CZECH REPUBLIC: GLOBAL FINANCIAL CRISIS

UNCLAS SECTION 01 OF 04 PRAGUE 000683 SENSITIVE SIPDIS E.O. 12958: N/A TAGS: EFIN ECON PREL EZ SUBJECT: CZECH REPUBLIC: GLOBAL FINANCIAL CRISIS CONTRIBUTING TO SLOWDOWN OF ECONOMIC GROWTH REF: PRAGUE 501 (U) This cable is Sensitive but Unclassified. Please protect accordingly. ¶1. (SBU) Summary: The Czech Republic has so far escaped the worst of the global financial crisis. The conservative Czech banks remain relatively healthy, with significant capital and liquidity, despite disruptions to the interbank lending and government bond markets. The global crisis is, however, contributing to a slowdown of Czech economic growth, mainly by depressing demand in Western Europe for Czech exports. Banks are also tightening lending rules making mortgages and loans harder to obtain. The small, underdeveloped stock market has fallen 45 percent in the past 30 days. Delays in privatizations of Prague Airport and Czech Airlines as well as declines in FDI are also possible (although not certain). Nevertheless, analysts still expect around four percent real GDP growth in 2008 and roughly two and half to three percent in 2009 (following three years of over six percent growth). ¶2. (SBU) Believing that panic poses the greatest threat, Czech authorities continue to reassure the public that although the recent period of "extraordinarily good times is over" there is nothing to fear. The GoCR has introduced a bill to increase the amount of deposits guaranteed by the state to cover 97 percent of all Czech deposits. One of the GoCR's biggest concerns, however, is that international investors will fail to distinguish the Czech economy from its less healthy neighbors and pull their money out of the region en masse. The USG should likewise distinguish the Czech economy from others in the region. End summary. Czech Banks Remain Relatively Healthy -------------- ¶3. (SBU) The Czech Republic experienced a significant financial crisis from 1997-2002 that cost around 20-30 percent of GDP to fix. The result was a consolidation of the banking market and fairly conservative banks. Because Czech banks concentrate almost exclusively on the domestic market, they have had little or no exposure to U.S. mortgage-backed securities or credit default swaps. (Note: While a few of the banks had some exposure to Icelandic banks and funds this exposure appears relatively small. A few local municipalities also had Icelandic investments. End note.) Local analysts and government officials continue to report that Czech Banks have significant liquidity and are well capitalized. ¶4. (SBU) According to Patria Finance's David Marek, deposits are the main source of funding for the banking system. The average bank's loan to deposit ratio is under 75 percent, providing it with significant liquidity and making it less dependent on the interbank lending market or other forms of funding. Banks mainly offer loans and are not generally involved with more sophisticated and opaque debt instruments. According to Czech National Bank Board member Eva Zamrazilova, the level of household indebtedness is also low, under 20 percent of GDP, of which 12 percent of GDP is from mortgages. Unlike elsewhere in the region, Czech households borrow almost exclusively in Czech crowns from Czech banks. Czech corporate debt is similarly low, while general government debt is only 28.1 percent of GDP. The level of non-performing loans is 2-3 percent of mortgages and 6-8 percent of consumer credits. Although the Czechs have a significant trade surplus (5.4 percent of GDP in the second quarter),they have a modest current account deficit (1.9 percent of GDP in 2007 and 2-2.5 percent of GDP forecast for 2008) thanks to the high level of dividends paid on FDI. On September 30, the CNB had roughly USD 37 billion in foreign reserves. Crisis Depressing Demand for Czech Exports -------------- ¶5. (SBU) The crisis's greatest impact to date has been to contribute to the current slowdown of Czech economic growth, mainly by depressing demand for Czech exports. The global financial crisis did not cause this slowdown, it was already occurring. The Czech business cycle peaked in 2007, tax changes that went into effect January 1 blunted a growing real estate boom and a strong crown hurt exports, investment and tourism (ref a). The global crisis, however, is contributing to the slowdown's severity. ¶6. (SBU) The Czech economy has one of the largest manufacturing sectors in the EU. Most Czech manufacturer goods are exported. In 2007, the export to GDP ratio was PRAGUE 00000683 002 OF 004 70.8 percent. In 2007, 85.3 percent of Czech exports went to other EU countries, 30.8 percent to Germany alone. As a result, the Czech economy is especially sensitive to any Western European economic downturn. Credit Drying Up -------------- ¶7. (SBU) Banks are also tightening their lending practices in an effort to maximize liquidity and protect against any future difficulties. As a result, loans and mortgages are reportedly becoming much more difficult to obtain. Some families and businesses who would have qualified for loans earlier this year are no longer eligible. During the first three quarters of 2008, mortgage lending has fallen 15.4 percent year on year. (Note: A significant part of this decline is attributable to a tax change that went into effect January 1, which increased the VAT on real estate from five to nine percent. Despite the drop, mortgage lending is still well above 2006 levels. End note.) While some non-bank financial companies have reportedly emerged to try to fill the void, the shortfall in available credit is likely to be another drag on future growth. Stock Exchange Down 60 Percent; Not Main Source of Capital -------------- -------------- ¶8. (SBU) The