Recent Development of Recent Development of the the Czech EconomyCzech Economy

and and Perspective of Euro Adoption in New Perspective of Euro Adoption in New

Member StatesMember States

Ludek Niedermayer Czech National Bank, Prague

www. .cz

New millenium - More growth …New millenium - More growth …

• From the beginning of decade the economy accelerates its growth, in spite of not always favorable external conditions;

• Export and investments are leaders of growth in 2006, consumption (and investments) growth is picking up now. -2

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HDP Spotřeba domácností Fixní investice

……inflation inflation mostly below the target mostly below the target ……

• In 2006 (1-3 Q) inflation is pulled up by regulated prices and energies, net inflation is still low;

• In 2007 (1- 3 Q) inflation still below the target but heading up, recently 4% y-o-y (food, energy);

• In 2008, inflation will be pushed up by increase of VAT and other taxes;

• But the monetary policy will react on 2nd round effects only, the expecatations;

• Wages are crucial.

• Globaly, is inflation on the rise?

Meziroční inflace v %

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……allows low nominal interest rates…allows low nominal interest rates…

• The inflation in this decade was most of the time below the target;

• Even long term interest rates often below Euro rates, boosting lending market;

• Low nominal rates have made CZK financing currency for many investors. Summer market volatility has brought correction;

• Market is now again expecting appreciation;

• FX rate uncertainty is one of the key risks of any CNB forecast.

Swap rates (1,5,10 Y)

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3M pribor

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Surplus in trade balance despite high Surplus in trade balance despite high energy costs and growth of demand...energy costs and growth of demand...

• Change of foreign trade balance into surplus caused mainly by growth of export (role of FDI);

• Current account deficit is outcome of negative balance of income (mostly reflects the profit of FDI). Part of profit is reinvested, but proportion fluctuates;

• Currently speed of growth of exports similar to imports, but new capacities can bring improvement;

• Market pays more attention to external balance now.

Current account and its components / GDP ratios (moving annual cumulations in %)

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trade balance balance of servicesincome balance current transferscurrent account

1998 1999 2000 2001 2002 2003 2004 2005CZ 16,7 24,4 29,6 34,3 37,7 34,9 37,8 42,2AT 6,9 7,2 10,8 11,7 11,2 10,8 . .DE 5,1 7,3 15,7 13,8 15,1 15,5 14,2 .PT 11,7 12,7 16,9 19,1 20,7 20,5 21,6 .HU . . . . . . 37,0 35,6PL . 11,7 13,9 16,1 15,9 17,5 22,7 22,5SI . . . 10,5 11,8 12,6 14,3 14,9SK 6,4 . . . 22,9 20,6 . .Zdroj. Eurostat, výpočet ČNB

FDI on GDP

… … good macro is pushing CZK …good macro is pushing CZK …

• Trend of CZK appreciation continues since 90´s and is one of key factors of low inflation;

• Pro appreciation – strong fundamentals (including BoP until recently), EU catch up;

• Against – sometime regional links, low nominal interest rates, perspective of the BoP;

• Recent financial turbulence has caused appreciation of CZK, as many short positions have been cancelled.

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… … labour market improvement labour market improvement substantial, is it just cyclical?substantial, is it just cyclical?

• Unemployment falls slowly in 2005-6, share of long-term unemployment is high;• Since mid 2007, decline more evident despite of no substantial improvement of labour market

regulations;• Employment increased more than 1,7% in 2007; • Growing evidence of labour shortage in recent months, outflow of foreign workers is a real threat;• Openness of market (access of non-residents) can compensate small flexibility of domestic labour

market;• Than, issue of outflow of foreign labour creates new risk.

Míra nezaměstnanosti a Beveridgeova křivka (sezonně očištěné údaje)

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… … and fiscal policy is source of and fiscal policy is source of concern…concern…

• Effort to consolidate public finance „in good times“ was „limited“;

• EU commitment not respected;• Since 2007, new social transfers

approved, in 2006 tax cuts;• Reform package (tax reform and

some expenditure cuts) effective next year, is not primarily focused on deficit reduction;

• After deficit reduction in 2008, year 2009 uncertain;

• Brussels commitment should be respected as the minimal effort.

