Czech convergence and impact of world economic crises on Czech republic Ludek Niedermayer Director, Consulting, Deloitte CR December 2009

Czech convergence (pre crises)

3 © 2009 Deloitte Czech Republic Success story, mainly in this decade Since start of this decade, very strong performance of Czech economy GDP in euros has doubled, macro stability was preserved Inflation was volatile but low, CA has been supported by surplus of in foreign trade The key weakness was in the area of publics policies Even with around 5% growth of GDP, the budged was not able to reach „close to balance“ Total debt has increased to around 30% of GDP, but declining IR helped to hold cost of debt service low

4 © 2009 Deloitte Czech Republic FX played role Exporters handled stress well Low inflation was reached mainly via exchange rate channel (and flexibility of the economy) CZK was gradually appreciating against euro, the key currency for export and import (ex energy) The economy was able to withhold appreciation of REER in this decade without creating large fragilities With passing time, the „depreciation cushion“ from start of the reform was fading away, some types of the production are not possible to do at the Czech prices – economy is gradualy changing structure Volatility of the currency is recently of more concern, as part of the economy is supplying to very competitive markets Recovery on the way? Impact of world economic crises on Czech republic and region

5 © 2009 Deloitte Czech Republic Summary : The economy is strong in macro stability and private sector, publics sector policies is lagging behind The key bottle necks of ČR Weak fiscal situation, the fast growth of revenues was hiding the budgetary problems and was transformed into permanent expenditures Reform of pension system did not take place Just small changes in health care, underestimated impact of demography No euro strategy, ideology instead of pragmatism EU „schizophrenia“ The crises also has shown up, the potential role of the government in the economy is larger than expected, and so the quality of publics service matters a lot… Relatively strong external position (BoP and publics external debt) of ČR There are some macro fragile countries in the region, the others were partly affected by regional sentiment Good indicators of financial stability (loan to deposit ratio, FX lending, FX financing) Asset bubbles not too evident In some countries, high proportion of FX lending, in some cases also impact of weakness on the „owners“ But still, impact of the slow down visible everywhere (asset quality decline, temporary increase of fiscal deficits) All countries in the region do suffer from large deficits, practically in no cases financial system was collapsing Recovery on the way? Impact of world economic crises on Czech republic and region

6 © 2009 Deloitte Czech Republic Czech EU / Euro debate Combination of: Strong growth Low nominal IR CZK excellent for storage of value Skepticism of some parties about EU Low willingness to consolidate publics finance Lead to no enthusiasm about Eurozone entry Even worse, the plan of social democratic government (2009 or 2010) was canceled as part of pre election campaign But due to the structure of the economy, the euro adoption is not as indifferent, as some economists think. Recovery on the way? Impact of world economic crises on Czech republic and region

Czech economy dealing with crises

8 © 2009 Deloitte Czech Republic From Golden years to crises Czech economy before crises reached most likely peak of the cycle Fast CZK appreciation in 1H of 2009 created large problems for economy Economy – private or publics - was totally unprepared for crises And politicians tried to play it down at the beginning The result for 2009 GDP would be close to 5% decline, instead of 5% average growth before the crises Recovery on the way? Impact of world economic crises on Czech republic and region

9 © 2009 Deloitte Czech Republic Czech recession Delayed start, but than large impact Wrong assumption (of the politician) about relative safety of the economy Strong link to EU market (cars and EU exports) High export to GDP proportion, high concentration Citizens affected by information similarly to any other country Small space for government policy Small countries have per se limited options, domestics demand stimulation does not work On the contrary, mainly for „floaters“, the macro stability is key priority The hypotheses, that “new countries“ will be less affected, did not work. The output losses will be substantial. In selecting government policies, not the stimulation of demand, but the support of eemployment is the key measure In Czech, situation was complicated by political crises Since 2Q, there are signs of stabilisation of economy. Recovery could be slower than expected, pre crises growth is “unlikely to be reach soon (if ever)“ Recovery on the way? Impact of world economic crises on Czech republic and region

