## _cr1060

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---

### Pre-crisis strengths (staff appraisal)
- Integration with the EU and large foreign direct investment (FDI) inflows fostered trade integration and underpinned an export-led expansion.
- Improved fiscal performance contributed to a comfortable external position.
- Credible inflation targeting resulted in generally low inflation and interest rates.
- A liquid and conservative banking sector limited balance sheet vulnerabilities.
- Growth stood above 6 percent during 2005–07.

### Impact of the crisis and near-term outlook
- Real economy:
  - Output fell by 4⅓ percent in 2009.
  - GDP projected to grow by 1½ percent in 2010 and by 2.6 percent in 2011 (staff projections).
  - Fixed capital formation likely to remain depressed; consumer spending expected to decline.
  - Real GDP (change in percent, 2005–2011): 6.3; 6.8; 6.1; 2.5; -4.3; 1.7; 2.6.
- Labor market:
  - Unemployment rate (Survey-based, percent): 7.9; 7.1; 5.3; 4.4; 7.2; 8.8; 8.5 (2005–2011).
  - Unemployment rate (Registered, percent): 8.9; 8.1; 6.6; 5.4; 8.2; 9.9; 9.6 (2005–2011).
- Inflation:
  - CPI (year average, 2005–2011): 1.9; 2.5; 2.8; 6.3; 1.0; 1.6; 2.0.
  - New inflation target of 2 percent effective January 2010.
  - VAT and excise hikes expected to push average headline inflation to over 1½ percent in 2010.
- External sector:
  - Drop in exports offset by larger fall in imports, improving the trade balance.
  - FDI more than halved and no longer fully finances the current account deficit; rising inflows of EU funds filled the gap.
  - Current account (percent of GDP, 2005–2011): -1.3; -2.4; -3.2; -3.1; -2.1; -1.7; -2.4.
  - Trade balance (percent of GDP, 2005–2011): 2.0; 2.0; 3.4; 2.8; 2.9; 2.9; 3.3.
  - Gross international reserves (US$ billion, 2005–2011): 29.6; 31.5; 34.9; 37.0; 42.7; 45.9; 47.5.

### Monetary policy and financial conditions
- CNB actions:
  - Policy rate cut totaling 275 basis points through December 2009, having begun easing in August 2008.
  - CNB kept key policy rate unchanged at 1 percent in its February 4 meeting (Statement by Staff Rep).
  - Recommendation: supportive stance appropriate for now, should shift to tightening as recovery gathers momentum.
- Money and credit indicators:
  - Broad money (end of year, percent change, 2005–2011): 8.0; 9.9; 13.2; 6.6; 4.3; 4.0; n.a.
  - Private sector credit (percent change, eop, 2005–2011): 20.8; 21.6; 27.3; 16.0; 2.8; 1.5; n.a.
  - Three-month interbank rate (year average): 2.0; 2.3; 3.1; 4.0; 2.2; n.a.; n.a.
  - Ten-year government bond (year average): 3.5; 3.8; 4.3; 4.6; 4.7; n.a.; n.a.

### Fiscal impact, outlook, and required consolidation
- Crisis fiscal impact:
  - Overall deficit widened by 4 percentage points to 6.0 percent of GDP in 2009.
  - Fiscal measures and automatic stabilizers increased overall fiscal deficit by some 4 percentage points of GDP in 2009.
- Key fiscal indicators (percent of GDP, 2005–2011):
  - General government revenue: 41.4; 41.1; 41.9; 40.9; 38.8; 40.7; 40.8.
  - General government expenditure: 45.0; 43.7; 42.5; 42.9; 44.8; 45.8; 46.1.
  - Net lending / Overall balance: -3.6; -2.6; -0.7; -2.0; -6.0; -5.1; -5.3.
  - General government debt: 29.7; 29.6; 29.0; 30.0; 34.2; 37.9; 40.5.
- Medium-term projections and risks:
  - Without consolidation, deficit projected to remain above 5 percent of GDP over the medium term.
  - Public debt projected to double to 60 percent of GDP in less than a decade (staff projection narrative).
  - Public sector debt (percent of GDP, baseline, 2005–2015): 29.7; 29.4; 29.0; 30.0; 34.2; 37.9; 40.5; 44.1; 46.7; 48.6; 50.3.
  - Gross financing need (percent of GDP, 2005–2015): 9.3; 9.2; 6.1; 8.9; 13.5; 12.2; 13.7; 14.5; 14.4; 14.8; 15.2.
- Required consolidation:
  - Structural adjustment of at least 0.7 percent of GDP per year estimated to achieve deficit below 3 percent of GDP in 2013 as mandated by ECOFIN.
  - Staff: starting fiscal consolidation could lower borrowing costs and crowd in private investment.
- 2010 budget assessment and measures:
  - 2010 budget relies mostly on permanent indirect tax increases and temporary expenditure cuts that expire in 2011.
  - 2010 Austerity Measures (fiscal impact in 2010 compared to unchanged 2009 policies, percent of GDP): Total: 2 .1; Revenue Increases: 1.8; Expenditure Cuts: 0.3.
    - VAT increase by 1 pp in both rates: 0.5.
    - Increase in excise taxes: 0.3.
    - Increase in real estate tax: 0.1.
    - Income tax and Social security contributions: 0.9.
    - Expenditure cuts include wage bill savings: 0.1 and a pension freeze in 2010: 0.2.
  - Staff projects these measures will lead to a structural improvement of 1.2 percent of GDP.

### Fiscal consolidation strategy (2011–13) — staff recommendations
- Expenditure-side priorities:
  - Rationalize mandatory expenditures and the generous welfare system.
  - Re-organize public institutions and positions to reduce the wage bill without cutting wage levels.
  - Introduce means-testing to improve targeting of social benefits.
  - Improve efficiency of public services delivery and public procurement.
- Revenue-side priorities:
  - Expand the tax base by eliminating exemptions and loopholes.
  - Unify VAT rates at the higher rate and tax real estate property based on market value.
  - Consider revisiting the corporate income tax rate, which is below the OECD average.
  - Improve tax administration to increase revenue collection efficiency.
- Political economy note:
  - Authorities warned that unifying VAT rates and property tax measures may lack near-term political support; caretaker government preparing an Exit Strategy as an options-based approach.

### Long-term pressures: demographics, pensions, and health care
- Demographics and fiscal impact:
  - Age-related spending projected to increase by 6 percentage points of GDP over the next 50 years, bringing total age-related spending to about one quarter of GDP (about 23½ percent of GDP by 2060 in another table).
  - Old-age dependency ratio set to triple to 61 percent over the next 50 years.
  - Elderly projected to account for one third of the population in 2060 compared with 14 percent in 2007.
- Pensions:
  - Parametric changes to the PAYG system effective January 2010 are welcome but insufficient.
  - Further measures recommended to better link contributions to benefits and increase effective retirement age:
    - Move forward to 2020 the increase in the statutory retirement age to 65 (staff recommendation example).
    - Reduce period for early retirement back to 3 years (staff recommendation example).
  - Consideration of a fully funded second-pillar private pension scheme and prefunding additional reserves.
- Health care:
  - User fees introduced in 2008 could be means-tested.
  - Recommend establishing a broadly representative working group to lead reforms focused on institutional reform (reduce coverage of publicly provided services, allow greater private provision, introduce competition) and financing reform (voluntary insurance, personal health accounts, choices in plans).

### Banking sector soundness, supervision, and policy recommendations
- System strengths:
  - Healthy capital and liquidity buffers, strong retail funding, limited foreign currency risk exposure.
  - Loan-to-deposit ratio well below 100 percent; foreign currency loans: virtually zero for households and around 18 percent for nonfinancial corporations (end-2008).
- Crisis response:
  - No bank recapitalization or exceptional measures required.
  - Deposit insurance limit raised to €50,000.
  - CNB widened liquidity-providing operations and strengthened liquidity monitoring.
- Asset quality and provisioning:
  - NPLs reached almost 5 percent of total loans (Sep-09); coverage by loan loss provisions declined to about 60 percent from 70 percent at end–2007.
  - Return on equities declined by less than 2 percent.
- Supervisory recommendations:
  - Continue monitoring high single-borrower concentration and commercial real estate exposure.
  - Improve macro-prudential analysis by accounting for liquidity, market, and credit risk interactions and integrate it with supervision.
  - Review Deposit Insurance Fund (DIF) arrangements: shorten pay-out period, establish DIF resource target, consider temporary contribution increases, ensure timely information sharing between CNB and DIF, and consider DIF role in assisted P&A transactions if least-cost principle satisfied.
  - Leverage EU supervisory framework revision to strengthen cross-border coordination.
- Legal updates:
  - Amendment to the Act on Banks effective September 2009: allows bridge bank creation, empowers special administrator for P&A transactions, streamlines capital increase procedures, strengthens CNB oversight including temporary prohibitions/restrictions.

### Capital markets and public debt management
- Domestic bond and capital markets underdeveloped and inefficient; trading remains thin due to opaqueness of public debt management.
- Recommendations:
  - Enhance transparency of the government bond market (adhere to announced bond issuance sizes).
  - Rationalize subsidies and tax exemptions for deposits in building societies and voluntary third-pillar pension contributions.
  - Improve regulation regarding third-pillar pension funds.
- Public debt projections and vulnerabilities:
  - Public sector debt projected to rise from 34.2 (2009) to 50.3 (2015) (percent of GDP, staff baseline).
  - Debt-stabilizing non-interest current account: -2.0 (Table 6 memo).
  - External debt (percent of GDP, baseline, 2005–2015): 37.3; 40.1; 43.6; 37.2; 41.9; 45.2; 46.2; 48.1; 48.6; 48.3; 47.9.

