 15 percent
    - Phased reduction of Corporate Income Tax rate to 19 percent
    - Increase in lower VAT rate to 9 percent
    - Introduction of ceiling on social security contributions
  - Expenditures (1/2 percent of GDP):
    - Reduction of sickness benefits
    - Deindexation of social benefits
    - Introduction of user fees in health care
- Growth and inflation
  - Staff projects 2009 GDP growth around 1½ percent.
  - Headline inflation expected to decline to 2½ percent in 2009.
- Downside risks
  - Possible credit crunch, deeper eurozone recession, reduced FDI; prolonged credit squeeze could produce deeper downturn.

### Financial sector: strengths, rising risks, and supervisory recommendations
- Strengths and vulnerabilities
  - Banks profitable with comfortable liquidity; interest income from consumer and mortgage lending large and growing.
  - Loan-to-deposit ratios average 70–80 percent.
  - Liquidity risk rising, especially at smaller banks; reliance on foreign parents increases vulnerability.
  - Corporate credit risk up; real estate sector main driver of corporate credit growth.
- Foreign bank presence and exposures
  - Czech Republic accounted for 11 percent of total foreign claims on emerging Europe as of end-2007.
  - Claims by foreign banks on non-bank private sector ≈ 56 percent of Czech GDP at end-2007 (one-third volatile short-term).
  - Four largest foreign-owned banks account for 60 percent of assets, 55 percent of loans, 64 percent of deposits.
- Supervisory and crisis-preparedness recommendations
  - Widen acceptable collateral in interbank market; improve government bond market transparency.
  - Monitor contingent liabilities and liquidity positions daily; collect up-to-date data on liquidity transfers overseas.
  - Implement systemic assessment framework and pre-agreed approach for discretionary interventions.
  - Apply Pillar II of Basel II promptly; calibrate Deposit Insurance Fund and clarify scheme features in legislation.
  - Consider formal private-sector arrangements and proactive cooperation with home-country authorities.

### Monetary policy transmission, exchange rate assessment, and competitiveness
- Transmission and communication
  - Effectiveness of traditional monetary transmission channels uncertain; CNB to act with agility.
  - Communication should anchor expectations to 2 percent target from January 2010.
  - Publication of forecast exchange-rate path from 2009 is a technical fine-tuning, not a shift to greater exchange-rate focus.
- Competitiveness and exchange-rate assessment
  - Competitiveness adequate but under pressure; real REER (CPI or unit labor cost adjusted) appreciated ≈ 10 percent in first half of 2008.
  - Koruna surge partly driven by “safe-haven” status; weakened by almost same amount since October.
  - Staff analysis: koruna broadly in line with fundamentals; balance of payments consistent with external stability.
- Key figures from Current Account Balance analysis (2008, percent of GDP)
  - Current account balance: -2.2
  - Adjustments: 0.87
  - Domestic output gap: 1.77
  - Foreign output gap: 0.29
  - Lagged effects of exchange rate changes: -1.19
  - Underlying current account balance: -1.3
  - NFA-stabilizing current account: -2.2
  - Current account norm: -2.2
- Estimates of REER Misalignment (2008, percent; reference period August 18-September 15, 2008)
  - Macroeconomic Balance Approach: 5
  - External Sustainability Approach: 3
  - Equilibrium Real Exchange Rate Approach: 6
  - Average: 5?2 (as shown in source)

### Structural reforms and medium-term agenda
- Planned reforms
  - Health: user fees introduced; voluntary supplementary health insurance proposed.
  - Pensions: regulatory reforms in private pensions; voluntary partial opt-out to funded pension considered.
  - Tax administration: integration with customs and social contribution systems planned; modernization program needed.
- Staff recommendations
  - Support efficiency-enhancing measures and further reforms to tax-benefit system and labor market to raise potential growth and fiscal savings.
  - Recognize political economy constraints—near-term difficulty of implementing some reforms.

### Key macroeconomic indicators (selected exact values)
- Real economy (change in percent, 2003–2009)
  - Real GDP: 3.6, 4.5, 6.3, 6.8, 6.0, 4.0, 1.5
  - Domestic demand: 4.1, 3.2, 1.3, 5.4, 5.1, 2.5, 1.5
  - CPI (year average): 0.1, 2.8, 1.8, 2.5, 2.8, 6.7, 2.6
  - Unemployment rate (survey-based, percent): 7.8, 8.3, 7.9, 7.1, 5.3, 4.0, 5.1
  - Gross national savings (percent of GDP): 21.1, 22.4, 24.3, 23.9, 24.8, 22.9, 22.7
  - Gross domestic investments (percent of GDP): 27.4, 27.6, 25.7, 26.5, 26.5, 25.1, 25.2
- Public finance (percent of GDP, 2003–2009)
  - General government revenue: 40.7, 42.2, 41.3, 41.1, 41.6, 41.1, 40.8
  - General government expenditure: 47.3, 45.1, 44.8, 43.8, 42.6, 42.6, 43.3
  - Net lending: -6.6, -2.9, -3.6, -2.7, -1.0, -1.5, -2.5
  - General government debt: 30.1, 30.4, 29.7, 29.6, 28.9, 29.3, 30.1
- Balance of payments / external sector (selected)
  - Trade balance (percent of GDP): -2.7, -0.5, 2.0, 2.0, 3.4, 2.6, 1.5
  - Current account (percent of GDP): -6.2, -5.2, -1.3, -2.6, -1.8, -2.2, -2.5
  - Gross international reserves (US$ billion): 27.0, 28.4, 29.6, 31.5, 34.9, 38.4, 43.7
  - Reserve cover (months of imports): 5.5, 4.5, 4.1, 3.6, 3.2, 2.7, 3.0
- Vulnerability and financial sector indicators (latest observations)
  - Capital adequacy ratio (percent): 14.5, 12.6, 11.9, 11.5, 11.5, 12.9 (Sep-08)
  - NPLs (percent of total loans): 4.9, 4.1, 4.3, 3.6, 2.7, 3.1 (Sep-08)

### Medium-term macro scenario (selected projections, 2009–2013)
- Real GDP growth (percent): 1.5 (2009), 2.3 (2010), 4.5 (2011), 4.5 (2012), 4.5 (2013)
- CPI inflation (period average, percent): 2.6 (2009), 2.0 (2010), 2.0 (2011), 2.0 (2012), 2.0 (2013)
- Gross domestic savings (percent of GDP): 22.7 (2009), 22.7 (2010), 23.3 (2011), 23.5 (2012), 24.4 (2013)
- Gross capital formation (percent of GDP): 25.2 (2009), 25.4 (2010), 25.7 (2011), 26.1 (2012), 26.4 (2013)

