Zdeněk Hrdlička, Head of the Fiscal Unit within the Ministry of Finance’s Financial Policy Department comments on the Czech Republic’s fiscal concerns and future plans.
12/3/09
Introduction: My area of work concerns preparing a fiscal outlook and convergence program; these are the main two papers, which introduce the Czech Republic’s fiscal policy to the public. Right now preparing the fiscal framework means working on the budget.
Could you discuss how your fiscal forecast has changed since the start of the crisis up until now?
It has changed dramatically, of course. We expected that the deficit for this year would be 2% of GDP, however now we will see a rate of 6.6%, maybe even worse. The difference is huge. It’s possible to say that there are two main reasons. This is due first of all to the crisis, and there are very strong automatic stabilizers in the Czech Republic. We have very strong fiscal automatic stabilizers (and this is typical for continental Europe, and maybe even more so for the Czech Republic). So the drop in tax revenues was very large. However this drop was caused by the crisis and by our previous measures from 2007 in which we planned to lower tax revenues for the public. So these were two reasons for this development.
According to our statistical office there is a drop in GDP by 5%. I wouldn’t say that this is extremely dramatic. In fact, in Prague you can’t see any change. It’s possible to see some local problems in rural areas. But, you know, the previous times were strongly related with low interest rates for loans. Some special parts of industry were heavily dependent on these loans and after the crisis they didn’t have any chance to finance their needs, so they went bankrupt. This was typical of the glass industry. It was obvious that they couldn’t compete with the Chinese glass industry. They should have had their own specialized products, but this wasn’t the case so they went bankrupts. It’s partially related to the crisis, but these industries were dead in fact before the crisis; the process of ending went more quickly before the crisis, but in two years they would have had the same result.
Under what circumstances do you believe the Czech Republic will have better interest rates?
I am not quite sure that it is possible to return back to very low levels of interest rates. Risks are higher and we wouldn’t likely see such low interest rates for several years at least.
What future do you see for the financial sector once the recession has finished?
I can speak more about the Czech financial sector, and in fact we had very serious crisis let’s say ten years ago. This is the reason our banks are very cautious at the moment, and were not affected by the crisis. They still have the same profit ratio as a year before or as in 2006, and are doing extremely well. So our financial sector is in very good shape.
However, our banks are owned by foreign banks. These mother banks set the rules such as to whom we should lend money, how to borrow, how to lend money, to what extent and so on. They are very cautious now, so interest rates are higher now in the Czech Republic. After several years the Czech National Bank has higher interest rates than the euro zone, so a higher level of interest rates here reflect this fact. It was after, maybe ten years, when our rates were lower than in the EU.
Do you think it’s possible for the Czech Republic to become less connected with Western Europe in the future, aside from this bank relationship?
No, I don’t see this possibility. However, you know the Czech Republic is in a quite different state than many of Eastern European countries. We have a very high savings ratio, and in fact these banks are owned by foreign companies, but they don’t need foreign funds. With this ratio loan, bank loans comprise about 80% of national deposits, so in fact we don’t need foreign funds to banks. From this point of view our banks are independent.
To return back to the crisis, we saw here declining fiscal and economic predictions from month to month. Why do you think analysts underestimated the impact?
Yea, you are right. We prepared the macroeconomic forecast in the Ministry of Finance, and we didn’t want to cause problems for banks, and so on. It was obvious that the outcome could be worse, but we thought that it would be better not to increase panic.
Public panic or panic for policymakers?
I would say public panic. There are two things mixed here sometimes. In fact the financial crisis did not hit the Czech Republic, but of course the economic crisis did affect us. The Ministry of Finance told the public that the financial crisis couldn’t hit us, but of course economic crisis could come.
So you published these forecasts with the knowledge that it could be worse?
We were aware that the risk is to decrease the expectation of growth. Your estimate is just one point, but in fact you can expect some trajectory. It was obvious that our predictions were on the upper end of this interval.
What accounted for that difference between the actual and projected? Were there any specific problems?
