The Czech Republic on its Way Towards the Euro Conference: "Competitiveness of the South Eastern European Countries: Challenges on the Road to EU Skopje, May 30, 2008 Petr KRÁL Monetary and Statistics Department Czech National Bank

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 membership Pre-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 membership Pre-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-owned property kicked-off the inflow Král (2004):Identification and Measurement of Relationships Concerning Inflow of FDI: The Case of the Czech Rep. (CNB Working Paper)Král (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 membership Pre-accession economic developments (iii) inward FDI has been both vertical benefiting from the comparative advantage of the Czech economy in terms of input prices, government promotion of FDI and economic stability and horizontal focusing on the LR growth and market size prospects arising from the expected Czech Republic’s future accession to the EU FDIs were coming prevailingly from EU countries (Germany, Austria, Netherlands?)

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

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

12 Economic aspects of the euro adoption Why 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 adoption Possible 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 the euro adoption Timing 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  Government  Convergence programme of the CR 

16 Euro-adoption plans of the Czech Rep. First EA Accession Strategy (2003) Common stance by the CNB and the Government Benefits outweigh risks, but risks 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 Inflation  Fiscal deficit  BUT 2008 Public debt  ERM II  LT sustainability? LT IR 

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

19 Euro-adoption plans of the Czech Rep. Economic Alignment (ii) 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 vis-à-vis the euro area, 2001:Q1-2006:Q1 Correlation of GDP Growth

20 Euro-adoption plans of the Czech Rep. Economic Alignment (iii) 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 revised downwards Long-term sustainability remains an issue Fiscal deficits

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

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 (1 st 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 attention