Czech Republic--Article IV Consultation Discussions, Preliminary Conclusions of the Mission
IMF News, May 7, 2002
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- Published: May 7, 2002
Mission overview
- Document date: May 7, 2002.
- Purpose: Describes the preliminary findings of IMF staff at the conclusion of the mission as part of Article IV consultations.
- Main assessment: The Czech economy has been resilient despite global slowdown and a sharp appreciation of the koruna, supported by buoyant FDI and structural reforms; however, short-term weakness and medium-term fiscal sustainability remain key concerns.
Macroeconomic conditions and outlook
- Recent shocks and resilience:
- Global slowdown further reduced demand for Czech exports.
- The Czech koruna appreciated sharply.
- Despite these shocks, the economy showed only modest deceleration, reflecting improving supply-side conditions from FDI and structural reforms.
- Short-term outlook:
- Weak foreign demand will continue to constrain growth in the first half of 2002.
- Rapid appreciation of the koruna will weaken external competitiveness; effects may be largely in the pipeline.
- CNB interest rate cuts over the past months will be helpful.
- The mission expects GDP growth to be 3-3.25 percent in 2002, and to accelerate next year.
- Inflation and labor market:
- Inflation has continued to fall since mid-2001; expected to stay on a decelerating path, before turning upward in late-2002.
- Inflation is expected to fall below the CNB's target range temporarily from mid-2002 to early-2003, but from mid-2003 onward will likely return to the range.
- Unemployment remains high; much reflects skill and regional mismatches and low worker mobility.
- Long-term unemployment is high, suggesting slack in the economy may be smaller than the headline unemployment figure implies.
- External accounts:
- Current account deficit in 2002 will likely remain broadly unchanged from last year at some 5 percent of GDP.
- FDI inflows in the pipeline (greenfield and privatization) will amply finance this deficit.
Fiscal policy assessment and risks
- 2001 and 2002 fiscal performance:
- Better-than-expected 2001 outturn owed to cyclical and special factors, not deliberate consolidation.
- The 2002 budget does not aim to correct fiscal imbalances and appears expansionary.
- General government deficit—excluding privatization receipts, proceeds from the sale of Russian debt, and transfers to transformation institutions—is projected to increase by 2.4 percentage points of GDP over the estimated 2001 outturn.
- Sources of fiscal slippage:
- Higher spending, including more ambitious extrabudgetary fund plans for transport and housing.
- Transfer of spending responsibilities to local governments and extrabudgetary funds without commensurate reduction in the state budget.
- Lower revenues (as a share of GDP) as one-off 2001 factors are not repeated.
- Increasing complexity of fiscal accounts due to extrabudgetary funds and additional local government layers, reducing Ministry of Finance monitoring ability.
- Mission recommendations and quantified targets:
- The envisaged expansion is cyclically unwarranted and counter to medium-term consolidation.
- The mission advocates restraining the expenditure ratio to its 2001 level.
- This implies a reduction—relative to the budget—in general government expenditures (excluding transfers to transformation institutions) of CZK 35 billion, or 1.5 percent of GDP.
- Recommended targeted cuts: expenditures that least affect future growth, including subsidies to public enterprises and construction savings accounts.
- Medium-term fiscal sustainability challenges:
- Realization of contingent liabilities from bank restructuring.
- Costs related to EU accession.
- Drying up of privatization proceeds.
- Growing future imbalances in the public pension system.
- Mounting infrastructure spending needs.
- Urgent need for fundamental reforms to reduce mandatory spending, notably pension and social benefit reform.
- The mission urges political consensus and prompt action by the government and parliament emerging from upcoming elections.
Monetary and exchange rate policy
- CNB performance and inflation targeting:
- In 2001 the CNB achieved its end-year net inflation target under dynamic domestic growth.
- Headline inflation expected to fall below the continuous target band for a sustained period from mid-2002, owing to output gap and lagged effect of koruna appreciation.
- Koruna appreciation and policy implications:
- Factors cited for appreciation: market concerns about conversion of privatization receipts, forthcoming large greenfield FDI, gains in productivity and efficiency, expectations of EU accession and euro adoption, speculative excesses, exporters' hedging.
- The mission regards the recent 50 basis point cut in the repo rate as consistent with inflation-targeting objectives.
- Rapid koruna appreciation and lower inflation had tightened monetary conditions; the interest rate cut helps avoid undershooting the inflation target over the 12-18 month horizon and may ease upward pressure on the exchange rate.
- Risks and recommended actions:
- Balance of risks to inflation lies on the downside.
- Exchange rate pass-through to inflation appears limited historically, but increased retail competition may transmit lower import costs to consumers.
- If reduced profitability in traded sectors causes temporary cutbacks in investment and employment, downward inflation pressure may increase.
- Authorities have tools within the inflation targeting framework to prevent exchange rate instability.
- The government–CNB agreement to withhold all government foreign currency receipts from the market should be fully used, including proceeds from Transgas.
