Council opinion of 10 July 2007 on the updated convergence programme of the Czech Republic, 2006-2009
Date: 2007-07-10
Institutions: Council of the European Union
Subjects: Czechia, budget estimate, economic convergence, economic forecasting, public finance, stability programme

1.9.2007

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Official Journal of the European Union

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(Resolutions, recommendations, guidelines and opinions)

OPINIONS

COUNCIL

COUNCIL OPINION

of 10 July 2007

on the updated convergence programme of the Czech Republic, 2006-2009

(2007/C 204/01)

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 particular
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 10 July 2007 the Council examined the updated convergence programme of the Czech Republic,
which covers the period 2006 to 2009. The submission of the update was delayed to 15 March
2007, compared to the 1 December deadline in the code of conduct due to the political situation in
the Czech Republic, where a permanent government was approved by Parliament on 19 January
2007 following general elections in June 2006.

The macroeconomic scenario underlying the programme envisages that real GDP growth will decrease
from 6,1 % in 2006 to 4,9 % in 2007 and broadly stabilise thereafter. Assessed against currently
available information, this scenario appears to be based on plausible growth assumptions. The
programme's projections for inflation also appear realistic.

For 2006, the general government deficit is estimated at 2,9 % of GDP in the Commission services'
spring 2007 forecast, against a target of 3,8 % of GDP set in the previous update of the convergence
programme. Stronger GDP and employment growth as well as the roll-over of a marked proportion
of unspent budgetary allocations contributed to the lower-than-targeted deficit.

(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

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(4)

(5)

(6)

(7)

(8)

(9)

The main goal of the programme's medium-term budgetary strategy is to achieve long term sustain-
ability of public finances, notably by making progress towards the medium term objective (MTO) for
the budgetary position of a structural deficit (i.e. cyclically-adjusted balance net of one-off and other
temporary measures) of 1 % of GDP. According to the programme, the headline deficit should widen
to 4,0 % of GDP in 2007 mainly as a result of discretionary increases in social expenditure and then
gradually decline, to 3,5 % of GDP in 2008 and 3,2 % of GDP in 2009. The primary deficit is
projected to narrow from 2,4 % of GDP in 2006 to 1,6 % of GDP in 2009. The envisaged fiscal
consolidation, after 2007, relies on increased revenue by 0,4 percentage point of GDP over the
programme period, in particular ‘other revenues’ (without specifying the actual measures, but which
presumably concern EU transfers), which will more than compensate for a decline in taxes and social
contributions. On substance, however, the consolidation is expenditure driven with a consistent
decline in public consumption mainly due to government sector wage restraint, which will more than
offset the increase in public investment and interest expenditure. Compared with the previous update,
the new programme postpones the planned reduction of the deficit below the 3 % of GDP reference
value by at least two years against a more favourable macroeconomic scenario. It has to be noted that
the programme also presents an alternative proposed by the new government which presents lower
deficit targets of 3,2 % of GDP in 2008 and 2,8 % of GDP in 2009. This relies on a range of policy
measures as well as introducing greater flexibility into public finances by reducing the proportion of
mandatory expenditures. However, these are based on still to be finalised and approved policy
measures and the programme offers a coherent and sufficiently quantified medium term fiscal frame-
work only for the higher deficit targets mentioned above.

The structural deficit calculated according to the commonly agreed methodology is planned to dete-
riorate from around 3½ % of GDP in 2006 to some 4½ % of GDP in 2007 before gradually
improving to 3½ % of GDP in 2009. As in the previous update, the medium term objective (MTO)
for the budgetary position presented in the programme is a structural deficit of 1 % of GDP. In
comparison with previous update the achievement of the MTO has been postponed by one year, until
2013. As the MTO is more demanding than the minimum benchmark (estimated at a deficit of
around 1½ % of GDP), achieving it should fulfil the aim of providing a safety margin against the
occurrence of an excessive deficit. The MTO 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. The risks from the
macroeconomic scenario are broadly neutral, while tax projections seem on the whole based on
prudent assumptions. The envisaged fiscal consolidation in the programme relies heavily on public
consumption expenditure restraint, but
the programme does not provide sufficient supporting
information on how this will be achieved. On the other hand, the Czech Republic has built up a
good track-record in recent years, although achieving its budgetary targets has been facilitated by
higher-than-expected growth. There is also a political risk associated with the finely balanced parlia-
mentary situation.

In view of this risk assessment, the budgetary stance in the programme is inconsistent with a correc-
tion of the excessive deficit by 2008 as recommended by the Council on 5 July 2004. Given that the
economy is currently enjoying ‘good times’ and that growth is higher than anticipated at the time of
the July 2004 Council recommendation, there is ample opportunity to strengthen the consolidation
effort and achieve a steeper reduction than projected in the programme.

Government gross debt is estimated to be at 30,4 % of GDP in 2006, well below the 60 % of GDP
Treaty reference value. The programme projects the debt ratio to increase by almost 2 percentage
points over the programme period.

The long-term budgetary impact of ageing in the Czech Republic is well above the EU average, influ-
enced notably by a substantial increase in pension expenditure as a share of GDP as well as a signifi-
cant increase in health care expenditure. Implementation of structural reform measures notably in the
field of pensions and health care aimed at containing the significant increase in age-related expendi-
tures would contribute to reducing risks to the sustainability of public finances. The budgetary posi-
tion expected at the end of the programme period, which has worsened compared with previous exer-
cises, constitutes a risk to sustainable public finances even before the long-term budgetary impact of
an ageing population is considered. Consolidating public finances further than currently planned
would contribute to reducing risks to the sustainability of public finances. Overall, the Czech Republic
appears to be at high risk with regard to the sustainability of public finances.

