## _cr14256

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---

### Response to Past Fund Policy Advice
- General finding: Policy implementation broadly consistent with IMF advice with the fiscal stance an exception.
- Key recommendations and implementation status:
  - "Further pro-cyclical fiscal policy should be avoided until the economic recovery gains strength."
    - Implementation: Not implemented. Structural balance improved in 2013 largely due to inability to execute spending, especially investment, owing to political and legal bottlenecks.
  - "Adopt a fiscal rule which has wide coverage, is easy to monitor, incorporates a debt brake, and is monitored by an independent Fiscal Council."
    - Implementation: Not yet implemented. New proposal by the Ministry of Finance broadly in line with these recommendations is under discussion.
  - "If a persistent and large undershooting of the inflation target is in prospect, foreign exchange interventions could be employed to help guide inflation expectations toward the target."
    - Implementation: Implemented. CNB intervened in the foreign exchange market in November 2013.
  - "Continue improving the financial sector supervisory architecture."
    - Implementation: Implemented. Supervisory resources boosted; regulation modified in line with EU initiatives; stricter regulation of credit unions under preparation.

### Context and recent developments
- Output and demand:
  - Recovery driven by strong external demand and pickup in domestic demand; exports (mainly automobiles and machinery) triggered recovery; investment contributed strongly in 2013:Q4.
  - Year-over-year growth: 2.9 percent in 2014:Q1.
- Labor market and wages:
  - Unemployment (seasonally adjusted): 6.6 percent in 2014:Q1 from 7.2 percent a year earlier.
  - Real wages declined through 2013 but recorded a solid increase in 2014:Q1.
- Inflation and prices:
  - Headline inflation: declined from 3.4 percent (September 2012) to zero in June 2014.
  - Two thirds of decline due to moderation of food and energy prices.
  - Non-energy goods inflation (HICP basis): -0.6 percent in November 2013 to 0.7 percent in June 2014.
  - Inflation averaged 0.2 percent year-over-year in first half of 2014.
  - Inflation excluding indirect tax changes and fuels: 1 percent.
- Fiscal developments:
  - Structural deficit narrowed by 1.3 percentage points of GDP following cumulative 2.4 percentage point consolidation during 2011–12.
  - Headline deficit: 4.2 percent of GDP in 2012 to 1.5 percent in 2013.
  - European Council abrogated the EDP in June 2014.
- Monetary policy and exchange rate:
  - Policy rate at the zero lower bound; CNB committed "to prevent excessive appreciation of the koruna below CZK27 per € by intervening in the foreign exchange market".
  - Exchange rate around CZK27.5 per €; no FX intervention since November 2013.
  - De facto exchange rate arrangement reclassified from free floating to other managed, effective November 7, 2013.
- Banking and financial conditions:
  - Capitalization ratio: 16.5 percent at end-2013 vs 15.6 percent in 2012.
  - Credit growth subdued at 3.0 percent, mainly due to weak corporate demand.
  - Five-year CDS around 50 basis points.
  - 10-year bond yielded average of 1.5 percent in June.
- External sector:
  - Current account deficit: 1.4 percent of GDP in 2013.
  - Staff projects narrowing to 0.2 percent of GDP (staff assessment: in line with fundamentals).

### Staff assessment and projections
- Exchange rate and competitiveness:
  - EBA Current Account Balance approach: ~5 percent overvaluation in 2013 relative to cyclically-adjusted norm of 0.4 percent of GDP deficit.
  - Benchmarked to a 2 percent of GDP deficit that would stabilize net foreign assets: 2013 suggests a very slight undervaluation.
  - Multilateral REER approach finds 18 percent overvaluation; staff treats with caution.
  - Overall assessment: exchange rate in broad equilibrium; increased confidence with koruna 6 percent weaker than 2013 average.
- Outlook (staff projections):
  - Real GDP growth: 2.5 percent in 2014.
    - Contribution: one third from foreign demand; two thirds from domestic demand.
    - Exports projected to grow 7 percent in real terms in 2014.
  - Medium-term output growth: stabilizes around 2 percent.
  - Current account: stabilizes around a small deficit of ½ percent of GDP.
  - Inflation: projected to move gradually toward 2 percent target.
- Key macro projections (selected entries):
  - Real GDP growth (percent): 2012 -1.0, 2013 -0.9, 2014 2.5, 2015 2.5, 2016 2.4, 2017 2.3, 2018 2.1, 2019 2.1
  - Inflation (period average, percent): 2012 3.3, 2013 1.4, 2014 0.6, 2015 1.9, 2016 2.0, 2017 2.0, 2018 2.0, 2019 2.0
  - General government overall balance (percent of GDP): 2012 -4.2, 2013 -1.5, 2014 -1.2, 2015 -1.4, 2016 -1.2, 2017 -1.1, 2018 -1.1, 2019 -1.0
  - General government gross debt (percent of GDP): 2012 46.2, 2013 46.0, 2014 44.3, 2015 44.3, 2016 44.1, 2017 43.5, 2018 42.9, 2019 42.3
  - Current account (percent of GDP): 2012 -1.3, 2013 -1.4, 2014 -0.2, 2015 -0.3, 2016 -0.4, 2017 -0.4, 2018 -0.4, 2019 -0.4
  - Reserves (US$ billions): 2012 45, 2013 56, 2014 58, 2015 61, 2016 63, 2017 66, 2018 70, 2019 73
  - Gross external debt (percent of GDP): 2012 52.2, 2013 56.1, 2014 54.4, 2015 52.0, 2016 49.8, 2017 48.1, 2018 46.9, 2019 46.1

### Risks to the outlook
- Balance of risks: broadly balanced.
  - Upside: recovery in trade partners, domestic slack, supportive policies, improving automotive cycle.
  - Downside: escalation of geopolitical tensions affecting exports and energy security; faltering euro area recovery; risk of low growth becoming self-reinforcing via low investment in physical and human capital.
- Authorities' view:
  - Broad agreement with near-term outlook and balance of risks.
  - Prioritized sustaining or strengthening policies supportive of domestic demand and boosting potential growth.
  - Concerned about externally-driven downside risks and potential re-emergence of financial stress in the euro area.

### Fiscal policy — framework, stance, and recommendations
- Medium-term objective and framework:
  - Authorities committed to 1 percent of GDP structural deficit as medium-term objective.
  - Draft Fiscal Framework Reform (FFR) features:
    - Expenditure ceilings derived from medium-term objective.
    - A debt brake rule starting at 55 percent of GDP.
    - A Fiscal Council.
  - Staff views:
    - Structural deficit rule strikes right balance.
    - Debt brake could introduce pro-cyclical bias, but current debt provides buffer.
    - Independent Fiscal Council with sufficient capacity would strengthen framework.
    - Staff urged expeditious approval of the FFR to anchor fiscal policy.
- Near-term fiscal stance and projections:
  - Fiscal stance projected neutral in 2014.
  - Convergence Programme (CP) headline deficit projection: 1.8 percent of GDP for 2014.
  - Staff projection general government deficit in 2014: 1.2 percent of GDP (assuming approved expenditure ceilings respected).
  - CP headline deficit projection for 2015: 2.3 percent of GDP (actual target likely lower); staff projects general government deficit in 2015 at 1.4 percent of GDP assuming CP expenditure allocations respected, implying moderate structural easing of ½ percentage point.
  - CP projects structural deficit of 1.7 percent of GDP in 2017; public debt would decline to about 42 percent of GDP by 2019 per this fiscal path.
- Staff recommendations and concerns:
  - Need clarity on fiscal targets and underlying policies pending adoption of medium-term fiscal framework.
  - Fiscal targets should be consistent with 1 percent of GDP structural deficit and balance sustaining recovery with infrastructure needs.
  - Staff supported increase in capital spending financed by modest increase in structural deficit to 1¼ percent of GDP during 2014–15.
  - Recommendation that better-than-expected tax revenues not be channeled to re-current spending.
- Capital expenditure efficiency:
  - Staff emphasized need to improve efficiency of capital expenditure.
  - Higher utilization of EU funds should be first step.
  - Eliminate obstacles in planning and implementation without compromising governance.
  - Within 1 percent of GDP structural deficit envelope, increases in capital spending can be financed through rationalizing re-current spending and stepped-up tax administration.
  - Staff noted introduction of a new lower VAT rate was much less efficient to address social priorities than more targeted measures and complicates tax administration.

### Monetary policy
- Staff baseline:
  - With recovery gathering momentum, inflation set to rise gradually toward CNB's 2 percent target.
  - Headline inflation very low—weighed down by administered prices and food—while core and demand-sensitive components stronger.
  - Effects of weaker exchange rate and recovering demand expected to push inflation gradually toward 2 percent over the monetary policy horizon.
- Inflation expectations:
  - Increased following exchange rate move and CNB’s commitment to maintain exchange rate floor into early 2015.
  - Expectations matched CNB’s forecast for slight overshoot in first half of 2015 before moderating to 2 percent by end-2015.
- Staff recommendations:
  - Continue focus on inflation targeting and maintain current supportive monetary conditions.
  - Keep exchange rate floor in place for now.
  - Recommend return to floating exchange rate once deflation risks recede and inflation forecast/expectations and wage developments are entrenched around target.
  - Recommend abolishing exchange rate floor in one step rather than gradually; interest rate hikes to follow in due course.
- Authorities’ views:
  - Broad agreement with inflation outlook and commitment to inflation targeting while using foreign exchange intervention to achieve inflation objective.
  - Noted negative price shocks more pronounced than pre-intervention forecasts; maintained intervention policy until at least second quarter of 2015.

