The Czech Republic on its Way Towards the Euro

1. The Czech Republic on its Way Towards the Euro Petr KRÁL Monetary and Statistics Department Czech National Bank Conference: "Competitiveness of the South Eastern European Countries: Challenges on the Road to EU Skopje, May30, 2008

2. Presentation Outline • Milestones on the Czech Republic's way to the West • Economic effects of the EU membership • Economic aspects of the adoption of the euro • Euro-adoption plans

3. Milestones on the Czech Republic's way to the West • Successful transition from central planning to a functioning market economy • 1989 – “Velvet Revolution” in former Czechoslovakia • 1993 – split of Czechoslovakia into the Czech Republic and Slovak Republic • 1995 – OECD membership • 1999 – NATO membership • 2004 – European Union membership (derogation on euro introduction • Characteristics of a small open economy

4. Economic effects of EU the membershipPre-accession economic developments (i) • Fundamental transformation steps and so-called transitory recession (1990 – 94) • Demand-driven economic recovery with supply side lagging behind resulting into an overheating (1994 – 1997) • Financial and subsequent economic crisis (1997 – 1999) • Abolition of pegged ER combined with monetary targeting (1997) and adoption of inflation targeting framework (1998) • Supply-side improvements (FDIs) and acceleration of convergence (2000 – )

5. Economic effects of EU the membershipPre-accession economic developments (ii) • massive inflow of FDI started in 1998 (paradoxically in economic bad times) • introduction of government investment incentives and privatization of state-ownedproperty kicked-off the inflowKrál (2004):Identification and Measurement of Relationships Concerning Inflow of FDI: The Case of the Czech Rep. (CNB Working Paper) • subsequently enterprises under foreign control begun to gain growing share on economic activity

6. Economic effects of EU the membershipPre-accession economic developments (iii) • inward FDI has been bothvertical benefiting from the comparativeadvantage of the • Czech economy in terms of input prices, government promotion of FDI andeconomic stability • andhorizontal focusing on the LR growth and market size prospects arising from • the expectedCzech Republic’s future accession to the EU • FDIs were coming prevailinglyfrom EU countries (Germany, Austria, Netherlands?)

7. Economic effects of EU the membershipPre-accession economic developments (iv) • as a result the Czech Republic became one of the most FDI penetrated country in the region • and in the world and openness and export performance of the country are also tremendous • positive effects of inward FDI on the supply side of the economy (capital stock + crowding-in • effects, primary and secondary technological spillovers) contributed significantly to the gradual • acceleration of potential (non-inflationary) output growth

8. Economic effects of EU the membershipEU entry – acceleration of ongoing trends and new phenomena (i) • EU single market – 4 freedoms of movement • Goods • Services • Labour • Capital • EU regulations • Acquis communautaire • EU norms, tax harmonization, common policies (e.g. trade, agriculture) • Access to EU funds • “Reputation” effect

9. Economic effects of EU the membershipEU entry – acceleration of ongoing trends and new phenomena (ii) • acceleration of GDP growth and its potential • speed-up of the real convergence vis-à-vis western countries • rapidly growing export capacities are the main driver (extreme in 2004) • steadily increasing openness of the economy

10. Economic effects of EU the membershipEU entry – acceleration of ongoing trends and new phenomena (iii) As a result, trade balance turned to positive numbers being driven by the surplus of the trade with SITC 7 items Czech exports have developed specialized in machinery and transport equipment, mainly as a result of FDI

11. Economic effects of EU the membershipEU entry – acceleration of ongoing trends and new phenomena (iv) Macroeconomic policies • MP – EU entryitself no major challenge (tax harmonization: no large price shock) • FP – task to meet Stability and Growth Pact requirements

12. Economic aspects of the euro adoptionWhy to adopt the euro • Legal obligation (no opt-out clause, only derogation) • Economic reasoning • Exchange rate and interest rate stability • Lower transaction cost (reduction in exchange rate risk, access to more liquid financial markets) • Higher price transparency • Disciplining effect on domestic economic policies • Final step in the EU integration

13. Economic aspects of the euro adoptionPossible risks • Loss of independent monetary policy • Interest rates handed over to ECB => ECB’s common monetary policy does not have to fit the Czech reality => Limited reaction to asymmetric shocks • Solution ?! • Economic alignment • Flexible alternative stabilization mechanisms • Fiscal policy • Labour market • Inflation acceleration

