INTERNATIONAL MONETARY FUND
Czech Republic-2000 Article IV Consultation Mission
Concluding Statement-May 9, 2000
1. The mission welcomes that, after the long and deep recession, signs of recovery are emerging, as evidenced by recent releases of various economic indicators. The important question is whether the nascent recovery can develop into robust, sustainable, and non-inflationary growth.
2. Certain elements conducive to growth are in place. A strengthening of recovery is underway in the EU, the Czech Republic´s major trading partner. The recent sharp increase in foreign direct investment (FDI) reflects primarily an acceleration of privatization, but improvements in investor sentiment are also reflected in additional greenfield investment, with positive employment and growth effects. Low inflation and, perhaps more importantly, low inflationary expectations and sizable slack in the economy, suggest that there is ample room for domestic demand to expand without raising serious concerns about inflationary or current account pressures. However, ongoing restructuring of the banking and traditional corporate sectors continues to act as a drag on the economy. As a result, economic growth is unlikely to exceed a modest 1 1/2-2 percent this year.
3. Under these circumstances, the mission considers that macroeconomic policies should remain supportive for the time being. At the same time, however, improved economic conditions should allow the authorities to gradually shift their focus to medium-term policy objectives. The envisaged modest expansion in the (cyclically-adjusted) general government budget deficit this year is appropriate in the context of weak growth. However, beyond 2000, steps must be initiated to reform the structure of expenditures and revenues so as to improve the medium-term fiscal outlook. The current accommodative monetary stance remains appropriate but, increasingly, attention will need to shift to ensuring price stability for next year and beyond. Moreover, to avoid a loss in external competitiveness as well as a premature tightening of monetary conditions, the authorities should resist any significant appreciation of the koruna until the recovery gains further momentum. Over the past six months, there has been a marked acceleration in the preparation of structural reforms, including in the banking and corporate sectors. It is imperative that they should now proceed at full steam, making wise use of the emerging recovery and taking advantage of foreign investors´ improved sentiment. While the positive impact of the structural policy measures may not be felt immediately, they are necessary to improve the Czech Republic´s medium-term growth potential.
4. The mission supports the Czech National Bank´s (CNB´s) current interest rate policy, but looking ahead, policy will need to be adjusted flexibly to provide a favorable environment for economic activity within the context of medium-term price stability. The mission also welcomes the successful foreign exchange market intervention in late March that prevented a tightening of monetary conditions. Avoiding unwarranted appreciation will help sustain the economic recovery; at the same time, the CNB should not create a false impression that it has an exchange rate target. The mission welcomes the CNB´s recent announcement of the end-2001 net inflation target, and considers the target range of 2-4 percent appropriate. The likely undershooting of the end-2000 target is unfortunate, and efforts should be made to improve inflation forecasting to facilitate forward-looking policy making. However, under the current circumstances of low and stable inflation, policy should be geared to preserving hard-won disinflation gains. The government´s endorsement of the 2001 inflation target is a major achievement, reflecting an improved coordination of policies by the monetary and fiscal authorities. This increases the target´s credibility, and will help induce changes in the way the private sector formulates its price- and wage-setting behavior.
5. The mission has closely followed the ongoing efforts by Parliament to amend the CNB Act, and has a number of serious concerns. The mission is of the strong view that central bank independence, especially operational independence, is necessary for sustained good macroeconomic performance. Operational independence implies, first of all, that given agreed monetary policy objectives, the central bank should not receive instructions from any source regarding its policy decisions. Second, once appointed, the monetary policy decision makers should be protected from political interference. To enhance the stability of monetary policy decision making, appointments to the CNB board should be staggered and of sufficient duration. Moreover, dismissal should be permitted only in cases of criminal misconduct. Third, the central bank should be financially independent to avoid the situation where interference by an outside body into its financial matters results in a distortion of its policy making. Fourth, the central bank should be given the policy instruments to conduct its operations consistent with the stated objectives and not be constrained in respect of their use. The mission hopes that Parliament will exercise its wise discretion and come to a conclusion that puts the CNB on a par with global and EU standards.
