Public Information Notice No. 00/60

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

August 9, 2000

On July 26, 2000, the Executive Board concluded the Article IV consultation with Czech Republic.¹

Background

Following a severe and protracted recession, a modest economic recovery has taken hold in the Czech Republic owing to the relaxation of macroeconomic policies and an acceleration of structural reforms. The underlying cause of the recession was inadequate restructuring of the corporate and banking sectors which impaired the supply side of the economy and led to a burgeoning external current account deficit in 1996. The recession was compounded by contractionary monetary and fiscal policies in response to a series of currency attacks during the first half of 1997, and policies remained tight until late 1998 partly out of concern about contagion from the Russian crisis. Tight macroeconomic policies-together with favorable temporary factors-succeeded in bringing down inflation and reducing the current account deficit, but at a heavy toll in terms of economic activity. A subsequent loosening of policies and advances with structural reform, including bank and enterprise restructuring, have underpinned the return to positive economic growth. However, the pace of expansion is expected to remain weak in comparison to other advanced transition economies until substantial progress has been made in reducing the backlog of structural reforms.

Economic growth turned modestly positive after the first quarter of 1999, headed by a rebound in household consumption and a recovery of demand in European Union (EU) trading partners. However, investment remained weak owing to banking and corporate sector restructuring. Inflation continued to decline during the first half of 1999 to reach very low levels but subsequently picked up modestly due to adjustment of administered prices and rising world oil prices. Net inflation, at 1½ percent at end-1999, undershot the Czech National Bank's (CNB) target range of 4-5 percent. Cyclical and structural factors led to sharply higher unemployment during 1999; nonetheless, real wages also rose strongly partly due to the unexpectedly large drop in inflation.

Subdued domestic demand and strong export growth narrowed the external current account deficit to some 2 percent of GDP in 1999 and exports expanded by 9 percent in volume terms. Foreign direct investment (FDI) related capital inflows surged in the second half of the year, and net inflows reached a level that was more than double the current account deficit, leading to upward pressure on the koruna. The CNB intervened on a few occasions beginning in the fourth quarter of 1999 to resist the appreciation of the currency.

In response to weak economic activity, the authorities allowed a significant widening of the fiscal deficit while official interest rates were cut aggressively. The general government deficit (excluding privatization and grants to transformation institutions) increased to 3¼ percent of GDP in 1999 from 2 percent of GDP in the previous year, with a further expansion to 4¼ percent of GDP envisaged for 2000. However, in view of the widening output gap, the structural deficit is estimated to have increased by ½ percentage point of GDP in 1999 with a more modest increase expected for 2000. The CNB reduced its key policy interest rate (the two-week repo rate) by nearly 10 percentage points from mid 1998 to November 1999, but the sharp deceleration in inflation and strengthening of the koruna reduced the implied easing of monetary conditions.

On the structural front, banking sector woes continued, but steady progress was made in privatizing banks, improving the legal framework governing economic transactions and restructuring several key enterprises. Two large state-owned banks were sold during 1999-2000, and the sole remaining large state-owned bank is slated for privatization by early 2001. In preparation for their sale, a large part of their non-performing loans was transferred to the state-owned "consolidation" bank. Weak management and imprudent lending contributed to the decapitalization of a major privatized bank, which was placed under CNB administration and subsequently resold in June 2000. A number of legal reforms, including a revised Bankruptcy Act, were recently introduced which aim at increasing the transparency of the business environment, strengthening creditors' rights and reducing the often long delays in the resolution of legal claims. Their effectiveness will, however, depend on the manner and speed with which they are applied by the courts. The state-owned Revitalization Agency selected eight large industrial companies for organizational and financial restructuring, but progress has been hindered by difficulties in getting shareholders and creditors to share the financial burden.

The economic recovery is expected to continue, supported by strengthening demand in the EU, a sharp increase in privatization and greenfield FDI, and low inflation and inflationary expectations. However, ongoing restructuring in the banking and traditional corporate sectors will in the short run act as a drag on the economy by restraining credit and contributing to unemployment, As a result, growth will reach a modest 2-2½ percent in 2000, with a pickup to 3-3½ percent in 2001 as these negative factors recede. The main stimulus to economic activity is expected to come from fixed capital formation, while consumption would grow at a more modest rate and net external demand would exert a slightly positive influence as foreign demand strengthens further. However, due to higher oil prices and the spillover of increased investment demand onto imports, the external current account deficit is expected to rise to 3½ percent of GDP in 2000. Renewed enterprise restructuring is expected to lead, after a pause early in the year, to a further rise in the unemployment rate to 10½ percent by end-2000 and 11 percent by end-2001.

