Council opinion of 4 March 2008 on the updated convergence programme of the Czech Republic, 2007-2010
Date: 2008-03-04
Institutions: Council of the European Union
Subjects: Czechia, budget estimate, economic convergence, economic forecasting, public finance, stability programme

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Official Journal of the European Union

20.3.2008

COUNCIL OPINION

of 4 March 2008

on the updated convergence programme of the Czech Republic, 2007-2010

(2008/C 74/06)

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 4 March 2008, the Council examined the updated convergence programme of
Republic, which covers the period 2007 to 2010.

the Czech

The Czech Republic is experiencing a period of high growth which is expected to moderate in the
medium term. The recent sharp fall in unemployment can be mainly accounted for by cyclical factors.
Structural rigidities still appear to remain in the labour market, indicated by a high level of vacancies,
evidence of skills mismatches, and regional disparities in unemployment, which will need to be
addressed by future employment policy.

The stabilisation programme adopted in 2007 appears to be a step in the right direction while
further measures will be necessary to continue fiscal consolidation. Notably, risks remain with respect
to long-term sustainability of public finances, given the ageing population and current state of
pension and health care systems. A well-devised pension reform could also have a positive impact on
potential growth. While taking into consideration the good track record of the Czech Republic, infla-
taxation and rising international
tionary pressures are set
commodity prices.

to increase due to rises in indirect

The convergence programme estimates GDP growth to be about 6 % in 2007 and moderate to about
5 % over the rest of the programme period. Assessed against currently available information (2), this
scenario appears to be based on plausible assumptions. The Commission services' autumn 2007 fore-
cast expects private consumption growth to remain strong on the back of high wage increases in the
private sector and rising employment, while moderating from the high level in 2007 linked to the
government's planned fiscal consolidation. Both the convergence programme and the Commission
services' autumn forecast predict a steep rise in inflation in 2008 due to increases in indirect taxation
and rising commodity prices, which may weigh on nominal convergence.

(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://ec.europa.eu/economy_finance/about/activities/sgp/main_en.htm

(2) The assessment takes notably into account the Commission services' autumn forecast and the Commission assessment of

the October 2007 national reform programme.

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(4)

(5)

(6)

(7)

(8)

For 2007, the Commission services' autumn forecast and the convergence programme estimate a
general government deficit of 3,4 % of GDP, which is 0,6 percentage points below the target set in
the previous update. However, recent information on budgetary implementation indicates that the
2007 outturn could be significantly better than envisaged in the current programme: the most recent
information suggests that the general deficit in 2007 could be about 2 % of GDP. The lower estimated
fiscal outcome is mainly due to the base effect of a higher revenue-to-GDP ratio in 2006 than antici-
pated in the previous convergence programme, as well as some expenditure restraint in 2007 and
dynamic revenue growth thanks to stronger nominal GDP growth than anticipated. A lower 2007
deficit compared to the 2006 budgetary outcome is in line with the invitation in the Council opinion
of 10 July 2007 on the previous update of the convergence programme (1) to limit the budgetary
deterioration in 2007.

The main goal of the budgetary strategy in the programme is to correct the excessive deficit in 2008
and thereafter to continue consolidation towards the achievement of the medium-term objective
(MTO), which is a structural deficit of 1 % of GDP, in 2012. The general government deficit is
projected to decrease from 3,4 % of GDP in 2007 to 2,9 % of GDP in 2008, 2,6 % of GDP in 2009
and 2,3 % of GDP in 2010. The primary deficit follows a similar path, narrowing from 2,3 % of GDP
in 2007 to 1,1 % of GDP in 2010. The consolidation will be mainly expenditure-driven. In particular,
the expected fall in the revenue-to-GDP ratio (partly attributable to the introduction of a flat tax in
2008) will be more than offset by a cut in the expenditure-to-GDP ratio. The latter is relatively
broad-based but affects social and welfare benefits most significantly; public investment is the only
spending category that is planned to increase as a share of GDP. Building on the better-than-expected
outturn in 2006, the targets for public finances have been improved compared to those in the
previous convergence programme. The most recent estimate of a lower general deficit in 2007
implies that these targets should be comfortably within reach.

