October 2000 Staff Visit Concluding Statement

In recent months, there have been increasing signs that the economic recovery is strengthening and its base  broadening. Macroeconomic policies have been appropriately supportive of the recovery, but as it becomes more robust, the key question is whether these policies need to be adjusted. The mission considers that, although some slack remains in the economy and there is no near-term threat to inflation, the strengthening recovery implies that there is less need for policies to add demand stimulus. Under these circumstances, the first-best strategy is to start consolidating public finances in 2001, through structural reform measures that have a lasting effect on the fiscal deficit, while maintaining a broadly accommodative monetary policy. However, the 2001 budget contains no significant reform measures, and the mission estimates that the budget represents a further increase in the structural deficit. This is regrettable, as the current cyclical strengthening offers an opportunity to embark on overdue medium-term fiscal reforms. In that sense, the medium-term starts now. The failure to take timely fiscal action will add to demand pressures and may necessitate an inopportune monetary tightening just as the recovery gathers momentum, which would result in a policy mix that could undermine the sustainability of the recovery.

Macroeconomic conditions

Since our last visit in May this year, the recovery has strengthened and broadened. We expect that this year´s growth rate will be 2.3-2.5 percent, and around 3-3.5 percent next year, with an upside risk to these forecasts. In our view, these rates are broadly consistent with the economy´s current potential growth rate. Experience in other advanced transition and emerging market countries would indicate that potential growth in the Czech Republic should be much higher. While the buoyant foreign direct investment (FDI) inflows will gradually raise potential growth, further progress in privatization, bank and corporate sector restructuring, and legal and other institutional reforms is needed to achieve more rapid growth rates over the medium term which would facilitate catch-up to the European Union (EU).

Inflation has picked up, primarily reflecting higher imported oil prices and food prices, but there is little evidence so far that the underlying inflationary trend is rising. Nominal wages are growing slightly faster than inflation, though well within productivity growth, an important requirement for keeping inflation under control. Unemployment has declined from the peak reached at the end of 1999, but continues to be high, suggesting that there is still some slack in the economy. The trade and current account deficits are expanding, but are far outweighed by FDI inflows, which have put upward pressure on the koruna. However, this has been mitigated by autonomous outflows by residents notably portfolio investment in foreign equities.

Main policy recommendations

In light of the still moderate pace of expansion and the slack in the economy, we believe that any major policy tightening would be premature. However, there is now less need for macroeconomic policies to support domestic demand. In our view, the first-best policy strategy would be to avoid further expanding structural fiscal deficits by introducing fiscal measures that have lasting effects on deficit reduction, while broadly maintaining the current accommodative monetary policy. This policy mix would help prevent real interest rates and the real exchange rate from rising, which would strengthen the sustainability of the current recovery. However, if fiscal deficits are not contained, the Czech National Bank (CNB) may have to raise interest rates substantially at some point to keep inflation within its target range. This could crowd out private investment, and encourage a sharper real appreciation of the koruna and a larger current account deficit than desirable, which could threaten the recovery process.

Fiscal policy

We estimate that the 2001 budget is inconsistent with fiscal consolidation. In our assessment, the broader-defined general government deficit (which incorporates the central and local governments and all extrabudgetary funds, but excludes privatization proceeds and grants to transformation institutions to cover past losses) is set to expand from 5.2 percent of GDP in 2000 to more than 6 percent of GDP in 2001. This deterioration is due both to an increase in spending and to a decline in tax revenue. Enhancing tax administration efforts alone is unlikely to offset the incipient revenue decline. The resulting fiscal impact on aggregate demand-which is measured by the change in the structural deficit that is derived after adjusting for the cyclical position of the economy is likely to exceed 1 percent of GDP in 2001.

In order to reduce the structural fiscal deficit in the near term, low priority expenditures should be cut and tax reforms should be implemented. In the short term, potential candidates for cutting include: (i) support to state enterprises; (ii) purchases of capital equipment and infrastructure building that are likely to yield a low return; and (iii) social assistance which due to the generosity of some benefits discourages job search. On the revenue side, measures include: (i) raising social contribution rates for the self employed to levels comparable to those for employees; (ii) shifting several goods and services (including telecommunications, construction, and heating) from the preferential to the standard VAT rate, which is consistent with EU requirements; and (iii) expanding copayments to a much wider range of medical services. Over the medium term, in order to ensure the long-term sustainability of public finances, further reform of the social security system is unavoidable. Currently, budgetary transfers to households, including pensions, absorb 20 percent of GDP and this share will rise in the second half of the decade as demographic pressures intensify. The current proposal to create a separate social insurance fund represents only an institutional change that will not, of itself, improve the financial viability of public finances. The recent decision to eliminate incentives for early retirement is a welcome step, but additional measures are needed to reduce pension expenditure over the longer term, including by raising retirement ages above the new levels that are currently being phased in and by reducing wages used for calculating benefits accruing during non-contributory periods.

Recorded public debt in the Czech Republic at 15 percent of GDP at end 1999 is rather low, but is understated by the amount of publicly-guaranteed loans that the government is likely to be called upon to cover. In addition, government debt is set to rise sharply owing to two factors. First, the government will assume a significant amount of debt related to the further cleanup of the banking sector. Second, public debt will increase by more than 5 percent of GDP during 2000-01 in order to finance the overall deficit, notwithstanding substantial privatization receipts. In the absence of decisive expenditure reductions including through reform of social security public debt will continue to mount and its growth could accelerate once privatization proceeds dry up. The resulting increase in public debt will raise debt servicing costs and risks triggering sharply higher longer-term interest rates.

