GLOBAL FINANCIAL CRISIS: CZECH DOMESTIC AND

UNCLAS SECTION 01 OF 05 PRAGUE 000059

SENSITIVE
SIPDIS

STATE FOR EEB/IFD/OMA, EEB/EPPD AND EUR/CE
STATE PLEASE PASS USTR

E.O. 12958: N/A
TAGS: EFIN ETRD ECON PGOV EZ
SUBJECT: GLOBAL FINANCIAL CRISIS: CZECH DOMESTIC AND
INTERNATIONAL RESPONSE

REF: A) 08 STATE 134459 B) 08 PRAGUE 683
C) PRAGUE DAILY JAN 26 D) PRAGUE DAILY JAN 20
E) PRAGUE DAILY JAN 9 F) PRAGUE DAILY JAN 6
G) PRAGUE DAILY JAN 5 H) 08 PRAGUE DAILY DEC 18
I) 08 PRAGUE DAILY DEC 12 J) 08 PRAGUE DAILY DEC 11
K) 08 PRAGUE DAILY DEC 9 L) 08 PRAGUE DAILY NOV 25
M) 08 PRAGUE DAILY NOV 18 N) 08 PRAGUE DAILY NOV 7

(U) This cable is sensitive but unclassified. Please
treat accordingly.


1. (SBU) Summary: Although the domestic banking system
has remained relatively healthy, the small, open, export-
oriented Czech economy is suffering from a significant
drop in external demand for Czech exports. According to
recently released figures, exports fell a record 18
percent, industrial production 17.4 percent and retail
sales 6.3 percent year on year in November, while
unemployment rose 0.7 percentage points to 6 percent in
December. The car industry, which together with its
suppliers accounts for as much as 20 percent of Czech
manufacturing, has been especially hard hit. Many
analysts now expect the Czech economy to stagnate in
2009, with possible negative growth in the first two
quarters. The European Commission and Finance Ministry,
however, continue to expect modest growth of 1.7 and 1.4
percent respectively.


2. (SBU) PM Topolanek created a ten person national
economic council on January 8 to advise the government on
an appropriate response to the economic slow down.
Analysts note that since the economyQs main challenge is
a drop in external demand, domestic remedies, such as a
fiscal stimulus, can only help at the margins. While
some modest measures are likely, including additional
interest rate cuts, more state export guarantees, and
cuts in employee contributions to social programs,
Finance Minister Kalousek opposes any measures that would
significantly increase the Czech RepublicQs modest budget
deficit. Kalousek also intends to bring his fiscal
discipline zeal to EU and G-20 discussions on responding
to the global financial crisis. The European Commission
is representing the Czech EU presidency in the G-20
working groups but the Czechs plans to participate
actively in the senior-level discussions. End Summary.

Czech Financial System Remains Relatively Healthy


3. (SBU) Despite the global financial crisis, Czech banks
have remained relatively healthy. The Czech Republic
experienced a significant financial crisis from 1997-2002
that cost around 20-30 percent of GDP to fix. The result
was the consolidation of the banking market, the removal
of non-performing debts from balance sheets and fairly
conservative banks and consumers. Czech banks are not
heavily leveraged, focused almost exclusively on the
domestic market, and have largely eschewed complicated
opaque investment vehicles in favor of domestic lending.
Lending is financed by deposits; the Czech banking
systemQs average loan to deposit ratio is less than 75
percent (Ref B).


4. (SBU) The Czech RepublicQs largest bank, CSOB, has
been hardest hit by the global crisis, but despite
writing off over 12 billion Czech crowns (approximately
USD 600 million) of collaterized debt obligations (CDOs)
and exposure to Icelandic banks, remained profitable in

2008. At the beginning of 2009, CSOB had a capital
adequacy of over 10 percent and a loan to deposit ratio
of 70 percent. The other major banks have fared
significantly better. The second largest bank, Ceska
Sporitelna, reported a return on equity of 22.5 percent
and an increase in net profits of 21 percent for the
first three quarters of 2008. The third largest,
Komercni Bank, reported an increase in net profits of 22
percent during the same period.


