02 August 2013

IMF Executive Board concludes 2013 Article IV consultation with the Czech Republic

The economy has avoided serious imbalances in the recent volatile economic environment, benefitting from strong policy frameworks and sound fundamentals. However the export-led recovery observed in 2010–11 subsided as euro area import demand slowed.

Pro-cyclical fiscal consolidation continued in 2012 resulting in a stronger structural fiscal position than before the crisis. The overall deficit without one-offs in 2012 was 2.5 per cent of GDP, down from 3.2 per cent of GDP in 2011. The structural balance improved by 1.5 per cent of GDP on account of a combination of revenue measures, in particular an increase of the reduced VAT rate by 4 percentage points, and expenditure measures. Fiscal over-performance relative to the budget was largely due to under-execution of capital spending, down by 0.6 per cent of GDP compared to 2011, to 3.1 per cent of GDP.

The Czech National Bank (CNB) continued to take a leading role in countering economic weaknesses. It cut the policy rate by 70 basis points in three steps in June, October and November to 0.05 per cent, and committed itself to continued low rates. Long-term money market rates also moved lower in the face of weak growth and inflation expectations. The falling rates, however, did not translate into faster credit growth. Credit to the corporate sector and households grew only by 2.6 per cent at end-2012 compared to 6.3 per cent of the previous year. Increased cautiousness about economic prospects played a role in limiting both credit demand and, to a lesser extent, supply.

The Czech economy, despite its strong fundamentals, is in the midst of a prolonged recession because of the euro area slump and weak domestic demand. A further slowdown in the euro area would exacerbate the situation, creating the risk of lower growth in the long run. Short-term macroeconomic policies should therefore be geared toward supporting the economy and not creating additional drag. Boosting potential growth in the medium- to long-term will require implementation of additional structural reforms.

Given the large fiscal consolidation achieved so far, further consolidation efforts should be avoided until the economic recovery gains strength. Thus, fiscal over-performance, particularly at the expense of capital spending, should be avoided as well as further pro-cyclical fiscal tightening in the event of weaker than expected economy activity. A neutral fiscal stance would be appropriate over the next few years until the economic recovery gains strength.

The structural balance rule and debt brake being considered for the new fiscal framework would enhance the transparency and predictability of fiscal policy and reduce pro-cyclicality. The framework’s effectiveness and credibility would be enhanced by its design and adoption being rooted in broad consensus and incorporating an independent fiscal council. The structural target adopted should strike the right balance between short- and medium-term demand stabilisation concerns with the long-term sustainability considerations, including the need to stabilise debt in the near future.

If a persistent and large undershooting of the inflation target is in prospect, additional tools should be employed. Foreign exchange (FX) interventions would be an effective and appropriate tool to address deflationary risks in the context of inflation targeting framework. This is expected quickly to increase the price level and help increase inflation expectations toward the target. The operational aspects of possible FX interventions should pay due regard to transparency. This would allow the market to form expectations in accordance with the CNB’s inflation target.

Banking supervision should proactively ensure that provisions are adequate and buffers remain strong. The main risk is a protracted or deeper recession that would harm asset quality of the Czech banking sector. While existing capital and liquidity buffers are expected to keep the system resilient, proactive supervision would add to the strength in the face of potential further economic weakening.

Improvements of the financial stability framework would help safeguard the Czech financial system against a wide range of risks. The authorities’ efforts to implement the recommendations by the Fund’s FSAP Update in December 2011 are welcome. It is important to adopt the draft proposal on the regulation of credit unions. Improvements in the areas of bank resolution and deposit insurance need to be implemented. It would be important to strengthen the cooperation between home and host supervisors and make preparations for a more integrated European financial policy framework.

Enhancing investment in both physical and human capital especially FDI is critical for future growth and moving up the value added chain. Reducing uncertainty by improving the legal framework and minimising administrative costs for formation, restructuring, and liquidation of firms could significantly contribute to a better business environment. A highly capable and skilled workforce is essential to attract more knowledge intensive industries placed higher in the value added chain. Higher labour participation would enhance potential growth while active labour market policies providing information, counselling, and retraining would help avoid long-term negative impact of unemployment. For some segments of the workforce such as women with young children where labour market participation is low, targeted policies such as public support for childcare could be effective.

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