12/9/09

When the crisis first manifested in the Czech Republic, what worried you and your colleagues most?

For [CzechInvest] the crisis first started when it began in the US. Most projects were basically put on hold. The positive side about it is that not all of them were cancelled. Most of the projects that we were working on were just postponed until the crisis is gone. This is happening right now; the US and world economies are getting better. You know, these developments started in the US and took about a quarter and a half of a year before they spread worldwide. Right now we are having more projects from the US and elsewhere as well.

New investments in the Czech Republic have basically taken a one-year holiday, or a year and a half holiday, but they are getting better right now, so to speak.

Did investment participation decrease as the effects worsened for the Czech Republic and the effects were felt in the EU?

Well it depends because, yes, it hit the Czech Republic at the end of last year, November/December. But you know, when you are concerned with new projects, then you need certain criteria to be met in your state, like the level of unemployment and so on. Before 2009, we had a different problem. The unemployment rate in the Czech Republic was so low that many investors said, we won’t be able to find anyone here, even though there were regions in the Czech Republic where unemployment was quite high, like northern Moravia or northern Bohemia. Also, a few investors just said, well the unemployment rate is so low that we don’t want to consider the Czech Republic at all. So, when the crisis came, some projects took advantage, or will take advantage of this in the near future. Yes, in this sense it helped, even. As you can see (from this graph), this is the structure of new investment projects mediated for the Czech Republic by CzechInvest. (R&D, Services, and Manufacturing) As you can see, investments are more and more into services and R&D, and less into manufacturing. This is precisely because of the low unemployment rate in the Czech Republic. There is no more space for large projects like Hyundai – large car producers.

By the way, Hyundai started about two months ago, and they aim to create about 12,000 new jobs in the region. (This includes all the suppliers, etc.) So this is a great project for the region as it is now, but there is hardly room for something as large as this anymore in the Czech Republic, even during the crisis. Maybe there are a few regions in the Czech Republic where this can be built like the Zlin region with the new strategic industry zone that has been opened there about a month ago. But, this is basically the last place in the Czech Republic where something like this can be built.

Perhaps this is an advantage because you can focus more on R&D and services development?

Yes, this is true. Though there is more to it; there are two parts to it. Around 2007, two new European programs to support investment in R&D and services started. We are administrating these programs, so they are logically more visible in our statistics, but they also definitely helped attract even more investors into R&D. This is one part.

The long-term part is that when you have not very complicated investment into manufacturing, you can place it anywhere in the world, Romania, China, you name it. But after a while, when investors realize when the Czech Republic is quite a good place to be in and quite pro-business, a lot of companies realize that it’s actually a wise thing to invest into R&D here. The examples include a Japanese manufacturer of car air-conditionals in Liberec. Others are Panasonic and many more. These are companies that first came to the Czech Republic with manufacturing and now are much more into R&D because it’s even better for you when you have manufacturing and right next to it you have R&D which you can directly apply into manufacturing. This is true for the long-term anywhere else in the world. There was a project where, coincidentally, one company built almost the same plant in the Czech Republic and one in Romania, and the Czech plan is much better off now. It has been enlarged; they have invested more money into it and have also established more R&D there, whereas the Romanian one didn’t go as well. The Czech Republic seems to be a good place for such investments.

By the way, about a year ago IBM restructured their whole business for the CEE, Middle East, and Africa region. They have reestablished their headquarters for this region in Prague. This location was in Vienna, and they decided to establish a new headquarters here. I spoke with them, and they said, well basically we were considering our other options in the region like Poland and Hungary and Slovakia, and Prague was the only logical choice after we visited all the other sites. They really felt that the Czech Republic was the most pro-innovation and forward thinking of this region. That was quite a nice discovery.

How much money do you think will come in/investment increase because of this?

This is a difficult question. If you see here, we have statistics of CzechInvest, just of our projects. This is the volume of new investment and number of new projects. As you can see, super projects invested such as TCP or Hyundai carry great weight. In 2000, we had a record year for FDIs worldwide, and its been dropping ever since then. In the first half of 2009, CzechInvest mediated 10 billion CZK for the Czech Republic, which is about 40% less than the same time the previous year. There rough estimate is that it can be 40 % less in 2008, which means that about 20 billion CZK worth of investment through CzechInvest for the Czech Republic, but these are very rough figures.

Maybe what is more important is that, if you look at these graphs, at the end of the 90’s, the world was also in a recession. But as you can see in the end, the Czech Republic was a winner. We hope that a similar trend will be seen now. As I said, we won’t have large projects as TCP, because space for such large projects is quite limited. But we believe, and we have seen this trend, that there will be a lot of investment into R&D and into high-tech manufacturing, especially due to the crisis.

The crisis is driving many companies to consider options to lower their total cost. This is true even of companies who were not at all concerned before the crisis, like those who supply higher-end automotive manufacturers in the Czech Republic and in Europe. Their margins were quite high, and they thought it would be too expensive to move somewhere else, but in the end the crisis was forcing them to rethink their decisions. Yes we are seeing some of these companies start to be interested in the Czech Republic. It’s quite early to say which companies will finally decide to invest in the Czech Republic. But at the moment we have at least two companies that are exactly like this. They were based elsewhere and they want to centralize their production in the Czech Republic to have one single bigger plant with lower costs. Not just because of wages but also because of the possibility to invest into newest technology and into production that will be cheaper than elsewhere. (Technologically cheaper)

Do you have any programs encouraging this sort of investment?

Yes. We have the national investment incentive scheme that has been running since 2008. It was promoted quite heavily until now. It allows companies to be awarded cash grants for creating new jobs and for retraining in regions where the unemployment rate is 15 % above the state average. This includes quite a low number of regions, and CzechInvest is trying to make the government broaden the scope of the program. But also within this program you can have tax deductions from the income tax for your company. Basically if you invest, lets say, 1 million USD, you can have 40 %, that is 400,000 USD, worth of tax deductions in income tax over the course of 5 years, which is quite a narrow margin. We are also trying to persuade the government to make this duration longer. It used to be 10 years, we believe at least 7 years would be a better incentive for a company to invest in the Czech Republic. Because, if you compare our investment schemes to our neighbors’, the good thing is that we have a law on investment incentives which is not true of Slovakia, for example. This makes investors feel safer and more equal. But it also limits the opportunities. For example, a few weeks ago the Slovakian government awarded about 30 million euros I believe, to a company that produces LCD displays. This is not possible under the Czech rules for investment incentives.

Actually, this investment supported by the Slovaks is actually quite low-tech. Of course there are other projects that we would like to see in the Czech Republic that might be tempted to come here or elsewhere because of the ability to draw cash-funds. This is not possible in the Czech Republic, but Germany does give cash grants, Slovakia does give cash grants, so this is a good measure to promote investment.

This is true for manufacturing. Regarding investment into R&D, we have European structural funds. They are quite a strong incentive for investors because, again, you can have up to 60 % worth of your initial investment back from the European structural funds. For a large company it’s 40 %, small company it’s 60 %, and for a middle-range company it’s 50 %. You can choose from what to count this percentage. It can be from initial investment into the building, new technology, etc., or from two years’ wages. So you sum that up and you can get some % from the government back.

Have you seen great response to this program?

Yes.

Do you expect the government incentive funds will decrease because of their focus on decreasing expenditures due to the deficit?

Regarding investment, these European structural funds are different. They are given through 2010 and 2013. Regarding the investment incentives, if you lower taxes for someone, you don’t pay them anything. This basically means no expenditure for the state to prolong the tax-deduction time. But it’s true that these incentives have been diminished over the course of the year. They were actually changed last year quite drastically, they were cut quite heavily even before the crisis started. The number of regions where you could have cash grants –  well what is important is the change of time by which you can take out cash deductions, from 10 years to 5 years.

We’ve actually conducted studies with regards to effectiveness of investment incentives. For every dollar placed into investment incentives, the state gets 2.5 dollars back. Of course we did it so it may have been biased, but we really tried hard to make it not biased. There were also some other findings about this that not all the new jobs created were really created, they were moved from some other sphere. But in the end, it was clear that it really is a good thing and produces more for the government.

You said that when the crisis first started in the US, some projects were postponed. Were there any specific sectors that felt this change the most?

It was felt among all sectors. Across the board. It will take time for the number of new projects, for the inflow if FDI incentives to recover. You can cancel a project the next day, but it takes time to renew it. For example, with Japanese investors this might take 2.5 years. Regarding the sectors, it really is across the board, with maybe an exception in IT and software development because we are quite strong in those fields. Actually, in the first half of 2009, every third project was software development. And 85% of all projects were in services and R&D.

Are there any moves to encourage green technology?

Well if you consider this a move, CzechInvest officially established this sector as one of the most important sectors for investment – about ¾ of a year ago. So yes, there was a move to promote this. But it’s true that (I can’t speak for the sector because I’m not an expert) that with the European drive for renewable energy, most visible for solar energy in Germany, there are companies that are considering manufacturing solar panels in the Czech Republic. This is precisely because Germany has some quite strong incentives for solar power production. You need to have solar power plants to produce power. Some companies were interested in producing them in the Czech Republic. There are some operating in the Czech Republic, both manufacturing, but also some are really creating them. (Like there is one in northern Moravia making silicone for it, among others.) Also, regarding renewable energy, there is high demand in the Czech Republic (true also for Czech Invest) because we run an expansive database with business properties. Many investors approach us asking if we can advise them on a place to build a solar power plant in the Czech Republic. The incentives for creating solar panels in the Czech Republic are quite strong, but they are being diminished, again, because of the crisis. It’s true that they were really quite high.

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Do you believe investment is the key to bringing the Czech Republic out of the recession? Will the country experience the same patterns as in 2000?

Hopefully. If we go back into time in ‘98 when the investment scheme was adopted in the Czech Republic, the reason behind this was after 40 years of a centrally-planned economy, we have large (old, not green) companies in the Czech Republic, not competitive, with outdated technology and no managerial skills in many cases. They were just desperately competing, and in fact they cannot compete at the new market. The main reason to establish an investment incentive scheme was to be able to attract more foreign investors into the Czech Republic. Not just because of creating new jobs and building new plants, but exactly because they bring new technology and new skills and changing the Czech industry from really having industry and machinery that was dictated from Russia to something that is much more normal. This really worked out. If you look at the average unemployment rate in the Czech Republic, you can see that it was quite steady up until 1997, when a small depression hit the Czech Republic. Then it grew through 2001 and 2002 and started to drop quite drastically. A large cause of this drop is thanks to new FDIs. Many of them were mediated through CzechInvest or through companies that attracted their suppliers into the Czech Republic through CzechInvest. We hope that we will see a similar trend in the near future, not just in the number of large projects, but more importantly in the number of high tech projects. It’s true that the government is supporting them quite strongly. For example, about a week ago, a new joint project between the Czech Republic and Israel was announced that will support industrial R&D with over 60 million CZK over the next seven years. This scheme will support directly research that has potential to be sold and marketed. Not just primary research but something you can really sell like robust software and so on. These are things that will make the Czech Republic much more competitive and much stronger in the future.

How would you like to alter the business environment so as to foster new investment and promote competitiveness?

That’s a good question. If you look at the graphs, it shows that it’s not as bad as it might seem. There are of course some things that might be better in the Czech Republic. I already spoke about the incentives that might be stronger, but under these times it’s quite difficult to persuade others to spend more on investment incentives even though it is an investment incentive. But, what can be better with the Czech environment, we may be able to adopt more flexible labor laws. That would allow for more flexibility in the market.

How would you like to see the Czech Republic distinguish itself as a member of the CEE region? (As compared to Hungary, for example)

We hope to stay in a good fiscal state (compared with Hungary, for example). Hopefully this would help. What some people from IBM said, that we want to be the innovation leader for the region. The third part of this is that the Czech Republic really is an innovation leader. This is the most important thing: new technology, R&D, and similar things. This is the logical development and logical placement of the Czech Republic, because everyone is competing form R&D and services, but we are coping quite well and we believe that we can continue with this trend. This will mean more investment into education, into more vocation training, into being able to provide investors with people that are qualified to work with high technology. Not just high technology, but middle range technology. What is happening in the Czech Republic is that there are limited people who can work on new CNC computers, CNC machines, and a lack of people that want to work in lower tech environment. This is something that will be solved by new investment into R&D because the demand for what people want to do and what investors want people to do will be more consistent. Investors will want people who are capable of working with higher technology, and also people will want to work with higher technology. The state also need to educate them to be able to do that. This will be true of the Czech Republic hopefully in the next 10 years.

