Public Information Notice No. 01/71

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the Czech Republic

July 25, 2001

On July 16, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Czech Republic.¹

Background

After three years of recession, the economy grew by 2.9 percent in 2000, supported by a revival of investment in primarily foreign-owned firms and a modest increase in household consumption. Economic growth strengthened to 3.8 percent in the first quarter of 2001, as investment continued to expand briskly and household consumption rebounded. However, the expansion has been uneven, with vibrant, export-oriented firms with foreign participation leading the recovery and raising the economy's competitiveness, while a large number of less-dynamic firms are in need of restructuring and continue to generate losses. Nonetheless, the base of growth has broadened as local firms have begun to benefit from the presence of foreign-owned companies-primarily as suppliers of components. Strong demand from the European Union led to rapid export growth, but imports (primarily of investment goods) grew even faster, generating a negative contribution from the external sector.

New job creation has outweighed layoffs from enterprise restructuring only since mid-2000 and the unemployment rate has declined only slowly to a seasonally-adjusted 8.5 percent in mid-2001, which helped contain wage demands well within productivity growth. Low mobility of labor has led to large regional disparities in unemployment rates.

Consumer price inflation ended 2000 at 4 percent, 1.5 percentage points higher than in the previous year, owing to temporary factors including higher imported fuel costs and a strong U.S. dollar. However, net inflation targeted by the Czech National Bank (CNB) (which excludes administered price and indirect tax changes) was 3 percent at end 2000, below the CNB's target range. Headline inflation edged up to 5.5 percent in June 2001, but underlying inflation remains subdued due to strong competition in the retail sector and restrained wage demands.

Deteriorating terms of trade and strong imports of capital equipment led to a sharp widening of the external current account deficit in 2000 to 4.8 percent of GDP, which was amply financed by foreign direct investment (FDI) inflows. The trade deficit doubled to 6.6 percent of GDP in 2000, despite rapid export volume growth, reflecting effects of higher oil prices and strong imports of capital goods and intermediate products. Incoming FDI reached 9 percent of GDP in 2000. On a net basis, capital inflows amounted to 6.8 percent of GDP. These trends continued in the first quarter of 2001, with the external current account deficit reaching 5.6 percent of GDP, while FDI and other capital inflows remained strong. The koruna has strengthened modestly since early 2000 vis-à-vis the euro and in nominal effective terms, and has been relatively unaffected by recent turmoil in emerging markets.

Monetary conditions have remained supportive, with a decline in real interest rates offsetting the real effective appreciation of the koruna. The CNB lowered its key policy interest rate in February 2001 to 5 percent from 5.25 percent. While market rates tracked the decline in official interest rates, aggregate bank lending to the private sector has remained subdued. Nonetheless, credit to households and to enterprises under foreign ownership did expand in 2000 and early 2001, while credit to the traditional enterprise sector continued to decline.

Against the background of a still nascent recovery, fiscal policy was expansionary in 2000, with the general government deficit (excluding privatization receipts and bank restructuring costs) increasing by nearly 1 percentage point to 4.1 percent of GDP. For 2001, the general government deficit is budgeted to expand by a further 1.6 percentage points to 5.7 percent of GDP. In addition, bank restructuring costs could add up to 5 percent of GDP to the government's total financing requirement. The authorities plan on privatization proceeds of some 8.8 percent of GDP to cover most of this need.

On the structural front, an amendment to the Bankruptcy Act was passed to strengthen creditor rights, but creditors continue to express dissatisfaction with the enforcement of bankruptcy procedures. With the recent privatization of Komercni banka, the last major state-owned bank, the banking sector is now largely foreign owned. Cleaning up the banks shifted a large stock of nonperforming assets to the state work-out bank, but the pace of their disposal has so far been slow. Large-scale enterprise privatization is slated for this year and next, but the state of international markets could result in delays. Corporate profitability is increasing, but restructuring of a large segment of enterprises is proceeding slowly. These enterprises continue to generate losses and remain highly indebted. The Revitalization Program for nine large enterprises has led to several privatizations, but restructuring plans for a number of other companies have been frustrated by inadequacies in the legal system and a lack of support from other creditors.

