Public Information Notice No. 98/12

Press Information Notice: IMF Concludes Article IV Consultation with the Czech Republic

March 6, 1998

The IMF Executive Board on February 13, 1998 concluded the 1997 Article IV consultation¹ with the Czech Republic.

Background

After achieving early and decisive progress in stabilization and structural reform, the Czech Republic has experienced large macroeconomic imbalances in the last few years. Huge capital inflows in 1994-95 complicated monetary management under a fixed exchange rate regime and stimulated domestic demand, while weak corporate governance fueled wage growth. As a result, the current account deficit widened sharply, to 7½ percent of GDP in 1996, and the rate of inflation exceeded that in the Czech Republic’s main trading partners. Real GDP growth picked up to nearly 6 percent in 1995, but slowed to about 4 percent in 1996.

Notwithstanding a tightening of monetary policy from mid-1996, the current account imbalance widened further in early 1997 owing to high wage growth, lack of fiscal support, and a nominal appreciation of the koruna within the exchange rate band. As a result of the market’s reassessment of the fundamentals and contagion effects from Thailand, in May 1997 speculative pressures against the koruna led to the adoption of a managed float and a depreciation to 10-12 percent below the former central parity. In the second half of the year, fiscal and monetary tightening, increased exchange rate flexibility and strengthened foreign demand all contributed to restoring order in the foreign exchange market and to a narrowing of the external deficit. Nevertheless, political uncertainty and contagion effects from the East Asian currency crises contributed to further depreciation pressures in the last quarter of 1997; this prompted temporary increases in interest rates and intervention in the foreign exchange market by the Czech National Bank (CNB). More recently, the market has reacted relatively favorably to the appointment of a new cabinet, while the intensification of the Asian crisis has had little effect on the Czech Republic.

The current account deficit narrowed to 6–6½ percent of GDP in 1997, with all of the improvement concentrated in the second half of the year when the deficit was about 5 percent of GDP. After five quarters of sluggish export performance, exports began to grow rapidly from the second quarter of 1997, mainly reflecting the recovery of economic activity in western Europe, the sharp deceleration of domestic demand, and the beneficial effect of previous foreign direct investment. The growth of imports decelerated sharply. The capital account is estimated to have recorded a surplus of 3 percent of GDP in 1997; of this, one half was in the form of nondebt capital inflows. Total gross external debt was US$22 billion at end-1997, equivalent to about 40 percent of GDP. The debt service ratio remains relatively low and the Czech Republic enjoys an investment grade sovereign rating by foreign agencies. Official reserves amounted to US$9¾ billion at end-1997, equivalent to 4½ months of merchandise imports.

Developments in the domestic economy were on the whole disappointing in 1997. A steep decline in investment kept real GDP growth to 1–1½ percent despite the strength of exports. Consumption also weakened in the second half of 1997. Extensive floods in July caused physical damage valued at 4 percent of GDP and lowered output growth by ½ percentage point. Unemployment rose from 3½ percent at end-1996 to 5¼ percent at end-1997. Inflation reached 10 percent in the 12 months to end-1997, up 1½ percentage points from the previous year; this reflected larger increases in administered prices. Nominal wage growth decelerated significantly but remained high in relation to productivity gains.

Fiscal and monetary tightening were key to the improvement in the external position. The general government deficit was contained to about 2 percent of GDP in 1997, compared with a deficit of 1¼ percent of GDP in 1996, notwithstanding the impact of floods (about 1¼ percent of GDP) and lower than expected economic activity. This was made possible by expenditure cuts of 2½ percent of GDP, announced in April-May. Broad money growth was kept within or below the 7–11 percent target range throughout 1997—down from almost 20 percent in mid-1996. Interest rates have trended upward since April 1997.

The pace of enterprise restructuring and financial sector reform has been sluggish in recent years. As a consequence of voucher privatization in 1991–94, diffuse ownership and residual state shareholdings have preserved a controlling state interest in major enterprises and banks, and progress toward effective privatization of these entities has been relatively slow. The resulting weak corporate governance has contributed to rapid real wage growth. Furthermore, sluggish economic activity and relatively high real lending rates have adversely affected the financial position of banks. The central bank has been involved in restructuring of the smallbanks over the past few years through mergers, liquidations and capital injections to clean up portfolios. The government recently reached agreement on the sale of the state’s remaining share in one of the four major banks, and technical preparations are underway for the sale of the state’s stake in the other three major banks.