If I can make an analogy with another state, we can look at Ireland, back in the 60’s, it was a large countryside with a lot of people working on farms and so on. Then they started to heavily promote the country as a good place for FDI into manufacturing. After about 10 years, the trend changed from manufacturing into R&D, and then about another, say 10 years, it was not just for foreign companies, but genuine Irish companies that bought some parts of the companies – managers buy parts of the company that wants to move and essentially establish a new plant, or people working there gain the necessary skills and decide to establish a new plant on their own. This was basically what happened and we hope that this will happen in the Czech Republic as well. It happens sometimes, but not on a large scale. It may cost about 10 years to start happening on a large scale in the Czech Republic. The main change in the Czech Republic occurred over the course of 10 years, after the state started to invest heavily into manufacturing. Hopefully in a few more years we may see Czech companies being key players on the world stage.

With providing of capable, high-tech oriented work force, what do you see as the most valuable programs to promote this? How helpful would reforms in education, or use of marketing be?

Both are right, and both need to work together. I’m not sure if there’s any third way. For example, CzechInvest organizes regular meetings between companies, regional governments, and schools within regions, where companies can say what they want, schools can tell companies what they can provide, and the government pools together these two sides and says what they can offer. This is one way to harmonize the school environment with the government and business environment. I believe that the part of this on the school side is quite good at the moment. They are able to produce what companies want from them, but what is lacking is the marketing. We need to persuade more people to take up technical studies. Again, CzechInvest is doing something with this, but I’m not sure that this is entirely up to us. We organize some event called technology day. We try to convince high school students to go to technical universities. We had one in Brno and we will have another one in January in Prague. So yes, marketing technical studies for students is maybe now the most important way to approach this topic.

12/8/09

Introduction:

Basically what I am responsible for is to track the impact of the crisis and recession on the Czech economy. This is my temporary agenda. I’m interested in monetary policy and financial markets.

What were you most concerned about when it became clear that the crisis would affect the Czech Republic?

Well, definitely it was clear that something is wrong in the United States. We at first thought that this would lead to just some slowdown of the Czech economy. If I remember well, in the January forecast of 2009, we still projected some slow economic growth, and only in the April forecast did we project an economic downturn.

My personal concern was not about the financial sector because our financial sector is quite strong, but maybe about unemployment. Also recently I’ve started to be worried about the fiscal issue with the deficit and debt. But the unemployment, for me, is a big problem. On one hand, you have the total unemployment which is projected to peak next year and then gradually decline. The peak will be around 10% according to the method used by the Ministry of Labor and Social Affairs. But what you don’t see in this aggregate number is large regional differences. There are regions where now you have unemployment at 15%, and now the big problem with labor market is the number of unemployed people per one vacancy. Just today the Ministry of Labor issued statistics for November, and we’ve got some 509,000 unemployed people, but only 33,000 vacancies, so you get some 15 or 16 people for one vacancy, but this is just the average. There are regions where we have 40 or 50 people for just one vacancy.

Is there something the Ministry of Finance could do to address this issue, aside from maybe some tax reforms?

This is definitely a political issue. Politicians have to decide on the proper policies to deal with this problem. I personally liked those social security contributions reductions because I think this was aimed to keep people and jobs. Because if you reduce social security contributions paid by employers you reduce the cost of labor. But these were abolished because the concerns about the state of public finance grew quite large.

How do you think politicians can combat this difference between the effects in urban or rural areas?

Well, definitely what’s the problem is low regional and professional mobility of the labor force. People are reluctant to, let’s say, work some 50 or more km away from their homes. I think that there was a proposal to subsidize these distant travels to work. Also what could be helpful are some training courses, where people could change their qualifications or acquire some new skills. The combination of these two things would be helpful, but still I think it’s a long-term issue because people are not used to traveling large distances to work.

Are they interested in acquiring these new skills, or looking towards science as an employment option?

I don’t know to be honest. I think that if you are in a region where there is no demand for your skills, you have no other option than either to move somewhere else or to try to acquire new skills if you don’t want to stay unemployed. Actually, there is a program called ‘educate yourself’, which is one of the anti-crisis measures. Although, its scale is quite limited. Basically, firms that send their employees to those training courses to acquire some additional skills get some subsidies. It’s partially paid by the Czech state, but the majority is paid by the EU.

Returning back to duties of the Ministry, do you use other materials aside from your Macroeconomic Forecast (e.g. Czech National Bank forecasts) when you make these publications?

Every month we make our internal survey of forecasts of other institutions to get an idea of what they are thinking concerning future developments. We also, twice a year, make a similar survey, which is then published on the Web page of the Ministry of Finance. Maybe it might make some members of the Ministry change their thoughts, consider how other institutions differ in opinion. I think that mostly we make our own opinion based on the data we have.

Can you talk a bit about the forecasts for 2011 and 2012? There is a projected 2% GDP growth.

Well we have 2.8% for 2011 and 3.3% for 2012.

How can you account for the potential for a second dip, let’s say when Germany and other EU members introduce their austerity packages?

What is uncertain right now is what will happen when all of those fiscal stimulation measures will be phased out. What we believe in right now is that there will be no second dip in economies and markets. Although, I think that one cannot complete exclude this possibility. But, I think that when all of those fiscal stimulation measures will be gradually phased out, the economic situation will be strong enough that the recovery will be sustained.

How about exports and demand from other countries? Do you think this will fluctuate alongside the introduction of austerity packages in other countries?

Certainly, yes. Our export this year has extraordinarily good results. Because, all of those fiscal stability measures. For example, there is quite a big impact of the car scrapping scheme in Germany. Also, we’ve got lower prices of oil than we had in Europe before, so this helps our foreign trade balance as well. Definitely what we can expect is that when the situation abroad changes, then it will impact our foreign trade performance. But, well, with regards to our October forecast, in comparison with the previous July forecast, we somewhat improved the expectations regarding the development abroad. They compare the July and October forecast in the beginning of the publication. On the one side, you have improvement or better than expected development abroad, but on the other side you have the fiscal consolidation package effect in the Czech Republic. Basically these two effects offset each other. It’s interesting, because in the July and October forecasts, GDP growth is the same; this is just the key explanation.

What worries you most with these low expectations of GDP growth? Is the deficit of highest concern at this point?

The deficit and debt is of high concern because, I think that the Commission has already launched their excessive deficit procedure with the Czech Republic. What we are obliged to do is reduce the deficit below 3% of GDP by 2013. If we don’t succeed, there might be some negative consequences in terms of payments from EU funds. Also, if we don’t succeed, the markets might view this as a negatives sign, and we might have some other problems. For example, increased costs of financing the deficit. Definitely the state of public finance is a big concern.

What tradeoffs do you face when trying to tackle the issue of public finance?

One has to take into account the effects on the economy, but maybe if one decides to lower the deficit, then the tradeoff is how to do that – if you want to reduce expenditures or increase revenues, or a combination of these two. This is basically a political issue. Even if the political parties reach a consensus that the deficit has to be reduced (which I hope they will reach, because the EU will put us under pressure with this issue) then you have the Civic Democrats who want to reduce expenditures, and Social Democrats and Communists who want to increase revenues of the state budget. Reaching a consensus in this respect will be difficult. Personally I hope that we will make something of the deficit, and that something will really help our budget, even medium and longer-term, so that there won’t be some short-term measures.

What do you side with more, Civic or Social, as far as increasing revenues or decreasing expenditure?

Well, I think it should be a combination of both. The political structure may change somewhat. At one time the Social Democrats might be more powerful, and other times it might be another party. It is good that they reach a consensus. Even if there are some other elections in the future, power rebalanced, they will stick to their previous changes.

What programs do you think will suffer most as a result of consolidation?

I think that cutting expenditures and social spending will be particularly difficult given the high weight the Social Democrats and Communists put on this issue. Maybe wages in the public sector will be cut. For example, pensions might be increased less. Also, spending on infrastructure might be reduced. There might be some increase in taxes.

We will have elections in May or June of next year. Maybe what’s interesting is the new political partly, TOP09. They are more similar to the Civic Democrats than the Social Democrats. If they make some good results in the elections, there might be a shift in the balance of political power towards more cutting expenditure approach.

Are they garnering a lot of support?

The election surveys indicate that they might get something between 10 and 15%. They might even be the third largest party.

With regards to austerity measures, what do you want to see implemented for 2011, or is it too difficult to say at this point?

You just cannot keep cutting expenditures all the time. In my view, cutting expenditures and increasing revenues should be balanced.

What do you see as useful in NERV’s recent publication offering a vision for the Czech Republic?

To be honest, I did not read their final report. As far as I know, what you should take into account is informal institutions. You cannot take what they made in Finland and make an exact replica and apply it in the Czech Republic because the informal institutions are different. I even talked to one of the NERV members, and he basically said that the ‘copy paste’ approach is not feasible. Definitely what they did in Finland is make huge investments into education and research and development (R&D). I also support this. Interestingly enough, Finland is doing pretty poorly these days. I looked today at their recent GDP development, and I was quite shocked because in the third quarter of 2009, they declined by 9% almost on year on year basis. I really would be interested to know why this is so.

Do you think there are some improvements that can be made in the country’s fiscal framework? (This was one of NERV’s recommendations.)

What we should do in my view is change the structure of expenditures. You’ve got 80% mandatory expenditures. If you want to cut you have to change them all, which may be pretty difficult. Maybe changing the rules or lowering the share of mandatory expenditures would be helpful. Personally, I think that ensuring some medium and long-term sustainability of public finance is what we have to do very quickly.

Do you see that being possible, given that you have an interim government in place?

Well, it will be difficult. I think that the situation is no longer sustainable. You cannot run large deficits if you have quite nice economic growth, it’s not possible to do so in the long-run, so you have to make some changes.

Are politicians convinced of that?

I think some of them are, but not all maybe. I think that the pressure the EU puts on the Czech Republic with this respect might be quite helpful. You know, if we don’t put our public finance in good shape, then we might face some really ugly consequences. This definitely might make politicians take some more decisive action.

In the case that the Czech Republic reaches below 3% GDP goal by 2013, will they then look towards adopting the euro?

With regards to the euro adoption, you’ve got your Maastricht criteria, which is a necessary condition. What we also pay attention to is how our economy is really prepared for euro adoption – how much we can take advantage of the common currency. We of course also focus on how the business cycle in the EU or in the euro area and the Czech Republic differs. The Ministry of Finance and CNB published a joint report of these issues. I think that we won’t have the euro before 2015. I even read that Governor Tuma, in an interview, suggested that the koruna might have 100 years anniversary, which would mean that we wouldn’t have the euro in 2018.

Do you think the business cycle is coming in line with that of the EU?

I do not know much about this issue.

How can the Ministry of Finance help promote export demand, perhaps from Germany and other EU countries?

Our possibilities are quite limited. What the government can do, and what it did do, is to raise the funds that the Czech Export Bank, for example, has available. There are, I think, two specialized institutions; one is Czech Export Bank, and another is some kind of export insurance guarantee agency, which guarantees export loans that banks provide to exporters. The idea is that if you increase resources of these institutions, they might be able to support more export loans. Also if private banks have some guarantees, they are more willing to extend loans to our exporters. But you’ve got to have demand first. I think we have no way to make foreign firms purchase our products.

Is there any way to encourage foreign investment?

We’ve got an FDI subsidy scheme. Basically in the past, this was an important factor behind the strong inflow of FDIs, but these were mainly directed to what I would call assemblies. We just import some components, assemble them here and then export. I think there was a shift in the FDI subsidy scheme towards more high tech investment and R&D investment. Definitely this is a way to encourage this kind of investment. Maybe what would also be useful is to increase expenditures in education in the Czech Republic because you need to have a skilled labor force to attract those kinds of investments.

How about changes concerning the infrastructure of education? Is there optimism to be held in this regard?

As far as education is concerned, this has been recently a big issue in the Czech Republic because of the proposed changes in financing of the Academy of Science, which is an academic institution engaged in research in many fields. Education is chronically underfinanced in my view, so I think we should put more money into education. There is also a pressure to have more people with university degrees, but I am quite personally convinced that everyone is talking about quantity and nobody is interested in the quality of education. Maybe we should prefer that we have fewer people with university degrees, but better educated.

Do you think that, right now, there is enough support for high-tech investment among the population? (Enough potential employees to support this kind of growth)

I’m sure that we have enough highly skilled people, that we are attractive enough for FDIs into R&D and high technology.

How about distinguishing the Czech Republic among other CEE economies? Would potential FDI contributors from the West be able to distinguish between the Czech Republic and Hungary, for example?

As far as FDIs are concerned, I’m quite sure that investors who want to invest in the Central European region distinguish pretty well. Then you have, for example, short-term financial investments, like portfolio investment, etc. In this respect, I don’t think it’s even possible to make those people distinguish between, for example, the Czech Republic and Hungary. You’ve got an investor in Japan or the US, and he might not even know where our country is, and just to tell him that we’re in a better shape than Hungary…though with regards to FDIs I don’t think this is a problem. If you make a decision that you invest in Central Europe, then you come here and have a very close look at individual countries, then you make a decision.

