US embassy cable - 05PRAGUE204

UNCLAS SECTION 01 OF 03 PRAGUE 000204 
 
SIPDIS 
 
STATE FOR EUR/NCE, EB/CBA AND EB/IFD/OIA 
COMMERCE FOR 4232/ITA/MAC/MROGERS 
TREASURY FOR OIA 
 
E.O. 12958: N/A 
TAGS: EINV, ECON, EZ 
SUBJECT: FIRMS WITH FOREIGN INVESTMENT ADD MORE VALUE, HAVE 
CHANGED FACE OF CZECH INDUSTRY.  HOW TO KEEP THEM COMING? 
 
 
1.  Summary:  Much of the Czech Republic's economic growth 
over the past several years has been attributable to 
significant flows of foreign direct investment (FDI) that 
have made the country the destination for more such 
investment per capita in recent years than any other country 
of central and eastern Europe.  FDI has transformed the Czech 
economy with new capital, technology and management methods. 
Foreign investors pay above-average wages that have boosted 
real incomes over the past five years and advanced the 
convergence of the Czech economy with that of its EU 
partners.  Besides contributing directly to GDP, FDI has 
helped to increase the quality of Czech exports to the extent 
that they have easily held up under the pressure of a rising 
exchange rate.  On the other hand, some resentment among 
Czechs has surfaced recently over foreign investor's 
supposedly "excessive" repatriation of earnings and their use 
of government investment incentives.  The USG will have to 
formulate a position on continuation of investment incentives 
if the opposition ODS, which opposes them, takes power in 
2006.  The ODS has no plans to disturb incentives already 
granted.  The challenge for the Czech Republic in the near 
future will be to continue to attract high levels of foreign 
investment, or to find new factors that can contribute as 
strongly to growth.  End Summary. 
 
2.  The Czech Republic has been remarkably successful in 
attracting foreign investment, based on its relatively lower 
labor costs compared to Western Europe, its well-educated 
workforce, its central location in Europe, and the incentives 
it offers to investors.  Using OECD figures on investment 
from 1994 to 2003, the stock of foreign investment in the 
Czech Republic per capita was $3715, compared to $3176 in 
Hungary, $2037 in Slovakia and $1347 in Poland.  2003 was a 
relatively slow year in the Czech Republic for FDI, but the 
Czechs still edged out the Hungarians for the per capita 
honors among the Visegrad countries, according to the OECD. 
Investor interest revived in 2004 and the Czech Republic 
should again be drawing significantly more per capita on an 
annual basis than its neighbors, if the trends of the first 
two quarters of 2004 continue. 
 
3.  A recent study by the Czech Statistical Office indicates 
that firms under foreign control with more than 100 employees 
are one-third more productive than similarly-sized Czech 
firms.  Firms under foreign control are 26% of registered 
companies with more than 100 employees.  However, among such 
large companies, they produce 43% of added value, 47% of 
total revenues, 52% of gross profits, and 70% of exports. 
The major sectors into which foreign investment flowed over 
the 1990's are banking and finance, telecommunications, 
packaged food and drink, automobiles and auto parts, and 
tobacco.  Interestingly, some Czech subsidiaries are doing 
better financially than their foreign parent firms.  This is 
true of some of the banks.  Another example is Skoda Auto, 
which is not burdened by over-employment and strikes that 
hamper its parent Volkswagen.  Skoda is becoming a foreign 
investor itself, with assembly plants in Ukraine, Bosnia and 
India. 
 
4.  Foreign investment has transformed the face of Czech 
industry over the past ten years.  The list of the twenty 
largest Czech firms in 1994 was almost exclusively composed 
of firms in the iron, steel, energy and chemical sectors, 
along with the telephone and tobacco monopolies.  The 2003 
list contains some of the same names, such as CEZ, the 
state-owned electrical utility, but now features Foxconn, a 
computer and electronics producer based in Taiwan, retailers 
such as Holland's Makro and Ahold, auto parts maker Bosch, 
and mobile phone operators Eurotel and T-Mobile.  Other 
foreign names on the 2003 list are Siemens and Ispat, the 
Anglo-Indian firm that owns the steelworks at Nova Hut. 
Steel and chemicals have not disappeared from the list and 
are still key Czech products for both domestic use and 
export. 
 
5.  The government recognizes that the Czech Republic cannot 
continue forever as a low-wage manufacturing economy, and is 
trying to sharpen the focus of its investment incentive 
scheme to attract research and development and business 
support services.  Forty percent of the investment going 
through the investment promotion agency CzechInvest is now 
flowing into such businesses.  Companies such as Exxon-Mobil, 
DHL, IBM, Honeywell, Accenture and others have located R&D or 
services centers in the Czech Republic over the past few 
years. 
 
