## 1. External Sustainability and Competitiveness ## Source details **Canonical URL:** [1. External Sustainability and Competitiveness](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16213.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16213.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16213.pdf.json) --- ### Context and recent developments - Economic performance: - Real GDP growth: 4.2 percent in 2015; output expanded by 3.0 percent y-o-y in 2016:Q1. - Contributions to 2015 growth: government consumption, investment, and inventories accounted for close to half of economic growth; private consumption and investment also contributed in 2016:Q1. - Labor market and wages: - Private sector employment growth: 2 percent y-o-y in 2016:Q1. - Unemployment rate: 4.1 percent in April 2016. - Labor participation: 75 percent. - Real wage growth: 3.9 percent in 2016:Q1. - Minimum wage: cumulative increase of 24 percent during 2014–16; now at 35 percent of the average economy-wide wage (EU average 42 percent). - Inflation and expectations: - Headline inflation: 0.3 percent in 2015; 0.5 percent y-o-y in 2016:Q1; eased to 0.1 percent y-o-y in May 2016. - Core inflation: around 1 percent. - One-year ahead inflation expectations: 1.7 percent in May 2016; three-year expectations anchored at 2 percent. - Fiscal outcomes: - Fiscal deficit: narrowed from 1.9 percent of GDP in 2014 to 0.4 percent in 2015 (against a 1.9 percent target). - Public debt: declined to 41 percent of GDP in 2015. - Structural balance note: stripping net EU revenues out of the structural balance shows the structural deficit widened by 1 percentage point in 2015. - Monetary and FX policy: - CNB policy rate: 0.05 percent since November 2012. - Exchange rate floor: introduced at CZK 27 per euro in November 2013; extended commitment until end-2016. - CNB FX interventions: purchased €12.2 billion during July 2015–April 2016 to defend the floor. - Banking and credit: - Deposits grew by 8 percent y-o-y in 2016:Q1. - Credit to the private sector growing at around 8-9 percent since August 2015. - External position: - Current account surplus: 0.9 percent of GDP in 2015. - Net international investment position: –31 percent of GDP in 2015. - Reserves increased (reserves as share of GDP reported elsewhere as 36 percent; reserves noted as about 123 percent of the IMF composite reserve adequacy metric). ### Outlook and key macro projections - Short- and medium-term outlook: - Short-term: economic activity expected to decelerate in 2016; private consumption to remain robust; slowdown in EU-fund absorption to weigh on growth. - Medium-term: output growth set to stabilize at slightly above 2 percent in line with potential. - Inflation path: expected to reach 2 percent target in 2017 as oil price base effects fade and domestic demand pressures rise. - Current account: projected to remain in a small but declining surplus, then move toward a deficit as investment improves. - Selected projections (percent unless stated otherwise): - Real GDP growth: 2013 -0.5; 2014 2.0; 2015 4.2; 2016 2.2; 2017 2.7; 2018 2.4; 2019 2.2; 2020 2.2; 2021 2.2. - Inflation (period average): 2013 1.4; 2014 0.4; 2015 0.3; 2016 0.6; 2017 1.9; 2018 2.0; 2019 2.0; 2020 2.0; 2021 2.0. - General government overall balance (percent of GDP): 2013 -1.3; 2014 -1.9; 2015 -0.4; 2016 -0.6; 2017 -0.6; 2018 -0.5; 2019 -0.5; 2020 -0.5; 2021 -0.5. - General government gross debt (percent of GDP): 2013 45.1; 2014 42.7; 2015 41.1; 2016 40.8; 2017 39.8; 2018 38.9; 2019 37.9; 2020 37.1; 2021 36.2. - Current account (percent of GDP): 2013 -0.5; 2014 0.2; 2015 0.9; 2016 1.4; 2017 1.0; 2018 0.6; 2019 0.1; 2020 -0.4; 2021 -0.8. - Reserves (in billions of euros): 2013 41.0; 2014 44.2; 2015 60.4; 2016 67.0; 2017 74.9; 2018 80.5; 2019 83.5; 2020 85.7; 2021 86.1. ### Risk assessment (selected) - Balance of risks: tilted to the downside. - External risks: - Weaker external demand (euro area, China, emerging markets); geopolitical risks and Brexit; global financial turbulence leading to safe-haven inflows and appreciation pressures. - Financial stability risks: - Prolonged low interest rates could lead to overvaluation of real estate and other asset prices absent effective macroprudential measures. - Upside risks: - Larger-than-expected positive effects from supportive macro policies, lower oil prices, improved sentiment, and ECB quantitative easing. ### Staff appraisal (summary) - Overall assessment: "The Czech economy has been performing very well." - Remaining challenges: - CNB exchange rate floor helped keep inflation positive, but inflation still below target. - Potential growth below level needed for fast convergence to income levels of other advanced European countries. - Policy challenge: create conditions for sustained increase in potential growth while maintaining macroeconomic stability. --- ### Policy agenda — Fiscal policy and public finances - Near-term stance and targets: - Authorities’ 2016 Convergence Program targets headline deficits of 0.6 and 0.5 percent of GDP for 2016 and 2017. - Staff baseline: slight widening in the structural fiscal deficit to 0.8 percent of GDP in 2017 versus the 1 percent MTO; near-term stance judged appropriate given slowdown and low inflation. - Revenue and spending dynamics: - Measures to fight tax evasion (electronic VAT reporting, rollout of electronic evidence of sales) expected to yield gains; projected revenue gains to be more than offset by increases in public wages, child tax credits, new hires in education and police, and topping-up of automatic pension indexation. - Staff urged restraint on additional wage and benefit hikes pre-elections until tax collection strengthening is established. - Staff advised resisting shifting more items to the reduced VAT rate and recommended that future tax cuts be part of a broader tax system review. - Medium-term strategy and fiscal framework: - Staff baseline projects structural deficit declining to ½ percent of GDP over the medium term, below the 1 percent MTO, providing space to accommodate fiscal priorities including higher public investment. - Staff reiterated recommendation for speedy adoption of fiscal framework legislation—under consideration by Parliament—to anchor policy, reduce pro-cyclicality, and enhance predictability. - Pension system concerns and advice: - Recent legislation allows discretionary pension increases beyond automatic indexation in certain cases and up to a limit. - Plans to cap statutory retirement age and granting early retirement benefits to some miners raise sustainability concerns. - Staff urged refraining from ad hoc pension adjustments beyond the standard indexation formula and from imposing an ex-ante limit on maximum retirement age. - Public debt management recommendations: - Public debt projected to decline to around 36 percent of GDP by 2021 under current policies; sustainable under alternative negative-shock scenarios. - Ministry of Finance performed buybacks of short-maturity bonds financed by long-term issuance; average maturity of public debt decreased after issuance of two- and three-year bonds with negative auction yields. - Recommendation: consider increasing average maturity of debt to take advantage of current low interest rates and lower debt service. - EU funds absorption: - Strengthen capacity to absorb EU funds; past delays and highest rate of financial accounting corrections in the EU (2007–13 program). - Centralized management by Ministry of Regional Development improved absorption; control systems under strain, raising concerns about irregularities. - Staff urged ensuring compliance with EU requirements to launch large transport projects and systematically follow up and correct systemic shortcomings identified by the Supreme Audit Office in EU Structural and Cohesion Funds utilization. ### Fiscal policy: authorities’ stance (authorities’ statements) - Authorities re-affirmed commitment to fiscal discipline and efforts to further reduce the deficit. - Structural deficit described as "already well below the medium-term objective." - Near-term stance described as "slightly expansionary" and considered necessary given the "moderate level of public debt and its projected decline." - Authorities expected the structural deficit to reach the MTO already in 2017, citing a larger-than-Fund-staff estimate of the output gap. - Acknowledged political pressures pre-elections but committed to Convergence Program targets. - Hoping for expeditious approval of fiscal responsibility legislation. --- ### Monetary policy: stance, tools, and recommendations - Current stance and instruments: - CNB policy rate: 0.05 percent (technical zero); exchange rate floor at CZK 27 per euro used since November 2013 as an additional instrument. - CNB purchased €12.2 billion during July 2015–April 2016 to defend the floor; extended commitment to end-2016. - Staff recommendations: - Maintain focus on inflation targeting and prepare for monetary policy normalization. - Treat exchange rate floor as temporary; prepare for eventual exit to a floating exchange rate. - Be ready to use discretionary FX interventions and reduce interest rates to negative levels if needed. - Clear communication on inflation targeting to guide expectations during normalization. - Consider readiness to introduce mildly negative interest rates if downside risks materialize; timing dependent on inflation, capital inflows, and appreciation pressures. - Given banking reliance on domestic deposits and sizable excess liquidity, recommend tiered negative deposit interest rates excluding parts of deposit base to mitigate profit impacts. - Authorities’ views: - Agreed on need for accommodative policy given anti-inflationary balance of risks. - Emphasized maintaining exchange rate floor till end-2016 and readiness to raise it further if disinflationary pressures increase sharply. - CNB board discussing pros and cons of negative interest rates; CNB and commercial banks operationally ready for introduction and did not see significant banking-sector risks from mildly negative policy rates. - Assessed the koruna "broadly in line with the long-term fundamentals" and foresaw a smooth exit to a fully floating exchange rate while retaining readiness to intervene to smooth excessive volatility. ### Empirical assessment of the exchange rate floor (Annex IV / empirical methods) - Three empirical strategies analyzed the floor’s impact on inflation: event study, difference-in-difference (DiD), and synthetic control. - Event study (open-economy New Keynesian Phillips curve, pre-event sample 2008:Q1–2013:Q3): "The introduction of the floor has helped keep inflation above zero." Effect became statistically significant towards beginning of 2015 (95 percent confidence interval). - DiD preferred-model estimate: introduction of the floor brought Czech inflation up by 0.5 percentage points compared with the control group. - Synthetic control: constructed counterfactual from Denmark, Lithuania, Slovakia, and Slovenia; synthetic method supports that the floor alleviated deflationary pressures. - Conclusion: all methods support the view that the exchange rate floor helped prevent Czech inflation from entering negative territory, though causality should be interpreted with caution given non-random treatment. --- ### Financial sector stability and macroprudential