Identifier
Created
Classification
Origin
05PRAGUE1325
2005-09-13 12:35:00
UNCLASSIFIED
Embassy Prague
Cable title:  

CZECH REPUBLIC: IS RUNNING IN PLACE GOOD ENOUGH

Tags:  ECON EFIN EINV EZ PGOV 
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UNCLAS SECTION 01 OF 04 PRAGUE 001325 

SIPDIS

SENSITIVE BUT UNCLASSIFIED
STATE FOR EUR/NCE ERIC FICHTE, EB/IFD, E DAN MORRISON
STATE PLEASE PASS USTR LISA ERRION
COMMERCE FOR ITA/MAC/EUR MIKE ROGERS
TREASURY FOR OASIA ANNE ALIKONIS

E.O. 12958: N/A
TAGS: ECON EFIN EINV EZ PGOV
SUBJECT: CZECH REPUBLIC: IS RUNNING IN PLACE GOOD ENOUGH
FOR THE ECONOMY?

REF: A. PRAGUE 1176

B. PRAGUE 911

C. PRAGUE 707

UNCLAS SECTION 01 OF 04 PRAGUE 001325

SIPDIS

SENSITIVE BUT UNCLASSIFIED
STATE FOR EUR/NCE ERIC FICHTE, EB/IFD, E DAN MORRISON
STATE PLEASE PASS USTR LISA ERRION
COMMERCE FOR ITA/MAC/EUR MIKE ROGERS
TREASURY FOR OASIA ANNE ALIKONIS

E.O. 12958: N/A
TAGS: ECON EFIN EINV EZ PGOV
SUBJECT: CZECH REPUBLIC: IS RUNNING IN PLACE GOOD ENOUGH
FOR THE ECONOMY?

REF: A. PRAGUE 1176

B. PRAGUE 911

C. PRAGUE 707


1. (SBU) SUMMARY: According to the GOCR,s June 2005
economic strategy, the Czech Republic hopes to reach the EU
average GDP per capita by 2013 (from USD 19,700 to USD 30,000
using PPP). To this end, the Czech economy,s near term
outlook remains strong. Real GDP growth reached 4.4 percent
in 2004 due to a surge in investment and exports related to
EU entry, and is projected to remain healthy in 2005-2006.
2005 2Q GDP reached 5.1 percent, the best since 1996.
Inflation (CPI) remained low in 2004 at 2.8 percent and is
likely to remain below the three percent Maastricht
Convergence Program target through end-2006. Such rosy
figures, however, do not tell the whole story. As noted
recently by IMF staff, the Czech Republic,s main problem is
that growth cannot be sustained if problems stemming from
continued rigidities in the labor market and the
business-legal environment, and challenges from a fast-aging
population are not addressed in a timely fashion (2005
Article IV Staff Report). With June 2006 elections looming,
meaningful reforms under the current center-left Social
Democrat (CSSD) government seem unlikely before the
elections. The likelihood of reform after the elections will
depend heavily on the nature of the coalition government,
particularly on the degree of success by the more
business-friendly center-right Civic Democrats (ODS) (Reftel
C). END SUMMARY.

--------------
Investment Climate
--------------

2. (U) An often-cited statistic indicative of the dynamic
Czech economy is that it enjoys the highest per capita
Foreign Direct Investment in the region (USD 3,000 per capita
FDI for a population of 10 million). In fact, Fitch upgraded
the investment rating for the Czech Republic on August 26
from A minus to A. While there is no question about the
attractiveness of the Czech Republic to foreign investors
given its central location, highly skilled labor force,
relative low wages, and free access to the rest of the EU

market, the sustainability of FDI inflows, particularly given
increasing regional competition, is a key distraction.
Although neighboring countries like Slovakia are starting
from a lower base, the possibility of their more forward
leaning and more business-friendly policies drawing FDI away
from the Czech Republic is a constant preoccupation.
Investors cite weak creditor rights, excessive discretion of
bankruptcy judges, and cumbersome and lengthy legal
procedures as key continuing problems with the local
investment climate.


3. (U) Although official figures tend to underestimate US
investments because a significant portion of US FDI comes
through third countries, particularly through the
Netherlands, US FDI in the Czech Republic is listed at 5.3
percent of total 2004 FDI, behind he Netherlands at 30.3
percent and Germany at 20.4 percent. While there is no
American flagship investor in the Czech Republic currently,
the biggest names include Conoco/Dupont (USD 695 million),
Philip Morris (USD 440 million),Pepsi-Cola (USD 305 million)
and Coca-Cola (USD 210 million).


