Czech Republic: Staff Concluding Statement of the 2017 Article IV Mission

IMF News, May 15, 2017

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Published: May 15, 2017

Overview

The Czech economy is doing well: growth is solid, unemployment is low, inflation is back at the target level, public finances are in good condition, and the banking system is liquid and profitable.
Key challenges: increasing household financial vulnerabilities; shortages of labor, especially skilled labor; and needed improvements in several aspects of public administration and processes.
Policy response requires a combination of monetary, macroprudential, financial, structural, and fiscal measures.

Outlook and Risks

Growth and inflation projections and constraints:
- Real GDP growth is projected to increase to 3 percent in 2017, largely driven by domestic demand.
- Labor shortages are expected to constrain growth to about 2½ percent over the medium term.
- Inflation is expected to reach 2.3 percent this year, before falling to the 2 percent inflation target.
Key uncertainties and risks:
- The future exchange rate path after removal of the euro:koruna floor is highly uncertain.
- Projection assumes modest annual appreciation of the koruna and gradual interest rate increases.
- Unwinding of large financial positions built up by foreign investors could make the exchange rate erratic.
- Assumed significant increases in labor productivity are crucial given a shrinking workforce and existing labor shortages.

Monetary Policy

Assessment:
- The time was right for leaving the exchange rate floor: headline inflation is at target, external deflationary pressures have faded, and the real exchange rate remains moderately below equilibrium.
- The economy is running slightly above capacity, labor markets are tight, and credit growth is high.
Policy approach:
- Agree with a gradual, data-driven approach to raising interest rates.
- Letting the exchange rate find its natural value and observing economic reaction to the transition is appropriate.
- If market conditions become disorderly, moderate foreign exchange intervention could be valid, but interventions should not counter the natural structural adjustment of the exchange rate.

Macroprudential Policy

Household vulnerabilities:
- Rapid credit growth raises concern that some households are becoming overstretched.
- Although average household debt is relatively low, it has been increasing rapidly; some households borrow high amounts relative to incomes.
Tools and powers:
- A wider range of macroprudential tools should be applied; the CNB has been restricting loan-to-value limits but lacks the full toolset to target household vulnerabilities such as high lending multiples relative to income.
- It is crucial that the CNB be given binding powers over loan-to-value (LTV), debt-to-income (DTI), and debt-servicing-to-income (DSTI) ratios.
- Legislation providing powers over LTV, DTI and DSTI ratios should be put in place shortly without being watered down; these tools are not substitutes for each other, and prudential tools like bank capital requirements are not well suited to addressing borrower vulnerabilities.
Housing supply and taxation:
- Supply distortions amplify house price fluctuations—complex permits processes limit supply response.
- Introducing value-based property taxation, with a suitable phase-in period, could help dampen the cycle.

Financial Policy

Banking system condition:
- The banking system is liquid and profitable; banks are typically funded mainly through deposits and have ample access to liquidity; profitability is high in terms of returns on equity and assets.
Vigilance and supervision:
- No signs of significant system-wide weaknesses so far, but acceleration of credit growth raises concern that lending standards may slip.
- Rigorous stress tests and increased frequency of on-site inspections are important.
- Supervision needs more granular data, such as on real estate and household debt.
- The increase in foreign exchange lending to corporates warrants close attention.

Structural Reforms

Labor market and skills:
- Revise labor market incentives to boost labor force supply and quality: reduce the relatively high tax wedge and marginal tax disincentives to enter the workforce; deter early retirement.
- Female labor participation is notably low for women with small children; tax system penalties for reentering the labor force, limited affordable childcare, and lack of flexibility in part-time contracts reduce participation and lifetime female earnings.
- Address skill mismatches by strengthening vocational training, apprenticeships, and in-work and life-long learning schemes.
Regulatory environment and permits:
- While overall competitiveness and product market regulation rankings are good, planning and building permit processes are perceived as cumbersome, opaque, and inconsistent—contributing to real estate supply problems and slowing infrastructure spending.
- Recommend a thorough review and benchmarking to best practices to simplify procedures, reduce administrative burdens on start-ups, and foster competition.
Infrastructure and funds absorption:
- Infrastructure coverage and quality remain below the EU average.
- Improved efficiency in absorption of public funds (EU and national) could instrumentalize addressing infrastructure needs.

Fiscal Policy

Fiscal framework and current stance:
- A new fiscal law establishes an independent fiscal council and sets fiscal limits for general and local government.
- Strong growth and better revenue collection mean a surplus of 0.4 percent of GDP is expected for 2017, despite increases in public sector wages and social spending.
- If conservative spending policies remain, combined with improved tax collection, continued small surpluses from 2018 are implied.
- These surpluses and steady nominal growth would bring the public debt to around 26 percent of GDP by 2022.
Policy recommendations:
- Given relatively low public debt, prioritize raising growth potential via modestly higher investment in physical and human capital rather than sizeable short-term stimulus—the economy is operating slightly above capacity.
- Consider using surpluses to finance infrastructure and skills while leaving some margin for uncertainty about future revenues and availability of EU funds after 2020.
- Adjust composition of tax and expenditure policies: rationalize healthcare spending, ensure pension sustainability through gradual increases in retirement age, and better target direct taxation and social security contributions to create room for public investment and reduce tax distortions affecting the labor force.
Public investment strategy and debt management:
- Public investment spending lacks a medium- and long-term strategy; no single ministry coordinates planning for all infrastructure; low EU funds absorption led to a sharp contraction in public investment in 2016.
- Recommend assessment of public investment management to establish a unified and transparent long-horizon infrastructure plan.
- Current debt management strategy places high weight on short-term outcomes; authorities should lock in low rates for longer while opportunity remains.
- 10.5 percent of state debt is exposed to foreign exchange risk.
- Recommend debt management pursue minimizing costs and risks over the medium term, including complete hedging of foreign exchange rate risks, and consider achieving suitable operational independence.

The mission is grateful to the Czech authorities for their excellent cooperation and warm hospitality, and would like to thank them and representatives from the private sector, social partners, and academic institutions for candid and constructive discussions.