REPORT FROM THE COMMISSION - Czech Republic - Report prepared in accordance with Article 104(3) of the Treaty

1. Introduction and justification of the report

On 7 April 2004, the Commission published its Spring 2004 forecasts. According to these forecasts, which took into consideration data reported by the Czech Republic and validated by Eurostat in March 2004, the general government deficit in the Czech Republic reached 12.9% of GDP in 2003, thus exceeding the 3% of GDP Treaty reference value.

Table 1: General government balance and debt (% of GDP) (a)

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(a) Nominal GDP since 2000 is taken from the 2003 EDP notification.

Source: Eurostat and Commission Spring 2004 forecasts.

At this stage, the estimated figure for the 2003 deficit provides evidence on the existence of an excessive deficit in the Czech Republic, in the sense of the Treaty and the Stability and Growth Pact. The Commission therefore has decided to initiate the excessive deficit procedure (EDP) for the Czech Republic.

The application of the EDP is governed by Article 104 of the Treaty and Council Regulation (EC) No 1467/97 "on speeding up and clarifying the implementation of the excessive deficit procedure", which is part of the Stability and Growth Pact (SGP).

Article 104(3) of the Treaty stipulates that "if a Member State does not fulfil the requirements under one or both of these criteria [1], the Commission shall prepare a report. The report of the Commission shall also take into account whether the government deficit exceeds government investment expenditure and take into account all other relevant factors, including the medium-term economic and budgetary position of the Member State. ..."

[1] The criteria are (a) whether the ratio of the planned or actual government deficit to gross domestic product exceeds the reference value of 3%, unless: either the ratio has declined substantially and continuously and reached a level that comes close to the reference value; or, alternatively, the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value; (b) whether the ratio of government debt to gross domestic product exceeds the reference value of 60%, unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace.

The present report prepared by the Commission according to Article 104(3) assesses recent and current budgetary developments in the Czech Republic and reviews the short-term prospects in the light of overall economic conditions and policy action taken by the government.

2. Recent macroeconomic developments and prospects

After the currency crisis in 1997 leading to a 10% depreciation of the Czech koruna, the Czech economy faced a recession. In 1998, real GDP contracted by 1% and grew by a meagre 0.5% in 1999. Thereafter, GDP growth resumed to about 3%, with the exception of 2002 when the country was hit by serious floods. The growth performance has been underpinned by structural changes, in particular in the banking sector. The restructuring process has been supported by significant FDI inflows which have been the main driving force behind domestic investment and employment creation. Albeit resilient to an unfavourable external environment in recent years, GDP growth has been relatively low, in particular when compared with some other new Member States. Real convergence in terms of GDP per capita has increased, reaching almost 64% of the EU-15 average in 2003. GDP growth is predicted to be 2.9% in 2004, the same as in 2003, and to accelerate to 3.4% in 2005.

As regards growth composition, domestic demand has been the main driving force of GDP growth. The positive contribution of external trade in the late 1990s was mainly the result of the depreciation of the Czech koruna in 1997. The net external contribution has turned negative since 2000, reflecting the high import intensity of domestic demand. The period of strong domestic demand 2001-2003 was supported by an expansive fiscal policy. For 2004 and 2005, the Commission forecasts a somewhat weaker contribution of domestic demand and a diminishing negative contribution of external trade.

Table 2: Macroeconomic developments and outlook

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(a) Net lending/borrowing vis-à-vis the rest of the world = current account + capital account

Source: Eurostat and Commission Spring 2004 forecasts.

As a result of the economic slowdown of 1997/1998, unemployment increased steeply from 4.8% in 1997 to 8.6% in 1999. After a further slight increase in 2000, unemployment decreased in the following period of economic recovery, but only marginally, which points to its structural nature. In addition to the ongoing restructuring process, unemployment is expected to be affected by the 2003 public finance reform, according to which public sector employment should be reduced by 2% annually over the period 2004-2006. The unemployment rate is expected to exceed 8% in 2004 and 2005.