### Selected balance of payments and vulnerability indicators (key figures)
- Balance of payments (millions of U.S. dollars, 2005–2011) — Current account balance: -1,578; -3,558; -5,747; -6,642; -4,122; -3,384; -4,849.
- Exports (US$ millions, 2005–2011): 77,973; 95,147; 122,697; 145,749; 108,940; 116,937; 126,564.
- Imports (US$ millions, 2005–2011): 75,451; 92,304; 116,788; 139,382; 103,196; 111,107; 119,740.
- Net factor income (US$ millions, 2005–2011): -5,975; -7,486; -12,735; -17,285; -12,411; -10,246; -11,830.
- Change in reserves (millions of U.S. dollars, 2005–2011): -3,879; -92; -868; -2,419; -2,639; -1,590; -1,743.
- Selected vulnerability indicators (latest/proj): Total gross external debt (percent of GDP): 38.2; 41.3; 37.3; 40.1; 43.6; 37.2; 41.9 (Proj). NPLs in percent of total loans: 4.9; 4.0; 3.9; 3.7; 2.8; 3.3; 5.0 (Sep-09).

### Structural reform priorities
- Boost productivity and labor participation, and attract FDI by:
  - Promoting work incentives through tax-benefit changes.
  - Improving labor market flexibility and education quality.
  - Reducing barriers to business entry and exit.
- Capital markets deepening and public sector efficiency improvements emphasized as growth-supporting measures.

### Administrative note and stakeholders’ views
- Recommendation: next Article IV consultations on a standard 12-month cycle.
- Authorities broadly agree with staff on crisis impact, recovery prospects, need for fiscal adjustment and structural reforms, monetary strategy, and financial sector assessment; differences on feasibility/timing of some fiscal, pension, health, and capital market reforms were noted.
- Executive Board assessment (March 2, 2010 PIN):
  - Monetary and fiscal easing appropriate; supportive monetary stance should shift to tightening as recovery strengthens.
  - 2010 budget seen as balancing sustainability and recovery; Directors cautioned against additional spending prior to May general elections.
  - New government needs a credible, durable consolidation plan; a number of Directors urged emphasis on expenditure reductions and public service efficiency improvements.

*Source: IMF staff report content (Selected Economic Indicators, 2005–10) as provided in the document _cr1060.*

### 1. Selected Economic Indicators, 2005–10 ........................................................................10

### Selected Economic Indicators, 2005–10

### Staff appraisal — pre-crisis strengths
- Integration with the EU and large foreign direct investment (FDI) inflows fostered trade integration and underpinned an export-led expansion.
- Improved fiscal performance contributed to a comfortable external position.
- Credible inflation targeting resulted in generally low inflation and interest rates.
- A liquid and conservative banking sector limited balance sheet vulnerabilities.

### Impact of the crisis and near-term developments
- The highly open economy was significantly affected by the global crisis:
  - Output fell by 4⅓ percent in 2009.
  - A downturn in the euro area—especially in Germany—depressed exports.
  - FDI dropped and lending standards tightened, leading to a decline in investment.
  - Private consumption held up despite rising unemployment, reflecting supportive fiscal policy.
- External position:
  - Drop in exports was offset by a larger fall in imports, improving the trade balance.
  - FDI more than halved and no longer fully finances the current account deficit; rising inflows of EU funds filled the gap.
  - Initial koruna depreciation was reversed; the real exchange rate remains in line with fundamentals.
- Banking sector:
  - Healthy capital and liquidity buffers, strong retail funding, and limited foreign currency risk exposure removed the need for recapitalization or exceptional measures.
  - Interbank market liquidity and domestic bond market trading remain below pre-crisis levels.

### Policy response
- Monetary:
  - The Czech National Bank (CNB) cut the policy rate by a total of 275 basis points through December 2009, having begun easing in August 2008.
  - Easing combined with verbal interventions kept inflation largely positive but well below target.
- Fiscal:
  - Automatic stabilizers and fiscal measures increased the overall fiscal deficit by some 4 percentage points of GDP.
  - The 2010 budget relies mostly on permanent indirect tax increases and, to a lesser degree, on temporary expenditure cuts that expire in 2011.

### Short-term outlook and monetary guidance
- GDP is projected to grow by 1½ percent in 2010, supported by exports and inventory buildup; fixed capital formation likely to remain depressed.
- Consumer spending expected to decline due to rising unemployment, slowing wage growth, and unwinding of fiscal stimulus.
- Inflation:
  - Recently-approved VAT and excise hikes expected to push average headline inflation to over 1½ percent in 2010.
  - New inflation target of 2 percent came into effect in January 2010.
- Recommendation: supportive monetary stance appropriate for now, but should shift to tightening as recovery gathers momentum.

### Fiscal challenges and recommendations
- Crisis impact on public finances:
  - Sharp widening of the overall deficit in 2009 and rapid debt accumulation.
  - In absence of additional measures, budget deficit projected to remain above 5 percent of GDP over the medium term.
  - Public debt projected to double to 60 percent of GDP in less than a decade.
- Required consolidation:
  - A structural adjustment of at least 0.7 percent of GDP per year is estimated to be required to achieve a deficit below 3 percent of GDP in 2013 as mandated by ECOFIN.
  - This would not be sufficient for long-term debt sustainability given population aging pressures.
- 2010 budget assessment:
  - Balances fiscal sustainability and recovery support.
  - Given very low fiscal multipliers in the highly open economy, additional fiscal stimulus would have limited effect.
  - Starting fiscal consolidation could lower borrowing costs and crowd in private investment.
- Medium-term consolidation strategy (2011–13) should focus on both expenditures and revenues:
  - Expenditures:
    - Rationalize mandatory expenditures and the generous welfare system.
    - Re-organize public institutions and positions to reduce the wage bill without cutting wage levels.
    - Introduce means-testing to improve targeting of social benefits, yield savings, and enhance work incentives.
    - Improve efficiency of public services delivery and public procurement.
  - Revenues:
    - Expand the tax base by eliminating exemptions and loopholes.
    - Unify VAT rates at the higher rate and tax real estate property based on market value.
    - Consider revisiting the corporate income tax rate, which is below the OECD average.
    - Improve tax administration to increase revenue collection efficiency.
- Political economy:
  - Authorities warned that unifying VAT rates and property tax measures may lack near-term political support.
  - The caretaker government is preparing an Exit Strategy from the Crisis as an options-based approach to fiscal consolidation.

### Demographics, pensions, and health care
- Long-term fiscal challenge from aging:
  - Age-related spending projected to increase by 6 percentage points of GDP over the next 50 years, bringing total age-related spending to about one quarter of GDP.
- Pensions:
  - Significant parametric changes to the PAYG system effective January 2010 are welcome but insufficient.
  - Further changes should better link contributions to benefits and increase the effective retirement age:
    - Example measures: move forward to 2020 the increase in the statutory retirement age to 65 and reduce the period for early retirement back to 3 years.
  - Consideration over the medium term of a fully funded second-pillar private pension scheme and prefunding additional reserves to finance future PAYG deficits or transition deficits.
- Health care:
  - User fees introduced in 2008 were a first step and could be means-tested.
  - Recommend establishing a broadly representative working group to lead reforms focused on:
    - Institutional reform—reduce broad coverage of publicly provided and insured services, allow greater scope for private provision, and introduce more competition among insurers and providers.
    - Financing reform—introduce voluntary insurance, personal health accounts, and choices in health benefit plans to ensure long-term financial sustainability.

### Structural reforms and growth
- Crisis likely to have long-lasting adverse effects: collapse in investment and slowdown in total factor productivity reduced growth in 2009–10.
- Growth unlikely to reach pre-crisis levels due to abating convergence, worsening demographics, and global uncertainties.
- Priority structural reforms to boost productivity and labor participation and attract FDI:
  - Promote work incentives through tax-benefit changes.
  - Improve labor market flexibility and education quality.
  - Reduce barriers to business entry and exit.

### Capital markets and public debt management
- Domestic bond markets and capital markets remain underdeveloped and inefficient:
  - Trading remains thin due to opaqueness of public debt management.
  - Capital market development hampered by poorly-targeted subsidies and tax exemptions on certain savings products and outdated private pension fund regulations.
- Recommendations to support market functioning:
  - Enhance transparency of the government bond market, for example by adhering to announced bond issuance sizes to enable accurate pricing.
  - Rationalize subsidies and tax exemptions for deposits in building societies and contributions in voluntary third-pillar pension funds.
  - Improve regulation regarding the third-pillar pension funds.

### Banking sector soundness and supervision
- Credit quality pressures:
  - Nonperforming loans expected to rise, pressuring profitability.
  - High single-borrower concentration in the corporate sector and commercial real estate exposure require vigilance.
- Banks’ strengths:
  - Soundness, low loan-to-deposit ratio, and parent banks' commitment bode well for resumption of lending as outlook improves.
- Supervisory framework:
  - Sound framework further strengthened by widening remedial measures.
  - Important deposit insurance reforms are pending in parliament.
  - Need to review timeliness and periodicity of information sharing between CNB and Deposit Insurance Fund given shortening of pay-off period.
  - CNB should continue efforts to:
    - Improve macro-prudential analysis by accounting for liquidity, market, and credit risk interactions.
    - Enhance integration between macro-prudential analysis and supervision activity.
- Cross-border coordination:
  - With virtually complete foreign ownership of banks, intensive supervisory coordination with cross-border authorities remains crucial.

### Administrative and procedural recommendation
- It is recommended that the next Article IV consultations take place on a standard 12-month cycle.