The outcome for 2008 could be better than expected while the balance of risks is neutral with
respect to budgetary outcomes from 2009 onwards. On one hand, the Czech Republic has a history
of achieving lower-than-planned deficits and the latest estimate for 2007 is significantly better than
foreseen in the programme, which may have a favourable base effect from 2008. While there are a
large amount of tax changes occurring, which makes forecasting difficult, the programme's tax esti-
mates appear cautious. On the other hand, the targeted consolidation requires significant expenditure
restraint, including public sector wage restraint and cut backs in the number of public employees,
while expenditure ceilings have been breached in previous years. After 2008, further consolidation
measures remain to be spelled out.

In view of this risk assessment, namely in the light of the better-than-expected outturn in 2007, the
budgetary stance in the programme seems consistent with a durable correction of the excessive
deficit by 2008, as recommended by the Council. This is conditional on continuing expenditure
the tax reforms in the stabilisation
restraint and a close monitoring of
programme. However, a sufficient safety margin against breaching the 3 % of GDP deficit threshold
with normal macroeconomic fluctuations would not be achieved within the programme period. In
the years following the correction of the excessive deficit, the pace of adjustment towards the MTO
implied by the programme should be strengthened and backed up with measures to be in line with
the Stability and Growth Pact. In particular, while the Czech Republic has experienced a period of
strong growth, the programme target for 2010 implies that a significant adjustment will have to be
made in 2011-2012 to achieve the MTO by 2012.

impact of

the fiscal

The Czech Republic appears to be at high risk with regard to the sustainability of public finances. The
initial budgetary position in the programme is not sufficiently high to stabilize the debt ratio over the
long-term. The long-term budgetary impact of ageing is well above the EU average,
influenced
notably by a substantial increase in pension expenditure as a share of GDP as well as a significant
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 expenditures
would contribute to reducing risks to the sustainability of public finances. While initial steps have
been made to reform the health care system, reform of the pension system still lacks implementation
against a definite timetable.

(1) OJ C 204, 1.9.2007, p. 1.

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(9)

The convergence programme seems to be consistent to some extent with the October 2007 imple-
mentation report of the national reform programme. The national reform programme includes a
number of actions taken with the objective of improving the long-term sustainability of public
finances; increasing the amount and quality of education and research; and increasing the motivation
to take up employment. While the convergence programme does not provide systematic information
on the direct budgetary costs associated with the main reforms envisaged in the national reform
programme, the programme's budgetary projections seemingly take into account the public finance
implications of the reforms envisaged in the implementation report of the NRP.

(10)

The budgetary strategy in the programme is partly consistent with the country-specific broad
economic policy guidelines included in the integrated guidelines in the area of budgetary policies
issued in the context of the Lisbon strategy given the limited actions on pension and health care
reform.

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

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

The overall conclusion is that the programme is consistent with a correction of the excessive deficit in
2008, conditional on continuing expenditure restraint and close monitoring of the impact of the fiscal
impact of the tax measures in the stabilisation package. Owing to the positive macroeconomic outlook and
a likely better 2007 budgetary outturn than expected in the programme, there could be ample opportunity
to bring the 2008 deficit below the 3 % of GDP reference value by a larger margin, and to achieve stronger-
than-targeted fiscal consolidation afterwards. The main risks are in the reliance on reductions to public
sector employment and relate to the fact that further consolidation measures remain to be spelled out
after 2008. The Czech Republic remains at high risk with respect to the sustainability of public finances,
while first steps have been made on health care reform.