5. (SBU) The Czech Republic has not experienced a
financial crisis in 2008-09, maintains Unicredit Bank
Chief Analyst Pavel Sobisek. While a couple of banks had
temporary liquidity problems in 2008, the Czech National
Bank (CNB) reacted quickly to prevent any serious
problems from emerging. He conceded that the interbank
lending market is not functioning, as banks do not trust
one another, but argued that this has not been a problem,

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as banks can easily borrow what they need from the CNB.
According to Finance Minister Kalousek, the Czech
Republic is only one of three OECD countries that has not
had to inject capital into its banking sector.


6. (SBU) Unicredit Bank Chief Analyst Sobisek also
maintained that the Czech Republic is not experiencing a
credit crunch. Statistics, he argued, show that the
volume of bank loans has continued to increase, albeit at
a much slower rate than before. He did admit that many
banks have tightened their loan criteria and are
reluctant to lend to certain sectors such as to real
estate developers. Fewer companies, however, are also
seeking credit as they have decided to postpone new
investments until better times. Others, however, argue
that while credit is still available to large customers,
credit has become much more difficult and expensive for
small and medium enterprises to obtain. According to a
Chamber of Industry survey, two thirds of companies
reported that credit is now more scarce. Latest
estimates show a 20 percent decline in the volume of new
mortgages in 2008.

Real Economy Suffering from Drop in Demand for Exports


7. (SBU) While Czech banks remain relatively healthy, the
Czech real economy is suffering from a significant drop
in demand in Western Europe for Czech products. As an
open, export-oriented economy, the Czech Republic is
especially sensitive to economic slow-downs in its main
trading partners. The annual volume of Czech exports
exceeds 80 percent of the Czech RepublicQs GDP. Over 80
percent of Czech exports go to other EU member states.
Over 30 percent of total exports go to Germany alone.
According to Ceska Sporitelna Bank analysts, for every
percentage point drop in German GDP growth, Czech GDP
growth drops by roughly 0.4 percentage points.


8. (SBU) The Czech Statistical Office recently released
figures for November showing a record year on year drop
in exports (18 percent),industrial production (17.4
percent) and the value of new industrial orders (30.2
percent). Retail sales also fell 6.3 percent.
Unemployment increased 0.7 percentage points to 6 percent
in December (although is still well below the December
2006 level of 7.7 percent). While these numbers were
partly inflated due to fewer working days this November
than last, the drop was much more severe than anyone
expected, causing many analysts to further revise their
growth forecasts for the fourth quarter of 2008 and for
all of 2009 downward. While the European Commission and
Finance Ministry continue to forecast modest growth in
2009 of 1.6 and 1.4 percent, respectively, many private
analysts now expect the Czech economy to stagnate, with
possible negative growth in the first two quarters.


9. (SBU) The Czech economy has been helped by the fact
that it entered into late 2008 in strong shape. Real
economic growth had exceeded 6 percent annually from
2005-2007 and remained above 4.2 percent year on year for
each of the first three quarters of 2008. Unemployment
hit record lows in July of 5.2 percent (4.3 percent using
EU counting methods),leading many businesses to view a
shortage of labor as the largest constraint to continued
strong economic growth. To fill the gap, Czechs imported
thousands of laborers from abroad, including from
Ukraine, Vietnam and Mongolia. The Czech national debt
is roughly 30 percent of GDP and private indebtedness is
also relatively low.


10. (SBU) Nevertheless, a few industries have been
especially hard hit. Several large historic firms in the
Czech crystal and ceramic industry, which had been
struggling for some time, have now closed or filed for
bankruptcy, sending several thousand people out of work.
Four and five star hotels in Prague are reporting
occupancy rates down 30 percent on 2007 levels since
summer 2008. The car industry, which had until recently
been flourishing, grew only 1 percent for the year after
expanding by as much 9.5 percent during the first three
quarters. The Czech Republic is the second largest
producer of cars per capita in the world and the car
industry accounts for as much as 20 percent of
manufacturing. All major vehicle manufacturers have cut
production by as much 25 percent, laid off most non-

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contract workers and implemented a four day work week.
The automobile industry association is predicting that by
summer, car manufacturers and their suppliers will have
let go 13,500 of the industryQs roughly 130,000
employees. Skoda AutoQs External Relations Director
Radek Spicar told us that the current situation was
unique in that none of their export markets was immune
from the crisis. As a result demand for their product
was falling not only in Western Europe, but in Russia,
Ukraine, India, and Asia as a whole.

