US embassy cable - 05PRAGUE1686

C O N F I D E N T I A L PRAGUE 001686 
 
SIPDIS 
 
SIPDIS 
 
STATE FOR EUR/NCE, EUR/ERA, EB/IFD/OMA, E STAFF DAN MORRISON 
TREASURY FOR OASIA ANNE ALIKONIS 
STATE PLEASE PASS USTR LISA ERRION 
COMMERCE FOR ITA/MAC/EUR MIKE ROGERS 
 
E.O. 12958: DECL: 11/17/2015 
TAGS: ECON, EFIN, ELAB, ETRD, EZ, PGOV 
SUBJECT: CZECH REPUBLIC'S MACROECONOMIC FAIRYTALE AND MIXED 
EUROZONE PROSPECTS 
 
REF: A. PRAGUE 1325 
     B. PRAGUE 1586 
     C. 04 PRAGUE 0204 
 
Classified By: Econ Officer Karen Reider for reasons 1.4 (B) and (D) 
 
1. (U) SUMMARY: The Czech Republic is enjoying unprecedented 
GDP growth (5.1 percent in 2Q 2005), doubling of foreign 
direct investment from 2004 to 2005 (to USD 10 billion), the 
first trade surplus since the country's birth (USD 2 billion 
or 1.7 percent of GDP) and a possible budget surplus.  On 
November 1, the Ministry of Finance raised its GDP growth 
forecast for 2005 from 4.0 to 4.8 percent, and growth for 
2006 to 4.4 percent.  However, there is general consensus 
that this macroeconomic fairytale will not last due to the 
lack of structural reforms undertaken by the GOCR to enhance 
the flexibility and competitiveness of the Czech economy. 
During introductory calls at the Czech National Bank (CNB) 
and with local economists, econoff heard a consensus view 
that entry into the euro is a political decision, and that 
adopting the euro without adequate structure reforms would 
render the Czech economy impotent to deal with the downturn 
of the business cycle and external shocks.  Between now and 
the expected June 2006 elections, neither the current 
macroeconomic stability nor the lack of political will for 
reforms is likely to change.  However, the Finance Ministry 
announced the Czech Republic intends to enter the ERM-II 
during the second half of 2007 with the goal of joining the 
eurozone in 2010.  END SUMMARY 
 
2. (U) Econoff met separately with Czech National Bank (CNB) 
Deputy Governor Ludek Niedermayer, Vice-Governor Miroslav 
Singer, and Chief Executive Director and Board Member 
Michaela Erbenova to discuss the GOCR's eurozone prospects. 
Econoff also met with leading economists, including 
Raiffeisenbank Chief Economist and former Finance Minister 
Dr. Pavel Mertlik, Patria Finance Chief Economist David 
Marek, and Charles University economics professor Ondrej 
Schneider. 
 
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Eurozone in 2010 or 2013? 
------------------------- 
 
3. (U) The GOCR announced 2010 as its target date for 
adopting the euro, the third and final stage of the European 
Monetary Union, which means that the Czech Republic would 
need to start ERM-II negotiations with the European Central 
Bank (ECB) in 2006, then join ERM-II in mid-2007 for two and 
a half years prior to joining the eurozone.  While the 
announcement came after the Slovak Republic's 
earlier-than-expected announcement to join ERM-II on November 
26, both the CNB and Deputy Prime Minister for Economic 
Affairs Martin Jahn emphasized that countries should join the 
eurozone when they are ready; it is not a race, as often 
portrayed by the media.  In fact, in late October, prior to 
Slovakia's decision to enter ERM-II, Finance Minister Sobotka 
publicly announced: (1) plans to create a task force next 
spring to prepare for the eurozone; (2) one of his deputy 
finance ministers Tomas Prouza will serve as national 
coordinator for the euro; (3) a detailed plan of euro 
adoption will be available at the end of 2006, followed by a 
public campaign on euro benefits; (4) all price tags and 
wages will be listed in both euros and Czech crowns starting 
July 2009. 
 