### Financial sector
- Soundness and resilience:
  - Financial sector sound and resilient; Czech banks largely owned by euro area banking groups, self-financed, low loan-to-deposit ratio, strong capital and liquidity buffers.
  - Profitability moderated; capitalization above 16 percent.
  - CNB stress tests: aggregate capitalization would remain above 13 percent in severe stress (regulatory minimum 8 percent).
  - Czech subsidiaries largely self-funded and net creditors vis-à-vis abroad.
- Credit growth:
  - Subdued at 3.0 percent; likely to be boosted by recovery.
  - July lending survey: credit standards eased for corporates for first time since 2011.
  - Approval rates for most loan categories remain high; lack of fixed investment activity and internal financing limit corporate credit demand.
- Regulatory and supervisory improvements:
  - Increased on-site inspection resources.
  - Draft law on credit unions prepared.
  - EU Directive on access to activity of credit institutions and prudential supervision implemented.
  - Systemic banks notified of upcoming capital buffer requirements; largely in compliance at current capital levels.
  - Work on EU unified resolution schemes and deposit insurance ongoing.
- Authorities’ positions:
  - Shared staff’s assessment of healthy financial sector.
  - Domestic balance sheet recession seen as main risk but with smaller likelihood.
  - Considering pros and cons of opting into euro-area banking union ahead of euro adoption; detailed study being prepared.

### Structural policies and potential growth
- Staff estimates:
  - Current potential output growth: 1.6 percent.
  - Potential growth projected to increase but constrained to 2 percent over medium term.
- Demographics:
  - Working age population projected to decline by 0.36 percent per annum during 2010-50 (Appendix wording: "Working age population is projected to decline by 0.36 percent per annum during 2010-50.").
  - Appendix I also notes a projected decline of 0.4 percent annually during 2010–50 in a closely related passage.
- Key constraints:
  - Low labor force participation in some demographic groups; skill mismatches; low R&D investment.
- Policy proposals and reform priorities:
  - Reduce labor market rigidities; strengthen public employment services.
  - Expand affordable high-quality child-care and rental housing.
  - Target policies to raise labor participation (noted overall labor force participation around 73 percent; authorities’ 2011 reform aims at 75 percent by 2020).
  - Upgrade skills via apprenticeship programs, vocational training with businesses, and incentives in education to match workforce needs.
  - Reduce uncertainty in tax policies, simplify tax compliance, combat corruption per 2014 National Reform Programme.
  - Strengthen R&D, improve infrastructure, facilitate SMEs’ expansion, better integrate into international value chain.

### Potential growth analysis (Appendix I)
- Cross-country regression (pool-OLS on country-five year intervals) findings (dependent variable: per-capita real GDP growth in 5 years):
  - Selected coefficients (with significance):
    - GDP/GDP of US: -0.0110* (standard error 0.00556)
    - Investment over GDP in 5 years: 0.0970** (standard error 0.0396)
    - Growth of ULC in previous 5 years: -0.0762** (standard error 0.0323)
    - Growth of TFP in 5 years: 0.696*** (standard error 0.120)
    - Growth of world trade stock in 5 years: 0.170** (standard error 0.0693)
    - Observations: 47
    - R-squared: 0.798
    - Significance: *** p<0.01, ** p<0.05, * p<0.1
- Model-based potential:
  - Model-predicted per capita real GDP growth for Czech Republic over 2014–19: 2.6 percent.
  - Staff baseline assumes average potential real GDP growth of 2.2 percent over 2014–19.

### Staff appraisal and recommendations (summary)
- Economy strengthening but challenges remain: recovery from prolonged recession, inflation below target, medium-term fiscal plans not fully elaborated, low potential growth.
- Fiscal policy:
  - After sharp consolidation, adopt growth-friendly fiscal strategy with clear medium-term fiscal framework enshrined in legislation.
  - Increase capital spending financed by slight near-term relaxation of fiscal stance; avoid using revenue over-performance to raise re-current expenditure.
  - Medium-term deficit objective should be part of a legislative framework including debt brake and independent Fiscal Council.
- Monetary policy:
  - Continue inflation targeting and maintain supportive conditions; keep exchange rate floor in place for now due to sizable output gap and very low inflation.
  - Return to floating exchange rate once deflation risks recede and inflation forecast/expectations are entrenched.
- Financial sector:
  - Continue vigilance and proactive supervision; progress supervisory architecture in line with EU/global initiatives.
- Structural reform:
  - Renew momentum to raise physical and human capital investment, improve business environment, increase labor participation, strengthen R&D and technical skills.
- Procedural recommendation:
  - Next Article IV consultation with Czech Republic recommended on standard 12-month cycle.

### Public debt dynamics, DSA and stress tests (selected)
- Debt-to-GDP and projections:
  - Debt-to-GDP: 46 percent in 2013; 44.4 percent in 2014–15 (temporary stabilization); 42.3 percent in 2019.
- Change in gross public sector debt (selected years and cumulative):
  - 2012: 2.2
  - 2013: 4.7
  - 2014: -0.1
  - 2015: -1.7
  - 2019 cumulative: -3.7
- Primary (noninterest) revenue and expenditure (percent of GDP, selected):
  - Primary revenue: 39.3 (2012), 40.1 (2013), 40.7 (2014), 41.1 (2015), 40.6 (2016), 39.8 (2017), 39.8 (2018), 39.7 (2019)
  - Primary expenditure: 41.5 (2012), 43.1 (2013), 41.0 (2014), 41.1 (2015), 40.8 (2016), 39.8 (2017), 39.7 (2018), 39.7 (2019)
- Automatic debt dynamics (contribution, percent of GDP): 0.2 (2012), 1.2 (2013), 1.3 (2014), -0.6 (2015), -0.1 (2016), -0.1 (2017), -0.5 (2018), -0.6 (2019)
- Effective interest rate (defined as interest payments divided by debt stock at end of previous year): 2.0 (2014), 4.1 (2015), 4.1 (2016), 3.0 (2017), 2.6 (2018), 2.5 (2019) in baseline entries.
- Shock and stress tests:
  - Main risk: combined macro-fiscal shocks (real GDP growth, primary balance, real exchange rate, real interest rate).
  - Under combined shock scenario: public debt would increase sharply and stabilize around 62 percent of GDP; gross financing needs would climb to 14 percent of GDP in 2019.
- Baseline scenario key inputs (selected):
  - Real GDP growth: 2.5 (2014), 2.5 (2015), 2.4 (2016), 2.3 (2017), 2.1 (2018), 2.1 (2019)
  - Inflation: 0.9 (2014), 1.7 (2015), 1.8 (2016), 1.9 (2017), 1.9 (2018), 2.0 (2019)
  - Primary Balance: 0.0 (2014), -0.2 (2015), 0.0 (2016), 0.1 (2017), 0.0 (2018), 0.1 (2019)

### Data, statistics, and surveillance notes
- National accounts and GDP measurement:
  - Value added in small scale private sector likely underestimated due to underdeveloped data collection and unrecorded activity from tax evasion.
  - Discrepancies between production and expenditure-based GDP estimates large and subsumed under change in stocks.
  - Quarterly national accounts derived from enterprise reports and surveys; subject to nonresponse bias; quarterly reporting not mandatory.
  - Transition to ESA 2010 scheduled for September 2014; new estimates due September/October 2014 incorporating new data sources.
- External sector and trade statistics:
  - Revisions to export data processing aligned external trade statistics with EU practice.
  - Fixed base price indices for exports and imports currently unavailable.
  - From 2014, external sector statistics compiled according to BPM6 and ECB/Eurostat legal requirements.
- Monetary statistics:
  - Monetary survey data adequate for policy; large variations in interbank clearing account float require caution.
  - CNB implemented ECB framework in 2002 for monetary data collection and reporting; harmonization with IFS achieved.
- Fiscal statistics:
  - Annual and quarterly fiscal data compiled on ESA95; from September 2014 GFS data will be based on ESA 2010 with likely revisions to deficit and debt levels from 1995 onwards.
- Key surveillance indicators (as of July 18, 2014) — data frequency and latest observations provided in source (exchange rates current; reserves May 2014; GDP 2014 Q1; etc.).
- Fund relations and statistical notes:
  - Membership Status: Joined 01/01/1993; Article VIII.
  - Quota: 1,002.20 SDR Million (100.0 percent of Quota).
  - Fund Holdings of Currency: 624.85 SDR Million (62.35 percent).
  - Reserve position in Fund: 377.35 SDR Million (37.65 percent).
  - Last Article IV Consultation: concluded on July 24, 2013; staff report and press release published on August 2, 2013.
  - Exchange rate (June 30, 2014): CZK 27.45 per euro; CZK 20.10 per U.S. dollar.
  - Data provision: Subscribed to SDDS in April 1998; core surveillance data availability specified in source.

### Selected indicators and near-term outlook highlights
- Growth and inflation:
  - Real GDP projected increase: 2.5 percent in 2014 and 2015.
  - Medium-term growth projected close to 2 percent.
  - Inflation forecast to converge to 2 percent by end-2015.
- Fiscal and debt (baseline):
  - Debt-to-GDP: 46 percent in 2013; 44.4 percent in 2014–15; 42.3 percent in 2019.
  - Gross financing needs projected to stay below 9 percent of GDP throughout projection period (table entries show 1.5 in 2014; 5.5 in 2015; rising to 8.6 in 2019).
- Selected historical and projected series (excerpted):
  - Nominal GDP (US$ billions): 2013 198.4; 2014 200.0; 2015 208.9; 2016 216.7.
  - Real GDP (change in percent): 2013 -0.9; 2014 2.5; 2015 2.5; 2016 2.4.
  - Exports (change in percent): 2013 0.2; 2014 7.2; 2015 5.0; 2016 4.0.
  - Unemployment rate (percent): 2013 7.0; 2014 6.4; 2015 6.0; 2016 5.6.
  - Gross international reserves (US$ billion): 2013 56.2; 2014 57.9; 2015 60.8; 2016 63.4.
  - Real effective exchange rate (CPI-based; 2005=100): 2013 118.8.