### Appendix I — Fund relations and data notes (selected exact values)
- Membership: Joined 1/01/1993; Article VIII
- Quota: 819.30 SDR Million (100.0 percent)
- Fund holdings of currency: 714.33 SDR Million (87.19 percent)
- Reserve position in Fund: 104.98 SDR Million (12.81 percent)
- Exchange rate as of December 8, 2008: CZK 19.895 per U.S. dollar
- Last Article IV Consultation: Concluded on January 23, 2008; Staff report and PIN published on January 28, 2008

### Staff statement updates (as of February 6, 2009)
- Recent developments
  - Industrial production: fell by 17 percent in the year to November 2008.
  - Retail sales: dropped by over 6 percent in the year to November 2008.
  - Exports: fell by almost 18 percent.
  - Imports: declined by 13 percent.
  - Consumer price inflation: declined to 3.6 percent in the year to December 2008.
- Staff projection revision
  - 2009 growth projection lowered to -1¼ percent from 1½ percent.
- Authorities' projections and fiscal updates
  - Ministry of Finance 2009 growth forecast: 1.4 percent (down from 3.7 percent).
  - Ministry of Finance raised projected 2009 fiscal deficit to 3 percent of GDP from 1.6 percent of GDP; higher deficit mainly reflects lower revenues and partial drawdown of reserves.
  - 2008 deficit outturn: around 1¼ percent of GDP.

*IMF staff report content from the 2008 Article IV Consultation with the Czech Republic (PIN No. 09/46, April 14, 2009).*

### 1.       Background,       2006-08......................................................................................

### _cr09122 - 1.       Background,       2006-08......................................................................................

### Staff appraisal and summary — key findings
- Growth and near-term outlook
  - Following three years of rapid growth, the economy is set to slow sharply in 2009: growth is projected at 1½ percent, down from the average growth of 6 percent recorded during 2005-2007.
  - Downside risks stem primarily from tighter credit conditions that could hold back domestic spending, and a deeper recession in the eurozone than now expected.
- Inflation and monetary policy
  - With inflation likely to fall below the Czech National Bank’s (CNB) target of 3 percent, scope exists for further monetary easing.
  - Falling commodity prices and weakening demand are projected to help bring inflation down to 2½ percent in 2009.
  - Recent cuts in the policy rate are appropriate; anchoring expectations to the new target of 2 percent from January 2010 will be important.
- External position and exchange rate
  - Export competitiveness is adequate and the external position has remained strong.
  - The modest current account deficit is expected to be comfortably financed by direct investment inflows.
  - Staff view: the koruna is broadly in line with fundamentals and consistent with external stability.
- Financial sector vulnerabilities
  - Liquidity has tightened considerably in interbank markets; trading in the government bond market froze temporarily in October.
  - Large presence of foreign banks with significant exposure to emerging Europe has given rise to uncertainty about the risk of cutbacks in lending.
  - Credit risk, especially in the corporate sector, has risen significantly amid the worsening outlook for economic activity.
- Policy stance and fiscal space
  - Authorities have strengthened the fiscal position and committed to nominal expenditure ceilings, creating room for countercyclical policy.
  - For 2009, allowing automatic stabilizers to operate fully would imply a deficit of about 2½ percent of GDP, higher than currently budgeted (1.6 percent of GDP).
  - With low government debt and limited macroeconomic imbalances, room exists for a discretionary fiscal stimulus under a more adverse scenario; stimulus measures need to be temporary and well targeted.

### Introduction — context and mission
- Mission details
  - Report based on discussions held in Prague during November 13-24, 2008.
  - Mission team: Mr. Subhash Thakur (head), Ms. Sònia Muñoz (EUR), Ms. Li Lian Ong (MCM), Ms. Anita Tuladhar (FAD); Messrs. Willy Kiekens (Executive Director) and Stanislav Polak (Senior Advisor) also joined.
  - Meetings with Minister of Finance Miroslav Kalousek, CNB Governor Zdeněk Tůma, other senior officials, Parliament representatives, financial and business sectors, academia, and media.
- Political and institutional backdrop
  - A three-party center-right coalition, ruling since January 2007 with a very thin majority, faces elections in 2010.
  - The Czech Republic assumes the rotating EU Presidency from France in January 2009.
- Exchange regime
  - Exchange regime classified as an independent float (Informational Annex).
  - The Czech Republic has accepted the obligations of Article VIII, Sections 2, 3, and 4, and maintains an exchange system free of restrictions on the making of payments and transfers for current international transactions.

### The setting — macroeconomic developments 2006–08
- Growth dynamics and demand composition
  - Slowdown in growth in 2008 to 4 percent of GDP led by domestic demand, especially private consumption.
  - High oil and food prices and an increase in the value added tax dented household real disposable incomes.
  - Tight labor market and falling export profit margins due to a strong koruna held back fixed investment.
  - The gathering recession in advanced economies began to slow growth in Q4 2008 given high trade openness.
  - Forward-looking indicators suggest the downturn is continuing to deepen; output gap remains positive but capacity constraints have eased.
- Inflation developments
  - Headline inflation accelerated to above 6 percent, well above the central bank’s target of 3 percent, driven by oil and food price increases, higher indirect taxes and demand pressures.
  - Regulated prices and indirect taxes accounted for more than 60 percent of the rise in inflation.
  - Underlying inflation also rose in the first half of 2008 despite the strong koruna; since September 2008 inflation started to decline following the fall in global commodity prices.
- Monetary policy actions and interest rates
  - CNB raised its policy rate throughout 2007 and in February 2008 by a total of 125 basis points to 3¾ percent.
  - CNB cut the policy rate by 25 basis points in August 2008.
  - CNB cut the policy rate by 75 basis points in early November 2008.
  - A further 50 basis point cut in mid-December 2008 brought the policy rate to 2¼ percent.
  - The koruna strengthened by 12 percent through July 2008, which helped keep monetary conditions tight.

