One of the most affluent countries in central and eastern Europe (CEE), the Czech Republic has ridden out the economic impact of the Covid-19 pandemic reasonably well, despite suffering one of the world’s highest death tolls per head. The government and central bank were able to step in rapidly, though their efforts to support incomes and jobs have attracted criticism in some quarters.
The relatively high share of industry in gross domestic product (GDP) led to a shallower recession than might have been the case, and the country can now look forward to a robust recovery. The Czech economy contracted by 5.6% in 2020, slightly less than the EU average of 6.1%, and is expected to rebound by 3.4% this year, picking up pace to 4.7% in 2021, according to forecasts by Komerční Banka (KB).
“Yet again, the Czech economy has shown its resilience and flexibility,” says Jan Vejmělek, chief economist at KB. Mr Vejmělek notes that the country has survived the collapse of communism and the loss of key eastern European markets in the early 1990s; the global financial crisis of 2007-09; the European debt crisis; and the shock from Moscow’s annexation of Crimea and subsequent sanctions on Russia.
Rapid response
When the pandemic reached the Czech Republic in March 2020, the government responded quickly, closing borders and mandating mask-wearing before most EU countries. It also introduced measures to support employment, incomes, and businesses; moratoriums on loan repayments; and restrictions on insolvency petitions.
While the speed of the reaction has been widely praised, overall the government response has drawn some criticism. Disbursement of funds to businesses were complicated and in some cases delayed, and opportunities to support investment were under-exploited. Some measures largely benefited those whose incomes were largely not affected by the crisis, including a Kcs79bn ($3.8bn) cut in personal income taxes.
The government used the crisis as a pretext for huge but unsubstantiated transfers of money to certain parts of the population
“The government used the crisis as a pretext for huge but unsubstantiated transfers of money to certain parts of the population, such as pensioners, doing so at the cost of further increases in the public debt,” says Michal Skořepa, an economist at Česká spořitelna, part of the Erste Group.
The government has also been criticised for its inconsistent public health approach to the pandemic, which arguably contributed to the death toll of more than 30,000.
The Czech National Bank (CNB), meanwhile, was one of the few central banks in the EU able to address the crisis without resorting to unorthodox policies such as quantitative easing and negative interest rates. The bank’s base rate stood at 2.25% in mid-March 2020; three cuts over two months took it to 0.25% at the end of May. It also eased macroprudential requirements to encourage continued lending.
Momentum building
The country was hit hard by successive waves of Covid-19 between October 2020 and March 2021. As a result, GDP fell by 2.1% year-on-year and 0.3% quarter-on-quarter in the first quarter of 2021. However, with Covid-related restrictions easing while many support measures remained in place, and the EU vaccine programme picking up pace, economic growth resumed in mid-April. Domestic and international factors are boosting the recovery.
“From the second quarter, we expect the economy to start growing rapidly and above-average growth to continue in the medium term,” says Mr Vejmělek. “As an open economy, [the country] will benefit from the recovery of global trade, while the elevated level of household savings will support domestic consumption.”
In the medium term, the economy’s continued strength will be influenced both by global trends and its ability to adapt to them. As in other CEE countries, there are questions over whether the (foreign-owned) automotive industry and large utilities such as CEZ – one of Europe’s largest energy companies – can move quickly enough to capture new markets and avoid being left with stranded assets. The automotive sector accounts for 9% of GDP and nearly a quarter of exports.
“To maintain its dynamics the Czech economy must keep up with electrification, robotisation and green trends,” says Tomas Vlk, head of research at Patria Finance. “Some problems for the small open economy may also stem from progressive deglobalisation.”
Mateusz Szczurek, lead economist for central and south-eastern Europe at the European Bank for Reconstruction and Development (EBRD), and a former Polish finance minister, takes an upbeat view on the country’s ability to manage these challenges.
“As the global automobile sector moves towards electric and hydrogen vehicle production, it’s quite possible that the Czech Republic will be able to make a success of the shift,” he says. “The structure of the Czech economy is the most important factor in supporting the recovery. There is a reshaping of global value chains that could benefit advanced industrial centres like the Czech Republic.”
CNB vs inflation
More immediately, the authorities must contend with a rapid uptick in inflation, which hit 3.1% in April 2021. Imported inflation is a significant factor, as is a faster-than-expected reopening leading to a strong rebound in domestic demand from households with savings to spend. Meanwhile, an overheating labour market and surging housing prices belie the recession, Mr Vlk notes.