In fact, these huge changes in the economy are very problematic. Statistical offices all over the world are not exactly able to distinguish among components of growth; this is typical. There are huge changes in inventories, but you don’t know about these changes. After some time, statistic offices change these numbers, and put these changed inventories into investment and consumption, and so on. But now we just see that there was a drop in investment by 1%, and one quarter after there was an increase by 15%. There’s nothing to be said about this; you are just left at a loss. These days it is very difficult to realize from statistic data how the economy is behaving and what will be the future.
What do you think will be the long-term implications of the 6.6% deficit?
Of course there is a very strange dynamic in debt growth. With higher debt and higher interest rates, we will have to pay more for this increase. It means lower funds for public services, social transfers, and so on. It’s problematic and the development isn’t nice. Just before we introduced our last austerity packaged, we expected that by the end of 2012 we would reach 60% ratio of debt on GDP. This the Maastricht criteria, so crossing this border would be bad
How would ‘crossing this border’ change your position within the EU?
In fact at the moment I would say that even half of EU member have crossed this border. It’s something like a magic border.
How much have EU regulations affected your policiy proposals or measures passed?
Just now the Czech Republic was included in the Euro Council’s excessive deficit procedure; as a result we have to report our procedure for improving our deficit. This is our main press from the EU, and thank God for this because otherwise our politicians would just spend money. It’s very useful, in fact, to have this Stability and Growth Pact and to be in the EU and receive some outside pressure. This of course means some support for us as employees of the ministry when we go to politicians and say, look you have to change these things.
What are some plans you have that you report to them?
I believe it was made before this procedure, however, we introduced an austerity package. Maybe we will be the first country in the EU, possibly with Ireland, to introduce an improvement in the deficit in 2010. All countries would like to start with conservation in 2011. This package consists of measures on the revenue and expenditure side. Higher taxes are designed to last indefinitely but our expenditure measures are introduced just for 2010. This means we will improve our deficit for 2010, and then it will go down slightly in the future. These measures are not enough to reach our goal, 3% of GDP, so we will have to introduce some other measure. At the moment we still have to prepare some materials for this, but it’s not possible to speak about it.
Do you think that the deficit will have long-term implications if it stays at the current rate? Will it have negative implications for the recession?
In the end it will have implications for social spending, but you know the situation is not so bad. In ten years, it could be a real and serious problem, maybe like in Hungary, but we have still five or ten years, five with these problems. However, we have to all look forward, it’s not possible to wait. It’s better to start with press on politicians saying that it’s necessary to start with some measures.
What is the reaction of politicians to this?
It’s a difficult situation, as you know. We will have elections next year; according to public finance theory, just before elections all politicians want to spend money to reduce taxes increase social transfers and social benefits, but it will not be case. There are huge risks and the deficit for next year could be worse in the case that politicians pass new laws according to social benefits, so on.
How can the ministry combat this?
We are the servants of politicians, so we cannot fight. But we have to write a report saying that it’s not sustainable, that it’s not quite a good idea, that we should do something else, something different. It’s not our job and we can’t make miracles.
What do you see as the next government’s most pressing issues aside from the deficit?
There should be serious cuts in expenditure, however this is not too easy. I would even prefer a very serious look at some specific items. It’s quite interesting, in fact almost half of households get some social support, but this is crazy. It’s expensive, because you have lots of clerks who should distribute this money, and average support is very small so it’s totally ineffective. On the other hand, you can save an uninteresting amount of money with cuts in these programs.
At this moment (during the crisis) it’s very expensive to fund public transport and infrastructure. Especially in the Czech Republic, these projects are very expensive. It’s more expensive to build one km of highway in the Czech Republie than it is in Germany, but in fact our wage level is one-third that of Germany’s, so I can’t see why it’s so expensive. It’s terrible, and during the crisis it’s stupid to pay so much. Just at the moment I would prefer to cut and postpone investments in infrastructure. We can live and survive without it, and simply cannot afford it right now. There could be some specific cuts in social programs however, doing so is not easy and in any case it’s necessary to support some groups of society.