policy - System resilience and capital: - Capital adequacy ratio: 16.7 percent in 2015. - Nonperforming loan ratio: 5.5 percent in 2015. - Loan-to-deposit ratio: below 80 percent. - Credit growth and housing: - Credit to non-financial corporations expanded by 6 percent last year (driven by manufacturing, real estate, and energy). - Household credit growing at 8 percent, driven by mortgages. - Mortgage lending at a 10-year high; mortgage rates at historic lows. - Residential housing offer prices increased by 10 percent y-o-y in 2015:Q4 despite a 16 percent increase in housing starts. - Estimated average apartment "price-to-annual wage ratio of 4". - Vulnerabilities and recommendations: - Tighten mortgage lending standards and make CNB recommendations legally binding. - Consider granting CNB authority to issue binding macroprudential regulations. - If mortgage trends persist, further tighten macroprudential stance. - Prefer targeted measures: raise risk weights on mortgages, lower LTV limits with possible regional differentiation, guidance on maximum debt-to-income limits. - CNB increased countercyclical capital buffer to 0.5 percent effective 2017 and ready to increase further. - Regulatory and supervisory progress: - Largely implemented 2012 FSAP recommendations. - Bank Recovery and Resolution Directive (BRRD) transposed into local law; CNB designated resolution authority. - Deposit Guarantee Scheme Directive transposed via change in the Act on Banks effective January 2016. - Consumer Credit Act transposing the Mortgage Credit Directive currently in Parliament. - Stress tests indicate sufficient capital to cover two-year losses; sector resilient under adverse scenarios. --- ### Structural reforms and potential growth (Box 2 and main text) - Potential growth estimation and projection: - Methods used: Hodrick-Prescott (HP), multivariate filter (MVF1), multivariate filter with financial frictions (MVF2), and production function approach (PF) over 2001-2015:Q2. - Potential growth "is recovering from post-crisis lows but is projected to remain subdued at about 2–2½ percent." - Potential growth reached an average of 2½ percent in 2015 (except PF) and projected to remain well below pre-crisis levels. - Drivers of deceleration and recovery: - Deceleration largely due to a decline in TFP contribution and labor force reduction. - Recovery since 2013 driven by higher labor force participation that offset decline in working-age population. - Output gap: - All estimates suggest the output gap closed in mid-2015. - Output gap expected to turn positive in 2016 (0.3-0.7 percent) consistent with staff baseline estimate of 0.2 percent and move to zero thereafter. - Structural reform priorities: - Labor market: improve tertiary education and vocational training; consider a dual vocational education system; more flexible immigration policies; incentives for labor mobility. - Investment: raise private and public investment, improve EU-fund utilization efficiency. - Innovation: steadfast implementation of National Research, Development and Innovation Policy for 2016–20 to improve coordination, prioritization, and cooperation between research centers and business. - Business environment: improve predictability of policy and regulation, reduce administrative burden, increase efficiency of judicial procedures, address high labor taxation and construction permit difficulties. --- ### Debt sustainability and stress-test findings (Annex VII) - Recent and projected debt path: - Public debt: 41 percent of GDP in 2015; projected to decline to 36 percent of GDP by 2021 under baseline. - Debt-to-GDP ratio in reported table: 2014 45.1; 2015 42.7; 2016 41.1; 2017 40.8; 2018 39.8; 2019 38.9; 2020 37.9; 2021 37.1 (and elsewhere 36.2 percent cited as medium-term target). - Baseline fiscal assumptions: - Structural deficit: 0.3 percent of GDP in 2015 → 0.6 percent in 2016 → 0.5 percent over the medium term. - Real GDP growth: close to potential at 2.2 percent over the medium-term. - Inflation (GDP deflator): projected to move toward 2 percent in 2017. - Gross financing needs (percent of GDP): 2014 6.8; 2015 8.5; 2016 5.9; 2017 6.2; 2018 5.5; 2019 6.2; 2020 6.1; 2021 5.9 (one chart entry shows 6.3 for 2021). - Stress-test scenario (shock to real GDP growth): - Public debt would rise to 48 percent of GDP and gross financing needs would increase to 11 percent of GDP by 2018; thereafter debt declines to 47 percent of GDP and gross financing needs drop to 8 percent of GDP by 2021. - Key fiscal and debt indicators (selected exact figures preserved from tables): - Nominal gross public debt (selected): 2014 34.9; 2015 42.7; 2016 41.1; 2017 40.8; 2018 39.8; 2019 38.9; 2020 37.9; 2021 37.1. - Effective interest rate (percent): 2014 3.8; 2015 3.1; 2016 2.7; 2017 2.6; 2018 2.9; 2019 3.1; 2020 3.4; 2021 3.8. - Primary (noninterest) revenue (percent of GDP): 2014 39.0; 2015 40.6; 2016 42.0; 2021 42.9. - Primary (noninterest) expenditure (percent of GDP): 2014 41.0; 2015 41.4; 2016 41.5; 2021 41.4. --- ### Policy priorities and recommendations (summary) - Fiscal: - Adopt fiscal framework legislation quickly to anchor policy, reduce pro-cyclicality, and enhance predictability. - Resist pressures to reduce taxes and increase current spending in run-up to elections. - Avoid ad hoc pension changes that jeopardize long-term sustainability. - Improve public investment planning, prioritization, and procurement to raise growth impact of EU funds. - Monetary and macro-financial: - Maintain inflation-targeting focus; keep monetary policy accommodative until inflation forecast and expectations are anchored around 2 percent. - Prepare for exit from exchange rate floor; readiness to use negative interest rates and tiered arrangements if necessary. - Strengthen macroprudential measures in housing market: make CNB recommendations binding, raise risk weights, lower LTV limits, consider regional differentiation, and set guidance on debt-to-income limits. - Structural reforms: - Raise potential growth by boosting TFP and human capital, reforming tertiary and vocational education, improving R&D coordination, and easing administrative and institutional impediments to investment. - Strengthen measures to absorb EU Structural and Cohesion Funds while ensuring compliance with EU rules and audit recommendations. *IMF staff report: 1. External Sustainability and Competitiveness (Czech Republic) — content unit _cr16213.* ### 1. External Sustainability and Competitiveness ___________________________________________________ 19 ### 1. External Sustainability and Competitiveness ### Context and Recent Developments - Czech economic performance recently has been "impressive", driven by a favorable external environment, high EU fund utilization, and accommodative macroeconomic policies; output has surpassed its pre-crisis level and unemployment has sharply declined. - Inflation remained well below target despite the CNB’s exchange rate floor and very low policy interest rates, partly due to the slump in oil prices. - Fiscal policy has been prudent, but fiscal framework legislation to anchor policy, avoid pro-cyclicality, and enhance predictability is yet to be approved by parliament. - Growth performance has supported political stability of the government coalition that took office in January 2014; challenge is to create conditions for sustainable strong growth while maintaining macroeconomic stability. Key recent indicators - Real GDP growth: 4.2 percent in 2015 (highest in the CEE region); output expanded by 3.0 percent y-o-y in 2016:Q1. - Contributions to 2015 growth: government consumption, investment, and inventories accounted for close to half of economic growth; private consumption and investment also contributed in 2016:Q1. - Labor market (2016:Q1 / April): private sector employment growth 2 percent y-o-y in 2016:Q1; unemployment rate 4.1 percent in April; labor participation 75 percent; real wage growth 3.9 percent in 2016:Q1. - Minimum wage: cumulative increase of 24 percent during 2014–16; now at 35 percent of the average economy-wide wage (EU average 42 percent). - Inflation: headline 0.3 percent in 2015; 0.5 percent y-o-y in 2016:Q1; eased to 0.1 percent y-o-y in May; core inflation around 1 percent; one-year ahead inflation expectations 1.7 percent in May 2016; three-year expectations anchored at 2 percent. - Fiscal outcome 2015: fiscal deficit narrowed from 1.9 percent of GDP in 2014 to 0.4 percent in 2015 (against a 1.9 percent target); public debt declined to 41 percent of GDP. - Fiscal structural balance note: stripping net EU revenues out of the structural balance shows the structural deficit widened by 1 percentage point in 2015. - CNB monetary stance: policy rate at 0.05 percent since November 2012; exchange rate floor introduced at CZK 27 per euro in November 2013. - CNB FX interventions: purchased €12.2 billion during July 2015–April 2016 to defend the floor; extended commitment to the floor until end-2016. - Banking sector: deposits grew by 8 percent y-o-y in 2016:Q1; credit to the private sector growing at around 8-9 percent since August 2015. - External position: current account surplus 0.9 percent of GDP in 2015; net international investment position –31 percent of GDP; reserves increased. ### Outlook and Risks - Short-term outlook: economic activity expected to decelerate in 2016; private consumption to remain robust; slowdown in EU-fund absorption to weigh on growth. - Medium-term: output growth set to stabilize at slightly above 2 percent in line with potential. - Inflation path: expected to reach the 2 percent target in 2017 as oil price base effects fade and domestic demand pressures rise. - Current account: projected to remain in a small but declining surplus, then move toward a deficit as investment improves and in line with fundamentals. - Key macro projections (selected): - Real GDP growth: 2013 -0.5; 2014 2.0; 2015 4.2; 2016 2.2; 2017 2.7; 2018 2.4; 2019 2.2; 2020 2.2; 2021 2.2 (percent) - Inflation (period average): 2013 1.4; 2014 0.4; 2015 0.3; 2016 0.6; 2017 1.9; 2018 2.0; 2019 2.0; 2020 2.0; 2021 2.0 (percent) - General government overall balance: 2013 -1.3; 2014 -1.9; 2015 -0.4; 2016 -0.6; 2017 -0.6; 2018 -0.5; 2019 -0.5; 2020 -0.5; 2021 -0.5 (percent of GDP) - General government gross debt: 2013 45.1; 2014 42.7; 2015 41.1; 2016 40.8; 2017 39.8; 2018 38.9; 2019 37.9; 2020 37.1; 2021 36.2 (percent of GDP) - Current account: 2013 -0.5; 2014 0.2; 2015 0.9; 2016 1.4; 2017 1.0; 2018 0.6; 2019 0.1; 2020 -0.4; 2021 -0.8 (percent of GDP) - Reserves (in billions of euros): 2013 41.0; 2014 44.2; 2015 60.4; 2016 67.0; 2017 74.9; 2018 80.5; 2019 83.5; 2020 85.7; 2021 86.1 Risk assessment - Balance of risks tilted to the downside: weaker external demand (euro area, China, emerging markets) could weigh on exports; geopolitical risks and Brexit could increase market uncertainty; global financial turbulence could generate safe-haven inflows and appreciation pressures. - Financial stability risks: prolonged low interest rates could lead to overvaluation of real estate and other asset prices absent effective macroprudential measures. - Upside risks: larger-than-expected positive effects from supportive macro policies, lower oil prices, improved sentiment, and ECB quantitative easing. ### Policy Agenda — Fiscal Policy (A) - Near-term stance: - Authorities’ 