*International Monetary Fund staff report excerpts and boxes from _cr14256 (Czech Republic Article IV consultation materials) as provided in the source content.*

### 1. Response to Past Fund Policy Advice __________________________________________________________ 17

### 1. Response to Past Fund Policy Advice

### Context and recent developments
- The economy turned a corner after prolonged stagnation and significant fiscal consolidation that "went beyond what was necessary under the Excessive Deficit Procedure (EDP)".
- Recovery drivers:
  - Strong external demand and a pickup in domestic demand.
  - Exports (mainly of automobiles and machinery) triggered the recovery; investment contributed strongly in 2013:Q4.
  - Year-over-year growth reached 2.9 percent in 2014:Q1.
- Labor market:
  - Unemployment declined to 6.6 percent (seasonally adjusted) in 2014:Q1 from 7.2 percent a year earlier.
  - Real wages declined through 2013 but recorded a solid increase in 2014:Q1.
- Inflation:
  - Headline inflation declined from 3.4 percent (September 2012) to zero in June 2014.
  - Two thirds of the decline accounted for by moderation of food and energy prices.
  - Non-energy goods inflation (HICP basis) rose from -0.6 percent in November 2013 to 0.7 percent in June 2014.
  - Inflation averaged 0.2 percent year-over-year in the first half of 2014.
  - Inflation excluding indirect tax changes and fuels reached 1 percent.
- Fiscal developments:
  - Sharp fiscal adjustment led to exit from the EDP and kept debt levels contained, but exacerbated the recession.
  - Structural deficit narrowed by 1.3 percentage points of GDP following a cumulative 2.4 percentage point consolidation during 2011–12.
  - Headline deficit declined from 4.2 percent of GDP in 2012 to 1.5 percent in 2013.
  - The European Council abrogated the EDP in June 2014.
- Monetary policy and exchange rate:
  - Policy rate at the zero lower bound; CNB resorted to foreign exchange intervention consistent with Fund advice.
  - CNB committed "to prevent excessive appreciation of the koruna below CZK27 per € by intervening in the foreign exchange market", implying a 6 percent depreciation expected to bring inflation to target.
  - Exchange rate around CZK27.5 per €; no FX intervention since November 2013.
  - De facto exchange rate arrangement reclassified from free floating to other managed, effective November 7, 2013.
- Banking and financial conditions:
  - Capitalization ratio reached 16.5 percent at end-2013 compared with 15.6 percent in 2012.
  - Credit growth subdued at 3.0 percent, mainly due to weak corporate demand.
  - Five-year credit default swaps around 50 basis points.
  - 10-year bond yielded an average of 1.5 percent in June.
- External sector:
  - Current account deficit broadly stable at 1.4 percent of GDP in 2013.
  - Staff projects narrowing of the current account deficit to 0.2 percent of GDP (staff assessment: in line with fundamentals).

### Staff assessment and projections
- Real exchange rate:
  - EBA methodology yields mixed results: Current Account Balance approach suggests a ~5 percent overvaluation in 2013 relative to a cyclically-adjusted norm of 0.4 percent of GDP deficit.
  - Benchmarked against a 2 percent of GDP deficit that would stabilize the net foreign asset position, 2013 suggests a very slight undervaluation.
  - Multilateral REER approach finds an 18 percent overvaluation, but staff treats this with caution.
  - Overall staff assesses the exchange rate to be in broad equilibrium; confidence increased with koruna 6 percent weaker than the 2013 average.
- Outlook (staff projections):
  - Growth projected at 2.5 percent in 2014.
    - One third contribution from foreign demand; two thirds from domestic demand.
    - Exports projected to grow 7 percent in real terms in 2014.
  - Medium-term: output growth stabilizes around 2 percent.
  - Current account stabilizes around a small deficit of ½ percent of GDP.
  - Inflation projected to move gradually toward the 2 percent target.
- Key macroeconomic projections table (selected entries):
  - Real GDP growth (percent): 2012 -1.0, 2013 -0.9, 2014 2.5, 2015 2.5, 2016 2.4, 2017 2.3, 2018 2.1, 2019 2.1
  - Inflation (period average, percent): 2012 3.3, 2013 1.4, 2014 0.6, 2015 1.9, 2016 2.0, 2017 2.0, 2018 2.0, 2019 2.0
  - General government overall balance (percent of GDP): 2012 -4.2, 2013 -1.5, 2014 -1.2, 2015 -1.4, 2016 -1.2, 2017 -1.1, 2018 -1.1, 2019 -1.0
  - General government gross debt (percent of GDP): 2012 46.2, 2013 46.0, 2014 44.3, 2015 44.3, 2016 44.1, 2017 43.5, 2018 42.9, 2019 42.3
  - Current account (percent of GDP): 2012 -1.3, 2013 -1.4, 2014 -0.2, 2015 -0.3, 2016 -0.4, 2017 -0.4, 2018 -0.4, 2019 -0.4
  - Reserves (in billions of dollars): 2012 45, 2013 56, 2014 58, 2015 61, 2016 63, 2017 66, 2018 70, 2019 73
  - Gross external debt (percent of GDP): 2012 52.2, 2013 56.1, 2014 54.4, 2015 52.0, 2016 49.8, 2017 48.1, 2018 46.9, 2019 46.1

### Risks to the outlook
- Balanced risks:
  - Upside: recovery in trade partners, domestic slack, supportive policies, improving automotive cycle.
  - Downside: escalation of geopolitical tensions in the region affecting exports and energy security; faltering euro area recovery impacting trade and investment; risk of low growth becoming self-reinforcing via low investment in physical and human capital.
- Authorities' view:
  - Broad agreement with near-term outlook, medium-term prospects, and balance of risks.
  - Authorities saw externally-driven downside risks and potential re-emergence of financial stress in the euro area (e.g., from Asset Quality Review and stress tests).
  - Authorities prioritized sustaining or strengthening policies supportive of domestic demand and boosting potential growth.

### Policy discussions — fiscal policy
- Medium-term objective and framework:
  - Authorities committed to a 1 percent of GDP structural deficit as medium-term objective.
  - Ministry of Finance prepared an updated draft Fiscal Framework Reform (FFR) to submit to Parliament later this year.
  - Draft FFR features:
    - Expenditure ceilings derived from the medium-term objective.
    - A debt brake rule starting at 55 percent of GDP.
    - A Fiscal Council.
  - Staff view:
    - Structural deficit rule strikes the right balance between reducing debt and creating fiscal space.
    - Rule would help eliminate pro-cyclical bias and be consistent with EU fiscal framework.
    - Debt brake could introduce pro-cyclical bias, but current debt level provides an adequate buffer.
    - An independent Fiscal Council with sufficient capacity would strengthen the framework.
    - Staff urged expeditious approval of the FFR to anchor fiscal policy.
- Near-term fiscal stance and projections:
  - Fiscal stance projected neutral in 2014.
  - Convergence Programme (CP) headline deficit projection: 1.8 percent of GDP for 2014.
  - Staff projection for general government deficit in 2014: 1.2 percent of GDP (assuming approved expenditure ceilings respected), implying a broadly neutral fiscal stance.
  - CP headline deficit projection for 2015: 2.3 percent of GDP (actual target likely lower); staff projects general government deficit in 2015 at 1.4 percent of GDP assuming CP expenditure allocations are respected, implying a moderate structural easing of ½ percentage point.
  - CP projects structural deficit of 1.7 percent of GDP in 2017 and reiterates commitment to medium-term deficit objective; public debt would decline to about 42 percent of GDP by 2019 per this fiscal path.
- Staff recommendations and concerns:
  - Need for clarity on fiscal targets and underlying policies pending adoption of the medium-term fiscal framework.
  - Fiscal targets should be consistent with a 1 percent of GDP structural deficit and balance sustaining recovery with infrastructure needs.
  - Staff supported an increase in capital spending financed by a modest increase in the structural deficit to 1¼ percent of GDP during 2014–15.
  - Staff recommended that better-than-expected tax revenues not be channeled to re-current spending.

*International Monetary Fund staff summary based on the Czech Republic Article IV consultation materials in the provided content.*

### 18.      Staff emphasized the need to improve the efficiency of capital expenditure. Higher

### 18. Staff emphasized the need to improve the efficiency of capital expenditure. Higher

### Fiscal policy: capital expenditure and fiscal framework
- Staff emphasized the need to improve the efficiency of capital expenditure.
- Higher utilization of EU funds should be the first step.
- Eliminating obstacles in planning and implementation of public projects without compromising governance would help improve capital spending efficiency.
- Within the envelope of a 1 percent of GDP structural deficit, increases in capital spending can also be financed through rationalizing re-current spending and stepped-up efforts to improve tax administration.
- Staff noted that the introduction of a new lower VAT rate was a much less efficient way to address social priorities than a more targeted measure would be, and also an unwelcome complication for tax administration.
- Authorities:
  - Reaffirmed commitment to the medium-term fiscal objective, but not to a particular timeline to achieve it.
  - Acknowledged upside risks to revenue that, were they to materialize, would lead to a 2014 fiscal outturn better than the one projected in the CP.
  - At end-July they revised their deficit projection to 1.5 percent of GDP.
  - The draft Fiscal Framework Reform foresees the medium-term objective of 1 percent of GDP structural deficit being reached in 2020.
  - As of now, the authorities saw the 3 percent of GDP headline fiscal deficit threshold (i.e., the EDP limit) as the only binding requirement for fiscal policy.
  - Expected to elaborate position on the path and timeline for reaching the medium-term objective in the course of preparation of the 2015 budget, with detailed discussions in the fall among coalition partners.
  - Noted expenditure pressures that may lead to an increase in expenditure ceilings and highlighted an infrastructure deficit in transportation and energy due to compression of public investment.
  - Saw benefits from a slight fiscal expansion as insurance against downside macroeconomic risks.
  - Noted that approval of the new fiscal framework by Parliament could take time.