14. Economic aspects of theeuro adoptionTiming of the euro adoption • Formal conditions • Maastricht criteria • Price stability • Inflation: below three best performing EU countries’ inflation +1.5 pp • Sustainability of government finance • Fiscal deficit: < 3% of GDP • Gov. debt: < 60% of GDP • Exchange rate stability • Exchange rate: ERM II participation for 2 years without sever tensions • Durability of convergence • LT interest rate: below three best (inflation) performing EU countries’ IR +2.0 pp • Compatibility of legal framework • Including the central bank status with EU regulation • Informal conditions • Economic consideration • Symmetry • Flexibility

15. Euro-adoption plans of the Czech Rep.Strategic documents • CNB & Government • The CR’s EA accession strategy • First in 2003 • Updated in 2007 • Assessment of the fulfilment of the Maastricht convergence criteria and the degree of economic alignment of the CR with the EA • CNB • Analyses of the CR’s current economic alignment with the EA • http://www.cnb.cz/en/monetary_policy/strategic_documents • Government • Convergence programme of the CR • http://www.mfcr.cz/cps/rde/xchg/mfcr/xsl/conv_program.html

16. Euro-adoption plans of the Czech Rep.First EA Accession Strategy (2003) • Common stance by the CNB and the Government • Benefits outweigh risks, butrisks can be reduced • quality preferred to speed • CNB will continue in IT until the CR adopts the euro • Participation in ERM II only for minimum possible period • 2 years • Expected date of the euro adoption => 2009 – 2010 conditional on • Criteria fulfilment • Including a consolidation of public finances • Achievement of a sufficient level of real convergence • Adequate progress with structural reforms • Leading to a sufficient degree of economic alignment

17. Euro-adoption plans of the Czech Rep.Fulfillment of the Maastricht criteria Fiscal deficit Inflation  LT sustainability? BUT 2008 ERM II  Public debt  LT IR 

18. Euro-adoption plans of the Czech Rep.Economic Alignment (i) Long-run convergence 2006; euro area average = 100 • Progress achieved • Important gap persists for the CR – especially in the price level • =>expectationofthe real exchange rate appreciation

19. Euro-adoption plans of the Czech Rep.Economic Alignment (ii) Correlation of GDP Growth vis-à-vis the euro area, 2001:Q1-2006:Q1 • Major difference between the cycle of the CZ and EA real GDP growth • Low correlation with the euro area characteristic also for macroeconomic shocks • Higher level of correlation seems to prevail for industrial production

20. Euro-adoption plans of the Czech Rep.Economic Alignment (iii) Fiscal deficits • Fiscal deficit structural in nature • Little room left for automatic stabilizers • Some reforms have been implemented, some are in the pipeline and some have been announced • Figures for 2007 - 2008 revised downwards • Long-term sustainability remains an issue

21. Euro-adoption plans of the Czech Rep.Economic Alignment (iv) LT unemployment and regional differences Long-term unemployment:: % share of long-term unemployed (12Ms or more) in total unemployment, 2006 Variation coefficient of regional unemployment: NUTS2, 2005, CNB calculation Both indicators are relatively high – showing structural problems on the labour market (including low mobility)

22. Euro-adoption plans of the Czech Rep.An Up-dated EA Accession Strategy (2007) (i) • Strategy from 2003 has proven to be useful and in some sense fulfilled • BUT • Major obstacle was seen in fiscal consolidation • EDP should be abrogated ASAP (1st stage of fiscal reforms) • Maastricht criterion not ambitious enough • Medium-term objectives (SGP) should be targeted • Long-run challenges stemming from demographic changes have to be addressed • Still low flexibility and efficiency of the economy • the labour market must be markedly enhanced

23. Euro-adoption plans of the Czech Rep.An Up-dated EA Accession Strategy (2007) (ii) • Conclusion • No particular date of entry proposed • New euro-adoption date will not be set until sufficient progress is made in fiscal consolidation and flexibility of the economy • The same conclusions drawn in the last annual Assessment of the fulfilment of the Maastricht convergence criteria and the degree of economic alignment published at the end of 2007 • CR will not initiate the ERM II entry in 2008

24. Thank you for your attentionwww.cnb.czpetr.kral@cnb.cz