2016 Convergence Program targets headline deficits of 0.6 and 0.5 percent of GDP for 2016 and 2017. - Staff baseline: implies slight widening in the structural fiscal deficit to 0.8 percent of GDP in 2017 versus the 1 percent medium-term deficit objective (MTO); near-term stance judged appropriate given slowdown and low inflation. - Revenue and spending dynamics: - Measures to fight tax evasion (electronic VAT reporting, rollout of electronic evidence of sales) expected to yield gains, but projected revenue gains to be more than offset by increases in public wages, child tax credits, new hires in education and police, and topping-up of automatic pension indexation. - Staff urged restraint on additional wage and benefit hikes pre-elections until tax collection strengthening is established. - Staff advised resisting shifting more items to the reduced VAT rate and recommended that future tax cuts be part of a broader tax system review. - Medium-term strategy and fiscal framework: - Staff baseline projects structural deficit declining to ½ percent of GDP over the medium term, below the 1 percent MTO, providing space to accommodate fiscal priorities including higher public investment. - Staff reiterated recommendation for speedy adoption of fiscal framework legislation—under consideration by Parliament—to anchor policy, reduce pro-cyclicality, and enhance predictability. - Pension system concerns: - Recent legislation allows discretionary pension increases beyond automatic indexation in certain cases and up to a limit. - Plans to cap statutory retirement age (which is increasing by two months every year and will remain below the EU average) and granting early retirement benefits to some miners raise sustainability concerns. - Staff urged refraining from ad hoc pension adjustments beyond the standard indexation formula and from imposing an ex-ante limit on maximum retirement age. - Structural fiscal reforms recommended: - Address rising health-care costs and improve efficiency and outcomes; incentivize substitution from higher-cost hospital-based care to lower-cost outpatient services. - Narrow labor tax wedge (above OECD average) to improve labor market outcomes; close loopholes allowing lower effective tax and contribution rates for the self-employed. - Improve planning, prioritization, and quality of transport infrastructure investment; address weaknesses in public procurement. - Public debt management: - Public debt projected to decline to around 36 percent of GDP by 2021 under current policies; sustainable under alternative negative-shock scenarios (Annex VII). - Ministry of Finance performed buybacks of short-maturity bonds financed by long-term issuance; average maturity of public debt decreased after issuance of two- and three-year bonds with negative auction yields. - Recommendation: consider increasing average maturity of debt to take advantage of current low interest rates and lower debt service. - EU funds absorption: - Strengthening capacity to absorb EU funds is a key priority due to past delays and highest rate of financial accounting corrections in the EU (2007–13 program). - Ministry of Regional Development given powers for centralized management and coordination; absorption rate rose sharply in 2014–15 but control systems under strain, raising concerns about irregularities. - Start of 2014–20 program projects slower than previous period partly due to Environmental Impact Assessment incompatibilities with revised EU standards. - Staff urged ensuring compliance with EU requirements to launch large transport projects and systematically follow up and correct systemic shortcomings identified by the Supreme Audit Office in EU Structural and Cohesion Funds utilization. *IMF staff report: 1. External Sustainability and Competitiveness (Czech Republic)* ### 19. The authorities re-affirmed their commitment to fiscal discipline. They pointed to ### _cr16213 - 19. The authorities re-affirmed their commitment to fiscal discipline. They pointed to ### Fiscal policy and public finances - Authorities re-affirmed commitment to fiscal discipline and strong efforts to further reduce the deficit. - Structural deficit reported as "already well below the medium-term objective." - Near-term stance described as "slightly expansionary" and considered necessary to support the economy given the "moderate level of public debt and its projected decline." - Authorities expected the structural deficit to reach the MTO already in 2017, citing a larger-than-Fund-staff estimate of the output gap, and to remain at that level over the medium term. - Acknowledged political pressures: "pressures for higher current expenditures and lower taxes would probably increase in the run-up to the elections," but committed to adhere to fiscal deficit targets of the Convergence Program. - Hopeful that approval of fiscal responsibility legislation would occur expeditiously. - Agreed on the need to narrow the labor tax wedge and address the rise in health care costs. - Health-care measures taken: - Introduction of centralized public procurement for selected pharmaceuticals. - Envisaged changes in allocation of health premiums among insurance funds to better reflect patient cost profiles. - Engaged with the European Commission on resolving incompatibility of existing EIA with revised EU-wide standards to enable large EU-financed transport infrastructure projects. - Optimistic that the new Public Procurement Act would increase transparency and reduce administrative requirements. ### Monetary policy - Consensus on maintaining current supportive monetary conditions given downside balance of risks. - Noted shift in inflation drivers: reduced role for output gap; increased role for external factors including euro area inflation spillovers, commodity price changes, and exchange rate movements. - Positive real economy and labor market dynamics reduce likelihood of damaging second-round low-inflation effects, but domestic demand and tight labor market give positive price impetus offset by declining import prices. - Agreement to maintain accommodative monetary conditions "until the inflation forecast and inflation expectations become entrenched around the inflation target." - With current policies through end-2016 (including the exchange rate floor), inflation projected to reach the central bank’s 2-percent target in mid-2017. - Staff recommendations: - Maintain focus on inflation targeting and prepare for monetary policy normalization. - Exchange rate floor treated as temporary instrument; successful in mitigating deflationary pressures (Annex IV). - CNB should prepare for eventual exit to a floating exchange rate and be ready to use discretionary FX interventions and reduce interest rates to negative levels if needed. - Clear communication on inflation targeting to guide expectations during normalization. - On negative interest rates: - Recommended readiness to introduce mildly negative interest rates if downside risks materialize, timing to depend on inflation, capital inflows, and appreciation pressures, following lessons from international experience (Annex V). - FX reserve-to-GDP ratio noted as "(at 40 percent)". - Given reliance of Czech banks on domestic deposits and sizable excess liquidity, negative rates could substantially impact net margins; mitigation via tiered negative deposit interest rates excluding parts of deposit base suggested. - Authorities’ views: - Agreed on the need for accommodative policy given anti-inflationary balance of risks. - Noted wages grow "more moderately than hoped" and were concerned about low inflation affecting wage agreements. - Emphasized maintaining exchange rate floor till end-2016 and readiness to raise it further if disinflationary pressures increase sharply. - Reiterated commitment to inflation targeting and floating exchange rate regime when normalization allows. - CNB board discussing pros and cons of negative interest rates; CNB and commercial banks operationally ready for introduction and did not see significant banking-sector risks from mildly negative policy rates. - At current juncture, authorities did not view interest rate differential with the euro as main driver of capital inflows. - Assessed the koruna "broadly in line with the long-term fundamentals" and foresaw a smooth exit to a fully floating exchange rate while retaining readiness to intervene to smooth excessive volatility. ### Financial sector stability and risks - Financial system described as "stable and resilient to shocks." - Stress tests indicate banks sufficiently resilient; sector capital buffer strong: "a capital adequacy ratio of 16.7 percent in 2015." - Bank profitability remains strong despite low interest rates due to strong credit growth and cost reduction; however, persistently low rates could negatively affect profitability going forward. - Nonperforming loan ratio: "5.5 percent in 2015." - Banking sector largely self-financed with deposits; loan-to-deposit ratio "below 80 percent." - Credit growth: - Credit to non-financial corporations expanded by "6 percent" last year, driven by manufacturing, real estate, and energy. - Household credit growing at "8 percent" on account of strong demand for mortgages. - Credit standards for loans to non-financial corporations eased in 2016:Q1 in most sectors; mortgage standards broadly unchanged. - Housing market risks: - Mortgage rates at historic lows; new mortgage lending at a 10-year high. - Residential housing offer prices increased by "10 percent y-o-y in 2015:Q4" despite a "16 percent increase in housing starts." - Slight deterioration in affordability indicators despite strong wage growth and continued decline in interest rates. - Estimated average apartment "price-to-annual wage ratio of 4" noted as still low by international standards. - Policy recommendations to prevent housing vulnerabilities: - Tighten mortgage lending standards and make CNB recommendations legally binding. - Consider granting CNB authority to issue binding macroprudential regulations. - If mortgage trends persist, further tighten macroprudential stance. - Prefer targeted measures: raise risk weights on mortgages, lower LTV limits with possible regional differentiation, and issue clear guidance on maximum debt-to-income limits. - Regulatory and supervisory progress: - Largely implemented 2012 FSAP recommendations (Annex II). - Bank Recovery and Resolution Directive (BRRD) transposed into local law, designating CNB as resolution authority. - Deposit Guarantee Scheme Directive transposed via change in the Act on Banks effective January 2016. - New harmonized resolution framework intended to minimize taxpayer exposure while maintaining financial stability. - Consumer Credit Act transposing the Mortgage Credit Directive currently in Parliament. - Authorities’ views on financial stability: - Broadly shared staff’s assessment; noted readiness to address risks. - Cited completed stress tests indicating sufficient capital to cover two-year losses. - Recognized increased potential systemic risk due to rising risk appetite, expected prolonged low interest rates, and strong housing market. - Increased countercyclical capital buffer to "0.5 percent effective 2017" and ready to increase further if credit growth accelerates. - Noted risk from feedback loop between real estate developments and mortgage lending, strong