Council opinion of 10 March 2009 on the updated convergence programme of the Czech Republic, 2008-2011
Date: 2009-03-10
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

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COUNCIL OPINION

of 10 March 2009

on the updated convergence programme of the Czech Republic, 2008-2011

(2009/C 62/02)

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 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)

On 10 March 2009, the Council examined the updated convergence programme of the Czech
Republic, which covers the period 2008 to 2011. The Council notes that the programme submitted
in November 2008, including the addendum forwarded in December 2008 appear to be too opti-
mistic in light of the unfavourable macro-economic developments.
It also notes that a second
package of stimulus measures have been announced on 16 February 2009, which is not covered by
this assessment.

Following three years of rapid expansion, growth in the Czech economy moderated in 2008 and is
set to slow further in 2009. Weakening external demand resulting from the global financial and
economic crisis will act as a significant drag on export growth for the highly open Czech economy.
In addition, domestic demand, particularly investment, is softening on the back of falling foreign
direct investment, tight credit conditions and a decline in business and consumer sentiment. In
response to the slowdown, the government introduced a fiscal stimulus package in the 2009 budget
including a range of revenue and expenditure measures. These are geared towards promoting
domestic demand and providing support to enterprises through the downturn. From 2010 on, the
economy should gradually recover in line with the expected improvement in the external environ-
ment. However, growth is not likely to return to the high rates before the crisis. This may have an
adverse effect on government finances, which over recent years have benefited from buoyant revenue
growth and which despite a relatively low government deficit and debt remain a concern in terms of
risks to their long-term fiscal sustainability due to a rapidly ageing population. The Czech National
Bank eased monetary policy in the second half of 2008 via successive interest rate reductions (from
3,75 % in July 2008 to 2,25 % in December 2008). The nominal effective exchange rate of the Czech
koruna appreciated slightly (by 1,3 %) during 2008.

(3)

The macro-economic scenario underlying the programme projects real GDP growth to fall from 4,4 %
in 2008 to 3,7 % in 2009 before recovering to an average rate of 4,8 % over the rest of the
programme period. Assessed against currently available information (2), this scenario appears to be
based on markedly favourable growth assumptions in 2009 and 2010, and on favourable ones there-
after, while this has to be seen against the programme cut-off date of 1 October 2008 and the major
economic developments that have followed since then.

In particular, in view of the rapid deterioration of the economic outlook for the Czech Republic's
main trading partners in recent months, exports are expected to decline much more sharply and their
recovery is likely to be more subdued than projected in the programme. Moreover, the swift turn-
around of the economy is based on the assumption that potential growth will not be affected by the
crisis which appears not very likely in view of the expected decline in investment growth, particularly
also of foreign direct investment. The programme's projections for inflation appear realistic.

(1) OJ L 209, 2.8.1997, 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 notably takes into account the Commission services' January 2009 forecast, but also other information

that has become available since then.

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(4)

(5)

(6)

(7)

(8)

(9)

For 2008, the general government deficit is estimated at 1,2 % of GDP in the Commission services'
January 2009 interim forecast, against a target of 2,9 % of GDP set in the previous update of the
convergence programme. The much better than expected outcome is largely due to a better starting
position from 2007 and the earlier reform package taken by the government. This was partly offset
by less favourable developments in 2008. In particular, while expenditure growth was broadly in line
with plan, revenue growth was slightly below target. The increase in the level of collected value added
tax has been slightly less than expected due to a slowdown in consumer spending which offset the
impact of the increase in the lower band of VAT implemented in 2008, while direct taxes have been
more in line with government predictions as the labour market has remained stable.

The target for the general government balance in 2009 is – 1,6 % of GDP, against a projection of
– 2,5 % of GDP in the Commission services interim forecast. The estimated net effect on the budget
balance of discretionary measures, adopted as part of the fiscal stimulus package and affecting the
revenue and expenditure side in roughly equal share, is about 1 % of GDP. These measures are coun-
terbalancing the originally restrictive stance of the convergence programme. In line with the Commis-
sion services' interim forecast, this implies a mild expansion of about 0,25 % of GDP. The impact of
automatic stabilisers on the deterioration of the budget balance is estimated at around 0,5 % of GDP.

The programme foresees the achievement of the MTO, a structural deficit of 1 % of GDP cyclically
adjusted net of one-off and other temporary measures, by 2012 (i.e. not within the programme
period). The headline and structural balance are both projected to improve after 2009, as a result of
expenditure savings, in particular with respect to intermediate consumption and compensation of
employees, projected to fall by more than 0,5 % of GDP per annum over the period 2009-2011.