6.  The 600 million euro Toyota-Peugeot-Citroen joint venture 
in Kolin is scheduled to begin producing its first cars for 
sale in February 2005.  However, CzechInvest rates the 
likelihood of another such gigantic single investment in the 
future as low.  Ford Motors recently decided to locate a 
plant in Slovakia -- the Czech Republic's closest competitor 
for major investment.  Legislators in the Czech Republic are 
warily eyeing Slovakia's flat 19% tax and more advanced 
pension and health care reforms.  CSSD legislators are 
doubtful that a flat tax could produce the needed level of 
revenue in the Czech Republic, and the chances of major tax, 
pension and health care reforms are dwindling away as the 
2006 elections approach. 
 
7.  The ODS made a flat tax a feature of its election 
campaign in 2002 and will do so again in 2006.  They promise 
a host of reforms that will benefit the climate for doing 
business in the Czech Republic, if they can force them 
through parliament after taking power.  However, the ODS is 
conceptually opposed to incentives as an economic distortion 
of investment decisionmaking, a drain on government finances, 
and unfair to domestic companies who cannot invest above the 
threshold amounts for receiving incentives.  The generally 
free-market ODS politicians are not hostile to foreign 
investment per se, but they feel no urge to give it special 
advantages over domestic companies.  The likely advent of an 
ODS government in 2006 would present the USG with a dilemma 
over whether to support the continuation of investment 
incentives.  In a recent meeting, the governor of the 
Moravian-Silesian region, Evzen Tosenovsky, assured us the 
ODS would never touch incentives already granted.  He also 
foresees that doing away with incentives will not be 
accomplished as easily as some in the ODS suggest, because of 
the wide range of laws that would have to be amended. 
 
8.  Investments of $10 million can qualify for incentives 
that include relief from corporate taxes for ten years, job 
creation grants, retraining grants and opportunities to 
obtain low-cost land.  The current system of incentives was 
developed with input from the European Union and was not 
affected by the Czech Republic's entry into the EU.  It is 
relatively transparent, with clear rules about who is and is 
not entitled to incentives.  If it were abolished, it is 
quite possible that the government would not be able to 
resist offering ad hoc incentives if presented with a large 
new investment proposal that would go to a neighboring 
country if the GOCR were unwilling to step up to the plate. 
Too-frequent resort to such ad hoc incentives would be less 
desirable than the system in place. 
 
9.  Doing business in the Czech Republic is still an exercise 
in red tape that probably affects domestic small and medium 
businesses even more than well-heeled foreign investors who 
have the support of the investment promotion agency 
CzechInvest.  The judicial system still operates glacially. 
More and more often, the European Court of Justice is 
imposing stiff penalties on the GOCR, recompensing citizens 
whose cases have languished for so long the Court deems their 
rights to have been violated.  Corruption is an ongoing 
problem, with 21% of Czechs sampled by the 2004 Transparency 
International Global Corruption Barometer poll admitting to 
having given a bribe in the past year.  Corruption can be 
particularly off-putting to American firms that face tougher 
standards than many of their foreign competitors.  The 
American Chamber of Commerce and the Embassy have stressed 
repeatedly to Czech politicians the importance of such basic 
reforms as simplifying the process of registering companies 
and modernizing the unwieldy bankruptcy laws -- changes which 
would also have a healthy impact on corruption.  The 
parliament recently amended the company registration law 
favorably.  It will likely soon amend the bankruptcy law to 
strengthen the rights of banks that lend to small businesses. 
 However, a much-needed comprehensive overhaul of the 
bankruptcy code is tied up in discussions within the 
government. 
 
10.  According to the Ministry of Finance, the final count of 
inward flows of foreign direct investment is expected to 
reach a satisfactory $4-4.5 billion in 2004, compared to $2.5 
billion in 2003.  The Czech Republic still retains its 
natural advantages: a skilled workforce, average wages only a 
quarter of those in the EU, a central location in Europe, a 
well-developed communications and transport infrastructure. 
The country is a pleasant place for managers to live, a 
factor that should not be discounted in investment decisions. 
 However, Czech politicians cannot ignore the competition for 
the investor's dollar or euro.  They must pay attention to 
fundamentals of the tax, legal and ethical environment that 
are just as important to investor's decision-making. 
 
CABANISS