Public Information Notice No. 08/08

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with the Czech Republic

January 29, 2008

On January 23, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Czech Republic.¹

Background

Economic performance remained strong in 2007, supported by continued robust growth of domestic demand. The current account deficit widened, but remained largely financed by inflows of direct investment. With vulnerabilities limited, the economy weathered the international financial market turmoil with minimal spillover impact. The strong economy boosted job creation while unemployment declined and capacity utilization reached record high levels. In this environment, inflation pressures mounted on account of higher domestic demand amid tightening labor markets as well as food and regulated price increases. Monetary policy was tightened in the second half of the year, although policy rates remain among the lowest in the EU.

Growth is projected to remain favorable, although its momentum will slow as the consumption boom decelerates and growth in the euro area weakens. Domestic demand will nevertheless remain the primary driver of growth as fixed investment rises. Risks to this growth outlook are mainly on the downside, stemming primarily from fragility of growth in major export markets following the ongoing financial market turbulence and continued euro appreciation.

Inflation is expected to almost double to above 5 percent, owing to food, energy and indirect tax increases, as well as demand and wage pressures. Risks of higher inflation expectations feeding into wage and price-setting remain while a slower pace of koruna appreciation could also increase inflation pressures. Shaping expectations is thus critical, especially with the planned lowering of the inflation target to 2 percent by 2010.

Strong growth has resulted in a more favorable fiscal outturn than budgeted in 2007. Buoyant tax revenues have helped offset the large increase in spending on social benefits stemming from pre-election commitments. Starting in 2008, the government is implementing a fiscal reform program, which will introduce a flat tax on personal income and lower corporate income taxes, planned to be offset with VAT and excise tax increases, and a tightening of the wage bill and social benefits including through health care reforms. The fiscal stance is thus expected to turn restrictive in 2008 with the general government deficit budgeted at 2.9 percent of GDP. Over the medium term, the authorities plan to lower the structural deficit to 2.3 percent of GDP in 2010 and to 1 percent of GDP by 2012.

Competitiveness remained strong. Although the koruna has appreciated rapidly in recent months, it has remained broadly in line with fundamentals. Trade performance has been robust, with double-digit growth in export volume and rising export market shares in both the EU and world markets. The current account deficit has widened slightly owing to the repatriation of profits by large exporters.

Credit growth has continued at a brisk pace, albeit from a low base. High demand for mortgage loans, supported by the low interest environment and increasing household repayment capacity led to sustained household credit growth. The authorities plan to further integrate supervisory functions to strengthen the efficiency of supervision.

Executive Board Assessment

Executive Directors commended the authorities for the Czech economy's strong fundamentals, which have helped sustain the growth momentum with low unemployment, and underpin further strides toward convergence with the EU-15. Directors considered that sustaining this success in the face of a less benign global environment and rising supply constraints calls for a tight policy stance in the near term and steadfast commitment to sustainable fiscal consolidation and complementary structural reforms. Directors welcomed the authorities' updated euro accession strategy and their commitment to a sustained implementation of the Maastricht criteria, which would provide a solid foundation for euro adoption.

Directors commended the authorities on their prudent monetary policy, and supported the recent policy tightening to counter rising inflation pressures. With inflation set to rise to well above the target of 3 percent, Directors stressed the importance of ensuring that expectations remain well anchored to the inflation target through further timely monetary policy action. The appropriate pace of monetary tightening will depend, inter alia, on the degree of koruna appreciation and second-round effects of indirect tax and energy and food price increases. The planned downward shift in the inflation target to 2 percent from 2010 underscores the importance of preserving the Czech National Bank's high credibility. In this context, Directors encouraged the authorities to build further on welcome recent steps to enhance the transparency of monetary policy communication.

Directors welcomed the staff's assessment that the exchange rate of the koruna is broadly in line with fundamentals and consistent with external stability. Trade performance has been robust with rising export shares and the moderate current account deficit is financed largely by direct investment inflows.

While encouraged by the better-than-expected fiscal outturn for 2007, Directors noted that it largely reflected strong cyclical revenue gains. They recommended that such cyclical gains be saved and the underlying fiscal adjustment planned in the budget for 2008 implemented in full, leading to an appreciably better-than-budgeted deficit. Such prudence in 2008 would support the anti-inflationary stance of monetary policy and minimize the risk of breaching the targets for fiscal consolidation in 2009-10.

Directors broadly welcomed the modifications to the tax regime contained in the tax and welfare reform package recently approved by parliament—most notably the shift from direct to indirect taxation. At the same time, they considered that further measures would be needed to advance the goal of fiscal consolidation. Directors stressed that, in setting their fiscal priorities, the authorities will need to strike a careful balance between spending and revenue measures, and assign priority to the formulation of durable expenditure measures, since in the absence of such measures tax cuts could be ill-afforded.

Directors highlighted the important role of measures to promote labor participation and lower structural unemployment in alleviating fiscal adjustment. Directors therefore called for the adoption of targeted active labor market policies, easing regulations regarding hiring and dismissals, and an improved design of the tax-benefit system to enhance incentives to work. Directors noted that a more flexible labor market would also facilitate a smoother entry into the euro area. In this regard, they also encouraged further efforts to enhance business competitiveness.

In view of the coming challenge of population aging, Directors reiterated the importance of early and comprehensive pension and health care reforms. Along with the welcome increase in the retirement age to 65 years, complementary reforms to raise the effective retirement age and promote reliance on private pensions will also be needed. Directors welcomed the introduction of co-payments in health care as a step that should help contain excess demand pressures.

Directors viewed the Czech financial system as generally sound. They encouraged the authorities to ensure that household credit risks do not build up in an environment of rising interest rates and house prices. The large foreign presence of banks as well as the expected implementation of Basel II and the Markets in Financial Instruments Directive in 2008 call for enhanced coordination with foreign supervisors. Directors welcomed the financial authorities' efforts to further integrate supervisory functions.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.