Executive Board Assessment

Executive Directors commended the authorities for their determined response to the major challenges they had faced in mid-1997—namely, a large external imbalance and disorderly conditions in the foreign exchange market, owing in part to spillover effects from the East Asian currency crises. They noted that monetary and fiscal tightening, and the timely adoption of a managed float, were key to the subsequent narrowing of the current account deficit and the return of relative stability in the foreign exchange market. However, Directors observed that the costs had been high—unavoidably so given the size of the external imbalance—as evidenced by a steep decline in investment and growth, and a rise in unemployment. Noting that the external position remained fragile and inflation high, Directors stressed the need to maintain tight financial policies and to implement a much more vigorous approach to wage discipline. Restructuring of enterprises and addressing weaknesses in the banking system were also seen as essential for setting the stage for renewed growth in a noninflationary environment.

Directors welcomed the authorities' objectives of reducing the external imbalance and the rate of inflation in 1998 through a further deceleration of nominal wage growth, continued tight macroeconomic policies, and accelerated structural reform. Against the background of a still large current account deficit and a vulnerable external position, Directors stressed the importance of adhering strictly to announced policy intentions in order to sustain adjustment and strengthen market confidence, and in view of the upcoming elections, they emphasized the need for any future government to continue the policies and structural reforms now underway.

Directors agreed that wage restraint was key to the continued adjustment. They noted that, while wage growth had slowed significantly in 1997, this was due mainly to strict limits on wage increases in the budget. Wage growth in the rest of the economy, albeit decelerating, was still high, owing in large part to developments in state-controlled enterprises. They welcomed, therefore, the authorities' intention to reduce nominal wage growth in state-controlled enterprises sharply in 1998, which could have a favorable demonstration effect on other sectors. They also noted, however, that wage discipline could only be lastingly addressed through structural reform, notably completion of the divestment of state-controlled enterprises. A few Directors proposed a more comprehensive incomes policy to encompass the private sector. These Directors suggested that the government, in consultation with the private sector, consider setting general wage guidelines as a guide to wage bargaining at a decentralized level. Other Directors, however, thought that such an incomes policy would reintroduce rigidities in the wage bargaining system without addressing the root cause of wage pressures, which was weak corporate governance.

Directors generally stressed the continuing need for a tight fiscal policy stance in support of the stabilization effort. They commended the authorities for the sizeable expenditure cuts announced in April-May 1997 in response to depreciation pressures on the koruna. As a result of these measures, it had been possible to contain the fiscal deficit in 1997 despite lower than expected economic activity and the sizeable impact of flood-related expenditures in July. Directors also welcomed the authorities' plans to reduce the general government deficit to 1 percent of GDP in 1998. However, Directors were concerned that the authorities' revenues and expenditures projections may be too optimistic and that further fiscal measures could be needed to achieve these targets. In this regard, they welcomed the authorities' intention to take additional measures as needed during the year. A number of Directors encouraged the authorities to aim at achieving a small budget surplus over the medium term, particularly if wage growth turned out to be higher than envisaged and external adjustment showed signs of slowing.

Directors commended the CNB for its handling of the currency crisis through determined use of interest rate policy and increased exchange rate flexibility. The CNB's policies had been successful in stabilizing the exchange rate at an acceptable level without imposing undue burdens on the banking and enterprise sectors. Directors stressed that the vulnerability of the external position and the persistence of inflation meant that monetary policy would have to remain restrictive. Indeed, they noted that the CNB should stand ready to increase interest rates to support the exchange rate and the stabilization effort. In this regard, Directors observed that in the current environment there was no apparent conflict between the inflation and the external current account objectives. Many Directors, therefore, agreed on the potential benefits, in terms of guiding policies and signaling the market, of the new monetary policy framework based on inflation targeting. However, a few Directors questioned whether inflation targeting was appropriate at this stage of development of the economy. While Directors generally agreed that, were a conflict to arise between objectives, the CNB should assign priority to the external objective, some argued that this could put the inflation targeting mechanism and its benefits in doubt.

Directors were concerned about the condition of the banking system, given the large share of nonperforming loans and the effects of tight financial policies and the economic downturn on bank profitability. They stressed the need to monitor the banks closely; this would require additional resources devoted to bank supervision and more frequent on-site inspections. They also encouraged the timely passage of legislation to ease the foreclosure process and improve the tax treatment of provisioning. Directors welcomed the efforts to restructure the small banks, the plans to privatize the large state-controlled banks, and the recent measures to strengthen the legal and regulatory framework. They urged the authorities to follow through on these plans and to reinvigorate their efforts to strengthen the financial position of the banks.

Regarding structural reform, Directors regretted the continued delays in the privatization process, and urged the authorities to accelerate privatization in order to improve corporate governance and foster the restructuring of the economy. They welcomed recent measures to promote reform of the capital market, including the establishment of a Securities and Exchange Commission, but cautioned that it would take time to improve the functioning of themarket and strengthen investor confidence. The need to ensure the long-term viability of the pension system through appropriate reforms was also mentioned.