Commission Report (2002): Czech Republic

The existence of a functioning market economy

The governments since 1997 have been able to maintain a general consensus about economic policy priorities in the framework of EU accession. However, there have been different views on the speed and sequencing of the economic reform path. These different views have at no point put into question the overall commitment to EU accession. Policy co-ordination between the government and the Czech National Bank (CNB) has broadly worked well and the independence of the CNB has finally been enshrined with the amendment of the Act on the CNB in 2002. The Czech Republic has participated in the pre-accession Fiscal Surveillance. At the end of August 2002, it submitted its latest pre-accession Economic Programme, which was adopted by the government on 28 August 2002.

Average growth of 1.1% over the period has been composed by two years of contraction in 1997 and 1998 and a subsequent recovery. Macroeconomic stability has been regained. Prior to the recovery, the economy had to go through its first post-transition crisis which was provoked by macroeconomic imbalances coupled with substantial shortcomings on the microeconomic reform agenda. The implementation of an austerity package consisting of tight fiscal and monetary policies led to an output decline in 1997 and 1998, but adjusted economic fundamentals subsequently improved the conditions for growth. Since 1999, the economy has been recovering again with average growth of 2.4% since then. First, the economic pick up was driven by external demand and -- to a lesser extent -- by private consumption while fixed investment was still declining. With growth prospects improving on the back of an increasingly stable macroeconomic environment and attractive investment incentives, fixed investment has since been boosted. This has been supported by very high foreign direct investment. Domestic demand has become the driving force of economic growth, a development which has cushioned the impact of the 2001 economic slowdown in the EU. In 2001, GDP increased at the same growth rate of 3.3% as in the previous year, though with a clear deceleration over the course of the year. Fixed investment grew by a substantial 7.2% and household consumption by 3.9%. External trade contributed negatively to growth as imports grew faster than exports. The performance in the first quarter in 2002 has extended the slowdown of GDP growth. The growth rate reached 2.5% year-on-year with household consumption increasing by 4.1% and fixed investment 8.1%. It is worth noting, that the growth in fixed investment was strongly pushed up by sizeable investment expenditures by the Czech army. Exports and imports both grew at the same rate of 3.1%.

In August 2002, the Czech Republic was seriously hit by devastating floods. Preliminarily, the damage has been estimated to amount up to CZK 100 billion (EUR 3.3 billion). While most of the damage has to be covered by private households and insurance companies, public finances will also be affected by necessary contributions to flood relief. The overall economic impact of the flood cannot yet be assessed but it is likely to slow down economic growth in 2002.

The current account deficit averaged 4.1% of GDP between 1997 and 2001. Since 1998, the deficits have been financed by high inflows of foreign direct investment. In 1996/1997, the economy was confronted with unsustainable current account deficits due to soaring deficits in foreign trade. The implementation of the austerity measures in 1997 led to a temporary sharp deceleration of imports. With the economy recovering since 1999, the trade and current account deficits have widened again. However, the trade deficits have been dominated by investment good imports and there is no indication so far that consumer goods imports are getting out of hand. In 2001, the trade balance recorded a deficit of 5.5% of GDP and the current account deficit ended up at 4.7% of GDP. The deficit was easily financed by a financial account surplus. In the first quarter of 2002, the trade balance posted an estimated deficit of 4.6% of GDP and the current account deficit reached 4.2% of GDP.

Unemployment remains high due to restructuring and structural mismatches on the labour market. The unemployment rate (labour force survey data) has more than doubled, from 4.3% in 1997 to 8.8% in 2000. Its decrease to 8% in 2001 appears to be in particular the result of an amendment to the Labour Code limiting overtime work. The unemployment rate reflects the impact of the 1997 crisis and subsequent economic restructuring which only started at a late stage in the transition process. Employment fell in each year between 1997 and 2000, amounting to a cumulative loss of employment of nearly 5% during that period. Only in 2001 was a small rise in employment of 0.3% registered. Though the adjustment process has been accompanied by accelerating investment and new employment opportunities, these have not been able to compensate for the job losses. The composition of unemployment reveals the structural shortcomings in the labour markets. Workers in sectors undergoing restructuring find it difficult to move to other sectors or regions with a higher growth potential since flexibility and mobility are hampered by deficiencies in re-qualification and the scarcity of affordable housing in more prosperous regions. In certain circumstances, the social benefit system may work as an disincentive to take up work. Hence, while some regions and sectors suffer from high and even increasing unemployment, others are reporting the first signs of shortages in the skilled labour force.

