Czech Republic -- 2004 IMF Article IV Consultation Mission, Preliminary Conclusions
IMF News, May 25, 2004
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- Published: May 25, 2004
Accession and policy priorities
- Accession to the European Union marks the completion of transition for the Czech Republic and shifts policy focus to furthering catch-up to EU income levels and adopting the euro.
- Comparative strengths: a skilled work force, an open regime for trade and capital flows, and a large manufacturing and service base.
- Policy priorities going forward:
- Fiscal and monetary policies to promote macroeconomic stability.
- Measures to contain and offset fiscal risks and enhance financial sector supervision.
- An efficient business-legal system.
- Flexible product and labor markets.
Economic outlook and near-term performance
- 2003 performance:
- Growth of 2.9 percent driven by strong consumer demand, rapid consumer borrowing, fast real wage gains from unexpectedly low inflation, and a surge in public investment.
- Current account deficit widened to 6½ percent of GDP, reflecting significant outflows of income from foreign direct investment and one-off factors.
- Trade deficit narrowed slightly; financing shifted to non-FDI sources as privatization slowed and ownership of two large foreign-owned firms changed.
- 2004 projection:
- Growth should firm to about 3¼ percent as EU demand picks up, with composition shifting toward net exports and export-related fixed investment.
- Current account deficit projected to fall to under 5½ percent of GDP.
- Downside risks: a more restrained EU recovery, sustained high world oil prices, and faster koruna appreciation.
- Medium-term prospects:
- Potential output growth expected to gradually rise to 3¾ percent over the next few years, conditional on restoring fiscal viability, improving the business environment, and increasing labor market flexibility.
Monetary and exchange rate policy
- Recent developments and inflation drivers:
- Easing monetary conditions supported growth, but inflation recovered in late 2003 due to a poor harvest (rising food prices), koruna depreciation, and wage growth in excess of productivity in the non-traded sector.
- Administrative measures (taxes and regulated prices, EU-related trade regime changes) expected to have a combined direct impact of around 1½ percentage points on inflation.
- Inflation outlook and policy stance:
- Year-on-year headline inflation expected to peak at around 4 percent at end 2004, then decrease as direct VAT effects dissipate.
- Second-round effects on future inflation are not expected to be significant due to the anchor role of the inflation target and weak labor market conditions.
- Recommendation: monetary policy should soon enter a tightening cycle as slack diminishes to keep inflation close to the middle of the CNB's target band; timing and size of rate increases should account for growth robustness and exchange rate effects.
- Inflation-targeting framework:
- CNB target set at 3 percent with a tolerance margin of ±1 percent to ensure continuity and alignment with the euro-area stance during the pre-euro period.
- CNB intends to continue IT during the pre-euro period of ERM2; responsibility for meeting Maastricht fiscal criteria and boosting resilience lies beyond the CNB.
- With the euro changeover projected for 2009-10, authorities should start preparations now, prioritizing placing the fiscal deficit on a firm downward path and bolstering labor market flexibility.
Fiscal policy: developments, risks, and recommendations
- Recent deterioration:
- General government deficit (excluding privatization receipts and transfers to transformation institutions) widened to above 5 percent of GDP in 2003.
- Public debt continued to climb; on some measures the Czech Republic has "graduated" to a moderate debt level.
- Little progress with entitlement reforms (pensions and health care) leaves public finances ill-prepared for population aging pressures.
- Government medium-term plan (2004-06):
- Plan aims to gradually return the general government deficit during 2004-06 to its 2002 level relative to GDP while accommodating EU accession costs and gradually reducing corporate income taxes.
- Plan structured as an explicit medium-term framework with a rolling 3-year horizon and expenditure ceilings.
- 2004 implementation and slippage:
- Despite the state budget expenditure ceiling being observed, the general government deficit (excluding privatization receipts and transfers to transformation institutions) is projected to widen by over 1 percentage point to 6.4 percent of GDP.
