On June 22, 2018, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Czech Republic.
Growth has been strong, broad-based and job rich. The economy grew at 4.4 percent last year, led by strong domestic demand. The unemployment rate fell to a record low of 2.3 percent in April 2018, even with increased participation, and real wage growth reached 6.5 percent in the first quarter of this year. Meanwhile, headline and core inflation are close to the target of 2 percent.
Growth is projected to remain strong this year, at 3.7 percent, but labor shortages are putting constraints on future growth. Firms report hiring problems, especially of those with appropriate skills, with more than one vacancy per unemployed person. Longer-term growth will depend on the potential for productivity to compensate for the decline in labor supply. In the near term, a decline in global trade (such as from increased protectionism) is a major risk for a small economy highly dependent on external demand, particularly from the euro area, but also indirectly from other regions given how tightly integrated is the Czech economy into supply chains.
Monetary policy has continued gradual normalization. The central bank has gradually raised the policy rate to 0.75 percent after foreign exchange interventions ceased in April 2017. The nominal effective exchange rate has appreciated by 6 percent since the floor was lifted, notwithstanding some recent depreciation.
The banking system is well capitalized, liquid, and profitable. Private credit growth is in line with nominal GDP growth, but household lending is growing more quickly and some households have become highly leveraged. To address risks, the Czech National Bank has further tightened the macroprudential stance by announcing recommended limits to debt-to-income and debt-service-to-income ratios.
Strong tax revenues and lower capital and social benefits spending resulted in significantly better fiscal balances than expected, with the overall balance reaching 1.6 percent of GDP in 2017. Together with a negative interest-growth differential, this drove public debt down to 35 percent of GDP. The overall balance is expected to be the same this year and then gradually ease to about 1 percent of GDP.
Several structural measures were implemented recently, including the simplification of building permits procedures, reform of regional education funding to improve the quality of regional education, and vocational training reform aimed at increasing coordination with businesses. However, challenges remain, in particular the need to increase participation and productivity as much as possible as the working population ages and shrinks in size.
Executive Board Assessment
Executive Directors commended the Czech Republic’s strong economic performance. They noted that the economy has strong fundamentals and a favorable outlook. Nonetheless, a decline in the labor force will pose a challenge to continued strong growth over the longer term. Directors encouraged the authorities to maintain prudent macroeconomic policies and step up structural reforms to boost potential growth and productivity.
Directors broadly concurred that, given the uncertainty about the inflation outlook and interest rates still close to zero, the gradual normalization of monetary policy remains appropriate. Directors noted, however, that the Czech National Bank (CNB) should continue to communicate its readiness to raise rates earlier than currently projected if inflationary risks intensify. Directors took note of the staff’s external sector assessment and the authorities’ views. They suggested that greater elaboration on the assumptions justifying the overall assessment would be useful.
Directors agreed that the high leverage of some households could become a source of financial vulnerability, and welcomed the additional macroprudential measures announced by the CNB. They recommended that the CNB be given binding powers over loan‑to‑value, debt‑to‑income, and debt‑servicing‑to‑income ratios to ensure the enforceability of these prudential measures. Directors underscored the importance of better access to data for effective financial supervision.
Directors welcomed the authorities’ continued fiscal discipline. They emphasized that fiscal policy should avoid procyclicality. Although some proposals such as extra spending on education and infrastructure could boost productivity, fiscal policy overall should avoid adding to demand pressures in the economy. Directors noted that demands on the budget will increase over the longer term as the population ages, and urged the authorities to address long‑run spending issues related to healthcare and pensions.
Directors underlined the need to step up structural reforms in the face of the unfavorable demographic outlook. Policies aimed at increasing the participation of young women and older workers could help slow the decline in the labor force. A number of measures could facilitate higher productivity, including realigning tax incentives to guarantee the best use of resources, enhancing the efficiency of public services, improving the business environment for smaller and younger firms, having a unified long‑term plan for infrastructure, and enhancing the framework for life‑long learning.
It is expected that the next Article IV consultation with the Czech Republic will take place on the standard 12‑month cycle.
Image credit: IMF
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