III. ECONOMIC TRENDS AND OUTLOOK Introduction: The post-revolutionary Czechoslovak government made economic transformation its number one priority. By applying restrictive macroeconomic policies and rapidly privatizing much of the economy, the Czechoslovak and subsequently Czech government succeeded in maintaining relative macroeconomic stability while privatizing a significant percentage of the economy, devaluating the Czechoslovak Crown, carrying out major structural and institutional transformations at the microeconomic level, and decreasing government subsidies to former state enterprises. All of this was accompanied by significant new legislation aimed at overhauling the banking system, establishing capital markets, permitting restitution of private property, and creating conditions for a free market. Not surprisingly, however, making the transition from a centralized, government- dominated economy toward a modern, western-style one has not been without pain. GDP dropped approximately 5 percent in 1990, approximately 15 percent in 1991, and a further 7 percent in 1992, and began to bottom out in 1993 and will likely show positive growth in 1994. Consumer prices rose nearly 10 percent in 1990, approximately 60 percent in 1991, 11 percent in 1992, and 21 percent in 1993. The latter rise was due partly to the imposition of a 21 percent value-added tax in that year, however. In short, the period 1990-1992 was marked by significant downturn in the economy and general living standards, while the overall situation bottomed out and began to improve from late 1992 until the present time. Greatly complicating the basic economic transformation of the post-revolutionary government were a series of virtually simultaneous external shocks. The absorption of East Germany by West Germany in 1990 represented the first shock as East Germany was a major trading partner for Czechoslovakia, accounting for approximately 10 percent of its foreign trade. Another shock came from the collapse of the Soviet economy and recession in Central and Eastern Europe. The switch on January 1, 1991 from CMEA trade with its low standards of quality and artificial price supports to free trade based on world prices also resulted in a significant decline in terms of trade for Czechoslovakia. Official calculations indicate a 26 percent worsening of the country's terms of trade in the first quarter of 1991, 28 percent in the second, and a cumulative 22 percent decline in the first three quarters of the year. Moreover, official estimates suggest that terms of trade did not improve in Czechoslovakia in 1992, but that they only began to get better in early 1993. The final set of shocks came on January 1, 1993, when the country separated and the demand for Czech goods by Slovakia declined significantly. Given this backdrop, the success of the government's reform efforts are impressive: while its trade markets were collapsing, it successfully undertook a truly massive economic reform program while at the same time keeping unemployment and inflation under control. The government guided the economy through the initial troubles by maintaining fairly strict monetary and fiscal policies, and will likely continue to do so until it believes the Republic has made it through the transformation process. The policies of the current government have permitted the Republic to do what many emerging countries have failed to accomplish, namely to undertake some systemic economic reform while maintaining economic and social stability. This relatively tight monetary and fiscal policies are not the sole reason for the fairly quick recovery of the Republic, however. Unlike many countries in transition, the Czech Republic is small, homogeneous in population, and generally united in support of economic reforms. This has permitted the Government to pursue its radical economic agenda with virtually no organized, serious political opposition. In spite of the tremendous and unsettling changes which the current government has wrought in this country, public approval ratings consistently hover at nearly 60 percent. In addition, its fortuitous geographical proximity to Germany and Austria has given it excellent access to those markets as well as permitted a huge tourist trade from those countries. Trade and Balance of Payments: Key to the recovery has also been Czech industry's remarkable ability to make the shift from trading in the eastern markets to trading in the west. In 1989, trade with the former socialist countries accounted for 60 percent of trade. This dropped to 50 percent in 1990, 40 percent in 1991, and is currently less than 20 percent of exports and imports. This shift has been accompanied by a decrease in the overall volume of foreign trade, however. In nominal terms, total overseas trade in 1989 was 11 billion U.S. Dollars, decreasing to 8.7 in 1990, and 8 billion in 1991. The turnaround came in 1992, however, when total foreign trade (including that with Slovakia) increased to 9 billion U.S. Dollars, followed by 9.6 billion for 1993, and probably nearly 11 billion for 1994. Roughly 30 percent of the Republic's total exports are made up of heavy machinery and factory equipment, while the country exports approximately that same amount in semi-finished goods. Chief among the latter category are cement, steel, raw timber, building stone, gravel, sand, leather, glass, and ceramics. Imports have more than kept pace with exports, however, meaning that the Czech Republic faces regular trade deficits. In 1993, for instance, the balance of trade in convertible currencies was in deficit by approximately 500 million USD. Statistics for the first quarter of 1994 show an overall surplus of approximately 60 million USD, although this is likely a temporary condition brought about by the cyclical nature of the Czech trade balance. In dollar terms, the chief imports are machinery and transportation equipment, which represent almost 40 percent of goods brought into the country in 1993. Automobiles, computer goods, and service machines and equipment make up almost 20 percent of imports, while consumer products comprise an additional 