Are there other sectors which are promising engines of long-term growth for the country?

I think that it might be some sectors of industry that make use of the output of R&D, for example. In my view, what is promising is information technology. What is also promising is green technology. Also, what might be good from the long-term view is the so-called nanotechnology.

With regards to industry, will they not move further East within the next ten years as their factories become outdated?

Maybe some companies will move further East, but I think that it won’t be a large-scale issue.

You mentioned green technology. How can the Czech Republic expect to get ahead in this sector when most countries are looking to specialize in this same area?

Definitely it’s hard to compete if you have many competitors. I hope that we are smart enough that we will get some part of that total pie that will be divided between countries, but I really don’t know how we should do that. We might support education and research in this area and hope that there will be some people with good entrepreneurial behavior and business ideas, and they would succeed. But I really don’t know how you would decide some specific measures to promote this kind of activity.

Are there any other policies that you’d like the country to implement to come out of the recession?

The data, or GDP, suggests that we have bottomed out and that some mild recovery might be on the way. To design policies to get us out of the recession, it’s maybe too late to do this. What we can do is have some policies that will promote further growth and that will make the economic growth sustainable in the long-term. In this regard, besides the good shape of public finance, what might be helpful are policies regarding the labor market and that will increase its flexibility.

How can you expect that the government will increase investment if they have to simultaneously cut expenditures?

What the government can do is to make more use of PPP projects. Anyway, I don’t think that any wise enough government would cut investment expenditures that support long-term growth.

Do investment measures fall in the category of the 80% expenditures that are bound by law?

Investments are in those remaining 20%. Those 80% are mainly pensions and social security expenditures. Of course you have wages of employees in the public sector.

When do you expect the Czech Republic will return to its former levels of growth?

Well, the pre-crisis period was an exceptional one. You know, the forecasts expect 3.3% growth in 2012. We might achieve somewhat better results in 2013 and onwards. 2011 is the year when we could have, again, some nice growth performance.

How do you think the country can tackle this issue of long-term vision, in the sense that the interim government’s capabilities are quite limited, and the next government will likely not maintain a long-term perspective by the end of their term…?

This is interesting, but not a question for me. It’s all dependant on the political situation and on the will of politicians to make the changes the country would need. What I personally hope for is that the next government, be it left or right wing, will have a position strong enough to really make the changes it wants to do. Because if you have a weak government, then you propose a change, then it is amended in Parliament, and you basically end up doing nothing. It’s much harder to achieve something if you have a weak position in the Parliament.

Is there anything else that worries you about the economy that we haven’t discussed?

Maybe another problem is that we should deal with is population aging. What we need to do is some reform of our pension system. We currently have a pay as you go system, and of course people might save in pension funds, but they are not obliged to do so. Maybe we should have a pension system with more pillars. Pay as you go system is one pillar, another pillar is obligatory savings, and of course a voluntary pillar. Again, this issue is extremely difficult from the political point of view. The views of politicians differ too much. Maybe they even don’t want to hear arguments of each other, just stick to their own view and don’t listen to the others’ view even of the others might be right. It is important for me because if we don’t do something about the pension system now, then we can have really big problems with public finance in the long-term.

12/8/09

Introducing thoughts:

[This section of the Ministry of Finance publishes quarterly forecast for the public, and has just released their Macroeconomic Forecast paper in October 2009.] Right now we are focusing on consolidation plans scheduled to release in January, 2010. (In fact for all European countries, this date has been pushed back from December, which is helpful because we can then use data from 2009.) But for the Czech Republic, we have the specific problem of an interim government, making it difficult to prepare a convergence program with some clear declaration of a path for fiscal consolidation. This is of course one problem.

The second problem is volatility concerning the development of the financial economic crisis. Of course we are a bit optimistic concerning next year, but are still very conservative with our predictions; for next year we speculate some 0% GDP growth. But of course it is possible now that it will be double. In our situation it is just very difficult to prepare these mid-term materials.

How would you like to combat the volatility of the financial crisis?

According to our forecasts, we expect small growth for next year, and a bit more for 2011 and 2012. The Ministry conducts macroeconomic colloquia twice a year; our last one was in November, and some of the results of this colloquium were published. If you compare different forecasts of different institutions (e.g. ČNB, Česka Spořitelna), the Ministry of Finance is a bit more pessimistic and conservative. For example, the last OECD outlook for the Czech Republic for 2010 estimated 2% GDP growth. But, you never know. These are only forecasts, and of course reflect different approaches of different groups. We just have to wait and see. Forecasts are not easy to produce during normal times, and during this very unusual time (with many factors to take into consideration), these forecasts are difficult to produce. It must be noted that our development and GDP growth are closely related to Germany, our main partner in foreign trade; we are critically dependent on the development of the EU, but especially on Germany.

Is this 2% forecasted GDP growth for 2011 unrealistic, should Germany introduce austerity packages?

It may be. We had a fresh example of this relationship concerning foreign trade and these good observed results. Germany had some strong support programs for cars, and Skoda benefited from this support. But of course next year will be different. Whether developments within the German and EU economies will be beneficial for us – of course there will be some development increase and recovery in Germany and other EU countries, but we don’t know which part of this recovery is because of massive fiscal support or from government support of the economy. We don’t know if these developments are healthy, temporary, because of this fiscal pulse, or not. This is the question, and especially for next year. Maybe this is the reason for our conservative forecasts, because we don’t know.

What brought the change from more optimistic readings of the economy (for mid-year forecasts over the course of 2009 gradually worsened) to a pessimistic outlook?

Last year maybe we were too optimistic. There is a very long-term preparation procedure of state budget proposal. For the state budget proposal preparation we use the July forecast. The developments of a few months reflect that of the whole year. In the middle of last year (before Lehman brothers fell, and so on) – some forecasts were according to previous developments, devoid of expected developments with a very deep impact of the crisis. (The same can be said for the OECD forecast.) The state budget proposal was prepared according to this past July forecast, and it was very difficult to change it. At the end of last year and beginning of this year, almost all countries changed their forecasts from small amount of positive GDP growth to a large negative GDP growth percent. It was a very unusual situation, and it is very difficult to predict. (Same goes for the IMF, OECD)

What concerned you and your colleagues most with regards to the crisis?

The main problem of these negative developments and GDP decline is unemployment. Even with some recovery, we expect an aggregate increase in unemployment because of some postponed effects, and so on. This is the main problem. Of course there will be some big impact on the fiscal side, of the state budget. The decrease of social and tax revenues on one hand, and on the other hand big expenditures concerning unemployment support and so on.

Are you optimistic about the excessive deficit procedure and deficit developments?

I can only say that in the case of the same development, it will not be possible to reach mid-term objectives of 3% in 2013. We will have a meeting with the Minister and some responsible deputies concerning the convergence program, reacting on some recommendations of the European Council’s excessive debt procedure. We are preparing some list of revenue and expenditure possibilities – how to solve this problem and decrease the deficit by 1% per year. Of course it is possible to do; you can increase taxes, and there is some possibility to change expenditures, but it of course depends on the decision of the new cabinet after elections. We only prepare the state budget for next year for this cabinet, some austerity package.

You know the discussions in Parliament are horrible – this is a nice way to spend taxpayers’ money. It’s very difficult to find some sources for additional expenditures. In our convergence program we tried to include a list of possibilities; it depends on the new government’s decisions. Some changes, and especially increase in taxes, will be necessary, but the proposals are subject to differing standpoints.  There are possibilities to change expenditures, but you know, I remember a decision passed which proposed to decrease the number of state employees by 3% per year. The first measures were passed two years before the revolution based on perestroika messages. This was 22 years ago, and if you compare the Federal Ministry of Finance and the Czech Ministry, the numbers are quite similar; of course it’s not correct to compare these numbers, but you see some interesting results. Really it is possible to make these changes; you would save some money from wages cuts, but you also make state employees more effective. But these changes are very difficult to make in the Czech Republic, and you know it’s very difficult to make a comparison of state positions with Western countries (UK, US). This is one big reason for skepticism concerning expenditures. And these expenditure cuts do not only concern only wages; of course there are other things concerning public procurement, so it’s possible to save a lot of money. 

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.

11/24/09

Opening Remarks:

As you know, I am the head of the Tax and Customs Policy division. So of course my main field of interest is taxes – tax revenues, customs revenues, how much we will collect for years to come. This is my area of professional review that was affected by the crisis because there were some discretionary measures undertaken by the government in the first half of this year to help companies overcome the crisis. In the second half we concentrated more on the consolidation package so as not to have too large a deficit. We always have to calculate the budgetary and customs impact for the coming years.

Could you discuss how the tax policy changed when it was clear the crisis was to manifest in the Czech Republic?

When the crisis was fully present in our country (and in other countries around) the government said, well we should do something to start to react in some way. Then the National Economic Council of the government (NERV) was established, and they proposed several measures. The first one from the spring was concerned with what to do to help companies overcome the crisis. In the field of taxation, the main ideas were first to ease the management of cash flow, so to move some payments which under normal circumstances we would collect this year, and postpone them to some later date, either by just a few dates or to next year. One example of this was the income tax for which you have to pay quarterly prepayments and then settlement next year. And so we said OK, small companies with up to five employees are exempt from these prepayments. But if you have any taxes for 2009, you will pay all the taxes in 2010. We don’t require you to pay prepayments and then only settlement. You calculate the tax, compare it to the prepayments, and you either pay on top of that or you get refunded the money overpaid last year.

And then also the individual financial offices were instructed (the law provides individual agreements between financial office and company) to decrease this level of prepayments depending on the situation of the company. So they were instructed to treat favorably those companies which exempt more employees which were not guaranteed in bulk. This was a governmental decision; so they were instructed to treat them favorably and postpone these prepayments. This was one area.

There were other areas; one main measure concerned the VAT (value added tax) which you submit monthly or quarterly and end up paying taxes or refunding input VAT. There is a period of 30 days after which all the refunds should be returned by the financial office back to tax payers. [The new measure said that if] the taxpayer submits taxes electronically, they should be refunded within 15 days. So again, bring money faster to the companies so that they don’t have cash flow problems.

The last measure, if I remember well, increased the speed of depreciation periods. Normally we have five groups of assets; the first group is depreciated for three or four years, then the next group in six years. Those two groups consist of are cars, computers, basic machinery, the last group of real estate, and the remaining two groups of heavy machinery (10, 12 years) It was said for the first two groups (which are consumption goods and goods which can be changed quite easily for years 2009 and first half of 2010) that if you acquire these assets, then you are granted faster depreciation periods. You can depreciate it in just one year (changed from three or four years), or from five or six years to two years. The point is that those rates were changed to help companies buy assets in these troubled years so that they can deduct them from tax payments more quickly. What they would normally over three years they do now in one year. They don’t pay that many taxes now, but they can pay more in the time to come.

Do you have data from these measures to assess their effectiveness in promoting cash flow?

We have some data, though not about this depreciation because we will find out only when companies file tax returns in about June of next year. With regards to VAT payments, there will be some data concerning the amount of tax returns that were filed electronically and so what amount was returned faster. There was also another incentive in passing this measure, for the Minister of Finance hoped to promote electronic filing. Although it has been allowed for five or seven years, only 1% of companies use it. I don’t know if these measures really helped promote it or not.

With regards to the abolishment of the decrease of prepayments, I saw some data somewhere in the first half of the year, and there was quite an extensive impact. The amount of money was more than 10% of the total tax revenues. So if normally from corporate tax we collect 150 billion Czech crowns (Kc), the revenues were more than 20 billion Kc, so more than 10% of revenues were decreased because of that in the first half. If things go in the same direction, there could be the same numbers in the second half. This was definitely one thing that helped companies.

For how long were these measures in place?

Those decrease of prepayments and faster return of VAT refunds were introduced someone in February or March. The faster depreciation rates required a change of legislation. The legislation was changed September or October, but everyone prepared for these changes and knew they would be valid in the end of 2009 and first half of 2010. Of course some companies need to do some preliminary calculations, but it’s important when they file the tax return. So lets say in June, most of the companies filed in June. It’s important when they calculate how much they have to pay.

Are you still focusing on anti-crisis measures or looking more towards the deficit?

So as I said, in the first half we introduced mainly those measures. There were other measures which were shifts of money from one period to another, so basically not paying now but paying later. There were also some permanent tax decreases; one of them was the VAT on passenger cars. Normally if a business buys anything and uses it when they conduct business, they can deduct the VAT input from their VAT output. So they can deduct the VAT owed to the government. This was valid for all-purpose engine cars created since 1993. […] Now we said, OK, lets change this measure and allow also deductions of VAT for all passenger cars in the full amount. […] The main point is that passenger cars now can be bought without VAT. This measure also required legislation; again there was a decrease of taxes.

