MONETARY POLICY REPORT | SUMMER 2024 (appendix)
(authors: Barbara Livorová, Ondřej Michálek, Karel Musil, Adam Ruschka a Matěj Šarboch)
The Czech economy has experienced some major shocks in recent years. These have deflected it from its steady state, to which it is now gradually returning. But is it returning to the medium-term growth path that was previously assumed in the CNB’s modelling system, namely long-term potential output growth of 3% a year? The following analysis gives several reasons why the growth has been rather slower in recent years.
Developments over the last 25 years
The Czech economy has undergone many structural changes over the past 25 years, often in response to sizeable economic shocks such as the 2008 Global Financial Crisis (GFC) and the Covid pandemic. To be able to identify precisely all the structural breaks in the Czech economy, we analysed a set of almost 30 time series covering the real economy and the labour market.[1] Chart 1 presents the frequency of these structural economic changes each year. It shows they are concentrated in some years more than others. We identified at least four periods of “large” structural breaks since 2003. Most of them coincide with major political and economic events.
Chart 1 – The Czech economy has undergone at least four periods of fundamental structural breaks
frequency of structural breaks; calculation: CNB
The first break in the time series appears shortly before the Czech Republic’s accession to the EU in 2004. This period was characterised by brisk economic growth due primarily to high trade surpluses, reflecting a boom in the free movement of people, goods, services and capital. The second break identified falls in the period around the outbreak of the GFC in 2008, when the world’s economies (including the Czech one) faced sharp declines in GDP and growth subsequently remained subdued. The next structural break is identified in 2016. It does not have direct economic or political causes. However, it turns out to be crucial for the conclusions of the analysis presented below. The last large break identified occurred in early 2020 in the wake of the outbreak of the Covid pandemic. It was followed by further major shocks, such as the energy crisis, Russia’s invasion of Ukraine and the ensuing episode of high inflation. Not enough time has passed for us to explore in detail the post-2020 period and any structural breaks in long-term trends that may have occurred in recent years. To better understand the current macroeconomic situation, it is nonetheless useful to know where the steady state of the Czech economy was before the pandemic, that is, in the period beginning with the changes identified around 2016.
Changes in trends around 2016
The first interesting angle of view on the changes around 2016 is the sectoral situation. After 2016, there is a de facto stagnation of production in industry, which until then had been the backbone of the Czech economy (see Chart 2). Growth in industrial production is driven almost solely by the broadly defined automotive industry. Even car production itself hit the output ceiling around 2016. Since then, only the manufacture of auto parts, components and spare parts for export has been growing in the Czech Republic. The stagnation of domestic industrial production has been reflected (unlike in Poland) in a halt in the growth of Czech exporters’ market share in Germany, Czech Republic’s biggest trading partner. The German economy is, moreover, a key market for the Czech automotive industry.[2]
Chart 2 – Growth in Czech industrial production is driven solely by the automotive industry
index (February 2022 = 100); constant prices; seasonally adjusted; source: CZSO, calculation: CNB
Growth in production in industry is reflected in growth in the sector’s gross value added (GVA).[3] GVA growth is gradually slowing, though the changes in trend in the GVA share of industry in total GVA are more marked. This share rose steadily from 16% at the end of the 1990s to around 27% in 2016 and has since been broadly flat (see Chart 3). The opposite trend is apparent in services. Growth in its value added has been rising sharply since 2016 and its share in total GVA is heading upwards after having stagnated for around 20 years. The annual number of hours worked provides a similar picture (see Chart 4). In industry, the absolute number of hours worked and their share in the total have both long been falling moderately, while in services, their absolute number is rising moderately but their share in the total is flat.
Chart 3 – The prevalence of services over industry has been increasing since 2016
shares in gross value added in %; prices of 2020 (chain-linked); seasonally adjusted; source: CZSO, calculation: CNB
Chart 4 – The share of hours worked in the total is decreasing in industry and flat in services
shares in hours worked in %; seasonally adjusted; source: CZSO, calculation: CNB
In 2016, the growth model of the Czech economy – based on high-performing industry, which until then had been a major driver of the convergence of the Czech economy – clearly started to run out of steam. All this was going on amid an overheated labour market and – by Czech standards – high nominal (and also real) wage growth. Increasing household purchasing power amplified the already robust growth in household consumption, which went hand in hand with a boom in services. This kept overall economic growth high despite the stagnant industrial sector. The expanding household consumption, growing importance of services and exhausted labour market were observed against a background of convergence of the Czech economy towards advanced Western European economies. It is nonetheless clear from the data that the convergence has begun to slow in recent years, especially compared to Poland (see Chart 5). In the Czech economy, the expansionary phase of the business cycle, which was common to the majority of European countries, was thus not associated with an improving long-term trend. On the contrary, its growth slowed further (see Chart 6).