4. (SBU) CORRUPTION: A September 6 public opinion poll
identified corruption as the number one problem in the Czech
Republic. Transparency International Czech Republic (TI)
reports that non-transparent public contracts caused a loss
of CZK 32 billion (about USD 1.5 billion) in 2004. TI
attributes this to the lack of efficient controls in the
government procurement process and excessive influence by
politicians in public contract awarding procedures. In June
2004, TI published the results of its two-part Visegrad-4
Corruption Index (V4 Index) covering five areas of public
administration: public procurement tenders, internal audit
and control mechanisms, codes of ethical behavior, conflicts
of interest, and public accessibility to information
(www.transparency.cz ). Part one looked at existing
anti-corruption tools while part two surveyed the perceptions
of anti-corruption tools, efficiency, as seen by the public.
Under part one, the Czech Republic came in third, with
Hungary and Poland faring better and only Slovakia faring
worse. Under part two, however, the Czech Republic came in
last place with particularly bad results in the area of
conflicts of interest. This study confirms widely held
perceptions of endemic corruption, particularly in the form
of conflict of interest with so many public officials
simultaneously holding paid positions with commercial firms
that bid on government contracts.
--------------
Structural Reforms
--------------

5. (U) The GOCR,s main vulnerability regarding the
Maastricht Convergence Program is its fiscal deficit (5
percent of GDP in 2004),largely arising from structural
issues outlined below, most of which relate to an anticipated
demographic shock resulting from a combination of a
fast-aging population and low fertility rates. Further
complicating the fiscal deficit pressures is that
approximately 85 percent of the federal budget is
non-discretionary. On September 5, the Prime Minister
Paroubek and Finance Minister Sobotka announced that the
Czech Republic is aiming to adopt the euro in 2010, a year
later than previously planned. The main challenge remains
reducing the structural fiscal deficit in a sustainable
manner, below 3 percent of GDP by 2008. Post will report on
the 2006 budget by septel.


6. (U) TAX REFORM: Tax reform, currently under discussion
in Parliament, is the most likely structural reform to be
implemented in the run-up to the June 2006 elections. In
response to regional tax competition (e.g. Slovakia,s flat
tax rate of 19 percent),the GOCR started to phase in
reductions in corporate income taxes and is planning to
introduce permanent personal income tax cuts for low- and
middle-income taxpayers in 2006. The ruling Social Democrat
party (CSSD) has proposed a more progressive tax regime by
lowering the tax rate for the bottom two income brackets.
While the opposition Civic Democrat party (ODS) will accept
the CSSD plan for political reasons, the ODS prefers lower
tax rates across income brackets and in fact, the flat tax is
the flagship of the ODS. One source close to President
Klaus, camp of the ODS says that if the ODS wins in 2006, a
flat tax regime would be a foregone conclusion. The ODS
proposes a flat tax of 15 percent for both corporate income
tax and VAT (the minimum per EU regulation),as well as no
new tax incentives, arguing that the current average VAT paid
by Czech consumers is currently around 14.6 percent
(pensioners pay around 13 percent given great dependence on
goods vice services). The current tax regime is as follows:
corporate income tax of 26 percent for the tax period ending
in 2005 and 24 percent in 2006 and thereafter; progressive
personal income tax with rates from 15 to 32 percent; 5 or 19
percent VAT.


7. (U) PENSION REFORM: The Czech Republic has the second
lowest fertility rate in the world and about one quarter of
the current population is pensioners. By 2050, the elderly
will account for 53 percent of the population, and the
working-age population will shrink by 22 percent compared
with 2005. Therefore, pension reform is one of the most
pressing and politically charged debates. Next year,s
budget proposal earmarks over USD 10 billion for pensions --
almost 30 percent of all spending. The IMF staff project
budgetary spending on pensions and health care will increase
from 14 percent of GDP in 2005 to 22 percent of GDP by 2050.
There are two parts to the existing pension system: the
mandatory basic pension insurance scheme, which is a
pay-as-you-go system, and a voluntary supplementary,
capital-funded, state-subsidized supplementary pension scheme
based on defined contributions.


8. (U) In June, the GOCR submitted to the EU its NationalStrategy Report on
Adequate and Sustainable Pensions, which
concluded that the current pension system will be viable for
about the next 20 years but not beyond unless further reforms
are implemented. During a July meeting with mainstream
political leaders, PM Paroubek said parties should reach a
reform consensus by the end of October. On August 31,
political parties made partial progress in parliament by
agreeing to the establishment of a reserve fund and
increasing the age of retirement tied to rising life
expectancy. Political leaders must agree on what percentage
of the GDP should go to the pension system; the current
figure is about 8 percent of GDP. The ruling Social
Democrat party (CSSD) proposes to introduce personal
accounts, which would enable people to contribute to personal
investment funds during their productive years so they can
control their retirement payouts. The opposition Civic
Democrat party (ODS) wants to introduce a flat-rate pension
and lower the mandatory contribution amount for workers so
that all people receive the same lower pensions.