[…] There were some other measures in the area of the Ministry of Labor, which had some complicated design. There were some credits, or deductions from social security contributes that were regressive. (The lower the salary the higher the deductions.) So we started at a certain level, and then it went down … so they introduced this measure in June or July. Later on when we started to discuss the consolidation package, there was an agreement made between the government and trade unions and some unions of employers abolishing this particular measure. It will be formally enforced this year and next year and valid only up until December.

It’s not a very consistent policy, but that’s how it goes. In the first year everybody wanted to help companies. Then they find out, oh come on the deficit will be too high and so they have to do something, lets also look at those measures. Companies say, this measure is too complicated, so if you scrap it we don’t care, and so the government decided to scrap it. But I don’t know much about it because this concerns the Ministry of Labor (upon the advice of the Economic Council).

When we started to think about consolidation and some measures which could decrease the deficit, we didn’t want to go back to, lets say, reintroduce the impossibility to deduct VAT on passenger cars. We wanted to come up with something else, and that’s why, you maybe know from newspapers, we came up with several tax increasing measures. They were not targeted at some special companies in trouble like the previous measures, but rather were the most general measures. We decreased VAT rates by 1%, and we increased the rates of excise on beer, spirits, mineral oils, and cigarettes. And we also doubled real property tax rates which go to the municipality, so basically they will have twice as much money. (Estimated 80% increase of their revenue.)

These other measures – VAT and excise – they go partly to the state budget, partly to regional government budgets, partly to community municipalities. These are the main measures on the tax side. There were also some measures on the expenditure side, but I don’t know that much about them.

Do you think that the Ministry was preemptive in implementing these tax increasing measures?

Just last week I was at the OECD and there was a tax policy and analysis working group gathered. This included all the OECD countries. We discussed some of these measures; last year in May and in November, the discussion was mainly on the reaction, response of tax policy to the main financial crisis, and everybody started to describe their measures. My understanding was that the development in all countries in 2008 and early 2009, everyone concentrated on helping companies and promoting consumption. They discussed this scrap car program – you get some money when you buy a new car and get rid of your old car. (In the US there was money put into those programs.)

Now the focus has switched to consolidation. My understanding is that this is a development in all countries. First the government was eager to do something to help companies, and now everyone has noticed that the deficit will be too high, especially in the European Union (EU) where there are very tight rules. Excessive deficit procedure was also initiated from the sight of the European Commission (EC), so we had to do something. And there were a few countries that said they think the crisis, or lets say recession, will still be here. So they still need to do the opposite, which means helping companies and decreasing taxes. One of these countries was Germany; they were saying, we don’t think that the crisis or recession is over, we don’t think that it’s time to increase taxes again, we still have some other packages for the next year. But most of the countries of development had the same stance as the Czech Republic. Now everybody is designing or has recently designed some consolidation packages, or tax increasing measures, basically.

The difference is that those decreasing measures were mainly targeted at some special groups and now the focus is on more general measures and consumption taxes such as VAT. (This is very broad. Everybody pays some part of an increased VAT.)

Whether it was too early or not – I’m not sure. This development has occurred in all countries, so I think if you compare us to Sweden, Belgium, and the Netherlands, they said something similar as we did. Same timing and similar thinking in governmental developments.

How can you account for the fact that projection for GDP growth is about 0 – 1 % growth, and that the recession is likely to continue? Do you think the Czech Republic is right in passing these austerity measures, or should we be leaning more in the direction of Germany?

It’s hard to say what will be more advisable. When we were discussing these measures in the first half of this year, I always advocated to not decrease some taxes on a permanent basis. We should only do those cash flow switches lets say, so to allow companies to pay later. I was already thinking that when tax revenues fall quickly because of the crisis, it’s not good to decrease taxes as we did because there will be harsh consequences for our deficit and we will have to do something later (which we now do). But there were other people, and especially in the government’s National Economic Council, who basically said, no, we propose these tax decreasing measures. So my understanding is that this was the correct way to try to decrease the deficit for next year. Whether the crisis will be here or not – of course the predictions for this at times are very inaccurate. In the fall and spring outlook publications of this year, every prediction was getting worse and worse. Now the predictions have stabilized, lets say half a year already it has been roughly the same. If it’s indeed true that next year we will have zero or around zero growth (which I don’t know I’m not myself engaged in these macro-forecasting exercises), then I think it’s not necessary to do any special measures to promote consumption. Even in the US now you can see that if you promote consumption of cars in one period, you basically steal the consumption from the future. Which means that once the governmental programs stop, no one will buy cars for half a year and the car industries will be in the same recession that they avoided before. So this is quite an easy critique of those programs.

So I think the governmental ideas or intentions to decrease the deficit are correct and right ones in place in today’s situation. The increases in taxes are not that big, 1% basically. No one will not recognize any change in prices. It will bring some money to the pockets of the government, so I think this is the correct way. Though as I said, I wouldn’t even introduce some of those measures before. I have maybe a different approach than was decided for the country.

With regards to your plans for 2010 and on, do you think that the tax revenues generated will be sufficient to reduce the deficit?

Probably not, we will have to think again of some new sources of extra money. Perhaps this means we have to increase some existing taxes or even introduce some new ones, but it’s always hard to do the latter.
As I said, the EC initiated the excessive deficit procedure, and we have to show them a trajectory towards basically zero deficit, or at least below 3% of GDP (which is the Maastricht criteria). Currently it’s about 6%. So we need to show some reliable path from this 6% over three years. There are still more plans to come. Our situation is also complicated by the fact that we don’t have an appointed political government right now because we have what’s called an expert government, so our Finance Minister climbed from the lowest rank up to deputy Minister just last year, and he is responsible for the budget now as minter. His main area of interest is the budget and low deficit. He doesn’t need to take care of what voters will say for a particular measure – he doesn’t want to be reelected and does not have any political alliances.

So we could propose some measures, but in June there will be elections, and so this government doesn’t have any power to actually change something or does not want to even engage in political discussions. Probably the ministry will only prepare some possibilities, proposing what the newly elected government can do this on the tax side and on the expenditure side. The next political government with a clear political majority in the Parliament will have to decide which path to take.

I think at least preparing some menu of possible changes is OK in the given situation.

What policies do you expect for the new government to be elected?

It depends if the right or left wing will be elected, so it’s hard to say. If the Social Democrats will win, then of course they will rely more on taxation; they will probably reintroduce progressive taxation on personal income tax. For two years already we have had a flat tax with just one rate like in other Eastern countries. They will maybe increase at least slightly the tax on corporations and businesses. If the right wing party wins, they will probably focus more on cutting expenditure, and if they increase taxes they will probably increase consumption taxes.

What obstacles do you face when trying to press forward tax measures within the Ministry and within Parliament?

In my experience with the implementation of the last consolidation package, or the ‘Janota package’ as it has been nicknamed, there was the idea that we should do something for next year. In the beginning of October, there should have been elections, but the constitutional courts objected to this. Janota and his Ministry thought they would be in office only until September or end of October and so they didn’t want to pass any measures for 2010. When they found out they would be in office for more than half of 2010, he understood that we must take some action and propose this package.

Our work within the Ministry was OK because we all decided on the measures. My colleagues and I proposed something on the tax side – an increase of all consumption taxes by some small amount, proposed this and that, etc. The proposal changed a bit once we engaged in political discussions. Janota is more inclined towards the right wing and listens to them more, so he removed from the package some points that those members of Parliament would have difficulties supporting, and so on. But of course the Social Democrats have their say as well. Then it was proposed in the government, I don’t know what discussions they had, but in the end the government approved it and in the Parliament there was not much opposition against it.

There were some lobbyists, from the tobacco industry, for example (it was one shining example). We introduced or proposed some measure to increase taxes on cigarettes, so of course they guarded their interests; any increased tax means lower profits for them. They lobbied extensively to both parties, so several members of Parliament started to say ‘I think these taxes are too much, I have some proposal’…they succeeded because the lobbyists were very effective. The increase in taxes was not as high as we had proposed, but it was not such a big deal. We will have to increase the tax because of EU regulations for 2014 anyway.

I don’t want to say that it was smooth, but there were no major obstacles in the way of negotiating and approving this package, at least from what I know. Of course I was only involved in the beginning when the measures were proposed and calculated and described. Farther steps I maybe watched in Parliament, but was mostly not involved.

Furthermore, I think in the media it was treated quite positively; even all of the journalists who are mainly young, liberal (libertarian) – right wing orientated with small state, low taxes view – were quite in favor of this package. When some members of Parliament wanted to change some aspects of the package, even they wrote something to support this package – I was quite surprised. Maybe it was because of the crisis for in the past 10 years it hadn’t been the case that if the Ministry were to increase taxes, it was always commented on negatively by the media. So even public opinion was quite favorable. They even showed some cases of a mother and father who are both unemployed and who were quoted saying, yes, we understand and see that this is correct, to increase VAT. […]

Overall, I think there were no major programs to get this approved, aside from these small lobby changes and discussions.

With regards to plans for the future, it’s hard to tell because of the elections; no one will say during the elections, I will increase taxes. Our Minister maybe will want to present something before the elections so they can comment on it. As it usually goes, the coalition government will always have some excuse once elected; in the elections we said this, but under this new view and circumstances, we need to treat it a little differently. Maybe during the election campaign they will say it’s impossible to increase taxes, but then even the right wing party, after the elections will increase taxes because they will see that the deficit will be really too high.

How will the Ministry and the government being able to combat the rising unemployment?

First thing, the Minister of Finance is not responsible for combating unemployment. This mainly pertains to the Ministry of Labor and Social Affairs. It’s true that we are thinking about what we can do in taxes. In taxes you can increase the willingness of people to become employed. There are some ways like income tax credit which they first introduced in the UK, which basically means you have some tax reductions for everybody, but it goes gradually down so that it doesn’t take that much money out of the tax revenues; it’s only targeted to low income people. We can again introduce some progressive taxation. We have today a 15% rate…. we could propose a lower rate for low income, higher for high income, which would increase net salary. So this measure is targeted at people who live from some unemployment subsidies, transfers from the government for whom these social subsidies are so high that they don’t want to become employed. This is what we could do in the tax system, but with the economic crisis in our world economy, it’s not the case that there is a lot of growth and some people just don’t want to work because they rely on social benefits. Today there are no free jobs so even if the people would like to work they cannot. It is hard to start their own business even though there are some subsidies for that, and so on.

So we could do something to improve the design of tax systems, but it probably will not help that much.

I think the main problem of the crisis (and what would help) is access to credit and money from companies. Banks are very cautious now, they have stopped borrowing, so companies are having trouble getting credit. When this improves, things may gradually improve on the unemployment side.

Will the tax measures you’ve proposed be effective in promoting business in the Czech Republic?

With regards to taxation and growth, there was one OECD study published one or two years ago called Tax and Growth, and they tried to identify those taxes, which are the least problematic and which are the greatest obstacles. (If you concentrate on the fact that taxes take money from the private sector, all taxes are obstacles, despite the fact that the public sector does finance something with these revenues.)

They identified that the least growth distorting taxes are real estate taxes paid by households (not by companies). […] Then there are consumption taxes, especially broad consumption taxes, like VAT which has the same rate for all goods and services. Then you have the personal income tax and corporate income tax. Corporate income tax has the greatest negative effect on growth. That’s why in the consolidation package we concentrated on increasing real estate taxes and consumption taxes. This will probably be the way for the future; we will probably have to introduce just one VAT rate for 2010. It’s also possible that we will introduce direct taxes on income and corporations and increase them. Most likely, or at least my advice will be, to increase those taxes only by a small amount, and concentrate more on increasing real estate and consumption taxes. This should be the strategy which, in times when you need to increase taxes (which always affects growth in some way) does so in the most growth enabling way. We are aware of this problem, but we will try to tackle it as best as possible.

Is there some way you can influence foreign investment through your policies?

Somewhere around 2000, we put into place some measures mainly designed to attract Foreign Direct Investment (FDIs). There were some investment incentives comprised of several spending programs and tax holidays for five years, under some circumstances for ten years. We were quite successful (but it was quite easy during times of growth); especially after the EU accession, we attracted a lot of foreign investment; also domestic companies benefited from that. (Germany took the most advantage of these subsidies, then French and American companies.) This resulted in quite a large growth, over 6% of real GDP growth. We have a lot of new (mainly) car factories. We became quite a big car producer when you calculate car production per capita. I think we were second place only to Slovakia (which has only 5 million, and we are 10 million, so two factories here means twice as much income per capita there) Now in times of crisis, it’s apparent that we are maybe over reliant on foreign investments, and especially in the manufacturing industry. I don’t know the last statistics, but probably we will have now quite a high share of industry, of manufacturing, in our GDP. In Western countries, perhaps Western Europe, they concentrate more on services; services represent maybe more than half of their GDP. So I would say, in my personal view that it’s already enough with attracting foreign direct investment, especially in the fields of manufacturing and so on. In ten years or more, when there will be economic growth and the work force will be more educated in Eastern countries like Russia, the Ukraine, or somewhere in Asia, they will still have lower salaries. It’s only natural that when our factories become obsolete in ten or twenty years, they will build a new factory not in our country but in another; our solution was only a temporary one. It worked well for ten years, but in the next ten years, who knows. For the coming years, we should focus mainly on services and innovation, things of that nature. Putting cars together from parts – it’s not a solution for the future. It was OK for the last ten years, maybe the next ten years it will still be OK, but not in the long run.