Prague Stock Exchange Index has fallen nearly 60 percent since June and 45 percent over the past 30 days. The index is now at it lowest level since the Czech Republic acceded to the EU in May 2004. The market has moved largely in parallel with world markets, not due to local fundamentals. Some stocks reportedly have a PE ratio as low as two to one. Stock mutual funds have experienced similar drops. ¶9. (SBU) Although significant, local analysts warn not to exaggerate the markets, importance. Czech companies have not traditionally used the market as a major source of capital, preferring bank loans instead. Few major companies are listed. Ordinary Czechs are generally not invested in the market, either directly or through mutual funds, although they do have some exposure through pension funds. According to the CNB's Zamrazilova, the stock market only accounts for around 10 percent of Czech's savings. (Note: On October 22, the Vienna Stock Market (Wiener Borse) purchased a majority stake in the market for an undisclosed sum. The sale had been planned for some time and reported suitors included NASDAQ. End note.) Money market funds have also experienced losses of around 2 percent on average. So far in October, Czechs have withdrawn a record net 10.2 billion CZK from money market funds, most of which has been deposited in local bank accounts. Global Credit Crunch May Restrict FDI, Complicate Privatizations -------------- -------------- ¶10. (SBU) Other potential consequences of the global financial crisis could include less foreign direct investment into the Czech Republic as the global credit crunch restricts access to and increases the cost of international financing. Some analysts have speculated that the crisis may decrease interest in the GoCR's planned privatization of the Prague airport and Czech Airlines, driving down the price or even prompting delays. Businesses Feeling the Pain -------------- ¶11. (SBU) Czech businesses, especially exporters are feeling the pain from the slowdown of the Czech economy. Many Czech businesses, especially related to the automobile, crystal, real estate development, and high-end tourism sectors have reported significant drops in orders. The automotive industry is the heart of the Czech economy and accounts for roughly 16 percent of Czech manufacturing. The Czech Republic's largest company, Skoda, temporarily stopped production for several days due to lower orders and, for the first time in its history, dropped the base price on all of its cars. Several automotive part suppliers have cut personnel. Last month, a major crystal glass manufacturer declared bankruptcy after over a century in business, although it was having problems long before the recent slowdown. ¶12. (SBU) Four and five star hotels in Prague are reporting occupancy rates down as much as 30 percent from last year. While there is no real estate index, real estate developers are already reporting drops in property prices between 10 and 20 percent. (Note: the drop in occupancy rates and property prices is also a result of an increase in supply. More new PRAGUE 00000683 003 OF 004 retail property became available in 2008 than in any year before. Several new luxury hotels opened this year. End note.) Retail spending was down in August for the first time in months. Again, this slowdown was not caused by the global crisis, although the crisis is contributing to its severity. 2009 Growth Still Expected at 2.5 to 3 Percent -------------- - ¶13. (SBU) Despite the challenging economic environment, analysts continue to expect the Czech economy to grow roughly 4 percent in 2008 and between 2.5-3 percent in 2009 (the government's estimates are slightly higher.) Inflation, which is currently an unusually high 6.6 percent (partly due to one time tax changes that went into effect January 1),is expected to fall to roughly 3 percent in 2009. Unemployment, which has been at historic lows of around 5 percent (around 2 percent in Prague),is gradually increasing and is expected to reach around 6.5 percent by the end of 2009. Over the past few years, many businesses had been reporting that the shortage of labor, both qualified and manual, was the single most significant barrier to further economic expansion in the Czech Republic. ¶14. (SBU) The Czech Crown (CZK),which floats freely, has depreciated slightly over the past month, falling from roughly 24 to the Euro on September 22 to 26.2 on October 21, only to rebound up to 24.7 on October 28. Against the dollar the Crown has fallen from 16.2 in mid September to 19.8 today. Exporters and analysts have welcomed the weakening of the crown as a needed correction. Earlier this year the Crown was the fastest appreciating currency in the world, reaching a peak in July of 23 CZK to the Euro and 14.4 to the USD, prior to a interest rate cut in August. The CNB did not participate in the coordinated rate cuts on October 8, but did hint that a cut was likely at the November 6 CNB meeting. Czech interest rates are among the lowest in Europe. The 2W repo rate and discount rate are 3.5 and 2.5 percent respectively. Panic Seen as Greatest Threat -------------- ¶15. (SBU) Both analysts and the government believe that panic is the greatest threat. They believe that the conservative Czech financial system and the inward-looking, conservative Czech population will muddle through, although as the Finance Minister put it, "the extremely good times are over" and the Czechs "will get rich more slowly." Should there be significant panic and bank runs, however, all bets are off. Thus the government has sought to reassure the public that it has nothing to fear. ¶16. (SBU) The GoCR has also submitted a bill to parliament that will increase the level of the guarantee of bank deposits to