- Causes: larger subsidies, higher capital spending, decline in nontax revenue, loopholes in expenditure ceiling coverage (e.g., capital injections via lending and subsidies through the National Property Fund not covered), and post-budget compensation measures without offsets.
- Recommended corrective actions to restore credibility:
- Find savings of ¼-½ percent of GDP in 2004.
- Broaden the coverage of expenditure ceilings to the widest possible range of spending items and general government units; improve coordination across central, regional, and municipal governments.
- Adhere to expenditure targets and avoid post-budget spending measures; respect expenditure ceilings even when higher revenues arise.
- Enhance clarity of communications by using a consistent set of fiscal indicators (preferably those in the medium-term framework) and explain fiscal projections and performance for both general government and the state budget.
- 2005-06 challenges and medium-term targets:
- Medium-term plan targets an evenly-phased deficit reduction for 2005-06.
- 2006 faces a fall in revenues due to prior reductions in corporate and personal income tax burdens, requiring substantial spending cuts in an election year.
- Authorities should bring forward to 2005 significant permanent savings totaling 1¾ percent of GDP to increase credibility and reduce required adjustment in 2006.
- Recommendation to reduce the deficit below 2 percent of GDP by 2008-09 and to speed up pension and health care reforms; health care measures likely to shift a larger share of the financial burden to final users.
- Long lags in pension reform effects warrant early action and social consensus building.
Financial sector issues
- Positive indicators: strong bank profitability, declining nonperforming loans, and rebounding bank lending led by credit to households.
- Emerging risks:
- New loan structures and household indebtedness increase systemic risk not captured by individual bank-based or backward-looking indicators.
- Need for enhanced supervisory capacity and broader stress testing that includes credit-risk scenarios where household loan quality degrades differently from historical corporate loan patterns.
- Data gaps: comprehensive household indebtedness data (debt concentrations and volume of nonbank debt) and indicators of debt servicing capacity (e.g., disposable income of indebted households).
- Growing mortgage lending suggests housing market risks; recommend establishing a database of residential real estate transactions to monitor prices and turnover.
- Institutional reform:
- Merging financial supervisors could bring synergies but should not distract from effective oversight.
Structural issues and competitiveness
- State involvement and privatization:
- Continued reduction of direct state involvement in the enterprise sector will improve resource allocation efficiency.
- Privatization has slowed; recommendation to continue expeditious privatization, accelerate disposal of assets held by the Czech Consolidation Agency (CKA), and strictly limit the number of sensitive companies excluded.
- All state support to sensitive companies should be transparently recorded in general government accounts; no additional bad assets should be transferred to the CKA prior to its closing in 2007.
- The Czech railway system remains a drain on public resources; devise a transparent restructuring plan to improve budgetary outcomes.
- Taxation and investment climate:
- Corporate income tax: government plans to reduce the statutory tax rate to 24 percent by 2006 while shortening depreciation periods; IMF view prefers reducing tax deductions and allowances with offsetting declines in the statutory rate.
- Need for an efficient and predictable business-legal environment (bankruptcy and commercial registry laws) to attract small- and medium-sized enterprises; recommend enacting amendments to existing laws without delay to bridge gaps before comprehensive new laws take effect.
- Labor market:
- Recent trends raise concerns about eroding labor market flexibility: rising unemployment (particularly long-term), ossified regional differences, skill mismatches, and insufficient incentives for job search among some groups.
- Policy recommendations:
- Consider compulsory activation through training or work for the long-term unemployed.
- Reduce impediments to labor mobility, including easing rent control.
- Upgrade transport infrastructure, reduce non-wage labor costs, and keep labor market regulations sufficiently flexible.
- Promote life-long upgrading of skills to move up the technology ladder.
- Acknowledge some measures involve fiscal costs and would require restructuring public spending.
Closing and administrative notes
- The authorities are thanked for their cooperation, hospitality, and stimulating discussions.
- Document date: May 25, 2004.
International Monetary Fund — Czech Republic -- 2004 IMF Article IV Consultation Mission, Preliminary Conclusions