buy-to-let mortgage growth, and some estimates of mild apartment overvaluation. - CNB monitoring developments, collecting loan-by-loan data, and reviewing need and modalities for tighter prudential measures including making them binding. ### Structural reforms and potential growth - Observed that higher potential growth is necessary for faster convergence with other advanced economies. - Noted that gap between Czech per capita income and EU average has ceased falling, largely reflecting slowdown in Czech growth from "an annual average of 4.5 percent during 2000–07 to 0.9 percent during 2010–14." - Structural reform priorities: - Labor market: - Labor force participation increased but remains low in some segments, especially low-skilled. - Projected labor force decline due to demographics and potential skill shortages. - Recommended improving tertiary education and vocational training; consider introduction of a dual vocational education system, more flexible immigration policies, and incentives to boost labor mobility. - Investment: - Average post-crisis investment rate near its optimal value (Annex VI) but driven partly by extraordinary EU-fund drawdown that will be hard to sustain. - Challenge to increase private and public investment and improve EU-fund utilization efficiency. - Innovation: - R&D expenditure increased significantly, "reaching the EU average in 2014," but outcomes remain weak. - National Research, Development and Innovation Policy for 2016–20 includes measures to improve coordination, prioritization, and cooperation between research centers and business; steadfast implementation recommended. - Business environment: - Czech Republic ranks highly overall in business climate indicators. - Improved from "53rd to 37th place" in Transparency International’s Corruption Perception Index in 2015 due to changes to public procurement rules and proof-of-property-origin legislation. - Slipped from "33rd to 36th place" in Doing Business Indicators in 2015; highlighted high labor taxation and difficulties dealing with construction permits. - Remaining weaknesses in business regulation and institutional quality noted; staff urged improving predictability of policy and regulation, reduce administrative burden, and increase efficiency of judicial procedures including formation, restructuring, and liquidation of firms. - Authorities’ views on reforms: - Confident in reform agenda in National Reform Program for raising medium-term potential growth. - Emphasized need to jump-start large infrastructure projects; new construction law (in Parliament) and new public procurement law expected to increase infrastructure spending, improve EU fund efficiency, and raise absorption. - Measures to help parents and women returning from maternity leave (increase tax allowance starting from the second child) and improve childcare availability to boost labor participation. - Policies to support immigrant integration (Fast Track project and Welcome Package) and cooperation with industry to identify jobs for immigrants, noting gradual approach. - Measures underway to enhance business environment: improvements in electronic points of single contact for entrepreneurs and regular evaluation of administrative tax burden. ### Staff appraisal (summary) - Assessment: "The Czech economy has been performing very well." - Supportive macroeconomic policies over the past three years, favorable external environment, and high utilization of EU funds contributed to strong output growth and steady unemployment decline, enhancing market confidence. - Remaining challenges: - CNB exchange rate floor helped keep inflation positive, but inflation still below target. - Potential growth below level needed for fast convergence to income levels of other advanced European countries. - Policy challenge: create conditions for sustained increase in potential growth while maintaining macroeconomic stability. *Source: IMF staff report content from the provided PDF excerpt.* ### 35. The authorities’ medium-term fiscal deficit objective is appropriate, but needs to be ### 35. The authorities’ medium-term fiscal deficit objective is appropriate, but needs to be ### Fiscal policy: assessment and recommendations - The projected slight widening in the structural fiscal deficit over the near term is warranted by the expected growth slowdown and with inflation well below target. - With the structural deficit already below the medium-term deficit objective, there is space to increase public infrastructure to support faster medium-term potential growth. - Key policy recommendations: - Resist pressures to reduce taxes and increase current spending in the run-up to next year’s elections. - Eschew changes in the pension system that could jeopardize its long-term sustainability. - Adopt fiscal framework legislation quickly to anchor fiscal policy and guard against pro-cyclical tendencies. - Institutional recommendation: - Anchor the medium-term fiscal deficit objective in fiscal framework legislation. ### Monetary policy: inflation targeting and normalization - The central bank should continue to focus on inflation targeting and set the stage for monetary policy normalization. - With the balance of risks for inflation remaining on the downside, monetary policy should remain accommodative until the inflation forecast and inflation expectations become entrenched around the inflation target. - Preparatory actions for exiting the exchange rate floor: - Begin preparing for the eventual exit from the exchange rate floor to a floating exchange rate. - If downside risks for inflation materialize, the Czech National Bank (CNB) could employ other tools to counter an undesirable tightening of monetary conditions. - The CNB should be ready to use negative interest rates to help mitigate speculative capital inflows and discretionary interventions in case market conditions became disorderly. - Use clear communication about the CNB’s focus on inflation targeting to guide expectations and reinforce the credibility of the framework. ### Financial stability: vigilance and macroprudential stance - Banking sector resilience: - The banking sector is self-financed with a low system-wide loan-to-deposit ratio and strong capital and liquidity buffers. - Mortgage market vulnerabilities: - Recent trends in the mortgage segment suggest an increase in potential vulnerabilities. - The CNB has issued recommendations to tighten mortgage lending standards; for effectiveness, these recommendations would need to become legally binding. - If current trends in the mortgage segment continue in the coming months, the macroprudential stance should be further strengthened. - Regulatory progress: - Authorities have made further progress in strengthening the supervisory and regulatory framework. - Implementation status: largely completed the implementation of the 2012 FSAP recommendations, including the transposition of the Bank Recovery and Resolution Directive into local law. ### Structural reforms: priorities to raise growth potential - Ambitious structural reforms are key to raising Czech Republic’s growth potential. - Priority areas: - Enhance investment in physical and human capital, and promote innovation. - Ensure compliance with EU environmental regulations for large infrastructure projects. - Boost the effectiveness and efficiency of infrastructure spending. - Reform tertiary education and vocational training to attract more knowledge-intensive industries and prevent skill shortages. - Improve coordination and prioritization of R&D spending and cooperation between research centers and business. - Improve predictability of policy and regulation, reduce administrative burden, and enhance efficiency of judicial procedures to raise investment. ### Consultation cycle - Recommendation: - The next Article IV consultation with the Czech Republic should be held on the standard 12-month cycle. ### Risk Assessment: selected risks, likelihoods, impacts, and policy responses - Global risks: - Tighter or more volatile global financial conditions — Relative Likelihood: High; Impact if Realized: Low. - Policy response: Maintain accommodative monetary conditions while loosening the fiscal stance to absorb shocks. - Heightened risk of fragmentation/security dislocation in part of Europe — Relative Likelihood: High; Impact if Realized: Low. - Policy response: An easing bias would be appropriate provided supply constraints do not become binding. - Sharper-than-expected global growth slowdown — Relative Likelihood: High/Medium; Impact if Realized: Medium. - Policy response: Support domestic demand and diversify trade partners and specialization. - Persistently low energy prices — Relative Likelihood: High; Impact if Realized: Medium. - Policy response: Consistent monetary framework and CNB’s transparent communication strategy, emphasizing the priority of the inflation objective and the temporary role of the FX floor. - British voters elect to leave the EU — Relative Likelihood: High; Impact if Realized: Medium/Low. - Note: The UK is the 4th export partner of the Czech Republic, accounting for 5 percent of total export. - Policy response: Maintain accommodative monetary conditions while loosening the fiscal stance. - Domestic risks: - Permanently lower potential growth — Relative Likelihood: Medium; Impact if Realized: Medium. - Policy response: Advance structural reforms and safeguard public investment. - Financial stability risks arising from the housing market — Relative Likelihood: Medium; Impact if Realized: Low. - Policy response: Tighten macroprudential regulations (risk weights, LTV and DTI limits). ### External sustainability and competitiveness: key findings and statistics - Staff assessment: Czech Republic’s external position is broadly in line with fundamentals and desirable policies. - Current account and valuation: - EBA current account methodology suggests a current account gap of 2 percentage points of GDP, pointing to a moderate undervaluation of 4 percent in 2015. - External Sustainability approach indicates an undervaluation of 4.4 percent. - REER methodology suggests a 10 percent overvaluation based on fundamentals; staff view this as inconsistent with export performance. - Current account dynamics: - The current account turned positive in 2014–15 driven by an improving trade balance, strong exports, low oil prices, and a depreciating currency. - International investment position and external debt: - IIP improved to –31 percent of GDP in 2015. - External debt increased from 68.8 percent of GDP in 2014 to 70.8 percent in 2015. - Foreign reserves: - Official foreign exchange reserves have been increasing and are adequate. - Reserves as a share of GDP: 36 percent. - Reserves stand at about 123 percent of the IMF composite reserve adequacy metric. - Staff expects further inflows of EU funds and a persistent current account surplus to contribute to further reserve accumulation in the near term. - Exchange rate and competitiveness indicators: - The real exchange rate has been depreciating moderately in recent years, especially in ULC terms, suggesting improving competitiveness. - Non-price competitiveness: the Czech Republic lags other OECD countries in business regulation and institutions, while showing good performance in quality of trading across the border and credit market rigidities. - Additional data points and visuals referenced (textual): - Current Account and International Investment Position (Percent of GDP) figure. - Share of World Imports (Percent of world imports 2010=100) figure. - Real Exchange Rate (2010=100) and NEER, REER (CPI based), REER (ULC manufacturing-based) series. - Czech Republic: Reserves as Percent of Metric and Suggested Adequacy Range time series. *Source: IMF staff report excerpts contained in the provided content unit.