Czech Republic - Economic update

Economic growth driven by consumption

The revised GDP estimate for the third quarter of this year not only confirmed the Czech economy’s good condition but also fared a bit more favourable than the preliminary figures as published in mid-November suggested. According to current figures, the economy has maintained a stable growth rate of 0.6% quarter-on-quarter and 2.4% year-on-year. This time, growth was not driven by the manufacturing industry but by the trade, transport, hospitality and accommodation sectors, followed by the construction industry which, after long years, finally enjoyed a boom boosted by both commercial construction and public infrastructure projects (figure CZ1). On the demand side (figure CZ2), just as expected, the driving force was household consumption, stimulated by a strong wage growth of 6% in real terms and record employment.

Figure CZ1 - Contributions to Czech real GDP growth by sector (% change year-on-year, sa)

Source: KBC Economics based on CSU (2018)

However, investments also rose considerably, particularly in relation to machinery, equipment and ICT. Companies use them in an effort to increase their production capacity, productivity and substitute for the lack of employees. The third-quarter GDP and adjusted figures for the first half of the year call for adjustments to the annual GDP estimates. From this perspective, the resulting pace of the economy is likely to be slightly lower than originally estimated. However, the view of the economic development does not change fundamentally – it is only partially refined.

Although the CNB forecast implies acceleration of the Czech economy, soft indicators are far from hinting anything like this so far. The last PMI has been the worst in over two years, due largely to poor new orders. For the time being, new orders do not show any acceleration, rather just maintaining a steady GDP path, namely growth based primarily on consumption (on the demand side) and retail (on the supply side). At the same time, not even the construction industry can be relied on for growth as strong as we have seen of late. New orders have been growing at a moderate pace, and recent data on new construction projects or new building permits are suggesting that the strong period of residential construction seems to be coming to an end.

Labour market tension pushes wages up

The situation in the Czech labour market has been stable over the last few months and remains tight. The harmonised unemployment rate (2.2%) is still the lowest across the EU while vacancy rate is the highest. The situation of young people under 25 is also significantly more favourable than in other European countries, with unemployment in their group currently falling to 5.2%, while the EU total exceeds 15%. The lack of labour force participants is still driving wages up (despite the record-breaking employment and increasing participation rates). In the third quarter, wages grew by 8.5% yoy (6% in real terms). However, this is not solely due to the labour market situation but also to the significant increase in salaries in the public sector and the minimum and guaranteed wage increases applicable since the beginning of the year. Despite the rapid wage growth, the cost competitiveness of domestic companies has remained considerably more favourable when compared to all the old EU member countries.

Despite of the labour market developments a consumption-driven economy, the inflation rate remains close to the central bank’s 2% target. It has even descended closer to it in the past months. The main pro-inflation factor is the housing costs, reflecting the rapid rise in real estate prices and the associated rent growth, as well as the energy prices growth in response to price developments in the European market. We do not expect any of this to change in the next few months. Inflation may rise even above the 2.5% threshold at the beginning of the year, but not for too long. With the statistical comparative basis kicking in, inflation should return to the CNB’s target level in a relatively short time. The global prices of commodities, energy and food remain a risk factor. And of course, the CZK exchange rate contributes with a certain level of uncertainty in the price outlook.

CNB in apprehensive mode

After raising its main interest rate in November (for the fifth time this year) to 1.75%, the CNB might just wait until at least February for the next rate hike. The performance of the economy does not show any fundamental deviations from the central bank’s November forecast. Economic growth is slightly weaker, wage growth slightly faster and inflation still lags behind expectations. The only thing that the Central Bank is currently worried about is the Koruna exchange rate. The Czech currency remains significantly weaker than the CNB has anticipated, so it has actually become the main reason why anyone even speculates about any further rate growth (the forecast favours rate stability until 2020). The CNB assumed that the strengthening of the CZK would be sufficient to tighten monetary conditions, meaning that the bank would not have to implement any further interest rate increases. Although this has yet to happen - mainly due to the negative sentiment in emerging markets, or in view of the persistent CZK overbuying - external risks are in favour of moderate progress. Therefore, we assume that the CNB will wait to increase rates in February, when it is clear how much the potential risks are actually coming true. We continue to believe that the koruna will strengthen in the coming year, albeit significantly more slowly than expected by the central bank.

Towards the end of the year, government spending has traditionally deteriorated, and the state budget deficit reached half of this year’s plan in November. However, the state finance result is still very likely to be significantly more positive when compared to the approved budget for this year. At the same time, it is almost certain that the entire public finances will show a slight surplus in 2018 due to the improved economic management of local administrations. So, the total public debt in relation to GDP may decline further this year. The state expects a deficit of CZK 40 billion for 2019; the budget priorities remain social expenditures, wages of certain categories of state employees and, thirdly, also investments. Unless there is an unexpected fall in economic growth, the budget deficit should not exceed the projected value. On the other hand, it is evident that with the current structural budget surplus will decrease significantly and rapidly with any further growth of mandatory spending in the years to come.

As can be seen from the Ministry of Finance (MF) issue policy, the state is far from suffering a lack of liquidity. The state is not releasing any new government bonds to the market in December, which is one of the reasons why the long-term yield curve has been revised downwards in the past weeks. However, after quite a long time, the Ministry of Finance addressed the population with an offer of bonds offering a six-year reinvestment bond with an average taxed rate of about 1.6% per annum. Until the issue has been closed completely, the level of interest amongst the population remains unclear. On the other hand, given the households’ very low share of the current state debt, we do not expect residents to become a significant player in the (re)financing of the government debt.

Figure CZ2 - Contributions to Czech real GDP growth (% change year-on-year, sa)

Source: KBC Economics based on CSU (2018)
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