CZECH REPUBLIC: ECONOMIC OPTIMISM PREVAILS DESPITE

C O N F I D E N T I A L PRAGUE 001239

SIPDIS

SIPDIS

STATE FOR EUR/NCE, EUR/ERA, EB/IFD/OMA, E STAFF DAN MORRISON
TREASURY FOR OASIA ANNE ALIKONIS
STATE PLEASE PASS USTR LISA ERRION
COMMERCE FOR ITA/MAC/EUR MIKE ROGERS
NSC FOR DAMON WILSON AND TRACY MCKIBBEN

E.O. 12958: DECL: 10/05/2016
TAGS: ECON EFIN ETRD ENRG PGOV EZ
SUBJECT: CZECH REPUBLIC: ECONOMIC OPTIMISM PREVAILS DESPITE
POLITICAL UNCERTAINTIES

REF: PRAGUE 1173

Classified By: Pol-Econ Counselor Michael Dodman
for reasons 1.4 b+d


1. (SBU) SUMMARY: Recent articles in the international press
about reform fatigue and political instability in Central
Europe have received much attention locally. There is strong
consensus among local economists and financial institutions
that the Czech Republic's economic situation differs
significantly from that in Hungary. The continued
appreciation of the Czech Crown against major currencies, low
interest rates/bond yields, credibility of Czech monetary
policy, and low debt/GDP ratio are key indicators. Czech
macroeconomic fundamentals remain sound with no signs of
trouble in the short to even medium term, despite the
political uncertainties. Fiscal policy remains the greatest
vulnerability (reftel) for the medium term outlook, with
increasing concerns about the lack of transparency in the
Czech budget process. With still no viable government in
place four months after the June 2006 general elections, and
the 2007 draft budget that violates the Maastricht
convergence criteria for the first time awaiting
Parliamentary approval, financial markets are keeping an eye
on a possible change in the outlook by international credit
rating agencies. END SUMMARY


2. (U) STRONG MACROECONOMIC FUNDAMENTALS: What differentiates
the Czech economy from others in the region is its sound
macroeconomic fundamentals, and not just in relative terms.
According to private sector analysts, Czech economic growth
remains robust with GDP growth of 6.1% in 2005, 6.1%
forecasted for 2006, and 5% forecasted for 2007. Inflation
(CPI) is expected to increase slightly from 3% in 2006 to 3.1
- 3.5% in 2007, mostly due to a rise in administered prices
(utilities). While the 2007 inflation forecast remains
within the Czech National Bank's (CNB) target band of 3% plus
or minus 1%, given that it is towards its upper limit, the
CNB raised interest rates by a quarter percent to 2.5% (still
the lowest in the EU) on September 27 and is expected to
raise another quarter percent in October.


3. (U) For the external sector, the trade balance remains
positive while the current account deficit has slightly
deteriorated from 2% of GDP in 2005 to 3.5% of GDP in 2006.
Exports and export-oriented foreign direct investment inflows
continue as leading factors of Czech GDP growth, but domestic
consumption is taking an increasingly bigger piece of the
pie. Czech exposure to foreign currency and "hot money"
remains low, as evidenced by the vast majority of consumer
loans and home mortgages denominated in local currency unlike
other countries in the region. External sovereign debt
remains around 36% of GDP, well below the Maastricht
convergence criteria of 60% of GDP.


4. (U) TROUBLE AT THE FINANCE MINISTRY: On September 29,
Finance Minister Vlastimil Tlusty fired long-time First
Deputy Finance Minister Janota, based on Janota's public
objections to Tlusty's newspaper advertisements about the
size of the public debt. In a two-page ad entitled
"Information for Citizens of the Czech Republic on the State
of Public Finances," Tlusty included a chart showing
government debt from 1993 to 2009 ballooning significantly
and blaming former Prime Minister Jiri Paroubek for the state
of public finances. Janota's name appears below the chart in
bold as the source of information, an obvious attempt at
giving credibility to the information since Janota is a
highly regarded official who has served nine Finance
Ministers over a 14 year career at the Finance Ministry in
charge of constructing the budget. Janota went on TV
objecting to being named as the source and called Tlusty a
"liar" and the ads irresponsible for risking alarm by Czech
government bond holders. As Janota and financial analysts
point out, Tlusty included contingent liabilities from
pending law suits in his government debt figures in the ad
that are not normally included in the calculation of external
debt.