How can you attract higher value added investment such as research and development?

Frankly speaking I don’t know. In 2005 we introduced some tax credits for research and development (R&D). R&D is normally a cost for companies, so with this measure they deduct it. We have introduced some extra allowance in the amount of 100%, so basically deducted twice from our costs. We have some ground agency which promotes something. Whether this is sufficient or not, I don’t know. I’m not an expert in this field. Again at the OECD meeting there was some new innovation strategy, a new study they are preparing. Maybe we can draw some ideas from somewhere else. It also requires a change in thinking from members of Parliament, which I’m not sure they fully understand.

Do you feel that the Czech Republic has been effective in distinguishing itself among other CEE Economies?

It is difficult to say. Of course from my point of view we are different from Hungary; their public finance and economic development is quite different from our. But whether it’s possible someone else from the United States or perhaps over the ocean to distinguish among some small countries, I don’t think ordinary people could tell. Maybe some experts would know.

What is perhaps now more distinct – people can tell there are different developments in different parts – is say between European countries and some Baltic states. The Baltic States were given as the example as Eastern European Tigers. Now we see that their economic development was not built on such a strong base as in Central Europe. So maybe those two regions will now be differentiated. But the four most similar countries – Poland, Czech Republic, Slovakia, and Hungary – I don’t know. I think no, normal people would not be able to say what is different from one country to the next.

Could potential investors in R&D make this distinction?

Maybe they see bad developments now in Hungary. Whether this can really help distinguish among the countries, I’m not sure. I know, for example, speaking about R&D, that in Hungary they also introduced some measures, not in R&D but in some other field, maybe film production.

I don’t know whether our 100% tax allowances are really such a strong incentive. The main reason why we wanted to do it was to promote R&D development here. So for our national producer Skoda, for example, we wanted some R&D of new engines. We wanted the new engine lab to be situated in our country; I don’t know whether they succeeded. This particular tax credit was one way to attract them. They are currently moving car production to the Ukraine, and even to India and China. We would like for our country to have R&D, at least for example we will succeed in having Skoda’s research in our country for in the case of Skoda, there are some historical ties, and maybe Volkswagen understands that, but for other companies, I don’t know. We should try, because this is the only way for the future.

What are your thoughts on NERV’s recommendations to follow the example of Finland’s economy?

I was two weeks ago in Parliament for a meeting of some committee on business affairs and environment. There were two members of NERV presenting their final report called ‘From Helsinki with Love’, and they were explaining why they went to Finland, what they learned there; (I was also discussing this at the OECD meeting with a Finnish delegate, so it was quite interesting;) they tried to persuade members of Parliament that what we really need is a professional approach to economics – they said how it works in Finland, and they have some similar national economic council comprised of some government, trade union. In our country we have something similar to that, but also some experts. And they paid recently for some study by Michael Porter, a top economist employed in these affairs. They produce work of this sort and discuss it in a very official manner. These NERV representatives urged members of Parliament to become more professionals like in Finland. Whether this can really be the case, I’m afraid it’s not that easy. It takes maybe one generation before things will change in way that can be comparable to Finland. At least the ideas, and some directions that we should follow are present. Whoever is interested can read what should be done – what is one possible way for the country to improve. I hope things will gradually improve, but as I said, it requires some changes in thinking for top members of society.

What do you think are the most troublesome long-term problems the country can face?

In my professional view of public finance, it’s mainly the deficit because we are unable to cut the expenditures. I think the expenditures are too high – there is not enough control. All the ministries are always able to advocate why they need extra money for certain spending programs. We need some treasury, because we don’t have a treasury as such. This problem is also connected with corruption, because if you don’t have control over expenditures, you can easily put some money into someone’s pocket who actually shouldn’t get it. For example in Parliament the NERV members said that in Finland all of the spending programs have some evaluation of costs and benefits. They calculate some spending ratios, and when they have to cut something, they start with the lowest ratio – so only those with the most profitable spending potential are realized. Something like that should be implemented in our country. (By the way, when I said corruption, I did not mean bribing; in our country corruption is more present in the scope of friendships. Sometimes it helps, if you have some problems and are unable to solve them in a normal way, to use these corruption friendships. There’s not actually that much bribing, but because in the past we were always ruled by some ‘evil state’ and would try to find ways around the rules imposed, this tradition continues. The people – when they find conditions to be unfavorable to them, they try to find a way out – friends, or friends of friends who could change the rules a little bit, etc.) So this is all interconnected – the poor control over spending programs, which means lower than best possible functioning of public services, and thus soft corruption. I think this is one of the greatest problems in our country, and especially because it is quite widespread and people view it as an OK practice.

19 November, 2009

When the crisis first manifested, what were you and your colleagues most concerned about?

This raises the questions when was actually the first moment [of the crisis]. I have to say that in the Czech Republic, the situation was different than in some Western European countries or in the United States. First of all, we heard some news from abroad. We heard about the financial crisis, and we didn’t have, exactly, the financial crisis here. So, when the crisis started in the US, it was a big issue for us. We started to write a bit more about the foreign economic issues, etc. We had in mind the question, “How can it influence the Czech Republic”

We knew that maybe our banks were not so active in such risky assets as banks in the West, so we were quite sure that our central bankers would say, it can’t be a big problem for us. They were right. But on the other side, it was also clear that the economic weaknesses in the West can influence the Czech Economy. Which, actually, proved right and maybe the influence was even bigger than we expected for the recession was quite severe, both in the US and Central Europe. Then, we started to think more about the macroeconomic consequences, etc. The fear was that the recession could be quite long. So that was the main issue at this point in time.

You said that the banks were not conducting such risky business as in the US and Western Europe. Did you see the recession as consistent with this, or more severe than expected?

Generally, I would say the recession is more severe, that’s right, because there was still – I think many people underestimated the possible consequences of the crisis, both on the economic level, maybe in the press as well in some way. We wanted to be more critical, of course, but still maybe even for us it was surprising that it can be so severe here.

It’s true that we were quite lucky that the financial part of the crisis was not so bad, but the economic recession was more severe than expected.

At the beginning of the crisis, what role did the press play in influencing Czech confidence and mentality?

I would say that there was the discussion, to what extent the press can influence the Czech Republic when the crisis started in the US and Western Europe. The government said that the consequences would not be so big, while the more critical position of others was that we should be more aware of the risk. Maybe now I will move to the mixed media, which is closer to the political right. They were more optimistic because, also the economic journalists in newspapers said that the financial crisis will not be in the Czech Republic as it was in the West. Maybe, well, I’m not now 100% sure, but I think that some newspapers like Pravo, which is rather left wing, was more aware of some problems that could appear because they were closer to the opposition in this way. But concerning the further development, I would say that in some way, the journalists helped make the situation calmer, because, in fact at the beginning of this crisis when we had this financial crisis in the West, it was necessary not to overestimate the crisis, not to create panic. I think the economic journalists have to respect the situation and to explain the fact that the financial crisis is not influencing us directly.

Maybe the other side of the coin was that we underestimated the economic consequences.

What measures did the government set forth initially when it became clear that the recession was to occur here?

Well the reaction of the government was based on having the situation under control in such a way that we wouldn’t have a lot of panic. It’s impossible to say that they were very active in some anti-crisis measures but were passive in fact. But on the other side this was more or less correct at the beginning, because really the main aim at the beginning, before the crisis started to influence our economy, it was necessary not to create panic.

Of course afterwards, after some signs of economic consequences, the government started to be more active in some anti-crisis measures. However, I think that the Czech government was always on the cautious side – for example, within the EU, they were always telling our European partners that we don’t have to make some unnecessary measures.

Here on the economic side, but also on the side of the economic journalists, there was the fear that the EU will not react in a proper way. They would create a lot of expenses in order to deal with the crisis. We saw this as rather dangerous because, for us, the budget crisis was in some way a greater danger than the direct consequences of the crisis.

In some way I think it’s proved to be quite a relevant point because now it seems that the budget deficit coming from these anti-crisis measures can be a very negative aspect, and that now it starts to be a very important topic in many countries. I would say that the reaction of the Czech government was always more proactive than in other countries.

It’s interesting you should use the word proactive, because I perceive, just from reading current events, that they are very inactive with regards to the budget.

Right. I think it’s a paradox, because in fact we started to implement some anti-crisis measures like the reduction of the social contributions, and also, in the field of taxes, etc., which were some anti-crisis measures, and were in some ways similar to those that were worked out in other countries, but it was rather limited here in the Czech Republic.

However, the universal opinion is that we started the exit strategy earlier than some other countries. And in fact we now have the situation where some anti-crisis measures were adopted a few months ago, but we already started to remove them without having any effect, and we started to speak a lot about the budget deficit, which is actually, you are right – now they are very inactive in reducing the budget deficit – but this can be seen as an exit strategy already, rather than as anti-crisis measures.

Of course it’s up to the observer to judge. Maybe there can be different opinions on this. We started with some anti-crisis measures, but we have started to remove them and implement our exit strategy. Now our main concern is to reduce the budget deficit, but at the time, some other countries in the West said, of course we have to reduce the budget deficit, but now we still have to implement some anti-crisis measures.

What were some (more specifically) anti-crisis measures implemented here? You mentioned tax reduction…

Yes, tax reduction, social contribution; there was also a plan to have support for removing old cars; there was a plan proposed, actually proposed by the Social Democrats, by the left-wing opposition party. (It is difficult to judge who is actually the opposition because we have the non-party government, but yes, more or less the social democrats were the opposition from the government of Mirek Topolanek)

So it was this plan that was adopted in the anti-crisis measures. However, the plan was removed because with this reduction of the budget deficit for there is no money for this measure. This is another example.

Actually we started to increase taxes, which is also in the opposite direction from what was proposed in the anti-crisis measures.

Do you think the government is preemptive in decreasing the budget deficit and implementing an exit strategy?

Well it’s very difficult to answer this question. It is my opinion that on one side, our government was always right to take into consideration these budget deficit consequences. I agree with their approach not to be very active with the anti-crisis measures. But on the other side, I have to admit that it is a bit confusing because we started some anti-crisis measures, limited, but still, and we didn’t see the outcome; we have already started our exit strategy. So yes, from this point of view it is a bit confusing.

Do you think there will be enough political will and consensus to actually follow through with the exit strategy and sufficiently reduce the fiscal deficit?

It will depend a lot on the next election. Now, this non-political government is fighting for reducing the public deficit. However, these measures are for next year. Nobody knows what will happen with the budget for 2011. So, I would say that the Social Democrats, who can win the next election, might be less active in reducing the public deficit, and I see this as a threat. But on the other side, within the Social Democratic party, there are people who know that the deficit is a problem. So I think that there will be people who will fight within the government formed by the Social Democrats and within the party in the future. So it’s not really clear, it will develop in the future with further political development.

Do you believe that the next government will be able to take into account NERV’s suggestion (as published in its final report of 09/2009) to follow Finland’s example, or do you think the Czech Republic is headed in the direction of Hungary’s economy?

First of all, I have to say that the Social Democrats were never in favor of this NERV institution. So, they were rather critical to what they said, and I wouldn’t expect that they would really accept NERV’s outcomes. On the other side, there are some good economists within the CSSD as well. So, probably these economists would think about the public finances in a similar way. As I said, there can be a struggle between the populists and the economists within the party.

I would say that some measures proposed by NERV could be adopted without saying that these are the suggestions of NERV. But because of the pragmatic approach, it can be really accepted by the Social Democrats as well. We will see.

Still I think within the Czech Republic, there is a bigger awareness about the public finances problems than there was in Hungary. So I wouldn’t expect a situation similar to this Hungarian situation of a few years ago. On one side, it can seem that now already the public deficit is growing, and the public debt, etc. So the situation even now could be, according to some observers, similar to the Hungarian situation, but I think there is a big difference because Hungary had this deficit before the crisis, so they were punished very quickly by the financial markets. Now the financial markers are not so straightforward in punishing the countries with big public deficits because we see now a big public deficit in the US and the UK, and in some way in this situation of the crisis, it is maybe not normal acceptable if we want to struggle through the crisis. Now I am not speaking about my personal opinion but rather about the overall picture, how it is perceived by the relevant economists and in some way by the financial markets.