Chart 5 – The convergence of the Czech economy to the EU average slowed after 2016
% of real GDP per capita relative to EU average (100); seasonally adjusted; source: Eurostat, calculation: CNB
Chart 6 – The long-term trend has been slowing despite the expansionary phase of the business cycle
y-o-y changes in %; prices of 2020 (chain-linked); seasonally adjusted; source: CZSO, calculation: CNB
The nominal exchange rate of the koruna against the euro was strengthening rapidly before the GFC. However, the rate of appreciation then slowed sharply, partly because of the CNB’s exchange rate commitment. The real exchange rate, which takes domestic and foreign consumer prices into account, showed a similar trend. Renewed real appreciation was evident only during the pandemic and subsequent years. However, this was probably due to higher inflation in the Czech Republic than in the rest of the world rather than reflecting the steady state. Further significant nominal appreciation of the koruna is unlikely given that the CNB and major foreign central banks have the same inflation targets and the real steady-state appreciation of the Czech currency is expected to slow. The slower convergence of the Czech economy will meanwhile be reflected in a lower rate of real exchange rate appreciation.
Long-declining growth potential and productivity
Looking at long-run growth through the lens of factors of production, it can be shown that until 2017 the effect of decreasing productivity growth was counterbalanced by labour market developments. This period saw a long, steady decline in both the unemployment rate and its trend (steady-state) component, the natural rate of unemployment.[4] This implicitly increased the stock of labour available in the economy. However, this process probably halted sometime before 2018 and the labour market thus stopped supporting growth in the potential output of the Czech economy via this channel. The second factor of production possibly responsible for the Czech economy’s weakening performance is the stock of capital. Investment is nonetheless traditionally strong in the Czech Republic. As a percentage of GDP it is one of the highest in Europe and has long been stable. The net capital stock, defined as gross fixed capital formed in previous years net of capital stock depreciation, is also highly stable. The final factor that might explain the slowing growth in the potential output of the Czech economy is multi-factor productivity. As it is not directly observable, we instead use whole-economy labour productivity in our description.
Labour productivity[5] has long been rising, but the rate of increase is slowing (see Chart 7). This is consistent with the situation of a converging, increasingly wealthy economy and with economic theory (beta-convergence). Productivity growth was above the trend on average during 2016–2019. However, the economy was simultaneously in the expansionary part of the cycle, so the positive deviation is due more to the cyclical position. It generally holds, though, that aggregate productivity growth in the Czech economy is slowing. This is undoubtedly having a negative effect on potential output growth.
Chart 7 – Productivity growth has long been slowing in the Czech economy
CZK/hour; prices of 2020 (chain-linked); seasonally adjusted; source: CZSO, calculation: CNB
From the sector perspective, it follows that industry was more productive than services most of the time after the GFC (see Chart 8), although the differences are not large. The ongoing migration of workers from industry to services was thus not a key driver of productivity or potential output in the Czech economy.
Chart 8 – Industry has been the driver of productivity since 2008
CZK/hour; prices of 2020 (chain-linked); seasonally adjusted; source: CZSO, calculation: CNB
Institutions, innovation, infrastructure
The causes of the subdued productivity growth[6] can also be sought among soft indicators such as quality of institutions, R&D intensity and infrastructure development. An indicator of Czech infrastructure that does not put the Czech Republic in a very flattering light is the length of new motorways in kilometres a year. The figure is gradually rising, but a pace mostly not exceeding 20 km of new motorways a year leaves room for improvement. The poor situation in the Czech Republic is also evidenced by Eurostat data, as the country ranks 18th in the EU in terms of kilometres of motorways per 1,000 square kilometres of territory. The situation in the Czech Republic is also dire when it comes to modernising the railway network and building new high-speed lines.
Another indicator comes from the World Bank country ranking.[7] The starting a business index describes the institutional environment and contains information on the time and cost of starting a company in a country. The more new businesses there are, the more likely it is a highly productive business or industry will emerge to drive the economy forward. The Czech economy ranked 81st among the almost 200 countries compared in the period under review and has been slowly slipping down the ranking since 2017 (see Chart 9). This is again fostering a gradual slowdown in productivity growth.
Chart 9 – The conditions for starting a business in the Czech Republic worsened in the pre-pandemic period
score; Czech Republic’s Doing Business ranking shown above columns; source: World Bank
The situation in the field of innovation as a driver of progress in the Czech economy is none too rosy either. R&D expenditure is still on an upward trend, but as a percentage of GDP it halted below the 2% level in 2014 (see Chart 10). Moreover, private investment in basic and applied research in the Czech Republic also cooled significantly after 2016 (see Chart 11).
Chart 10 – The flat R&D spending as a percentage of GDP is not favourable either
CZK billions; constant prices; source: CZSO
Chart 11 – Private investment in basic and applied research also cooled significantly
CZK billions; constant prices; source: OECD
The number of patents granted with effects in the Czech Republic paints a similarly dismal picture (see Chart 12). Their total number rose in 2016–2019 and would probably have continued to do so had it not been for the Covid downturn, but the number of patents from Czech inventors has been falling since 2016 and has long accounted for less than 10% of total patents granted. The number of patent applications from applicants from the Czech Republic is also falling. Moreover, growth in the proportion of university graduates in the Czech Republic has been slowing since 2016. By contrast, the average level of this indicator in the EU as a whole has been rising at the same pace as in previous years. For the Czech economy, this implies a loss of competitiveness in terms of human capital. This is again contributing to the slowdown in productivity growth.