* ### Box 2. Potential Growth ### Box 2. Potential Growth ### Estimation methods - Potential output is estimated over the 2001-15:Q2 period using four methods: the Hodrick-Prescott (HP) filter, the multivariate filter (MVF1), the multivariate filter with financial frictions (MVF2), and the production function approach (PF). - MVF1: "models potential output in relation to actual GDP, unemployment and inflation." - MVF2: "takes into account financial cycles and capacity utilization." - PF: "employs a Cobb-Douglas production function and removes cyclical factors pertaining to capital and labor—using capacity utilization, the NAIRU, and average hours worked—and thus, the remaining residual captures the ‘structural’ component of total factor productivity (TFP)." ### Recent levels and projections - Potential growth "is recovering from post-crisis lows but is projected to remain subdued at about 2–2½ percent." - Potential growth "decelerated sharply during the crisis coming to a standstill in 2012–13." - Since then it has been growing, "reaching an average of 2½ percent in 2015 (according to all estimates, with the exception of the production function)." - It "is projected to remain at well below pre-crisis levels and thus would be insufficient to speed up income convergence with other advanced EU economies." ### Drivers of the deceleration and subsequent recovery - The deceleration of potential growth was largely due to: - "a decline in contribution of TFP and labor force reduction." - "Negative TFP growth remained a drag on potential output since 2010, while the contribution of capital declined but remained positive." - The increase in potential growth since 2013 was driven by: - "recovering contribution of labor reflecting higher labor force participation that more than compensated the decline in working age population." ### Output gap assessment and near-term path - "All estimates suggest that the output gap closed in mid-2015." - The output gap "is expected to turn into a positive range of 0.3-0.7 percent in 2016 (consistent with the staff’s baseline estimate of 0.2 percent) and move to zero in the following years." - "However, it is important to bear in mind that significant uncertainty surrounds these estimates." *Source: IMF staff estimates.* ### Annex I. Response to Past Fund Policy Advice ### Annex I. Response to Past Fund Policy Advice ### Fiscal and monetary policy implementation - Adopt a growth-friendly fiscal strategy entailing a slight relaxation of the fiscal stance in the near term and a medium-term objective of a 1 percent of GDP structural deficit. - Implemented. "The fiscal stance is projected to ease slightly in 2016–17, but the structural deficit is expected to stay below the medium-term deficit objective of 1 percent of GDP—recently confirmed in the 2016 Convergence Program." - Adopt a fiscal rule with wide coverage, easy monitoring, a debt brake, and oversight by an independent Fiscal Council. - Not yet implemented. "A government proposal, broadly in line with these recommendations, is under discussion in parliament." - Maintain focus on inflation targeting while evaluating conditions for monetary policy normalization and mechanics of implementation. - Implemented. "The Czech National Bank has committed to maintaining the exchange rate floor through end-2016, while emphasizing in its communication the temporary nature of the floor and the exit horizon." - Strengthen supervisory architecture and transpose the Bank Recovery and Resolution Directive (BRRD). - Implemented. "The Bank Recovery and Resolution Directive was transposed into local law, making the CNB a designated resolution authority. The CNB largely completed the implementation of 2012 FSAP recommendations (Annex II)." - Prioritize structural reforms: research and innovation, apprenticeship programs, simplifying tax compliance and administrative procedures, and improving infrastructure. - In progress. "The 2016 National Reform Program envisages a number of actions, including on Research and Development policy. The new public procurement law and construction law are expected to help speed up infrastructure investment." --- ### Annex II. FSAP Recommendations and Implementation ### Macroprudential framework - Elevate financial stability to a policy objective in the CNB law. - Implemented. - Improve CNB decision-making mechanisms to take timely action on systemic risk. - Implemented. "Regular meetings on financial stability have been instituted. Capital reserves according to the CRDI IV/CRR have been introduced and regularly re-assessed (counter-cyclical buffer quarterly, DSIB buffers annually). Regular monitoring of risks associated with lending to real estate sector was introduced and the results serve as the input to decision-making process (biannually)." - Upgrade stress testing framework, focusing on group-wide risk monitoring. - Implemented. ### Regulation and supervision - Increase supervisory staff to strengthen intrusiveness of supervision. - Implemented. "Significant increase of prudential on-site and off-site examination staff enabled to increase the frequency and the scope of inspections, to focus more intensively on problem credit institutions and to shorten significantly the AML/CFT on-site supervisory cycle across all the financial sectors." - Introduce a "prompt corrective action" framework. - Implemented. "Supervisory off-site manual has been updated. Manual contains supervisory actions for particular level of capital adequacy thresholds considering capital requirements arising from Pillar 1 as well as Pillar 2... Manual also reflects new rules arising from CRDIV/CRR including capital buffers and consequent supervisory actions in case of breach of these buffers." - Set large exposure limits in line with globally agreed levels. - Partially implemented. "Large exposure limits are currently stipulated in Regulation (EU) No 575/2013 ..." - Continue close monitoring of significant transactions between subsidiaries and parents and take action if necessary. - Implemented. "CNB imposed extraordinary reporting duty on selected credit institutions ... provide information about transactions with significant effect on exposure to parent company or other institutions from the group." - Strengthen framework for supervising financial conglomerates. - Implemented. "The Financial Conglomerates Directive (FICOD I) has been implemented." ### Credit unions (CU) sector - Strengthen CU sector by restructuring existing institutions. - Implemented. "Legislation (in line with IMF recommendations) has been effective since 2015. Big credit unions need to convert into banks or scale down, new rules include increase of contributions to the reserve fund, to the Czech DIF and loans to a CU member limitation, enhances involvement of CU members. The amount of credit a union can provide to its member (or connected members) is set to CZK 30 000 000. The postponed rule will introduce a minimum ratio between the deposits and the member interests (10:1) ... CNB started to monitor in detail liquidity and other aspects of credit unions..." ### Crisis management and resolution - Operationalize framework for providing public support to banks; adjust threshold for imposing conservatorship. - Partially implemented. "Public support to banks is covered both by the BRRD (transposed with effect on 1 January 2016) and the Commission 'Banking' Communication from 30 July 2013 (not reflected in legislation yet)... the institute of conservatorship has been replaced by new tools - (i) temporary administration for the early intervention phase and (ii) special management for the resolution phase. CNB has been assigned as the National Resolution Authority." - Enhance governance of the Deposit Insurance Fund (DIF), increase target size, strengthen budgetary financing provisions, clarify payout trigger, and allow DIF to fund transfer of deposits via purchase & assumption agreements. - Implemented. Key details: - DGSD transposed via change in the Act on Banks effective 1 January 2016. - Both the ex-ante funded DIF and the National Resolution Fund (NRF) are operational. - "The DIF is fully funded (already exceeding the target level of 0.8% covered deposits) and continues to collect maintenance-level contributions." - "The NRF starts from zero and will reach the target level of 1.0% covered deposits in 2024, in 9 installments." - Combined DIF and NRF contributions are risk-weighted; increases in NRF contributions have been matched by decreases in DGS contributions. - Trigger to pay out insured deposits is clearly stated in DGSD transposition and from July 2016 will be shortened to 7 days. - DIF assets can be used in resolution in certain instances. - Governance strengthened through the Financial Market Guarantee System (FMGS); Minister of Finance appoints 5 supervisory board members (2 from MoF, 2 from CNB, 1 from banking industry, subject to conflict-of-interest rules). - Budgetary financing of potential shortfalls in DIF and NRF is part of the new legislative framework, but has not been tested. --- ### Annex III. EU Structural and Investment Funds ### Allocation and administration - Czech Republic allocation: €48.5 billion (30 percent of GDP) over two program periods (excluding agricultural subsidies and the Rural Development Fund). - Funds administered by national authorities and monitored by the European Commission (EC). National authorities select projects under "operational programs" and "priority axes." Reimbursements are made upon presentation of vetted and certified invoices; national authorities provide co-financing—typically, around 15 percent. - Effective national co-financing ranged from 30 percent in 2008 to 15 percent in 2015 because certain costs (e.g., most land purchases and VAT on certain inputs) must be fully covered by national authorities. ### Absorption, irregularities, and recent trends - By end-2014: Czech Republic had the fourth lowest absorption rate in the EU at 64 percent and the highest financial corrections (a cumulative 5 percent of the total allocation). - Centralized management by the Ministry of Regional Development starting in 2014 led to significant improvement. "The absorption rate rose sharply in 2015, bringing the cumulative absorption rate to date to 88 percent, still well below the regional average." - EU-fund related inflows amounted to about 3.3 percent of GDP in 2015. Share of ESIF-financed projects in total public investment increased to 26 percent in 2015 from 1 percent in 2007. - Estimated overall growth contribution from EU-funded investment: 1.8 percent of GDP (assuming same import component as other investment). - Risks from expedited spending: - Potential compromise of efficacy and adverse fiscal effects if project selection prioritized spending speed over quality. - EC will not reimburse costs from implementation errors; some grants could be re-directed to other