Economic Survey of the Czech Republic 2010: The challenge of fiscal consolidation after the crisis

 

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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of the Czech Republic published on 6 April 2010. 

 

Contents

The collapse of external demand hit an already slowing economy hard…

After several years of growth averaging close to 6% per annum, the economy slowed markedly in 2008, entering a sharp recession in the fourth quarter. Real GDP is projected to have fallen by 4.1% in 2009. This reflected the collapse of world trade that followed the onset of the global financial crisis. The economy’s integration in international supply chains, particularly its specialisation in the export of consumer durables and capital goods, made it vulnerable to such a global trade shock. The trade collapse quickly triggered a contraction in domestic demand, especially fixed investment. Private consumption growth turned negative in the third quarter of 2009, as households responded to rising unemployment and a sharp slowdown in wage growth. On the production side, most major sectors contracted, with tradables suffering the most. Manufacturing alone accounted for around half the total drop in gross value added, and service sectors linked to the cycle in manufacturing, like trade and transport, were also hit hard.


Real GDP turned around in the second quarter of 2009, driven by a slight pick up in exports against a backdrop of falling imports and decelerating consumption. The export recovery seems to have owed much to the adoption of car scrapping schemes and other measures to support the automobile sector in major export markets. Overall, the strength of the recovery will depend chiefly on the growth of world trade. Domestic demand will remain weak, with government consumption constrained by the need to bring down the budget deficit and private consumption growth depressed by rising unemployment, a bleak outlook for wage growth and the impact of fiscal consolidation measures.


After a short but sharp recession, the economy has returned to growth

Quarterly contributions to growth

 Source: OECD, National Accounts Database.

Although growth has resumed, the consequences of the recession for employment and living standards are still unfolding. Unemployment surged in the first quarter of 2009, which saw the largest one quarter increase in joblessness since the early 1990s, and reached 7.3% in the  fourth quarter. It would probably have risen higher still but for widespread use of the unsubsidised and collectively agreed “partial unemployment” provisions introduced into the Labour Code in 2007 (essentially a short time working regime). The evidence suggests that nominal wage flexibility also played a part in the labour market adjustment. While the employment impact of the recession was and remains painful, the response so far suggests that the labour market has become more flexible in recent years.


The banking system has weathered the crisis relatively well

The banking sector appears to have come through the downturn in reasonably good shape, although bank portfolios are yet to feel the full impact of the financial consequences of the contraction. Credit conditions grew tighter, particularly for households and borrowers in struggling sectors like construction. While interest rates on new loans to households rose, the tightening of credit to non financial firms appears to have taken the form of tougher non interest conditions. Interest rates on new loans to business actually fell slightly, but the decline was far smaller than the drop in the Czech National Bank’s (CNB) policy rate. Banks increased risk premia rather than passing on policy rate cuts to borrowers. This helped them to recapitalise so as to cope with the growth of non performing loans.


The resilience of the banking system reflected a number of factors, including prudent macroeconomic management and market structure. Low inflation and interest rate spreads meant that there was little incentive to borrow in foreign currency. In addition, Czech banks had pursued fairly conservative strategies, reflecting both the lessons drawn from past banking crises and their ability to make healthy profits from “normal” banking business. Their net external investment position was and remains positive, with domestic lending financed by the domestic deposit base. Finally, as subsidiaries of foreign banks, most Czech banks did not invest in “toxic” assets, even if their foreign parents did so.


Monetary policy helped cushion the shock

With inflation falling and the koruna near historically high levels, the CNB began to ease monetary policy in August 2008, cutting its main policy rate in stages by a total of 275 basis points over sixteen months to a historic low of 1.0%. It also responded to the turmoil in international financial markets in the autumn of 2008 by introducing a new facility for providing liquidity to banks, with the option of using government bonds as collateral. In the end, this facility was little used, and no bank required any direct public support. A significant weakening of the koruna against other major currencies in late 2008 and early 2009 also provided some relief to the tradable sector, although it was by no means sufficient to offset the collapse in external demand. Moreover, for many firms, the currency’s volatility in 2009 was more of an issue than its level.


Fiscal policy moved rapidly from stimulus to consolidation

In an effort to address the unfolding crisis, the government in late 2008 and early 2009 adopted a range of fiscal stimulus measures amounting to about 2.2% of 2008 GDP, spread across 2009 10. The failure to pursue fiscal consolidation more vigorously during the years of strong growth that preceded the crisis meant that there was no fiscal space for any larger stimulus. The authorities in any case recognised that, in such an open economy, using fiscal policy to stimulate aggregate demand would not be effective. The stimulus measures therefore primarily targeted the supply side. They were aimed at limiting employment losses by reducing non wage labour costs, mitigating the investment contraction and supporting exports by providing guarantees, which were becoming increasingly unavailable due to dysfunctional global financial markets.


