Long-term outlook for Czech Republic

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FINANCIAL TIMES

The Czech Republic’s D1 motorway is a symbol of the country’s squandered natural advantages and its challenges. The ageing backbone of the country’s road system has become paralysed this year by long delayed repairs – creating traffic jams that have sometimes stretched 30km – exposing the cost of the failure to build an alternative east-west route since the collapse of communism 25 years ago.
The motorway network was once one of the country’s strengths compared with neighbours such as Poland, but while the latter used EU funds to revolutionise its roads, the Czechs have allowed theirs to deteriorate, with projects often running massively over budget and mired in allegations of corruption.
“There is no doubt that in the past [infrastructure projects] were suspected of corruption,” says Vladimir Dlouhy, a former economy minister who now heads the Hospodarska Komora, the country’s main business organisation.
But corruption has not just hamstrung the improvement of the road network and the efficient use of EU funds; the public’s disgust with the country’s deadlocked and corrupt political system now threatens to depress growth prospects. The gloomy miasma has now become self-perpetuating, Mr Dlouhy says, warning that “general public distrust contributes to slow growth”.
This mood shows no sign of lifting, despite the belated return of economic growth in the middle of last year. The economy has rebounded impressively since austerity policies were abandoned, growing 2.6 per cent in the second quarter. But the long-term growth outlook remains worrying, casting doubt not just on whether the country can ever catch up with western Europe, but also whether it can avoid being overtaken by its poorer neighbours.
The Czech Republic remains stuck at the level of 80 per cent of EU GDP per capita (adjusted for purchasing parity), and has even fallen back from a peak of 83 per cent in 2007 before the global financial crisis. As the OECD reported in March: “the income convergence process vis-à-vis the euro area has stalled”.
The centre-right governments in power from 2007-2013 reacted to the crisis by imposing rigid austerity policies, slashing the government budget deficit from 4.2 per cent of GDP in 2012 to 1.5 per cent in 2013. Together with tumbling German industrial demand for Czech intermediate goods, this pushed the economy into a double-dip recession for most of 2009-2013.
The centre-left government that took office in January has abandoned the previous goal of balancing the budget by 2016 and has cut some VAT rates, raised the minimum wage, and restored full pension indexation. Its medium-term fiscal target is now to run a 1 per cent structural deficit.
“The main value-added of this government is the return to non-ideological, pragmatic economic policies,” says Jan Mladek, economy minister.
The central bank has also maintained an extremely loose monetary policy, keeping the key two-week repo rate at 0.05 per cent to stave off deflation and intervening to weaken the koruna. The bank says it expects to maintain the current policy stance until 2016.
The improving eurozone environment and the relaxation of fiscal policy have pulled the Czech Republic sharply out of recession, causing analysts hastily to revise their forecasts. Industrial exports have been the motor; the country could even record its first current account surplus for more than two decades this year. However, domestic consumption and investment have also now begun to revive, making the recovery more broadly based, says Jan Vejmelek, chief economist of Komercni Banka.
In the longer term, no one predicts a return to the vibrant growth rates of the first half of the noughties when the country attracted huge foreign direct investment (FDI) inflows and became tied to the German economy.
Mr Vejmelek predicts growth of 2.9 per cent this year, when he says the Czech Republic will finally reach its pre-crisis level of output, and 3.3 per cent next year, but he says that 2 per cent is a more realistic trend rate.
This year the country has recorded a couple of FDI successes, notably by attracting automotive parts supplier Hyundai Mobis and Nexen Tire of South Korea. Mr Mladek now plans to resuscitate CzechInvest, the country’s foreign investment promotion agency, and secure more investments from Asian and Bric countries.
But the old model of relying on the country’s cost advantage compared with western Europe to attract foreign investment seems to be broken. Czech productivity has stagnated, while labour costs have crept upwards. Skills and education – once a comparative advantage – are now also a concern, with not enough students choosing technical subjects.
The country is also struggling to generate domestic start-ups in the high-tech industry or services. Research remains highly academic, and finance is hard to come by.
The previous centre-right government tried and failed to reform the costly pension and healthcare systems, and the current government, an uneasy coalition between the Social Democrats and the centrist Ano party, seems to have agreed to shelve the most contentious reforms, such as adopting the euro