### Financial markets and banking sector — pressures and policy responses
- Banking system structure and risks
  - Very high level of foreign ownership of banking assets: 97 percent.
  - Off-balance sheet liabilities: derivatives transactions account for more than 80 percent of the total and are equivalent to 3 times on-balance-sheet assets; assets under custody account for 10 percent of the total; contingent liabilities in the form of commitments, guarantees and pledges given are equivalent to one-fifth of on-balance-sheet assets.
  - Depositors made temporary withdrawals in mid-2008, contributing to tighter liquidity.
  - Banks’ exposures to sub-prime securities and involvement in structured financial products appear to be insignificant.
- Deposit insurance adjustments
  - In mid-October 2008, authorities raised the deposit guarantee to cover 100 percent of deposits up to € 50,000—from the previous coverage of 90 percent up to € 25,000—aligned with the EU agreement.
- Interbank market and liquidity
  - Interbank market tightened considerably; PRIBOR rose and its term structure spreads widened, reflecting higher perceived counterparty risk.
  - Banks holding surplus koruna liquidity were reluctant to lend beyond the overnight market.
  - CNB’s aggressive policy rate cut in early November 2008 aimed in part at easing interbank market conditions.
  - Activity in the foreign exchange swap market reportedly declined; foreign exchange liquidity itself was not an issue.
- Government bond market stress and central bank measures
  - Trading in the government bond market came to a virtual standstill in mid-October 2008 as liquidity disappeared, forcing cancellation of planned bond issuances.
  - CNB introduced a two-week repo facility in October 2008; a three-month repo facility was made available in November 2008.
  - The government shifted to issuing floating rate treasury bonds; some liquidity reportedly returned to the market.
  - Government and private sector were able to issue bonds in foreign currency over the past year, though issuances fell in recent months.
- Equity market and credit risk
  - Equity market fell sharply in late 2008, converging with regional peers after outperforming much of the year.
  - Sharpe ratios of major parent banks were largely in line with other European stocks.
  - Credit risk, especially corporate, has risen significantly amid the economic slowdown.

### External position and balance-sheet indicators
- Current account and financing
  - Current account deficit narrowed to 1.8 percent of GDP in 2007.
  - Widened to 2.3 percent of GDP in Q3 2008 due to declining exports and a large dividend outflow but remained comfortably financed by direct investment inflows.
- External debt and reserves
  - External debt at 43 percent of GDP at end-2007.
  - Short-term debt rose to $23 billion.
  - International reserves rose modestly to $34 billions, covering about 3 months of imports.
- External issuance
  - Corporate and financial sector external bond issuance activity shown for 2003–08 (figures in source); issuance activity declined in late 2008.

### Policy recommendations and medium-term priorities
- Monetary policy
  - Further monetary easing appropriate given receding inflation pressures; CNB should ensure communication anchors expectations to the new 2 percent target from January 2010.
  - Continue to support interbank market functioning via liquidity facilities and by widening acceptable collateral in repo operations.
- Financial stability measures
  - Maintain and expand measures to improve liquidity and support smooth functioning of markets.
  - Consider widening the range of instruments acceptable as collateral in the interbank market.
  - Mitigate perceptions of rising counterparty risks and promote greater transparency in the government bond market.
  - Financial supervisors should remain vigilant, ensure toolkit sufficiency to address emerging weaknesses, and strengthen financial safety nets and crisis preparedness.
  - Proactive collaboration with financial authorities and governments in home countries of foreign subsidiaries is crucial.
- Fiscal policy
  - Fiscal policy should support growth while being mindful of potential financing constraints and medium-term fiscal goals.
  - Allow automatic stabilizers to operate fully in 2009, implying a deficit of about 2½ percent of GDP (versus currently budgeted 1.6 percent of GDP).
  - There is room for a temporary, well-targeted discretionary fiscal stimulus under a more adverse scenario given low government debt and limited macroeconomic imbalances.
  - Faster implementation of EU-funded projects can help boost demand while safeguarding the long-run fiscal position.
- Structural reforms and medium-term agenda
  - Restore momentum of reforms to address long-term challenges and raise potential growth.
  - Create fiscal space to cope with demographic transition through greater efficiency in public spending.
  - Recent health and parametric pension reforms should help reduce fiscal pressures and increase labor force participation.
  - Improve incentives to work through reforms of the labor market and the tax-benefit system; structural reforms’ beneficial effects should reinforce each other to promote economic stability and sustained growth.

*This report is based on discussions held in Prague during November 13-24, 2008; mission team and meetings as described in the source document.*

### 15.      The fiscal position has strengthened considerably. Strong revenue gains and

### The fiscal position has strengthened considerably

### Fiscal position and recent measures
- General government deficit (ESA-95 basis) narrowed to 1 percent of GDP in 2007.
- Authorities project a deficit of 1¼ percent of GDP for 2008—less than half the initial budgeted amount.
- Staff projects a deficit of 1½ percent of GDP for 2009, implying a small fiscal stimulus.
- Fiscal reform package (Box 1) — fiscal impact in 2008:
  - Revenues (0 percent of GDP):
    - Introduction of flat Personal Income Tax rate of 15 percent
    - Phased reduction of Corporate Income Tax rate to 19 percent
    - Increase in lower VAT rate to 9 percent
    - Introduction of ceiling on social security contributions
  - Expenditures (1/2 percent of GDP):
    - Reduction of sickness benefits
    - Deindexation of social benefits
    - Introduction of user fees in health care

### Growth outlook and inflation
- Staff projects a severe slowdown in 2009 to around 1½ percent GDP growth.
- Factors weighing on growth:
  - Shrinking demand from the euro area, especially Germany, will curtail exports and direct investment inflows.
  - Tightening credit conditions and shrinking profit margins will weigh on capital spending, offsetting stimulus from the new automobile plant and rising inflows of EU funds.
  - Household consumption expected to grow only modestly as plummeting confidence and rising unemployment overshadow the favorable impact of declining inflation on real disposable incomes.
- Inflation:
  - Headline inflation expected to decline to 2½ percent in 2009.
  - Falling commodity prices and weakening demand should reduce both core and headline inflation.

### Downside risks to the baseline
- Risks tilted to the downside, including:
  - Possible credit crunch holding back corporate and household spending.
  - Deeper-than-projected recession in the eurozone.
  - Financial market uncertainty across the eurozone reducing foreign direct investment.
- A more adverse scenario: a prolonged credit squeeze could produce an even deeper downturn than the baseline.

### Financial sector: strengths and rising risks
- Strengths:
  - Banks have enjoyed strong profits and comfortable liquidity.
  - Interest income—driven by consumer and mortgage lending—has been the largest and growing share of net income.
  - Loan-to-deposit ratios averaging 70–80 percent.
- Rising risks:
  - Liquidity risk is rising due to rapid growth in bank lending and declining banking system liquidity; liquidity risk at smaller banks has increased markedly.
  - Reliance of smaller banks on foreign parents, which have reportedly set liquidity limits, increases vulnerability to retrenchment of funds.
  - More volatile short-term lending (attributed to parent lending to branches) is rising as a proportion of total loans to banks.
  - Credit risk, especially to the corporate sector, has increased significantly:
    - Rapid rise in property prices and housing construction increases the possibility that a reversal in the property market would affect credit risk of households and corporates.
    - The real estate sector is the main driver of corporate credit growth.
    - Loans may not have been adequately priced given strong competition among lenders.
- Foreign bank presence and exposures:
  - The Czech Republic accounted for 11 percent of total foreign claims on the emerging European region as of end-2007.
  - Claims by foreign banks on the non-bank private sector amounted to about 56 percent of Czech GDP at the end of 2007, of which one-third is attributable to more volatile short-term claims.
  - Lending by major foreign subsidiaries is predominantly in local currency and largely financed by local deposits.
  - The four largest banks, all foreign-owned, account for 60 percent of total banking assets, 55 percent of loans and 64 percent of deposits; they comprise CS (Erste Bank, Austria), CSOB (KBC Bank, Belgium) and KB (SG, France), and Unicredit Bank (Unicredit, Italy).