Inflation has remained at relatively low levels. After peaking at 9.7% in 1998, the inflation rate dropped to a very low 1.8% in the following year. However, since the beginning of the economic pick-up, as price deregulation measures have also been taken up again and pushed by the increase in international commodity prices, the inflation rate edged up to 3.9% in 2000 and 4.5% in 2001. Throughout the first half of 2002, inflationary pressures were subdued. Slackening economic activity, low international commodity prices but also the strong Czech crown have contributed to this development. In the first half of 2002, consumer price inflation was 3% higher than in the corresponding period of the previous year.

The current monetary and exchange rate policy framework of direct inflation targeting and a managed exchange rate float have served the economy well. Inflation targeting was introduced in 1998, with net inflation serving as the reference until 2001. In the first years, the inflation targets of the CNB were undershot. With its ``Setting of the Inflation Target for the Period 2002 to 2005''., the CNB has embarked upon headline inflation targeting which helps ensure that the public accepts the targets. The inflation target is set as a band which should fall continuously from 3% to 5% in January 2002 to 2% to 4% in December 2005. In the event of unexpected moves in regulated prices, the CNB has the option of applying escape clauses in order to meet its targets. Since its sharp depreciation in 1997, the Czech crown has shown an appreciating trend against the euro. This upward movement has accelerated strongly since the end of 2001 when conjectures on high foreign capital inflows due to planned privatisations, the run up to EU accession and market perceptions of possible dates of the adoption of the euro, fuelled market expectations. In the first half of 2002, the Czech crown appreciated nominally by 9.2% against the euro. In the light of the strong upward move of the exchange rate, the government and the CNB agreed in mid January 2002 on a joint strategy to prevent a further strengthening of the Czech crown. Essentially, the strategy aims at withholding foreign currency denominated public revenues, in particular privatisation receipts, from the market. Additionally, the CNB has attempted to contain the appreciation by a mix of interest rate cuts, market interventions and public declarations. However, the CNB has made clear that its policy interventions do not aim at reversing the general trend of appreciation of the Czech crown but at preventing excessively strong fluctuations and an exchange rate which is not anchored in real sector developments. Overall, monetary policy has been accommodating since 1998. Policy rates have been cut back several times, recently reaching 3% for the main interest rate, the two-week repo rate. The real short-term interest rate has equally significantly been falling from around 11% in 1997 to 0.5% in 2001. Monetary conditions reflect the low inflationary environment and the strong exchange rate of the Czech currency.

Reluctance to undertake comprehensive expenditure reforms has led to a deterioration in public finances. The previous government pursued only modest fiscal consolidation, but the fiscal programme of the newly-elected government is not very ambitious in this respect, either. On the basis of harmonised EU standards (ESA 95), the general government deficit has averaged 3.8% of GDP from 1997 to 2001. In 2001, the deficit reached 5.5% of GDP and it is anticipated that it will surge to 6.6% of GDP in 2002. Public budgets have to swallow the costs resulting from the delayed implementation of structural reforms, in particular the clean-up of the banking sector and the restructuring of the corporate sector. The previous government`s efforts to reform the pension system have been insufficient: it has only modified relatively generous early retirement schemes and strengthened the relationship between contributions and benefits. Mandatory and quasi-mandatory expenditures of the state budget have increased by roughly 10 percentage points of GDP since 1995 and account for about 80% of state budget spending. This has translated into pro-cyclical budgets in 2001 and 2002. The fact that public budgets suffer from a large share of mandatory and quasi-mandatory expenditures which leaves only tight room for fiscal manoeuvring proves particularly unfortunate in view of the necessary spending on flood relief. The government has announced that it does not intend to increase the planned state budget deficit in 2003 to shoulder the additional financial burden but rather that it will give priority to tax increases and to discretionary expenditure cut backs. However, the urgency of a comprehensive reform concept with clear priorities in the area of mandatory expenditures should not be affected by the impact of the floods. Without tackling this problem medium-term fiscal consolidation is unlikely to be reached.