So what the financial markets will judge is the strategy for the next years, namely whether the country is able really, to reduce the deficit. And I must say, I think the Czech Republic is not so bad off in this field because still there is the chance for us to reduce our deficit if there is the political will, which of course is always the question mark; but maybe we are in a better situation than many other countries in this way.

How does that affect your opinion on the Czech Republic’s potential as an emerging market and its ability to distinguish itself among other CEE Economies?

Actually, our government wanted at the beginning of this year, for example, to make sure that we are not put in the same basket as Hungary and some other countries, which really face a very severe economic situation. So now the question is whether we want to be judged as an emerging market at all.

In some ways it can even be advantageous because after the economic recovery I think that investors would again come to the emerging markets and they will differentiate among those markets, so we will see if, for example, the situation will improve. Right now Hungary is making very important measures to deal with their situation, so maybe their situation is not as bad as it can seem right now.

But still I think that the Czech Republic can be seen as a safe emerging market. From this point of view, it can be a rather quite good situation for us. So we are not so risky, but still emerging.

And do you think that the media can play a role in encouraging this perception of the economy? How about the government?

Yes, but what I was thinking now, well, was that also the image abroad can be improved in some way. Of course, the local media cannot do very much in this regard, so maybe the newspapers like the Financial Times are better placed for this task. But what we can do is to explain what measures can be done that; for example, explain that the situation with the public deficit is to be improved, so in this way we can play a role.

The government can help if they produce a very clear strategy for next year – that we will really reduce the public deficit, and really improve the situation in public finances.

Do you think that the strategies in place are just that – clear strategies?

I would call it a clear strategy – there are some plans. But I think that the strategy should be worked out after the election because everyone will wait for the next government.

How do you think that the government or perhaps media as well, can encourage FDIs?

Now the situation with the FDIs is quite specific in the Czech Republic because we benefited very much from FDIs in the last decade, lets say. And in some way we reached the point where we reached the limits because at some point it is very difficult to attract new investment when we have quite a lot of investment here already.

In this regard we have the example of the automotive industry, which is very important for the Czech Republic now. In fact, we have three big factories – Skoda-Volkswagen, Toyota, and Hyundai. So now it is very difficult to imagine that we would attract another big automotive company to invest in the Czech Republic. I think the market has in some way reached its limits. Now the task is to rather attract very high tech investment; this can be from software firms or traditional industry with very modern technology. That’s the problem now: we have quite a lot of investment, but sometimes it is not so modern. Now the quality [of investment] is more important for us than the quantity. In this way, of course, it’s necessary for the government to show that the Czech Republic [is a suitable environment] for high technology. That we are already moving to the higher stage of modern economy, that we can support the science here, research and development, that it is really worth investing in very modern industries here in the Czech Republic; this needs support in education. Actually we have some problems in this field. There is a lot of criticism concerning our education system which I think is correct, so that’s what we have really to improve now – our education system, our system of research and development, and to show the people, the world, that we are able to modernize our economy in this way.

On the other side, I would say that it is inevitable that some foreign invest will migrate further east to the Ukraine. We just have to accept this because the work force is cheaper in the Ukraine and Asia. We will have to work more on attracting a more qualified work force. Well actually [our first task is] to improve the quality of our work force, but also to attract investment that is interested in more sophisticated things.

What do you believe are the country’s long-term risks, excluding the deficit?

Well I think I have mentioned it already. The risk is that we will not be able to improve significantly our education system. Concerning the macroeconomic situation we have also to make an important reform of the pension system and of health care, which is also related to public finances. Without reforming pensions and health care, we will have a bigger deficit in the future – even more dangerous than current deficit caused by the crisis (which is more or less manageable in a few years, I think). But without reforming the pension system and health care we will have more serious problems with the public deficit and with public finances in the future.

What business opportunities excite you most?

Research and development – to attract new industries, some strategic services let us say, high tech industries – that’s the challenge really, for the economy.

Concerning the recession: do you think a second dip is likely?

It is likely. I think there are two options and we will see which one will prevail. Either we can have a second Wave of the crisis, which is quite possible. As I said, the automotive industry is quite important in our economy, and the automotive industry was supported by some measures in Germany and in other countries where there was support for removing old cars and incentives for buying new cars. This helped our manufacturers, especially Skoda. As a result of the removal of those measures in Germany and other countries, it seems quite possible that next year there will be a new wave of the crisis for these industries. But we will see.

The other option is we will come out of recession, but growth will be very slow for a long period of time.

For 2010 – GDP growth is estimated 0-1%. What is your opinion on that subject?

I would expect rather lower, perhaps 0, maybe 1%. I wouldn’t expect a fast recovery. But, in some way, we will face consequences of the crisis, which we hadn’t been exposed to with such severity until now, for example unemployment. Now it will be very difficult to reduce unemployment. We can have recovery without reducing unemployment.

For example, in the social field in relationship to unemployment, still there can be a very difficult period extending through the next one or two years.

Czech people’s optimism [for the government and for the economy] has largely dissipated as compared to the sentiments of 20 years ago. What can people take stock in once more?

Concerning the economic situation I think the skepticism will not disappear. Especially because of the situation with unemployment, etc., which will rather grow slightly. This data will not be more optimistic in the next few years. I think it’s very difficult to find anything that will be a very big push of optimism for the people. The situation is still rather bad in this field.

What lessons has the country learned from the 90’s crunch? Has it helped in dealing with the crisis?

Yes, this experience helped with the financial part of the crisis because, as I said, we were not very influenced by the financial crisis. After the events of 90’s, the banks were privatized, they were rather cautious in moving to risky assets, they started of course to be more and more involved in loans for consumers, and this trend has been growing during recent years quite significantly.

In comparison to Western countries, the debt of consumers is lower than in the West.

We have to face the issue now because our people are not aware of the risks of various forms of loans. There is some very risky business coming to the market – some institutions which are not part of the bigger banks, but smaller financial institutions offering very dangerous loans. In fact, they want to hide to the people that it is not advantageous to accept these loans.

Concerning the macroeconomic picture, I would say the banks were rather cautious. Also, we also had an autonomous system of regulation. The Czech National Bank is still responsible for regulating the financial market, and in my opinion they are doing this job quite well. Also, the experience of the 90’s was knowledge that the Czech National Bank took into consideration; the regulation is quite good, I think.

On the other side, some people might say the problem is that we are not part of the broader European market. For the financial crisis, this was an advantage because our autonomous system of regulation actually helped make sure the financial crisis wouldn’t affect us so much.

Do you believe there will be a second wave of regulation concerning these risky loans?

Actually, that’s an interesting point because the opinion of Czech National Bank right now, and also to some extent of the government, is that there’s the risk of overregulation in the West, in the European Union within the G20 group. On one side I said the regulation is quite good here in the Czech Republic. My personal opinion is that the Czech bankers are right in making the point that the problem in the EU and in the West was not a lack of regulation, but maybe that the regulation was not good in some way; maybe it was not implemented properly. I would suggest, as the Czech National Bankers suggest, thinking about better implementation of regulation rather than regulating new businesses and other industries like hedge funds, for example. This is not so important, because actually it’s not the hedge funds that caused the crisis – it was the financial banks in the US and in the West.

I would be also afraid that in some way we would over regulate and create some negative consequences from this. For example, the Czech president would say that the problem was not a lack of regulation, the problem was rather a lot of regulation we had in a past. That’s not my exact opinion, but in some way we should think about the risk of overregulation, that’s a point that I would agree on.

How can the Czech Republic create a more suitable environment for businesses?

I think the situation concerning starting a business improved. Five or seven years ago, the situation was much more negative in this field. I expect that there can be some further improvement, but concerning the legal and business environment, I would say that there was certain progress.

For me, the main thing we should do now is to show that we can support modern technology, education, research and development – this is our main task. Concerning the business environment, we can still improve some things and think once more about our legislation. On other side we have a tax system which is in some way more transparent than it was a few years ago; we have a single tax rate both for people and for corporations. I think we can continue with improving this. I would be afraid that the left-wing government would make this system more complicated, so we will see.

Still, I think the system can be made more transparent in some way. Of course we should think more and more about the regulation impact of the legislation which is maybe the field in which the government made quite a lot of promises to assess every new piece of legislation from the point of view of the regulation impact on business. I think much more can be done in this field, so from this point of view the situation can be bettered. I hope there will be an improvement; whether it can really happen we will see.

16 November, 2009

Introductory remarks about the crisis.

I think the first point that should be mentioned is that the crisis has two parts, at least. The first part was the financial crisis, and then we have been now enjoying the general economic recession. There is a big difference between the financial crisis in Central Eastern Europe, or at least in the Czech Republic, and in Western Europe, for instance, and the United States. For, the Czech banks were not hurt by the financial crisis as much as their counterparts in the Western countries were for many reasons.

One [reason], perhaps most important, is that the financial market here hadn’t been that developed, or in other words the banks were able to generate profits without being involved in that risky, or potentially risky as it has been perceived now (it was perceived less at that time), operations than the banks in Western Europe and in the States. So it was a big advantage. For instance in the Czech Republic the banks didn’t receive any help from the state. There was no need to recapitalize the banks or to use some dumping for bad loans or to offer extensive guarantees to the population, companies or the interbank market, etc. So this was a big advantage, which doesn’t mean that we were not touched by the financial crisis, for the population here was aware and reading newspapers that something was wrong. I think at that time we were a bit angry with the journalists for we thought that they were exaggerating that [fact]. And of course some people started to ask themselves whether their deposits are safe in the bank or whether their investments are safe, investment funds. And also if they looked at the development market price in some funds they had to notice that, for instance, in some money market funds that they were used to seeing increasing all the time (and it was alternative to saving accounts), that they showed a decrease in price because part of their investments were for instance in Iceland, and just by the fact that it was not a bulk of the investment, there were portfolios that were broad enough, then the impact of the price was significant or visible and this was enough to give some people reason to think about that.

Fortunately, after some time the situation has calmed and this was fine. But, I think of course, it was not possible not to react to what had happened abroad. There were two channels how the reaction has arrived. One channel is that the banks in this country have been owned by mother banks in Western Europe. I think that also these mother banks, (I don’t say that the management here wouldn’t do that themselves but perhaps to a slightly lesser extent) tightened credit conditions; there has not and will not be a credit crunch, but the risk premiums have increased and it’s not that easy to get a loan as it had been the case before. Also, the demand for loans has decreased, so both the supply side and demand side of the loan market have experienced a change. As a result, the growth rate of loans has been decreasing. This aspect – why there is a decrease in demand for loans – is because the companies in the Czech economy, which is very much open and export oriented, suffered a blow from dropping demand, and from first of all Western Europe, our main trading partner. This means that their quality of clients has also decreased and this is the reason why we also had here a recession. It’s a relatively deep recession, close to 5% this year, and it’s to a large extent an important recession.

And what’s the outlook: there is a big degree of uncertainty about the future. I think that we can do hardly more to join what the majority believes will be the case, and this is that the worst is behind us. We have two quarters of growth and we think that probably in the first half of 2010 we can experience another weakening, but after that we could return to a growing economy again. However, of course, at lower growth rates and GDP than we were used to since the beginning of this century. And for 2010 our forecast is 1% GDP growth, something like that. But I think that really it’s very hard to predict what will happen.

When the crisis first manifested in the Czech Republic, what were you and your colleagues most worried about?

I personally started to perceive that something went wrong when we heard about this mortgage crisis and subprime [mortgages] in the United States. We were asked then to write a short memorandum on that: how we perceived the situation was serious and what the implications and consequences could be. I remember that we also used an input from our colleagues in Belgium. The outcome was that, we said, well, this subprime market is a relatively small segment even in the United States of the whole residential housing, and the whole residential housing, again, is a small part of the big United States economy, and so we think that implications or consequences for the European economy and the Czech economy would be rather small.

This was probably the prevailing belief among most economists, at least those I know or have been surrounded by. Then the situation changed on the 15th of September 2008, when Lehman Brothers collapsed. Perhaps even before when Bear Stearns showed what they showed. At that time we thought that it wouldn’t be that banning, that something bad happened. But we couldn’t imagine the true depth of the problems until perhaps November, December of last year. And it was interesting, I don’t want to defend ourselves, but if you want to go through the forecasts prepared by various sources and institutions, (there is for instance a material called consensus forecast where you will find forecast of many institutions involved in these markets, analysts from various institutions) they tried to guess the GDP growth rate, unemployment, and other macroeconomic indicators in various time horizons. For instance, in GDP you could observe the month-by-month outlook percentage. We started with, I don’t know, 4% growth for 2010, and then it was 3%, 2% and so on. I think that really there were not many analysts, observers or politicians who would believe or were afraid that what did happen could happen. So we really underestimated the true extent of the problem.

As the outlook worsened, how did you have to change your long-term strategic plans?