### Authorities’ views (summary)
- Broad agreement with staff on crisis impact, recovery prospects, need for fiscal adjustment and structural reforms, monetary strategy, and financial sector assessment.
- Differences with staff on:
  - Specific medium-term fiscal consolidation strategy feasibility.
  - Feasibility of proposed pension and health reforms.
  - Pace and scope of measures to address capital market impediments.
- Fiscal consolidation:
  - Authorities cited lack of broad political consensus and doubted near-term support for VAT unification and property tax.
  - They see merit in an options-based Exit Strategy document to inform the incoming government.
- Pensions and health:
  - Authorities acknowledged demographic challenges and welcomed parametric pension changes but questioned feasibility of larger reserve accumulation or further privatization revenues.
  - Supported a complementary fully-funded second pillar but worried voluntary opt-outs would disproportionately involve wealthier individuals.
- Capital markets and financial system:
  - Authorities agreed on imperfect government bond market functioning and the distorting effects of subsidies and tax exemptions, but emphasized political constraints on abrupt removal.
  - Amendments to private pension fund law are pending in Parliament; approval is uncertain.
- CNB views:
  - Agreed high single-borrower concentration and CRE exposure warrant monitoring but were not viewed as immediate acute concern.
- Information sharing:
  - Authorities agreed on the need to review information sharing between CNB and DIF given shorter depositor pay-off periods.

*Source: IMF staff report content (Selected Economic Indicators, 2005–10).*

### 27.      While supporting closer cooperation and collaboration among home/host supervisors,

### _cr1060 - 27.      While supporting closer cooperation and collaboration among home/host supervisors,

### Home/host supervision and EU-wide resolution concerns
- Authorities supported closer cooperation and collaboration among home/host supervisors.
- Authorities expressed concerns about an EU-wide cross-border bank crisis and resolution framework because fiscal responsibilities remain at national levels.
- Harmonization of national insolvency and commercial laws would be required for an EU-wide framework.

### Real economy: growth, demand, and prices (2005–11)
- Real GDP (change in percent): 6.3; 6.8; 6.1; 2.5; -4.3; 1.7; 2.6 (2005–2011, Est./Proj. as in Table 1)
- Domestic demand (change in percent): 1.3; 5.5; 5.2; 1.1; -5.3; 0.6; 2.1
- CPI (year average): 1.9; 2.5; 2.8; 6.3; 1.0; 1.6; 2.0
- PPI (year average): 3.1; 1.5; 4.1; 4.5; -3.1; n.a.; n.a.
- Unemployment rate (in percent), Survey-based 1/: 7.9; 7.1; 5.3; 4.4; 7.2; 8.8; 8.5
- Unemployment rate (in percent), Registered 1/: 8.9; 8.1; 6.6; 5.4; 8.2; 9.9; 9.6
- Gross national savings (percent of GDP): 24.4; 24.4; 23.8; 22.2; 20.9; 21.0; 20.3
- Gross domestic investments (percent of GDP): 25.7; 26.8; 27.0; 25.3; 23.0; 22.7; 22.7

### Public finance and fiscal balances (percent of GDP, ESA-95 basis)
- General government revenue: 41.4; 41.1; 41.9; 40.9; 38.8; 40.7; 40.8
- General government expenditure: 45.0; 43.7; 42.5; 42.9; 44.8; 45.8; 46.1
- Net lending / Overall balance: -3.6; -2.6; -0.7; -2.0; -6.0; -5.1; -5.3
- General government debt: 29.7; 29.6; 29.0; 30.0; 34.2; 37.9; 40.5
- Primary balance (memo): -2.4; -1.5; 0.5; -1.0; -4.8; -3.4; -3.3
- Cyclically adjusted primary balance (staff estimates): -2.4; -1.6; -0.1; -1.4; -3.3; -2.0; -2.2

### Money, credit, and interest rates
- Broad money (end of year, percent change): 8.0; 9.9; 13.2; 6.6; 4.3; 4.0; n.a.
- Private sector credit (percent change, eop): 20.8; 21.6; 27.3; 16.0; 2.8; 1.5; n.a.
- Three-month interbank rate (year average): 2.0; 2.3; 3.1; 4.0; 2.2; n.a.; n.a.
- Ten-year government bond (year average): 3.5; 3.8; 4.3; 4.6; 4.7; n.a.; n.a.

### External sector: trade, current account, reserves (2005–11)
- Trade balance (percent of GDP): 2.0; 2.0; 3.4; 2.8; 2.9; 2.9; 3.3
- Current account (percent of GDP): -1.3; -2.4; -3.2; -3.1; -2.1; -1.7; -2.4
- Gross international reserves (US$ billion): 29.6; 31.5; 34.9; 37.0; 42.7; 45.9; 47.5
- Reserve cover (months of imports): 4.4; 3.5; 3.0; 3.0; 4.3; 4.3; 4.1
- Nominal effective exchange rate, pa (2000=100): 125.3; 131.7; 135.4; 142.5; 149.5; n.a.; n.a.
- Real effective exchange rate, pa (CPI-based; 2000=100): 125.5; 132.6; 136.8; 148.8; 155.1; n.a.; n.a.

### Balance of payments (millions of U.S. dollars, 2005–11)
- Current account balance: -1,578; -3,558; -5,747; -6,642; -4,122; -3,384; -4,849
- Trade balance (exports minus imports): 2,522; 2,843; 5,909; 6,367; 5,745; 5,830; 6,825
- Exports: 77,973; 95,147; 122,697; 145,749; 108,940; 116,937; 126,564
- Imports: 75,451; 92,304; 116,788; 139,382; 103,196; 111,107; 119,740
- Net factor income: -5,975; -7,486; -12,735; -17,285; -12,411; -10,246; -11,830
- Financial account balance: 6,379; 4,204; 6,382; 8,973; 4,122; 3,384; 4,849
- Direct investment, net: 11,630; 4,043; 8,955; 8,972; 1,735; 2,425; 3,764
- Change in reserves 1/: -3,879; -92; -868; -2,419; -2,639; -1,590; -1,743

### Fiscal composition (consolidated general government, percent of GDP, 2005–11)
- Total revenue: 41.4; 41.1; 41.9; 40.9; 38.8; 40.7; 40.8
  - Current taxes on income, wealth, etc: 9.2; 9.2; 9.4; 8.6; 7.3; 6.9; 6.9
    - Personal income tax: 4.6; 4.2; 4.3; 4.0; 3.4; 3.4; 3.4
    - Corporate Income Tax: 4.5; 4.8; 5.0; 4.4; 3.9; 3.4; 3.4
  - Social contributions: 16.2; 16.3; 16.3; 16.2; 15.0; 15.8; 15.8
  - Taxes on production and imports: 11.5; 10.9; 11.2; 11.0; 10.9; 12.2; 12.1
    - VAT: 7.1; 6.5; 6.4; 6.9; 6.8; 7.3; 7.3
    - Excise: 3.7; 3.8; 4.0; 3.4; 3.4; 4.1; 4.1
- Total expenditure: 45.0; 43.7; 42.5; 42.9; 44.8; 45.8; 46.1
  - Final consumption expenditure: 22.1; 21.3; 20.3; 20.4; 21.2; 21.0; 20.6
  - Social benefits other than social transfers in kind: 12.6; 12.6; 12.8; 12.8; 13.6; 13.9; 14.0
  - Interest: 1.2; 1.1; 1.1; 1.1; 1.2; 1.7; 2.1
  - Gross fixed capital formation: 4.9; 5.0; 4.7; 5.0; 5.0; 5.5; 5.7
- Change in debt (percent of GDP): 1.3; 2.0; 2.1; 2.2; 5.2; 5.9; 5.6
- Total adjustment (cash-accrual, valuation, discrepancies): 1.3; 0.5; 0.9; 0.6; 0.0; 0.5; 0.4

### Selected vulnerability indicators and macro environment (2003–09, latest observations)
- Real GDP growth (in percent), Latest/Proj: 3.6; 4.5; 6.3; 6.8; 6.1; 2.5; -4.3 (Proj)
- CPI inflation (period average): 0.1; 2.8; 1.9; 2.5; 2.8; 6.3; 1.0 (Proj)
- Short-term (ST) interest rate (PRIBOR, average): 2/ 2.1; 2.6; 2.2; 2.6; 3.1; 4.0; 1.5 (Dec-09)
- EMBI secondary market spread (bps, end of period): ...; 14.7; 14.2; 19.8; 28.5; 185.3; 83.4 (Nov-09)
- Exchange rate NC/US$ (end of period): 25.7; 22.4; 24.6; 20.9; 18.1; 19.3; 18.4 (Dec-09)
- Net FDI inflows (percent of GDP): 2.1; 3.6; 9.4; 2.8; 5.1; 4.1; 0.9 (Proj)
- Exports (percentage change of US$ value, GNFS): 24.0; 35.7; 17.1; 21.2; 28.0; 19.6; -22.4 (Proj)
- Gross international reserves (GIR) in US$ billion: 27.0; 28.4; 29.6; 31.5; 34.9; 37.0; 42.7 (Proj)
- Total gross external debt (in percent of GDP): 38.2; 41.3; 37.3; 40.1; 43.6; 37.2; 41.9 (Proj)
- Public sector overall balance (percent of GDP): -6.6; -2.9; -3.6; -2.6; -0.7; -2.0; -6.0 (Proj)
- Financial sector: Capital adequacy ratio (in percent): 14.5; 12.5; 11.9; 11.5; 11.5; 12.3; 13.7 (Sep-09)
- NPLs in percent of total loans: 4.9; 4.0; 3.9; 3.7; 2.8; 3.3; 5.0 (Sep-09)

### Medium-term macro scenario and projections (2005–15)
- Real GDP growth (percent, projections): 2009: -4.3; 2010: 1.7; 2011: 2.6; 2012–2015: 3.5 each year (Table 5)
- CPI inflation (percent): 2009: 1.0; 2010: 1.6; 2011: 2.0; 2012–2015: 2.0 each year
- Gross domestic savings (percent of GDP) projected to rise from 20.9 (2009) to 22.4 (2015)
- General government debt projected to rise from 34.2 (2009) to 50.3 (2015)
- Current account balance (percent of GDP) projected: 2009: -2.1; 2010: -1.7; 2011: -2.4; 2012: -2.7; 2013: -3.0; 2014: -2.6; 2015: -2.5