projects. - Projection for 2016: Ministry of Finance projects EU grants (without agricultural subsidies) would decline by €2 billion (about 1.3 percent of GDP) in 2016 due to transition from planning to implementation stages. ### Policy recommendations to maximize growth impact - Better planning of public investment. - Costing and prioritization of public investment plans. - Employ a standard methodology for cost-benefit analysis and project appraisal. - Account for potential project risks and introduce a central review process for major projects. - Implement more efficient and open procurement processes. ### Audit findings (Box 1) — SAO 2007–13 audits: systemic shortcomings and recommendations - High-frequency shortcomings: control work by entities in implementation structure and legislative issues. - Medium-frequency shortcomings: assessment and selection of projects, financial shortcomings, contract and support decision weaknesses, administrative work. - Low-frequency shortcomings: breaches of contractual duties by beneficiaries, deficiencies in public procurement, badly designed assessment criteria, unsatisfactory program outcomes. - SAO recommendations for 2014–20 programming period include: - Simplify implementation systems and subsidy provision processes. - Simplify rules and reduce paperwork. - Define overarching development strategies and more precise targeting. - Set specific and measurable goals. - Focus on efficiency and effectiveness in selection and financing. - Improve control systems and monitoring systems focusing on outcomes and impacts. --- ### Annex IV. Impact of the Exchange Rate Floor on Inflation ### Objective and empirical strategies - Aim: analyze extent to which CNB's exchange rate floor affected Czech inflation by constructing a counterfactual for inflation in absence of the floor. - Three empirical strategies implemented: - Event study exploiting pre-intervention sample to forecast inflation absent the FX floor. - Difference-in-difference regression comparing Czech inflation evolution with a control group of similar countries. - Synthetic control method selecting a control group that best matches pre-treatment characteristics. ### Event study approach - Based on an open-economy New Keynesian Phillips curve estimated on the pre-event sample 2008:Q1–2013:Q3; forecasts used to measure "abnormal" inflation due to intervention. - Result: "The introduction of the floor has helped keep inflation above zero." After the introduction of the floor, actual and predicted headline inflation series diverged, with the forecast trending down into negative territory. - Statistical significance: "However, the effect of the introduction starts to be significant towards the beginning of 2015 (with a 95 percent confidence interval)." *Source: Annexes I–IV, _cr16213 - Annex I. Response to Past Fund Policy Advice* ### 4. A difference-in-difference ### 4. A difference-in-difference ### Methodology: difference-in-difference (DiD) - Purpose: estimate effect of a policy change on a treated group by comparing outcomes before and after intervention for a Treated Group versus a Control Group. - Estimator: the difference in the average outcome in the treated group before and after treatment minus the difference in the average outcome in the control group before and after treatment. - Application: test whether inflation in the Czech Republic behaved differently after November 2013 than inflation in a control group of similar European countries. - Parallel trends check: inflation in the Czech Republic and in the control group followed parallel trends before the introduction of the exchange rate floor, supporting the validity of the control group for DiD analysis. - Key date: 2013:Q4 identified as the date of the introduction of the exchange rate floor. ### Empirical findings from DiD - Across all model specifications, the interaction term (treatment × post) is positive and significant. - Preferred-model estimate: the coefficient on the interaction term indicates that the introduction of the floor brought Czech inflation up by 0.5 percentage points compared with the control group. - Qualitative finding: average inflation in the control group has been lower than in the Czech Republic after 2013:Q4, supporting the hypothesis that the exchange rate floor helped prevent inflation from going into negative territory. - Caveat: treatment is non-random; the introduction of the exchange rate floor was not randomly assigned to the Czech Republic. Causality should be interpreted with caution. ### Synthetic control method - Rationale: semi-parametric approach to construct an appropriate control group as a weighted average of unaffected countries (Abadie et al., 2010). - Mechanism: search for weights W to match pre-treatment inflation and predictors of the treated unit as closely as possible. - Implementation for Czech inflation: the synthetic counterfactual accurately reproduces values of inflation and inflation predictors for the Czech Republic prior to treatment. - Optimal donor combination prior to treatment: inflation in Denmark, Lithuania, Slovakia, and Slovenia best replicate Czech pre-treatment inflation. ### Placebo and robustness checks - Placebo test: estimate the same synthetic control model treating each other country as if it were treated in 2013:Q4. - Expectation: if donor countries were unaffected by the Czech policy, there should be no large post-2013:Q4 deviations for the “fake” treated countries. - Result: especially at the end of the time series, inflation in the Czech Republic is among the highest and there is no evidence for large treatment effects for the other synthetic series. - Euro-area exclusion robustness: excluding countries that joined the euro from the estimation period yields a similar pattern to the full sample, but the fit of the synthetic series is poorer. - Limitation of synthetic control: does not provide standard errors; placebo distribution used to assess inference. ### Conclusions (from empirical analysis) - All three employed methods (DiD, synthetic control, and associated robustness checks) support the idea that the exchange rate floor alleviated deflationary pressures in the Czech Republic. - Despite lack of a causal interpretation (due to non-random treatment), results show the introduction of the exchange rate floor as an additional instrument for achieving the inflation objective prevented Czech inflation from entering negative territory. ### Annex V — Negative Interest Rate Policy: considerations for the Czech Republic - International experience: - Since mid-2014, negative policy rates were used by: the ECB, the Bank of Japan, the Swiss National Bank (SNB), and the Danish and Swedish central banks. - Recent international experience with negative policy rates has been broadly positive: they help deliver additional monetary stimulus and easier financial conditions, supporting demand and price stability. - Transmission and macro effects: - Negative interest rates eliminate the zero lower bound and could boost operational independence of the central bank while preserving transmission to the real economy. - They encourage more spending and less saving, potentially shifting aggregate demand up depending on investment opportunities (TFP growth), confidence, and health of domestic balance sheets. - By discouraging capital inflows, negative rates put downward pressure on the currency, supporting external demand and helping close the output gap. - Risks and thresholds: - Deeply negative rates can lead to cash hoarding. Estimated thresholds for cash hoarding range from 0.2–1 percent costs of storing cash to 2–3 percent convenience fees associated with use of credit and debit cards. - Evidence so far shows cash ratios in countries with negative rates were not unusually high; negative rates of around 2 percent appear possible without causing large-scale shift to cash. - Central banks can deploy measures to make cash operations less attractive. - Bank profitability and financial stability: - Negative deposit rates could hurt bank profitability; extent depends on how much banks’ funding costs fall and the elasticity of credit demand to lending rate cuts. - Risk that banks reluctant to impose negative deposit rates on depositors will instead raise lending rates to maintain margins. - Preliminary Czech estimate: in the case of a 45 basis point interest rate cut (to the level of the current ECB deposit rate) the annual profits of the Czech banks could drop by around 7 percent. - To limit adverse impact, negative rates could be applied in tiers, excluding certain parts of deposits and targeting the marginal rate on excess reserves. - Empirical example: Denmark cut the deposit rate to –0.75 percent and used tiered arrangements to mitigate adverse effects on bank profits; Danish experience provides little evidence of severe adverse effects on lending rates up to -0.75 percent. - Financial-stability tradeoffs: - Further monetary easing poses risks: search-for-yield could create asset price bubbles and loose credit standards; insurance companies and pension funds hurt by lower long-term rates may shift to riskier assets. - Empirical observations: - So far, no evidence of cash hoarding or impaired money market functioning in economies with negative policy rates. - Transmission mechanism appears to work but pass-through to the real economy has been partial and smaller than a symmetric interest rate cut at positive levels; impact on inflation expectations has been limited. *Source: IMF staff estimates.* ### 5. In our analysis, the “golden-rule” of capital accumulation is calculated for most EU ### _cr16213 - 5. In our analysis, the “golden-rule” of capital accumulation is calculated for most EU ### Methodology and sample - Analysis period: two nine-year periods, 2000–08 and 2011–19. - Average pre- and post-crisis investment rates estimated over 2004–08 and 2011–15, respectively, and compared to the “golden-rule”, long-run benchmarks. - Data sources: Eurostat and the European Commission (EC)’s AMECO database. - Countries excluded from the sample: euro area members that had programs with the EU and IMF and Latvia. - Rationale for Latvia exclusion: AMECO estimates of capital stock translate into depreciation rates of over 20 percent, signaling inconsistency between source data and AMECO assumptions. ### Calibration and parameter estimation - Capital share of output: - Estimated as one minus the labor share of output. - Labor share calculated from national accounts data through 2014 and assumed to gradually converge to its 2000–15 average by 2019. - Adjustment for misclassification of labor income: economy-wide compensation of employees is adjusted upwards by a portion of self-employment income so that the share of labor compensation in value added generated by the household sector equals the observed ratio in the rest of the economy. - Czech Republic: adjustment increases average labor share in gross value added over 2000–2015 from 44 percent to 53 percent. - Region-wide correction: by 10 percentage points to around 56.5 percent. - Note: Similar adjustments to raw data are made in the Penn World Tables. - Capital stocks, depreciation rates, and TFP: - Taken from AMECO, where capital stocks use the perpetual inventory method with investment and depreciation from national accounts and an assumed initial