The CNB has an inflation target of 2%, with a 1% tolerance band either side, and is likely to act soon. “The CNB has a strong reputation for sticking to its price stability mandate,” says Mr Szczurek. “The bank was quick to move towards the normalisation of monetary policy in the past, and is likely to move in the same direction in 2021, being quicker than some to tighten in response to elevated inflationary pressures.”
Indeed, the bank’s May 2021 decision to lift banks’ countercyclical buffers is a signal that it sees the economy returning to normal — though lenders will have a year to comply with the rise.
Komerční Banka forecasts inflation of 2.5% in 2021, even with 25 basis point hikes expected in August and November, given the lag in monetary policy impact. The bank says markets appear to be counting on the CNB raising rates over a two-year period.
EU funds hold promise
The fiscal outlook is affected not only by the coronavirus crisis — the Czech Republic ran a deficit of 6.2% of GDP in 2020 — but also by elections due in October 2021. With polls tightening, unwinding some of the supposedly temporary fiscal measures included in the government’s economic support packages is likely to prove difficult, leaving a significant gap in public finances.
KB forecasts a deficit of 6.5% of GDP for 2021 and 4.2% for 2022. Nonetheless, analysts are generally in agreement that the government should have no difficulties securing financing, and the country’s debt – which could near 50% of GDP in the next two years – remains relatively low.
The ministry of finance’s stance, outlined in a statement to The Banker, is that economic recovery is a precondition of medium-term fiscal consolidation, and that such consolidation must not hamper growth. The ministry argues that controversial pre-pandemic increases in public sector wages were limited to teachers and health and social care workers.
There is a reshaping of global value chains that could benefit advanced industrial centres like the Czech Republic
Prime minister Andrej Babiš has pledged that reductions in the tax burden worth 2% of GDP made in 2020 will last for just two years, before a wholesale tax reform is implemented. This, however, depends on the election result. “The risk premium may rise as well, if October brings out a government which will downplay the need to consolidate public coffers so that the country’s credit rating falls,” says Mr Skořepa at Česká spořitelna. “But it seems that most political parties are aware of this need so I still think a rating downgrade is not very likely.”
The country will also benefit from substantial sums in amounts of EU funding over the coming years. The government still has at its disposal €11bn from the previous EU budgetary period (2014-20), and will receive a further €38bn from the 2021-27 Multiannual Financial Framework (MFF) and post-covid Next Generation EU fund. Some €7bn from the MFF will go towards areas including the digital transformation and green transition, potentially addressing some of the structural challenges the Czech economy faces.
Around €1.6bn from the Just Transition Fund will go towards mitigating the impact of the transition towards climate neutrality in the regions most affected. The country also has €21bn from the Cohesion Fund for physical infrastructure, small businesses, and research and development, among other areas; and €8bn in agricultural funding.
Eurozone question remains
The election may also put the question of eurozone membership back on the political agenda. The country is traditionally eurosceptic, and Mr Babiš’s populist ANO 2011 party has said it will not seek to join the single currency. However, recent polls put the opposition pro-euro Pirates and Mayors party in the lead.
“The new crisis response mechanisms in the euro area and the EU’s better, quicker response to a major crisis with Covid than seen in 2008 are arguments for euro adoption,” says the EBRD’s Mr Szczurek. “The Czech Republic would be happy to be in ‘core Europe’ for political purposes.”
Mr Vlk notes that some businesses struggled with the koruna’s fluctuations over the past year. Yet some observers believe the currency’s free float may have come into its own during the crisis, with its rapid 5% depreciation in early 2020 helping cushion the initial economic impact. The currency is now trading around the level it did pre-crisis. Meanwhile, Czech voters continue to be wary of greater fiscal union. “I think that the crisis has underlined the independence argument as the European Central Bank is coming even more under pressure of fiscal dominance with all the EU asset-buying programmes,” says Mr Vlk.
Steady as she goes
The lacklustre appetite for fiscal union is partly testament to the Czech Republic’s robust economic performance over the past three decades. A growing fiscal gap and the challenges of industrial transition loom on the horizon, among global post-pandemic uncertainties, but the coming year could again bear testament to the country’s strengths.
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