4. (U) According to the November 23 joint report by the CNB, 
Ministry of Finance and the Ministry of Industry and Trade 
assessing the GOCR's readiness to adopt the euro, the Czech 
Republic is currently in compliance with two (price stability 
and durability of convergence) out of the four Maastricht 
criteria under the EU convergence program and one criteria 
(exchange rate stability) can only be proven under ERM-II. 
Therefore, the one area of deficiency is long-term 
sustainability of the government financial position due to 
its failure to observe budgetary discipline (sovereign debt 
figure is well under the 60 percent/GDP convergence criteria 
at 24 percent/GDP).  The final recommendation of the report 
is that the Czech Republic should not/not attempt to enter 
the ERM-II during 2006, and that "any future change regarding 
this recommendation depends primarily on progress with the 
public finance reform and other reforms directed at 
increasing the flexibility of the Czech economy, and 
particularly that of the labor market." 
 
5. (C) CNB's Erbenova and Singer both noted that a small open 
economy such as the Czech Republic naturally has much to gain 
by adopting the euro, but that it is hardly a reason to rush 
in to it.  Singer explained that it is best to work out the 
kinks now before joining the eurozone; it would be much worse 
for the Czech Republic to fail to meet the convergence 
criteria two years after adopting the euro.  Erbenova 
stressed the need for structural reforms before the Czech 
Republic adopts the euro to make the economy more flexible, 
especially in the labor market, and lamented that reforms are 
going in the opposite direction.  She added that the CNB was 
"increasingly queasy" about adopting the euro in 2010, 
although the CNB has remained silent about its queasiness in 
recognition that the euro is a political decision.  Erbenova 
confessed that if the ruling left-center Social Democrats 
(CSSD) were to win in the June 2006 elections and reform 
continues to be stalled, the delicate CNB-government 
relationship would be strained. 
 
6. (U) The opposition center-right Civic Democrats (ODS) does 
not believe the Czech Republic should adopt the euro until 
2012 - 2013.  In fact, President Vaclav Klaus, one of the 
most vocal euro-skeptics on the continent, has gone as far as 
to say that the Czech Republic should wait until the 
inevitable crash of the euro system in 10 - 15 years (per 
reftel C, Klaus believes that without a unified EU fiscal 
policy, which is only possible under full political 
integration a la the EU constitution, the cost of a unified 
monetary policy is too high to maintain).  Other ODS members, 
including shadow Finance Minster Vlastimil Tlusty, propose 
the following eurozone preparation scenario:  drastic cuts in 
taxes, followed by drastic increase in the budget deficit, 
which would provide needed pressure and incentive to 
subsequently drastically cut expenditures.  Such radical 
ideas make analysts understandably nervous. 
 
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Key Vulnerabilities: Fiscal Discipline and Labor Flexibility 
--------------------------------------------- --------------- 
 
7. (U) Economists point to indexation and mandatory spending 
as the two main culprits requiring reform to establish fiscal 
discipline.  The GOCR's budget is a cyclical budget, which is 
indexed to the previous year's budget instead of to the 
previous year's spending levels.  In addition, mandatory 
expenditures has been increasing since 2002 elections.  In 
2006, 62 percent of the budget will go towards mandatory 
expenditures, the biggest chunk of which is welfare payments. 
 Pensions, welfare benefits and sickness benefits will make 
up 40 percent of the 2006 budget, reflecting an 8 percent 
increase from 2005, which is about 3 percent faster than the 
rate of economic growth.  The joint report on eurozone 
prospects (para 4) states that the temporary decline in the 
government deficit to 3 percent of GDP in 2004 cannot be 
regarded as sustainable, and the earliest the Czech Republic 
would be able to fulfill the Maastricht convergence criteria 
for public finance sustainability is by 2008, but only if 
reforms continue. 
 
8. (U) Charles University economist Schneider explained that 
the "living minimum standard" of the Czech social welfare 
system guarantees a certain level of benefits (by topping off 
unemployment benefits or by paying the entire sum), which has 
both fiscal and labor flexibility implications.  The GOCR 
spends about CZK 56 billion (USD 2.33 billion) per year on 
social benefits (about 3 percent of GDP).  The "living 
minimum standard" benefits received by a family of two 
parents and one child is just below the net average wage of 
Czech workers while the benefits received by a family of two 
parents and two children is slightly above the net average 
wage.  Schneider noted this reality explains why low wage 
workers are so difficult to hire in the Czech Republic, as 
frequently heard from private companies.  Schneider added 
that because the Czech labor code provides such generous 
benefits for all employees, the number of union members is 
low in the Czech Republic.  Comparing the situation to the 
rest of Europe, Raiffeisenbank's Dr. Mertlik said the amount 
of Czech social benefits is not the highest in the Europe, 
but the standard of qualifications and enforcement of those 
benefits criteria is one of the loosest in Europe.  The Czech 
labor situation and implications of the new draft labor code 
is reported reftel B.  CNB contacts agree the flexibility of 
the Czech labor market has worsened since 2003, when it 
issued its previous assessment of the Czech Republic's 
eurozone prospects. 
 