### Supervisory and crisis-preparedness recommendations
- Immediate and ongoing measures suggested by staff:
  - Widen the range of instruments acceptable as collateral in the interbank market, in addition to government bonds; if insufficient, mitigate perceptions of rising counterparty risks.
  - Ensure greater transparency in the government bond market, e.g., adhere strictly to announced size of bond issuances and consider local market development when determining types of issuances.
  - Vigilant monitoring of contingent liabilities of the banking system and ensure banks can cover such liabilities if they materialize.
  - Implement a system to monitor liquidity positions of banks on a daily basis, collect up-to-date information on transfer of liquidity overseas, and monitor exposures of foreign subsidiaries to parent banks.
  - Implement a framework for systemic assessment to review potential effects of a crisis.
  - Establish a consistent, pre-agreed approach among relevant authorities for discretionary intervention decisions.
  - Put in place modalities for the application of Pillar II of Basel II as soon as possible to ensure banks remain well-capitalized.
  - Calibrate features of the Deposit Insurance Fund to ensure transparency and credibility; clarify capacity and features of the scheme in pending legislation.
  - Consider formal arrangements with the private sector and proactive collaboration with financial authorities and governments in home countries of foreign banks.

### Monetary policy scope and challenges
- Shift in stance: mid-year shift toward easing as balance of risks moved from inflation to growth.
- With inflation likely to fall below the CNB’s target of 3 percent amid a sharp slowdown, scope exists for further easing.
- Under the baseline, staff and the CNB expect inflation to drop below 3 percent in 2009, driven by weaker domestic demand, the lagged impact of the currency appreciation, and falling commodity prices.
- Pace and magnitude of easing depend on:
  - Movements in the koruna.
  - Extent of weakness in demand (could be worse if a credit crunch materializes).
- Staff simulations (IMF’s Global Integrated Monetary and Fiscal model), assuming the lower inflation target from 2010 is fully credible, suggest that a substantial cut in the policy rate may be needed.
- A strong adverse shock to the euro area, hitting Czech exports, would require an additional cut in the policy rate, depending on the behavior of the exchange rate.
- The appreciation of the koruna has been an important disinflationary influence; simulation results suggest exchange rate shocks are likely to be swamped by the impact of the slowdown in activity.

*Source: _cr09122 - 15.      The fiscal position has strengthened considerably. Strong revenue gains and*

### 26.      The effectiveness of the traditional channels of monetary policy transmission has

### _cr09122 - 26.      The effectiveness of the traditional channels of monetary policy transmission has

### Monetary policy transmission and inflation targeting
- The effectiveness of the traditional channels of monetary policy transmission has become more uncertain.
- CNB officials were aware of the need to act with particular agility.
- Staff stressed that communication strategy should ensure that expectations were well anchored to the new inflation target of 2 percent from January 2010.
- Officials noted that the recent decision to publish a forecast exchange-rate path beginning in 2009 was a technical fine-tuning of the inflation targeting framework and should not be interpreted as giving greater weight to the exchange rate.

### Maintaining competitiveness
- Competitiveness is adequate but under incipient pressure.
- Export volumes enjoyed double-digit growth for the greater part of the year, with market shares continuing to expand.
- Staff and the authorities shared the assessment that the koruna was broadly in line with fundamentals, a view supported by estimates based on the CGER methodology (Box 4), despite some recent erosion of competitiveness due to the lagged effects of the earlier appreciation and rising unit labor costs.
- Authorities had expressed concerns about the damaging effects on activity of an excessively strong koruna, although these have been assuaged to some extent by the recent reversal of the appreciation.
- Planned privatization of the remaining state-owned assets is estimated at about 1.9 percent of GDP and, together with expected large inflows of EU funds in coming years, could put upward pressure on the koruna.
- The CNB renewed its 2002 agreement with the government to limit any appreciation in the event of large privatization revenues or inflows of EU fund.
- CNB officials acknowledged that this policy was likely to pose challenges for reserve management, especially in view of the sizeable losses already incurred by the CNB.
  - Accumulated losses were 26 percent of total assets at end-2007.

### Exchange Rate Assessment (Box 4)
- Staff analysis suggests that the koruna is broadly in line with fundamentals and consistent with external stability.
- The real exchange rate, adjusted for either relative consumer prices or unit labor costs, appreciated by around 10 percent in the first half of 2008.
- The surge in the koruna may have been driven by its “safe-haven” status in a period of enhanced uncertainty.
- Since October, heightened risk aversion towards emerging market assets and a possible correction from earlier high levels weakened it by almost the same amount.
- The balance of payments is consistent with external stability.
- The gap between the actual and the underlying current account is not considered significant, suggesting that the rise in the deficit reflects cyclical and transitory factors.
- The underlying current account is broadly in line with its equilibrium level.

Key figures from the analysis of the Current Account Balance, 2008 (Percent of GDP)
- Current account balance: -2.2
- Adjustments: 0.87
- Domestic output gap: 1.77
- Foreign output gap: 0.29
- Lagged effects of exchange rate changes: -1.19
- Underlying current account balance: -1.3
- NFA-stabilizing current account: -2.2
- Current account norm: -2.2

Estimates of REER Misalignment, 2008 (In percent)
- Reference period August 18-September 15, 2008
- Macroeconomic Balance Approach: 5
- External Sustainability Approach: 3
- Equilibrium Real Exchange Rate Approach: 6
- Average: 5?2 (as shown in source)

### Supporting growth and preserving fiscal sustainability
- Immediate challenge for fiscal policy is to support growth while protecting gains from recent fiscal consolidation.
- Authorities sought to lower deficit targets while adhering to nominal expenditure ceilings, affirming commitment to a medium-term objective of a deficit of 1 percent of GDP by 2012.
- Early savings created room for automatic stabilizers and allowed for a cyclical margin to stay within the SGP limit of 3 percent of GDP.
- Savings helped support the government’s liquidity position, relieving near-term financing pressures in a tight financial market.
- Officials noted rising pressure for stimulus is testing fiscal discipline and could put at risk achievements of earlier reforms.

