Council opinion of  24 January 2006  on the updated convergence programme of the Czech Republic, 2005-2008
Date: 2006-01-24
Institutions: Council of the European Union
Subjects: Czechia, stability programme

7.3.2006

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Official Journal of the European Union

C 55/5

COUNCIL OPINION

of 24 January 2006

on the updated convergence programme of the Czech Republic, 2005-2008

(2006/C 55/02)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveil-
lance of budgetary positions and the surveillance and coordination of economic policies (1), and in particu-
lar Article 9(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

(3)

On 24 January 2006 the Council examined the updated convergence programme of the Czech
Republic, which covers the period 2005 to 2008.

After achieving progress in economic reforms and in stabilisation by mid-1990s, the Czech Republic
experienced macroeconomic imbalances, leading to a foreign-exchange crisis in May 1997 and to an
economic recession in 1997-1999. Comprehensive structural reforms in the financial and enterprise
sectors helped the economy to recover from 2000. Since then real annual GDP growth averaged
about 3 %, compared to an average annual growth rate of 1,7 % in the EU. The programme contains
three different scenarios for the macroeconomic and budgetary projections: an ‘optimistic’ scenario,
a ‘baseline’ and a ‘pessimistic’ scenario. The ‘baseline’ scenario is considered as the reference scenario
for assessing budgetary projections because, assessed against currently available information,
it
appears to be based on plausible growth assumptions, tilted to favourable in the outer year. It envi-
sages that real GDP growth will slightly decrease from 4,8 % in 2005 to 4,3 % on average over the
rest of the programme period. The cyclical component of growth is likely to be higher than implied
by the programme's projections. The programme's projections for inflation appear to be on the low
side.

On 5 July 2004, the Council decided that the Czech Republic was in excessive deficit. According to
the Council recommendation under Article 104(7) of 5 July 2004, the excessive deficit has to be
corrected by 2008. In its opinion of 18 January 2005 on the previous update of the Czech Repub-
lic's convergence programme covering the period 2004-2007, the Council recommended to the
Czech Republic ‘to allocate higher-than-budgeted revenues to deficit reduction and adhere strictly to
the medium-term expenditure ceilings for central government, which become legally binding from
2006’. Furthermore, the Czech Republic was invited ‘to step up the pension reform and to undertake
the reform of the healthcare system to improve the long-term sustainability of the public finances’.

(4)

The programme broadly follows the model structure and data provision requirements for stability
and convergence programmes specified in the new code of conduct (2).

(1) OJ L 209, 2.8.1997, p. 1. Regulation as amended by Regulation (EC) No 1055/2005 (OJ L 174, 7.7.2005, p. 1). The

documents referred to in this text can be found at the following website:
http://europa.eu.int/comm/economy_finance/about/activities/sgp/main_en.htm

(2) The programme provides all compulsory and most optional data prescribed by the new code of conduct.

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(5)

(6)

(7)

(8)

The general government deficit for 2005 is estimated at 3,2 % of GDP, based on the Commission
services' autumn 2005 forecasts, against a targeted deficit of 4,7 % of GDP in the previous update
and compared to a very cautious estimate of 4,8 % of GDP in the current update. The Commission
services' estimate of the deficit outcome reflects more recent information on the budgetary perfor-
mance of the central government, in particular of the state budget, which recorded higher-than-
planned tax revenues and an under-execution of expenditures of about 1,5 % of GDP.

This update aims at reducing the general government deficit to below the 3 % of GDP reference
value in 2008, in line with the Council recommendation under Article 104(7). In particular,
it
projects the deficit to be cut by over 2 percentage points of GDP between 2005 and 2008 and the
primary deficit by 2,3 percentage points. However, excluding the impact of two one-off expendi-
tures in 2005, the improvement in the nominal deficit over the period is only 1 percentage point of
GDP. The deficit reduction mainly reflects a cut in the expenditure ratio (by 2,3 percentage points
of GDP) over the programme period, while revenues are broadly unchanged (-0.2 percentage point).
Public consumption and social transfers are the expenditure items that are planned to decline most
as a percent of GDP. Public investment is foreseen to rise strongly, from 5 % of GDP in 2004 to
over 6 % of GDP in 2008, well above the EU average (2,5 % of GDP in 2005). Compared with the
previous programme,
the November 2005 update broadly confirms the planned adjustment,
although the underlying macroeconomic scenario is considerably stronger.