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(10)

The convergence programme does not contain a qualitative assessment of the overall impact of the
November 2006 implementation report of the National Reform Programme within the medium-term
fiscal strategy. In addition, it provides no systematic information on the direct budgetary costs (or
savings) associated with the main reforms envisaged in the National Reform Programme with the
exception of the increase in research and development expenditure in the 2007 budget, but the
budgetary projections in the programme seemingly take into account the public finance implications
of the actions envisaged in the National Reform Programme. The measures in the area of public
finances envisaged in the convergence programme seem consistent with those foreseen in the
National Reform Programme. In particular, the shift in the tax burden from direct to indirect taxation
and additional support for research and development.

(11)

The budgetary strategy in the programme is not consistent with the broad economic policy guidelines
included in the integrated guidelines for the period 2005-2008 given, in particular, the deviation
from the adjustment path set by the Council in July 2004 for the correction of the excessive deficit
and the lack of progress on pension and health care reform.

(12) As regards the data requirements specified in the code of conduct for stability and convergence

programmes, the programme provides all required and most of the optional data (1).

The overall conclusion is that, in spite of better growth prospects and a lower deficit outcome in 2006 than
anticipated, the programme postpones the correction of the excessive deficit until 2010, compared with the
2008 deadline set in the July 2004 Council recommendation under Article 104(7). Given the sustained
growth, the postponement, which reflects the higher deficit due primarily to planned increases in social
expenditure in 2007, would also result in a pro-cyclical expansionary stance of fiscal policy.

The adoption and implementation of the fiscal consolidation included in the Law on Stabilization of Public
Finances currently debated in the Parliament would be a step in the right direction.

In view of the above assessment the Council invites the Czech Republic to:

(i) limit the budgetary deterioration in 2007 and ensure the correction of the excessive deficit in a credible

and sustainable manner by 2008 at the latest;

(ii) adjust the composition of expenditure in order to reduce the share of mandatory expenditure;

(iii) in view of the projected increase in age-related expenditures, improve the long-term sustainability of

public finances by implementing the necessary pension and health care reforms.

Comparison of key macroeconomic and budgetary projections

Real GDP
(% change)

HICP inflation
(%)

CP Mar 2007

COM May 2007

CP Nov 2005

CP Mar 2007

COM May 2007

CP Nov 2005

2005

2006

2007

2008

2009

6,1

6,1

4,8

1,6

1,6

1,5

6,0

6,1

4,4

2,4

2,1

2,2

4,9

4,9

4,2

2,6

2,4

2,0

4,8

4,9

4,3

2,5

2,9

2,1

4,8

n.a.

n.a.

2,5

n.a.

n.a.

(1) In particular, the data on general government expenditure by function for 2009 are not provided.

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Output gap
(% of potential GDP)

CP Mar 2007 (1)

COM May 2007 (3)

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 (1)

CP Mar 2007 (6)

COM May 2007

CP Nov 2005

CP Mar 2007

COM May 2007

CP Nov 2005

CP Mar 2007 (1)

COM May 2007

CP Nov 2005 (1)

CP Mar 2007

COM May 2007 (4)

CP Nov 2005 (5)

CP Mar 2007

COM May 2007

CP Nov 2005

2005

2006

2007

2008

2009

– 0,7

– 1,1

– 0,8

– 3,6

– 3,5

– 4,8

– 2,5

– 2,4

– 4,1

– 3,4

– 3,1

– 4,5

– 3,4

– 2,0

– 3,4

30,4

30,4

37,4

0,9

0,4

– 0,1

– 3,5

– 2,9

– 3,8

– 2,4

– 1,8

– 3,0

– 3,9

– 3,1

– 3,8

– 3,9

– 2,8

– 3,8

30,6

30,4

37,1

1,1

0,5

0,3

– 4,0

– 3,9

– 3,3

– 2,6

– 2,8

– 2,4

– 4,4

– 4,1

– 3,4

– 4,4

– 4,1

– 3,4

30,5

30,6

37,9

1,0

0,5

0,8

– 3,5

– 3,6

– 2,7

– 2,0

– 2,6

– 1,7

– 3,9

– 3,8

– 3,0

– 3,9

– 3,8

– 3,0

31,3

30,9

37,8

1,0

n.a.

n.a.

– 3,2

n.a.

n.a.

– 1,6

n.a.

n.a.

– 3,5

n.a.

n.a.

– 3,5

n.a.

n.a.

32,2

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) Based on estimated potential growth of 4,2 %, 4,6 %, 4,8 % and 4,9 % respectively in the period 2005-2008.
(4) One-off and other temporary measures taken from the Commission services' spring 2007 forecast (1,1 % of GDP in 2005 and 0,2 %

of GDP in 2006 — both deficit increasing).

(5) One-off and other temporary measures taken from the CP 2005 programme (1,1 % of GDP in 2005 — deficit increasing).
(6) Alternative deficit targets based on as yet unapproved measures of the new Czech government: 3,2 % of GDP in 2008, 2,8 % of GDP

in 2009.

Source:
Convergence programme (CP); Commission services' spring 2007 economic forecasts (COM); Commission services' calculations.