### External debt sustainability (2005–15)
- Baseline external debt (in percent of GDP): 37.3; 40.1; 43.6; 37.2; 41.9; 45.2; 46.2; 48.1; 48.6; 48.3; 47.9
- Change in external debt: -4.0; 2.8; 3.6; -6.4; 4.7; 3.3; 1.0; 1.9; 0.5; -0.3; -0.4
- External debt-to-exports ratio (in percent): 51.8; 52.4; 54.4; 47.9; 63.5; 65.0; 64.3; 61.6; 58.1; 54.4; 50.9
- Gross external financing need (in US$ billion): 25.2; 25.8; 24.9; 36.3; 36.9; 35.4; 38.1; 41.0; 44.2; 46.3; 49.1
- Debt-stabilizing non-interest current account: -2.0 (Table 6 memo)

### Public sector debt sustainability (2005–15)
- Public sector debt (percent of GDP), baseline: 29.7; 29.4; 29.0; 30.0; 34.2; 37.9; 40.5; 44.1; 46.7; 48.6; 50.3
- Change in public sector debt: -0.4; -0.2; -0.5; 1.0; 4.2; 3.7; 2.6; 3.6; 2.6; 1.9; 1.7
- Identified debt-creating flows (percent of GDP): -1.8; -0.2; -1.1; 1.2; 5.7; 4.2; 2.9; 3.9; 3.0; 2.3; 2.1
- Primary deficit (percent of GDP): 2.4; 1.5; -0.5; 1.0; 4.8; 3.4; 3.3; 3.3; 3.2; 3.2; 3.2
- Primary balance required to stabilize debt (debt-stabilizing primary balance, percent of GDP): -1.2 (Table 7 memo)
- Public sector debt-to-revenue ratio: 71.7; 71.6; 69.1; 73.3; 88.0; 93.1; 99.3; 106.2; 112.3; 116.8; 121.1
- Gross financing need (percent of GDP): 9.3; 9.2; 6.1; 8.9; 13.5; 12.2; 13.7; 14.5; 14.4; 14.8; 15.2
- Gross financing need (in billions of US$): 8.0; 8.5; 6.2; 9.4; 14.4; 13.1; 15.3; 16.5; 17.3; 18.9; 20.7

### Key macroeconomic assumptions underlying projections
- Real GDP growth (percent): historical variability shown; projections follow above series.
- Nominal external interest rate (in percent): e.g., 3.6; 3.7; 4.3; 3.7; 3.4; 4.3; 0.7; 3.4; 3.3; 3.5; 3.6; 3.6; 3.7 (as in Table 6 assumptions)
- Growth of exports (US$ terms, percent): strong historical variation; 2009: -23.1; projected recoveries thereafter.
- Net non-debt creating capital inflows (percent of GDP): historical and projected values shown (e.g., -7.5; -4.3; -5.3; -4.2; -0.2; -0.4; -1.0; -1.1; -1.1; -1.1; -1.0)

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

### 1.      The Czech Republic’s macroeconomic position was very strong prior to the

### _cr1060 - 1.      The Czech Republic’s macroeconomic position was very strong prior to the

### Pre-crisis macroeconomic position and structural strengths
- Growth stood above 6 percent during 2005–07 before slowing in 2008.
- Large foreign direct investment (FDI) inflows fostered trade integration and underpinned an export-led expansion.
- Higher initial standard of living than most other countries in the region contained consumption convergence pressures.
- An improved fiscal performance contributed to the comfortable external position.
- Credible inflation targeting helped maintain low inflation, with the exception of a short-lived spike in 2008 mainly due to supply shocks and one-off tax increases.
- With domestic interest rates lower than in the euro area until recently, private sector borrowing in foreign currency has been quite modest.
- A liquid and conservative banking sector limited the build-up of balance sheet vulnerabilities.

### Impact of the global financial crisis on the real economy (findings)
- Global recession, especially in the main trading partner Germany, depressed Czech output by 4⅓ percent largely through falling exports (which account for almost 80 percent of GDP) and FDI-financed investment.
- Private consumption grew modestly despite rising unemployment, fuelled by low inflation and stable net incomes that benefited from fiscal automatic stabilizers and discretionary measures.
- High frequency indicators point to a recent stabilization of both investment and exports.
- Escalating global risk aversion led to:
  - considerable liquidity tightening in the Czech interbank market,
  - a slowdown in trading activity in the government bond market,
  - rising funding costs,
  - currency depreciation,
  - more stringent credit conditions.
- Overall market sentiment has largely recovered since the initial turmoil.
- Risks in the banking system were contained, allowing the economy to tide over an extended political gridlock and the global market turmoil with relatively low banking and exchange rate losses.

### Banking sector resilience and reasons for lower vulnerabilities (Box 1)
- The Czech Republic differed from many CEE peers where booms were fuelled by buoyant credit growth often denominated in foreign currency.
- Explanatory factors:
  - Higher initial income in the early 1990s → lower convergence pressures and lower borrowing and lower external current account deficits relative to Poland and Hungary.
  - Low-inflation and low-interest environment; no history of hyperinflation; early shift to inflation targeting increased monetary credibility.
  - Persistent currency appreciation helped achieve a low level of inflation rapidly.
  - Fiscal prudence with low deficit and public debt burden.
  - Supply-side shocks and expansion of low-cost, high-efficiency retail sector during 1997-2005 lowered distribution margins.
  - Resulting negative interest spreads vis-à-vis the euro area and households’ risk-averse attitudes made foreign currency borrowing less attractive.
  - Banking sector characteristics: high liquidity buffers, conservative retail-oriented business model, funded domestically, low loan-to-deposit ratio.
  - Historical bank restructuring in the late 1990s removed bad assets and preserved the depositor base.
  - Large capital inflows in the 1990s were partially absorbed by the CNB through regular open-market operations.
  - Government incentives to save and conservative household behavior helped establish a sound deposit base.
  - Banks maintained a relatively low risk-weighted-to-total asset ratio.

### Real economy indicators and labor market (Figure 2 summary)
- The economy started slowing dramatically at end-2008 and fell into recession in the first half of 2009 as investment and exports fell sharply.
- Consumption held up due to still positive real wage growth.
- Labor markets deteriorated sharply and capacity utilization reached a historical low.
- Industrial production, retail sales, and goods exports showed significant declines through 2009.

### Inflation and monetary policy response
- Against the CNB target of 3 percent (+/-1 percentage point band), both headline and core inflation fell sharply in 2009 due to weakening domestic demand and falling commodity prices; lagged appreciation effects turned inflation negative in October 2009 before disinflation reversed in late 2009.
- The CNB gradually cut the policy rate by a total of 275 basis points starting in 2008, combined with occasional well-timed verbal interventions.
- The traditional monetary transmission mechanism weakened; market rates have been less responsive and retail lending rates did not fully follow policy rate declines, especially for the household sector.
- The CNB considered alternative options for further monetary easing if conventional measures proved insufficient; direct foreign exchange interventions were seen as the most viable alternative monetary policy option, should the need arise.

### Credit developments
- Total private sector credit growth slowed to 1½ percent year-on-year in November from 23 percent the year before, mainly due to a contraction of corporate credit.
- The decline in corporate credit reflects unfavorable investment sentiment and tighter credit conditions.
- Household credit continued double-digit growth but slowed due to uncertainty about future household income.
- Mortgage lending performed relatively well; nonperforming loans of nonfinancial corporations were rising faster owing to declining economic activity.

### Asset prices and financial markets (Figure 3 summary)
- Real housing prices declined by 10 percent in the first half of 2009 but have since stabilized.
- Equity markets fell sharply through March 2009 and partly recovered later; less than 4 percent of households own stocks directly, so negative wealth effects from equities are small.
- The koruna became temporarily a high return currency due to near-zero rates in the US and unwinding of previous positions, contributing to its strengthening in mid-2009; since late 2009 the koruna was again used as a funding currency towards higher-yield neighboring countries.
- Tightness in money markets started to ease as evidenced by a declining PRIBOR, although term structure spreads remained high.
- Financial entities and the government continued to issue bonds in foreign currency over the last year.

### External position and competitiveness
- The drop in exports was accompanied by an even larger fall in imports, improving the trade balance despite the real appreciation.
- Lower dividend payments reduced the current account deficit.
- FDI inflows more than halved and no longer fully finance the current account; rising inflow of EU funds helped fill the gap.
- Other investments declined as bank subsidiaries repaid loans to parents abroad, though flows reversed somewhat in the second half of the year.
- Portfolio investment increased reflecting government issuance of the Eurobond.
- International reserves rose slightly to $41 billion (about 4 months of imports), partly due to the SDR allocation.
- External debt was modest at 37 percent of GDP at end-2008.
- Staff believes the koruna has remained broadly in line with fundamentals as indicated by three CGER methodologies.
- REER depreciated about 11 percent on the back of the crisis; trends started to reverse in Q2 2009 as market sentiment improved.
- After significant weakening in 2008, export profitability improved but then deteriorated in part due to exporters’ over-hedging.