What definitely was done was there were some attempts to work out some alternative scenarios of what could happen, and to start talking with the management at lower levels, also in various segments, and ask them what and how they would react if this or that scenario turned true.

The bank as such, as I already mentioned before, tightened the credit policy. I think also that also after the experience of people’s fear that was voiced, manifested in various ways, also in the press, the safety of investments was increasingly stressed at the cost of market share or aggressive policy and risky business. What was very important was not to lose confidence of investors for this is death for all financial institutions.

So there was an immediate reaction to keep the confidence, to stop risky activities, to wait what happens when the situation will evolve, and then a longer term effort to start thinking about what the implications of that could be and what adjustments can be made or should be made to stay among the leading bank here in times when the dust settles and the new landscape is to live in.

Could you be more specific about how they planned to go about doing that – to keep stability?

I can’t, for I am just an analyst. I am not a member of the country team.

How did the CSOB’s [outlook and policies] differ given that KBC got money from Belgium? As you mentioned earlier, the Czech banks did not receive any money from the Czech government. Did any of that money come through here from the mother bank?

No. I think that what our Belgian friends would like is for the money to come from here to Belgium, not the opposite.

I think that here the situation is different from the Belgian or Western Europe situation in the sense that banks here are over liquid since the transition. So there have been many more deposits than loans. Our loans savings ratio is some 70%, so we were not forced to borrow money from someone else or from the central bank for we had enough liquidity. This was a big advantage, I think. The question one could put on the table is, when we were over liquid, why the mother banks did not suck the money off the daughters and in the Czech Republic it’s impossible by law, so to say; the regulatory principles don’t allow the banks to move money out, so it was fine and we never had trouble with liquidity.

I read that the CSOB had some troublesome assets they had to get rid of. Was this problematic?

Ah you mean the CDOs? Of course we had a small portion of those toxic assets, but it was a much smaller fraction [as compared to], for instance, the [amount] KBC had. We had to, or we have written it off already. As the rating worsened for those assets, we have decreased their value in our portfolio. So it was the reason why – in one quarter we had much lower profits than analysts were used to. But still we ended with a [positive outcome], not with a loss. I think that now the situation is such that what we can expect nice surprises because, not that in the accounting the value of some of those assets is zero, but the true value is hopefully not zero. It will be obvious, not now but in the future, so it was a precautionary measure, so to say, to set [those assets] to zero. We then would have some items that were valued at zero but will now have some extraordinary profits. I think that really from that side we don’t have to worry.

For Czech citizens, most of their interaction with the bank concern standard procedures such as deposits and loans; they are charged high fess and there isn’t much transparency of those fees. Do you expect there to be a big change in this regard?

I don’t think there will be a big change due to the crisis, also for the reason that the crisis was a rather mild financial crisis.

There will be changes, [for one], due to the competition which is here. We can discuss how feared the competition is, but definitely there are six large banks, or large enough that they are able to compete. There will be also another factor which I think is perhaps more important and that is that the structure of the banking receivable, so the revenues, will change overtime. I think, and again I am not a director of the bank but this is a consensus here, that banks here are earning money from a different structure of operations compared to the UK, for instance, or the United States. For here there is a much lower share of sophisticated banking services that obviously are bearing high margins to the banks in developed countries, so there is a much larger [amount] of this low cost, easy, simple operations like credit account, private banking, etc.

The banks are at the pressure of the shareholders to generate above average profits for otherwise why would you invest in a risky region without receiving extra ordinary high profits. The only solution is that you will have to earn money also on the class of operations that haven’t been taxed or charged with such high fess in countries where there is another way to get money from investors like funds or asset managements of various kinds.

This is perhaps a region [in which] I suspect, while also despite the existing competition among the banks, the fees are still relatively high because all the banks here have been under the same pressure under their respective share holders to generate profits and profit growth, so they have no other way to reach the tasks and get bonuses…but this can change and this will change as the living standards and wealth in this country increase, it’s just a matter of time.

Do you see regulation playing a role in this, either from the EU or from the Czech government?

The third party’s pressure of the banks playing a role? I don’t think so. I think that what’s fine is that the Czech government is pushing on more transparency and things like this. I think it’s fine, on the other hand I think most problems in this area were not originating in the segment of banking institutions, but rather non-banking financial institutions because there is a relatively strong market of credit-offering institutions that haven’t been subject to such strong regulation. If you read these horrible stories in newspapers about these interest rates, maybe dozens percent per annum or of very strange contracts, then it’s mostly originating in these institutions, not the banks. Which doesn’t mean the banks or insurance companies would always prepare very simple, transparent contract for their clients, definitely not. And I am not very much afraid of that; I think it is gradually improving regardless of the crisis.

You spoke about the Czech Republic being a developing market. Do you think the crisis has affected its potential as an emerging market?

Definitely, yes, in a broad sense. Yea, sure there was this negative impact on industry, exports, and unemployment. There was also a negative impact on currency so it has contributed to currency volatility, for the Czech Republic has been perceived as an emerging market so potentially risky that at the moment there is increasing risk aversion in the world. This means that investors are selling off these potentially risky assets and they don’t always differentiate between the Czech Republic, Hungary, Latvia and Poland. This then [brings] a decreasing value of the currency, or depreciation.

But now, for instance, since the situation started to improve in the States, the opposite process is taking place, so these currencies are again gaining strength. This is interesting -this increased volatility has its cost in terms of, for instance, planning in companies, planning revenues, and all that. Now the discussion is legitimate – whether it would be better to have a singular European currency instead of the Czech crown. There is no consensus on that, for there are people who say, look, the Czech crown is fine, it could depreciate, and others say, well, but we have this benefit of a stable currency and you have this increased volatility. [This discussion] has no clear outcome because it is more based on ideological prejudices and things like this that on economic analysis.

But this was also a cost of the financial crisis. In broad terms that [the crisis] is perhaps, I would have to excuse [the following] to all who lost their jobs, […] to some degree positive [with regards to] the problems that were on the surface copulating for a long time. They became obvious and hopefully we will improve the business environment based on the crisis, and this is not bad. The problem is that some companies also disappeared that were cautious, that were reasonably managed, or that had a vision, but they had the pity of being swept down by the 5% average.

Do you anticipate the level of foreign investment fluctuating?

I think yes, sure. For instance I think one of the most obvious consequences of this crisis was that volume of transferable transactions fell. All transferable transactions, so foreign trade but also foreign capital flows. We don’t have data for 2008, and what’s available is preliminary data, but I am sure that the volume of foreign direct investments (FDIs) inflow and also outflow (but inflow is more important for us) definitely had decreased. But I am not that skeptical about that for we have been now living in a world of overcapacity. When Bernanke, too, points to future Monetary Policy and interest rate settings, he says that there are very low dangers of increasing inflation in the near future because there are strong slacks in the economy and I think the same holds here. So we can live without a steady flow of FDIs if that’s just an interruption and it’s not a general change in the direction of the flow from CEE Economies to the Balkans or the Ukraine, of which I am not afraid. It’s a long-term issue, definitely, whether we will be able to lure investors that would require more sophisticated production.

[…] Perhaps if we are able to produce a competitive labor force here for such sophisticated, high value added, productions… but this is more about education.

What opportunities for the country’s growth excite you most?

There is one general argument why the financial sector could prosper here. There is an empirical fact that if your wealth increases and society gets more rich, then the volume of financial assets compared to GDP increase. So financial depth of the market increases with increasing wealth of the country. As the emerging markets are still […] catching up to developed Western Europe, for instance, then based on that there should be space for further expansion of financial services. So this is one reason.

Second reason is that I think there is still an underlying hypothesis that in these countries, and the Czech Republic is no exception, it should be possible to increase productivity faster than in the developed Western Economies. […][1] There is potential for these CEE countries to strengthen in the long run against the Euro, for instance, or dollar. If this is true, then the growth rate in this country should be above the growth rate of Western Europe or of the United States. This is again a reason why these faster growing economies should acquire more financial services, and also a different structure of financial services

So this is, I think, mainstream reasoning which hopefully will confirm itself in the future, but it’s rather general.

You seem very optimistic generally about the country’s prospects despite the pessimistic outlook for growth. But is there anything that keeps you awake at night?

Optimistic prospects: I think that really this country should be able, under normal circumstances, to reach some growth rate, sustainable growth rate, of 3% to 4 %. We had 7%, it was too much, it was this bubble that was growing in the world and of which we were a part, but I think 3%, 4%, which is more than the European percentage, should be achievable.

The risks are twofold. My impression is that the number of recessions and sharp turns in the business cycle has been increasing in the past decade. This is for many reasons, which go beyond this discussion. I can’t exclude that after this originally dot com bubble, stock bubble and housing bubble there will be another bubble waiting around the corner, and we will suffer through that new bubble in two or three years. Again nobody would be prepared … and this would be a problem for this region.

Second problem, this time internal, is what happens with public finance and the balance of the public budget. We were able to live with a 3% deficit in terms of 7% GDP growth. Now, when facing the recession, we will have some 6% public budget deficit and fast growing mandatory expenditures, also due to demographic changes and an aging population. If the interest rates would increase on the market, then it would mean we would pay more to service the debt. What I am still missing is will, political will, and some national consensus to implement fiscal reforms that would make it easier for the finance minister to balance the budgets and expenditures. And I am afraid that in this region, which I know best, we have an example of Slovakia, and another one of Hungary, where they also had problems including fiscal problems, but were able to address them only when the situation turned really bad. Until then, the population is calm and quiet and not ready to sacrifice anything. I am afraid that this scenario could turn into a reality also in this country, for I cannot see any improvements in the budget policy for the years to come. So this is, I think, the most serious issue or macroeconomic issue we observe here. There may be others emerging which we can’t recognize for the time being, which are much more dangerous, but this one has been with us for many years, this [issue of] fiscal policy.

The crisis did not hit the nation with such force as in other European and CEE countries. A number of factors are in play here; for one, the Czech Republic’s economy is still in its developing stages. The banking sector on average experienced a 20% to 30% growth a year in loan volumes, a growth percentage not seen in neighboring developed European economies. Furthermore, many local bankers did not employ such risky practices as CDOs (collateralized debt obligations). They did not need to employ riskier practices such as leveraged loans and securities to reap a profit; banks make their money through traditional services such as savings and loans. This meant that when the financial crisis hit, they did not have to rid themselves of troublesome assets.

Furthermore, the percentage of savings is traditionally higher than that of loans. The ratio of debt to GDP is very low in comparison to Western European and CEE Economies, particularly the ratio of external debt to GDP. Czech banks had a higher amount of capital reserves and making them less dependent on external financing. This is also related to the local credit crunch of the 90′s, in which “Czech banks and their regulators have learned a lesson in lending conservatism… Back then, the government had to bail out or close down financial institutions plagued by toxic assets, all at high taxpayer expense. ‘The banks have certainly learned from this past experience,’ said Lávička, ‘and now thoroughly review [borrowers’] business plans and guarantees,’” (Prague Monitor Magazine) Part of conservative lending means maintaining a high capital base. The Czech Republic also implemented strict supervision of the financial sector as a result of the 90′s crash. This no doubt helped prevent riskier behavior and more sever effects from the current crisis.

One downfall of the Czech banking system concerns the system of fees and exorbitant prices Czechs have to pay for everyday services. Banks have low transparency on their system of fees, making choosing a bank difficult for clients. Furthermore, the arduous process required in changing banks prevents some from changing to an account with lower fees. The market mechanism is not able to function properly as a result of these characteristics, keeping bank fees high.

Because these basic services are the main source of revenue for banks, they have little incentive in making their services more client friendly. One analyst interviewed in the Prague Monitor is of the opinion that should banks lower their fees, they would encourage more advanced lending services and thus not see a decline in profits. These characteristics no doubt contribute to the nation’s status as an inhospitable environment for business growth. (Red tape still sticks to business, The Prague Post, September 23-29, 2009.)

One option in changing the unfavorable banking infrastructure is to increase transparency and the ease with which clients can change banks as regulation discussion is on the table. Oversight implemented in this way would encourage the market mechanism and provide a more favorable growth environment for both households and firms.

Czech Business Weekly, CEE banks slightly ahead of the pack. November 02, 2009, Anna Sieczkos.

Prague Monitor Magazine, 16 October – 12 November 2009, Defying the Crunch, pages 10 – 13.

I used the Czech National Bank’s Financial Stability Report, 2007 to evaluate the Czech Republic’s financial status and resilience shortly before the crisis of September, 2008. My next step from here will be to create a glossary of terms I did not understand (bolded below), and to look at the Financial Stability Report for 2008.

Note: The 2007 Financial Stability Report was published in early 2008, thus many of the CNB predictions were made in the context of more recent developments.