- Converting foreign exchange inflows on the market by the government would drive up the exchange rate and be costlier.
- The mission commends the government's intention to pay foreign suppliers and creditors directly from foreign exchange proceeds and encourages continuation given expected privatization inflows.
- Euro accession and preparation:
- EU accession implies eventual adoption of the euro when Maastricht criteria are met.
- Medium-term benefits of euro zone membership are clear due to close goods and capital market integration with the EU.
- The new government should promptly formulate views on a timetable and concrete steps toward euro adoption and disclose them as appropriate to reduce uncertainty and currency speculation.
- The period until EMU should be used to implement fiscal consolidation and increase labor market flexibility.
- Annual medium-term pre-accession economic programs (PEPs) can frame policies to meet macroeconomic and structural objectives by the target EMU entry date.
Structural reforms and institutional issues
- Bank and asset restructuring:
- Renewed interest in disposing of bad assets is welcome; bad assets deteriorate over time.
- With pending transfer of further assets from CSOB stemming from the old IPB, total non-performing assets on CKA books could reach some CZK 300 billion.
- In most cases private sector is more efficient at corporate restructuring; recommended method is direct sales of packages of assets to private institutions.
- CKA should ensure maximum competition, high yields, large-enough packages to attract first-tier bidders, transparent and well-structured sales processes, sufficient time for bidder evaluation, and clear rules applied equally.
- Next package sale should be part of a predictable sequence of disposals.
- Fiscal transparency and reporting:
- Czech Republic meets many objectives in the Code of Good Practices on Fiscal Transparency; 2001 budgetary rules improved accountability.
- Creation of extrabudgetary funds for a significant share of public spending poses challenges for efficiency, control, and transparency.
- Fiscal reporting does not fully reflect potential future fiscal risks (past guarantees, tax concessions, current commitments).
- The mission welcomes disclosure of contingent liabilities in the last PEP.
- Recommended further step: consider preparing and publishing an annual statement on contingent liabilities, tax expenditures, quasi fiscal activities, and current commitments entailing significant future obligations.
- Financial sector and regulation:
- Financial sector stability has increased after bank privatization; bulk of banking sector now in private hands with strategic investors.
- Newly-privatized banks likely to be cautious lenders initially; medium-term benefits from a more efficient banking system expected.
- The recently-approved Banking Act amendment extends consolidated supervision to cover credit risk and market risk and strengthens anti-money laundering provisions.
- Importance of efficient cooperation among supervisory agencies and with foreign supervisors emphasized.
- Legal/regulatory framework and judiciary:
- Problems remain in bankruptcy process and commercial registers.
- Current bankruptcy process is too slow and favors liquidation over restructuring.
- Proposals for a new bankruptcy law are at drafting stage; rapid adoption after full consultation is encouraged.
- Strengthening the judiciary via specialization, education, and training is crucial for legal certainty.
- Commercial register delays persist; solution lies in full application of the law or operating registers outside the court system.
- Significant scope remains to improve legal and regulatory environment to enhance the investment climate.
- Labor market and social benefits:
- Need to increase labor market flexibility to raise employment and match labor supply to incoming foreign capital.
- Skill and regional mismatches and rising long-term unemployment are worrisome.
- Remedies include attracting FDI to high-unemployment regions and gradually relaxing rent control to facilitate mobility.
- Social benefit system issues: undifferentiated application and too-high benefit levels relative to potential wage income reduce work incentives.
- Suggested reforms: graduated decline in some benefits over time, stricter means testing, adjusting the Minimum Living Standard to reflect true minimum living costs.
- Some occupation-specific severance benefits are not tied to job-search activities; part of these benefits should be linked to workers' efforts to find new jobs.
Key policy recommendations and priorities
- Short term:
- Use recent CNB interest rate cuts and the government–CNB agreement to withhold government foreign currency receipts to stabilize exchange rate pressures.
- Maintain vigilance on inflation risks given downside tilt.
- Medium term:
- Restrain general government expenditure ratio to 2001 level; reduce general government expenditures by CZK 35 billion, or 1.5 percent of GDP, relative to the 2002 budget.
- Prioritize reforms of the pension and social benefit systems to ensure fiscal sustainability and improve work incentives.
- Accelerate corporate sector restructuring and privatization of non-performing assets via competitive, transparent package sales.
- Improve fiscal transparency by publishing annual statements on contingent liabilities, tax expenditures, quasi fiscal activities, and significant current commitments.
- Strengthen legal and regulatory frameworks: adopt a new bankruptcy law, improve commercial register functioning, and strengthen the judiciary.
- Enhance labor market flexibility and target policies to reduce skill and regional mismatches, including regionally-targeted FDI attraction and conditionality on severance benefits.
- Strategic:
- The new government should formulate and disclose a timetable and concrete steps toward euro adoption and use the pre-EMU period to solidify fiscal consolidation and labor market flexibility.
- Build broad-based political consensus to pursue reforms despite possible short-term costs.
International Monetary Fund — May 7, 2002.