The budgetary outcomes are subject to downside risks. The macro-economic scenario which under-
pins the budgetary targets appears markedly favourable. An annual reduction by more than
0,5 percentage point of GDP in intermediate consumption and compensation of employees could
entail risks for the overall quality of public services without significant efficiency-enhancing measures.
The projected decline in expenditure on social payments does not seem to take into account the
likely increase in unemployment benefits due to the expected worsening of the labour market.
Furthermore, tax reductions in the fiscal stimulus package may not be offset by future savings. The
expenditure targets in the programme are based on ceilings in the medium-term expenditure frame-
work which in the past have been exceeded. Revenues may also be lower than predicted due to the
slowdown, while the revenue assumptions in the programme appear to be on the cautious side.

The long-term budgetary impact of ageing is above the EU average according to the projections made
in 2005, which are based on the common methodology; the long-term sustainability of the Czech
Republic is therefore assessed to be at high risk. Initial phases of pension and health care reforms
have been introduced which will reduce expenditure. However, more needs to be done in both areas,
taking into account the principles of equity accessibility and sustainability. While the budgetary posi-
tion in 2008, as estimated in the programme, is markedly improved, it is largely due to a better
starting position in 2007 rather than discretionary measures, and still compounds the impact of
population ageing. Achieving primary surpluses over the medium term and implementing further
structural measures aimed at curbing age-related expenditures would reduce the risks to the
long-term sustainability of public finances.

In 2004, the Czech Republic introduced a medium-term budgetary framework which sets annual
targets for the State budget over three years. The targets are based on nominal expenditure ceilings
and estimated revenue calculated on the basis of projected GDP growth. Since the start of the
medium-term budgetary framework, the initial expenditure limits have been exceeded by raising
expenditure on a discretionary basis and in the outturns. In 2006 and 2007, outturn expenditure
exceeded the initial ceilings by on average 7 %. The Czech Republic is planning several changes aimed
at improving budgetary management and enhancing tax collection. Output and target orientated
budgeting has been introduced from January 2009. There will be increased integration and simplifica-
tion of the tax system from January 2010 and there will be modernised administrative support to
facilitate the work of the treasury department, for which tenders were launched in 2008. These
measures will help to improve budgetary implementation while adhering to expenditure ceilings will
depend on further discretion.

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(10)

(11)

In response to the financial crisis, the Czech Republic took a number of measures, including an
increase in capital of the Czech Export Bank, the Export Guarantee and Insurance Corporation, the
Czech-Moravian Guarantee and Development Bank, totalling CZK 2 billion. The bolstering of the
capital of these institutions will help exporting firms, especially SMEs. In addition, the coverage of the
deposit guarantee scheme was increased to EUR 50 000.

In line with the EERP agreed in December by the European Council, the Czech Republic adopted a
recovery plan consisting of stimulus measures. Within an overall mildly expansionary fiscal stance,
these measures are an adequate response to the macro-budgetary situation given the concern for a
broader consolidation effort in light of the risks to long-term sustainability from rapid ageing. The
stimulus measures taken by the Czech authorities can be regarded as in line with the EERP in that
they are timely and targeted.

The decrease of social insurance contributions paid by employees by 1,5 percentage points, which is,
though, not easily reversible, will support households' disposable income. This measure will also have
a structural impact on the labour market with respect to raising supply and placing downward pres-
sure on gross wages. In addition, the decision to invest in construction and modernization of infra-
structure within the State Fund for Transport Infrastructure is likely to help sustain employment and
aggregate demand. These measures are related to the medium-term reform agenda and the country-
specific recommendations proposed by the Commission on 28 January 2009 under the Lisbon
Strategy for Growth and Jobs. In light of the worsened economic outlook, the government announced
a second set of measures on 16 February 2009.

(12)

The projected fiscal stance is mildly expansionary in 2009 according to the Commission services'
January 2009 Interim Forecast, partly due to an exceptional increase granted for public sector wages.
The structural balance improves after 2009 mainly thanks to expenditure restraint. The achievement
of the fiscal targets may be difficult without further measures, given the programme's favourable
macro-economic assumptions, and concrete actions to back-up the planned expenditure reductions.

(13) 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 government deficit in the Czech Republic over recent years has been relatively
low, while the debt ratio has been below 30 % of GDP, thus clearly below the 60 % reference value. The
mildly expansionary fiscal stance, including stimulus measures, appears appropriate in light of the economic
downturn and in line with the EERP, however, will affect public finances. Moreover, there are risks attached
to the budgetary projections, in particular in view of the favourable growth assumptions, the lack of concrete
actions to support the planned expenditure reductions from 2009, and a track record of exceeding expendi-
ture ceilings set in the medium-term budgetary framework. Due to a rapidly aging population, concerns
remain regarding the long-term fiscal sustainability. Overall, these risks point to the need for medium-term
fiscal consolidation and further efforts in structural reforms.