### Monetary policy
- Staff baseline: with the economic recovery gathering momentum, inflation is set to rise gradually toward the central bank’s target.
- Headline inflation remains very low—weighed down by administered prices (e.g., gas and electricity) and food—while core measures and demand-sensitive components of inflation are generally stronger and exceed headline inflation.
- Demand for durables is strengthening; labor income growth is gaining momentum, underpinning solid consumption trends.
- Under staff’s baseline, the effects of the weaker exchange rate and recovering demand conditions are expected to push inflation gradually toward the central bank’s 2 percent target over the monetary policy horizon.
- Inflation expectations have increased following the exchange rate move and CNB’s stated commitment to maintain the exchange rate floor into early 2015 as an instrument for achieving the inflation objective.
- Inflation expectations have matched the CNB’s inflation forecast for a slight overshoot of the inflation target in the first half of 2015, before moderating to 2 percent by end-2015.
- Staff recommendations:
  - Continue to focus on inflation targeting and maintain the current supportive monetary conditions for now.
  - Keep in place the exchange rate floor for now, even though it has not been binding.
  - Recommend a return to a floating exchange rate once deflation risks recede, and the inflation forecast and inflation expectations, as well as wage developments, become entrenched around the central bank’s target.
  - Recommend abolishing the exchange rate floor in one step rather than gradually; interest rate hikes would follow in due course.
- Authorities’ views:
  - Broadly agreed with the inflation outlook and commitment to inflation targeting while continuing to use foreign exchange intervention policy to achieve the inflation objective.
  - Noted that negative price shocks have been more pronounced than pre-intervention forecasts and the hoped-for overshoot of inflation relative to target is now unlikely.
  - Decided to maintain the intervention policy as an instrument for achieving their inflation objective for longer, announcing in June that the policy will be in place until at least the second quarter of 2015.
  - Once exit conditions are in place, they would return to a floating exchange rate and would consider exit modalities in detail in the fall.

### Financial sector
- Staff assessment:
  - The financial sector is sound and resilient.
  - Czech banks are largely owned by euro area banking groups, are self-financed with a low system-wide loan to deposit ratio and strong capital and liquidity buffers.
  - Profitability moderated somewhat on the back of still-weak credit growth, but helped to further strengthen banks’ capital to above 16 percent.
  - Recent CNB stress tests indicate that aggregate bank capitalization would remain above 13 percent, significantly better than the regulatory minimum of 8 percent, even in a severe stress scenario with a large output drop and protracted stagnation.
  - Many Czech bank parents are going through the ECB’s comprehensive risk assessment, but their Czech subsidiaries are self-funded and net creditors vis-à-vis abroad, and should be relatively resilient to shocks to parents.
- Credit growth:
  - Likely to be boosted by the recovery.
  - Credit growth remains subdued due to low credit demand and somewhat tighter lending standards, but this is seen as a cyclical phenomenon.
  - July lending survey showed credit standards to corporates were eased for the first time since 2011.
  - Approval rates for most loan categories remain high; lack of fixed investment activity and financing from internal resources limit corporate credit demand, but initial signs of recovery seen.
- Regulatory and supervisory improvements:
  - Supervisory resources have been increased for on-site inspections.
  - Draft law on credit unions prepared to reduce reputation risks.
  - Implementing law of the EU Directive on access to the activity of credit institutions and prudential supervision has been approved by Parliament.
  - Systemic banks have been notified of upcoming capital buffer requirements, with which they would be largely in compliance at current capital levels.
  - Work on EU-wide unified resolution schemes and deposit insurance framework is continuing.
- Authorities’ views:
  - Shared staff’s assessment of a healthy financial sector.
  - Saw a domestic balance sheet recession as the main risk, but with smaller likelihood than before.
  - Highlighted ongoing follow-up on FSAP recommendations and supranational regulatory initiatives.
  - Considering pros and cons of opting into the euro area banking union ahead of euro adoption; a detailed study is being prepared for discussion in the fall.

### Structural policies and growth prospects
- Staff estimates current potential output growth at 1.6 percent.
- Potential growth projected to increase over the medium term but constrained to 2 percent over the medium term.
- These rates are well below the level necessary to facilitate convergence of Czech per capita output to the level of other advanced European economies.
- Employment rate expected to remain stable, but with declining working age population the economy would require wider sources of labor supply.
  - Working age population is projected to decline by 0.36 percent per annum during 2010-50.
  - Total population is projected to grow by 0.15 percent per annum over the same period (based on the medium fertility scenario in UN’s World Population Prospects: The 2012 Revision).
- Labor force participation of some demographic groups is low; skill mismatches and low investment in research and development (R&D) are constraints.
- Policy proposals and reform priorities:
  - Continue reforms to reduce labor market rigidities, including more flexible employment arrangements and strengthened public employment services.
  - Expand affordable high-quality child-care facilities and rental housing availability.
  - Target policies to raise labor participation in segments such as women with young children; note that overall labor force participation is around 73 percent and the authorities’ 2011 reform strategy aims at 75 percent by 2020.
  - Upgrade skills and address technical skill shortages via education and training of less-advantaged populations (e.g., apprenticeship programs), vocational training in cooperation with businesses, and incentives in education to better match workforce needs.
  - Reduce uncertainty regarding tax policies, simplify tax compliance, and combat corruption in line with the authorities’ 2014 National Reform Programme to enhance the business environment.
  - Strengthen R&D, improve infrastructure, facilitate SMEs’ expansion, and better integrate into the international value chain.

### Staff appraisal and recommendations
- The Czech economy is strengthening but continues to face challenges: recovery from prolonged recession, falling unemployment, recovery driven by exports and increasingly by domestic demand, but inflation still well below target, medium-term fiscal plans not clearly elaborated, and potential growth low.
- Fiscal policy:
  - After sharp fiscal consolidation over the last three years, a growth-friendly fiscal strategy with a clear medium-term fiscal framework is needed.
  - An increase in capital spending financed by a slight relaxation of the fiscal stance in the near term would be appropriate to sustain the nascent recovery and improve infrastructure.
  - Avoid using revenue over-performance to ratchet up re-current expenditure.
  - Authorities’ commitment to a medium-term objective for the structural deficit is welcome and should be backed by a clear strategy on underlying fiscal targets and policies.
  - The medium-term deficit objective should be cast in a medium-term fiscal framework—enshrined in legislation—that would also include a debt brake rule, and an independent Fiscal Council.
- Monetary policy:
  - The central bank should continue to focus on inflation targeting and maintain the current supportive monetary conditions for now.
  - Keep the exchange rate floor in place for now given sizable output gap, very low inflation, and not-yet-anchored inflation expectations.
  - Return to a floating exchange rate once deflation risks recede and inflation forecast and expectations become entrenched around the target.
- Financial sector:
  - The financial system is sound and resilient; continued vigilance and proactive supervision are necessary.
  - Gradual improvements in supervisory architecture should continue in line with European and global initiatives.
- Structural reform:
  - Renewed structural reform momentum is required to unleash full growth potential.
  - Implement reforms to enhance investment in physical and human capital and improve the business environment to support advancement in the international value chain.
  - Continue efforts to increase labor participation and emphasize strengthening R&D and technical skills upgrading.
- Procedural recommendation:
  - It is recommended that the next Article IV consultation with the Czech Republic be held on the standard 12-month cycle.

*International Monetary Fund — Staff report excerpts (sections 18–35, Risk Assessment Matrix)*

### Box 1. Response to Past Fund Policy Advice

### _cr14256 - Box 1. Response to Past Fund Policy Advice

### Response to past Fund policy advice (Box 1)
- General finding: Policy implementation has been broadly consistent with IMF advice with the fiscal stance being an exception.
- Key recommendation: "Further pro-cyclical fiscal policy should be avoided until the economic recovery gains strength."
  - Implementation: Not implemented. The structural balance continued to improve in 2013; however, much of this improvement was due to an inability to execute spending, especially in the investment area, owing to political and legal bottlenecks.
- Key recommendation: "Adopt a fiscal rule which has wide coverage, is easy to monitor, incorporates a debt brake, and is monitored by an independent Fiscal Council."
  - Implementation: Not yet implemented. A new proposal by the Ministry of Finance, broadly in line with these recommendations, is under discussion.
- Key recommendation: "If a persistent and large undershooting of the inflation target is in prospect, foreign exchange interventions could be employed to help guide inflation expectations toward the target."
  - Implementation: Implemented. As it became clear that inflation will remain below target for a significant period of time, and facing risks that inflation expectations will become unanchored, the Czech National Bank intervened in the foreign exchange market in November 2013.
- Key recommendation: "Continue improving the financial sector supervisory architecture."
  - Implementation: Implemented. Supervisory resources have been boosted to intensify on-site supervision. Financial sector regulation is being modified in line with EU-wide initiatives. Stricter regulation of credit unions is under preparation.

### Competitiveness assessment (Box 2)
- Exchange rate and competitiveness:
  - The koruna has depreciated moderately since mid-2011 against the background of financial turmoil in the euro area.
  - This depreciation mitigated lingering real appreciation from the 2007–08 spikes in the exchange rate, with additional impetus from the CNB intervention in November 2013 to ease monetary conditions.
  - The CPI-based real exchange rate remains higher than its 2006 level.
  - The real exchange rate deflated by unit labor costs in the manufacturing sector is now slightly lower than its historical average due to favorable wage productivity dynamics.
- Export performance:
  - Despite recent exchange rate depreciation, Czech export market share has not yet increased.
  - Export market share has been broadly stagnant in the post-crisis period with some evidence of underperformance since 2011.
  - Export performance lags that of Slovakia, which has a similar industrial structure and is oriented towards the same export markets.
- External position and reserves:
  - Current account deficits have been largely financed by FDI inflows; net international investment position (NIIP) has stabilized, and reserves are strong.
  - Reflecting the high FDI stock, the Czech Republic has traditionally had a large income deficit that outweighs the trade surplus to produce moderate current account deficits.
  - The accumulated external deficits over the years have led to a moderate negative NIIP of about 45 percent of GDP, but the NIIP has stabilized in recent years.
  - Excluding the FDI stock, the NIIP is positive reflecting low external indebtedness and a strong reserve position.
  - Foreign exchange reserves are well above the suggested adequacy range, providing ample cushion against external shocks.