### Fiscal anti-crisis measures (selected fiscal impact in 2009, percent of GDP)
- Total impact on overall deficit: -2.0
  - (+) Revenue cuts: -1.5
    - Social security contributions (including the 2007 Reform): -1.0
    - Decrease in the CIT rate (from 2007 reform): -0.2
    - Broadening of the VAT deductions on personal vehicles: -0.1
    - Other measures: -0.3
  - (-) Expenditure increases: 0.6
    - Traffic infrastructure: 0.2
    - Provision of transport services: 0.1
    - Guarantees and support of SMEs: 0.1
    - Increase in public sector wages (net impact): 0.1
    - Support of agriculture entrepreneurs: 0.1
    - R&D and fiscal impact of R&D spending: 0.1
    - Other measures: 0.1

*IMF staff report content as provided.*

### 8.      The fiscal position has

### 8.      The fiscal position has

### Fiscal deterioration and 2009 outcomes
- The overall deficit increased by 4 percentage points to 6.0 percent of GDP in 2009.
- More than half of the widening reflected discretionary measures, including those from the 2009 Anti-Crisis Package and the impact of the 2007 reforms, which reduced CIT and social contributions rates.
- Revenue and expenditure indicators (percent of GDP):
  - Revenues: 41.9 (2007 Staff), 40.9 (2008 Auth.), 38.8 (2008 Staff), 39.5 (2009)
  - Expenditures: 42.5 (2007 Staff), 42.9 (2008 Auth.), 44.8 (2008 Staff), 46.0 (2009)
  - Overall Balance: -0.7 (2007 Staff), -2.0 (2008 Auth.), -6.0 (2008 Staff), -6.6 (2009)
  - Structural Balance (Cyclically-Adjusted Primary Balance in percent of potential GDP): -0.1 (2007 Staff), -1.4 (2008 Auth.), -3.3 (2008 Staff), -4.4 (2009)
  - Primary Budget Balance: 0.5 (2007 Staff), -1.0 (2008 Auth.), -4.8 (2008 Staff), -5.3 (2009)
- Changes contributing to primary balance deterioration (percent of GDP):
  - Change in Primary Balance: -1.5 (2007), -3.8 (2008), -4.3 (2009)
  - (+) Automatic Stabilizers: -0.1 (2007), -2.0 (2008), -1.4 (2009)
  - (+) Change in Structural (= - Fiscal Stimulus): 1.3 (2007), 1.8 (2008), 2.9 (2009)
  - 2007 Reform Package effect: 0.6
  - (+) Revenue Measures (2007 package): 0.0
  - (-) Expenditure Measures (2007 package): -0.5

### Macroeconomic outlook: gradual recovery with risks
- Staff projects GDP growth of 1.7 percent of GDP in 2010 driven by pickup in foreign demand (especially Germany).
- Expected weak components:
  - Fixed capital formation and corporate credit growth projected to remain depressed.
  - Consumer spending expected to suffer due to declining disposable income from rising unemployment, low wage growth, and withdrawal of fiscal stimulus.
- Short-term risks:
  - Downside: weaker-than-projected export markets; prolonged global financial market strains; temporary loss of momentum after inventories rebuilt and car scrapping bonuses expire.
  - Upside: faster-than-projected global recovery.
- Long-term outlook:
  - Potential growth severely curtailed by crisis: collapse in investment and slowdown in total factor productivity reduced growth rate in 2009–10.
  - Growth not expected to reach pre-crisis levels due to abating convergence, worsening demographic trends, and global growth uncertainties.
- Structural reform needs to boost potential output and competitiveness, focusing on increasing labor participation, productivity, labor market flexibility, higher education and R&D efficiency, and improving business climate to attract FDI.

### Fiscal outlook and projections without consolidation
- Staff projects that without consolidation measures:
  - The deficit would remain above 5 percent of GDP over the medium term.
  - Public debt rising to 48 percent of GDP by 2014.
- ECOFIN-mandated deficit target: below 3 percent of GDP by 2013.
  - Staff calculation: achieving this target will require a structural adjustment of at least 0.7 percent of GDP per year, starting in 2011.
  - This adjustment alone will not ensure long-term debt sustainability given aging-related spending pressures.
- Fiscal projections, Revenues and Expenditures (percent of GDP), 2008–2015:
  - Revenues: 40.9 (2008), 38.8 (2009), 40.7 (2010), 40.8 (2011), 41.5 (2012), 41.6 (2013), 41.6 (2014), 41.5 (2015)
  - Expenditures: 42.9 (2008), 44.8 (2009), 45.8 (2010), 46.1 (2011), 47.0 (2012), 46.8 (2013), 46.8 (2014), 46.8 (2015)
  - Interest Expenditures (o/w): 1.1 (2008), 1.2 (2009), 1.7 (2010), 2.1 (2011), 2.1 (2012), 2.1 (2013), 2.1 (2014)
  - Overall Balance: -2.0 (2008), -6.0 (2009), -5.1 (2010), -5.3 (2011), -5.5 (2012), -5.2 (2013), -5.3 (2014), -5.3 (2015)
  - Structural Balance (Cyclically-Adjusted Primary Balance): -1.4 (2008), -3.3 (2009), -2.0 (2010), -2.2 (2011), -2.5 (2012), -2.7 (2013), -2.9 (2014), -3.2 (2015)
  - Primary Budget Balance: -1.0 (2008), -4.8 (2009), -3.4 (2010), -3.3 (2011), -3.5 (2012), -3.2 (2013), -3.2 (2014), -3.2 (2015)

### 2010 budget and austerity measures
- Without policy change, unchanged policies would lead to deficit widening to over 7 percent of GDP.
- The 2010 budget relies on permanent tax increases and temporary expenditure cuts.
  - Staff projects these measures will lead to a structural improvement of 1.2 percent of GDP.
- 2010 Austerity Measures (fiscal impact in 2010, compared to unchanged 2009 policies, percent of GDP):
  - Total: 2 .1
  - (+) Revenue Increases: 1.8
    - An increase in VAT by 1 pp in both rates: 0.5
    - An increase in excise taxes: 0.3
    - An increase in the real estate tax: 0.1
    - Income tax and Social security contributions: 0.9
  - (+) Expenditure Cuts: 0.3
    - Social security contributions: -0.1
    - Lower sick leave and maternity-leave benefits: 0.1
    - Wage bill savings: 0.1
    - A pension freeze in 2010: 0.2

### Policy assessment and recommended consolidation strategy
- Assessment:
  - The 2010 budget balances preserving fiscal sustainability and supporting recovery.
  - Given low fiscal multipliers in a highly open economy, additional fiscal stimulus would have limited effect.
  - Poorly-targeted spending initiatives (e.g., 13th month pension) should be resisted due to likely higher imports and limited domestic stimulus.
  - Starting fiscal consolidation can lower borrowing costs and crowd in private investment.
- Recommendations for 2011–13 consolidation:
  - The incoming government must propose a credible and durable consolidation plan with broad social and political support.
  - International experience: expenditure-based consolidations tend to be more durable.
  - In the Czech Republic, medium-term adjustment should cover expenditure measures, particularly reducing high mandatory spending (about 70 percent of total).
  - There is scope to raise revenues and improve tax efficiency; emphasis should be on indirect taxes as direct taxation restrains growth more.
- Staff-proposed measures:
  - Expenditure measures:
    - Rationalize mandatory expenditures and the generous welfare system.
    - Re-organize public institutions and positions to reduce overall wage bill without reducing wage levels.
    - Introduce means testing to improve targeting of social benefits, yield savings, and enhance work incentives.
    - Improve efficiency of public services delivery and public procurement.
  - Revenue measures:
    - Expand the tax base by eliminating exemptions and loopholes.
    - Unify VAT rates at the higher rate and replace across-the-board subsidization with direct means-tested cash subsidies where appropriate.
    - Taxation of real estate property should be based on market values (current revenue about one fifth of the OECD average).
    - Revisit combination of social security and personal income taxation that results in low work incentives for low and middle incomes.
    - Consider whether the current corporate income tax rate (below OECD average) should be reconsidered.
    - Improve tax administration to enhance revenue collection efficiency.

### Long-term fiscal pressures: aging, pensions, and health care
- Demographic projections and fiscal impact:
  - The old-age dependency ratio is set to triple to 61 percent over the next 50 years.
  - The elderly projected to account for one third of the population in 2060 compared with 14 percent in 2007.
  - Total age-related public spending projected to increase by close to 6 percentage points of GDP over the next 50 years, reaching 23½ percent of GDP by 2060.
  - Aging will have a bigger fiscal impact on the Czech economy than on its neighbors.
- Pension reform priorities:
  - Near-term parametric changes effective January 2010 include:
    - Gradual increase in retirement age to 65 by 2030.
    - Gradual lengthening of required insurance period from 25 to 35 years of work.
    - Further reduction in old-age pensions when retiring early.
    - Tightening criteria for disability pensions.
    - Gradual extension of the period for early retirement from 3 to 5 years (noted as having a negative impact on effective retirement age).
  - Further recommended near-term and medium-term measures:
    - Better link contributions to benefits.
    - Move forward introduction of the increase in retirement age to 65 to year 2020.
    - Reduce period for early retirement back to 3 years.
    - Consider moving to a fully funded second-pillar private pension scheme.
    - Consider additional prefunding of reserves to finance future PAYG deficits or transition deficits if moving toward private funds, financed through upfront fiscal consolidation measures or privatization revenues.
- Health care reforms:
  - User fees introduced in 2008 were a first step; they could be made means tested.
  - Need institutional and financing reforms to enhance efficiency and ensure long-term sustainability.
  - Reforms could build on the 2006–08 government proposal:
    - Reduce broad coverage of publicly provided and insured services.
    - Allow greater scope for private sector provision and more competition among insurers and providers.
    - Introduce voluntary insurance, personal health accounts, and choices in health benefits plans.
  - Recommendation to establish a broadly representative working group to lead complex reform efforts.