9. (U) HEALTH REFORM (Reftel A): The Czech Republic,s
share of public spending on healthcare is among the highest
in the OECD. The crux of the problem is poor incentives for
cost control by providers and virtually free services for
users. According to the World Bank, in 1999 the Czech
Republic health spending was USD 950 per capita, compared to
USD 756 per capita in Hungary and USD 522 per capita in
Poland. Despite its importance and fiscal implications,
there is a clear lack of consensus on the healthcare debate.
The payroll tax currently consists of 12.5 percent paid by
employees (4.5 percent for healthcare and 8 percent for
social security) and 35 percent paid by the employer (9
percent for healthcare and 26 percent for social security).
According to the January 2005 Ministry of Health,s Proposed
Healthcare Policy for 2005-2009, one of the key problems of
the healthcare system is overdue payables for the General
Health Insurance Company (VZP),which as of June 2004
amounted to USD 290 million. In July, Health Minister
Emmerova approved reforms measures, including USD 126 million
for VZP and USD 34 million to the other eight
semi-privately-run health insurance companies. These
measures distinctly lack any patient co-payments measures and
insufficiently address the long-term implications of an aging
population receiving free healthcare.


10. (U) LABOR REFORM (Reftel B): The cost of the current
level of unemployment (8 - 9 percent),in the form of
benefits paid and taxes foregone, equals the size of the
current budget deficit (about USD 4.2 billion). According
to the IMF, a virtually flat employment trend (2004
unemployment rate of 8.3 percent) despite solid GDP growth in
recent years is indicative of labor market rigidity. Any
future reforms must address tightening of benefit
entitlements, encourage retraining, and increase geographical
mobility of workers. The average monthly wage in the Czech
Republic is around USD 735. The current system of
unemployment benefits pays USD 175 per month per person,
which starting in 2006 will reach USD 183 per month, and
lacks any incentives for finding work. Czech workers take
more sick days than most other EU member states at 18.4 days
per worker per year. The Ministry of Labor has drafted a new
Labor Code, which on August 28 PM Paroubek cited it as a
priority before the 2006 elections. However, the bill faces
strong opposition from the business community, including from
the American Chamber of Commerce, who views the code as a
step backward because it does not make the labor market more
flexible and better trained. Local businesses often complain
about the lack of skilled workers, especially in the
mid-level technical fields. The opposition Civic Democrat
party (ODS) is considering a "negative income tax" on
unemployment benefits, which would apply a shrinking
percentage of benefits that still keeps nominal benefit
levels increasing as you find work.

--------------
EU integration
--------------

11. (U) EU REGULATIONS: Since joining the EU in May 2004,
much of GOCR resources have been dedicated to EU integration
requirements. In August, the European Commission said the
Czech Republic came in 5th out of 25 EU member states in
terms of failure in adopting EU regulations, with only Italy,
Luxembourg, Greece and Portugal faring worse. In addition,
the EC warned three major steelworks that they would be
forced to return GOCR subsidies if they fail to make progress
in restructuring within the next 18 months, which are the
terms negotiated during EU accession talks for that industry.
The EC also noted the GOCR,s, along with 15 other member
states, slow speed in adopting EU directives for financial
market regulation, including a failure to adopt directives
for complementary oversight of financial conglomerates,
reorganization and liquidation of loan institutions and
reorganization and liquidation of insurance companies. The
EC warned that if the GOCR and the other 15 states did not
provide within two moths a satisfactory answer to its
criticism and a viable plan for future adoption of missed
directives, it would bring the issue to the European Court of
Justice.


12. (U) EU FUNDS: On August 15, the local equivalent of the
Wall Street Journal (Hospodarske Noviny) reported that the
GOCR will not be able to spend all of its EU fund allocations
due to delays in some programs, excessive bureaucracy and
delayed payments by the EU. The Czech Republic was allocated
CZK 10.6 billion (USD 445 million) in EU structural funds,
which it must spend by end 2006. Absorptive capacity and EU
bureaucracy are both obstacles to full and efficient use of
EU funds.

--------------
COMMENT
--------------

13. (SBU) Critics of the ruling Social Democrat party,s
(CSSD) economic policies frequently tout that unless the GOCR
adopts better policies, its traditionally considered "lesser
brother" Slovakia will surpass the Czech Republic as the
darling of Central Europe. While some politicians overuse
this argumentation, there is some truth to this claim in the
medium to longer-term as foreign investors look more and more
eastward for emerging opportunities. While the Czech
Republic has enjoyed a head start and suffered fewer economic
fools in its recent political history, there is no denying
that Slovakia is running faster, perhaps using its lower
starting point and opportunities accompanying EU accession as
motivation. As a recent local editorial noted, if the CR
wants to remain high on the investment map, especially as
investors look further east where labor is even cheaper, it
will have to deal with the bureaucracy, corruption and high
taxes that could eventually outweigh the low labor costs. It
won,t be enough for the CR to run in place.
CABANISS