### Links with Russia and Ukraine (Box 3)
- Real sector and trade links:
  - Real sector links with Russia and Ukraine, except for energy imports, are limited; direct financial links are negligible.
  - Direct trade links are moderate: Russia is the Czech Republic’s 8th largest export market with 3.2 percent of Czech exports going to Russia, and the 6th largest importer, with 5 percent of imports originating from Russia.
  - Czech exports to Ukraine are about 1 percent of total exports and imports from Ukraine represent 0.8 percent of total.
  - The share of Russian value added embodied in Czech gross exports is somewhat above 5 percent only in two industries.
  - Final demand from Russia, in particular for automobiles produced in the Czech Republic and supplied indirectly through the German-Central European Supply Chain, is an important driver for exports; lower growth in Russia could lower Czech exports.
- Energy dependency:
  - The Czech Republic has significant dependency on Russia and Ukraine for its energy imports.
  - The share of Russian gas in the Czech Republic’s total gas consumption is 80 percent—the third largest share after Finland and Belarus.
  - There is scope for re-routing gas imports through other countries and, with seasonally-low demand, the Czech Republic could overcome short-lived disruptions.
- Financial and tourism links:
  - Direct financial linkages are negligible, though there is a risk of contagion through confidence effects.
  - There is significant reliance on tourism from Russia; the number of Russian tourists increased sharply in recent years and is now the second largest after tourists from neighboring Germany.

### The fiscal framework (Box 4)
- Current framework weaknesses:
  - The current fiscal framework lacks a medium-term fiscal anchor and contributes to a pro-cyclical bias.
  - It consists of a medium-term fiscal target within the medium-term budgetary framework (MTBF) introduced in the 2004 Public Finance Reform.
  - The MTBF is a three-year rolling framework that converts general government balance targets into expenditure ceilings, currently the only binding numerical fiscal constraint for the state budget and six state funds.
  - In practice, the framework provides an effective constraint only on next year’s budget, thus lacking a proper medium-term fiscal anchor.
  - There is no enforcement mechanism or corrective actions and the coverage is limited to less than 60 percent of general government spending.
  - As a result, the Czech Republic stands relatively low in the European Commission’s (EC) ranking of fiscal rule strength.
- Proposed framework features:
  - Encompasses a structural balance rule, a debt brake supplemented with a debt restriction on local governments, and a deficit constraint on social security funds.
  - The debt brake starts to apply when public debt, adjusted for the Ministry of Finance’s liquid reserves, exceeds 55 percent of GDP.
  - The debt brake and the structural balance rule incorporate escape clauses applicable in cases of serious economic downturns, natural disasters, or emergency.
  - According to the debt brake, several automatic procedures would be launched when debt exceeds 55 percent of GDP: the state budget as well as budgets of public health insurance companies and local governments must target a balance or surplus; any new state guarantee would be provided only after a majority approval (by both Chambers of Parliament).
  - Potential risk: while the debt brake has the potential to introduce a pro-cyclical bias, the current debt level provides an adequate buffer against this risk.
  - The proposed structural balance rule foresees a limit of 1 percent of GDP for the structural deficit, identical to the medium-term objective agreed between the previous government and the EC. Adoption would align with the Fiscal Compact.
- Legal and institutional implementation:
  - The proposed framework is to be implemented by a Constitutional Law and an Act on Rules of Fiscal Responsibility.
    - The Constitutional Law incorporates the debt brake, Fiscal Council, and local governments’ debt rule and requires a super majority in both chambers of Parliament to be modified.
    - The Act specifies practical implementation of the Constitutional Act including the structural balance rule and requires a simple majority in both chambers of Parliament to be modified.
  - Transparency and accountability measures:
    - Introduction of a Committee for Budgetary Forecasts to assess government forecasts and require revision if deemed optimistic.
    - More demanding and regular reporting criteria, along with annual reports including on tax expenditures and contingent liabilities.
    - Establishment of an independent Fiscal Council with sufficient institutional and analytical capacity to enhance transparency and accountability.

*Source: _cr14256 - Box 1. Response to Past Fund Policy Advice*

### Box 5. Inflation Developments

### Box 5. Inflation Developments

### Summary
- While headline inflation remains low, driven by administered prices (much of it energy-related) and food price inflation, positive underlying trends in a number of indicators suggest that risks of a deflationary spiral have begun to recede.

### Underlying inflation indicators
- Indicators of core inflation are supported by currency weakness and economic recovery.
- Import prices spiked in late-2013 as a result of the exchange rate depreciation.
- Producer price indices of manufactured goods and market services have been exhibiting upward trends.
- Inflation excluding regulated prices and fuel turned positive for the first time in five years in April 2014.

### Inflation expectations
- Inflation expectations are on target.
- Analyst forecasts have converged toward the central bank’s 2 percent inflation target for the 12-month horizon, as market participants tuned down expectations of undershooting observed last year and overshooting expectations this year.

### Wages and labor-cost developments
- Wages are recovering.
- Nominal wages in the business sector performed strongly in the first quarter of 2014 following a bout of very weak performance.
- While some of the strength in average wages is due to the shifting of bonuses during the calendar year, even adjusted for this effect, private sector wage dynamics seem to have turned the corner.

*Source: Czech Statistical Office, Czech National Bank, Haver.*

### Appendix I. Potential Growth

### Appendix I. Potential Growth

### Key challenges and outlook
- Raising Czech Republic’s potential growth faces significant challenges.
- Working age population (ages 15–64) is projected to decline by 0.4 percent annually during 2010–50, implying medium-term growth will need a bounce back in labor productivity and higher labor force participation.
- Labor productivity improved only very little during 2008–13 after important pre-2008 gains.

### Productivity trends and demographic context
- Aggregate employment declined during 2008–13 while aggregate output dropped even more, suggesting possible labor hoarding; however, sectoral data provide mixed evidence:
  - Employment drop in manufacturing and real estate was larger than the output drop in those sectors.
  - Service sectors such as finance and insurance, and information and communication expanded significantly.
  - Sectors whose change in labor productivity seems not explained by labor hoarding account for more than 80 percent of the total labor force, suggesting the slowdown in labor productivity may be more entrenched than purely cyclical.
- Figure and data highlights:
  - Productivity growth series and HP-filtered trend shown for 1998–2013.
  - Adult population (ages 15–64) time series noted; “The peak was in 2010: 7,4 million.” (as presented in source).

### Growth model constraints and international evidence
- The Czech growth model relies on strengthening its position in the German-Central European Supply Chain (GCESC) by attracting FDI and using relatively cheap and high-skilled labor; this model faces limits as income convergence has substantially reduced unit labor cost differentials with Germany and regional competition has increased.
- Cross-country analysis (OECD countries with per capita income above Czech 2014 level) indicates higher per-capita real GDP growth is positively associated with:
  - A higher gap from the US income level.
  - More moderate historical ULC growth.
  - Higher TFP growth.
  - Higher capital formation (gross fixed capital formation).
- Regression analysis (pool-OLS on country-five year intervals) findings (dependent variable: per-capita real GDP growth in 5 years):
  - Coefficient interpretations:
    - A 1 percent increase in annual ULC growth implies a 0.1 percent decline in the annual per-capita GDP growth (reported in text as -0.1 percent effect; regression table reports Growth of ULC in the previous 5 years = -0.0762**).
    - A 1 percent increase in annual TFP growth would lead to a 0.7 percent increase in annual per-capita GDP growth (Growth of TFP in 5 years = 0.696***).
  - Regression table key values:
    - GDP/GDP of US: -0.0110* (standard error 0.00556)
    - Investment over GDP in 5 years: 0.0970** (standard error 0.0396)
    - Growth of ULC in the previous 5 years: -0.0762** (standard error 0.0323)
    - Growth of TFP in 5 years: 0.696*** (standard error 0.120)
    - Growth of world trade stock in 5 years: 0.170** (standard error 0.0693)
    - Growth of FDI stock in the previous 5 years: 0.0213 (standard error 0.0148)
    - Services share in export in the previous 5 years: 0.00464 (standard error 0.0152)
    - Export share in GDP in the previous 5 years: 0.00320 (standard error 0.00629)
    - Constant: -1.466 (standard error 1.037)
    - Observations: 47
    - R-squared: 0.798
    - Significance notation: *** p<0.01, ** p<0.05, * p<0.1
  - FDI stock growth, services share in export, and export share in GDP coefficients were all insignificant.

### Model-based potential growth estimate
- Model-predicted per capita real GDP growth for the Czech Republic over 2014–19 is 2.6 percent (based on regression coefficients and estimations/projections).
- Two reasons why 2.6 percent could be slightly over-estimated:
  - 0.7 percentage point of growth comes from the Czech Republic’s per capita GDP being on average 34 percent of the US per capita GDP in 2008–13 — viewed as catch-up potential rather than a pure projection.
  - 0.15 percentage point of growth comes from negative real ULC growth during 2009–14, which likely reflects the 2008 global financial recession rather than durable competitiveness gains.
- Staff baseline assumes average potential real GDP growth of 2.2 percent over 2014–19, which the analysis regards as in line with the above considerations.