Fiscal outlook and policy stance
- In October, the authorities projected a deficit of 1.6 percent of GDP for 2009, assuming growth of 3.7 percent, which implied a neutral fiscal stance.
- Cuts in the corporate income tax and social security contribution rates are largely offset by tightening of the wage bill and social transfers under the 2007 fiscal reform package.
- Staff judged a neutral stance appropriate, balancing support for growth and financing risks.
- With the growth assumption in the budget looking increasingly unrealistic, automatic stabilizers will need to be allowed to operate.
- Staff’s view: this would be consistent with a higher deficit of around of 2½ percent of GDP, mainly reflecting lower revenue collections.

Authorities’ stance and staff recommendations
- Authorities believed fiscal policy, while trying to support growth, needed to be mindful of potential financing constraints and medium-term fiscal goals.
- If growth worsened further, authorities would be prepared to consider a discretionary stimulus package, given low public debt and limited macroeconomic imbalances.
- Recent freezing of the government bond market, leading to cancellation of bond issuances, underscored potential financing risks.
- Staff welcomed authorities’ readiness to shift to a more expansionary fiscal stance as needed.
- Staff suggested measures to boost demand while safeguarding medium-term deficit objectives:
  - More rapid implementation of EU-funded projects.
  - Temporary measures well targeted to vulnerable groups.
- Staff advised that permanent tax cuts should be avoided, especially given the low tax-wedge already in place following the tax reform plan approved in 2007.

*Source: _cr09122 - 26.      The effectiveness of the traditional channels of monetary policy transmission has*

### 32.      Over the medium term, the authorities plan important structural reforms to

### _cr09122 - 32.      Over the medium term, the authorities plan important structural reforms to

### Structural reform plans and near-term political constraints
- Over the medium term, the authorities plan important structural reforms to ensure fiscal sustainability.
- Health sector:
  - Introduction of user fees has taken place.
  - A voluntary supplementary health insurance system is being proposed.
- Pensions:
  - Regulatory reforms in private pensions are being implemented.
  - A voluntary partial opt-out to funded pension is being considered.
- Tax administration:
  - Reform by integrating tax administration with customs and social contribution systems is being planned.
  - A comprehensive modernization program is needed for this integration.
- Political economy:
  - The authorities noted these steps remained politically difficult in the near term.

### Staff assessment and recommended reform areas
- Staff supported these efficiency-enhancing measures.
- Staff reiterated the scope for further reforms to:
  - The tax-benefits system to enhance incentives to work.
  - The labor market to enhance incentives to work, generate fiscal savings and raise potential growth.

### Key macroeconomic indicators (selected exact values from tables)
- Real economy (change in percent, 2003–2009):
  - Real GDP: 3.6, 4.5, 6.3, 6.8, 6.0, 4.0, 1.5
  - Domestic demand: 4.1, 3.2, 1.3, 5.4, 5.1, 2.5, 1.5
  - CPI (year average): 0.1, 2.8, 1.8, 2.5, 2.8, 6.7, 2.6
  - Unemployment rate (survey-based, in percent): 7.8, 8.3, 7.9, 7.1, 5.3, 4.0, 5.1
  - Gross national savings (percent of GDP): 21.1, 22.4, 24.3, 23.9, 24.8, 22.9, 22.7
  - Gross domestic investments (percent of GDP): 27.4, 27.6, 25.7, 26.5, 26.5, 25.1, 25.2
- Public finance (percent of GDP, 2003–2009):
  - General government revenue: 40.7, 42.2, 41.3, 41.1, 41.6, 41.1, 40.8
  - General government expenditure: 47.3, 45.1, 44.8, 43.8, 42.6, 42.6, 43.3
  - Net lending: -6.6, -2.9, -3.6, -2.7, -1.0, -1.5, -2.5
  - General government debt: 30.1, 30.4, 29.7, 29.6, 28.9, 29.3, 30.1
- Balance of payments / external sector (percent of GDP and levels):
  - Trade balance (percent of GDP): -2.7, -0.5, 2.0, 2.0, 3.4, 2.6, 1.5
  - Current account (percent of GDP): -6.2, -5.2, -1.3, -2.6, -1.8, -2.2, -2.5
  - Gross international reserves (US$ billion): 27.0, 28.4, 29.6, 31.5, 34.9, 38.4, 43.7
  - Reserve cover (in months of imports of goods and services): 5.5, 4.5, 4.1, 3.6, 3.2, 2.7, 3.0
- Fiscal composition (consolidated general government, percent of GDP, 2003–2009):
  - Total revenue: 40.7, 42.2, 41.3, 41.1, 41.6, 41.1, 40.8
  - Current taxes on income, wealth, etc: 9.6, 9.6, 9.1, 9.2, 9.3, 8.4, 8.1
    - Personal income tax: 4.9, 4.8, 4.6, 4.2, 4.3, 3.9, 3.9
    - Corporate Income Tax: 4.6, 4.7, 4.5, 4.8, 4.8, 4.4, 4.0
  - Social contributions: 15.1, 16.1, 16.1, 16.3, 16.3, 16.4, 15.9
  - Total expenditure: 47.3, 45.1, 44.8, 43.8, 42.6, 42.6, 43.3
  - Final consumption expenditure: 23.4, 22.1, 22.0, 21.3, 20.4, 20.1, 20.3
  - Social benefits other than social transfers in kind: 12.2, 12.8, 12.6, 12.7, 12.9, 12.6, 12.9
  - Primary balance (percent of GDP): -5.5, -1.8, -2.4, -1.6, 0.2, -0.2, -1.3
  - Cyclically adjusted balance: -4.6, -1.4, -2.9, -2.7, -1.7, -2.1, -2.2
- Vulnerability and financial sector indicators (latest observations):
  - Real GDP growth (in percent): 3.6, 4.5, 6.3, 6.8, 6.0, 4.0 (Proj)
  - CPI inflation (period average, in percent): 0.1, 2.8, 1.8, 2.5, 2.8, 6.7 (Proj)
  - Gross international reserves (GIR) in US$ billion: 27.0, 28.4, 29.6, 31.5, 34.9, 38.4 (Proj)
  - Total gross external debt (ED) in percent of GDP: 38.2, 41.3, 37.3, 40.2, 42.9, 40.3 (Proj)
  - Public sector overall balance (percent of GDP): -6.6, -2.9, -3.6, -2.7, -1.0, -1.5 (Proj)
  - Public sector gross debt (PSGD, in percent of GDP): 30.1, 30.4, 29.7, 29.6, 28.9, 29.3 (Proj)
  - Capital adequacy ratio (in percent): 14.5, 12.6, 11.9, 11.5, 11.5, 12.9 (Sep-08)
  - NPLs in percent of total loans: 4.9, 4.1, 4.3, 3.6, 2.7, 3.1 (Sep-08)