General government debt has been moderate but this does not completely reflect government's financial exposure. General government debt reached 23.6% of GDP at the end of 2001, up from 13.7% in 1998. Past and current levels of government debt do not fully reflect the actual picture of indebtedness as they include only part of the debt of the transformation institutions and guarantees of the government and the National Property Fund. The government has started to gradually internalise these respective liabilities in the general government debt. That adds substantially to the statistically reported stock of government debt over time.

Good progress has been made towards greater fiscal transparency and better fiscal management. The government has taken measures to improve the transparency and management of public finances, such as introducing new budgetary rules in 2001 and the integration of the Czech Consolidation Agency into general government as of September 2001. However, the government has also created new extra-budgetary funds, which have increased the complexity of public budgets. This development complicates the process of monitoring and controlling public spending. Also, the introduction of an additional layer of government in the context of decentralisation, the regional governments, represents a specific challenge to fiscal management. The changes that arise from this reform, such as transfers of properties and financial resources in line with responsibilities, require a number of transitory arrangements which make it more difficult to analyse and to monitor the fiscal developments in 2002.

The macroeconomic policy mix has been broadly adequate. With the implementation of the stabilisation measures in 1997, fiscal and monetary policies became tight and thus managed to successfully re-establish conditions for macroeconomic stability. Since then, monetary policy has followed an accommodating course focused on securing the inflation targets while also supporting economic growth. Fiscal policy has become increasingly expansionary. Therefore monetary policy has undertaken stronger efforts to secure macroeconomic stability. However, the strategy of the government and the CNB to keep the exchange rate at an appropriate level has underpinned the commitment of both policymakers to co-operate for the sake of preserving stability and growth. Overall, the continuous high inflows of foreign capital -- of which by far the majority is medium to long-term capital -- suggest that markets consider the macroeconomic conditions to be stable in the Czech Republic.

The majority of prices for goods and services and the trade and foreign exchange regimes have been liberalised in the first half of the 1990s. The deregulation of energy prices and rents is progressing well. Alignment of electricity prices for private households with cost recovery levels has been achieved. As regards the gas market, the process is near completion. .. The rent deregulation scheme provides for regular annual adjustments. The size of the adjustment depends on the evolution of the construction price index, and thus does not primarily take into account market rents. The persistence of a rent regime which does not sufficiently allow for direct market-based alignments continues to hamper labour market flexibility and acts as a strong disincentive for potential investors in housing.

The private sector is firmly established and accounts for the overwhelming part of the Czech economy. Private ownership has become the dominant form of ownership. In 2001, 79.8% of GDP was produced in private companies, in contrast to 74.7% of GDP in 1997. The land market has been liberalised and land registers, broadly speaking, work properly. The supply of industrial and commercial land has continued to exceed demand, although the market in economically booming regions like Prague is tighter. Overall, the state still owns a significant share of land.

The privatisation process is close to completion but some strategic enterprises in the corporate sector still await a change of ownership. The state, through the National Property Fund (NPF), has completed roughly 97% of the privatisation projects which were envisaged in 1991. Privatisations since the last regular report include the chemical holding Unipetrol which was sold to a domestic investor, the monopoly gas importer Transgas including the stakes in gas distribution companies, the steel producer Nova Hut and the telecoms operator Cesky Telecom. While some 230 companies remain to be privatised only a few of these can be considered financially and economically significant.

Market entry and exit mechanisms are working but need to be improved in order to make the economy more efficient. The business registration process and registration of modifications have remained unnecessarily lengthy procedures. The introduction of a 15-day limit within which the court must start processing an application, which entered into to force with the amendment of the Civil Proceedings Code on 1 January 2001, has not had so far a significant impact In the absence of a comprehensive approach to facilitate the whole registration process, procedures continue to be marred by unequal treatment and lack of transparency. In 2001, the number of newly created companies in the SME sector amounted to about 9,000 while the total number of SMEs reached some 770,000. Financing conditions for domestic start-ups have continued to be tight since banks apply tough business plan assessments and strict credit rules. The banks` cautious lending practices are a consequence of the unsatisfactory bankruptcy legislation which has not been changed since May 2000. Intensified training measures for judges and trustees aiming to make the implementation of bankruptcy procedures more effective have in no way been able to compensate the legislative deficiencies, though they have upgraded the skills of the staff involved. Overall, the use of composition as an effective means of resolving insolvency cases has remained very limited and creditor rights have remained weak.