The transparency of public finances has improved considerably with the introduction of new budgetary rules which, inter alia, limit actual spending to levels approved by Parliament, require Parliamentary approval for the issuance of guarantees, and call for consolidating the operations of the State Financial Assets into the state budget. However, there have also been some developments that undermine fiscal transparency, including carving out from the state budget the housing and transport funds in 2000 and the social insurance fund proposed for 2002. Focussing the discussion of fiscal policy at the state budget level therefore risks ignoring an increasingly important segment of the general government finances. In addition, the creation of separate funds endowed with privatization receipts generates additional liquidity pressures within the general government since positive cash balances in some agencies cannot automatically offset liquidity shortfalls in others. The quasi-fiscal activities of Konsolidacni banka and other transformation agencies also reduce the transparency of public finances.

Monetary and exchange rate policy

 A number of factors point to continued moderate inflation in 2001. These include the remaining slack in the economy and the expectation that real wage developments in 2001 will continue to stay within productivity increases. We expect that inflation in terms of the consumer price index (CPI) will rise from around 4 percent at the end of 2000 to around 4.5-5 percent at the end of  2001, as the process of price deregulation advances. Net inflation this year is expected to stay close to the lower bound of the CNB´s target range of 3.5-5.5 percent, and to be contained at end 2001 within the target range of 2-4 percent, which is appropriately set to incorporate a steady move toward price stability. Oil prices are a risk factor, but their impact is likely to be largely offset by productivity growth, and no major pass-through to the CPI seems to be in the pipeline. Hence, as long as oil prices do not rise further, they will tend to depress, rather than increase, inflation toward the end of next year.

Given the prospect of continued moderate inflation, and despite the stimulative nature of the draft 2001 budget, we see no need for substantial monetary tightening in the near future. This, however, does not exclude some upward adjustments to policy interest rates should the economy grow much faster than currently envisaged, or if signs emerge that higher imported oil prices are beginning to have adverse spillover effects on domestic inflation. Looking beyond 2001, if a withdrawal of fiscal stimulus does not take place in line with the acceleration of private demand, a major monetary tightening may become necessary at some point to keep inflation within the target range, which would result in an undesirable policy mix.

We believe that some strengthening of the koruna over the medium term is consistent with underlying fundamental trends and will not jeopardize export competitiveness. Nonetheless, since the foreign exchange market can occasionally overshoot, intervention to moderate large swings in the exchange rate that could create bandwagon effects may be useful. However, should the continued failure to consolidate the fiscal position necessitate monetary tightening, intervention to stem the appreciation of the koruna could be inconsistent with the monetary policy objective.

Structural issues

We welcome the acceleration of structural reforms over the past year. In particular, there has been considerable progress in strengthening the legal and regulatory framework supportive of an efficient market economy. This has allowed for a faster pace in adopting the EU´s acquis communautaire, a fundamental element in the process of EU accession.

The amendment of the Bankruptcy Act and the new Public Auction Law represent welcome steps. Recent use of the bankruptcy process for restructuring rather than liquidation is a positive sign that bankruptcy is increasingly recognized as a regenerative rather than a destructive process. However, we note the concern of market participants that the authority of the court to dismiss the creditor appointed trustee, and the often protracted judicial process, threaten to impede the full effectiveness of the reforms. Further legislative and judicial reform in this area will be necessary.

We welcome the amendment in recent months of several laws strengthening the functioning of securities markets, including the Commercial Code and the Securities Act. These are important steps in improving corporate governance in the Czech Republic. However, it is regrettable that the amendment of the Accounting Act has been delayed. The amendment aims at aligning Czech accounting rules more closely with international practice, and allows the largest companies to prepare accounts solely under International Accounting Standards both key elements in broadening the base and reducing the cost of Czech capital markets.

Strengthening the banking and corporate sectors are critical elements of structural reform and we urge the authorities to continue to pursue their restructuring with vigor. The privatization of Komercni banka should be completed without delay, thereby placing the last remaining large commercial bank in the private sector. The clean-up of commercial banks´ balance sheets should be concluded with minimal moral hazard. However, as a result, the Konsolidacni banka (KoB) group will find itself with bad assets that could reach 20 percent of GDP. Therefore, it should have the clear mandate to pursue debt work-outs in the most expeditious way. We welcome KoB´s success to date in selling some of its assets and support the market-oriented plan to sell a large package of bad assets in the coming months. We are encouraged by the success of the Revitalization Agency in achieving its first corporate restructuring results. Its selective and market driven approach has proven successful so far and should be maintained.

A sound and well-managed financial sector will be critical in supporting the Czech Republic´s economic growth in the coming years and preparing it for entry into the EU´s single market. A professional and independent central bank is a critical element in ensuring the stability of the financial sector, and we continue to regard some of the proposed amendments of the CNB Act with concern, especially if they are inconsistent with the requirements for EU accession. Over the coming months, the IMF and the World Bank will be working with the Czech authorities to examine in great detail the structure and stability of the Czech financial system in the context of a Financial Sector Assessment Program (FSAP). This work, which will be spread over several months, will assess the Czech Republic´s observance of international standards and codes in the financial area and identify the financial sector´s strengths and weaknesses as well as its vulnerability to shocks.