Tight monetary policy and the 1997/1998 economic recession caused a dramatic fall in inflation. Inflation has been targeted within a declining band of 3-5% (as of January 2002) to 2-4% by the end of 2005 [2]. The monetary authorities have been undershooting this target since early-2002 and the Czech Republic faced falling prices in 2003. In 2004, inflation is forecast to increase to 2.8% on average, mainly as a consequence of increases in indirect taxes. It is expected to remain at 2.8% in 2005, assuming that second-round effects of the tax increases are kept under control. Interest rates have declined to historical lows (since August 2003 the base rate has been 2%). Nominal wages are expected to increase by 4% in 2004 and 2005 and unit labour costs to be contained by productivity gains.

[2] The basic framework of monetary policy has remained unchanged since 1997, when the Czech National Bank (CNB) abandoned its fixed exchange rate regime for a managed float and adopted inflation targeting.

3. The situation of government finances

Since the end of the 1990s, the general government deficit has been widening, remaining well above the 3% of GDP reference value. In 2003, the deficit reached 12.9% of GDP (including the cost of a major one-off operation estimated at 6-7% of GDP). In addition, both the Commission and the national authorities forecast the deficit to stay well above the 3% threshold in 2004 and 2005. The debt-to-GDP ratio remains comfortably below the 60% of GDP reference value, but its dynamics in recent years is worrying.

The analysis of budgetary developments in the Czech Republic is complicated by the ongoing revision of national accounts, including budgetary statistics, which should be completed by June 2004, and by the general lack of ESA95 data on general government revenues and expenditures. The lack of ESA95 data concerns both the functional sub-components of revenues and expenditures and the institutional sub-components of the general government.

3.1. Recent budgetary developments until 2002

The steady widening of the deficit since the end of the 1990s has been heavily affected by two factors: first, by the operations of transformation institutions, in particular of the financial group of the Czech Consolidation Agency (CKA) [3], and second, by a rapid increase of social expenditures of the central government.

[3] The financial group of the CKA was officially established on 1 September 2001 and it is the successor to the former Konsolidacni Banka. The most important part of the whole group is the Czech Consolidation Agency itself. The rest of the group is composed of the CKA's subsidiaries - Ceska financni, Konpo, Sanakon, Prisko and the Revitalisation Agency (the last three being negligible in financial terms). Another transformation institution is the Ceska Inkasni operated by the Czech National Bank. Apart from the CKA, another important transformation institution is the National Property Fund.

The CKA has been used to improve the performance of the banking sector, in particular to prepare it for consolidation and privatisation, and to help with the restructuring of the business sector. Through the CKA, the Czech state has taken over many bad assets and explicit and implicit guarantees which caused the rapid deterioration of the deficit in recent years. For instance, in 2002, the deficit of 3.9% of GDP notified in April 2003 was revised upwards in August (the 2003 Pre-Accession Economic Programme, PEP) to 6.4% of GDP reflecting the inclusion of capital transfers to the CKA [4]. An even more rapid increase in public debt was prevented by high privatisation revenues.

[4] More information, in particular on the timing of changes in the fiscal position, will be known only in June 2004 when the Czech Statistical Office publishes revised national accounts data.

Social expenditures (pensions, maternity leave, family allowances etc.) have displayed the highest growth dynamics among all expenditure items. A significant fiscal consolidation package in 1997 and 1998 targeted the government-sector wage bill and capital spending but left entitlement programmes untouched. As a consequence the discretionary cut in spending was offset by increases in social expenditures. In the period 1995-2001, social expenditures almost doubled, rising twice as fast as total general government expenditures, so that they represented 1/3 of total spending in 2001 [5]. Social expenditures, for the most part mandatory, have been basically crowding out all other types of expenditure. Rapidly increasing mandatory and quasi-mandatory expenditures have contributed to the widening of the deficit, also when the economic recovery took hold in 1999.

[5] According to the GFS86 (Government Finance Statistics) methodology, which measures government revenues and expenditures on a cash basis. In GFS86 terms, total expenditure does not include transfers to transformation institutions.

Table 3: GDP growth and general government balance and debt (a)

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(a) Nominal GDP since 2000 is taken from the 2003 EDP notification.

Source: Eurostat and Commission Spring 2004 forecasts.

The time profile of the budget deficit to a large extent mirrors developments in the primary balance which has deteriorated from -3.4% of GDP in 1998 to -5.0% of GDP in 2002. Interest payments have remained well under control over the whole period, oscillating between 0.9% and 1.5% of GDP. This was due to decreasing interest rates thanks to the disinflationary environment which broadly offset the impact of rapidly increasing public debt.