### Debt sustainability frameworks (selected exact figures and dynamics)
- External Debt Sustainability Framework (2003–2013, selected):
  - Baseline external debt (percent of GDP): 38.2, 41.3, 37.3, 40.2, 42.9, 40.3, 43.0, 44.9, 45.5, 46.0, 46.3
  - Current account (in percent of GDP): -6.2, -5.2, -1.3, -2.6, -1.8, -2.2, -2.5 (2003–2009 series)
  - Gross external financing need (in US$ billion): 19.8, 27.1, 25.0, 25.8, 22.5, 34.1, 39.5, 42.3, 46.2, 51.6, 55.4
  - External debt-to-exports ratio (in percent): 61.8, 58.8, 51.8, 52.4, 53.3, 47.3, 49.2, 50.0, 47.8, 45.3, 42.6
- Public Sector Debt Sustainability Framework (2003–2013, selected):
  - Baseline public sector debt (percent of GDP): 30.1, 30.4, 29.8, 29.6, 28.9, 29.4, 30.2, 30.9, 30.2, 30.0, 29.8
  - Change in public sector debt (percent of GDP): 1.6, 0.3, -0.6, -0.2, -0.7, 0.5, 0.8, 0.8, -0.7, -0.3, -0.2
  - Primary deficit (percent of GDP): 5.5, 1.8, 2.4, 1.6, -0.2, 0.2, 1.2, 1.3, 0.5, 0.3, 0.4
  - Gross financing need (percent of GDP): 21.1, 15.6, 11.5, 10.6, 7.7, 9.1, 10.3, 10.3, 9.3, 8.0, 8.0
  - Public sector debt-to-revenue ratio: 73.8, 72.0, 71.9, 71.9, 69.4, 71.3, 73.8, 75.6, 73.8, 72.8, 72.7

### Medium-term macro scenario (selected projections, 2009–2013)
- Real GDP growth (percent): 1.5 (2009), 2.3 (2010), 4.5 (2011), 4.5 (2012), 4.5 (2013)
- CPI inflation (period average, percent): 2.6 (2009), 2.0 (2010), 2.0 (2011), 2.0 (2012), 2.0 (2013)
- Gross domestic savings (percent of GDP): 22.7 (2009), 22.7 (2010), 23.3 (2011), 23.5 (2012), 24.4 (2013)
- Gross capital formation (percent of GDP): 25.2 (2009), 25.4 (2010), 25.7 (2011), 26.1 (2012), 26.4 (2013)

*Source: Staff Report for the 2008 Article IV Consultation—Informational Annex (European Department), January 9, 2009.*

### Appendix I. Czech Republic: Fund Relations

### Appendix I. Czech Republic: Fund Relations (As of November 30, 2008)

### I. Membership Status
- Joined 1/01/1993; Article VIII

### II. General Resources Account
- Quota: 819.30 SDR Million (100.0 percent)
- Fund holdings of currency: 714.33 SDR Million (87.19 percent)
- Reserve position in Fund: 104.98 SDR Million (12.81 percent)

### III. SDR Department
- Holdings: 13.76 SDR Million (N/A percent allocation)

### IV. Outstanding Purchases and Loans
- None

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

### VI. Projected Obligations to Fund
- None

### VII. Exchange Rate Arrangement
- Currency: Czech koruna (created on February 8, 1993)
- Exchange rate history and regime:
  - May 3, 1993 to May 27, 1997: pegged to a basket (deutsche mark 65 percent; U.S. dollar 35 percent)
  - February 28, 1996: exchange rate band widened from ±0.5 percent to ±7.5 percent
  - May 27, 1997: managed floating introduced
  - Annual Report classification: independent float (de facto)
  - Since 2002: CNB has not engaged in direct interventions in the foreign exchange market
- International reserves affected by off-market purchases of large privatization receipts and EU transfers and the sales of the accumulated interest
- Exchange restrictions: none for current international transactions (Article VIII obligations accepted); maintains exchange restrictions 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))
- Exchange rate as of December 8, 2008: CZK 19.895 per U.S. dollar

### VIII. Last Article IV Consultation
- Concluded on January 23, 2008
- Staff report and PIN published on January 28, 2008

### IX. Technical Assistance (Selected, 1991–2005)
- FAD (Dec. 1991–Sept. 1993; multiple visits 1993–1999): VAT administration; public financial management; medium-term fiscal framework
- MCM (February 1992; June 1992; July 1992; December 1992 and February 1993; November 1993; April 1994; January 1995; May 1995; May 1996; April 1997; February–June 1999; June 1999): monetary management and research; foreign exchange operations; banking supervision; bond issuance and monetary management; banking system reform; monetary research; inflation targeting; integrated financial sector supervision (with WB)
- RES (September 1999; June–August 2000; February–March 2005): Inflation targeting (financed by MFD)
- STA (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; implementing GFSM 2001; GFSM 2001 Pilot Project

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

### XI. Safeguards Assessments
- Not Applicable

### Statistical Issues — Data Provision and Quality
- Data provision: adequate for surveillance; Czech Republic subscribed to the Special Data Dissemination Standard in April 1998; metadata and annual observance reports for 2006 and 2007 posted on the Fund’s Dissemination Standards Bulletin Board
- Data availability and lags:
  - Exchange rates and interest rates: reported daily with no lag
  - Gross and net international reserves: monthly with a one-week lag; also on a 10-day basis (with CNB’s 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: lag of about one month
  - GDP and balance of payments: quarterly with a lag of two to three months; main components of balance of payments available monthly since 2003
  - Annual Government Finance Statistics Yearbook: timely; covers all operations of the general government including extrabudgetary funds excluded from monthly data
  - Monthly fiscal data in IFS: cover state budget accounts; available with a two- to three-month lag
- Remaining data weaknesses and ongoing measures:
  - National accounts:
    - Value added in the small-scale private sector likely underestimated due to underdeveloped data collection and tax evasion
    - Large discrepancies between GDP estimates by production and expenditure methods are subsumed under change in stocks
    - Quarterly national accounts subject to bias from nonresponse and lumping of expenditure categories; large quarter-to-quarter swings hamper business cycle analysis
  - External trade statistics:
    - Revisions to export data processing have aligned practice with the EU
    - Continued weakness: unavailability of fixed base price indices for exports and imports; indices presented on basis of same month of previous year
  - Monetary survey data:
    - Large variations in the interbank clearing account float, especially at year-end, require caution
    - CNB has undertaken efforts to identify causes and adjust the data
    - Since 2002 CNB implemented ECB framework for monetary data collection/compilation; IFS monetary accounts derived from ECB framework and harmonized with CNB publications (presentation differences remain)
  - Fiscal data:
    - Annual fiscal data on ESA-95 basis prepared by Czech Statistical Office; quarterly non-financial accounts available; quarterly financial accounts being prepared
    - ESA-95 differs from national fiscal targeting methodology in institutional coverage and inclusion of financial transactions and accrual items
    - Ministry of Finance participated in Fund’s pilot project to transition to GFSM 2001 methodologies