Chart 12 – A decline in patents granted with effects in the Czech Republic also points to slowing growth potential
number of patents granted, source: CZSO
The slowdown in potential GDP growth from a modelling perspective
We incorporated the information described above into an analysis based on the World Bank’s Solow-Swan Growth Model.[8] As exogenous variables, we used the investment share of GDP, multi-factor productivity growth, human capital growth and demographic indicators (population growth, labour force growth and growth in the participation rate). The output is a forecast for growth in GDP per capita. The decrease in potential output growth was quantified using the observed slowdown in trend productivity growth after 2016. Ceteris paribus, the potential growth of the Czech economy slowed to around 2.5% between 2016 and 2023 (see Chart 13). If productivity growth were to continue decreasing at a similar pace in the future, potential output growth would slow further to 2% despite any temporarily favourable demographic factors.
Chart 13 – The potential growth of the Czech economy has declined in recent years
y-o-y changes in %
Note: Replication of an analysis conducted using the World Bank’s Solow-Swan Growth Model.
Up to now, the CNB has assumed long-run steady-state GDP growth of 3% in its quarterly macroeconomic forecasts.[9] However, our data analyses and model computations lead us to conclude that steady-state GDP growth has decreased by 0.5 pp to 2.5% over the past few years. Its rate of growth has been decreasing gradually since 2016, where a major structural break has been identified. The slowdown in the potential growth of the economy reflects a decrease in multi-factor productivity growth of the same magnitude. This is consistent with the decrease in the Czech Republic’s rate of catch-up with advanced economies.
In the light of our analyses, the long-run steady-state growth of the Czech economy used in the CNB forecast has therefore been lowered by 0.5 pp to 2.5% starting with the Summer 2024 MPR. Although the real exchange rate of the koruna has strengthened by 1.5% on average over the last decade, a lower steady-state rate of real appreciation can be expected in the future, owing to slowing convergence of the Czech economy. Consistent with the revision of potential output growth, the steady-state rate of real (and hence also nominal) appreciation of the koruna-euro exchange rate has also been reduced by 0.5 pp to 1% starting with this forecast. In the summer forecast, the change is made by means of expert adjustments. By the autumn forecast, the steady-state values themselves will have been recalibrated in the g3+ core forecasting model.
The reduction in the rate of long-term potential growth is crucial for interpreting economic developments, and that in turn has direct consequences for monetary policymaking. The lower steady-state growth rate over 2016–2019 consistently estimates the domestic economy as having been more overheated in that period. It also better explains the accumulated demand pressures that significantly contributed to the surge in inflation above the tolerance band in 2020 and its high levels in subsequent years. The lower potential output growth, and hence more open output positive gap, also better corresponds to the highly overheated labour market identified at that time (as expressed by LUCI). It also at least partly explains the only slowly recovering growth of the Czech economy (below 3%) after the Covid pandemic.
[1] Breaks are identified using the Chow test on 27 selected time series (e.g. the level of GDP, the level of wages and the unemployment rate) in individual quarters. The test identified at least one structural change in most quarters, but a low number of breaks can only be described as noise in the data. However, a period with five or more data breaks indicates a probable structural change where the functioning of the economy changed compared to the past.
[2] Box The position of Czech exporters on the German market by comparison with Poland in the Summer 2024 MPR analyses the position of Czech exporters on the German market.
[3] In this and the following charts, “industry” refers to manufacturing only. “Services” comprises wholesale and retail trade, transport, accommodation and food service activities, information and communication, financial and insurance activities, professional, scientific and technical activities and administrative activities.
[4] Growth in the labour force will be affected by migration, which, together with a growing share of workers of pre-retirement and retirement age, will offset the demographic effect of a gradual decline in the number of people aged 15–64 years which will occur over the next 15 years according to the CZSO’s demographic projection.
[5] Productivity is computed as the ratio of GDP to hours worked or, in sectoral terms, as the ratio of gross value added to hours worked. Whole-economy labour productivity can also be expressed in relation to total employment, but the results differ little.
[6] This section mentions possible factors that are holding back productivity growth in the Czech economy, so it may seem unbalanced or even alarmist. However, we should not forget that overall the Czech economy is one of the most advanced in the world. The list given here is therefore more a case of searching for a needle in a haystack that hides some of the facts.
[7] Until 2019, the World Bank issued an annual Doing Business publication ranking countries according to how business-friendly they are. This analysis is based on data from the last available Doing Business 2020, published in October 2019.
[8] More information about the model is available on the World Bank website.
[9] In the 1990s, a steady-state rate of potential output growth of 5% was assumed for the Czech economy. The rate was subsequently reduced to 4% and cut further to 3% around 2011, partly as a consequence of the GFC.