Czech Republic

Presentation of the Czech Republic Economic Survey at a High Level Seminar in Prague


Remarks by Angel Gurría, OECD Secretary-General

Prague, 6 April 2010

Ladies and Gentlemen,

It is a pleasure to be back to Prague and present the 2010 edition of the OECD Economic Survey of the Czech Republic. 

What a difference a year can make. As late as 2008, when the global crisis was already unfolding, it was still possible for scholars and commentators to write of the 21st century as “the age of the small state”. Changes in the international order following the end of the Cold War had greatly reduced the importance of size for national security. At the same time, globalisation was making domestic market size ever less important to a nation’s prosperity. Small, open states dominated the top slots when the world’s economies were ranked according to income per capita, competitiveness and other indicators of economic performance.

They also performed better on non-economic indicators of welfare, like the UN’s Human Development Index. A good deal of evidence suggests that small countries are less prone to civil strife and enjoy higher levels of social trust. That may be one reason why small Scandinavian states invest so much on health and education and fare so well on human development indices. Other things being equal, governments in small countries can also find it easier to craft and implement policy. At times, this has given them a role as policy innovators far greater than their size would suggest, a role that has sometimes brought benefits to their larger neighbours.

By the end of 2009, however, we had rediscovered the truth of the scholars’ metaphor that small open economies are like little sailboats in an open sea. They are more manoeuvrable and may well move faster than larger, heavier vessels, but they are far more vulnerable if an economic storm blows up. While some of the small countries that were hardest-hit by the crisis suffered as a consequence of their own policy errors, many others simply found themselves swamped by an economic typhoon brought about by policy errors committed elsewhere and economic developments beyond their borders.

The Global crisis and the Czech Republic

To a great extent, this has been the experience of your country. As shown in the OECD Survey of the Czech Republic, before the crisis, growth was slowing in 2008 and significant policy challenges remained. Nevertheless, Czech fundamentals were fairly sound. With manageable external and fiscal balances, a flexible exchange rate, low inflation, sound banks and an absence of domestic financial bubbles, the country did not look particularly vulnerable to the on-going international financial turbulence. Both the business environment and the functioning of the labour market were improving.

Indeed, the Czech Republic held up better than most of its regional peers during the early stages of the crisis. However, the contraction in the first quarter of 2009 was the fourth-largest in the OECD area. And the evidence suggests that this outcome owed much to the country’s high degree of international openness.

It is unlikely that domestic policy responses could have offset such a sudden and extreme collapse in external demand as the one experienced by the Czech Republic at the end of 2008. Moreover, the resumption of growth in the second quarter was driven largely by some recovery of demand in external markets, which remain critical to growth prospects. While there are important policy challenges to be tackled, the principal up- and down-side risks to the Czech recovery right now are largely concerned with developments abroad.

In spite of all this, pre-crisis ideas about the advantages of small states are real enough. I would like to explore this afternoon the implications of the recent crisis for the Czech Republic. How can it make the most of globalisation while mitigating the vulnerabilities that small size entails?

At a global level, there are two key points to consider. First, international openness matters. Small countries, like the Czech Republic, have for decades been among the chief beneficiaries of an open international economy, and they would lose the most from any global drift towards protectionism. Fortunately, the protectionist temptation has largely been resisted so far. 

My second observation is that the crisis has emphasised that now more than ever, our neighbours’ policy errors can cost us dearly. This highlights the need for international institutions, like the OECD, to support sound policy making and implementation. This support includes through peer reviews of economic policies, such as the OECD Economic Survey of the Czech Republic, which we are launching today.

What, then, is to be done if international openness is both vital to the prosperity of small economies and a source of vulnerability to decisions and developments beyond their control? The answer, if I may return to the sailboat metaphor, is to make the vessel as seaworthy as possible. In some respects, smaller countries simply have less room for policy error than their larger neighbours.

How does this apply to the Czech Republic? A sound macroeconomic framework and a robust system of financial supervision are of primary importance to limit vulnerability to external shocks. Even though the practitioners of “macroeconomic virtue” often got hit as hard as those who were indulging in “sin”. Countries’ pre-crisis fundamentals are important and policies do matter. Czech households and firms have entered the recovery without the kind of debt burdens that remain a drag on growth in many economies. The banking sector appears to have come through the downturn in reasonably good shape. The sector’s resilience owed much to banks’ own choices, but also to the policy framework, including an integrated system of financial supervision. As a result, the Czech Republic has avoided a banking crisis, and the authorities do not face the challenge of unwinding costly emergency interventions. 

Limiting vulnerability: OECD recommendations for a stable, transparent and effective fiscal framework

However, the principal weak spot in the Czech Republic’s macroeconomic framework – fiscal policy – has limited its options in the face of the crisis. The deterioration in the fiscal position in 2009 was far greater than anticipated. In hindsight, fiscal policy prior to the crisis appears more pro-cyclical than was appreciated. Even at the top of the cycle, in 2006-2007, the general government balance was in the red.
This meant that there was little room to allow the automatic stabilisers to work, let alone to undertake a significant discretionary fiscal stimulus. Yet recent events have highlighted the need for governments to maintain some fiscal room for manoeuvre. This need will be all the greater after the Czech Republic adopts the euro. Fiscal policy will then be even more important in cushioning shocks.