### Table of Common Indicators Required for Surveillance (As of October 27, 2008) — Latest Observation / Date Received / Frequency (Data frequencies abbreviated)
- Exchange Rates: 9/30/08 / 9/30/08 / D / D / D
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Sep. 2008 / 10/10/08 / D / M / M
- Reserve/Base Money: 8/01/08 / 9/15/08 / 10 days / 10 days / 10 days
- Broad Money: Aug. 2008 / 10/21/08 / M / M / M
- Central Bank Balance Sheet: 8/01/08 / 9/15/08 / 10 days / 10 days / 10 days
- Consolidated Balance Sheet of the Banking System: Aug. 2008 / 10/21/08 / M / M / M
- Interest Rates: 9/30/08 / 9/30/08 / D / D / D
- Consumer Price Index: Sep. 2008 / 10/16/08 / M / M / M
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Dec. 2007 / Jan. 2008 / A / A / A
- Revenue, Expenditure, Balance and Composition of Financing – Central Government: July 2008 / Sep. 2008 / A / A / A
- Stocks of Central Government and Central Government-Guaranteed Debt: July 2008 / Sep. 2008 / A / A / A
- External Current Account Balance: 2008 Q2 / Sep. 2008 / Q / Q / Q
- Exports and Imports of Goods and Services: June 2008 / Sep. 2008 / M / M / M
- GDP/GNP: 2008 Q2 / Sep. 2008 / Q / Q / Q
- Gross External Debt: 2008 Q2 / Sep. 2008 / Q / Q / Q
- International Investment Position: 2008Q2 / Sep 2008 / Q / Q / Q

- Notes on table:
  - 1 Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.
  - 2 Both market-based and officially-determined rates.
  - 3 Foreign, domestic bank, and domestic nonbank financing.
  - 4 General government includes central government (budgetary funds, extrabudgetary funds, social security funds) and state and local governments. State budget data available monthly; extrabudgetary funds only annually.
  - 5 Including currency and maturity composition.
  - 6 Includes external gross financial asset and liability positions vis-à-vis nonresidents.
  - 7 Frequencies: Daily (D); Weekly (W); Monthly (M); Quarterly (Q); Annually (A); Irregular (I); Not Available (NA).

### Statement by the IMF Staff Representative (February 6, 2009) — Key Updates and Projections
- Recent developments (since staff report issuance):
  - Industrial production: fell by 17 percent in the year to November 2008 (led by a sharp decline in the automobile sector)
  - Retail sales: dropped by over 6 percent in the year to November 2008
  - Exports: fell by almost 18 percent (led by vehicles and machinery)
  - Imports: declined by 13 percent
  - Consumer and business confidence: indicators fell further in January 2009
  - Consumer price inflation: declined to 3.6 percent in the year to December 2008 (a 15-month low), driven by prices of food and fuel
- Staff projection revision:
  - 2009 growth projection lowered to -1¼ percent from 1½ percent
  - Rationale: deepening recession in the euro area (especially Germany) and deteriorating domestic demand; marked slowdown in investment (especially automobile sector); weakening private consumption due to employment prospects and household confidence
- Authorities' projections:
  - Ministry of Finance growth forecast for 2009: 1.4 percent (down from 3.7 percent)
  - Revision driven by exports of goods and services expected to fall by close to 1 percent
  - CNB scheduled to publish latest assessment on February 5; market participants expect a sharp downward revision in growth forecast and a further cut in the policy interest rate based on CNB public statements
- Fiscal outlook and policy:
  - Authorities revised 2009 budget in late January
  - Ministry of Finance raised projected fiscal deficit to 3 percent of GDP from 1.6 percent of GDP (on ESA-95 basis)
  - Higher deficit mainly reflects lower revenues; to be partially financed through a drawdown of reserves
  - 2008 deficit outturn: around 1¼ percent of GDP (better than expected due to lower capital spending)
  - Revised 2009 budget implies a slightly expansionary fiscal stance for 2009

*IMF staff statement as of February 6, 2009 (information provided in the source content).*

### 5. The koruna continued to depreciate, in line with the trend in the regional

### 5. The koruna continued to depreciate, in line with the trend in the regional currencies.

### Exchange rate developments and competitiveness
- Against the euro, the koruna fell by 4.1 percent during January, following a decline of 6 percent in December 2008.
- Staff assessment: "the koruna exchange rate is broadly in line with fundamentals," though recent reversal of earlier appreciation has eased earlier concerns about an excessively strong koruna.
- Real effective exchange rate (CPI-based; 2000=100): 116.8 (2003); 118.3 (2004); 125.3 (2005); 132.3 (2006); 136.8 (2007); 148.5 (2008); n.a. (2009); n.a. (2010).
- Nominal effective exchange rate (2000=100): 116.8 (2003); 118.0 (2004); 125.3 (2005); 131.7 (2006); 135.6 (2007); 140.6 (2008); n.a. (2009); n.a. (2010).

### Macroeconomic outlook and growth projections
- Growth is projected to slow sharply in 2009 amid a gathering recession abroad and tightening credit at home.
- Real GDP (change in percent): 3.6 (2003); 4.5 (2004); 6.3 (2005); 6.8 (2006); 6.0 (2007); 4.0 (2008); -1.3 (2009); 1.4 (2010).
- Domestic demand (change in percent): 4.1 (2003); 3.2 (2004); 1.3 (2005); 5.4 (2006); 5.1 (2007); 2.5 (2008); -0.1 (2009); 1.3 (2010).
- CPI (year average): 0.1 (2003); 2.8 (2004); 1.8 (2005); 2.5 (2006); 2.8 (2007); 6.3 (2008); 2.1 (2009); 2.0 (2010).
- PPI (year average): -0.3 (2003); 5.7 (2004); 3.0 (2005); 1.6 (2006); 4.0 (2007); 4.4 (2008); n.a. (2009); n.a. (2010).
- Unemployment rate (survey-based, percent of total labor force): 7.8 (2003); 8.3 (2004); 7.9 (2005); 7.1 (2006); 5.3 (2007); 4.0 (2008); 5.3 (2009); 5.6 (2010).
- Unemployment rate (registered, percent of total labor force): 9.9 (2003); 9.8 (2004); 8.9 (2005); 8.1 (2006); 6.6 (2007); 5.3 (2008); 6.5 (2009); 6.9 (2010).
- Staff projection and risks: outlook clearly tilted to the downside; downside risks from a deeper recession in the euro area and tighter domestic credit.

