Czech Republic -Staff Visit
Concluding Statement -October 18, 1999
- The mission has been encouraged by signs that the economic recession is bottoming out, partly as a result of the easing of monetary and fiscal policies since late 1998. However, the signs remain tentative, and continued supportive macroeconomic policies will be needed. At the same time, it is clear that without rapid and substantial progress in the area of structural reforms, the Czech Republic will not be able to achieve the high, sustainable growth needed to raise income levels and employment. As we have stressed repeatedly in our concluding statements over the past few years, weak corporate governance and a flawed legal framework for business activities are at the root of the economic crisis. Everyone knows this, and it is therefore difficult to understand that there is not a strong and broad based political will to move forward on these issues.
- The government appropriately allowed the fiscal deficit to widen in 1999 in response to the weak economic activity, while the CNB can be commended for lowering interest rates speedily in line with the decline in inflationary pressures. Nevertheless, any recovery is likely to be slow, with real GDP flat at best this year and growing only 1-2 percent in 2000. The strengthening recovery in the EU will support the export sector, and the strong real wage growth in 1999 will boost household consumption this year and next. However, private investment remains constrained by the lack of access to new credits, low profitability in enterprises, and the absence of a well-functioning capital market, and these constraints will only ease gradually as the remaining state-controlled banks are privatized, enterprise restructuring progresses, and the legal framework is improved. As a result, unemployment is likely to rise further in 2000.
- The mission does not see any significant inflationary pressures ahead provided that wage settlements for 2000 are moderate and public finances remain under control. The slow recovery is unlikely to exert much pressure on domestic costs and prices in 2000, and while the rise in energy prices and end to the decline in food prices should lead to some increase in inflation over the next 3-6 months, net inflation at end-2000 should remain around the lower bound of the CNB´s target range of 31/2 -51/2 percent. CPI inflation would be no more than 2 percent in 1999 and 4 percent in 2000 on the assumption that administered price adjustments would contribute 11/2 percentage points to inflation next year.
- Over the balance of 1999 and in 2000, fiscal and monetary policy will need to remain supportive of the economic recovery while nominal wage growth needs to continue decelerating to preserve the low-inflation environment and avoid undermining external competitiveness. Subsequently, fiscal policy will need to be tightened to unburden monetary policy and avoid undue upward pressures on the exchange rate while creating room for the expansion of private investment. This of course is contingent on a firm economic recovery. Meanwhile the momentum with respect to structural reforms must beC repeat must beC accelerated to improve the supply side of the economy and ensure balanced growth.
- The proposed budget for 2000, after including the substantial share of spending taking place outside of the state budget, implies a broadly neutral fiscal stance with the general government deficit (excluding privatization revenues and bank restructuring costs) rising from a projected 4 percent of GDP in 1999 to 41/2 percent of GDP in 2000. In the mission´s view, such a fiscal stance is warranted given the continued macroeconomic fragility and concern not to withdraw support for the economic recovery. Should the recovery falter, the authorities should not attempt to offset lower revenues by delays or cuts in expenditures. Similarly, if growth turns out to be higher than expected, the gains in revenues should be used to reduce the deficit.
- At the same time, there is a pressing need to develop a clear fiscal consolidation strategy that would reduce the general government deficit to 2-3 percent of GDP by 2002-03. Without major policy adjustments, even if high economic growth were restored and tight control over discretionary, non-capital expenditures were maintained, the medium-term fiscal prospects would be bleak with the deficit likely to remain above 5 percent of GDP. This is the result of a low buoyancy of tax revenues, the large share of mandatory expenditures and subsidies to enterprises, and the need to increase public investment in a number of areas, including to facilitate the development of regions with very high unemployment. Reform of the tax system and entitlement programs-as well as steps to reduce the fiscal drain stemming from the public subsidies to, among others, public transportation and mining-will thus be inevitable to ensure the necessary fiscal adjustment over the medium term. The authorities have no time to waste in developing a fiscal strategy and preparing the required reforms as the associated legal changes take time to implement and a first set of measures should be ready in time for the 2001 budget.
- In the mission´s view, the authorities should attempt to stabilize the ratio of taxes to GDP at around its current level by broadening the tax base and increasing indirect tax rates, in particular by harmonizing the VAT rate at its higher level and raising certain excise taxes to EU levels. However, most of the adjustment would need to take place on the expenditure side. Many of the required measures in these areas are discussed in the recent World Bank Country Economic Memorandum. As far as pensions are concerned-as also noted in our last concluding statement-reforms could include removal of special preferences to certain groups, adjusting the indexation mechanism so as to be based solely on inflation, introducing actuarially fair early retirement provisions, and strengthening the link between contributions and benefits. To address longer-term demographic developments, a continuation of the ongoing phased increase in retirement ages-in line with rising life expectancy-will also be needed.