As the year unfolded, the budget balance deteriorated faster than had been anticipated. By the third quarter, the government was projecting deficits of 6.6% for 2009 and, if corrective action were not taken, over 7% for 2010. This raised the prospect of significant increases in the government’s cost of borrowing and of a crowding out effect that could inhibit the recovery of private investment. The government responded with a fiscal consolidation package ahead of the 2010 budget. On balance, the decision to withdraw from fiscal stimulus relatively early is to be welcomed. Domestic fiscal tightening is unlikely to be decisive with respect to the sustainability of the recovery, which depends chiefly on developments in external markets.


The fiscal position deteriorated throughout 2009

Central budget, CZK bn

Note: Balance is revenue minus expenditure.
Source: Ministry of Finance, Government Financial Statistics.

 

An ambitious medium term consolidation strategy is needed

The consolidation package was largely limited to 2010, because the government in office was a caretaker cabinet appointed following the fall of the previous centre right coalition. While the revenue measures adopted were of indefinite duration, changes on the expenditure side were confined to the coming year. One of the most important challenges for the government in 2010 is to formulate a credible multi year strategy for fiscal consolidation. The measures for 2010, like past Czech consolidation efforts, were heavily weighted towards the revenue side, partly in an effort to make up the revenue losses experienced in the wake of the crisis. However, a good deal of cross country empirical work suggests that consolidation is both more likely to be sustained and less likely to depress growth if it is based on spending restraint. There is also evidence to suggest that a substantial share of public spending in the Czech Republic is inefficient. Consolidation plans for 2011 and beyond should thus place greater emphasis on the expenditure side of the budget. Reducing the deficit from an estimated 6.6% of GDP in 2009 to a level below the Maastricht Treaty threshold of 3% of GDP as required under the EU’s Excessive Deficit Procedure will be an important milestone but is not a sufficient goal for fiscal policy. Ultimately, the government needs to aim for a structural balance close to zero to ensure long run fiscal sustainability and retain the capacity to rely on discretionary fiscal measures or automatic stabilisers to offset future shocks. The adoption of a structural indicator of the budget balance would strengthen the current system of nominal expenditure ceilings and would also increase the transparency of fiscal policy. The authorities may also wish to consider the examples of some other OECD member countries, which have adopted constitutionally entrenched fiscal rules.


While legislative change will be needed to bring about structural spending reductions in many areas, aspects of expenditure policy that are under the government’s direct control can be addressed relatively quickly. Reforms to the budgetary process, particularly as regards rigorous ex ante and ex post scrutiny of expenditure programmes, improvements in budgetary transparency and overhaul of public procurement practices are long overdue and could pay significant dividends in coming years. The speedy implementation of plans to shift to a treasury system of budgetary management should also be regarded as a very high priority. The unified accounting and real time financial management that the treasury system will bring should yield direct savings, by reducing debt service costs and administrative overheads, and should also make it easier to identify where there may be scope for further streamlining of expenditure. Since social spending represents the largest share of non discretionary expenditure it will also have to be addressed. A review of social spending should be undertaken, with particular attention to whether some benefits that are not income tested should be phased out at higher incomes. Some savings and revenue increases should also be generated by reforms of tax collection and further steps to improve tax compliance (see below).

 

The prospect of euro entry could facilitate consolidation

In view of the fiscal situation, adoption of the euro can only be a medium term prospect and will depend in part on economic and fiscal developments that are hard to predict at this point. The Czech Republic is unlikely to bring its deficit back below 3% before 2013, and the target date for entry will depend crucially on when this goal is reached. The previous government had planned to set a date in 2009, but domestic political developments and the economic crisis meant that this did not happen. As economic conditions normalise and the recovery takes hold, the next government should revisit the issue. After the policy zigzags, economic turmoil and exchange rate volatility of the last two years, clarity about meeting the conditions for euro accession, even if it is a medium term objective, would help reduce uncertainty for business. It would also help anchor expectations and mobilise political capital for a sustained fiscal consolidation effort and other structural reforms. The authorities should therefore outline a clear strategy to put in place on a sustainable basis the conditions for euro area entry.


