## Czech Republic -- 2004 IMF Article IV Consultation Mission, Preliminary Conclusions

_IMF News, May 25, 2004_

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## Bibliographic details
- Published: May 25, 2004

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### 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*

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## References

- [Czech Republic and the IMF](http://www.imf.org/external/country/CZE/index.htm)
- [Mission Concluding Statements](https://www.imf.org/en/news/searchnews)
- [PRESS CENTER](http://presscenter.imf.org/)
- [Article IV](https://www.imf.org/external/pubs/ft/aa/aa04.htm)
- [https://www.imf.org/en/home](https://www.imf.org/en/home)

_Source: https://www.imf.org/en/news/articles/2015/09/28/04/52/mcs052504_