CZECH REPUBLIC: INFORMATION REQUEST IN ADVANCE OF

C O N F I D E N T I A L SECTION 01 OF 06 PRAGUE 000120 SIPDIS STATE FOR EUR/CE AND EEB/OMA AWHITTINGTON TREASURY FOR IMB BMURDEN, WMONROE AND MBEASLEY E.O. 12958: DECL: 03/04/2019 TAGS: ECON EFIN PGOV EUN EZ SUBJECT: CZECH REPUBLIC: INFORMATION REQUEST IN ADVANCE OF G-20 MEETINGS REF: A. SECSTATE 17502 ¶B. PRAGUE 109 ¶C. PRAGUE 79 ¶D. PRAGUE 65 ¶E. PRAGUE 59 ¶F. 08 PRAGUE 683 ¶G. FEB 25 PRAGUE DAILY ¶H. FEB 23 PRAGUE DAILY ¶I. FEB 17 PRAGUE DAILY ¶J. FEB 13 PRAGUE DAILY ¶K. FEB 12 PRAGUE DAILY ¶L. FEB 11 PRAGUE DAILY ¶M. FEB 10 PRAGUE DAILY ¶N. FEB 09 PRAGUE DAILY ¶O. FEB 06 PRAGUE DAILY ¶P. FEB 02 PRAGUE DAILY AND PREVIOUS Classified By: DEPUTY POLITICAL/ECONOMIC COUNSELOR MARTINA STRONG. REASONS 1.4 B AND D. ¶1. (SBU) Summary: The Czech Government (GoCR) views the EU response to the financial crisis as an important test of its EU presidency. Within EU fora, the GoCR has consistently warned against protectionism and beggar-thy-neighbor policies, as well as revolutionary changes to regulation and oversight, while stressing the importance of sustainable public finance. The Czechs are willing to sacrifice these preferences, however, in the pursuit of a common EU approach to the crisis. In the G-20 context, Czech officials have stressed that their overriding goal is to represent a united EU position and to ensure that the London summit is able to agree on common guidelines that meet market expectations. ¶2. (SBU) The GoCR has not had to provide direct assistance to the inward-looking Czech financial sector, which remains profitable. Both public and household debt is relatively small, and households have not borrowed in foreign currency. The Czech current account deficit is modest and sustainable. All major banks, however, are owned by European banking groups, many of which have significant exposure to some of the more troubled economies in the region. While the banking sector remains relatively healthy, the small, open export-oriented real economy is suffering from a significant drop in external demand. The GoCR is very concerned about the potential consequences to the Czech economy should international investors put it in the same category as Hungary or Latvia. Consequently, the GOCR has opposed any regional internal EU programs, insisting that each country be judged on its own merits and on a case-by-case basis. End Summary. �A; Summary of Key Issues: ¶3. (U) The comments below are keyed to the questions in paragraph 5 of Ref A. ¶4. (SBU) Stimulus: On February 15, the GoCR announced an economic recovery package totaling approximately 2 percent of GDP. The program is designed to limit unemployment and support exports by cutting employer contributions to social security programs, accelerating depreciation on business equipment (including cars),refunding VAT paid by businesses on vehicles, deferring the tax payments of businesses with less than five employees and increasing the capital of two state-owned banks that specialize in SME loans and export guarantees. The government has resisted opposition calls for a car scrap subsidy and increasing pensions, arguing that stimulating local demand will do little to help the heavily export-oriented Czech economy. The GoCR plans to fund its PRAGUE 00000120 002 OF 006 program through increased public debt and the use of funds left over from previous state budgets. Current Czech public debt is under 30 percent of GDP. The 2008 Czech budget deficit was 1.2 percent of GDP. The budget deficit in 2009 is expected to reach 4 to 5 percent of GDP. ¶5. (SBU) Financial Sector: The Czech Republic had its own financial crisis in the late 1990s that led to government intervention to remove impaired assets and to consolidate and privatize the banking sector. The banks that emerged are very conservative and concentrate almost exclusively on the domestic market. Czech banks also are not highly leveraged and finance loans primarily through deposits (the average loan to deposit ratio is 77 percent). Consequently, Czech banks had only minimal exposure to mortgage backed securities, Icelandic banks, Lehman Brother or CDOs and have, at least so far, remained profitable. European banking groups currently own all major Czech banks. According to the Czech National Bank (CNB),Czech banks are net creditors rather than net debtors within their banking groups. The CNB closely monitors the relationship between the Czech subsidiaries and foreign parents to ensure that significant amounts of capital or liquidity are not leaving the Czech banking sector. While the GoCR supports increased coordination among national regulators, it opposes the creation of pan-European regulators. ¶6. (SBU) Real Economy: Manufacturing and especially the car industry are the heart of the small, export-oriented Czech economy, which is suffering from a significant drop in external demand for Czech goods. Exports, industrial output and new orders all experienced double digit drops in late 2008, and the economy is expected to contract by as much as 2 percent in 2009. The government is planning to refund VAT payments to businesses buying new vehicles and to accelerate depreciation on business vehicles. Since almost 90 percent of cars manufactured in the Czech Republic are exported abroad, the government has rejected calls for a car scrap subsidy or a broader stimulus program. The government is very conscious of EU internal market rules and its WTO commitments and has been a consistent advocate of the need to avoid protectionism and beggar-thy-neighbor policies. ¶7. (SBU) Social/Labor Impact: The Government is trying to support employment by reducing business contributions of employees to social security and by helping businesses through accelerated depreciation, tax deferrals and VAT refunds on cars. The GoCR has also began a program that will pay up to 2,000 newly unemployed foreign workers to return to their home countries, increase controls on illegal foreign workers, and make it harder to bring non-EU foreign labor to the Czech Republic. While there has been some criticism of the government for doing too little too late, as well as some scattered protests among unemployed workers, the level of public protest has remained modest. The GoCR has not increased benefits to the unemployed. ¶8. (SBU) Dimension of the Crisis: Czechs, by and large, seem optimistic that the economic slow down should peak this year, with the economy beginning to recover in late 2009. They