Member State profile
The economy of the Czech Republic

Škoda: one famous Czech export

The Czech Republic has traditionally had a strong focus on so-called secondary sectors, including transport and transport-related equipment, oil-refining products and chemicals, machinery production and – famously – brewing, along with a service industry which is currently experiencing stronger growth. The car-making industry has also attracted a number of foreign investors eager to take advantage of a cheap and highly skilled workforce. Czech car-maker Škoda is owned by Germany’s Volkswagen AG, Europe’s largest carmaker, while Korea’s Hyundai Motor Co. plans to build a new plant in the Moravia-Silesia region by 2009, which is expected to churn out 300 000 vehicles annually.

Transition to a market economy

Following the so-called ‘Velvet Revolution’ in 1989, the first democratic elections led to a comprehensive privatisation programme in Czechoslovakia, one of the region’s earliest. Unlike neighbouring countries, Czechoslovakia focused privatisation on domestic ownership, granting no fiscal advantages to foreign investors. These large domestic privatisations and the resulting upsurge in small enterprises fuelled economic growth for several years, aided by cost advantages in export markets and a substantial devaluation of the koruna in 1990. Three years after the 1993 break-up of Czechoslovakia, the Czech economy went into recession amid rising wage costs and inflation and a burgeoning current account deficit. Drawing on the experience of earlier privatisations and pursuing foreign capital, the government introduced an incentive scheme in 1998 for foreign investors. Foreign direct investment (FDI) inflows increased substantially, including an influx of greenfield FDI.

Growth resumed in 1999, with inflation cut to less than 2% and a moderation in wage rises from public sector restraint and a looser labour market. Export growth picked up, benefiting from the currency devaluation and resumed FDI inflows, which accounted for 11% of GDP in 1999. The renewed foreign investment helped modernise industrial capacity across several sectors and boost productivity. From 2001-2005, the contribution of productivity to GDP growth increased substantially.

However, the average number of hours worked and participation rates has remained below those of the other new Member States. “Thanks to a well-educated workforce and its central location in Europe, the Czech Republic was able to attract a considerable amount of foreign investment, which is key for enhancing the efficiency of the economy,” says Filip Keereman of DG ECFIN, responsible for monitoring and analysing the Czech Republic’s economic and budgetary development.

FDI on the up

Since 2000, the economy has enjoyed substantial foreign investment, with the Czech Republic receiving higher FDI inflows than any other Central and Eastern European country as a proportion of GDP. These have been mainly in motor vehicles, food products and tobacco and non-metallic industries, as well as large banks and utilities. An estimated 90% of the country’s banking sector is in foreign hands today. In 2005, the government sold its 51% stake in telecommunications firm Český Telecom to Spain’s Telefónica SA. In comparative terms, foreign firms appear to have been considerably more profitable than domestic ones.

After growing at record levels of 6% of GDP in 2005 and 2006, real GDP growth is expected to moderate slightly in 2007 and 2008 at around 5.25%, nearer the potential level and pulled mainly by domestic demand. The contribution of net exports, which had been the main economic driver in 2005, has gradually decreased due partly to rising imports.

Progress of the Czech economy towards EU income levels has been uneven. Between 1995 and 2000, the income differential between the Czech economy and the EU average widened significantly, mainly as a result of the recession. Since 2000, there has been steady convergence, with the Czech Republic reaching 73% of GDP in terms of purchasing power standard of the EU-25 average in 2005.

Path to the euro

Upon joining the EU in 2004, the Czech Republic pledged to eventually join the euro area and adopt the common currency. This process is governed by ‘convergence programmes’, prepared by each Member State and submitted to the Commission and the Council for agreement. These programmes, part of the Stability and Growth Pact, outline the economic measures each country will take to ensure price stability, sound public finances and strong, sustainable growth, which lays the groundwork for job creation. Specifically, countries must limit government deficits to within 3% of GDP and debt to within 60% of GDP. They are also obliged to bring inflation down to within 1.5 percentage points of the 12-month average inflation rate of the three EU nations with the slowest annual consumer-price growth.

The Czech Republic submitted its most recent convergence programme, covering the period 2006-2009, on 15 March 2007. Under the corrective arm of the Pact, the Council placed the Czech Republic in excessive deficit in July 2004. It has until 2008 to correct this deficit.

At 30.6% of GDP in 2006, the Czech Republic’s public debt is well below the reference value set down in the Treaty, but it is expected to rise by almost two percentage points between 2006 and 2009. Despite better growth prospects and a lower-than-expected deficit in 2007, the programme submitted in March 2007 nevertheless postpones the correction of the excessive deficit by at least one year compared to the 2008 deadline set in July 2004. The Council has recommended that the original deadline be adhered to.

General government balance projections in successive convergence programmes (% of GDP)

Note: PEP – pre-accession economic programme Source: Commission services' autumn 2006 forecast (COM) and successive convergence programmes

The government has taken a cautious approach to adopting the euro. In its strategy for euro adoption approved in August 2007, the government did not set a target date for entry, after dropping an earlier target of 2010, reasoning that it must first tackle the state of public finances as well as a tight and inflexible labour market.

Challenges ahead

While unemployment has fallen since 2000, the proportion of long-term unemployed remains high, with further falls likely to be tempered by structural factors, including a relatively high tax wedge on employment. Long-term unemployment remains stubbornly high due to a skills mismatch between many vacancies and job-seekers. Compared to other new EU Member States, the Czech Republic has a relatively low emigration rate, with Czechs generally preferring to stay home rather than seek employment abroad.

The annual budget includes a high proportion of social expenditures including for pensions and health care, which is increasing amid an ageing population and thereby putting the long-term sustainability of public finances at high risk. While the pension system is broadly in balance, this is expected to deteriorate in the medium term. In its stabilisation package, adopted by the lower house of parliament in August 2007, the Czech government pledged to make cutbacks in social expenditures to decrease the budget overall; pensions and health were not addressed.

The challenge in reducing the inefficiency of public spending will be to focus resources on promoting growth. Recent moves by the government to shift the tax burden from indirect to direct taxation and to lower taxes on labour are a step in the right direction. The Czech Republic also recently introduced measures aimed at improving the transparency and accountability of public finances.