On July 15, 2015, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with the Czech Republic and considered and endorsed the staff appraisal without a meeting.²

The Czech economy is growing strongly on account of improving domestic demand and robust exports. Growth accelerated in the first quarter of this year and high frequency indicators, including retail sales, production and consumer confidence suggest that the growth momentum has continued in recent months. The labor market also has been recovering fast and the unemployment rate declined to the lowest level since 2009. Led by an improving trade balance due to positive terms-of-trade developments, the current account turned to a surplus. In the face of a drop in energy and food prices, headline inflation decelerated sharply in 2014 and is hovering just above zero, while core inflation remains stable.

Following substantial pro-cyclical fiscal tightening in 2011–13, fiscal policy has been supportive of the economic recovery. Specifically, the general government deficit increased from 1.2 percent of GDP in 2013 to 2.0 percent in 2014, implying about a 1 percentage point easing in the fiscal stance. The relaxation was mainly due to a negative surprise in excise collections, and an increase in capital spending.

Monetary policy has remained accommodative. In November 2013, constrained by the zero lower bound and facing deflationary pressures, the Czech National Bank decided to use the exchange rate as an additional instrument for inflation targeting and announced its commitment “to prevent excessive appreciation of the koruna below CZK27 per € by intervening in the foreign exchange market”. The exchange rate has been hovering above that level without any official intervention in the foreign exchange market since November 2013.

The banking sector is stable and credit growth shows signs of a recovery. Czech banks are self-financed with a low system-wide loan-to-deposit ratio and strong capital and liquidity buffers. Despite a slight increase in the non-performing loan ratio to 5.6 percent last year, the ratio remains low. Credit growth is slowly recovering driven by demand from the corporate sector and recent lending surveys point to easing lending standards and gradually rising demand for credit. Funding costs have declined further.

The outlook is for strong growth and low inflation. Growth is projected to accelerate to 3 percent in 2015, mainly on account of higher investment and improving household consumption. Inflation is likely to remain very low in 2015, before rising gradually toward the cenral bank’s target in 2016, as base effects from the oil price shock fade and declining economic slack starts to pull inflation up. Over the medium term, output growth is set to stabilize at around 2¼ percent, but a period of faster growth is possible, driven by the strong pipeline of FDI coming into effect.

Executive Board Assessment

In concluding the 2015 Article IV consultation with the Czech Republic, Executive Directors endorsed staff’s appraisal, as follows:

The Czech economy is growing strongly but challenges remain. The economic upturn is driven by robust exports and improving domestic demand being helped by accommodative macroeconomic policies. The labor market has been recovering fast with strong employment gains and real wage growth picking up gradually. But while disinflationary pressures seem to have abated, inflation is still below the central bank’s target. In addition, potential growth is well below the level necessary to facilitate fast convergence toward the income levels of other advanced European countries. Thus, the challenge for the authorities is to create the conditions for sustainable growth while safeguarding macroeconomic stability.

Fiscal policy and the medium-term fiscal objective need to be anchored in fiscal framework legislation, and the composition of the budget should be improved. The remaining output gap, low inflation, and the fact that monetary policy is at the zero lower bound warrant maintaining a slightly accommodative fiscal stance this year, as planned by the authorities. At the same time, though, modest and very gradual fiscal consolidation will be necessary beginning next year, in line with the authorities’ commitment to a medium-term objective of a 1 percent of GDP structural deficit. Moreover, this objective should be cast in fiscal framework legislation that would include expenditure ceilings, a debt brake rule, and a fiscal council—thus helping anchor fiscal policy and guard against pro-cyclical tendencies. Finally, there is scope to improve budget composition, with increased capital spending to address infrastructure needs offset by efficiency gains in current spending and improved revenue administration.

The central bank should continue to focus on inflation targeting. The exchange rate floor has proven effective in fending off deflationary pressures, and in combination with recovering demand conditions, inflation is expected to rise toward the central bank’s target in the second half of 2016, thus facilitating an exit from the exchange rate floor. The central bank should thus maintain its focus on inflation targeting in its policymaking and communication, while continuing to evaluate the conditions that would trigger a normalization of monetary policy and the mechanics of its implementation. However, given the only gradual closing of the output gap and asymmetric risks at the zero lower bound, monetary policy will likely need to remain supportive for some time even after abolishment of the exchange rate floor and return to a floating exchange rate.

Continued vigilance will be needed to sustain the stability of the financial system. The banking sector is self-financed with low system-wide loan-to-deposit ratio and strong capital and liquidity buffers, which make it resilient to shocks. Moreover, bank supervision has been strengthened by increasing supervisory resources, approving a new law on credit unions, and starting utilizing the macroprudential toolkit of the Capital Requirements Regulation IV. Nevertheless, proactive supervision remains necessary along with further gradual improvements in the supervisory architecture, including the transposition of the Bank Recovery and Resolution Directive into domestic law.

An ambitious structural reform agenda is key to lifting Czech Republic’s potential growth. Sustained progress on wide-ranging reforms to increase labor market participation, enhance investment in human and physical capital, and improve the business climate is essential for higher investment and growth. Reforms of the labor market should aim at increasing labor participation among women with children and low-skilled workers, while greater emphasis should be placed on mitigating skills mismatches. Priority should also be given to promoting research and innovation, enhancing apprenticeship programs, simplifying tax compliance and other administrative procedures, and improving infrastructure.