The fiscal consequences of population ageing remain the principal long term challenge

Ensuring long term fiscal sustainability remains a serious challenge, owing chiefly to the fiscal consequences of rapid population ageing. The ratio of age related spending to GDP is projected to rise by 6.4 percentage points over the period to 2060. In the absence of policy change, the Ministry of Finance estimated even before the crisis that this would push the public debt past 60% of GDP shortly after 2040, rising to 250% of GDP around 2060. Post crisis debt dynamics look even worse. Two areas – healthcare and pensions – account for the largest part of this growth, with the latter by far the more important. Largely parametric reforms in these two areas have been initiated in recent years.


Recent legislation extending the increase in the retirement age will do much to fend off the threat of looming increases in pension spending, but on current projections pension expenditure is still set to rise from around 7.8% of GDP in 2007 to roughly 11 by 2060. Tackling this challenge without imposing large – and possibly unsustainable – increases in social security contributions or other taxes is likely to require a combination of both further parametric adjustments to the system and structural changes. A first step would be to take the recent changes in the retirement age further by phasing out the differentiation of women’s retirement ages. The possibility of instituting partial indexation of the retirement age to life expectancy should also be considered. Increasing labour force participation among groups with high benefit recipiency rates, as well as policies to boost labour supply, such as migration policy, could also help to address this problem.


The previous government’s pension reform plans envisaged the creation of a voluntary, fully funded, defined contribution “second pillar” to the pension scheme, which would be financed by allowing individuals to divert a portion of their pension contributions from the “first pillar” – a public pay as you go (PAYG) defined benefit system – to private pension funds. They would be required to top up this “carve out” with further contributions of their own. These plans are currently stalled, and recent turmoil on financial markets may have made it politically harder to win public support for funded schemes. Nevertheless, the case for diversification of retirement income sources remains as strong as ever, and the introduction of the second pillar would be a welcome step in this direction. However, given the highly redistributive nature of the first pillar, a voluntary carve out could undermine its financial sustainability. The better paid would face very strong incentives to take the carve out option, because the first pillar offers them much lower returns on their contributions than it does the low paid. The next government should resume work on the second pillar and should consider making it mandatory or, at the least, using “soft compulsion” by requiring individuals to opt out of it rather than into it. The regulatory framework will need to be designed so as to balance return considerations, income security and the need to minimise financial overheads.


Ambitious plans for healthcare reform have largely stalled, following a political backlash against the introduction of small user fees for doctor consultations, prescriptions, emergency room visits and hospital stays in 2008. There has been limited progress in respect of other aspects of healthcare reform, such as changes in price setting for pharmaceuticals or liberalising the rules that govern negotiations between insurers and healthcare providers. The benefits of these measures have yet to be seen. Other planned changes, such as improvements in the definition of the basic healthcare package provided by the public system and increases in the diversity of insurance products on the market have not been adopted at all. The government should revitalise the healthcare reform process, moving ahead with plans to redefine the basic publicly provided healthcare package and allow greater diversity of insurance products. It should also move to eliminate distortions in healthcare markets created by regional authorities’ ad hoc tinkering with the system of user fees.


Institutional innovations could yield greater policy coherence

In recent years, policy in many domains seems to have been characterised by frequent changes of direction and by difficulty in ensuring a co ordinated approach to policies that cut across the divisions between government ministries or between central, regional and municipal authorities. The independence of individual ministries and the lack of a strong institutional centre capable of ensuring unity in approach and consistency in implementation present a particular challenge when policy reform requires a whole of government approach, like regulatory reform or fiscal consolidation. These difficulties reflect such diverse factors as the country’s administrative traditions, the nature of the political system and the constitution. However, they are not insoluble problems. OECD governments are structured in a wide variety of ways and they have likewise evolved a wide range of mechanisms for ensuring policy coherence and fiscal discipline. A number of member countries achieve these objectives even in environments characterised by complex political coalitions, minority cabinets and a centre of government with relatively limited authority. Policymakers could profitably explore the potential for similar solutions to bring results by, for example, creating a fiscal council or similar institution to strengthen adherence to a rules based framework for fiscal policy. In terms of structural policy, mechanisms to strengthen high level communication and co ordination across ministries are needed in order to establish greater stability and coherence in policy making; here a council of chief economists, bringing together the top economists of the various ministries could have a role to play. Changes in the internal organisation of ministries may be needed to facilitate such cooperation. 
 

How to obtain this publication

The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations

Czech version

 

The complete edition of the Economic Survey of the Czech Republic is available from:

 

Additional information

For further information please contact the Czech Republic Desk at the OECD Economics Department at eco.survey@oecd.org.

The OECD Secretariat's report was prepared by William Tompson, Zuzana Šmídová, Laura Vartia, Zdeněk Hrdlička and David Prušvic under the supervision of Andreas Wörgötter. Research assistance was provided by Margaret Morgan.

 

 

 

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