Public Information Notice No. 02/84

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the Czech Republic

August 7, 2002

On July 26, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Czech Republic.¹

Background

The Czech economy has made significant strides in recent years, though important challenges remain. Following a period of inaction on the structural front and a protracted recession, growth has picked up and inflation remains subdued. Underlying this performance have been supportive macroeconomic policies, large foreign direct investment (FDI), and steady progress with structural reform. However, enterprise restructuring has led to rising structural unemployment and large regional disparities in unemployment rates. Sizable losses were accumulated by banks, which had to be transferred to the government to allow the banks to be sold to strategic investors, adding to medium-term fiscal pressures. Importantly, the fiscal reform agenda required for sustainability of public finances remains to be tackled.

Despite large trade and investment links with the European Union (EU), the Czech economy weathered the recent global slowdown remarkably well. Real GDP growth remained at 3.3 percent in 2001, notwithstanding slower EU export demand in the second half of the year.

Strong fixed investment and buoyant household consumption—underpinned by robust wage growth and modest gains in employment—helped sustain domestic demand. Moreover, the external current account deficit narrowed in 2001 as the growth of imports moderated more than exports, reflecting the large import content of exports and lower oil prices.

Sizable inflows of FDI (reaching cumulatively some 40 percent of GDP, the highest in the region) were the main driving force behind domestic investment and employment creation, and generated positive spillovers to domestic suppliers. FDI has also brought about increased access to major export markets, helping to cushion the impact on the Czech economy of the slowdown in external demand.

Large FDI inflows and anticipation of future inflows led to a rapid appreciation of the koruna over the last three quarters. Concerned about the effects on external competitiveness and growth, the Czech National Bank (CNB) cut interest rates by a cumulative 2.25 percentage points since late-2001 (the most recent was a 75 basis point cut in late July) and intervened in the foreign exchange market on several occasions to stem the currency's rapid rise and secure the inflation objective. In addition, the government and the CNB agreed in early 2002 not to convert foreign currency privatization receipts on the market.

Inflation declined sharply over the past 12 months, due to falling food and international commodity prices, weakening demand, and the stronger currency. Headline inflation—the measure targeted by the CNB since the beginning of 2002—fell to 2.5 percent in May from 5.9 percent in July 2001, dropping below the target band, while industrial producer prices have declined in recent months.

The real economy has yet to show any effects of the stronger koruna. Industrial production and sales have accelerated in recent months, while the trade balance has improved. However, given the speed and size of the appreciation, it is reasonable to expect that some of its effects may still be in the pipeline.

Despite plans to the contrary, the fiscal deficit contracted in 2001. At 2.9 percent of GDP, the adjusted general government deficit (which excludes privatization receipts, proceeds from the sale of mobile phone licenses and Russian debt from revenue, and grants to transformation institutions to cover costs of bad asset management from expenditure) came in about 2 percentage points below the budget target and 0.6 percentage points below the 2000 outturn. Cyclical and one-off factors contributed to this outcome.

Budget plans for 2002 envisage a substantial widening of the adjusted general government deficit, and contain no measures geared to fiscal consolidation. The 2002 budget implies an adjusted general government deficit of 5 percent of GDP. Over half the planned widening comes from higher spending by the two new extrabudgetary funds and the temporary duplication of spending responsibilities from the introduction of a new layer of regional governments.

Structural problems in the labor market seem to be gradually deepening. Large disparities in unemployment rates exist across different regions, age groups, and levels of educational

attainment. Moreover, more than half of the unemployed are now long-term unemployed, partly reflecting work disincentives created by the social benefit system. Although not yet an immediate threat, this adverse tendency could limit the economy's ability to attract future FDI and reduce the scope for sustainable growth over the medium term.

Executive Board Assessment

Executive Directors were encouraged by the way the economy has coped with the slowdown in foreign demand and appreciation of the koruna. This resilience is evidence of an improving supply side, brought about by buoyant FDI flows and structural reforms. Nevertheless, further progress is needed in tackling the looming fiscal imbalance and maintaining the reform momentum in key structural areas. Moving forward resolutely on these issues would accelerate the Czech Republic's convergence with its EU partners, and lay the groundwork to benefit from membership of the EU and, in due course, the euro area.