capital-to-output ratio in 1995 of 3 for the Czech Republic and 2 for all other CEE EU countries. - Depreciation rate assumed to remain at its last observed value (2014) over 2015–2019. - TFP calculated as a residual after subtracting contributions to GDP growth of capital and labor. - EC methodology: contributions computed assuming uniform labor share of output of 0.65 across countries. - In calibrating the Ramsey-Cass-Koopmans model, multifactor TFP growth is converted into a solely labor-augmenting one by dividing the AMECO series by the uniform labor share of output. - Rate of time preference (p): - Assumed common across all CEE EU countries and separately common across all euro area countries, and kept constant throughout the sample. - Imputed from Equation 6 in Box 1 as the values that make actual investment rate equal to the “golden rule” on average over 2000–19. - Resulting averages: 5 percent for euro area countries and 9 percent for CEE EU. - Interpretation: higher rate of return on capital in CEE EU implies higher p in CEE EU than in the euro area (consistent with Equation 3 in Box 1). ### Main findings: Czech Republic and CEE EU - Czech Republic: - The average investment rate was higher than its closed-economy, steady-state value both pre- and post-crisis. - Interpretation: Czech economy converging from above to its steady-state growth path. - Excess investment over the “golden rule” in both pre- and post-crisis years largely explained by utilization of EU Structural and Cohesion funds. - Post-crisis fall in investment net of EU funds matched closely the decline in the “golden rule”, indicating lower post-crisis investment appears optimal in response to deterioration in fundamentals—lower TFP growth and, to a lesser extent, worsening demographics. - Rest of CEE EU (regional patterns): - Pre-crisis investment rates exceeded optimal benchmarks by a wider margin in South-Eastern Europe; broadly in line across the Baltics and other Central European countries. - Higher-than-optimal investment rates in South-Eastern Europe better explained by overinvestment in residential construction than by convergence from above; supported by post-crisis slump in residential housing prices across the region. - Signs of an investment crunch in the Baltics and the rest of Central Europe in the post-crisis years; increased utilization of EU Structural and Cohesion funds over the last two years helped alleviate the credit crunch. - Country-specific outcomes: - Croatia and Estonia: investment rates have exceeded optimal values in both pre- and post-crisis years despite declines since 2008. - Slovenia: closed the gap between actual and optimal investment rates significantly after the crisis. - Lithuania and Slovakia, and to a smaller extent Hungary and Slovakia: experiencing sub-optimal investment rates where post-crisis decline of investment (net of EU funds) has been larger than the concurrent deterioration in the “golden-rule” benchmark. - Poland: the sole example of a country that stayed close to its steady-state equilibrium throughout the whole sample period. ### Quantitative calibration notes and illustrative statistics preserved from the source - Time periods explicitly used: 2000–08, 2011–19, 2004–08, 2011–15, 2000–15, 2011–19, 2015–2019. - Labor share adjustments for Czech Republic: from 44 percent to 53 percent. - Region-wide labor share correction: by 10 percentage points to around 56.5 percent. - Initial capital-to-output ratio (1995): 3 for the Czech Republic and 2 for all other CEE EU countries. - Depreciation rate anomaly for Latvia: over 20 percent in AMECO. - Imputed rate of time preference averages: 5 percent for euro area countries and 9 percent for CEE EU. ### Policy implications and priorities - For countries with declines in steady-state investment rates (examples: Bulgaria, Croatia, Czech Republic): - Policies should focus on raising TFP and human capital to return to the path of rapid convergence to the euro area. - For countries where investment rate declines were much larger than the deterioration in the “gold-rule” benchmarks (examples: Estonia, Hungary, Lithuania, Romania, Slovakia, Slovenia): - Policy priorities include overcoming credit constraints and institutional impediments that discourage private investment. - General implication: boosting TFP, improving demographics/human capital, and addressing institutional/credit constraints are central to reversing post-crisis investment slumps and supporting convergence. ### Box 1 — Ramsey-Cass-Koopmans Neo-Classical Growth Model (key relations used in calibration) - Representative household maximizes intertemporal utility with rate of time preference p; capital depreciates at rate δ. - Key first-order condition (log utility, discrete time): - Ct+1 / Ct = (1 + Rt − δ) / (1 + p) - Firm first-order conditions (Cobb-Douglas with capital share α and labor-augmenting technological progress x): - MPK = α Yt / Kt = Rt - MPL = (1 − α) Yt / Lt = Wt - Balanced growth conditions imply consumption and capital grow at rate (1 + x) (no population growth) or (1 + x + n) with population growth n. - Approximate relation for the rate of return on capital: - R ≌ p + δ + x, for small p and x (Equation 3) - Steady-state investment-to-output ratio (the “golden rule”): - Without population growth: I / Y = α (δ + x) / (p + δ + x) (Equation 5) - With population growth n: I / Y = α (δ + x + n) / (p + δ + x + n) (Equation 6) *Source: IMF staff analysis and derivations as presented in the document.* ### Annex VII. Debt Sustainability Analysis ### Annex VII. Debt Sustainability Analysis ### Overview and Key Findings - Public debt declined to 41 percent of GDP in 2015 as the authorities used available treasury liquidity to repay debt. - Provided the fiscal targets specified in the government’s convergence program are met, public debt is projected to stay on a downward path, reaching 36 percent of GDP over the medium-term on the back of the economic recovery and strong revenue collection. - Public debt and gross financing needs are relatively immune to a variety of isolated shocks, including a shock to real GDP growth. ### Baseline and Realism of Projections - Baseline fiscal stance: - Structural deficit: 0.3 percent of GDP in 2015 → 0.6 percent in 2016 (slight relaxation) → 0.5 percent of GDP over the medium term. - The 2016 structural relaxation is mostly due to the switch in the funding of capital expenditures from EU funds to domestic sources at the start of the new program period for EU funds. - Growth and inflation assumptions: - Real GDP growth: projected to grow close to potential at 2.2 percent over the medium-term. - Inflation (GDP deflator) projected to gradually move toward the 2 percent target, reaching it in 2017. - Debt dynamics under baseline: - Debt-to-GDP ratio: 41.1 percent in 2015 → 36.2 percent in 2021 (decline projected). - Debt expected to decline in 2016 despite an expansionary fiscal stance because nominal GDP growth is expected to exceed the contribution of the headline deficit and interest payments to the debt burden. - Gross financing needs projected to stay below 7 percent of GDP throughout the projection period. ### Shock and Stress Tests - Main short-term risk: a shock to real GDP growth. - Scenario described: assuming a shock to real GDP growth with consequent impacts on the primary balance, inflation, and the real interest rate: - Public debt would rise to 48 percent of GDP and gross financing needs would increase to 11 percent of GDP by 2018. - Thereafter, debt would decline to 47 percent of GDP and gross financing needs would drop to 8 percent of GDP by 2021. ### Key Statistics and Projection Path (selected exact figures) - Nominal gross public debt: - 2014: 34.9 - 2015: 42.7 - 2016: 41.1 - 2017: 40.8 - 2018: 39.8 - 2019: 38.9 - 2020: 37.9 - 2021: 37.1 - 2021 (medium-term target cited elsewhere): 36.2 percent of GDP - Public gross financing needs (in percent of GDP): - 2014: 6.8 - 2015: 8.5 - 2016: 5.9 - 2017: 6.2 - 2018: 5.5 - 2019: 6.2 - 2020: 6.1 - 2021: 5.9 - 2021 (projection chart): 6.3 - Real GDP growth (in percent): - 2014: 2.2 - 2015: 2.0 - 2016–2021: 4.2 (2016), then 2.2, 2.7, 2.4, 2.2, 2.2, 2.2 (as reported in table) - Baseline and many scenario entries note sustained growth near 2.2 percent over the medium term. - Inflation (GDP deflator, in percent): - 2014: 1.1 - 2015: 2.5 - 2016: 0.7 - 2017: 0.6 - 2018: 1.8 - 2019: 1.9 - 2020: 2.0 - 2021: 2.0 - Nominal GDP growth (in percent): - 2014: 3.3 - 2015: 4.5 - 2016: 5.0 - 2017: 2.8 - 2018: 4.5 - 2019: 4.3 - 2020: 4.2 - 2021: 4.2 - Effective interest rate (in percent): - 2014: 3.8 - 2015: 3.1 - 2016: 2.7 - 2017: 2.6 - 2018: 2.9 - 2019: 3.1 - 2020: 3.4 - 2021: 3.8 - Cumulative change in gross public sector debt (2014–2021): - 2014: 1.9 - 2015: -2.4 - 2016: -1.6 - 2017: -0.3 - 2018: -1.0 - 2019: -1.0 - 2020: -0.9 - 2021: -0.9 - Cumulative (2014–2021): -4.8 - Identified debt-creating flows (cumulative 2014–2021): -3.0 - Primary (noninterest) revenue and grants (percent of GDP): - 2014: 39.0 - 2015: 40.6 - 2016: 42.0 - 2021: 42.9 (cumulative note) - Primary (noninterest) expenditure (percent of GDP): - 2014: 41.0 - 2015: 41.4 - 2016: 41.5 - 2021: 41.4 (cumulative note) - Primary deficit (percent of GDP): - 2014: 2.0 - 2015: 0.8 - 2016: -0.5 - 2017: -0.2 - 2018: -0.2 - 2019: -0.3 - 2020: -0.3 - 2021: -0.2 - Cumulative (2014–2021): -1.4 - Automatic debt dynamics contribution (percent of GDP): - 2014: 1.0 - 2015: -0.1 - 2016: -0.2 - 2017: -0.1 - 2018: -0.6 - 2019: -0.5 - 2020: -0.3 - 2021: -0.2 - Cumulative (2014–2021): 0.0 (with noted -1.6 in another cumulative line) - Residual, including asset changes (percent of GDP): - 2014: -0.7 - 2015: -3.2 - 2016: -0.9 - 2017: 0.0 - 2018: -0.2 - 2019: -0.2 - 2020: -0.3 - 2021: -0.5 - Cumulative (2014–2021): -1.8 ### Composition of Public Debt and Alternative Scenarios (selected reporting) - Baseline scenario underlying assumptions (examples pulled from tables): - Real GDP growth (baseline): 2.2, 2.7, 2.4, 2.2, 2.2, 2.2 (2016–2021 entries). - Inflation (baseline): 0.6, 1.8, 1.9, 2.0, 2.0, 2.0 (2016–2021 entries). - Primary balance (baseline): 0.2, 0.2, 0.3, 0.3, 0.2, 0.2 (2016–2021 entries). - Effective interest rate (baseline): 2.6, 2.9, 3.1, 3.4, 3.8, 4.2 (2016–2021 entries). - Alternative scenarios presented in table form include: - Historical scenario with weaker growth (e.g., Real GDP growth 2.2, 1.9, 1.9, 1.9, 1.9, 1.9) and a Primary Balance path showing deterioration in early years (Primary Balance: 0.2, -1.6, -1.6, -1.6, -1.6, -1.6). - Constant Primary Balance Scenario (Primary Balance held at 0.2 across projection years). - A scenario labeled "Real GDP growth" showing a temporary negative growth shock in 2016–2017 (Real GDP growth: 2.2, -0.7, -1.0, 2.2, 2.2, 2.2) with corresponding Primary Balance impacts (0.2, -1.5, -3.2, 0.3, 0.2, 0.2). ### Graphical/Composition Highlights (as described) - Gross nominal public debt projected path shown by year from 2014 through 2021 (declining trend). - Public gross financing needs projected path shown year-by-year with values staying below 7 percent of GDP in projections. - Debt by maturity: medium and long-term and short-term composition illustrated for 2005–2021 (projection period inclusive). - Debt by currency: local currency-denominated versus foreign currency-denominated composition illustrated for 2005–2021 (projection period inclusive). ### Analytical Notes and Methodology Points (as reported) - Public sector definition: general government. - Effective interest rate defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year. - Automatic debt dynamics derived using formula with variables r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; e = nominal exchange rate depreciation. - Exchange rate contribution derived as ae(1+r). - Residual includes asset changes and interest revenues; for projections includes exchange rate changes during the projection period. *Source: IMF staff.