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Conv. Prog. XI/05 Budget Result Result adj. GDP

Risks for EconomyRisks for Economy• Growth perspectives in EU source of more concern than earlier;• Reaction of the economy on price increases next year;• Currency appreciation – at which level it can hurt the growth?

• Problems in the field of public finance still last;• Problems in structural sphere are not solved so far:

Pension reform; Changes in health care.

• Problems on labour market (partly flexibility of labour market, set up of social system and qualification / regional mismatch) – more should be done;

• Education system should better respond to a „real world“.

Czech Republic, new EU states and EuroCzech Republic, new EU states and Euro

Czech Republic, new EU states X Euro

Discussion on Euro in new EU states …Discussion on Euro in new EU states …

• New member countries do not have „opt out“, now more „outs“ than „ins“; from 10 new member countries 7 planned after EU accession to adopt Euro till the end of decade, first already in 2007;

• Reality different, so far, only Slovenia is in Eurozone, Cyprus and Malta will join next January;

• Some countries „changed their mind“ – issue of willingness to do now the fiscal reform key for many states;

• In CR the discussion on Euro was not a priority : Crown does not suffer from the lack of credibility and is stable in last

years, interest rates are not higher than in Eurozone; Financial market offers different types of short-term FX risk

management tools.

New EU states „at glance“New EU states „at glance“

• „South wing“ Small countries, only one „catching up economy; Managed float, relatively small financial market;

• North wing Small countries, fastly catching up, closely linked

to Scandinavia; Currency pegs for many years;

…………

• „Central Europe“ Medium size countries, „catching up economies; All forced to leave FX anchors, currently mostly

free floaters; More volatile economic development with periods

of divergence; More problems with fiscal policy.

Some aggregate figures – poorSome aggregate figures – poor and and cheapcheap neighbors… neighbors…

1998 1999 2000 2001 2002 2003 2004 2005 2006

CZ 61,7 60,9 60,2 62,1 62,7 65,8 68,6 69,5 72,1AT 116,1 116,1 117,1 112,2 113,3 115,2 116,1 115,8 117,1DE 107,1 107,0 104,2 103,0 102,4 104,4 104,4 103,1 102,8PT 67,0 68,6 68,6 68,2 68,5 68,8 67,8 68,0 67,7HU 46,1 46,9 49,3 51,9 54,7 56,8 57,6 58,4 59,4PL 41,8 42,5 42,5 42,0 42,9 43,9 45,8 45,9 48,1SK 45,7 44,5 44,1 46,3 48,3 49,3 51,0 53,9 57,0SI 67,1 68,7 68,1 68,2 70,8 72,3 75,1 76,4 78,8Zdroj: Eurostat, výpočet ČNB.

1998 1999 2000 2001 2002 2003 2004 2005 2006

CZ 43,4 42,9 45,1 47,6 53,2 50,0 50,7 55,3 57,8

AT 102,5 102,6 101,8 104,6 102,4 100,6 100,1 100,6 100,0

DE 110,3 109,1 109,3 109,0 107,7 104,2 103,1 103,1 102,5

PT 77,5 77,9 79,2 80,5 81,0 80,2 81,5 81,2 81,4

HU 44,0 44,7 46,9 49,2 54,1 54,0 56,9 59,1 56,5

PL 47,6 46,1 51,9 57,8 54,3 47,6 47,0 54,5 55,6

SK 40,3 38,2 42,1 41,4 42,6 45,8 49,6 51,3 53,7

SI 70,2 70,4 69,7 70,9 71,4 71,7 70,4 70,7 70,6Zdroj: Eurostat, výpočet ČNB.

GPD pre capita (EU – 12)

Price level (EU – 12)

Growing together ? No, thanks…Growing together ? No, thanks…

• GDP cycle symchronisation weak, as economy started its robust growth;

• Some benefits of both growth or even slow down of EU;

• Manufacturing influenced by German industry a lot (car market).

