Recent%20Development%20of%20the%20Czech%20Economy%20and%20Perspective%20of%20Euro%20Adoption%20in%20New%20Member%20States

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Recent Development of the Czech Economyand
Perspective of Euro Adoption in New Member States

• Ludek Niedermayer
• Czech National Bank, Prague

www. .cz
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Czech economy in 80s

• In 80s, Czechoslovakia one of the most rigid and
  most heavily regulated economies in the East
  block
• Level of macroeconomic stability, private savings
  and credibility of the currency relatively high
• Nominal inflation low, hidden inflation high
  (demand overhang on market with state controlled
  prices)
• Field for the monetary policy
• limited number of banks (monobank dissolved in
  Nov 89)
• no financial markets
• koruna not convertible, existence of limited
  black market.

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Economic reform January 91

• Liberalization of prices
• Liberalization of foreign trade
• Internal convertibility of Koruna (for CA
  transactions)
• Start of privatization
• Unification of exchange rates and introduction of
  fixed rate against trade weighted basket.
• Due to weak credibility, low capital inflows,
  financing through official resources at the
  beginning.

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Results early days
Note In 1993, split of Czech and Slovak
Federation Note Inflation in 1991 was 56,6, in
1993 VAT introduction
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Development in this decade

• Economy faced several problems at the end of 90s
• Growing demand, while slow change of suply side
• Growing internal and external imbalances
• Corporate governance problems (mainly banks)
• In May 97, CZK was forced out of semi-fixed FX
  regime, since 1998 CNB adopted inflation
  targetting
• Privatisation of banking sector (since late 90s)
• Changes in politics, policy of promotion of FDI

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New millenium - More growth

• From the beginning of decade the economy
  accelerates its growth, in spite of not always
  favorable external conditions
• Export and investments are leaders of growth in
  2006, consumption (and investments) growth is
  picking up now.

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inflation mostly below the target

• In 2006 (1-3 Q) inflation is pulled up by
  regulated prices and energies, net inflation is
  still low
• In 2007 (1- 3 Q) inflation still below the target
  but heading up, recently 4 y-o-y (food, energy)
• In 2008, inflation will be pushed up by increase
  of VAT and other taxes
• But the monetary policy will react on 2nd round
  effects only, the expecatations
• Wages are crucial.
• Globaly, is inflation on the rise?

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allows low nominal interest rates

• The inflation in this decade was most of the time
  below the target
• Even long term interest rates often below Euro
  rates, boosting lending market
• Low nominal rates have made CZK financing
  currency for many investors. Summer market
  volatility has brought correction
• Market is now again expecting appreciation
• FX rate uncertainty is one of the key risks of
  any CNB forecast.

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Surplus in trade balance despite high energy
costs and growth of demand...

• Change of foreign trade balance into surplus
  caused mainly by growth of export (role of FDI)
• Current account deficit is outcome of negative
  balance of income (mostly reflects the profit of
  FDI). Part of profit is reinvested, but
  proportion fluctuates
• Currently speed of growth of exports similar to
  imports, but new capacities can bring
  improvement
• Market pays more attention to external balance
  now.

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FDI on GDP
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good macro is pushing CZK

• Trend of CZK appreciation continues since 90s
  and is one of key factors of low inflation
• Pro appreciation strong fundamentals (including
  BoP until recently), EU catch up
• Against sometime regional links, low nominal
  interest rates, perspective of the BoP
• Recent financial turbulence has caused
  appreciation of CZK, as many short positions have
  been cancelled.

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labour market improvement substantial, is it
just cyclical?

• Unemployment falls slowly in 2005-6, share of
  long-term unemployment is high
• Since mid 2007, decline more evident despite of
  no substantial improvement of labour market
  regulations
• Employment increased more than 1,7 in 2007
• Growing evidence of labour shortage in recent
  months, outflow of foreign workers is a real
  threat
• Openness of market (access of non-residents) can
  compensate small flexibility of domestic labour
  market
• Than, issue of outflow of foreign labour creates
  new risk.

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and fiscal policy is source of concern

• Effort to consolidate public finance in good
  times was limited
• EU commitment not respected
• Since 2007, new social transfers approved, in
  2006 tax cuts
• Reform package (tax reform and some expenditure
  cuts) effective next year, is not primarily
  focused on deficit reduction
• After deficit reduction in 2008, year 2009
  uncertain
• Brussels commitment should be respected as the
  minimal effort.

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Risks for Economy

• Growth perspectives in EU source of more concern
  than earlier
• Reaction of the economy on price increases next
  year
• Currency appreciation at which level it can
  hurt the growth?
• Problems in the field of public finance still
  last
• Problems in structural sphere are not solved so
  far
• Pension reform
• Changes in health care.
• Problems on labour market (partly flexibility of
  labour market, set up of social system and
  qualification / regional mismatch) more should
  be done
• Education system should better respond to a real
  world.