6. Turning to fiscal policy in 2000, our interpretation of the initial policy stance-as measured by the general government deficit (on a cyclically-adjusted basis and excluding privatization revenues and bank restructuring costs)-is that it is appropriately supportive. Revenue performance has been strong so far this year, due in part to faster economic growth than assumed in the budget and structural factors leading to enhanced tax efficiency and a shortening of the collection lag. Expenditures have been low, reflecting both the late approval of the budget and seasonal factors. It is difficult, at this juncture, to accurately forecast fiscal developments in the remainder of the year, but the mission advises the authorities to remain vigilant in budget execution to ensure that it does not lead to a premature tightening of fiscal policy.
7. For 2001, the government is targeting a state budget deficit of CZK 20 billion, equivalent to a decline in deficits of 3/4 percentage points of GDP relative to this year´s budget. This-taken at face value-would represent a sizable policy tightening, although the overall impact of fiscal policy on the economy cannot be judged by the state budget alone. More importantly, however, the mission finds it unfortunate that no fundamental reform of mandatory expenditures (including pensions), which account for more than half of state budget expenditures, is planned to achieve this target. This leads one to question whether narrowly-focussed cuts in other areas will be sustainable or whether some expenditures will be transferred to other levels of government. Beyond 2001, medium-term fiscal projections provide an important vehicle for assessing fiscal sustainability under various macroeconomic and policy scenarios. The government´s current projection framework is a major step forward in this regard. The mission urges incorporating anticipated fiscal obligations (such as those associated with EU accession, arising from called government guarantees, and from demographic developments) to help formulate appropriate policy responses in order to assure fiscal sustainability.
8. The mission welcomes the new budgetary rules, which significantly increase fiscal transparency. However, the mission remains concerned about the creation of additional extrabudgetary funds, such as the recently approved fund for transport and infrastructure. There is no doubt that infrastructural investment is important for economic growth and for addressing regional disparities. However, despite operating the new funds under the provisions of the new budgetary rules, the earmarking of tax revenues can give rise to a tendency for such funds to outlive their original purpose and jeopardize medium-term fiscal stability. Also, the separation of expenditures can create fiscal transparency problems. The mission therefore urges extreme caution in the use of these vehicles.
9. The mission welcomes the government´s plan to proceed with privatization expeditiously. Improved foreign investor sentiment is welcome, and windfall privatization proceeds should be used primarily for reducing public debt and provisioning for the future. Adjustments to administered prices to date have also been useful. However, their full liberalization is essential in ensuring that the right price signals are in place to encourage the efficient allocation of productive resources. To this end, a schedule for completing the liberalization process should be announced soon.
10. An important macroeconomic issue relevant both to the monetary and fiscal authorities is how to cope with strong capital inflows that are likely to continue over the medium term. Experiences in other advanced transition countries suggest that the authorities need a consistent policy framework to address this issue. Currently, capital inflows do not pose a serious policy dilemma. However, as the pace of activity quickens, careful consideration of the policy mix will be required. Over the medium term, it is neither possible nor desirable for monetary policy alone to absorb the impact of inflows; thus, fiscal tightening would be necessary to avoid an overheating of the economy and an excessive expansion of the external current account deficit. Exchange rate flexibility would be useful to attenuate inflows as well as to prevent inflation. To make best use of the positive economic effects stemming from capital inflows, it is necessary to remove any distortions in relative prices and incentives. Structural reform should strengthen competitiveness, and thereby mitigate the adverse effect of an appreciation of the exchange rate. The financial sector supervisory authorities should be vigilant in their enforcement of prudential regulations in order to prevent severe disruptions to financial markets in the event of temporary reversals of capital inflows.