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Zdroj: Eurostat, výpočet ČNB.

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Zdroj: Eurostat, výpočet ČNB.

Trade argument holds? Yes !Trade argument holds? Yes !

• Very strnong trade relations;

• Similar development in investments side;

• Even 3rd country firms producing for EU market.

Zdroj: IMF, výpočet ČNB.

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Zdroj: IMF, výpočet ČNB.

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Euro dicsussion:Euro dicsussion:Economy vs. ideologyEconomy vs. ideology

• Often divided into „nominal convergence“ (mainly Maastricht treaty rules) and „real convergence“ (OCA).

• Fundamental and well-founded discussion on risks of FX volatility and competitive advantages of countries that will adopt Euro, or on costs of Euro adoption and benefits of independent monetary policy is not too advanced;

• Many economists do not believe it can bring exact results as exact arguments for or against could be hard to found.

• If anything matters, than it is flexibility of economy ...• …but it should be demanded also without EMU entry…• …and rate of flexibility is difficult to measure …

“ “ ReRealal CConvergenconvergencee – CR – CR ““ - +- +• Correlation of macro indicators

growing up but still “moderate“ at maximum;

• Structure of economy different from economies of most EU members;

• No inprovement of the flexibility of economy in recent years;

• Members of Eurozone grow more slowly than „outs“;

• To fulfil the criteria can be difficult.

• EU growth is a very strong determinant of our economic growth;

• Very high proportion of foreign trade with EU (FDI as well);

• Reduction of costs on foreign trade will accelerate economic growth;

• Euro adoption will solve some domestic problems.

… … rules and „new“ national rules and „new“ national strategies are there …strategies are there …

• Base to access nominal convergence is the fulfillment of Maastricht conditions;

• Real convergence is relevant for future development (cost / benefits) of a new member of Eurozone.

• Remaining „Outs“ have various strategies – in some cases the „first attempt“ has failed;

• Peggers are now strugling with high inflation (among other things);

• Slovakia on its way to adopt Euro in 2009;• For rest of the countries in our region, adoption of Euro

means more significant change of monetary policy. In some countries, not a clear politic support.

… … how are the rules applied ?…how are the rules applied ?…

• Case of Lithuania and Slovenia showed willingness of Eurozone to accept new members but at the same time illustrates that the examination is very strict;

• Next wave of Cyprus and Malta without big discussion;

• Recently more discussion about real convergence issues.

• So are new members ready?

• In general, economic situation and rate of convergence of 10 new members differs from the situation of most countries that have created monetary union.

Balance : Balance : CRCR vs. Maastricht vs. Maastricht

• Stable and safe observance of 3 % limit of public deficit requires changes in public finances (pension reform will can increase deficits in future too);

• Recent rigid interpretation of inflation criterion could be a source of concerns too and requires certain level of preparation;

• Capability to limit FX rate volatility, and pass „successfully“ ERM II and „correctly fix FX rate“, could be a challenge for macro policies (see Slovakia);

• Other two conditions (public debt and long term interest rates) seem to be easier to fulfil;

• What means sustainability? Maybe we will learn soon.

New EU New EU vs. Maastrichtvs. Maastricht : : State of play State of play

• Entry of new members into Eurozone in 2007 (Slovenia) and in 2008 (Cyprus, Malta);

• After „Lithuania case“ more concerns among applicants, but Cyprus treated „friendly way“;

• Baltic applicants out of game for some time due to very high inflation;Next on the line is Slovakia, that is more similar to other VI 4.

• Bad state of Hungarian public finances put off possibility of quick Euro adoption in Hungary, in Poland it is not a political priority;

• These countries do not want to stay at ERM for a long time;• New strategy for CR (after giving up date 1/1 2008) set no date

so far, yearly autumn evaluations will continue.

Ludek.Niedermayer@cnb.czLudek.Niedermayer@cnb.cz

www.cnb.czwww.cnb.cz