Looking ahead, economic growth is expected to reach 3-3.5 percent in 2001, propelled by strong investment demand and a building momentum in household consumption. However, with weakening demand in the EU, export growth will slow and the pace of intermediate goods imports will decline while imports of capital equipment should remain buoyant, resulting in a negative growth contribution from the external sector. Despite a weakening of external price pressures, inflation is forecast to rise somewhat above 4 percent, as domestic demand factors begin to exert a greater influence on price formation. Growing household consumption and the slowdown in trading partner demand are expected to balance the effect on the external current account of lower oil prices and a weaker U.S. dollar, which should keep the deficit near 5 percent of GDP this year.

Executive Board Assessment

Directors observed that the economic expansion had gained a broader footing, and commended the authorities for having installed a set of macroeconomic and structural policies that had so far contributed to this outcome. Directors noted the key role that foreign direct investment had played in improving productivity and international competitiveness, thereby laying the foundation for strong, sustainable economic growth. They considered that the challenge was to ensure fiscal sustainability and to maintain the momentum of structural reform in order to hasten the Czech economy's convergence with the European Union.

Directors considered that, in the period ahead, it would be critical to find the right balance of policies to ensure that the ongoing recovery would not stall while maintaining the long-term sustainability of public finances. They agreed that the appropriate policy mix would be an accommodative monetary policy and a tighter fiscal policy. Directors noted that fiscal policy should refrain from adding demand stimulus; any further expansion in the fiscal deficit could result in an unsustainable widening of the external current account deficit, particularly with export markets weakening, which could undermine medium-term growth. Also, government privatization receipts may be lower than expected, making it all the more imperative to resist spending pressures. Directors noted that extrabudgetary funds are non-transparent and complicate fiscal management. They cautioned, in particular, against recent initiatives, such as the "Big Bang" plan, which could work against the achievement of sustainable public finances. While Directors recognized that the authorities face political constraints, they urged them to prepare carefully, and implement expeditiously, fiscal reform measures to place public finances on a sound, medium-term footing.

Directors noted that flexibility in the conduct of monetary policy is key to ensuring that inflation remains under control. They saw no need for monetary policy to deviate substantially from its current accommodative stance, provided that domestic inflationary pressures remain broadly under control. Directors welcomed the new inflation-targeting framework, which would improve the transparency of monetary policy. However, they noted that the new framework would require the CNB to establish a clear distinction between the use of the target band for forward-looking policymaking, on the one hand, and for ex post performance evaluation, on the other, where the authorities are expected to explain clearly the reasons why inflation was outside the band. Directors considered that the authorities should examine carefully some of the operational aspects of the framework, especially how to handle administrative price and indirect tax adjustments, as well as the design and use of escape clauses.

The exchange rate was considered to be broadly in line with fundamentals, and it was agreed that intervention should be limited to moderating large fluctuations in the exchange rate, without attempting to influence productivity-driven medium-term trends. Looking further ahead, an important challenge for the authorities is to plan for the Czech Republic's eventual participation in the euro zone. In order to achieve a smooth progression through the wide bands of ERM-II and avoid exchange rate turbulence during this critical phase, Directors saw a need for further progress in a number of areas, including real convergence, financial sector stability, and a sound fiscal position.

Directors noted that recent improvements in productivity and international competitiveness indicate that structural reforms are bearing fruit. They noted that further progress is needed to expand the productive capacity of the economy in order to reduce regional disparities and enhance the Czech Republic's ability to compete effectively within the EU. In particular, legal and regulatory reforms, corporate sector restructuring, and reform of the pension system should proceed without delay. Directors considered it necessary to improve enforcement of existing laws and regulations-a step that would require a strong build-up of supervisory capacity, a more proactive approach by self-regulatory organizations, and improvements in the court system.

Directors welcomed the considerable progress in banking sector restructuring, and commended the authorities for their achievements and determination to complete the process. They were encouraged by the positive findings of the Financial System Stability Assessment and indications that some of the banks are now more receptive to expanding their lending activities. However, some concern was expressed about the slow pace of bad asset disposal, and the authorities were encouraged to refrain from disposal methods that would increase government intervention in the enterprise sector.

Directors observed that the Czech Republic meets the Special Data Dissemination Standard (SDDS) specifications for coverage, periodicity, and timeliness of the data, and that the quality of data is adequate for the purpose of surveillance.