Over the programme period, the structural balance (i.e. the cyclically-adjusted balance net of one-off
and other temporary measures) calculated according to the commonly agreed methodology is
planned to improve by ½ % of GDP. The programme sets the medium-term objective (MTO) for the
budgetary position at a structural deficit of ‘around’ 1 % of GDP, which it does not aim to achieve
within the programme period. As the programme's MTO is more demanding than the minimum
benchmark (estimated at a deficit of around 1,5 % of GDP), its eventual achievement should fulfil
the aim of providing a safety margin against the occurrence of an excessive deficit. The programme's
MTO is at an appropriate level under the current assessment because it adequately reflects the debt
ratio and average potential output growth in the long term.

The risks to the budgetary projections in the programme appear broadly balanced. On the one
hand, the track record of cautious budgetary planning indicates that outcomes could be better than
targeted (as was the case in 2004 and is expected by the Commission services also for 2005). The
growth assumptions underlying the budgets have usually been realistic and the assumptions about
tax elasticities cautious. Moreover, budgeted expenditures have not always been fully executed,
mainly due to the possibility to carry over unspent funds from previous budgetary years. On the
other hand, the programme refers to several (proposed) measures in the area of social spending
which would increase expenditure under this heading rather than decrease it, as projected in the
programme. Moreover, expenditure carryovers of more than 1 % of GDP were accumulated in 2004
and Commission services expect their volume to further increase in 2005. If these sizeable carry-
overs were spent in addition to all budgeted expenditures — which cannot be excluded especially in
the election year 2006 — budgetary outcomes could be worse than targeted, in particular in 2006.
Furthermore, the growth assumption in the final year of the programme seems favourable.

(9)

In view of this risk assessment, the budgetary stance in the programme seems consistent with a
correction of the excessive deficit by 2008 as recommended by the Council, which is the end-year
of the programme. However, the envisaged adjustment path in structural terms could be strength-
ened, especially when the possibility of a much better outcome in 2005 and the upward revision of
growth prospects are taken into account.

(10)

The debt ratio is estimated to have reached 37,4 % of GDP in 2005, well below the 60 % of GDP
Treaty reference value. The programme projects the debt ratio to increase by 0,5 percentage point
over the programme period.

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(11) With regard to the sustainability of public finances, the Czech Republic appears to be at high risk
on grounds of the projected budgetary costs of ageing populations. While the debt ratio is currently
relatively low in an EU perspective, the high deficit contributes to a rising debt ratio in the long-
term projections until 2050, which increases the risk to debt sustainability. At the same time, the
projected high increases of pension expenditure over the projection period are expected to put a
significant burden on the public finances. A rigorous implementation of the planned consolidation
of public finances over the medium term and a further strengthening of the budgetary position
together with additional structural reforms to contain the increase in age-related expenditures, in
particular on pensions and health care, appear to be of key importance in order to mitigate the risks
to public finance sustainability (1).

(12)

(13)

The envisaged measures in the area of public finances are broadly consistent with the broad
economic policy guidelines included in the integrated guidelines for the period 2005-2008. In par-
ticular, the programme foresees the correction of the excessive deficit in line with the Council's
recommendations. It also presents measures to promote a growth- and employment-oriented alloca-
tion of resources, in particular by decreasing the weight of the public sector in the economy and by
shifting the tax burden from direct to indirect taxation. However, while the government is aware of
the problem of the long-term sustainability, the programme does not present concrete steps to
address it.

The National Reform Programme of the Czech Republic, submitted on 14 October 2005 in the
context of the renewed Lisbon strategy for growth and jobs, identifies long-term sustainability as the
main challenge with implications for public finances. The budgetary implications of the limited
number of concrete reform measures specified in the National Reform Programme are reflected in
the budgetary projections of the convergence programme. The measures in the area of public
finances envisaged in the convergence programme are in line with the actions foreseen in the
National Reform Programme.
the convergence programme outlines measures to
support jobs and growth by changes in the revenue and expenditure structure (especially a shift of
the tax burden from direct to indirect taxation and a cut in government consumption and transfers)
and by making public investment a spending priority, but, as stated above, it does not present any
concrete reform steps to address the problem of long-term sustainability. The programme further
envisages a strengthening of the role of the medium-term expenditure ceilings by implementing the
binding principles on the headings of the state budget and of the state funds and by inclusion of
local governments in the budgetary planning process.