Executive Board Assessment

Executive Directors were encouraged by signs that economic recovery was now underway, and commended the authorities for the prudent and coherent macroeconomic policies that had contributed to this result. They noted that a number of elements conducive to growth were in place, including a better external environment, low inflation and inflationary expectations, a viable and competitive external position, and some progress with structural reforms. However, they observed that there are still reasons to be cautious about the strength of the recovery, as the ongoing banking and corporate sector restructuring could continue to act as a drag on domestic investment and consumption. These uncertainties might best be alleviated through a more decisive specification and implementation of the authorities' medium-term fiscal and structural objectives.

Directors agreed that macroeconomic policies needed to strike a balance between sustaining the pace of recovery and making progress toward achieving medium-term policy objectives. As regards fiscal policy, they thought that the current policy setting was broadly appropriate to support the recovery and considered that automatic stabilizers should be allowed to operate if downside risks materialized. At the same time, Directors also noted that, if the recovery gathered further momentum, a stronger fiscal position would become necessary, as was, indeed, already envisaged for the 2001 state budget. This would be all the more necessary if capital inflows remain strong, since monetary policy alone may not be sufficient to cope with a rising exchange rate and inflationary pressures stemming from a sustained strengthening of activity. Directors stressed that the authorities should focus on achieving medium-term fiscal sustainability. In this regard, reforming the pension and healthcare systems was critical, and they urged the authorities to formulate fundamental reforms expeditiously. There was also a call for greater efforts to deal with tax arrears.

Directors welcomed the new budget rules, which would improve fiscal transparency and accountability. However, they expressed concern about the establishment of new extrabudgetary funds (EBFs), and cautioned that the EBFs could become entrenched and pervasive, thereby undermining fiscal transparency and accountability. They called on the authorities to ensure the transparency of these funds and a prudent approach to their financing, scope, and timely termination, once the stated policy objectives had been achieved.

Directors considered that the stance of monetary and exchange rate policies has been suitably supportive of activity at the time when inflation was exceptionally low. Directors indicated that until the recovery was firmly established, the current accommodative stance should be maintained. At the same time, they suggested that the authorities should keep a watchful eye on the evolution of the economy and, as the recovery proceeds, they should be ready to adjust the monetary stance as needed to ensure price stability for the coming year and beyond. In this regard, Directors welcomed the Czech National Bank's (CNB's) end-2001 net inflation target, which signaled the intention to maintain the disinflation gains achieved so far. Directors encouraged the authorities to improve the inflation targeting framework, including forecasting. They also welcomed the government's endorsement of the target, which strengthens accountability and credibility. Directors expressed concerns, however, about some of the proposed amendments to the CNB Act currently under discussion in parliament, which could undermine the CNB's operational independence. Directors expressed the hope that the ongoing discussion would result in an Act that would ensure the independence of the Central Bank, on par with EU norms and international best practices.

Directors noted that the continued strong FDI inflows suggested that the upward pressure on the koruna would continue, and encouraged the authorities to take the necessary measures, including further intervention in the foreign exchange market, and on the fiscal side, to prevent excessive appreciation. Some Directors considered, however, that allowing the exchange rate to appreciate would be appropriate in light of the effects of structural reforms on productivity and economic efficiency.

Directors encouraged the authorities to accelerate structural reforms. In this regard, the recent privatization of a major state-owned bank, the plan to sell the remaining bank, the market-oriented approach to restructuring several large enterprises, and legal reforms including improvements in bankruptcy procedures, were steps in the right direction.

Directors noted some progress made in the regulatory framework for bank supervision, such as the incorporation of market risk into the capital adequacy requirement. However, the recent failure of IPB demonstrated the need to strengthen bank governance and the importance of further strengthening banking supervision. In this context, they welcomed the authorities' decision to participate in the Financial Sector Assessment Program later this year. Directors noted that legal impediments still tended to slow the recovery of claims against debtors and hence the overall speed of banking and corporate sector restructuring. While acknowledging the difficulties the authorities were facing in this regard, they noted the synergies among the various structural policy measures, and underscored the importance of moving forward on all fronts in order to achieve maximum results.

One consequence of the structural reforms, however, has been increased unemployment, which has risen to a high level over the past few years. Directors were concerned about the risk of unemployment becoming structural, and recommended that the authorities take steps to increase the flexibility of the labor market, notably by reforming the system of social benefits.

Directors recognized the high quality of economic statistics in the Czech Republic and noted that data provision to the Fund for surveillance is adequate. In particular, they noted the observance of the SDDS's prescriptions for data coverage, periodicity and timeliness, and for the dissemination of advanced release calendars. They welcomed the publication, since April 2000, of international reserve and foreign currency liquidity data according to the new template.