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Czech Republic, new EU states and Euro

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Discussion on Euro in new EU states

• New member countries do not have opt out, now
  more outs than ins from 10 new member
  countries 7 planned after EU accession to adopt
  Euro till the end of decade, first already in
  2007
• Reality different, so far, only Slovenia is in
  Eurozone, Cyprus and Malta will join next
  January
• Some countries changed their mind issue of
  willingness to do now the fiscal reform key for
  many states
• In CR the discussion on Euro was not a priority
• Crown does not suffer from the lack of
  credibility and is stable in last years, interest
  rates are not higher than in Eurozone
• Financial market offers different types of
  short-term FX risk management tools.

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New EU states at glance

• South wing
• Small countries, only one catching up economy
• Managed float, relatively small financial market
• North wing
• Small countries, fastly catching up, closely
  linked to Scandinavia
• Currency pegs for many years

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• Central Europe
• Medium size countries, catching up economies
• All forced to leave FX anchors, currently mostly
  free floaters
• More volatile economic development with periods
  of divergence
• More problems with fiscal policy.

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Some aggregate figures poor and cheap neighbors
GPD pre capita (EU 12)
Price level (EU 12)
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Growing together ? No, thanks

• GDP cycle symchronisation weak, as economy
  started its robust growth
• Some benefits of both growth or even slow down of
  EU
• Manufacturing influenced by German industry a lot
  (car market).

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Trade argument holds? Yes !

• Very strnong trade relations
• Similar development in investments side
• Even 3rd country firms producing for EU market.

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Euro dicsussionEconomy vs. ideology

• Often divided into nominal convergence (mainly
  Maastricht treaty rules) and real convergence
  (OCA).
• Fundamental and well-founded discussion on risks
  of FX volatility and competitive advantages of
  countries that will adopt Euro, or on costs of
  Euro adoption and benefits of independent
  monetary policy is not too advanced
• Many economists do not believe it can bring exact
  results as exact arguments for or against could
  be hard to found.
• If anything matters, than it is flexibility of
  economy ...
• but it should be demanded also without EMU
  entry
• and rate of flexibility is difficult to measure

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Real Convergence CR
-

• Correlation of macro indicators growing up but
  still moderate at maximum
• Structure of economy different from economies of
  most EU members
• No inprovement of the flexibility of economy in
  recent years
• Members of Eurozone grow more slowly than outs
• To fulfil the criteria can be difficult.

• EU growth is a very strong determinant of our
  economic growth
• Very high proportion of foreign trade with EU
  (FDI as well)
• Reduction of costs on foreign trade will
  accelerate economic growth
• Euro adoption will solve some domestic problems.

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rules and new national strategies are there

• Base to access nominal convergence is the
  fulfillment of Maastricht conditions
• Real convergence is relevant for future
  development (cost / benefits) of a new member of
  Eurozone.
• Remaining Outs have various strategies in
  some cases the first attempt has failed
• Peggers are now strugling with high inflation
  (among other things)
• Slovakia on its way to adopt Euro in 2009
• For rest of the countries in our region, adoption
  of Euro means more significant change of monetary
  policy. In some countries, not a clear politic
  support.

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how are the rules applied ?

• Case of Lithuania and Slovenia showed willingness
  of Eurozone to accept new members but at the same
  time illustrates that the examination is very
  strict
• Next wave of Cyprus and Malta without big
  discussion
• Recently more discussion about real convergence
  issues.
• So are new members ready?
• In general, economic situation and rate of
  convergence of 10 new members differs from the
  situation of most countries that have created
  monetary union.

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Balance CR vs. Maastricht

• Stable and safe observance of 3 limit of public
  deficit requires changes in public finances
  (pension reform will can increase deficits in
  future too)
• Recent rigid interpretation of inflation
  criterion could be a source of concerns too and
  requires certain level of preparation
• Capability to limit FX rate volatility, and pass
  successfully ERM II and correctly fix FX
  rate, could be a challenge for macro policies
  (see Slovakia)
• Other two conditions (public debt and long term
  interest rates) seem to be easier to fulfil
• What means sustainability? Maybe we will learn
  soon.

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New EU vs. Maastricht State of play

• Entry of new members into Eurozone in 2007
  (Slovenia) and in 2008 (Cyprus, Malta)
• After Lithuania case more concerns among
  applicants, but Cyprus treated friendly way
• Baltic applicants out of game for some time due
  to very high inflationNext on the line is
  Slovakia, that is more similar to other VI 4.
• Bad state of Hungarian public finances put off
  possibility of quick Euro adoption in Hungary, in
  Poland it is not a political priority
• These countries do not want to stay at ERM for a
  long time
• New strategy for CR (after giving up date 1/1
  2008) set no date so far, yearly autumn
  evaluations will continue.

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Ludek.Niedermayer_at_cnb.czwww.cnb.cz