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Czech Republic - Economy (Notes)

ECONOMY Of the former communist countries in central and eastern Europe, the Czech Republic has one of the most developed and industrialized economies. Its strong industrial tradition dates to the 19th century, when Bohemia and Moravia were the industrial heartland of the Austro-Hungarian Empire. The Czech Republic has a well-educated population and a well-developed infrastructure. The country's strategic location in Europe, low-cost structure, and skilled work force have attracted strong inflows of foreign direct investment (FDI). This investment is rapidly modernizing its industrial base and increasing productivity. The principal industries are motor vehicles, machine-building, iron and steel production, metalworking, chemicals, electronics, transportation equipment, textiles, glass, brewing, china, ceramics, and pharmaceuticals. The main agricultural products are sugar beets, fodder roots, potatoes, wheat, and hops. As a small, open economy in the heart of Europe, economic growth is strongly influenced by demand for Czech exports and flows of foreign direct investment. At the time of the 1948 communist takeover, Czechoslovakia had a balanced economy and one of the higher levels of industrialization on the continent. In 1948, however, the government began to stress heavy industry over agricultural and consumer goods and services. Many basic industries and foreign trade, as well as domestic wholesale trade, had been nationalized before the communists took power. Nationalization of most of the retail trade was completed in 1950-51. Heavy industry received major economic support during the 1950s, but central planning resulted in waste and inefficient use of industrial resources. Although the labor force was traditionally skilled and efficient, inadequate incentives for labor and management contributed to high labor turnover, low productivity, and poor product quality. Economic failures reached a critical stage in the 1960s, after which various reform measures were sought with no satisfactory results. Hope for wide-ranging economic reform came with Alexander Dubcek's rise in January 1968. Despite renewed efforts, however, Czechoslovakia could not come to grips with inflationary forces, much less begin the immense task of correcting the economy's basic problems. The economy saw growth during the 1970s but then stagnated between 1978-82. Attempts at revitalizing it in the 1980s with management and worker incentive programs were largely unsuccessful. The economy grew after 1982, achieving an annual average output growth of more than 3% between 1983-85. Imports from the West were curtailed, exports boosted, and hard currency debt reduced substantially. New investment was made in the electronic, chemical, and pharmaceutical sectors, which were industry leaders in eastern Europe in the mid-1980s. The 'Velvet Revolution' in 1989 offered a chance for profound and sustained economic reform. Signs of economic resurgence began to appear in the wake of the shock therapy that the International Monetary Fund (IMF) labeled the 'big bang' of January 1991. Since then, astute economic management has led to the elimination of 95% of all price controls, large inflows of foreign investment, increasing domestic consumption and industrial production, and a stable exchange rate. Exports to former communist economic bloc markets have shifted to western Europe. Thanks to foreign investment, the country enjoys a positive balance-of-payments position. Despite a general trend over the last 10 years toward rising budget deficits, the Czech Government's domestic and foreign indebtedness remains relatively low. The Czech koruna (crown) became fully convertible for most business purposes in late 1995. Following a currency crisis and recession in 1998-99, the crown exchange rate was allowed to float. Recently, strong capital inflows have resulted in a steady increase in the value of the crown against the euro and the dollar. The strong crown helped to keep inflation low. In 2004, inflation was about 2.8%, mainly due to increases in value added tax rates and higher fuel costs, and dropped to 1.9% in 2005. It hovered around 2.5% in 2006. The Ministry of Finance forecasts a rate of 2.4% for 2007. The Czech Republic will not adopt the euro earlier than 2012. The Czech Republic is gradually reducing its dependence on highly polluting low-grade brown coal as a source of energy, in part because of EU environmental requirements. In 2005, according to the Czech Statistical Office, 65.4% of electricity was produced in steam, combined, and combustion power plants; 30% in nuclear plants; and 4.6% from renewable sources, including hydropower. Russia (via pipelines through Ukraine) and, to a lesser extent, Norway (via pipelines through Germany) supply the Czech Republic with liquid and natural gas. The government has offered investment incentives in order to enhance the Czech Republic's natural advantages, thereby attracting foreign partners and stimulating the economy. Shifting emphasis from the East to the West has necessitated adjustment of commercial laws and accounting practices to fit Western standards. Formerly state-owned banks have all been privatized into the hands of west European banks and oversight by the central bank has improved. The telecommunications infrastructure has been upgraded and the sector is privatized. The Czech Republic has made significant progress toward creating a stable and attractive climate for investment, although continuing reports of corruption are troubling to investors. Its success allowed the Czech Republic to become the first post-communist country to receive an investment-grade credit rating by international credit institutions. Successive Czech governments have welcomed U.S. investment in addition to the strong economic influence of Western Europe and increasing investment from Asian auto manufacturers. Inflows of foreign direct investment in 2005 were $11.7 billion, more than double the previous year. In 2006, FDI dropped back to previous levels at roughly $6 billion. By U.S. Embassy estimates, the United States is among the top five investors in the Czech Republic since the revolution. The Czech Republic boasts a flourishing consumer production sector. In the early 1990s most state-owned industries were privatized through a voucher privatization system. Every citizen was given the opportunity to buy, for a moderate price, a book of vouchers that he or she could exchange for shares in state-owned companies. State ownership of businesses was estimated to be about 97% under communism. The non-private sector is less than 20% today. Unemployment declined to 7.7% in 2006. Rates of unemployment are higher in the coal and steel producing regions of Northern Moravia and Northern Bohemia, and among less-skilled and older workers. The economy grew 6.1% in 2005 and experienced similar growth in 2006. The current right-of-center coalition government has committed itself to reducing the deficit to 3% of GDP by 2008, from 4.7% in 2006. Planned reforms involving reduction of currently mandatory expenditures to meet Maastricht criteria for adoption of the euro will prepare the Czech Republic for accession to the euro zone in 2012 at the earliest. The Czech Republic became a European Union (EU) member on May 1, 2004. Most barriers to trade in industrial goods with the EU fell in the course of the accession process. The process of accession had a positive impact on reform in the Czech Republic, and new EU directives and regulations continue to shape the business environment. Free trade in services and agricultural goods, as well as stronger regulation and rising labor costs, will mean tougher competition for Czech producers. Future levels of EU structural funding and agricultural supports were key issues in the accession negotiations. Even before accession, policy set in Brussels had a strong influence on Czech domestic and foreign policy, particularly in the area of trade. The Czech Republic?s economic transformation is not yet complete. The government still faces serious challenges in completing industrial restructuring, increasing transparency in capital market transactions, transforming the housing sector, reforming the pension and health care systems, and solving serious environmental problems.