10 © 2009 Deloitte Czech Republic Crises – permanent loss of „value“ – read figures properly Recovery on the way? Impact of world economic crises on Czech republic and region Pre crises growth

11 © 2009 Deloitte Czech Republic Deficit growth – money are gone More of debt means also higher interest rates and thus problem for next budgets The impact of “not good policy” can be as high as 30 bil. (almost 1% of GDP) for all future budgets Reaching 60% of GDP debt means permanent increase of debt service of 70 bil. at current prices Comparison (data 2008) Social transfers – 54 mld. Defence budget – 54 mld. University expenditures – 26 mld. So far there is no awareness of politicians of possible problem Adjustment 1% (GDP) per year is for most of them too aggressive Recovery on the way? Impact of world economic crises on Czech republic and region Current "debt“ 30% GDP, interest 4% 2011 optimistic (40% / 5%) Higher interest rates(6%) 60% debt, at 5%

12 © 2009 Deloitte Czech Republic Short term outlook  State of global economy better than expected, the financial sector is not great concern  The world recovery should help to get Czech economy back to growth  In the short run, the investments, construction and mainly labor market will slow down Czech recovery  Inflation in near term not source of concern, but longer horizon is less clear  Still, being among the first countries starting with fiscal consolidation is good, the measures taken are less good (and changes are even worse)  Even in medium run, the potential of the economy is much lower than before crises  So the policies must be adjusted to this fact Nevertheless, it seems that competitive position of the economy is preserved, but it is one of the „most expensive“ in the region The problem is over capacity generated by global decline of the economy, so even relatively competitive countries will benefit just partly from this position The situation can improve, but still, it is not clear, where is world heading Recovery on the way? Impact of world economic crises on Czech republic and region

Crises and CZK or Euro (my view)

14 © 2009 Deloitte Czech Republic Floating CZK – great helper ? Weaker CZK helps. More volatile no Look at past From mid 2007 to mid 2008, CZK has appreciated from 28 to 23 The wage cost in Euro has increased in magnitude of 25% during 12 month This episode has weakened the Czech compatibility before the crises substantially Since start of the crises Depreciation reached max of 25%, volatility high Now, CZK has corrected the stronger level, but volatility is still hign Interest rates higher, but not much Hedging for exporters is difficult and expesive Euro is still (even more) priority for economy Recovery on the way? Impact of world economic crises on Czech republic and region

15 © 2009 Deloitte Czech Republic Impression from the crises Very similar impact of the crises to all „new member states“ (apart of Poland) Mainly among floaters different experience with FX regime: Poland and Czech seems happy with their choice, Hungary (and maybe Romania) would benefit from euro greatly Also impact on banking sector very different. In some countries (mainly Hungary), FX regime triggered large euro-isation of the banking balance sheets Nevertheless, the lessons (especially partial) from the event happening once in decades is not good base for evaluation of the euro adoption Some more universal facts should be taken into account: High growth in new members states has reduce gap between them and rest of EU. Adoption of the euro is less risky Links between new and old Europe are stronger, so the risk of asymmetrical shocks is lower Crises have shown, that cost of volatility is higher than expected and due to lower liquidity of the markets the hedging is more costly So in my option, in most cases, Euro in more appealing than before Recovery on the way? Impact of world economic crises on Czech republic and region

16 © 2009 Deloitte Czech Republic Desirable or feasible ? (yes and no, likely) In most of the new member states, the period of the robust growth was not used for consolidation of fiscal policy And in some cases, fiscal policy was pro cyclical While is should be relatively easy to consolidate after the crises, the politicians have different view So fiscal can be major obstacle While inflation can be also problem, the other key concern is continuing believe of some Eurozone members, that enlargement can undermine the credibility of the euro Recovery on the way? Impact of world economic crises on Czech republic and region

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