### Implications for policy and structural reform priorities
- Strengthen R&D and technology spillovers:
  - R&D spending was 1.8 percent of GDP in 2011, below the OECD average of 2.4 percent.
  - Private-sector R&D appears limited by weak cooperation between businesses, universities, and the government; government funding tends to favor basic research and large companies.
  - There may be scope for government support to strengthen private-sector R&D and enhance technology spillovers from GCESC to the domestic economy.
- Enhance domestic value-added in exports and integration into international value chains:
  - Domestic value added of Czech exports was around 55 percent in 2012, substantially lower than in other advanced economies.
  - Explanations include: Czech-produced intermediates are relatively little used in Czech exports/global production; services sectors are poorly integrated into the supply chain and services content in Czech exports is the lowest among OECD countries.
  - Enhancing integration of domestic firms into international value chains could support TFP growth via international technology spillovers.
- Address skill mismatches and improve tertiary education alignment with labor market:
  - The Czech Republic performs relatively poorly in aligning fields of study with job requirements (horizontal mismatch).
  - Concerns of insufficient incentives for education to shift toward market needs; university funding based on student numbers rather than job-market outcomes.
  - OECD suggests improving tertiary education quality, publicizing labor market outcomes by field and institution, and developing accreditation criteria accordingly.
  - Improving skills will both contain ULC growth and accelerate TFP growth (via higher measured TFP and increased capacity to absorb new technologies).
- Develop services sector and boost labor force participation (especially female participation):
  - Services sector hired 60 percent of the labor force in 2013 versus 70 percent in Germany and 80 percent in the UK.
  - The top five female-intensive sectors in Germany hired around 30 percent of total labor force in 2013; the same industries hired 38 percent in the UK and only 22 percent in the Czech Republic.
  - In 2013, 74 percent of employed women in the Czech Republic worked in services compared with 83 percent in Germany and 91 percent in the UK.
  - Recommendations include reducing domestic entry barriers in services and enhancing competition to develop services, raise female labor force participation, and prepare for an aging society.

*Source: Appendix I. Potential Growth, IMF staff analysis as presented in the supplied content.*

### 3.6 percent in 2015.

### _cr14256 - 3.6 percent in 2015.

### Growth and inflation
- Real GDP is projected to increase by 2.5 percent in 2014 and 2015.
- Medium-term growth is projected to converge close to 2 percent.
- The inflation rate is forecast to converge to the 2 percent target by end-2015.

### Fiscal outlook and debt projections (baseline)
- Debt-to-GDP ratio:
  - 46 percent in 2013
  - 44.4 percent in 2014–15 (temporary stabilization in 2015 reflects scheduled government structural stimulus)
  - 42.3 percent in 2019
- Gross financing needs are projected to stay below 9 percent of GDP throughout the projection period.
- Change in gross public sector debt (selected years and cumulative):
  - 2012: 2.2
  - 2013: 4.7
  - 2014: -0.1
  - 2015: -1.7
  - 2019 cumulative: -3.7
- Primary (noninterest) revenue and grants (percent of GDP): 39.3 (2012), 40.1 (2013), 40.7 (2014), 41.1 (2015), 40.6 (2016), 39.8 (2017), 39.8 (2018), 39.7 (2019), 40.8 (cumulative/aggregate)
- Primary (noninterest) expenditure (percent of GDP): 41.5 (2012), 43.1 (2013), 41.0 (2014), 41.1 (2015), 40.8 (2016), 39.8 (2017), 39.7 (2018), 39.7 (2019), 40.7 (cumulative/aggregate)
- Automatic debt dynamics (contribution, percent of GDP): 0.2 (2012), 1.2 (2013), 1.3 (2014), -0.6 (2015), -0.1 (2016), -0.1 (2017), -0.5 (2018), -0.6 (2019), -0.7 (end), -2.5 (cumulative)
- Interest rate/growth differential contribution (percent of GDP): 0.2 (2012), 1.2 (2013), 0.9 (2014), -0.6 (2015), -0.1 (2016), -0.1 (2017), -0.5 (2018), -0.6 (2019), -0.7 (end), -2.5 (cumulative)
  - Of which: real interest rate: 1.0 (2012), 0.8 (2013), 0.5 (2014), 0.5 (2015), 1.0 (2016), 0.9 (2017), 0.5 (2018), 0.3 (2019), 0.2 (end), 3.4 (cumulative)
  - Of which: real GDP growth: -0.7 (2012), 0.4 (2013), 0.4 (2014), -1.1 (2015), -1.1 (2016), -1.0 (2017), -1.0 (2018), -0.9 (2019), -0.9 (end), -5.9 (cumulative)
- Exchange rate depreciation contribution: -0.1 (2012), 0.0 (2013), 0.4 (2014)
- Other identified debt-creating flows: -0.2 (2012), 0.0 (2013–2019)
  - General government net privatization proceeds (negative): -0.2 (2012), 0.0 (2013–2019)
  - Contingent liabilities: 0.0 (2012–2019)
- Residual, including asset changes: 0.0 (2012), 0.7 (2013), -1.7 (2014), -1.1 (2015), -0.2 (2016), -0.1 (2017), 0.0 (2018), 0.0 (2019), 0.1 (end), -1.2 (cumulative)
- Effective interest rate (defined as interest payments divided by debt stock at end of previous year): 2.0 (2014), 4.1 (2015), 4.1 (2016), 3.0 (2017), 2.6 (2018), 2.5 (2019) in baseline table entries.

### Shock and stress tests
- Main risk: A combination of macro-fiscal shocks (simultaneous shocks to real GDP growth, the primary balance, the real exchange rate, and the real interest rate).
- Under the combined shock scenario:
  - Public debt would increase sharply and stabilize around 62 percent of GDP.
  - Gross financing needs would climb to 14 percent of GDP in 2019.

### Public DSA baseline and alternative scenarios (underlying assumptions and selected scenario inputs)
- Baseline scenario key inputs (selected):
  - Real GDP growth: 2.5 (2014), 2.5 (2015), 2.4 (2016), 2.3 (2017), 2.1 (2018), 2.1 (2019)
  - Inflation: 0.9 (2014), 1.7 (2015), 1.8 (2016), 1.9 (2017), 1.9 (2018), 2.0 (2019)
  - Primary Balance: 0.0 (2014), -0.2 (2015), 0.0 (2016), 0.1 (2017), 0.0 (2018), 0.1 (2019)
  - Effective interest rate: 2.0 (2014), 4.1 (2015), 4.1 (2016), 3.0 (2017), 2.6 (2018), 2.6 (2019)
- Historical scenario key inputs (selected):
  - Real GDP growth: 2.5 (2014), 2.5 (2015), 2.5 (2016–2019)
  - Primary Balance: 0.0 (2014), -2.1 (2015–2019)
  - Effective interest rate: 2.1 (2014), 4.1 (2015), 4.3 (2016), 3.5 (2017), 3.3 (2018), 3.4 (2019)
- Constant Primary Balance scenario key inputs:
  - Primary Balance: 0.0 (2014–2019)
  - Effective interest rate: 2.0 (2014), 4.1 (2015), 4.1 (2016), 3.0 (2017), 2.6 (2018), 2.6 (2019)
- Combined Macro-Fiscal Shock scenario key inputs (selected):
  - Real GDP growth: 2.5 (2014), -1.2 (2015), -1.3 (2016), 2.3 (2017), 2.1 (2018), 2.1 (2019)
  - Inflation: 0.9 (2014), -0.2 (2015), -0.1 (2016), 1.9 (2017), 1.9 (2018), 2.0 (2019)
  - Primary Balance: 0.0 (2014), -3.3 (2015), -5.4 (2016), 0.1 (2017), 0.0 (2018), 0.1 (2019)
  - Effective interest rate: 2.3 (2014), 4.2 (2015), 4.8 (2016), 4.6 (2017), 4.9 (2018), 5.3 (2019)

### Debt composition and market indicators (selected)
- Nominal gross public debt (percent of GDP): 33.2 (2012), 46.2 (2013), 46.0 (2014), 44.3 (2015), 44.3 (2016), 44.1 (2017), 43.5 (2018), 42.9 (2019), 42.3 (end)
- Public gross financing needs (percent of GDP): 3.1 (2012), 4.2 (2013), 1.5 (2014), 5.5 (2015), 7.1 (2016), 7.4 (2017), 8.1 (2018), 8.6 (2019), 8.4 (projection)
- Real GDP growth (percent): 2.6 (2012), -1.0 (2013), -0.9 (2014), 2.5 (2015), 2.5 (2016), 2.4 (2017), 2.3 (2018), 2.1 (2019)
- Inflation (GDP deflator, percent): 0.9 (2012), 1.6 (2013), 1.9 (2014), 0.9 (2015), 1.7 (2016), 1.8 (2017), 1.9 (2018), 1.9 (2019), 2.0 (end)
- Nominal GDP growth (percent): 3.5 (2012), 0.6 (2013), 1.0 (2014), 3.4 (2015), 4.3 (2016), 4.3 (2017), 4.2 (2018), 4.1 (2019)
- Sovereign spreads indicators shown in table: EMBIG (bp) 3/268; 5Y CDS (bp) 51
- Ratings in table: Moody's A1/A1; S&Ps AA-/A A; Fitch A+/AA-

### Fund relations and statistical notes (selected)
- Membership Status: Joined 01/01/1993; Article VIII
- Quota: 1,002.20 SDR Million (100.0 percent of Quota)
- Fund Holdings of Currency: 624.85 SDR Million (62.35 percent)
- Reserve position in Fund: 377.35 SDR Million (37.65 percent)
- SDR Department net cumulative allocation: 780.20 SDR Million (100.0 percent)
- Holdings: 751.39 SDR Million (96.31 percent)
- Last Article IV Consultation: concluded on July 24, 2013; staff report and press release published on August 2, 2013.
- Exchange rate (June 30, 2014): CZK 27.45 per euro; CZK 20.10 per U.S. dollar.
- Data provision: Subscribed to the Special Data Dissemination Standard in April 1998. Core surveillance data availability:
  - Interest rates and exchange rates: reported daily with no lag.
  - Gross and net international reserves: monthly with a one week lag; also on a 10-day basis with 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 data: quarterly with a lag of two to three months.
  - Main components of balance of payments: available monthly since 2003.
  - Annual Government Finance Statistics Yearbook data: available on a timely basis.
  - Monthly fiscal data in International Financial Statistics: available with a two- to three-month lag.

*Source: IMF staff.*

### 3.  While data quality is generally high, some deficiencies remain in certain areas, and the

### _cr14256 - 3.  While data quality is generally high, some deficiencies remain in certain areas, and the authorities are taking measures to improve data accuracy.