5. (SBU) LACK OF TRANSPARENCY: Economists agree that the
growing lack of transparency in public finance is the most
troubling aspect of current political fumblings. While that
lack of transparency thus far has not translated into

macroeconomic consequences, economists warn that it could in
a course of a "few years." David Marek of Patria Finance
noted that the budgetary process was pretty transparency for
the 2002 and 2003 budgets, but started to deteriorate, with
the 2007 budget by far the worst in terms of transparency.
Econoff's own experience in reporting on the 2007 budget
(reftel) revealed significant deterioration in the quality
of publicly available figures from 2005 to 2006, with a
significant gap between the figures quoted to the public
(deficit figures below 4% of GDP) versus the figures supplied
by Mr. Janota in a private meeting (deficit figures in the
4.2 - 5% range).


6. (C) CENTRAL BANK NERVOUSNESS AND DISMAL REFORM PROSPECTS:
One of the CNB board members told econoff October 2 that he
remains optimistic about the economy except for the political
uncertainty. He stressed, however, that even if the
political and public finance uncertainties continue, it would
take significant and prolonged deterioration before it has
impact on the macroeconomic framework. So while he is not
worried about the short to medium term macroeconomic outlook,
he is worried about the long term implications of the
political situation delaying key structural reforms in the
labor market, improving government efficiency and
transparency, and in education. In the medium term, he
admitted that CNB board members were "pretty nervous" about
the monetary policy framework because they were now less
certain about their expectation of continued nominal
appreciation of the Czech Crown.


7. (C) CREDIT RATING AGENCY CONCERNS ARE LONGER TERM: The
Czech Republic currently has the following sovereign ratings:
Moody's A1 with a positive outlook, S&P A2 with a positive
outlook, Fitch A2 with a stable outlook. Econoff and poloff
met with S&P analysts October 2 during their annual
surveillance visit to discuss current political developments
and implications for reform prospects. S&P believes the
Czech business environment, growth, and external debt
position all look strong, and that any problems for the Czech
Republic are long-term issues such as pending pension and
healthcare reforms. They warned that significant
deterioration in the fiscal position may result in a change
in the outlook from positive to neutral, and clarified that a
"significant" fiscal deterioration would be a deficit in the
4.5 - 5% of GDP range and that their rating outlook was in
the six-month to two-year range. When asked how much current
political developments would bear on its rating review, they
replied that it all depended on how it affects Czech reform
prospects. S&P warned that Czech competitiveness was a key
consideration in the longer term, pointing out that while
Czech labor flexibility is still in relatively good shape,
its weakness in education and R&D spending may bear
consequence in the future.


8. (C) COMMENT: The Czech economy is doing just fine, despite
the political uncertainty. Economists generally agree that
ODS Finance Minister Tlusty "gets it" in terms of fiscal
responsibility, but has to contend with the populist elements
of his own party. While it is disappointing that the
pro-business ODS seems to be focusing more on how to finance
the significant increase in expenditures (through further
privatization of the crown jewel electricity company CEZ)
rather than cutting them, given the political environment, it
is also not surprising. With municipal and Senate elections
due at the end of October, and the prospect of early
elections in Spring 2007, the lack of fiscal discipline in
the Czech Republic is not/not a matter of a lack of know-how
but a lack of political incentive. While it is no comfort
that no one seems to know how the current situation --
political and fiscal -- will be resolved, at least on the
fiscal side, analysts remain optimistic.
GRABER