25 percent of the goods brought in from abroad. Despite regular trade deficits, however, the current account balance has remained positive. The year 1993, for instance, showed a surplus of 300 million USD. The gap between this figure and the trade deficit was made up chiefly by a large surplus in the balance of services, which totaled 1 billion USD in that year. Tourism was the chief contributor; approximately 80 million people visited the Czech Republic in 1993, and statistics show that this sector alone brought in nearly 500 million USD net. Transportation services contributed another 300 million USD. The Czechoslovak Government ran budget deficits of less than three percent of GDP from 1990 through the division of the country in 1992, and the Republic has kept a balanced or surplus budget since then. In 1993 revenues were roughly 10 billion USD and expenditures were slightly less for a total budget surplus of approximately 320 million USD. The 1994 budget will likely be somewhat higher, with revenues and expenditures targeted to reach approximately 13 billion USD. The current government intends to avoid deficit spending if at all possible, and projections for the next year or two indicate that it can likely achieve this goal through continued tight fiscal control and by significant infusions of funds from the sale of state enterprises. Including loal governments, the central government and extra budgetary funds, the general government's fiscal position will likely slip into a relatively small deficit for 1994. Foreign debt has also been kept quite low, and in fact the Czech Republic maintains one of the lowest foreign debts of any country in Central and Eastern Europe. As of the end of 1993, the gross foreign debt was approximately 8.7 billion dollars, or roughly 33 percent of GDP. This compares to roughly 60 percent of GDP for Poland and slightly over 80 percent for Hungary. The current government believes it can lower its foreign debt exposure before the turn of the century through the steady payment of interest and continued expansion of the economy. The current level of indebtedness is well within the limits specified by the Republic's agreement with the IMF. Industrial and Agricultural Output: Industrial output in Czechoslovakia dropped significantly after the 1989 revolution, due chiefly to the collapse of COMECON, the Warsaw Pact trading bloc, and to upheavals caused by the restructuring and wholesale privatization in what had probably been a too-heavily industrialized economy. Output continued to decline through 1993, which showed a 6 percent decline over the previous year. Early 1994 has begun to see the beginnings of a rise in industrial output, however. March 1994 showed an overall increase of nearly 1 percent over the same period in 1993, while output in smaller firms (those with 25 or fewer employees) increased by as much as 25 percent. It is difficult to determine whether these figures represent seasonal fluctuations, to which the Czech economy is highly subject or, more likely, whether they reflect a more general economic rebound. Currently, more than 60 percent of output is produced by at least partly privatized firms and by the end of 1994 private sector contribution to the GDP may be close to 80 percent. At that time, according to the current privatization timetable, as much as 90 percent of formerly state-owned property will be in private hands. These figures are somewhat misleading, however, as most of the large Czech enterprises are still subject to direct state control through large, if not controlling, blocks of shares purchased by the government through the National Property Fund (NPF). Labeling a firm as "privatized" only means that an undetermined percentage of the firm's shares are in private hands, ignoring what in some cases may be significant government ownership or control. Agricultural production has also fallen off, although generally not as much as that of the industrial sector. Czech agriculture suffered regular yearly declines of 2-12 percent since 1989, although 1993 showed a drop of only 1 percent. These losses resulted from several causes. First, significant restitution claims have taken a heavy toll on the amount of agricultural land available for use. Second, privatization of agriculture has dragged far behind that in other sectors of society and much of the farmland continues to be used in the same inefficient way as it was managed under communism. Third, young people are leaving the farms in increasing numbers for the more attractive and lucrative life in the cities. Despite the decline in industrial and agricultural production, however, employment levels have remained surprisingly stable. From near 100 percent employment at the time of the revolution, employment dropped only 0.1 percent in 1990, 5.4 percent in 1991, 2.6 percent in 1992, and another 0.1 percent in 1993. Unemployment in the Czech Republic currently varies between 3 and 4 percent, giving this country one of the lowest unemployment rates in Europe. Much of this can be attributed to the rapid and significant rise of the service sector, which absorbed much of the unemployment caused by the decline of the industry and agriculture. However, statistics indicate that much of this lack of unemployment is a result of labor hoarding and over-employment in the private sector. This is born out by figures for labor productivity, which showed decreases of 0.3 percent in 1990, 14.5 percent in 1991, 2.3 percent in 1992, and 1.2 percent in 1993. Unemployment levels vary significantly throughout the country. At the current time, for instance, there are not enough workers to fill all the available jobs in the capital city of Prague. On the other hand, certain formerly agricultural regions in northern Moravia show unemployment levels of as much as 15 percent. On the whole, however, it can be expected that unemployment will increase somewhat as the corporate restructuring takes its toll on the former over-employed large enterprises. Social Issues: In order to maintain control over spiraling wages and their probable effect on inflation, the government instituted wage