CZECH ECONOMY: A "CENTRAL EUROPEAN TIGER" ROARS

UNCLAS SECTION 01 OF 02 PRAGUE 000313

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

E.O. 12958: N/A
TAGS: ECON EFIN ELAB ETRD EZ PGOV
SUBJECT: CZECH ECONOMY: A "CENTRAL EUROPEAN TIGER" ROARS

REF: A. PRAGUE 119

B. 05 PRAGUE 1686

C. 05 PRAGUE 1325


1. Glowing 2005 Czech economic statistics led newspapers to
trumpet the Czech Republic as one of Europe's "Economic
Tigers". And in the run-up to the June 2-3 general elections,
every politician is taking full credit. GOCR figures put
2005 GDP growth at 6 percent, inflation stable at 2 percent,
doubling of foreign direct investment (FDI) at USD 11
billion, and the first foreign trade surplus in Czech history
(ref A). 2006 started off with the GOCR announcement that
industrial output grew by 15.1 in January 2006. The record
economic performance in 2005 is attributed to exports
(automotives),FDI (export-oriented manufacturing
multinationals),and domestic consumption (real estate and
consumer credit boom). The only less-than stellar figure is
the unemployment rate, which has been sticky at around 9
percent, although that rate is still significantly lower than
all of its neighbors except Austria.


2. The highly-manufacturing-and-exports-dependent Czech
economy remains vulnerable to business cycle swings, although
a major downturn is not expected any time soon. Fiscal
adjustment remains a key vulnerability as the GOCR gears up
to adopt the Euro as early as 2010. 2006 economic prospects
remain quite strong with GDP growth expected in the 5 to 6
percent range, although it is not likely to top the record
performance of 2005. Although the Czech National Bank (CNB)
has a more conservative estimate of 2005 GDP growth (4.3
percent),it is still above the Bank's 4 percent forecast.
Along with neighboring Slovakia, the Czech Republic's 2005
GDP growth ties it for fourth after the surging Baltics among
EU member states. According to Eurostat's preliminary
estimate, the Czech Republic in 2005 reached 74 percent of
the average EU GDP/capita. The Czech national economic
strategy remains to reach the EU average by year 2013.

-------------- --------------
Domestic Consumption as Important as Exports and FDI
-------------- --------------


3. Econoff met with local economists to review the rosy GOCR
economic statistics and challenged them to account for the
strong Czech economic performance and step out of their usual
role of focusing only on the weaknesses and vulnerabilities
the economy. According to Pavel Kohout of PPF, the 6 percent
GDP growth figure is significantly overstated due to the
Czech statistical office's (CZSO) methodological biases. The
CZSO applies its own deflator for each component of GDP,
which tends to understate the impact of world energy prices
on GDP when energy prices increase and in reverse, overstates
the impact when energy prices fall. Once this methodology is
accounted for, Kohout calculates the GDP growth for 2005 was
around 4.3 percent. Still, 4.3 percent growth is no laughing
matter, and Kohout believes domestic consumption boosted by
the local real estate boom and consumer credit boom is
contributing equally significantly to GDP growth as are the
more commonly credited export and FDI sectors. Banking
credits to households (mostly mortgages) grew by USD 4.2
billion from 2004 to 2005, and as in the United States, this
phenomenon can be explained by record low mortgage interest
rates (currently 3.7 - 4.5 percent for 10 or 20 year loans),
as well as baby boomers of the early 1970s who are starting
to enter the consumer credit market. Czech males between 30
and 35 years of age have the lowest unemployment rate in the
economy at 3 - 4 percent. Kohout calculates domestic
consumption accounted for up to 2.5 percent of GDP growth in

2005. For 2006, Kohout predicts GDP growth in excess of 4
percent, assuming there are no drastic changes in world
energy prices.

-------------- --------------
Manufacturing Dependence Means Business Cycle Dependence
-------------- --------------


4. Patria Finance's David Marek acknowledged that critics do
not have much room in the face of such robust figures for

2005. He did, however, flag the "strange" structure of the
economy that makes such robust growth unsustainable and
highly vulnerable to the business cycle. Specifically, Marek
noted the strong ratio of manufacturing, predominantly the
automotive industry, in the economy. The manufacturing
sector and related industries (plastics, rubber, steel)
account for about 25 percent of industrial output and up to
35 percent of GDP (using the Herfindahl Index). According to

PRAGUE 00000313 002 OF 002


Marek, this is the most concentrated figure among the EU-25
economies. Marek noted that the pending mega-FDI project by
Korean car manufacturer Hyundai would shift this
concentration even higher and make the Czech Republic that
much more vulnerable to the business cycle given the highly
cyclical nature of consumer demand for automobiles. (Note:
Hyundai and the Czech Republic have already signed a
memorandum of understanding for this one billion Euro plant,
which is expected to begin production in 2008.) Unlike
Kohout, Marek attributes 2005 GDP growth mostly to foreign
trade. And because the German economy, the Czech Republic's
largest trading partner, is likely to improve in 2006,
prospects for Czech GDP growth in 2006 are bright. Marek
described Czech domestic demand as "sluggish" with a 3
percent growth in 2005. He attributed the relative
sluggishness to the slow rise in disposable income resulting
from multinational companies, the largest employers in the
Czech economy, maintaining labor contracts that prevent a
rapid increase in wages to maintain competitiveness. Marek
also explained that while there is a strong labor movement in
the Czech Republic, labor unions are a force largely in the
traditional and increasingly uncompetitive industries, such
as textiles, and are relatively unimportant in car
manufacturing and other growth sectors.
CABANISS