the equivalent of 50,000 Euro, which according to Finance Minister Kalousek will cover 97 percent of all Czech deposits. (Currently only the first 90 percent of deposits up to the equivalent of 25,000 Euro is guaranteed). Critics note, however, that while Czech individuals and companies have around 1.6 trillion CZK in deposits, the deposit insurance fund reportedly contains only 10 billion CZK -- not enough to cover all the deposits in even one of the larger banks. While there have been some isolated reports of Czechs transferring their money to countries offering 100 percent deposit guarantees, this does not appear to have been widespread. European Ownership of Banks: Possible Channel of Contagion -------------- -------------- ¶17. (SBU) The European ownership of 97.6 percent of Czech banking assets also creates a potential channel for contagion, although fire walls exist. All of the major banks are owned by European banking groups: CSOB by the Belgian KBC Group, Ceska Sporitelna by the Austrian Erste, Komercni Bank by the French Societe Generale, UniCredit Bank by the Italian UniCredit Group, GE Money Bank by GE, and Raiffeisenbank by the Austrian Raiffeisenbank. Citibank and ING also have branch banks which have a small but still significant part of the market. ¶18. (SBU) To insulate the subsidiaries from the parent companies, the Czech banks are limited, by law, in the amount of funds they can loan to their parent company at 20 percent of their capital (this does not apply to branch banks such as ING or Citibank upon which there are no restrictions). Ceska Sporitelna has already reportedly lent at least 12 percent of its capital to Erste. According to Patria Finance's Marek, the major Czech banks are sound enough financially that they could survive on paper even if their parent company were to PRAGUE 00000683 004 OF 004 collapse. Major problems at a parent bank, however, could cause panic and trigger a run on its Czech subsidiary. Banks Hoarding Cash; Disrupting Bank Lending and Government Bond Markets -------------- -------------- ¶19. (SBU) Although the banks remain relatively healthy, they are accumulating reserves of cash and other liquid assets to guard against any possible future problems. Several IT providers have told us that the banks have cut their IT budgets significantly and are looking for other ways to cut costs. As mentioned above, they have also tightened their lending practices, making loans much more difficult to obtain. This desire to ensure maximum liquidity has also caused significant disruptions in the interbank lending market as banks stopped lending to each other for periods of over 24 hours. The CNB has downplayed the significance of this, noting the banks rarely lent money to each other prior to the global crisis. Nevertheless the CNB has stepped in to fill the gap. Starting October 15, it began to permit banks to borrow from it for periods up to 14 days using government bonds or other rather illiquid assets as collateral. Prior to this, the CNB was regularly removing significant amounts of excess liquidity from the market. ¶20. (SBU) The Czech banks have also been trying to unload Czech government bonds viewing them as largely illiquid, causing a significant drop in the price of these bonds. The GoCR canceled two planned bond emissions in an effort not to further disrupt bond prices. The GoCR did go forward with a bond emission on October 22. Despite offering a higher interest rate, the GoCR was reportedly able to sell only a little over half of the planned amount. Finance Ministry officials claim that the GoCR can easily forego this income until early next year. The price drop, however, is limiting the growth of Czech pension funds, which as a rule have only minimal exposure to the Czech stock market and are heavily invested in Czech government bonds. According to Zamrazilova, many of the banks now believe they have increased their liquidity enough to deal with the new situation, and thus we may soon see improvements in the interbank lending and bond markets. Comment: -------------- ¶21. (SBU) There are a number of obstacles the Czechs will need to continue to avoid. International investors could panic and leave the region en masse, failing to distinguish between the Czech Republic and some of its more economically challenged neighbors. The difficulties of a European parent bank, could lead to a run on a Czech subsidiary. The banks, desire for maximum liquidity could cause a significant credit crunch, leading to an increase in bankruptcies. Should one of the major property developers collapse, the property market could be thrown in chaos. Nevertheless, the Czechs believe, with reason, that thanks to their economy's strong fundamentals and their conservative, inward looking banks and people, they are well-positioned to ride out the worst of the storm, although growth will continue to slow and harder times are ahead. More long term challenges include diversifying their economy away from an over-reliance on the automotive sector as well as the fiscal imperative for significant pension and health care reforms to cope with an aging population. ¶22. (SBU) Domestically, the global crisis has yet to have had much political resonance. We do not anticipate the global crisis to affect our relations with the GoCR, which will continue to remain a strong U.S. ally. We need to be careful to avoid any statements or actions concerning the Czech Republic that could lead to the panic the GoCR is so assiduously trying to avoid. To this end, the USG should avoid publicly lumping the Czech Republic together with the region's more vulnerable economies, and, if asked, should express cautious optimism that the Czech economy can weather the world's current financial difficulties. Graber