Can you comment on NERV’s recent publication offering a vision for the Czech Republic? Do you think that the Czech Republic will be able to implement these recommendations?
I wouldn’t say that this was very useful material. There were at least 100 recommendations, and maybe ten of them were clever. On the other hand, during the next ten years we will be able to implement enough reforms to tackle with the Hungarian scenario, But it wouldn’t be by the recommendations from NERV.
What specific recommendations did you see as clever or feasible?
There was a recommendation to improve our fiscal framework and budgetary rules, but it was just a general idea. It’s necessary to list some details, to make this idea more accurate. I do agree that it is necessary to improve the budgetary process in the Czech Republic.
What specifically do you see as feasible in improving the fiscal framework?
I have just seen a very nice recommendation by employees of the Slovak Republic’s National Bank. These changes include limiting politicians’ power, so it’s very difficult to persuade them to approve it. Perhaps the situation will be worse before they will accept these recommendations.
Do you see politicians’ power as a long-term issue? And corruption?
Political power is not necessarily related with corruption. You know, investment in highways is about corruption, but not these budgetary topics. Is just that our politicians have limited foresight. Just after elections, they are able to introduce several good measures, but before elections they introduce not very good measures. This cycle lasts four years, and so they are not able to see forward. This is a long-term issue as well.
What future do you see for the Czech Republic? (e.g. GDP growth, vision for five years from now)
You know that almost all European countries have huge deficits and according to EU framework they will have to increase the surplus. This means very hard times for all European economies. We have a very small open globalized economy, so if the growth in Europe will be low, as will the growth in the Czech Republic. For the next five years, in the best case we could have 2% growth of GDP, not more.
Does this depend a lot on exports?
Yes, definitely.
How have exports fluctuated since the crisis?
It went down by 18%, but this is quite a normal figure during hard times. This stems from changes in demand from all European countries.
Do you expect any improvements for the near future?
Nowadays these forecasts for Europe are better than we have and work with. For the next few years, it could be slightly better. But after that starting from 2011, Germany will begin introducing their austerity packages, so we will see the reversed and the situation will worsen.
How do you think that the Czech Republic can seek to improve their growth potential? Could they improve the growth rate for the next few years?
Doing so is very difficult. You know investment in R&D is recommended and pronounced by all our government bodies. In fact, there was a conference of the Civic Party just two weeks ago, and they wanted to introduce some vision for 2020. I had the opportunity to comment on their recommendations for higher growth and R&D. I realized that there could be some support from the state, but these things depend on people. Partially we can increase salaries of scientists and so on. We can improve marketing to children saying that science is a great future, not to be a football player but a scientist, but these are only soft measures. You cannot have science without smart, competent, capable people, but this depends on the people. The chance of the state to do something is very low.
Can the state try to change the educational system to improve this?
I would say that it depends more on, as I said, marketing. To show that this part of life is interesting and these places are interesting, and scientists are important and have a high social status. This is not exactly related to education. The system of education in the Czech Republic was quite different from the system in Western countries. We still have a very low ratio of people with university education compared to Western countries. However, the average level of quality is lower, and you can see the decline in quality of university graduates. So while we administer more degrees, the quality of these degrees has decreased, so the trend is quite reversed and I don’t know how to improve the situation.
Can the Czech Republic do something to encourage foreign investments in R&D?
Yes, but it’s necessary to have good scientists. In the past, we tried to bring new investments into higher industry, and its obvious that this was a mistake. Now we are trying to bring small investment in services and development and so on. This is definitely a better attitude. Of course the volume of investments will be much lower based on the difference in target (when you want to build up a huge factory vs. when you have a small office). It’s not necessary to look at the volume of investments, but to the structure. This is much more important.
Investment could definitely affect the potential for growth in the Czech Republic.
Would you recommend that the country look towards other sectors aside from R&D, such as services?
Yes, definitely, to R&D and services. The share of industry in the economy is the highest in the EU. We would have to improve our sector of services.