11. Turning to structural reforms, the mission commends the authorities´ efforts to speed up the process in a number of key areas, including legal improvements and banking and corporate sector restructuring. In contrast to relatively slow progress in earlier years, the pace of adopting the European Union´s acquis communautaire has accelerated markedly this year. This process should facilitate the implementation of reforms that are needed in their own right to improve economic efficiency and growth prospects. Adopting the acquis will also entail additional fiscal pressures, only a part of which will initially be financed by the EU, thus requiring increased expenditure efficiency. However, post-entry net transfers from the EU should be substantial. The mission urges that alignment efforts continue apace to allow the Czech Republic to be among the first wave of new entrants into the EU.
12. The mission welcomes the latest amendment of the Bankruptcy Act. A smooth and rapid bankruptcy process is crucial for the functioning of a market economy, facilitating financial restructuring in an environment that protects both creditors´ and debtors´ rights. Strengthening creditors´ positions in some areas, such as the power of creditor committees to dismiss court-appointed trustees, are clear improvements. Several provisions of the amended law should reduce debtors´ ability to delay the bankruptcy process, which should help to ensure its effectiveness. The Law on Public Auctions, which facilitates the seizing of collateral in case of non-repayment of loans, should also contribute to a better balance between the rights of creditors and debtors. However, the bankruptcy process also depends on a number of other laws and on an effective judicial process; in these areas more progress is still needed.
13. In the area of banking sector reforms, the mission welcomes the speedy sale of Ceska sporitelna, and also the government´s intention to rapidly privatize Komercni banka. The problem of non-performing loans continues to restrict banks´ ability to supply credits needed for sustained recovery. In this regard, the new Public Auction Law and the latest amendment of the Bankruptcy Act are steps in the right direction, though their effectiveness remains to be seen. The mission considers that, to the extent that these legal changes prove to be effective, the CNB should relax the rule requiring banks to provision to 100 percent for "loss" loans backed by real estate collateral. The rule was introduced in the context of difficulties faced by creditors in seizing collateral, and an improvement in the latter should permit a corresponding relaxation of the CNB regulation. Another policy measure that would facilitate banking sector restructuring is to increase deductibility of specific provisions on classified loans, and also to allow full tax deductibility of accrued interest on nonperforming loans.
14. The organizational changes implemented at Konsolidacni banka (KoB) better equip it to recover rather than administer bad assets. The final step, changing KoB´s legal status from a bank to a work-out institution, should be taken as soon as feasible. The mission is encouraged by the work of the Revitalization Agency (RA). The decision to limit its involvement to a small number of companies should ensure that its administrative capacity is not overloaded, and the RA is well-equipped to design viable restructuring plans for the affected enterprises. In selected cases, cash injections, including for working capital, may be inevitable. However, care should be taken that these are strictly conditional on observing the restructuring plan prepared by the RA and that political judgements do not override its business orientation.
15. The mission is concerned about the sharp increase in unemployment over the past few years. In spite of the emerging recovery, the unemployment rate is expected to remain high, due to ongoing corporate restructuring. In order to minimize the risk that the high unemployment becomes structural, the government should pursue policies that improve labor market flexibility. The major factors hampering an efficient functioning of the labor market are high social benefits relative to average wages, a mismatch between redundant workers´ skills and the demands of new job opportunities, and limited labor mobility. Social benefits should be modified to increase job search incentives for the unemployed. Labor mobility has been hampered in part by rent controls; thus, rents should be adjusted toward market levels as soon as feasible, with necessary aid to low-income households. Targeted FDI incentives (including for job creation and retraining) to high unemployment regions should prove useful.
16. The mission welcomes progress made in drafting amended legislation governing the securities markets. The amendments to the Commercial Code and the Securities Act, in particular, reflect sound corporate governance principles, and would help develop better-regulated securities markets. The mission encourages rapid Parliamentary approval of these amendments so that they can become effective on January 1, 2001. We also encourage a timely amendment of the Act on the Securities Commission.
17. The mission welcomes progress made by the authorities in addressing the issues raised in the September 1999 Report on the Observance of Standards and Codes (ROSC). A summary of progress in this area, as well as an analysis of the Czech Republic´s economic developments and prospects, will be included in the staff´s full report, which will be published later this year.