Government Considering Modest Steps; Worried about Public
Finances


12. (SBU) The Czech National Bank (CNB) has responded
aggressively to the financial crisis, lowering its two
week repo rate by 75 basis points (bp) on November 7 and
by 50 bp on December 18. Since inflationary pressures
are no longer a concern (inflation is currently 3.6
percent and projected to fall below 2 percent by the end
of the year),the market widely expects another 50 bp cut
at the CNBQs next meeting in early February. The CNB has
also acted to provide liquidity into the banking and
government bond sectors by enabling banks to borrow money
directly from the CNB using government bonds as
collateral.


13. (SBU) With the exception of the Czech National Bank
(CNB),however, the governmentQs response to the economic
slowdown has so far been very modest. On January 1,
mandatory employee contributions to social programs were
cut by 1.5 percentage points and a small government
subsidy was offered to people under 36 buying a home.
Both of these actions, however, were planned
independently of the crisis. The government also made
available an additional 3 billion crowns (USD 150
million) in capital to the state-owned Czech Export Bank
and Czech-Moravian Guarantee and Development Bank to
allow them to increase export guarantees and corporate
lending. Finance Minister Kalousek has repeatedly said
that the government would take concerted steps to address
the crisis only if Czech economic growth slowed to less
than 2 percent. Now that it is clear that this condition
is being met, the government is scrambling to assemble a
package of crisis measures.


14. (SBU) After being unable to find anyone willing to
accept the proposed position of Deputy PM for Economic
Affairs, PM Topolanek announced January 8 the creation of
a 10-member National Economic Council, charged with
advising the government on an appropriate response to the
economic slow down. The Council consists of prominent
economists and representatives of the banking and car
industries. The opposition CSSD has refused to
participate in the Council in a move that is widely being
interpreted as an attempt to avoid being seen as sharing
political responsibility for economic slow down. CSSD
has presented its own proposals, which would be partially
financed by increasing taxes on the wealthy.


15. (SBU) The Council met with key Government Ministers
January 25. According to PM Topolanek, the Council
considered over 250 possible measures and gave priority
to accelerating depreciation of business assets
(including cars) lowering of social insurance
contributions for new or recently retrained employees,
providing state guarantees for corporate loans, and
increasing government spending on research, education,
the environment, infrastructure and some regional
projects. The Council and government are now preparing
concrete measures for inclusion in a crisis response
package that will be submitted to parliament in February.
A press conference has been tentatively planned for
February 15.


16. (SBU) Council Member and CSOB Chief Macroeconomic
Strategist Tomas Sedlacek reported that the Council had
agreed that the governmentQs basic priority should be to
help Czech exporters rather than to try to stimulate
domestic demand. Another Council member stressed to us
that it will be very difficult for the government to
address the economyQs main challenge (i.e., the drop in
external demand),although he noted other countries
stimulus packages will also help the Czech Republic.
Former Industry/Economic Minister and Council member

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Vladimir Dlouhy noted that domestic demand had fallen in
November, but preliminary data for December suggested
that the Czechs had not cut back on Christmas spending.
He too noted that since the Czech Republic was a small
open economy, any government actions would only help on
the margins. Nevertheless, he advocated for a government
fund designed to help SMEs get better access to credit at
more affordable rates.


17. (SBU) On January 26, Finance Minister Kalousek
introduced a revised budget with projected revenues based
on one percent growth. In December, the Parliament had
passed the original 2009 state budget -- which was based
on the unrealistic assumption of 4.8 percent growth --
with the caveat that it would have to be revised in early

2009. The newly revised budget makes only a few cuts and
increases revenues mainly by forcing each ministry to tap
into its reserve fund (i.e., unspent funds left over from
previous fiscal years). The newly revised budget
envisions a budget deficit of 73.3 billion crowns (or
roughly 2 percent of GDP).