Property rights are established and transferable. The investment climate has improved substantially over the past years, not least because of a comprehensive strategy to attract foreign direct investment. However, there are still some impediments to economic activity, such as those mentioned in the paragraph above. Small, and in particular domestic, enterprises are more affected by these problems while foreign-controlled companies are more able to bridge or circumvent these difficulties. The occurrence of economic crime has been a difficult challenge for the authorities to deal with even if progress has been achieved in fighting this phenomenon.

Privatisation and consolidation have laid the foundations for a solid financial sector which is able to fulfil its intermediation role. The financial sector as a whole is characterised by a relatively strong banking sector which has emerged from a long-winded and costly restructuring and privatisation process. Banking privatisation was completed in 2001. At the end of March 2002, the banking sector comprised 38 banks of which 26 had majority foreign ownership. About 95% of total banking assets are controlled by foreign-controlled banks. The market as a whole is fairly concentrated. In 2001, the three largest banking groups accounted for around 60% of total banking assets. While in general foreign ownership has been crucial in enhancing corporate governance and pushing forward business reorientation in the banking sector, this did not work well in the case of the Investicni a Postovni Banka (IPB) which was put under forced administration in June 2000 and subsequently sold to a big commercial bank in the Czech Republic. The non-performing assets of IPB are being transferred to the Czech Consolidation Agency and the final bail-out of IPB is likely to amount to some 4% of GDP.

The overall health of the banking sector has improved substantially over time. In the course of restructuring, large parts of the non-performing loan portfolios of the banks were shifted to the state`s bail-out institution. The clean-up of the bank portfolios has resulted in a decline in total assets to GDP (116% at the end of 2001 compared to 132% at the end of 1997) but has strengthened the overall health of the sector. At the end of March 2002, classified credits amounted to 19.6% of total credits, compared to 27% at the end of 1997 and 32.2% at the end of 1999. In March 2002, net profits to average assets increased to 1.46% up from losses of oe0.18% in 1997, and the capital adequacy ratio stood, at the end of March 2002, at 14.9% compared to 9.7%. Despite an increase in deposits from 63.3% of GDP in 1997 to 70.2% in 2001, the volume of outstanding credits to the private sector has decreased from 58.5% of GDP at the end of 1998 to 47.5% at the end of 2001. The ratio for credits to the corporate sector fell while the credit-to-GDP ratio for households was on the rise. The decline in business lending can partly be explained by the transfer of bad assets from the banking sector to the state`s bail out institution, but it is also due to the introduction of stricter risk assessments which has put an end to the way banks conducted their lending activities in the past, which was not always fully based on thorough commercial considerations.

The non-bank financial sector is still relatively small but stands ready to play a bigger role in intermediation. Market capitalisation of the equity market plunged from roughly 29.5% of GDP in 1997 to a mere 15.7% of GDP in 2001. This drastic decrease must be assessed partially as the result of an adjustment process of voucher privatisation related inflation of investment funds on the market. However, the equity market is characterised by low liquidity reflecting both demand and supply shortcomings. The bond market has developed better and comprises a sizeable volume of corporate bonds and government bonds. Capitalisation of this market amounted to 14.9% of GDP in 2001, up from 10.4% of GDP in 1997. In particular insurance companies and -- after a far-reaching consolidation process -- pension funds seem to be well placed for expansion.

The completion of privatisation and enhanced supervision have helped the stability of the financial sector. Further efforts to strengthen supervision in the non-banking sector, however, remains essential. Supervision of the financial sector is carried out by three bodies, the CNB, the Ministry of Finance and the Czech Securities Commission. They co-ordinate their supervisory work on the basis of a trilateral agreement. The aim of the supervisory bodies is to jointly develop a system of consolidated supervision, but, as yet no consensus has been achieved in this area. Supervision of the insurance sector, which is the responsibility of the Ministry of Finance continues to require special attention because of the long-acknowledged capacity problems.

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