On June 21, 2017, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with the Czech Republic.

The Czech economy has been doing well. It grew by 2.4 percent last year, and unemployment is now the lowest in the European Union. Headline inflation is at the target and external deflationary pressures have faded. In addition, nominal incomes are growing solidly.

Given momentum in the economy, real GDP growth is projected to increase to 3 percent in 2017, largely driven by domestic demand. But labor shortages are expected to constrain growth to about 2½ percent over the medium term. With tight labor markets and strong aggregate demand, inflation is expected to reach 2.3 percent this year, before coming back to the 2 percent target.

Monetary policy has been accommodative, but the process of normalizing monetary conditions has begun. The koruna:euro exchange rate floor that had been in place for over three years was removed in April. Capital inflows had accelerated in the run-up to the exit from the koruna floor. But financial market reaction to the removal of the floor has been muted, with the koruna appreciating by 2½ percent so far. The policy rate remains unchanged at 0.05 percent.

The banking system remains liquid and profitable. Private credit has continued to expand. The Czech National Bank has responded to risks arising from the residential housing market with steadily tighter limits on loan-to-value ratios, but some borrowers are nonetheless becoming overstretched.

Fiscal overperformance last year, including from lower capital spending and strong tax revenues, led to a surplus of 0.6 percent of GDP. General government debt has declined to just above 37 percent of GDP, one of the lowest levels in the EU. Strong economic growth and better revenue collection mean a surplus of 0.4 percent of GDP is expected for 2017; current policies and improved tax collection would imply continued small surpluses from 2018.

Some progress has been made on structural reforms, including measures targeted at R&D and the labor market. However, challenges remain, including with infrastructure, the planning framework for public investment, a high labor tax wedge, and shortages of skills. Additionally, complex administrative procedures for building permits limit the ability of housing supply to respond quickly to demand.

Executive Board Assessment [2]

Executive Directors agreed with the thrust of the staff appraisal. They welcomed the Czech Republic’s economic performance, including solid growth and high employment. They expected steady growth to continue, as in staff’s baseline scenario. At the same time, Directors noted that this relatively positive outlook is subject to risks and uncertainties, including those related to increasing household financial vulnerabilities and supply-side constraints. They encouraged the authorities to remain vigilant to the challenges ahead and to continue their policy efforts to promote growth and further boost resilience.

Directors welcomed the smooth exit from the exchange rate floor. They viewed the exchange rate path as an important source of uncertainty—they concurred that the exchange rate appears to be moderately undervalued, and that further appreciation is likely over the medium term, but the exchange rate could yet fluctuate as speculative positions are unwound. In the event of severe volatility, foreign exchange interventions could be used, but should not be employed to lean against natural structural adjustment. Directors supported the stance taken by the authorities and staff that, given the uncertainties, changes to the policy rate should be implemented cautiously.

Directors noted signs that some households are becoming overstretched as they borrow to finance house purchases. They concurred that, for the Czech National Bank to be able to guard against financial vulnerabilities, a wider range of tools is needed, and therefore supported recommendations that the CNB be given binding powers over loan-to-value, debt-to-income, and debt-servicing-to-income ratios. They agreed that the acceleration of credit growth raises concerns that lending standards might slip.

Directors agreed with staff’s emphasis on supportive structural policies. Labor—especially skilled labor—is in short supply, and the economy faces unfavorable demographics over the long term. Policies should be directed to boosting labor supply and quality, such as by addressing incentives for women with small children to participate and older workers to delay retirement, boosting skills, and investing in infrastructure. Addressing infrastructure and housing supply constraints would in turn necessitate improving the regulatory environment.

Directors concurred that, given the relatively low public debt ratio, fiscal policy should prioritize raising growth potential via modest increases in physical and human capital, rather than necessarily reducing debt. For such increases to be efficient and well targeted, the authorities should seek to establish a unified and transparent plan for infrastructure over the long term. Debt management should focus more on minimizing costs for an acceptable level of risk over the medium term, which would likely imply taking advantage of currently low rates and extending maturities.