### External position and reserves
- Trade balance (percent of GDP): -2.7 (2003); -0.5 (2004); 2.0 (2005); 2.0 (2006); 3.4 (2007); 2.6 (2008); 1.0 (2009); 0.5 (2010).
- Current account (percent of GDP): -6.2 (2003); -5.2 (2004); -1.3 (2005); -2.6 (2006); -1.8 (2007); -2.2 (2008); -3.1 (2009); -3.3 (2010).
- Gross international reserves (US$ billion): 27.0 (2003); 28.4 (2004); 29.6 (2005); 31.5 (2006); 34.9 (2007); 38.3 (2008); 44.4 (2009); 47.2 (2010).
- Reserve cover (in months of imports of goods and services): 5.5 (2003); 4.5 (2004); 4.1 (2005); 3.6 (2006); 3.2 (2007); 2.7 (2008); 3.0 (2009); 3.0 (2010).

### Fiscal position, stimulus measures, and medium-term framework
- General government revenue (percent of GDP): 40.7 (2003); 42.2 (2004); 41.3 (2005); 41.1 (2006); 41.6 (2007); 41.2 (2008); 41.1 (2009); 41.1 (2010).
- General government expenditure (percent of GDP): 47.3 (2003); 45.1 (2004); 44.8 (2005); 43.8 (2006); 42.6 (2007); 42.5 (2008); 44.4 (2009); 44.5 (2010).
- Net lending (percent of GDP): -6.6 (2003); -2.9 (2004); -3.6 (2005); -2.7 (2006); -1.0 (2007); -1.2 (2008); -3.3 (2009); -3.4 (2010).
- General government debt (percent of GDP): 30.1 (2003); 30.4 (2004); 29.7 (2005); 29.6 (2006); 28.9 (2007); 29.2 (2008); 31.4 (2009); 33.1 (2010).
- 2009 budget and expected deficits:
  - Budget adopted in October targeted a deficit of 1.6 percent of GDP.
  - With full operation of automatic stabilizers and fiscal stimulus plan, the deficit is now expected to be at 3 percent.
  - Assuming adherence to spending ceilings, deficit projections: 2.9 percent of GDP in 2010 and 2.5 percent in 2011.
- Czech government stimulus measures (equivalent to about 1 percent of GDP) include:
  - Cuts in employees’ social security contributions with a net budget cost of CZK 18.4 billion;
  - CZK 14.4 billion contribution to construction and modernization of infrastructure within the State Fund of Transport and Infrastructure;
  - Increase of salaries in the government sector by CZK 2.7 billion;
  - Increase of capital of the Czech Export Bank (CEB) and other export promoting institutions by some CZK 2 billion;
  - Increase in the capital of Supporting Guarantee Agricultural and Forestry Fund by CZK 0.3 billion;
  - CZK 0.6 billion investment incentives for technology centre projects;
  - CZK 0.5 billion for environment related projects, co-financed by EU Funds.
- Government spending cuts in 2009 under consideration: CZK 15 billion, or 0.4 percent of GDP.

### Financial sector resilience and supervision
- Financial sector stress increased in late 2008: liquidity tightened in interbank markets; trading in government bond market froze temporarily in October 2008; corporate credit risk rose.
- Strengths highlighted by authorities:
  - Main financial institutions remain sound, well-capitalized and profitable.
  - Growth opportunities in traditional banking and reasonable profitability.
  - Negligible share of structured credits, not exceeding 1 percent of total assets.
  - Stable funding by local deposits rather than by foreign funds; deposit-to-loan ratio is double the average ratio in the original members of the European Union.
- Deposit insurance and liquidity episode:
  - Temporary withdrawals likely stemmed from neighboring countries announcing more generous deposit insurance schemes.
  - After alignment with EU agreement in mid-October 2008 (covering 100 percent of deposits up to euro 50,000), withdrawals stopped.
- Staff cautions:
  - Concerns about high off-balance sheet liabilities and intensified concerns about the health of the banking sector.
  - Monitoring of main financial institutions is performed daily by the CNB.
  - Potential amendment to banking law to strengthen supervisory system as needed.
- Cross-border banking considerations:
  - Lending by subsidiaries of foreign banks is predominantly in local currency and largely financed by local deposits, reducing vulnerability.
  - Staff cautions against quick and significant reduction of exposures of foreign banks in the region; distinction noted between withdrawing existing funds and not extending new financing.
  - Prudential regulation constrains allocation of liquidity by a subsidiary to its foreign parent bank, limiting risk concentration on a counterpart to 20 percent of own capital.
  - Proactive collaboration with home-country authorities of foreign banks is warranted given the dominant presence of foreign banks.

### Monetary policy stance and inflation targeting
- The Czech National Bank cut the policy rate by a total of 200 basis points as ripple effects of the global financial crisis impacted the economy.
- Directors supported recent cuts and saw scope for further prudent easing depending on movements in the koruna and the extent of weakness in demand.
- Communication: central bank’s communication strategy should ensure expectations are well anchored to the revised inflation target of 2 percent, effective January 2010.
- With inflation projected to fall below the target of 3 percent and a sharp slowdown in prospect, further easing considered appropriate by Directors.

### Euro adoption considerations
- Czech Republic has improved nominal and real convergence indicators; government financial position no longer a barrier to Maastricht criteria after termination of the excessive deficit procedure.
- Inflation effect in 2008 subsided; inflation in 2009 expected to allow fulfillment of the price stability criterion; long-term interest rate criterion fulfilled.
- Czech Republic does not participate in ERM II and thus does not fulfill the exchange rate criterion.
- Present global financial crisis increased exchange rate volatility, making fulfillment of the exchange rate criterion within ERM II difficult and costly.
- Ministry of Finance and the CNB recommended that the government should not set a target date for adopting the Euro given current assessment and uncertain near-term outlook.

*Italic: IMF staff report content from the 2008 Article IV Consultation with the Czech Republic (PIN No. 09/46, April 14, 2009).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09122.pdf_