Directors welcomed the Czech Republic's good economic performance over the past year, with moderate growth, achievement of the inflation target, and a manageable—though sizeable—current account deficit, which was more than fully financed by capital inflows. The country's low external debt and high reserves have helped limit its external vulnerability.

Directors welcomed the key role that monetary policy has played in offsetting the tightening effects of the koruna's appreciation. In this regard, they saw the magnitude and speed of the recent appreciation as potentially posing a continuing challenge—since its effects on inflation and growth could still be in the pipeline. They therefore commended the recent decision to cut interest rates by a further 75 basis points, thus countering the undue tightening of monetary conditions, and reducing the risks of inflation undershooting its target band in the period ahead.

Directors commended the progress the Czech Republic has made in preparing for EU accession. EU membership would further integrate the economy into global markets, and improve its medium-term growth prospects. Directors welcomed the authorities' intention to develop a medium-term fiscal framework—complementing the medium-term monetary framework already in place. Together, these frameworks should be conceived in the context of the commitment to move to ERM2, and the ultimate goal of adopting the euro. This strategy would need to be underpinned by credible plans to reduce the fiscal deficit, which would also improve the short-term policy mix. Greater transparency in these issues would provide to exchange market participants a clearer frame of reference for basing expectations—which can only be helpful in avoiding market excesses.

Several Directors noted that ERM2 provides a potentially flexible framework within which to develop policy, while some cautioned that the multilateral decision regarding adoption of the euro must prudently take into account the progress made by the Czech Republic in achieving structural and fiscal readiness for euro area membership. They urged, at the same time, that the pace of such reforms should be rapid.

Directors expressed concern about the fiscal outlook, and stressed the need for decisive steps to achieve fiscal consolidation. They pointed out that the fiscal deficit, already large, would continue to expand in the absence of adjustment measures. Along with the realization of contingent liabilities and a decline in privatization receipts, this would push the government debt-to-GDP ratio above the Maastricht ceiling within a decade. This calls for decisive action to reduce the deficit, and in the view of most Directors, such action should be implemented urgently.

With regard to priorities in the public finances, Directors urged the authorities to press forward in tackling structural problems at all levels of government. Restraining expenditures in nonpriority areas, and introducing fundamental reforms in mandatory spending to rein in costs, would be crucial. In particular, the pension and social benefits systems needed to be revamped—while preserving their essential social safety net aspects—and the authorities were encouraged to implement the pension reform measures that had been identified. Directors also stressed that the increasing reliance on extrabudgetary funds is a setback to fiscal transparency. These funds should be integrated into the state budget, thus providing an accurate picture of the public finances that would facilitate greater efficiency and a broader reach as expenditure cuts are implemented.

Directors encouraged the new government to accelerate structural reforms, more broadly, to enhance the efficiency of the economy and improve the investment climate. They welcomed the privatization of a number of major state-owned companies over the past year, and urged completing the remaining privatization projects. The package sale of impaired assets acquired by the government from failed banks is needed to facilitate the restructuring of the corporate sector. Directors advocated further improving the legal and regulatory framework, including reform of the bankruptcy process and of the commercial registers. To help secure medium-term growth prospects, Directors urged the authorities to take measures to enhance the structure and efficiency of the labor market—striking a better balance between social and efficiency considerations, with a view to encouraging wider participation.

Directors welcomed the improvements in internal banking procedures brought about by privatization of the sector, which should enhance its long-term profitability and stability,

and allow it to better fulfill its intermediation role. At the same time, the increasingly complex structure of financial groups complicates supervision of the financial sector. Directors therefore endorsed the expansion of the Czech National Bank's authority to conduct consolidated supervision over certain types of financial groups, while highlighting the need for effective cooperation between the three institutions charged with financial sector supervision.

Directors welcomed the authorities' efforts to improve the quality of economic statistics and comply with international standards. They commended the ongoing harmonization of statistical methodology with international best practice, and the contribution to updating the Report on Standards and Codes modules. Directors also commended the legal amendments that would remedy weaknesses in the anti-money laundering framework.