In view of the above, and also given the need to ensure sustainable convergence, the Czech Republic is
invited to:

(i) implement the 2009 fiscal plans, including stimulus measures, in line with the EERP and within the

framework of the SGP;

(ii) carry out significant structural consolidation in 2010 and beyond towards the MTO, and back-up the

budgetary strategy with specific measures for reducing expenditure in 2010-2011;

(iii) continue with the necessary pension and health care reforms, given the projected increase in age-related

expenditures, in order to improve the long-term sustainability of public finances.

(1) In particular, the data on COFOG for 2011, liquid financial assets and net financial debt with respect to government debt,

which have the effect of making the assessment objectively more difficult, are not provided.

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Comparison of key macro-economic and budgetary projections

2007

2008

2009

2010

2011

Real GDP
(% change)

HICP inflation
(%)

CP Nov 2008

COM Jan 2009

CP Nov 2007

CP Nov 2008

COM Jan 2009

CP Nov 2007

Output gap (1)
(% of potential GDP)

CP Nov 2008

COM Jan 2009 (2)

CP Nov 2007

6,6

6,0

5,9

3,0

3,0

2,4

2,7

3,7

1,8

4,4

4,2

5,0

6,4

6,3

3,9

1,9

3,4

1,4

3,7

1,7

5,1

2,9

2,6

2,3

0,4

0,7

0,7

4,4

2,3

5,3

3,0

2,3

2,1

5,2

n.a.

n.a.

2,5

n.a.

n.a.

– 0,4

– 0,2

– 1,1

0,5

0,4

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

General government
revenue
(% of GDP)

General government
expenditure
(% of GDP)

General government
balance
(% of GDP)

CP Nov 2008

– 0,8

– 1,0

– 0,5

COM Jan 2009

– 0,8

– 0,3

– 0,8

– 1,1

CP Nov 2007

– 2,4

– 1,6

– 0,4

1,5

CP Nov 2008

41,7

41,0

40,6

39,6

39,0

COM Jan 2009

41,6

40,7

40,7

41,1

CP Nov 2007

39,8

39,5

38,1

37,1

n.a.

n.a.

CP Nov 2008

42,6

42,2

42,2

41,1

40,2

COM Jan 2009

42,6

42,0

43,2

43,4

CP Nov 2007

43,3

42,4

40,7

39,4

n.a.

n.a.

CP Nov 2008

– 1,0

– 1,2

– 1,6

– 1,5

– 1,2

COM Jan 2009

– 1,0

– 1,2

– 2,5

– 2,3

CP Nov 2007

– 3,4

– 2,9

– 2,6

– 2,3

n.a.

n.a.

Primary balance
(% of GDP)

CP Nov 2008

COM Jan 2009

0,2

0,2

0,0

0,0

– 0,3

– 0,4

– 0,1

– 1,3

– 1,1

CP Nov 2007

– 2,3

– 1,7

– 1,3

– 1,1

n.a.

n.a.

1,2

n.a.

n.a.

n.a.

n.a.

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

Structural balance (3)
(% of GDP)

Government gross debt
(% of GDP)

CP Nov 2008

COM Jan 2009

CP Nov 2007

CP Nov 2008

COM Jan 2009

CP Nov 2007

CP Nov 2008

COM Jan 2009

CP Nov 2007

2007

2008

2009

2010

2011

– 2,0

– 2,3

– 4,1

– 1,7

– 2,1

– 4,1

28,9

28,9

30,4

– 2,0

– 2,4

– 3,4

– 1,9

– 2,4

– 3,4

28,8

27,9

30,3

– 1,7

– 2,8

– 2,8

– 1,7

– 2,8

– 2,8

27,9

29,4

30,2

– 1,4

– 1,9

– 2,5

– 1,3

– 1,9

– 2,5

26,8

30,6

30,0

– 1,1

n.a.

n.a.

– 1,1

n.a.

n.a.

25,5

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 %, 4,5 %, 4,4 % and 4,2 % respectively in the period 2007-2010.
(3) Cyclically-adjusted balance excluding one-off and other temporary measures. One-off and other temporary measures are 0,1 % of GDP
in 2008 according to the most recent programme, which were allocated to the normal spending categories on the basis that the
components are recurring elements of government expenditure and of a small scale in the Commission services' January interim
forecast.

Source:
Convergence programme (CP); Commission services' January 2009 interim forecasts (COM); Commission services' calculations.