 
9. (C) Economists also believe that the inefficiency of the 
Czech government is another key vulnerability for public 
finance.  CNB's Deputy Governor Niedermayer pointed to the 
current fiscal position -- where the Finance Ministry seems 
unable to fulfill its own promised budget deficit -- as 
evidence.  Patria Finance's Marek pointed to the lack of 
transparency of the Czech fiscal statistics, citing the Czech 
Consolidation Agency as an example of something that sometime 
is and sometimes is not on the books as a government 
liability, and privatization receipts as an example of 
something that sometimes is and sometimes is not on the books 
as a budget revenue source.  Dr. Schneider, who teaches 
Public Finance at Charles University, pointed to the absence 
of required audits for government ministries as one glaring 
problem. 
 
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CARPE DIEM ECONOMIC POLICY 
-------------------------- 
 
10. (C) At end-November, the GOCR posted a small cumulative 
budget surplus (CZK 200 million or USD 8.3 million), after a 
3.4 percent of GDP deficit (CZK 93.7 billion or USD 4 
billion) in 2004.  In October, the cumulative budget surplus 
was CZK 15.2 billion or USD 633 million.  Instead of saving 
or investing the surplus, the Ministry of Finance is trying 
to spend it as fast as possible, up to the 3 percent of GDP 
deficit ceiling approved in the 2005 budget.  The CNB 
attributes the unexpected fiscal surplus to increased tax 
revenues resulting from this year's VAT harmonization with 
the EU and better than forecasted economic growth.  Noting 
the GOCR would have to spend CZK 100 billion during the last 
quarter of 2005 to reach the deficit ceiling, Erbenova 
criticized the Ministry for overstating the potential for a 
budget deficit and doubts the government could achieve a 
deficit even with significant one-off spending.  Others at 
the CNB and most economists assume the GOCR will meet its 
deficit ceiling. 
 
11. (U) Parliament approved the 2006 budget on December 2, 
and its basic parameters are: expenditures of CZK 958.8 
billion, revenue of CZK 884.4 billion, resulting in a deficit 
of CZK 74.4 billion (3 percent of GDP).  CNB Vice Governor 
Singer criticized the planned deficit, saying that if there 
was a time to lower the government deficit, it is now when 
the economy is at its peak.  More significant than the 
budget, however, is a separate bill on extra-budgetary funds, 
which has not yet been presented to Parliament and is 
routinely approved separately from the regular budget.  The 
extra-budgetary funds will likely include transportation and 
infrastructure projects, which in 2005 amounted to CZK 20 
billion (USD 833 million).  Given the current economic boom 
and June 2006 Parliamentary elections, analysts anticipate 
the extra-budgetary spending to be "expansionary" and even 
bigger than usual.  Post will report on the budget and the 
extra-budgetary fund via septel. 
 
12. (C) COMMENTS: It is the government's job not only to take 
credit and bask in the glow of rosy macroeconomic figures, 
but also to look ahead and take steps to minimize the effect 
of an inevitable cyclical downturn in the economy.  It would 
behoove any country to undertake costly reforms during the 
good times when the impact of reform is felt less than during 
hard times.  However, the Czech government, marred with 
political scandals that resulted in three Prime Ministers 
within two and a half years, is blinded by all the rosy 
statistics, preoccupied with upcoming elections in June 2006, 
and has all but neglected those duties.  Instead, the GOCR 
continues to pin all of its future economic prosperity on FDI 
inflows.  This kind of all-too-common shortsightedness has 
been criticized by the CNB and leading economists but so far 
has fallen on deaf ears.  As the joint report on the Czech 
Republic's eurozone prospects states, the loss of independent 
monetary policy will mean that the adjustment of the economy 
to shocks will place higher demands on other adjustment 
mechanisms -- primarily the stabilization function of public 
finances, labor market flexibility , and the financial system 
to absorb shocks.  The Czech are clearly failing to learn the 
lesson from the examples of Germany and France, where the 
lack of such flexibility has resulted in prolonged economic 
stagnation. 
CABANISS