In view of the above assessment and also in the light of the recommendation under Article 104(7) of
10 October 2007, and given the need to achieve sustainable convergence, the Czech Republic is invited to:

(i) exploit the likely better-than-expected 2007 budgetary outcome to bring the 2008 deficit below the 3 %

of GDP reference value by a larger margin by continuing to exercise expenditure restraint;

(ii) exploit the high rate of growth in the economy by further strengthening the pace of adjustment so as
to build a safety margin against breaching the reference value as soon as possible, and speed up the
achievement of the MTO;

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

public finances through the necessary pension and health care reforms.

Comparison of key macroeconomic and budgetary projections

Real GDP
(% change)

HICP inflation
(%)

CP Nov 2007

COM Nov 2007

CP March 2007

CP Nov 2007

COM Nov 2007

CP March 2007

(1) The data on COFOG for 2010 are not provided.

2006

2007

2008

2009

2010

6,4

6,4

6,0

2,1

2,1

2,4

5,9

5,8

4,9

2,4

3,0

2,6

5,0

5,0

4,8

3,9

3,8

2,5

5,1

4,9

4,8

2,3

3,2

2,5

5,3

n.a.

n.a.

2,1

n.a.

n.a.

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Output gap (1)
(% of potential GDP)

CP Nov 2007

COM Nov 2007 (2)

Net lending/borrowing
vis-à-vis the rest of the
world
(% of GDP)

General government
balance
(% of GDP)

Primary balance
(% of GDP)

Cyclically-adjusted
balance (1)
(% of GDP)

Structural balance (3)
(% of GDP)

Government gross debt
(% of GDP)

CP March 2007

CP Nov 2007

COM Nov 2007

CP March 2007

CP Nov 2007

COM Nov 2007

CP March 2007

CP Nov 2007

COM Nov 2007

CP March 2007

CP Nov 2007

COM Nov 2007

CP March 2007

CP Nov 2007

COM Nov 2007

CP March 2007

CP Nov 2007

COM Nov 2007

CP March 2007

2006

2007

2008

2009

2010

0,9

1,1

0,9

– 2,7

– 2,7

– 2,8

– 2,9

– 2,9

– 3,5

– 1,8

– 1,8

– 2,4

– 3,3

– 3,3

– 3,9

– 3,1

– 3,3

– 3,9

30,1

30,1

30,6

1,8

2,1

1,1

– 2,4

– 2,5

– 1,4

– 3,4

– 3,4

– 4,0

– 2,3

– 2,3

– 2,6

– 4,1

– 4,1

– 4,4

– 4,1

– 4,1

– 4,4

30,4

30,2

30,5

1,4

2,1

1,0

– 1,6

– 2,1

0,2

– 2,9

– 2,8

– 3,5

– 1,7

– 1,8

– 2,0

– 3,4

– 3,6

– 3,9

– 3,4

– 3,6

– 3,9

30,3

30,3

31,3

0,7

1,4

1,0

– 0,4

– 1,9

1,1

– 2,6

– 2,7

– 3,2

– 1,3

– 1,7

– 1,6

– 2,8

– 3,2

– 3,5

– 2,8

– 3,2

– 3,5

30,2

30,5

32,2

0,5

n.a.

n.a.

1,5

n.a.

n.a.

– 2,3

n.a.

n.a.

– 1,1

n.a.

n.a.

– 2,5

n.a.

n.a.

– 2,5

n.a.

n.a.

30,0

n.a.

n.a.

Notes:
(1) Output gaps and cyclically-adjusted balances according to the programmes as recalculated by Commission services on the basis of the

information in the programmes.

(2) Based on estimated potential growth of 4,5 %, 4,7 %, 5,0 % and 5,6 % respectively in the period 2006-2009.
(3) Cyclically-adjusted balance excluding one-off and other temporary measures. One-off and other temporary measures in the convergence
programme of November 2007 are 0,2 % of GDP in year 2006; deficit-increasing. There are no one-offs in the Commission services'
autumn forecast.

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