### Monetary policy stance and euro adoption
- Monetary policy:
  - Supportive stance appropriate for now but should shift to tightening as recovery gathers momentum.
  - Recently-approved VAT and excise hikes expected to push average headline inflation to over 1½ percent in 2010, still below the new inflation target of 2 percent (effective January 2010).
  - Fiscal package will somewhat contain domestic demand and suppress monetary-relevant inflation; second-round effects of indirect tax increases expected to be negligible given surplus capacity.
  - Easing cycle appears to have ended; policy should switch to tightening as recovery strengthens.
- Euro adoption:
  - No target date set. Announcement scheduled for November 1, 2009 was postponed until after spring 2010 elections.
  - Polls among domestic analysts: majority believe 2015 is the earliest realistic target date for euro adoption.

*Source: Ministry of Finance and IMF staff estimates; IMF staff analysis as presented in the provided content.*

### 21.      The Czech banking sector has so far weathered the global financial turmoil

### 21.      The Czech banking sector has so far weathered the global financial turmoil

### Resilience and funding structure
- Czech banks have weathered the global financial turmoil relatively well due to healthy capital and liquidity buffers, strong retail funding, and limited exposure to foreign currency risk.
- Banks are mainly foreign owned and follow a traditional retail-oriented business model with virtually no exposure to opaque structured products.
- Solvency and leverage ratios have been broadly in line with peers.
- Funding is mainly through domestic retail deposits; loan-to-deposit ratio is well below 100 percent.
- Share of lending in foreign exchange is minimal:
  - As of end-2008, the share of foreign currency loans was virtually zero for bank lending to households and stood at around 18 percent for nonfinancial corporations.
- These factors have made Czech banks less vulnerable to upheavals in foreign parents’ financial conditions and to global market volatility; contagion risks from regional shocks appear limited.

### Crisis response and policy measures
- The authorities did not implement bank recapitalization or other exceptional measures to shore up financial sector stability.
- Measures taken to support financial sector confidence were fairly limited:
  - Deposit insurance limit was raised to €50,000.
  - The CNB widened the range of liquidity-providing operations and strengthened monitoring of banks’ liquidity positions.
- During the crisis, foreign banks reduced exposure toward Czech banks, partially matched by a decline in Czech banks’ external assets; this trend reverted in Q2 2009, leaving no material shift in foreign banks’ net external position vis-à-vis Czech banks.
- CNB liquidity indicator:
  - Ratio of quick assets to total assets was 26.5 percent as of end-September 2009; it was 23 percent at the end of 2008.

### Local bond and capital markets — shortcomings and recommended reforms
- Local bond markets are not functioning efficiently and capital markets remain underdeveloped; trading remains thin despite CNB steps to improve liquidity due to opaqueness of public debt management.
- Capital market development is hampered by:
  - Poorly-targeted subsidies and tax exemptions on certain savings products,
  - Old regulations regarding private pension funds.
- Recommended measures to support market functioning:
  - Enhance transparency of the government bond market (for example, adhere to announced size of bond issuances to enable accurate pricing by dealers).
  - Rationalize subsidies and tax exemptions for deposits in building societies and contributions in voluntary third-pillar pension funds.
  - Improve regulation regarding the third-pillar pension funds.

### Asset quality, profitability, and provisioning
- The economic downturn and rising unemployment have led to deterioration in loan portfolio quality, particularly corporate loans.
- In early 2009, drops in trade flows and exchange rate weakening affected export-oriented firms; some firms were over-hedged.
- Banks tightened lending standards, restructured hedging for over-hedged firms, and reduced risk profiles of assets.
- As of end-September 2009:
  - Banks’ net operating income still showed positive growth but was partially offset by increasing provisioning on nonperforming loans (NPLs), which have reached almost 5 percent of total loans.
  - Coverage provided by loan loss provisions declined to about 60 percent from 70 percent at end–2007, mainly due to composition factors.
  - Return on equities has declined by less than 2 percent.
- Off-balance-sheet exposure:
  - Derivative instruments are mainly used for hedging exchange and interest rate risk rather than for speculative purposes; risks associated with off-balance-sheet operations remain limited.

### Nonbank financial institutions
- In 2008, insurance companies and pension funds suffered significant losses due to bond and equity market declines and fund withdrawals; partial recuperation occurred in 2009.
- In response:
  - Pension funds were recapitalized by their shareholders.
  - In 2009 accounting rules for pension funds and insurance companies were amended to allow valuing as hold-to-maturity government-bond holdings up to 30 percent of portfolios instead of mark-to-market.
  - Regulation on pension fund capital was tightened.
- Mutual funds experienced sizeable net redemptions in 2008 and early 2009; recent equity and bond market rebounds helped partial recovery.

### Outlook and supervisory recommendations
- Credit quality is the key challenge going forward and will put bank profitability under pressure:
  - Bank lending to the corporate sector is expected to remain depressed.
  - Retail credit growth is likely to slow owing to rising unemployment.
  - NPLs are expected to increase, though contained private sector debt levels and low interest rates may mitigate.
  - Lower revenues, higher provisioning, and reduced risk tolerance will pressure profitability.
- Positive factors supporting future lending capacity:
  - Czech banks display healthy capital buffers which the CNB estimates to be sufficient to withstand stress scenarios.
  - Parent banks have shown commitment to the market; some have raised fresh capital or are disengaging from public support.
  - Low loan-to-deposit ratio provides room for new lending, subject to deposit-generating capacity.
- Policy and supervisory actions recommended for the CNB:
  - Continue monitoring high single-borrower concentration in the corporate sector and commercial real estate exposure, and developments in banks’ profitability to preserve adequate capital buffers and liquidity positions.
  - Further improve macro-prudential analysis by taking into account interaction among liquidity, market, and credit risk.
  - Enhance integration between macro-prudential analysis and supervisory activity.
  - Further improve deposit insurance and bank resolution techniques:
    - Review Act on Banks provisions for the Deposit Insurance Fund (DIF) to shorten pay-out period, establish a target for DIF resources, temporarily increase credit institutions’ contributions, and consider potential recourse to state budget assistance if DIF cannot borrow from the market.
    - Ensure DIF access to timely and accurate information on insured deposits; review information sharing between CNB and DIF.
    - Consider envisaging potential use of DIF resources in carrying out “assisted” purchase-and-assumption (P&A) transactions provided the “least-cost-solution” principle is satisfied.
  - Leverage ongoing revision of the EU financial sector supervisory framework to strengthen liaison with home-country supervisors and contribute to a strong cross-border resolution framework.

### Legal and institutional updates
- A recent amendment to the Act on Banks, effective September 2009:
  - Allows creation of a bridge bank (which can be fully owned by the state) to take over ailing credit institutions.
  - Entrusts the special administrator of a bank in conservatorship with powers to carry out purchase-and-assumption (P&A) transactions.
  - Streamlines procedures for increasing a bank’s capital.
  - Strengthens CNB oversight powers on banks’ liquidity and enables the CNB to temporarily prohibit or restrict some banking activities across-the-board, including branches of foreign banks, if the stability of the banking and financial system as a whole is in jeopardy.
- Deposit insurance payout timing under EU Directive revision:
  - Payout delay is to be reduced to twenty working days; this period can be extended by additional ten days only under exceptional circumstances.

*Source: INTERNATIONAL MONETARY FUND — Staff Report for the 2010 Article IV Consultation—Informational Annex (February 5, 2010), section “The Czech banking sector has so far weathered the global financial turmoil.”*

### Appendix I. Czech Republic: Fund Relations

### Appendix I. Czech Republic: Fund Relations (As of December 31, 2009; unless specified otherwise)

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

### II. General Resources Account (SDR Million)
- Quota: 819.30 (100.0 percent)
- Fund holdings of currency: 665.33 (81.21 percent)
- Reserve position in Fund: 153.98 (18.79 percent)

### III. SDR Department (SDR Million)
- Net cumulative allocation: 780.20 (100.00 percent)
- Holdings: 794.44 (101.83 percent)

### 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 and External Payments Regime
- Currency: Czech koruna, created on February 8, 1993.
- Historical regime:
  - From May 3, 1993, to May 27, 1997: pegged to basket of two currencies: deutsche mark (65 percent) and U.S. dollar (35 percent).
  - On February 28, 1996: exchange rate band widened from ±0.5 percent to ±7.5 percent around central rate.
  - On May 27, 1997: managed floating introduced.
- De facto regime classification: free float (per Annual Report on Exchange Arrangements and Exchange Restrictions).
- 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 rate as of December 31, 2009: CZK 18.368 per U.S. dollar.
- Current international payments stance:
  - Accepted obligations of Article VIII; maintains exchange system free of restrictions on payments and transfers for current international transactions.
  - 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).

### VIII. Last Article IV Consultation
- 2008 Article IV consultation concluded on February 6, 2009.
- Staff report and PIN published on April 14, 2009.

### IX. FSAP Participation and ROSCs
- FSAP carried out in late 2000/early 2001.
- Financial System Stability Assessment considered by Executive Board on July 16, 2001.
- ROSCs on: banking supervision; data dissemination; fiscal transparency; securities market; and transparency of monetary and financial policies published on July 1, 2000.

### X. Technical Assistance (Selected 1991–2008 items)
- FAD: Regular visits and follow-up visits on VAT administration and public financial management (Dec. 1991–Sept. 1993; March 1993; September 1993; November 1993; January 1994; July 1994; May 1995; June 1995; June–July 1999; February 2008). Purposes include VAT administration, public financial management, medium-term fiscal framework, evaluation of merger of Tax and Customs Administrations (with the WB).
- MCM: Missions on monetary management, foreign exchange operations, banking supervision, bond issuance, inflation targeting, integrated financial sector supervision, AML/CFT Assessment (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; February 2000; January 2002; November 2002; May–June 2003).
- RES: Inflation targeting technical assistance (September 1999; June–August 2000; March 2001; June—July 2002; February–March 2005; April 2005) (financed by MFD).
- STA: Money and banking statistics, balance of payments, government finance, implementing GFSM 2001, GFSM 2001 Pilot Project (May 1993; February 1994; April 1994; November 1994; January–February 1999; May 2002; February 2003; November 2006).