18. (SBU) The revised budget, however, does not include
any of the new crisis response measures under
consideration by the Council. Council member Michal
Mejstrik reported that the Council still did not know the
level of funding the government was willing to devote to
the proposed measures. Kalousek, who has the reputation
as a strong fiscal conservative, has stressed that he
will do all in his power to prevent the budget from
ballooning, noting that in a period when all governments
are borrowing heavily, he was concerned that the
government bond market could burst. Given the right-of-
center political orientation of the current government,
as well as PM TopolanekQs strong support for Kalousek,
few analysts expect the government to put forward more
than a few relatively inexpensive crisis response
measures.

Czech EU Presidency Response: Stressing Fiscal Discipline


19. (SBU) Czech Finance Ministry officials have told us
that coordinating the EU response to the global financial
crisis is the MinistryQs main priority for the Czech EU
Presidency. Ministry officials have been having regular
meetings with UK finance officials to coordinate Czech
actions. While our working level contacts have stressed
the PresidencyQs responsibility to act as an honest
broker, Minister Kalousek told Ambassador Graber January
14 that he planned to interject three principles into EU
discussions:

The need for fiscal discipline. The Stability and
Growth Pact was not just for good times;

The need for fair economic competition and resisting
beggar they neighbor actions; and

The need for transparency. The rationale for, and
costs of, all measures should be presented to the public
clearly. One should not argue in favor of subsidies for
new cars based on environmental grounds when the real
purpose it to support the car industry.


20. (SBU) Kalousek told the Ambassador that he viewed the
financial crisis as primarily a problem of confidence and
thus did not believe that a large fiscal stimulus was the
answer. He also raised long term concerns about the
financing of debt, noting that even Germany was having
problems selling government bonds.


21. (SBU) Finance Ministry EU Department Head Drahomira
Vaskova told us that the European Commission is
representing the Czech EU Presidency in the G-20 Working
Groups, and that the main document for the EU Economic
and Financial Committee will also be prepared by the
Commission. The Czechs, however, plan to actively
participate in the political level meetings. The Czechs
are planning an informal ECOFIN meeting (meeting of EU
member state Finance Ministers) for Prague on April 3-4.
The main topics for discussion will be an assessment of
the economic and financial impact of the 2004 EU
enlargement and a discussion of the recommendations of
the Larosiere High-Level Group on financial supervision.
The Czechs are also considering inviting Treasury

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Secretary Geithner to participate in a working lunch with
his EU Member State counterparts on the global financial
crisis. Other priorities for the Czech Presidency
include preventing Qthe spread of protectionism and undue
state intervention,Q implementation of the European
Economic Recovery Plan, the review of the EU directive on
capital adequacy of investment firms and credit
institutions, negotiations on the EU directive regulating
the insurance sector, the regulation on credit rating
agencies, and the directive on electronic money
institutions, as well as modernizing rules for applying
VAT to financial and insurance services.

Comment


22. (SBU) The current Czech government is very fiscally
conservative and skeptical of pan-European regulations
and increased government involvement in the economy.
This world view is informing its actions both
domestically and internationally. Although the Czech
economy may contract in 2009, we do not anticipate a
significant Czech fiscal stimulus program or any bail
outs of key Czech industries. With it low government
debt, commitment to maintain fiscal discipline, still
relatively strong currency, and low current account
deficit (-2.3 percent on a yearly basis for the third
quarter in 2008) the Czech Republic is unlikely to
experience some of the same problems faced by other
countries in the region. Although the business community
continues to lobby for the rapid adoption of the Euro,
the crisis has done nothing to change the current
governmentQs (mainly ideological) reluctance to adopt the
common currency anytime soon. PM Topolanek again
postponed a decision on a target date until November and
suggested that even a goal of 2013 or 2014 was far from
assured.

Thompson-Jones