As you know, the government’s response to the rapidly widening deficit was to shift relatively quickly from stimulus to consolidation. On balance, this move is to be welcomed. Rapidly rising deficits put pressure on the government’s cost of borrowing – which would have offset much of the impact of further fiscal stimulus. But the need to tighten so early in the recovery has clearly made things tougher for firms and households. This could have been avoided if the budgetary position had been stronger in the first place.

In this, of course, the Czech Republic is not alone. The experiences of many OECD countries over the last two years have underlined the need for a more rigorous, rules-based approach to fiscal policy. For a start, the existing Medium-Term Expenditure Framework can and should be strengthened by adopting a structural budget-balance target to complement nominal expenditure ceilings. OECD analysis suggests that budget-balance rules generally work better when combined with expenditure ceilings. The EU countries that have achieved the largest reductions of government debt (relative to GDP) in recent decades, such as the Netherlands, Sweden and Finland, have supplemented deficit rules with expenditure ceilings.

To be effective, rules must be observed: in the past, this has been a problem in the Czech Republic. Expenditure ceilings have sometimes simply been revised upwards under political pressure. This points to a need for rules to be simple and transparent, in order to facilitate public and media monitoring, as well as assessment by independent authorities.

These considerations point to two advantages of expenditure ceilings. First, spending caps can allow individual ministers to be held accountable for breaches. This is something the Czech authorities may wish to consider in future. Secondly, nominal expenditure ceilings are transparent – and thus easy to explain and to monitor.

There may be a trade-off between sophistication and ease of monitoring. Rules that are more sophisticated economically might make monitoring and public discussion more difficult. The Swedish budgetary framework, which has proved very successful, might represent a good model for the Czech Republic. It combines multi-year expenditure ceilings with a structural balance target and a balance requirement for local governments. The Swedish rule also reflects the need to prepare for the long-term consequences of population ageing. This is something the Czech authorities may want to consider in setting a structural balance target.

The government may also wish to explore policy options chosen by other OECD member countries. Germany has recently incorporated a much improved, balanced budget, fiscal rule in its Constitution. Giving the rule a higher legislative status signals a strong political commitment to fiscal discipline. The crucial challenge is, however, to establish broad and enduring support across the political spectrum for a stable, transparent and effective fiscal framework.

The experience of the last Czech excessive deficit procedure suggests that the government should be particularly vigilant if growth turns out to be better than expected. During 2003 08, higher-than-projected growth made it relatively easy to meet the deficit targets, but, as a result, this period of strong growth was not fully exploited as an opportunity to put public finances on a sound footing. This experience is by no means uniquely Czech. It is well known that fiscal policy tends to be more counter-cyclical in downturns than in upswings. The result, over time, is a deficit bias.

Part of the solution is clearly to build conservative macroeconomic assumptions into the budgetary process and to set spending caps with counter-cyclical aims in mind. This can be facilitated by an independent institution monitoring the adherence to a fiscal rule, like the Fiscal Policy Council in Sweden. Creating such “watchdogs” to monitor the fiscal policy process should make it easier to avoid overspending in good times and thus to limit deficit bias.

The importance of structural reforms for fiscal sustainability

I have dwelt at length on fiscal policy and institutions – an area in which, it appears that small countries have played the kind of policy innovation role I mentioned earlier. This is not, however, to deny the importance of structural reforms. The Survey team will discuss these in depth in a few moments, but I would like to introduce some important points before I close.

Neither medium-term fiscal consolidation nor long-term fiscal sustainability are likely to be achieved without structural reforms. Like most previous Czech consolidation efforts, the most recent fiscal measures are heavily tilted towards the revenue side. The experience of other OECD countries shows that fiscal consolidation is much more likely to be sustained if it is based on structural reductions in public expenditure, which are also consistently associated with better growth performance. Plans for 2011 and beyond should thus place greater emphasis on expenditure. This will require reforms of both budgetary processes and mandatory spending programmes.

Structural rigidities are likely to be more costly to small economies. Structural reforms are also essential to make product and labour markets more flexible and competitive. This will be particularly important when the Czech Republic enters the euro area and will no longer be able to rely on exchange-rate adjustments in response to shocks.

Ladies and gentlemen,

The OECD Survey of the Czech Republic pays a great deal of attention to the challenges that lie ahead - both macroeconomic and structural - and sets out a series of recommendations. The resilience of the Czech Republic in the face of extraordinary challenges puts the country in a strong position to pursue and succeed in addressing the challenges that lie ahead.

In conclusion, the economic storms of the past couple of years have opened up an opportunity to draw the appropriate lessons and proceed with needed reforms. Crises often serve as triggers for reform, both by highlighting structural weaknesses and by accelerating reforms, which have so far proved difficult to implement. 

A crisis is a terrible thing to waste. With the right policies and institutions, the Czech economy can be made into an even faster, more seawhorty ship as it seeks to navigate the uncharted waters of a rapidly changing global economy. In doing so, you can count on the OECD for support  I hope that our Survey will help to enrich your policy debates and decisions.