### XI. HIPC Initiative
- Not Applicable

### XII. Safeguards Assessments
- Not Applicable

### Statistical Issues — Data Provision and Quality
- General adequacy: Data provision adequate for surveillance; Czech Republic subscribed to the Special Data Dissemination Standard in April 1998. Metadata and annual observance reports for 2006–2008 are posted on the Fund’s Dissemination Standards Bulletin Board.
- Timeliness and frequency highlights:
  - 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 one-week lag.
  - Consumer prices, reserve money, broad money, borrowing and lending interest rates, central government fiscal accounts, and foreign trade: monthly with a lag of between one and four weeks.
  - Final monetary survey: lag of about one month.
  - GDP and balance of payments: quarterly with a lag of two to three months.
  - Trade balance: monthly with a two–month lag.
  - Annual Government Finance Statistics Yearbook: covers all operations of general government including extrabudgetary funds excluded from monthly data; annual data available timely.
  - Monthly fiscal data in IFS: state budget accounts; two- to three-month lag.
- Noted data weaknesses and improvements:
  - National accounts: value added in small-scale private sector likely underestimated due to underdeveloped data collection and tax evasion; quarterly estimates for small enterprises (less than 20 employees) improved using administrative social insurance data; large discrepancies between production and expenditure GDP estimates subsumed under change in stocks; quarter-to-quarter swings in some seasonally adjusted series need smoother trend-cycle corrections.
  - External trade: recent revisions to export data processing brought statistics close to EU practice.
  - Monetary survey: large variations in interbank clearing account float, especially year-end, require caution; CNB efforts to identify causes and adjust the data; in 2002 CNB implemented ECB framework for monetary data to meet EU conventions—data harmonized with IFS though presentation differs somewhat.
  - Fiscal statistics: annual fiscal data on ESA-95 basis prepared by Czech Statistical Office; quarterly non-financial accounts compiled and quarterly financial accounts being prepared; Ministry of Finance uses ESA-95 for Convergence Program targets; ESA-95 differs from national fiscal targeting methodology in institutional coverage and inclusion of financial transactions and accrual items; Ministry participated in Fund pilot project transitioning to GFSM 2001.

### Table of Common Indicators Required for Surveillance (As of January 26, 2010) — Selected observations
- Exchange Rates: Latest observation 1/26/10; Date received 1/26/10; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Latest observation Dec. 2009; Date received 1/08/10; Frequency D; Frequency of Reporting M; Frequency of Publication M.
- Reserve/Base Money: Latest observation 12/31/09; Date received 1/14/10; Frequency 10 days; Frequency of Reporting 10 days; Frequency of Publication 10 days.
- Broad Money: Latest observation Nov. 2009; Date received 12/31/09; Frequency M; Frequency of Reporting M; Frequency of Publication M.
- Central Bank Balance Sheet: Latest observation 1/20/10; Date received 1/25/10; Frequency 10 days; Frequency of Reporting 10 days; Frequency of Publication 10 days.
- Consolidated Balance Sheet of the Banking System: Latest observation Nov. 2009; Date received 12/31/09; Frequency M; Frequency of Reporting M; Frequency of Publication M.
- Interest Rates: Latest observation 1/26/10; Date received 1/26/10; Frequency D; Frequency of Reporting D; Frequency of Publication D.
- Consumer Price Index: Latest observation Dec. 2009; Date received 1/11/10; Frequency M; Frequency of Reporting M; Frequency of Publication M.
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Latest observation Dec. 2008; Date received Jan. 2009; Frequency A; Frequency of Reporting A; Frequency of Publication A.
- Revenue, Expenditure, Balance and Composition of Financing – Central Government: Latest observation Nov. 2009; Date received 1/8/10; Frequency M; Frequency of Reporting M; Frequency of Publication M.
- Stocks of Central Government and Central Government-Guaranteed Debt: Latest observation 2009 Q3; Date received Dec. 2009; Frequency Q; Frequency of Reporting Q; Frequency of Publication Q.
- External Current Account Balance: Latest observation 2009 Q3; Date received Dec. 2009; Frequency Q; Frequency of Reporting Q; Frequency of Publication Q.
- Exports and Imports of Goods and Services: Latest observation Nov. 2009; Date received Jan. 2010; Frequency M; Frequency of Reporting M; Frequency of Publication M.
- GDP/GNP: Latest observation 2009 Q3; Date received Dec. 2009; Frequency Q; Frequency of Reporting Q; Frequency of Publication Q.
- Gross External Debt: Latest observation 2009 Q3; Date received Dec. 2009; Frequency Q; Frequency of Reporting Q; Frequency of Publication Q.
- International Investment Position: Latest observation 2009 Q3; Date received Dec 2009; Frequency Q; Frequency of Reporting Q; Frequency of Publication Q.

### Statement by the Staff Representative on the Czech Republic (February 22, 2010) — Key updates
- Recent macro developments:
  - Flash estimates: Czech economy contracted by 4.3 percent in 2009.
  - Unemployment: reached 9.8 percent in January (up from 9.2 percent a month earlier).
  - Inflation: year-on-year CPI increase at 0.7 percent in January (compared to 1 percent in December).
- Monetary policy:
  - CNB kept key policy rate unchanged at 1 percent in its February 4 meeting.
  - CNB Inflation Report expects inflation to remain subdued in first half of the year and to reach the 2 percent target in the first half of 2011.
- Fiscal policy and Convergence Program:
  - On February 8, government approved new Convergence Program aiming to reduce budget deficit to 4.2 percent of GDP in 2012.
  - Program implies an additional adjustment of 1.2 percent of GDP in 2013 to meet ECOFIN-mandated target.
  - Program emphasizes significant reductions in current (particularly mandatory) expenditures; new government must identify specific measures.
  - Program proposes one new revenue measure: introduction of a second PIT rate of 31 percent for incomes exceeding the social security ceiling.
- Financing conditions:
  - Rising euro-zone debt sustainability concerns have led to some increase in interest rates on government debt.
  - Authorities have not encountered financing problems.
  - Average yield at latest bond auction on February 10 was some 40 basis points higher than at previous auction in December 2009.
  - Although overall demand was twice the amount offered at that auction, authorities decided to sell only about 60 percent of the offered bonds.

*Appendix I. Czech Republic: Fund Relations (As of December 31, 2009; unless specified otherwise).*

### 5.      The general elections have been scheduled for May 28–29, 2010.

### 5.      The general elections have been scheduled for May 28–29, 2010.

### Background
- The IMF Executive Board concluded the Article IV consultation with Czech Republic on February 22, 2010.
- Pre-crisis fundamentals were strong, but the economy was hit by spillover effects due to its highly open nature:
  - A downturn in the euro area depressed exports and investment declined due to a drop in FDI and tighter bank lending standards.
- Monetary and fiscal easing cushioned the downturn:
  - Between August 2008 and December 2009 the Czech National Bank cut the policy rate by 275 basis points.
  - Automatic stabilizers and fiscal measures widened the budget deficit by 4 percent of GDP in 2009.
- Real output decline:
  - The real output decline is estimated to be 4⅓ percent in 2009.
- Recovery outlook:
  - GDP projected to grow by 1½ percent in 2010, supported by exports and a buildup of inventories.
  - Fixed capital formation expected to remain depressed; consumer spending expected to decline due to still-rising unemployment, slowdown in wage growth, and unwinding of fiscal stimulus.
  - Adverse effects of the crisis likely to be long lasting; medium-term growth not expected to reach pre-crisis levels.
- Inflation and external position:
  - Tax hikes in the 2010 budget expected to push average headline inflation to over 1½ percent in 2010, but still below the target of 2 percent.
  - External position remains solid; drop in exports accompanied by larger fall in imports, improving the trade balance despite real appreciation.
- Credit and banking:
  - Credit to the economy decelerated dramatically; household credit continued double-digit growth and mortgage lending performed relatively well.
  - Banking sector weathered turmoil relatively well due to healthy capital and liquidity buffers, strong retail funding, and limited foreign currency exposure; no bank recapitalization from public funds was necessary.

### Executive Board Assessment
- Entry to crisis:
  - Czech Republic entered the crisis from a strong macroeconomic position, bolstered by EU integration and sound policies.
- Policy response:
  - Directors viewed monetary and fiscal easing as appropriate.
  - External position robust; real exchange rate in line with fundamentals.
  - Banking sector weathered turmoil without need for recapitalization or exceptional measures.
- Outlook and policy stance:
  - Revival expected to be gradual and dependent on global recovery; supported by exports and inventory buildup.
  - Supportive monetary policy stance appropriate for now, should shift to tightening as recovery gathers momentum.
- Fiscal challenges and recommendations:
  - Main challenge: reverse recent widening of budget deficits sustainably.
  - 2010 budget viewed as appropriately balancing fiscal sustainability and supporting recovery; Directors cautioned against additional spending prior to May general elections.
  - New government needs a credible, durable medium-term fiscal consolidation plan to achieve debt sustainability; plan should draw on the recently approved Convergence Program.
  - Several Directors urged greater focus on expenditure reductions, including improving public service efficiency.
  - Recommendations included cutting expenditures (in particular mandatory spending), expanding the tax base, unifying VAT rates, and improving tax administration.
  - Reconsidering the Corporate Income Tax (CIT) rate was discussed; a number of Directors did not favor raising it.
  - Crucial to tackle longer-term fiscal challenges of pension and health care reforms, requiring broad political consensus.
  - Improved monitoring of budget execution emphasized.
- Structural reforms:
  - Directors called for swift implementation of growth-enhancing structural reforms to increase productivity and labor participation and improve the business climate.
  - Capital markets development hampered by poorly-targeted subsidies, tax exemptions on certain savings products, and old regulations on private pension funds; further measures suggested to support market functioning.
- Banking sector soundness:
  - Further improvements in cost efficiency important as downturn affects profitability; authorities encouraged to monitor developments.
  - Banks' soundness, low loan-to-deposit ratio, and parent banks' commitment bode well for resumption of lending as prospects improve.
  - Support for CNB’s efforts to integrate macro-prudential analysis and supervision; cross-border supervisory coordination crucial given virtually complete foreign ownership of banks.