controls to keep salaries, and thus labor costs, down. Partially as a result, purchasing power for the average Czech worker has declined severely since 1989. The sudden liberalization of prices caused a 25 percent decline in real income in 1991, although a 23 percent rise in nominal wages the following year resulted in an 11 percent real wage gain. The government imposed wage controls in that year, however, keeping real wages at essentially the same level and resulting in an overall 23 percent drop in purchasing power for the period 1989-1993. Statistical data, however, seems to show that real wealth is not falling quite as fast as income, indicating that Czechs are finding ways to supplement their incomes. Domestic and Foreign Investment: Since 1989, statistics show a major decline in the amount of domestic capital investment activity. Net fixed investment declined by 2.1 percent in 1990, 17.7 percent in 1991, increased by 6.3 percent in 1992, but fell another 8 percent in 1993. Overall, net fixed investment has so far tended to parallel the decline in GDP. This decline has been more than offset by foreign direct investment (FDI), however. The Czech Republic received approximately 2 billion U.S. Dollars in FDI by the end of 1993, and nearly 1 billion U.S. Dollars in foreign credits. Additionally, since 1993 there has been a heavy flow of foreign portfolio investment into the Czech stock market as well. In 1994, Standard & Poors issued the Republic a rating of BBB+, placing it somewhere among the lower tier European Union countries such as Portugal (AA-) and Greece (BBB-). Given the rising economic indicators and declining political risk factors, many expect the Republic to be up for positive re-assessment within the next few years. Conclusion: Most observers believe that the economy of the Czech Republic will likely continue to improve over the near to medium term. Growth should be in the neighborhood of 2 to 3 percent for 1994, and could tick up a percentage point or so per year for the next few years. The government is convinced it can keep its yearly inflation figures below 10 percent and that it can successfully complete the transition to a western-style market economy and be accepted as a member of the European Union sometime before the end of the millennium. There are, however, some potential clouds on the horizon. First, the industrial sector has yet to undergo major transformation or be subjected to significant bankruptcies. It is possible that, as the country undergoes this near-term microeconomic transformation, resultant unemployment levels could reach as high as 10 percent and result in a significant downturn in GDP growth, industrial production, and general economic competitiveness. Secondly, we note that general elections are due in 1996 which, some observers believe, is approximately when fallout from microeconomic transformation, chiefly in the form of bankruptcies and unemployment, may reach noticeable proportions. Should this be the case, it is possible that there may be a backlash similar to that experienced in Poland and Hungary. Although we do not believe the communists can ever return to Prague, it is possible that under this scenario a new regime might choose to slow the pace of economic transformation. On the other hand, there are those, including many foreign investors, who are extremely bullish on the Republic. They predict three to four percent growth in 1994 with continued high returns for the foreseeable future. In this view, the Republic will successfully make the transition to a western-style economy, weather the microeconomic transformation, absorb the bankruptcies, and sail cleanly into the EU sometime after 1996. The Embassy tends towards the more conservative of the two views, however. While acknowledging that there are yet many problems to be overcome in the Republic, we believe that sustained growth of one to three percent per year is realizable. We do not see any likely political opposition to the reform process and believe that the current government should have no problems remaining in power until at least 1996 and almost certainly in some form thereafter. Labor Force: The Czech labor force numbers approximately 5 million, of a population of 10.3 million. Wages in the Czech Republic are significantly lower than in Western Europe, and the work force is generally well-educated and disciplined. The Czech Republic's population is aging. During the last decades of Communist rule workers often continued in their jobs after normal retirement age, and many enterprises imported foreign labor from neighboring countries such as Poland and from Third World countries such as Vietnam or Angola. At present most guest workers have been sent home and many older workers have retired. This helps account for the Czech Republic's low rate of unemployment, currently under 4 percent. Other factors contributing to the low unemployment rate include the growth of the services sector and it ability to soak up excess labor from large enterprises and farms; effective information and training centers (labor offices) in each county; and an attitude of flexibility among workers willing to change jobs and locations. One million workers have changed employment since 1990. Despite a tight housing market, commuting--across borders to Germany or Austria or into major cities such as Prague--is common. More than half of the labor force still belongs to trade unions. The Czech-Moravian Confederation of Trade Unions (CMKOS) is a democratically structured organization which belongs to the International Labor Organization (ILO) and the International Confederation of Trade Unions (ICFTU). Most Czechs nonetheless associate CMKOS with its 1989 predecessor, the Communist ROH, whose assets CMKOS took over after the revolution. The CMKOS leadership states that it is committed to economic restructuring. In the context of the tripartite council, representing labor, business and government, labor has negotiated general agreements each year which set the parameters for collective bargaining and contract procedures. The Czech Republic has been virtually strike-free since 1989.