3.2 Budgetary developments in 2003

The budget planning for the year 2003 took place after parliamentary elections in June 2002 and the transition to a new government. The 2003 PEP targeted the general government deficit to increase from 6.7% in 2002 to 7.6% of GDP in 2003 (in ESA95 terms) [6]. However, due to the one-off imputation of state guarantees to ESA95 general government expenditure, which reflects the fiscal impact of the operations of the transformation institutions [7], the 2003 deficit reached 12.9% of GDP. The expenditure-to-GDP ratio for the general government increased sharply (from 52% in 2002 to almost 58% in 2003), whereas the revenue-to-GDP ratio remained almost unchanged (45%). Without the imputed state guarantees, the deficit would be about 6% of GDP, i.e. lower than expected in the 2003 PEP.

[6] Based on the old (lower) GDP figures.

[7] See footnote 3 and the second paragraph of Section 3.1.

Using GFS86 allows a better understanding of budgetary developments in 2003. In December 2002, the government expected relatively high economic growth (3.3%) and a general government deficit of 7.8% of GDP. In September 2003, the government modified the budget, reflecting mainly one-off spending related to arbitration proceedings against the CME [8] and expenditure for repair works after the 2002 floods. At the same time, the Czech Ministry of Finance revised its GDP forecast downwards. As a result, the expected general government deficit increased to 8.3% of GDP. When comparing the 2003 outcome with the original budget target of December 2002, the deficit-to-GDP ratio was 2 percentage points lower, despite a lower growth rate than originally expected and the inclusion of the one-off spending.

[8] In 1993, CME (Central-European Media Enterprises Group) bought the first Czech private TV broadcaster NOVA. CME sued the Czech Republic for not protecting its investment. In 2003, the Czech Republic lost the case before the arbitration court in Stockholm which cost it almost 0.5% of GDP (about 320 mil. EUR).

Table 4: Successive targets for the 2003 general government balance and estimated outcome

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(a) The figures for the state budget plans use the then most recent Macroeconomic Forecast of the Ministry of Finance.

(b) In GFS86 terms, excl. financial transactions (e.g. privatisation receipts).

Source: Commission services

The better-than-expected outcome of the general government deficit in 2003 at around 6% of GDP (without the imputed state guarantee) was mainly due to the positive execution of the state budget which is the biggest item of the general government. On the revenue side of the state budget, tax receipts were 2.3% higher than expected in the budget presented in December 2002. To this result contributed in particular VAT receipts (3.6% higher than expected), and excise duties (8% higher than expected) related to high household consumption in the second half of the year. On the expenditure side, unemployment benefits and capital expenditure were substantially higher than planned, by 10.3% and 9.2% respectively. Overall, expenditures were only 1.6% higher than foreseen in the budget.

Apart from the state budget, lower-than-planned spending of extra-budgetary funds and higher-than-expected revenues of the National Property Fund also contributed to the better-than-expected outcome of the 2003 general government budget.

On the whole, the upward trend in social spending was not reversed and the deficit, even when adjusted for the one-off imputation, remains high.

3.3. Prospects for 2004

In reaction to high deficits and increasing public debt, in 2003 the Czech government adopted a fiscal consolidation plan for the years 2004-2006. The aim of this plan is to reduce the general government deficit to 4% of GDP in 2006. The envisaged expenditure savings should ensure 70-80% of the total consolidation, while 20-30% should be achieved through increased revenues.

The three major expenditure-side measures are a cut in the wage bill of the public sector (including the reduction of public sector employment), reductions in discretionary spending of individual ministries and reductions in sickness benefits. Those three measures together constitute more than ¾ of all expenditure cuts. On the revenue side, a shift is foreseen in the tax structure: lower revenues from corporate income taxes (due to a reduction of the rate from 31% to 28%) should be more than offset by an increase in VAT and in excise duties. The 2004 budget incorporated the first stage of this adjustment effort, but the deficit is expected to remain high.