### Czech Republic: Selected Economic Indicators, 2005–11 (as presented)
- Real economy (change in percent)
  - Real GDP: 2005 6.3; 2006 6.8; 2007 6.1; 2008 2.5; 2009 -4.3; 2010 1.7 (Est. Staff Proj.); 2011 2.6
  - Domestic demand: 2005 1.3; 2006 5.5; 2007 5.2; 2008 1.1; 2009 -5.3; 2010 0.6; 2011 2.1
  - CPI (year average): 2005 1.8; 2006 2.5; 2007 2.9; 2008 6.3; 2009 1.0; 2010 1.6; 2011 2.0
  - PPI (year average): 2005 3.1; 2006 1.5; 2007 4.1; 2008 4.5; 2009 -3.1; 2010 n.a.; 2011 n.a.
  - Unemployment rate (in percent) Survey-based 1/: 2005 7.9; 2006 7.1; 2007 5.3; 2008 4.4; 2009 7.2; 2010 8.8; 2011 8.5
  - Unemployment rate (in percent) Registered 1/: 2005 8.9; 2006 8.1; 2007 6.6; 2008 5.4; 2009 8.2; 2010 9.9; 2011 9.6
  - Gross national savings (percent of GDP): 2005 24.3; 2006 24.2; 2007 23.9; 2008 22.2; 2009 20.9; 2010 21.0; 2011 20.3
  - Gross domestic investments (percent of GDP): 2005 25.7; 2006 26.8; 2007 27.0; 2008 25.3; 2009 23.0; 2010 22.7; 2011 22.7
- Public finance (percent of GDP) 2/ (ESA-95 basis)
  - General government revenue: 2005 41.4; 2006 41.1; 2007 41.9; 2008 40.9; 2009 38.8; 2010 40.7; 2011 40.8
  - General government expenditure: 2005 45.0; 2006 43.7; 2007 42.5; 2008 42.9; 2009 44.8; 2010 45.8; 2011 46.1
  - Net lending / Overall balance: 2005 -3.6; 2006 -2.6; 2007 -0.7; 2008 -2.0; 2009 -6.0; 2010 -5.1; 2011 -5.3
  - General government debt: 2005 29.7; 2006 29.6; 2007 29.0; 2008 30.0; 2009 34.2; 2010 37.9; 2011 40.5
- Money and credit (end of year, percent change)
  - Broad money 3/: 2005 8.0; 2006 9.9; 2007 13.2; 2008 6.6; 2009 4.3; 2010 4.0; 2011 n.a.
  - Private sector credit (percent change, eop) 3/: 2005 20.8; 2006 21.6; 2007 27.3; 2008 16.0; 2009 2.8; 2010 1.5; 2011 n.a.
- Interest rates (in percent, year average)
  - Three-month interbank rate: 2005 2.2; 2006 2.6; 2007 4.1; 2008 3.6; 2009 1.5; 2010 n.a.; 2011 n.a.
  - Ten-year government bond: 2005 3.6; 2006 3.7; 2007 4.7; 2008 4.1; 2009 3.7; 2010 n.a.; 2011 n.a.
- Balance of payments (percent of GDP)
  - Trade balance: 2005 2.0; 2006 2.0; 2007 3.4; 2008 2.8; 2009 2.9; 2010 2.9; 2011 3.3
  - Current account: 2005 -1.3; 2006 -2.6; 2007 -3.1; 2008 -3.1; 2009 -2.1; 2010 -1.7; 2011 -2.4
  - Gross international reserves (US$ billion): 2005 29.6; 2006 31.5; 2007 34.9; 2008 41.5; 2009 42.7; 2010 45.9; 2011 47.5
  - Reserve cover (in months of imports of goods and services): 2005 4.1; 2006 3.6; 2007 3.2; 2008 3.2; 2009 4.3; 2010 4.3; 2011 4.1
- Exchange rate
  - Nominal effective exchange rate, pa (2000=100) 3/: 2005 125.3; 2006 131.7; 2007 135.4; 2008 142.5; 2009 149.5; 2010 n.a.; 2011 n.a.
  - Real effective exchange rate, pa (CPI-based; 2000=100) 3/: 2005 125.5; 2006 132.6; 2007 136.8; 2008 148.8; 2009 155.1; 2010 n.a.; 2011 n.a.
- Sources cited in table: Czech Statistical Office; Czech National Bank; Ministry of Finance; and IMF staff estimates and projections.
- Notes in table:
  - 1/ In percent of total labor force.
  - 2/ On ESA-95 basis.
  - 3/ For 2009, data refer to November.

### Statement by Czech Executive Director and Advisor (February 22, 2010)
- Authorities broadly agree with staff appraisal, especially on need for fiscal consolidation and reforms in pension and health care systems.
- Political background:
  - Current caretaker government set up in early 2009 with limited mandate; general elections scheduled for May 2010.
  - Social Democrats (CSSD) generally prefer tax increases; Civic Democrats (ODS) favor cuts in mandatory expenditures and increased tax system effectiveness.
  - Neither major party has made strong commitments on pension and health care reforms.
- Economic background:
  - Real GDP fell by 4.3 percent y-o-y in 2009; GDP contracted by 4.2 percent in 4Q 2009.
  - Industrial production declined by 13.4 percent y-o-y in 2009.
  - Unemployment rate reached 6.8 percent in 2009; CNB estimates unemployment may reach a peak of 8.9 percent in 2010/2011.
  - Czech downturn similar to Western Europe but less severe than some Eastern European economies; decline reflects strong trade linkages to Western Europe, especially Germany.
  - Authorities expect some improvement in 2010 with more sustained rebound in 2011.
  - CNB expects GDP growth of 1.4 percent in 2010 and 2.1 percent in 2011; Ministry of Finance expects GDP growth of 2.6 percent in 2011.
  - Main drivers in 2010: net exports; household consumption expected to be quite weak.
- Monetary policy and banking sector:
  - CPI inflation bottomed in 2009, reaching 0.2 percent in 3Q 2009.
  - CNB decreased policy interest rates from 3.75 percent in August 2008 to 1 percent currently (as of statement).
  - CNB February 2010 forecast sees inflation returning to 2 percent target in first half of 2011.
  - Main drivers of inflation in 2010: tax changes, rise in regulated rents, growing gasoline prices, modest recovery in food price growth.
  - No apparent fundamental inflationary pressures; uncertainty in nominal wage growth.
  - Monetary policy transmission improving; CNB did not need non-conventional measures; liquidity-providing repo operations were used only to a very small extent.
  - CNB regards current CZK/EUR exchange rate as broadly in line with fundamentals; expects equilibrium real appreciation to resume medium-long term.
  - Macro-financial panel established before each monetary-policy meeting to integrate macro-prudential and supervision analysis.
  - Banking sector largely resilient: conservative models, healthy balance sheets, very low share of foreign exchange loans, well capitalized, domestically deposit-funded.
  - Economic downturn causing increase in non-performing loans, especially corporate loans; CNB stress-tests show sector can withstand significant default increases without government/central bank intervention.
  - Authorities view Deposit Insurance Fund (DIF) role as limited to a pay-box.
- Fiscal policy:
  - Fiscal position worsened: overall budget deficit in 2009 reached 6.6 percent of GDP; projected 5.3 percent of GDP in 2010 (MoF January 2010 numbers).
  - Public debt increased from 30 percent of GDP in 2008 to approximately 35.2 percent of GDP in 2009.
  - More than 70 percent of government expenditures are mandatory and quasi-mandatory; structural problems predate crisis.
  - Austerity package approved by current government aims to reduce deficit in 2010.
  - Shift from direct to indirect taxation in 2010; MoF’s long-term goal to unify VAT rate and move goods from lower to higher rate in medium term.
  - MoF working to review tax base and minimize exemptions by 2011; plans to establish one collecting agency for all taxes (except tariffs) by 2013 (in cooperation with World Bank).
  - MoF agrees social benefits system too generous and should be better targeted.
  - Government bond market slowly recovering; primary market demand for government bonds remains strong; debt management seen as transparent with publicly available strategy; no refinancing troubles expected in 2010 per MoF.
  - On February 8, 2010 government approved Convergence Program aiming for Maastricht fiscal criterion compliance by 2013 and reducing budget deficit to 3 percent of GDP by 2013; concrete measures to be approved by the new government.
  - On February 8, 2010 government approved exit strategy prioritizing consolidation and anti-corruption measures including harmonizing tax base for personal income tax and social and health insurance, reducing public sector wages, doubling real estate tax (confirmed), temporary changes or increases in indirect taxes and personal income tax, and various sectoral measures.
- Structural issues:
  - Pension and health care reforms welcomed but acknowledged as sensitive and requiring broad political consensus due to rapidly ageing population.
  - Some smaller pension system changes already approved to pay-as-you-go system and voluntary pension pillar.
  - Bezdek Committee for pension reform re-established to evaluate 2004–2005 findings and recommend suitable scenarios.
  - No platform yet set up for health care reform discussions, but all political parties see need for deeper structural reform.

*Public Information Notice (PIN) No. 10/36 — IMF Executive Board Concludes 2010 Article IV Consultation with Czech Republic (March 2, 2010)*

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