understand, however, that they are linked to their main export markets, especially Germany, and fear that the German recession could be deeper and more protracted than expected. Czech banks concentrate primarily on the domestic market and do not have extensive exposure to other countries, although their parent banks are very exposed to some of the more troubled economies in Central and Eastern Europe. The foreign borrowing of Czech households is a negligible 0.1 percent of total household borrowing. Corporate borrowing in PRAGUE 00000120 003 OF 006 foreign currency is less than 20 percent. The GoCR has contributed to EU programs to help Latvia. Fearing the consequences of being seen by international investors as in the same boat as some of the more troubled economies in the region, the Czech Republic has resisted any regional approach within the EU to the crisis, insisting instead that each country should be regarded individually and on a case by case basis. ¶9. (SBU) Role of the G-20: Finance Ministry Officials have told us that the GoCR does not have its own purely national objectives for the G-20 summit in London. Rather, as the EU presidency country, the Czechs want to accurately represent all 27 EU countries in the meeting. To this end, the Czech goal is to forge a common EU position before the G-20 meeting. The Czechs also believe that it is critical that the G-20 summit be regarded as a success as the markets will be watching closely. To this end, the Czechs believe that it is critical that the G-20 agree on a common set of guidelines. Objectives of the London G-20 Summit: ¶10. (SBU) The GoCR has consistently warned against protectionism, beggar-thy-neighbor policies and excessive public spending. Finance Minister Kalousek has also suggested that he favors evolutionary rather than revolutionary changes to financial regulation and oversight. He has cautioned that governments should take the time to get regulation right, rather than rush to pass new laws that could have unintended consequences. While supporting increased coordination of recovery programs and national regulators, the GoCR opposes the creation of any pan-European or global regulators. In general, the GoCR believes that it is important to follow EU rules in good times, but even more so in times of crisis. Finance Ministry officials have suggested, however, that the EU growth and stability pact may need to be revised to make it less pro-cyclical. The GoCR also views strengthening the EU internal market and removing remaining barriers to labor mobility and trade in services as one of the best ways of dealing with the economic crisis. ¶11. (SBU) The Czechs, however, view the EU's response to the financial crisis as an important test of their EU presidency and they take the Presidency's role of a neutral coordinator seriously. Thus, it is very important to them that the EU has a united position at the London summit, and that it is PM Topolanek representing the EU as a whole. They also believe that it is imperative that the G-20 demonstrate a united front and present a common set of guidelines on responding to the financial and economic crisis. Thus, they are willing to subsume their national preferences to this goal. Thus, in the G-20 context, they are likely to push only those issues identified as important to the EU, such as a common approach to impaired assets and eliminating tax havens. ¶12. (SBU) The GoCR is very concerned about the consequences of international investors tarring them with the same brush as other more troubled economies in the region. As a consequence, they opposed the Hungarian proposal for a special EU fund for EU CEE economies, insisting instead that the EU treat each country on its own merits, rather than by its geographic location. Impacts of the Global Financial Crisis ¶13. (SBU) According to Finance Minister Kalousek, the Czech Republic is ONE of only three OECD countries not to have had to recapitalize any of its banks. The Czech Republic had its PRAGUE 00000120 004 OF 006 own financial crisis in the late 1990s that led to government intervention to remove impaired assets and to consolidate and privatize the banking sector. Consequently, the banks that emerged are very conservative and concentrate almost exclusively on the domestic market. Czech banks are also not highly leveraged and finance loans primarily through deposits. According to the Czech National Bank, the average loan to deposit ratio is only 77 percent. ¶14. (SBU) Czech banks had only minimal exposure to more sophisticated investment vehicles such as mortgage-backed securities or CDOs. While Czech banks have written off some exposure to Lehman Brothers, Icelandic Banks, and CDOs, all major Czech banks reported profits for 2008. Banks may have more difficulties in 2009, however, as the real economy continues to contract. ¶15. (SBU) All major Czech banks are owned by European banking groups (including Erste, KBC, Societe Generale, etc). According to the CNB, in most cases, the Czech banks are net creditors rather than net debtors within their banking groups. The CNB closely monitors the relationship between the Czech subsidiaries and foreign parents to ensure that the parent banks are not sucking capital or liquidity out of the Czech banking sector. Czech authorities, believe the risk of the spread of contagion through the parent companies, is not great and that the subsidiaries could even survive the collapse of their parent. ¶16. (SBU) While major companies continue to have access to capital, SMEs and certain sectors (e.g., property developers) are reporting more difficulties in obtaining loans, as the banks have tightened their lending criteria and increased risk premiums. Over the past several years, interest rates in the Czech Republic have generally been below Euro interest rates, and up until mid-Summer, the Czech crown was on a strong appreciation trend. Thus, unlike some of their neighbors, Czech households have not borrowed heavily in foreign currency. According to the CNB, the foreign borrowing of Czech households is a negligible 0.1 percent of total household borrowing. ¶17. (SBU) In November 2008, the GoCR increased the Czech bank deposit guarantee to the equivalent of 50,000 Euro, up from the first 80 percent of the equivalent of 25,000 Euro. According to Finance Minister Kalousek, 97 percent of all household deposits are now covered. The CNB has also made it easier for banks to borrow directly from it and began acc_7n4