### National accounts and GDP measurement
- Value added in the small scale private sector is likely to be underestimated due to underdeveloped data collection mechanisms and a significant proportion of unrecorded activity stemming from tax evasion.
- Discrepancies between GDP estimates based on the production method and the expenditure method are large and are subsumed under change in stocks.
- Quarterly national accounts:
  - Derived from quarterly reports of enterprises and surveys.
  - Subject to bias because of nonresponse (quarterly reporting is not mandatory) and lumping of several expenditure categories in particular quarters by respondents.
  - Large swings in individual components of spending and overall GDP quarter-to-quarter bring into question the reliability of the quarterly data and hamper business cycle analysis.
- Transition to ESA 2010:
  - The Czech Republic is adopting the European System of Accounts 2010 (ESA 2010) in September 2014.
  - The transition from ESA 1995 (ESA95) requires a revision of national accounts data.
  - New data sources will be incorporated in the new estimates due to be published in September/October 2014.

### External sector and trade statistics
- Revisions to export data processing procedures have brought external trade statistics close to EU practice.
- A continued weakness is the unavailability of fixed base price indices for exports and imports; indices are currently presented on the basis of the same month of the previous year.
- Starting in 2014, external sector statistics are compiled according to the Balance of Payments and International Investment Position Manual, sixth edition (BPM6) and in accordance with legal requirements of the ECB and Eurostat.

### Monetary statistics and monetary survey data
- Monetary survey data provided to the European Department are generally adequate for policy purposes.
- Large variations in the interbank clearing account float, especially at the end of the year, require caution in interpreting monetary developments.
  - The CNB has made a major effort to identify the causes of these variations and adjust the data.
- In 2002 the CNB implemented the ECB’s framework for collecting, compiling, and reporting monetary data to meet EU statistical conventions.
  - Data published in IFS are based on monetary accounts derived from the ECB’s framework.
  - The same set of accounts forms the basis for monetary statistics published in the CNB’s bulletins and on the website, effectively harmonizing them with IFS (presentation differs somewhat).

### Fiscal statistics and government accounts
- Annual and quarterly fiscal data are compiled on an ESA95 basis by the Czech Statistical Office, including non-financial accounts, financial accounts, and financial balance sheets.
- Starting from September 2014, GFS data will be based on ESA 2010 methodology:
  - Likely to include revisions of the general government deficit and debt levels from 1995 onwards.
- The Ministry of Finance uses the ESA methodology for the Convergence Program targets.
- Adjustments are required when converting data from the national (fiscal targeting) methodology to ESA-based fiscal accounts; differences relate mainly to:
  - Coverage of institutions classified in the general government sector.
  - Exclusion of financial transactions.
  - Different classification of some specific government transactions (for example, called guarantees).
  - Time of recording of government transactions (ESA records transactions on accrual basis).

### Key surveillance indicators and data frequency (as of July 18, 2014)
- Exchange Rates: Date of Latest Observation — current; Date Received — current; Frequency of Data/Reporting/Publication — D D D.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of Latest Observation — May 2014; Date Received — Jun. 2014; Frequency — D M M.
- Reserve/Base Money: May 2014; Jun. 2014; M M M.
- Broad Money: May 2014; Jun. 2014; M M M.
- Central Bank Balance Sheet: Jun. 2014; Jun. 2014; M M M.
- Consolidated Balance Sheet of the Banking System: May 2014; Jun. 2014; M M M.
- Interest Rates: current; current; D D D.
- Consumer Price Index: May 2014; Jun. 2014; M M M.
- Revenue, Expenditure, Balance and Composition of Financing — General Government: 2012; May 2014; A A A.
- Revenue, Expenditure, Balance and Composition of Financing — Central Government: May 2014; Jun. 2014; M M M.
- Stocks of Central Government and Central Government-Guaranteed Debt: 2014 Q1; Jun. 2014; Q Q Q.
- External Current Account Balance: Mar. 2014; Jun. 2014; M M M.
- Exports and Imports of Goods and Services: Mar. 2014; Jun. 2014; M M M.
- GDP/GNP: 2014 Q1; Jun. 2014; Q Q Q.
- Gross External Debt: 2014 Q1; Jun. 2014; Q Q Q.
- International Investment Position: 2014 Q1; Jun. 2014; Q Q Q.

### Staff statement highlights (Statement by the IMF Staff Representative on the Czech Republic, August 27, 2014)
- CNB extended the timeline for using the exchange rate as an additional monetary policy instrument to end-2015.
  - New quarterly macroeconomic forecast foresees achievement of the inflation target conditional on continuation of current market interest rates and use of the exchange rate as a monetary policy instrument for inflation targeting until 2015:Q3.
  - CNB Board assessed risks to the new forecast as being to the downside, mainly from very low euro area inflation, and extended its guidance for using the exchange rate as a monetary policy instrument.
- Exchange rate developments:
  - Following the decision, the koruna entered a slight depreciation trend.
  - As of August 21, koruna was about 2 percent weaker than the level prevailing at end-July and about 4 percent weaker than the CNB’s floor of 27 koruny per euro.
- National accounts and growth:
  - Preliminary estimates suggest that real GDP grew 2.6 percent year-over-year in the second quarter of 2014.
  - Compared to the first quarter, real GDP remained unchanged mainly due to continued destocking of tobacco products following the excise tax hike.
- Inflation:
  - Headline inflation increased to 0.5 percent year-on-year in July from 0 percent year-on-year in June, mainly due to a slight acceleration of food price inflation.
  - Inflation excluding regulated prices, indirect price changes, food, and fuels remained unchanged at 0.7 percent year-on-year in July.

### Press Release summary and Executive Board assessment (Press Release No. 14/402, September 2, 2014)
- Macroeconomic developments:
  - The Czech economy exited the recession in 2013; recovery triggered by exports and increasingly supported by domestic demand.
  - High frequency indicators suggest growth has remained strong in recent months.
  - Unemployment entered a gradually declining path in 2013.
  - Exports are performing very well; current account deficit likely to narrow and approach balance this year.
  - Inflation has been falling and is fluctuating just above zero; core indicators on a moderate upwards trend.
- Fiscal outcomes:
  - Overall fiscal deficit narrowed from 4.2 percent of GDP in 2012 to 1.5 percent in 2013.
  - The adjustment was driven mainly by compression of capital expenditure and an increase in VAT rates.
  - Structural deficit narrowed by 1.3 percentage points of GDP following a cumulative 2.4 percentage point of GDP consolidation during 2011–12.
- Monetary policy and CNB interventions:
  - CNB used foreign exchange intervention to avoid deflation; commitment to prevent excessive appreciation below CZK27 per euro implied a 6 percent depreciation expected to bring inflation to target.
- Financial sector:
  - Banks improved capital position to a capitalization ratio of 16.5 percent at end-2013 compared with 15.6 percent in 2012.
  - Credit growth is currently low, likely to recover gradually given strong balance sheets.
- Executive Board recommendations and views:
  - Importance of a comprehensive growth strategy with supportive macroeconomic policies and accelerated structural reforms.
  - Support for growth-friendly fiscal strategy anchored in a clear medium-term framework; prudent near-term fiscal easing to increase capital investment, particularly infrastructure.
  - Continue to improve tax administration, combat tax evasion, and use revenue over-performance for priority expenditures and debt reduction.
  - Maintain current accommodative monetary stance by keeping the exchange rate floor in place while considering modalities for a timely exit; return to floating exchange rate once deflation risks recede and inflation forecast and expectations are entrenched.
  - Remain vigilant on financial sector supervision and improve supervisory architecture; consider implications of joining the euro-area banking union ahead of euro adoption.
  - Priority structural reforms: increase investment in physical and human capital, remove labor market rigidities, improve the business environment, promote labor participation, advance R&D, and upgrade technical skills.