* ### 4.2 percent. Improving household incomes, growing employment with low inflation and ### 4.2 percent. Improving household incomes, growing employment with low inflation and ### Economic outlook - Household consumption accelerated due to improving household incomes, growing employment, low inflation and increasing consumer confidence. - Authorities expect real GDP growth in 2016 of around 2.3 to 2.5 percent. - Continued support to growth from easy domestic monetary conditions, low oil prices and rising external demand. - Employment expected to continue growing. - Consumer price inflation: 0.3 percent in 2015; CNB expects 0.4 percent in 2016 and to reach the 2-percent target in mid-2017. - Unemployment: 5.1 percent in 2015; authorities expect 4.4 percent in 2016 with a continued downward trend. - Average real monthly wages: grew by 3.1 percent in 2015; expected to grow by 3.4 percent in 2016. - External position: current account surplus of 0.9 percent of GDP in 2015; expected surplus of 2 percent of GDP in 2016 owing to a very strong trade balance. ### Fiscal policy — objectives and outcomes - Government commitment: keep general government deficit below the reference value of 3 percent of GDP. - Medium-term budgetary objective: structural deficit of no more than 1 percent of GDP. - Key fiscal objectives: improved tax collection, more effective and transparent government expenditures, enhanced absorption and drawdown of resources from EU funds. - 2015 outturns: general government sector deficit of 0.4 percent of GDP; government debt of 41.1 percent of GDP. - 2015 structural balance: deficit of 0.3 percent of GDP (over-performance relative to MTO). - Authorities’ forecast: general government sector deficit of 0.6 percent of GDP in 2016 and 0.5 percent of GDP through 2019. - Structural balance: deficit of 0.6 percent of GDP in 2016, and around 1 percent of GDP until 2019. - Debt dynamics: stabilization of debt-to-GDP ratio at 2015 level in 2016; decrease to around 39 percent of GDP by 2019. - 2015 revenue drivers: capital transfers from EU funds increased by more than 84 percent compared to 2014; high increase in tax revenues including social contributions; record-low yields on Czech government bonds helped budget outturn. - General government investment: increased by approximately 30 percent in 2015, highest value since 1995, concentrated in EU projects generating a substantial fiscal impulse. - Investment outlook 2017–2019: expected systematic increase with annual growth of approximately 4.5 percent due to transition between Financial Perspectives; additional growth from national resources. ### Fiscal policy — expenditures and tax measures - Social measures in 2015: extraordinary indexation of pension benefits by 1.8 percent. - From January 1, 2016: indexation formula reverted to total sum of full consumer price growth and one third of real wages growth. - February 2016: one-off benefit paid to each pensioner due to low indexation; government approved change allowing discretion to adjust indexation up to 2.7 percent if standard rule yields lower amount. - General government wage bill: salary compensation estimated to increase by approximately 4 percent in 2016. - Tax collection measures: electronic VAT reporting effective January 1, 2016; fiscalization of cash payments to be implemented at the end of 2016. - Revenue expectations: 2016 revenues should decrease due to reduced EU funding but mitigated by taxes and social security contributions; indirect tax revenues expected to increase in 2016 mainly due to VAT collection from electronic VAT reporting. - Work in progress: new act on income taxes. - Public finance quality measures: central register of contracts; draft act on the monitoring and management of public finances. - Fiscal responsibility proposals approved by government in February 2015 (being submitted to Chamber of Deputies) include: (i) an independent expert Committee for Fiscal Forecasts; (ii) an independent National Budgetary Council; (iii) an expenditure fiscal rule for the general government; (iv) debt rules for local governments and the general government. - Interim measure: Ministry of Finance has its macroeconomic forecasts assessed by independent experts; assessments published and attached to key fiscal/budgetary documents. ### Structural policies - Government program priorities: support for business, effective labor market, functioning and transparent state administration, long-term sustainable pension scheme, investment in education, science and research. - 2016 National Reform Program focus: combat tax evasion, stabilize public administration, improve labor market (including mobility and protection of vulnerable groups), improve infrastructure, introduce new construction law, increase quality of primary and higher education. - Policies to strengthen innovation and investment: strengthen cooperation between research institutions and business sector, measures to establish a favorable investment environment, digitizing the economy. - Specific measures: decrease tax burden on labor of pensioners and families with children; relax conditions for material support for creating new jobs in investment incentive system. - Act on Public Procurement approved by Parliament on April 19, 2016: increase transparency and reduce administrative requirements. - Draft long-term budget until 2021 for national expenditure on research, development and innovation is being prepared. - Pension and health measures: penalty for early retirement increased since 2010; Pillar II of pension system cancelled as of January 1, 2016 with winding up process until end of 2016. - Pension insurance system regarded as sustainable with respect to stabilization at the end of the forecast horizon 2060. - Continued efforts to improve cost effectiveness and management of health care system, including public health insurance reforms. ### Monetary policy - CNB policy rate at “technical zero” (0.05 percent) since November 2012. - Since November 2013 CNB has used the exchange rate as an additional instrument within inflation-targeting to ease monetary conditions. - At the May 5 monetary-policy meeting, Bank Board kept interest rates unchanged at technical zero and committed to continue using the exchange rate instrument to keep exchange rate close to 27 koruna to the euro; asymmetric commitment only to intervene against appreciation below announced level remains unchanged. - CNB staff forecast: market interest rates flat at current level and exchange rate used as monetary policy instrument until mid-2017; increase in market interest rates thereafter. - CNB expects sustainable fulfilment of inflation target from mid-2017 as condition for return to conventional monetary policy; Bank Board stated it will not discontinue use of exchange rate instrument before 2017 and considers discontinuation likely in mid-2017. - Return to conventional policy is not expected to result in sharp appreciation to pre-intervention slightly overvalued koruna level because weaker koruna has passed through to price level and nominal variables; appreciation dampened by exporters’ hedging, closing of koruna positions by financial investors and possible CNB interventions. - Risks to forecast at monetary policy horizon assessed as slightly anti-inflationary; CNB ready to shift exchange rate commitment to a weaker level if systematic decrease in inflation expectations manifests in nominal variables, especially wages. - Bank Board discussed negative interest rates (May 5 minutes): prevailing view that negative rates are not appropriate to additionally ease monetary conditions directly, though could serve to defend exchange rate commitment or complement a move in exchange rate commitment level. ### Financial stability and macroprudential policy - Banking sector performance in 2015: increased profitability, sustained high capitalization, favorable liquidity; deposits increased despite declining deposit interest rates; long-term independence from foreign funding. - Credit risk decreased; structure of non-performing loans improved; aggregate provisions appear sufficient to cover current expected loss given default. - Insurance companies well capitalized and mostly maintaining stable profitability; pension management companies sector stable. - Financial cycle: Czech economy in growth phase of financial cycle. - CNB macroprudential action: countercyclical buffer rate set at 0.5 percent of exposures located in the Czech Republic with effect from January 2017 in response to rapid credit growth, increasing household debt relative to income and residential property price growth. - May 2016 decision: buffer rate left at current level for the time being; CNB ready to increase buffer if credit growth remains high, credit standards ease further and investor optimism continues. - New Financial Stability Report (June 14, 2016): increased attention to property market and house purchase loans; CNB does not assess trends as acute overheating but considers credit standards highly relaxed and identifies higher risk-taking by some institutions. - CNB recommendations tightening (announced June 14, 2016, effective October 2016 and April 2017): - Upper LTV limit: 100 percent reduced to 95 percent as of October 2016 and to 90 percent as of April 2017. - Current recommended limit of 10 percent of new loans with LTV of 90 percent to 100 percent will change to 10 percent of new loans with LTV of 85 percent to 95 percent as of October 2016. - Limit set at 15 percent of new loans with LTV of 80 percent to 90 percent as of April 2017. - New recommendation: institutions should use all available information to determine owner-occupied versus investment loans; for investment loans exhibiting higher risk characteristics, apply an LTV of 60 percent at most. - CNB seeks enactment of power to set risk parameters for house purchase loans in accordance with ESRB recommendations, including option to set binding LTV, LTI and DSTI limits and other risk parameters. - Stress test results: banking sector highly resilient to adverse scenarios; under the Adverse Scenario (strong recession and deflation) sector maintains capital adequacy sufficiently above regulatory threshold of 8 percent; sector highly resilient to short-term liquidity risk. - CNB stress test of public finance: current fiscal situation does not threaten banking sector stability; CNB will not apply additional capital requirements to credit institutions at the three-year horizon. - Recovery and Resolution Act: as of January 2016 CNB is resolution authority with exclusive power to create resolution plans for banks, credit unions and some investment firms. *IMF Article IV mission report content.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16213.pdf_