But that share might naturally go down overtime as industries will move farther East?
Yes, it’s possible. But the increase in investment of services and R&D would help lower this ratio.
Are there any policies that you would recommend to increase market potential and distinguish the Czech Republic among other CEE Economies?
All countries want to target biotechnology, green technology, and so on. I spoke with someone from the OECD, and it’s clear that all countries want the same specialization, which is impossible of course. So it’s difficult to pinpoint the right specialization.
How have your forecasting strategies changed as you’ve been coping with the crisis?
Maybe now we are more cautious and have conservative expectations. With regards to strategies, we switched from stimulus measures to austerity measures. We didn’t want any stimulus measures in the Czech Republic, however, we were preparing from the new presidency so it was impossible to not introduce a stimulus package as an EU presidency country. After that we immediately switched to austerity measures. Since then we have been preparing our politicians for austerity.
I understand that the deficit is a main concern. Do you believe the government was preemptive in implementing austerity packages? Was there enough time for other packages to come into force?
No, there was not enough time for this. As I said, we didn’t need stimulus packages. Therefore there’s no pity that part of them haven’t come into force. This is just my opinion, but I don’t think it’s such a big problem.
Do you think the austerity packages will properly address the deficit?
For next year, this is really the maximum we can introduce. We prepared two budgets and had several meetings with the Minister and with politicians. I really can say that it was the maximum that was possible.
Do you have faith that the next elected government will follow through with the maximum measures possible?
According to the decision of the European Council, we will have to reach the Maastricht criteria of the deficit by 2013. So yes, due to the pressure from the EU, the next government will move towards this goal. But you know, this Maastricht criteria is not a miracle; it’s better to have a surplus, of course, from the point of view of fiscal matters and with regard to the budget. It’s my work to protect the budget. Of course there are negative macro implications, but at least the structural deficit should reach 1%, so we still have a lot of work.
In the case of the Czech Republic, would you recommend the Euro adoption for the near future?
We are very cautious with the Euro adoption. My colleagues and I believe that it’s not the proper time to adopt the Euro. The reasonable time for it would be between 2016 and 2020. We have still enough time and our economy is not strong enough to accept the Euro. Our level of value added in the economy is not so strong and we are still not able to compete with Germany and the best European countries. It’s necessary to first improve this and then to accept the Euro with no problems.
What would be needed to improve the situation?
Perhaps just time. You know, as I said I don’t believe in a very strong state and it all depends on the ability of people. For them, it’s necessary to have time to adjust behavior. In the Czech Republic you saw huge progress over the last twenty years. So, yes, this factor of time is perhaps the most important. At the beginning of the 90’s, almost no one was able to communicate in English. This has changed; lots of people could work abroad, so on and so forth. It’s important that in the next ten years we will move forward.
Does this include increasing higher education?
Yes, increasing education. In the next few years it’s possible that salaries will go up slightly, and it means economic pressure on say, production with higher value added. This is important. Reasonable increase in salaries and wages would force entrepreneurs to improve the quality of their production. They could then compete on Western markets and then we can then become a part of the Euro zone.
Will the high savings ratio be helpful in the long run?
You know this ratio will decrease in the future. However, it wouldn’t reach, lets say, the level typical for the US. (Which is negative) We are close to the Germans, Swiss, and Japanese with a higher savings ratio level. It will go down or still remain high. It’s purely a feature of the economy. Theoretically it could help, however you could see Japan with extremely high savings ratio of households, but it must be somehow balanced by high expenditures of the government, and Japan has a 300% debt of GDP. So they have high savings ratio however the economy the last 20 years has not grown much.
Do you believe the Czech markets will see a second dip?
We expect for next year, lets say positive, in fact 0.8% real GDP growth. However, this possibility is still on the table.
On what variables would this depend?
It would depend on the problems in Germany mostly; this is typical. It’s said that we are almost one state of Germany. In the case that they would experience a second dip in the economy, it would be the same for us.