### Selected economic indicators (excerpted staff projections and historical values)
- Nominal GDP (USD billions): 2008 225.41; 2009 197.21; 2010 198.52; 2011 216.11; 2012 196.4; 2013 198.4; 2014 200.0; 2015 208.9; 2016 216.7.
- Population (millions): 2008–2016 ~10.3–10.6 (entries: 10.3 10.4 10.5 10.5 10.5 10.5 10.5 10.6 10.6).
- GDP per capita (USD): 2008 21,794; 2009 18,913; 2010 18,973; 2011 20,603; 2012 18,699; 2013 18,871; 2014 18,985; 2015 19,796; 2016 20,511.
- Real GDP (change in percent): 2008 3.1; 2009 -4.5; 2010 2.5; 2011 1.8; 2012 -1.0; 2013 -0.9; 2014 2.5; 2015 2.5; 2016 2.4.
- Domestic demand (change in percent): 2008 2.2; 2009 -5.4; 2010 2.0; 2011 -0.1; 2012 -2.9; 2013 -0.8; 2014 1.8; 2015 2.9; 2016 2.8.
- Private consumption (change in percent): 2008 2.8; 2009 0.2; 2010 0.9; 2011 0.5; 2012 -2.1; 2013 0.1; 2014 1.3; 2015 2.5; 2016 2.5.
- Investment (change in percent): 2008 1.9; 2009 -20.2; 2010 5.4; 2011 0.8; 2012 -5.0; 2013 -4.4; 2014 3.0; 2015 4.4; 2016 4.0.
- Exports (change in percent): 2008 4.0; 2009 -10.9; 2010 15.4; 2011 9.5; 2012 4.5; 2013 0.2; 2014 7.2; 2015 5.0; 2016 4.0.
- Imports (change in percent): 2008 2.7; 2009 -12.1; 2010 15.4; 2011 7.0; 2012 2.3; 2013 0.6; 2014 7.0; 2015 5.8; 2016 4.6.
- Output gap (percent of potential output): 2008 5.4; 2009 -2.7; 2010 -1.2; 2011 0.2; 2012 -1.3; 2013 -2.7; 2014 -1.9; 2015 -0.5; 2016 -0.1.
- CPI (average): 2008 6.3; 2009 1.0; 2010 1.5; 2011 1.9; 2012 3.3; 2013 1.4; 2014 0.6; 2015 1.9; 2016 2.0.
- Unemployment rate (percent): 2008 4.4; 2009 6.7; 2010 7.3; 2011 6.7; 2012 7.0; 2013 7.0; 2014 6.4; 2015 6.0; 2016 5.6.
- General government revenue (percent of GDP): 2008 38.9; 2009 38.9; 2010 39.1; 2011 40.0; 2012 40.3; 2013 40.9; 2014 41.3; 2015 40.7; 2016 40.0.
- General government expenditure (percent of GDP): 2008 41.1; 2009 44.7; 2010 43.7; 2011 43.2; 2012 44.5; 2013 42.3; 2014 42.5; 2015 42.2; 2016 41.1.
- Net lending / Overall balance (percent of GDP): 2008 -2.2; 2009 -5.8; 2010 -4.7; 2011 -3.2; 2012 -4.2; 2013 -1.5; 2014 -1.2; 2015 -1.4; 2016 -1.2.
- General government debt (percent of GDP): 2008 28.7; 2009 34.6; 2010 38.4; 2011 41.4; 2012 46.2; 2013 46.0; 2014 44.3; 2015 44.3; 2016 44.1.
- Broad money (M3) (end of year, percent change): 2008 13.6; 2009 0.2; 2010 1.9; 2011 2.8; 2012 4.8; 2013 5.8.
- Private sector credit (end of year, percent change): 2008 16.1; 2009 0.8; 2010 3.0; 2011 5.5; 2012 2.6; 2013 3.7.
- Three-month interbank rate (year average): 2008 4.0; 2009 2.2; 2010 1.3; 2011 1.2; 2012 1.0; 2013 0.5; 2014 0.4 (2014 entry is January-June average).
- Ten-year government bond (year average): 2008 4.6; 2009 4.8; 2010 3.9; 2011 3.7; 2012 2.8; 2013 2.1; 2014 2.0 (2014 entry is January-June average).
- Trade balance (goods and services) (percent of GDP): 2008 2.7; 2009 4.3; 2010 3.4; 2011 4.2; 2012 5.5; 2013 6.2; 2014 7.0; 2015 6.9; 2016 6.9.
- Current account balance (percent of GDP): 2008 -2.1; 2009 -2.5; 2010 -3.8; 2011 -2.9; 2012 -1.3; 2013 -1.4; 2014 -0.2; 2015 -0.3; 2016 -0.4.
- Gross international reserves (US$ billion): 2008 37.0; 2009 41.6; 2010 42.5; 2011 40.3; 2012 44.9; 2013 56.2; 2014 57.9; 2015 60.8; 2016 63.4.
- Gross international reserves (in months of imports of goods and services): 2008 3.2; 2009 4.5; 2010 4.0; 2011 3.2; 2012 3.7; 2013 4.6; 2014 4.5; 2015 4.4; 2016 4.3.
- Nominal effective exchange rate (index, 2005=100): 2008 121.6; 2009 116.2; 2010 118.7; 2011 122.4; 2012 117.7; 2013 115.7.
- Real effective exchange rate (index, CPI-based; 2005=100): 2008 125.6; 2009 120.5; 2010 122.5; 2011 125.1; 2012 121.3; 2013 118.8.

### Policy recommendations and actions described in the source
- Continue efforts to improve data collection for the small scale private sector and reduce underestimation of value added.
- Publish revised national accounts consistent with ESA 2010 and incorporate new data sources (publication scheduled for September/October 2014).
- Develop fixed base price indices for exports and imports to improve trade statistics.
- Maintain caution when interpreting monetary aggregates due to interbank clearing account float variability; continue CNB efforts to identify and adjust causes.
- Preserve harmonization of monetary statistics with ECB/IFS standards while clarifying presentation differences.
- Use fiscal space to support growth-friendly measures: increase capital investment, improve tax administration, combat tax evasion, and adopt a medium-term fiscal framework including fiscal rules, a debt brake, and an independent fiscal council.
- Maintain accommodative monetary stance while monitoring inflation risks and discussing modalities for a timely exit from exchange rate intervention once conditions permit.

*Italic: IMF staff report content and related statements as provided in the source document.*

### 2014. In 2014, the government’s fiscal policy strategy expects to utilize this newly-created fiscal

### 2014. In 2014, the government’s fiscal policy strategy expects to utilize this newly-created fiscal

### Fiscal policy stance and near-term outlook
- Government will utilize newly-created fiscal space in 2014 to support the domestic economy’s fragile recovery in the short term, with a neutral effect in the medium term.
- Government investment (mainly due to the increase in investment financed from EU sources) and government current spending (primarily on social benefits) are projected to pick up in 2014.
- Only relatively moderate discretionary tax measures are planned for 2014.
- The wage bill in the state administration was approved to increase by 2 percent in 2014.
- Tax revenues are expected to improve in 2014 on the back of the strengthening economy.

### Government debt and interest costs
- Gross government debt:
  - 46.2 percent of GDP in 2012
  - 46 percent of GDP in 2013
  - 44 percent of GDP in 2014
- Net financial government debt is estimated at 29.9 percent of GDP in 2014.
- Government debt denominated in foreign currency is estimated at 14 percent of total debt (or 4.1 percent of GDP, adjusted for collateral and assets).
- Expenditures on interest payments remain low; yields on government bonds remain at a historical low.

### Tax legislation changes and measures planned for 2015
- Lower House approved an increase in excise duty rates on tobacco products in line with EU requirements, particularly due to the currency depreciation.
- Planned amendments as of January 1, 2015:
  - Amend the personal income tax legislation, including by increasing tax credits for children and reintroducing tax discounts for pensioners.
  - Introduce a second, reduced VAT rate of 10 percent on drugs, books, and essential infant nutrition.
  - Abolish fees for prescription and outpatient treatment.

### Medium-term fiscal objectives and projections
- Government committed to medium-term structural deficit objective of 1 percent of GDP by 2020 and headline deficit below 3 percent.
- Government expects to reach a headline fiscal deficit of 1.7 percent of GDP in 2017.
- Structural deficit is expected to deteriorate to 1.7 percent of GDP by 2017 as a result of reduced emphasis on public sector consolidation.
- Government debt is projected to increase only slightly by 2017, in view of expected recovery of GDP growth.
- Medium-term fiscal policy priorities:
  - Increase effectiveness of tax collection and more successfully fight against tax evasion.
  - Rationalization of expenditure and savings in government sector’s current expenditure.
  - Wage bill in the state administration expected to grow by 1 percent in the medium term.
  - Wages of medical doctors should increase in 2015 and 2016.
  - Gross fixed capital formation of the government sector expected to be around 3 percent annually in the medium-term outlook horizon until 2017.
  - A larger amount of funding will be directed to the healthcare sector.

### Fiscal governance and legal frameworks
- Government committed to adopt the Fiscal Compact of the EU.
- Work continues on the Constitutional Act on Fiscal Responsibility with the aim of enacting it in 2015; the Act will introduce numerical fiscal rules, a debt break, and a fiscal council.
- Based on agreement between Government and two opposition parties, the new Civil Service Act is to be approved to enter into force on January 1, 2015.

### Structural policies and labor market measures
- Draft Act to introduce a new type of service to provide childcare was adopted by the Lower House of the Parliament (aimed at increasing labor force participation).
- Government aims to create suitable conditions for long-term sustainable employment via targeted active employment policy and modification of the investment incentive system to improve employers’ motivation to invest in regions with an above-average unemployment rate.
- Measures will be implemented to reduce entrepreneurs’ administrative and regulatory burden.
- Minimum wage should be increased annually to reflect the socio-economic environment and to raise it over time to 40 percent of the average wage.

### Pension policy and reforms
- Government returning to pre-2012 rules for pension indexation: indexation based on the CPI index and real wage growth.
- From 2015, the average, independently paid old-age pension will increase by at least 1.8 percent annually.
- Measures aim to stop the decrease of the real value of pensions and to prevent decrease of the standard of living of pensioners.
- 2011 measures increasing retirement age stabilized the average period of pension payments for the long term; government considered standardized procedures of regular revisions to the retirement age increase rate due to demographic uncertainty.
- An expert committee established to propose changes to the pension system to enhance long-term stability, sustainability of funding, and adequacy of benefits.
- Expert committee mandated to submit a proposal for termination of Pillar II of the pension system on January 1, 2016.

### Financial sector soundness and regulation
- Czech banking sector characteristics:
  - Well-capitalized with 17.1 percent capital adequacy ratio.
  - Return on equity of 18.4 percent.
  - Loan-to-deposit ratio of 74 percent.
  - Non-performing loans at 6.5 percent of total loans.
  - Non-performing loan provisioning at 48 percent.
- Banking sector features:
  - Traditional banking model, profitable, operate in environment of excess liquidity.
  - Bank lending predominantly financed by domestic deposits.
  - Foreign exchange loans to households are virtually non-existent.
  - Net external position of the Czech banking sector is positive.
  - Credit growth remains moderate; loans to households growth low; loans to non-financial corporate sector stagnating due to weak domestic demand.
- Stress tests and resilience:
  - CNB bank stress tests showed sector sufficiently resilient to very unfavorable shocks.
  - Insurance sector showed sufficient resilience due to large capital buffer.
  - Pension management company sector (pillar III) remains sensitive to a rise in yields on securities holdings.
- Regulatory developments:
  - EU Capital Requirements Directive (CRD IV) transposed into Czech law as of June this year, with selected parts taking effect in 2015 and 2016; banks already in compliance with the new regulation.
  - EU Directive on recovery and resolution of credit institutions and investment firms (BRRD) expected to be transposed into Czech law in 2015.
  - Authorities continue addressing weaknesses in non-systemic credit union sector by closing unviable businesses and strengthening regulation.
  - CNB increased staff in financial sector supervision in line with FSAP recommendations.

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

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14256.pdf_