“From the financial stability point of view, the development of the Czech economy in 2007 can be assessed as very successful, notwithstanding the shocks emanating from foreign financial markets. Despite a predicted moderation in economic growth, the current outlook for the next two years creates good conditions for maintaining the degree of financial stability already achieved. The main risks include a further deepening of the credit crisis in the advanced economies, a more pronounced slowdown in economic growth abroad and a continued very strong exchange rate of the koruna. These risks could slow net export growth, weaken domestic economic activity and, in turn, worsen the performance of the financial sector.”[2] Due to risk aversion and the credit crisis abroad, this will lead to tightened lending conditions in the Czech Republic. This is both a natural progression and desirable for financial stabilization.

As early as 2007, the Czech National Bank predicted a decline in financial stability in those countries directly affected by the credit crisis, a sharp decline in lending to the private sector in those countries, and a knock-off effect in other economies. The Czech koruna appreciated dramatically as a response to the credit crisis. This appreciation, combined with the decline of the euro brought concerns about net exports and the domestic economy’s welfare.

Risks in the financial sector as discussed in the previous year’s outlook report manifested in the US subprime mortgage crisis, “which gradually spilled over into other financial market segments and turned into [the] credit crisis in the first few months of 2008.” For this reason, one should expect a global downward outlook for the next two years, including a downward effect in the euro region, and likely a recession in the US.

The credit crisis will bring credit contraction in the US, and knock-off effects in other developed countries. “One of biggest risks over the next two years is a potential credit contraction in some advanced countries as problems with mortgage loans and related securities spread to other segments of the credit market. The major losses of some banks will lead to a decrease in the overall capital adequacy of banking sectors. The subsequent recapitalization of banks will negatively affect growth in lending to the private sector and economic growth.”

Central banks adopted monetary policy to respond to the turn in credit cycle. The Fed lowered monetary policy by 1.25% to 2%, and the ECB held their rate at 4%. The CNB increased its monetary policy rate by 0.25% a total of four times in 2007 to respond to inflationary pressures. Inflation is expected to return to target by the end of 2008, and interest rate to be stable for two years thereafter.

In the context of downward interest rates in main currencies, investors will seek out stable currencies such as the Czech koruna, putting upward pressure on the koruna. In the first phase of financial turbulence, the koruna appreciated due to investors’ shift away from the dollar towards the koruna, and domestic exporters’ sale of the euro in light of the appreciating koruna. The appreciation of the koruna combined with a decline in euro demand could have a significant negative effect on Czech economy through “deterioration in net export growth.”

Fiscal reforms[3] are impacting the behavior of economic agents and having varying effects on disposable income of households and corporations. The reform of public finances will cause volatile behavior of aggregate demand.

2008 will see slow growth in GDP and disposable income of households. The decrease in disposable income may hamper households’ ability to repay previous loans. “On the other hand, it may help to eliminate the excessively optimistic expectations which emerged at the peak of the cycle and supported a rapid rise in the indebtedness of households…”[4]

“The traditional macroeconomic sustainability indicators recorded strongly positive developments in 2007. The public budget deficit under ESA95 methodology fell to 1.6% of GDP and the ratio of public debt to GDP decreased to 28.7%. The current account deficit declined to 2.5% of GDP, while the surplus on the output balance increased.”[5]

Corporations (non-financial) maintained good financial conditions throughout 2007, but recorded a decrease in loans, which may indicate a future downturn in performance. Corporate credit risk remained low in 2007, but is expected to rise by 1 or 2% in 2008.

Koruna appreciation has so far had little effect on exporting-centered corporations’ credit risk. However, data analysis shows we can expect a higher credit default rate of exporting corporations due to their increased sensitivity to currency rates.

Household debt increased by one-third in 2007, reaching over CZK 800 billion, supported mostly by loans for house purchase. The increase in debt is accompanied by a decrease in savings rate, to 5.1%. Despite these negative changes, these rates are low compared to the Western European average and are expected to turn around in 2008.

Over indebted households, particularly those whose income is not rising as quickly as household prices, could face serious problems in the case of adverse macroeconomic developments.

“The shocks on the advanced financial markets manifested themselves in declining prices of a whole range of risky assets and rising volatility on equity, bond and foreign exchange markets. However, the domestic interbank money market remained fully operational and interest rates there were affected mostly by expected changes in CNB monetary policy. The Czech financial markets responded to developments in global financial markets similarly as during corrections in previous years. Share prices went down in line with the falls in foreign stock markets, while bond yields initially declined slightly and then stabilized.”

In Q1 of 2008, the global financial crisis put upward pressure on the Czech koruna risk premium due to increased sales of government bonds by foreign investors. “The interbank market also recorded a very modest increase in the credit risk premium and a decline in market liquidity.” The Czech banking sector responded with increased credit rates for only riskier credit segments.

Risky trends in housing as discussed in the 2006 Financial Stability Report continued in 2007. Housing prices continued to rise; there are indicators that the market is overheating, with Prague as the riskiest region. Rent returns are decreasing, making property purchases financed by mortgage loans more risky.

Housing completions increased in 2007, but a saturation of the flat market cannot be ruled out. Although stress tests have confirmed banks’ current resilience, tightened credit standards with regards to property development sector was an appropriate measure to the increased risks in this sector.

The financial crisis has had little impact on the Czech financial sector. Evidence of this is in the continued stability in the CERTIS interbank payment system and SKD short-term bond settlement system, and aided by a rise in use of the intraday credit by CERTIS participants.

The Czech financial sector saw high returns on assets and equity, setting the stage for future financial stability, assuming that a large percentage of returns are kept in the form of equity capital. Depth of financial intermediation increased significantly in 2007 (as measured by the ratio of financial assets to GDP). This reflects a rise in financial institutions’ assets accompanied by a growth in bank loans.

Characteristics of the Czech housing loan market make it less susceptible to credit risk and a crisis similar to that of the subprime mortgage crisis in the US. This includes in particular good collateralization of mortgage loans with property. “Given the favorable phase of the business cycle and the high credit growth in 2007, the loan default rate still probably undervalues the magnitude of the banking portfolio credit risk to some degree.

High rates of client deposits have helped maintain financial stability and prevent against “drying up of market liquidity”. Although, credit growth has exceeded deposit growth, and this trend will likely continue, requiring a response from banks with changes in balance-sheet liquidity management. Only banks with a strong deposit foundation will be resilient to changes in the financial market.

Implementation of Basel II and the changeover to new prudential rules in July 2007 was a significant challenge for the banking sector. Due to these changes, there was a decline in regulatory capital requirements. A rise in default from corporations and households in 2008 is likely; “this would imply some increase in the regulatory capital requirements in the period ahead.”

Insurance and pension scheme saw continued growth in 2007. However, asset price volatility and increased cost of intermediating new contracts may have an adverse effect in insurance companies and pension funds’ performance. Fund shareholders can protect against this risk through increased capital.

The financial sector has continued to show resilience to the market, credit, and some aforementioned risks. However, an extreme macroeconomic development impacting interest rates, the exchange rate, and GDP growth could require “capital injections” to maintain capital adequacy in the financial sector.

[3] Reference unclear to me. Were these domestic or global reforms?

[4] Although the 2006 FSR addressed the problem of excessive optimism, I am skeptical of this prediction. A look into the 2008 report may present a different assessment.

[5] There has been a lot of discussion of debt as a percentage of GDP, particularly under the context of the 2010 budget and where that will leave the Czech Republic. I understand that an increasing deficit should be avoided, but I still do not grasp all the subtleties and implications of varying debt percentages.

There are some economic ideas found in the CNB’s survey report that either I have not seen before, or whose meaning and implications I do not fully understand. I have bolded these ideas and plan to return to them as I continue my research.

A Look at the Economic Climate Before the Financial Crisis[1]

Conditions in the world economy were quite favorable, particularly for the Czech Republic. The euro showed continued strength, although as early as 2006 the CNB predicted continued cooling in the US and perceived sensitivity to bad news in the financial markets, which could (and of course did) lead to bad news for the Czech and world economies.

Because interest rates of major currencies remain low due to savings surplus, investors are in search of higher yield and thus riskier assets, putting upward pressure on the koruna. This could lead to risks in domestic academic activity, and possibly lead to a negative impact on the financial system.

Domestic indicators of macroeconomic growth were favorable. The Czech Republic saw a 6.1% increase in GDP primarily thanks to increased investment and consumer spending. Public deficit hovered around 3% of GDP, but foreign investors do not seem concerned, particularly in comparison to other (riskier) Central European Economies.

The Czech economy has developed around foreign investment, with a sizeable percentage of business ownership rooting in larger companies abroad. Characteristic of the Czech Republic is strong manufacturing presence, and out of all EU countries manufacturing accounts for the highest percentage of GDP. This should not be a reason for concern because ‘concentration in industries is low’.

All size enterprises saw positive returns, and corporate-indebtedness remained low, which leaves little risk for financial stability. Banks saw high returns on loans, particularly household loans. System of floating rates in place allows bank to react to external changes, but puts long-term loans during a period of increasing interest rates at a higher risk of defaulting.

High expectations of 2006 encouraged by high GDP rates (but in reality fueled by ‘easy fiscal policy’ and access to loans and low interest rates) puts the country at risk for high wage demands and excess household consumption and thus debt in the future. Household loans saw a 30% increase and banks are competing to increase their share in the household loans market. Household loans are at 20% of GDP, well below the EU average, and as such are not a risk for financial stability. Aggregate income households receive still exceeds interest paid on loans. However, a higher number a low-income households are defaulting on loans.

Volatility in the global financial markets and shocks of 2006 and 2007 lefts the Czech Republic mostly untouched. The Czech koruna did not experience fluctuations (Hungarian and Polish currencies depreciated during this period), signaling that investors understand the economic fundamentals that produce stability, and recognize the distinction between national and regional instability.

“Yields on ten-year Czech bonds [are anchored at low levels and] move in line with euro yields. The synchronisation of Czech and euro long-term bond yields suggests strong integration of the Czech and euro bond markets and may reflect the market expected adoption of the euro as well as high credibility of the Czech National Bank. On the other hand, the market-expected rise in short-term interest rates coupled with flat long-term rates could lead to a flatter Czech yield curve. Since the banking sector typically transforms short-term liabilities into long-term assets, a flat or inverted yield curve may squeeze profitability and increase interest rate risk.

Prague flat prices rebounded back to 2003 levels, and a housing bubble may emerge in the market. A comparison with German and Austrian levels shows this may not be connected to ‘fundamentals’. Loans within the housing market are at risk for default (2006 saw a rising number of construction and housing loans) should housing prices decrease.

“The major financial infrastructure systems continue to run faultlessly. The SKD short-term bond settlement system recorded no system-relevant failures in 2006. The CERTIS interbank payment system also ran smoothly in 2006. The new generation of CERTIS has a higher capacity, thus reducing the risk of system overload. The new generation also has lower running costs, which made it possible to reduce prices for its users.

“Financial intermediation in the Czech Republic, as measured by the volume of assets of financial institutions, grew by 7% year on year in 2006. Owing to similar nominal GDP growth, the depth of financial intermediation (as measured by the ratio of financial sector assets to GDP) was virtually unchanged”

‘The ratio of financial sector assets to GDP is one-third that of the euro regions. The same follows for bank assets.’

Foreign ownership plays a dominating role in the Czech financial sector. There is slightly less foreign ownership in non-bank investment firms and pension funds. Such strong ties have so far reaped positive results, but risks of such international dependence should not be disregarded.

The banking sector saw overall financial stability in 2006. Non-financial corporations are the largest group dominating bank loans, with household loans converging to the same number. Overall, bank lending rose by about 20%, attributed to the favorable economic environment and rise in household activity and demand.

The number of non-performance loans decreased in 2006, though the default rate – the alternative flow indicator – suggests that the share of non-performance loans overestimates the quality of loans. Nonetheless, CNB macroeconomic stress tests on credit, interest rates, and currency risks indicate that banks are quite resilient and averse to external shocks.

Mortgage loans show no sign of risk from banks’ perspective.

The Czech banking sector experienced high net profits in 2006, although this number was 3% lower than the previous year; dividends were the highest on record. All banks’ capital adequacy ratio exceeded the 8% regulated minimum, but fell slightly below 11.5%, due to lower net profits, rising dividends paid, and increase in capital requirements as a result of the rise in lending. “The decline in capital adequacy signals a fall in the level of risk coverage by disposable capital, although it may also signify more efficient capital utilisation.”

Insurance companies showed high profitability and stability despite slowing growth in premiums and a lower ratio of financial investment (life and non-life insurance) to GDP as compared to advanced EU countries.

Excessive optimism fostered by favorable conditions of the business cycle puts the economy at risk. “When borrowing and investing, economic agents should bear in mind that the dynamics of the economy also entail less favourable phases of the business cycle.” That being said, overall the Czech Republic has seen financial stability in 2006. The trends and groundwork are favorable for stability in future years.