In particular,

In view of the above assessment, the Council notes that the programme follows the deficit adjustment path
set by the Council recommendations under Article 104(7). In the light of these recommendations, the
Council is of the opinion that the Czech Republic should:

(i) strengthen, in the context of possible better budgetary outcome in 2005 as well as strong growth
outcome and prospects, the effort in the structural budgetary adjustment, in view of the small margin
below the reference value targeted for 2008 (which is the deadline for the correction of the excessive
deficit) and in order to speed up the attainment of the MTO;

(ii) enhance the quality of budgetary planning, in particular by analysing causes of significant expenditure

carryovers and reinforcing the medium-term expenditure ceilings;

(iii) improve the long-term sustainability of the public finances, in particular by accelerating the pension

reform and undertaking the reform of the healthcare system.

(1) Details on long-term sustainability are provided in the technical assessment of the programme by the Commission

services, to be published at the website:
http://europa.eu.int/comm/economy_finance/about/activities/sgp/main_en.htm

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Comparison of key macroeconomic and budgetary projections

2004

2005

2006

2007

2008

Real GDP
(% change)

HICP inflation
(%)

Output gap
(% of potential GDP)

General government
balance
(% of GDP)

Primary balance
(% of GDP)

Cyclically-adjusted
balance
(% of GDP)

Structural balance (2)
(% of GDP)

Government gross debt
(% of GDP)

CP Nov 2005

COM Nov 2005

CP Dec 2004

CP Nov 2005

COM Nov 2005

CP Dec 2004

CP Nov 2005 (1)

COM Nov 2005 (5)

CP Dec 2004 (1)

CP Nov 2005

COM Nov 2005

CP Dec 2004

CP Nov 2005

COM Nov 2005

CP Dec 2004

CP Nov 2005 (1)

COM Nov 2005

CP Dec 2004 (1)

CP Nov 2005 (3)

COM Nov 2005 (4)

CP Dec 2004

CP Nov 2005

COM Nov 2005

CP Dec 2004

4,4

4,4

3,8

2,6

2,6

2,7

– 1,9

– 1,4

– 1,3

– 3,0

– 3,0

– 5,2

– 1,8

– 1,8

– 4,0

– 2,4

– 2,5

n.a.

– 1,9

– 2,0

n.a.

36,8

36,8

38,6

4,8

4,8

3,6

1,5

1,7

3,2

– 0,8

– 0,2

– 0,9

– 4,8

– 3,2

– 4,7

– 3,5

– 1,9

– 3,4

– 4,5

– 3,1

n.a.

– 3,4

– 2,0

n.a.

37,4

36,2

38,3

4,4

4,4

3,7

2,2

2,9

2,6

– 0,1

0,6

– 0,4

– 3,8

– 3,7

– 3,8

– 2,5

– 2,3

– 2,4

– 3,8

– 3,9

n.a.

– 3,8

– 3,9

n.a.

37,1

36,6

39,2

4,2

4,3

3,8

2,0

2,6

2,2

0,3

1,2

0,3

– 3,3

– 3,3

– 3,3

– 2,0

– 1,9

– 1,7

– 3,4

– 3,8

n.a.

– 3,4

– 3,8

n.a.

37,9

36,9

40,0

4,3

n.a.

n.a.

2,1

n.a.

n.a.

0,8

n.a.

n.a.

– 2,7

n.a.

n.a.

– 1,2

n.a.

n.a.

– 3,0

n.a.

n.a.

– 3,0

n.a.

n.a.

37,8

n.a.

n.a.

Notes:
(1) Commission services calculations on the basis of the information in the programme.
(2) Cyclically-adjusted balance (as in the previous rows) excluding one-off and other temporary measures.
(3) One-off and other temporary measures taken from the fiscal notification (0,5 % in 2004) and from the programme (1,1 % in 2005);

both deficit-increasing.

(4) One-off and other temporary measures taken from the Commission services' autumn 2005 forecast (0,5 % of GDP in 2004, 1,1 % in

2005; both deficit-increasing).

(5) Based on estimated potential growth of 3,5 %, 3,5 %, 3,6 % and 3,7 % respectively in the period 2004-2007.

Source:
Convergence programme (CP); Commission services' autumn 2005 economic forecasts (COM); Commission services' calculations