The target for the general government deficit in 2004 has been 5.9% of GDP as put forward in the 2003 PEP. In nominal values, the Commission Spring 2004 forecast projects a slightly worse deficit than the Czech government. The difference reflects a less optimistic view on the final outcome of cuts in government consumption. It also takes into account a part of remaining state guarantees. However, because of the upward revision of GDP since the 2003 PEP, the deficit-to-GDP ratio turns out to be the same (5.9% of GDP). This means that there would be no progress compared to 2003 if one abstracts from the imputation of guarantees in 2003.

3.4. Recent debt developments and prospects

Although the debt-to-GDP ratio remains well below the 60% of GDP reference value, its dynamics have been worrying. Between 1998 and 2003, the debt-to-GDP ratio almost tripled. It reached 37.6% of GDP in 2003 and is forecast to rise to over 40% of GDP in 2004.

The steep increase in the debt ratio since 2002 is due to a combination of high fiscal deficits (including debt assumptions) and a drop in privatisation proceeds. However, the snowball effect is mitigated by a reduction in the implicit interest rate of government debt. This is because a part of government debt - in particular the government guarantees that are already recorded as government debt and that were recorded as deficit-increasing capital transfer in recent years - bears no interest [9].

[9] Some of these guarantees have not yet been called and have not yet led to any effective cash disbursement. However, they were already recorded as government debt given the expectation that the government will have to honour these commitments.

Table 5: Debt dynamics

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Source: Eurostat and Commission Spring 2004 forecasts.

4. Other relevant factors

4.1. Medium term prospects

According to the Czech pre-accession economic programme submitted in August 2003, the government planned to reduce the general government deficit to 4% of GDP in 2006 and to the Treaty reference value of 3% of GDP by 2008. These targets remain valid.

The medium term prospects for the Czech public finances will be affected by several institutional changes in the fiscal policy process. The government plans to adopt those changes in 2004. The major institutional innovation is the introduction of medium-term expenditure frameworks. With the annual budget for year n, the government has to present expenditure ceilings for years n+1 and n+2. Another important institutional innovation is the inclusion of the extra-budgetary spending under the budget headings of individual ministries.

By contrast, the administrative reform adopted in 2003, which created 14 new regional administrations as a further layer of territorial government, in addition to about 6000 municipalities, may make budgetary implementation more difficult.

Regarding long-term sustainability, some parametric reforms of the pension system were adopted in 2004. The government only agreed on some very general principles of future pension reform. A plan for the health care reform is still missing.

4.2. Investment

Article 104(3) of the Treaty foresees that the present Commission report "shall also take into account whether the government deficit exceeds government investment expenditure". Since 2000, the general government deficit of the Czech Republic consistently exceeded general government gross fixed capital formation (see table 3). This has been oscillating between 2.8% and 5.7% of GDP, well above the EU-15 average of 2.3% of GDP over the same period, reflecting the catching up processes in the Czech economy. Moreover, the government is likely to make commitments related to co-financing of EU-financed investment.

4.3. External account

The external account [10] deficit has been increasing since 1998 and is currently above 6% of GDP. This is the combined result of declining surpluses on the service balance and of large and increasing deficits on the income balance (mostly due to increases in both repatriated and reinvested profits in FDI companies). The trade deficit has diminished and reached around 3% of GDP, despite a strong appreciation of the Czech koruna and an economic slowdown in major trade partners in recent years. Although the external account deficits have been more than covered by surpluses in the financial account, the structure of the financial account surplus has recently changed. The financial account surplus in 2003 was mainly due to inflows of short-term capital, rather than of FDI inflows which dropped from around 13% of GDP in 2002 to around 3% of GDP in 2003.

[10] Net lending/borrowing vis-à-vis the rest of the world = current account + capital account. In the current system of national accounts, this is what corresponds to the concept of the "balances of payments on current account" mentioned in Article 121(1) of the Treaty.

5. Conclusions

The general government deficit of the Czech Republic increased to 12.9% of GDP in 2003 (including the cost of a major one-off operation estimated at 6-7% of GDP), in a context of solid economic growth. The excess of the general government deficit over the 3% of GDP reference value does not result, in the sense of the Stability and Growth Pact, from an unusual event outside the control of the Czech authorities, nor is it the result of a severe economic downturn.

According to the Commission Spring 2004 as well as the Czech authorities forecast, the general government deficit will, at around 6% of GDP, be well above 3% of GDP in 2004. The debt-to-GDP ratio is forecast to increase by some 3 percentage points to around 41% of GDP in 2004.