- The mission is concerned about the plans to establish new extra-budgetary funds and to finance increased expenditures on housing and infrastructure investments from additional privatization revenues and possibly other sources. The envisaged expenditures are undoubtedly important, even critical to medium-term economic growth. However, the appropriate fiscal policy in a given year is-from a macroeconomic perspective-independent of the nature of financing, and privatization revenues merely imply that less reliance will need to be placed on debt financing-not that additional expenditures can be undertaken. What would make the additional spending on housing and infrastructure investments possible is not the privatization revenues but the reduction in other categories of expenditures discussed above. One should not place the cart before the horse. Extra-budgetary activities also raise questions about control and transparency. However, the authorities´ commitment to and progress with improving transparency in fiscal and other areas-and the mission´s understanding that the planned new funds will be subject to strict budgetary control with inclusion in the general government accounts and approval by parliament of their budgets-is comforting.
- The planned freeze of the wage bill in the public sector is a welcome reversal of the excessive increases in real wages in 1999, which were partly the result of the unexpectedly sharp drop in inflation. At the same time, the stop-and-go wage policy of recent years is not the way forward. In the future, public sector wages should reflect developments in the private economy and a clearly defined, long-term employment strategy. In this context, it would be important to strengthen the civil service and administrative capacity by widening the salary scale so as to be able to attract and retain highly qualified persons in key positions. In the enterprise sector, wage demands next year should also take into account the larger than expected real wage increase in 1999, as well as the continued rise in unemployment and the need to tailor wage settlements to the financial situation in different industries and enterprises.
- With inflation expected to remain subdued, monetary policy should continue to be accommodating and there may be room for a further easing, especially if assurances are received that wage demands will be moderate and that additional fiscal expenditures will be offset by savings in other areas of the budget, the exchange rate comes under renewed upward pressure, and net inflation does not pick up markedly in the coming months. However, interest rates have already been reduced by a large amount, and the room for further cuts is by definition much more limited. A renewed appreciation of the koruna would not be welcome in the current economic situation, and the mission fully supports plans to sterilize potentially significant privatization-related foreign direct investment inflows as well as the intention to postpone government issuance of debt in international markets. Direct foreign exchange market intervention by the CNB as practiced recently could also be a useful tool.
- The authorities can be commended for the considerable progress made in recent months in the restructuring and privatization of state-controlled banks. This process must now be completed very quickly. The current situation has paralyzed much of bank lending, as the largest banks refrain from committing new resources pending privatization. Bad loans do not get better over time, and early action is likely to yield maximum results. Actions to strengthen banks´ balance sheets prior to sale should be consistent with maximizing the net sale value of the banks and avoiding any costly delays in the process. At the same time, steps to strengthen creditor rights, in particular legal reforms to facilitate foreclosure and the power to seize collateral, should be implemented as a matter of urgency to restore the necessary balance between debtors and creditors essential for a functioning market economy. This also would improve the attractiveness of banks to investors and pave the way to ease the tight provisioning rules imposed by the CNB, thereby alleviating the continuing credit crunch. The role of the Consolidation Bank is critical in dealing with the bad assets. Its transformation from a bank into a work-out institution and merger with Ceska Inkasni and Ceska Financni would not only allow it the necessary flexibility to maximize loan recovery but also increase transparency.
- The mission welcomes signs that the long overdue enterprise restructuring is now taking place. Progress has been made in preparing the industrial revitalization program, which will have a role to play in finding foreign strategic investors for the large industrial enterprises that are currently severely distressed. However, it is clear that to be successful, the revitalization agency will need to be very selective, focussing on a handful of firms that are deemed viable and for which there is foreign interest. Acquiring control of the selected companies must be based on a fair market value of the shares, and until this is achieved, great caution needs to be exercised in providing new resources for these firms. Once firms are taken over, restructuring will in many cases be needed before the divestment, and it will be important that the revitalization agency be free from political interference if a rapid sale is to be achieved. In some cases, implementation of the program may require resort to the bankruptcy process, which, it should be stressed, does by no means imply liquidation. Other financially troubled firms, including the many smaller ones which are not included in the revitalization program, will in many cases also need to go through this process.
- There is therefore an urgent need to strengthen the bankruptcy and judicial framework. In the short term, there is likely to be substantial merit in creating a fast-track bankruptcy mechanism, comparable to what has been done in other emerging and transition economies faced with a large amount of bad debt to work out. This would mean enhancing the position of creditors and the role of bankruptcy administrators in searching for a solution acceptable to all parties, while maintaining the role of the court system to seal the agreement. Over the medium term, there will be a need to review all the supporting legislation, including among others the civil procedure and tax codes, to ensure that the legislative process is fully supportive of a modern market economy. The training of judges and bankruptcy administrators in areas of business practice will be equally essential.
- In other areas of structural reform, the mission would emphasize the need to also accelerate the privatization of non-financial strategic enterprises such as telecommunications and utilities, and it welcomes efforts in this regard. Several strategic companies are likely to be attractive to foreign investors, who could bring in additional capital and undertake the required investments to make these more efficient and competitive. This venture should be supported by full liberalization of administered prices, and a schedule for completing this process over the next couple of years should be announced. In addition to improving the efficiency of resource allocation, this should also lead to fiscal savings.
- Political posturing and special interests must be set aside and can no longer be allowed to curb the pace and scope of structural reforms. Bold steps are urgently needed to undertake the many reforms required to lay the basis for high, sustainable growth in the years to come and to ensure that the Czech Republic is successful in its endeavor to seek early accession to the EU. Time is running out.