Czech Republic - Economic update February 2019
More signs of a cyclical slowdown
The Czech economy likely maintained the relatively strong growth
seen in the third quarter of 2018 (+0.6% qoq) through the final
quarter of the year. However, there are several signs pointing towards
an upcoming slowdown. For one, industrial production growth has been
weak (-1.4% yoy in December 2018), mainly due to production declines
in the automotive industry (-7% yoy). Although the working
day-adjusted figure for industrial production (+1.8% yoy) was
stronger, the industrial sector is clearly losing momentum. This is
also confirmed by the latest manufacturing PMI which fell further
below the 50 threshold in January due to significantly weaker orders.
The same evolution is illustrated by the national business cycle
survey (figure CZ1).
Figure CZ1 - Business confidence in industrial sector reflecting momentum loss (business cycle survey, balance)
On the other hand, the construction industry is holding up well. Nevertheless, given the sector’s relatively small size, this can only partly compensate for the manufacturing downturn. Moreover, growth in the construction sector is hampered by shortages of labour and materials. In addition, new orders indicate that we can expect a slower growth rate going forward compared to last year. The services sector cannot be relied on to provide any significant contribution to growth either, given a rather unconvincing performance of late. The only exception is retail, which faces increased consumer demand as reflected in a relatively high consumer confidence level. This stems from record employment levels, rapid wage growth, and relatively mild concerns about the future.
Labour market tightness, but no inflation pressures so far
The Czech labour market remains tight. While national statistics report a modest increase in unemployment at the turn of the year, it is only a seasonal fluctuation that will soon be offset by seasonal work increases. The unemployment rate will likely remain around 2% (according to Eurostat’s harmonised methodology), the lowest in the country’s history and the lowest in the EU. Though employment levels of both Czech and foreign employees are at record-highs, job vacancy levels are peaking. The number of vacancies has passed 330,000, which means there are currently three vacancies per unemployed person.
Such strong discrepancy between labour market supply and demand is also reflected in increased pressure on wage growth. Following the estimated wage increase of more than 8% last year, wage growth should slow down this year due to slower wage increases in the public sector. Even though wage growth remains above its long-term average and private consumption growth is supporting the economy, inflationary pressures remain moderate. Harmonised headline inflation only reached 1.6% yoy in December 2018 while core inflation was barely higher (1.7% yoy). The national inflation indicator, however, was somewhat higher (2.0% yoy in December, 2.5% yoy in January).
The inflation outlook does not suggest any sharp acceleration in price growth for the time being. Increased housing costs in the form of rising house prices, rents and higher energy prices are the main determinants of the current inflation level. Housing costs will remain important for overall inflation this year while pass through from high wage growth into prices will become more and more visible, particularly in services. Nevertheless, inflation should not move too far away from the central bank’s target thanks to, inter alia, cheaper fuel. This also means lower pressure on monetary policy tightening (see Box 4).
End of fiscal expansion?
Considerably higher income tax revenues led to a small government budget surplus in 2018, compared to a projected deficit of CZK 50 billion at the time the budget was approved. Thanks to the significantly positive development on the income side, reflecting a strong economic performance, public expenditures increased by 9.5%. The 2018 public budget surplus was probably close to 1% of GDP. As a result, public debt likely dropped to about 32% of GDP.
The Czech government has had the tendency to adopt pro-cyclical fiscal policies, meaning expansionary measures during economic booms and restrictive policies during downturns. One example of this was the period after 2008, when the government froze all public sector investment activity related to infrastructure building for years. In contrast, public investment has been an important growth contributor over the past couple years of strong economic growth. However, now that the Ministry of Finance and other institutions are projecting an economic slowdown, the fiscal policy stance is likely to change and become more restrictive again over the next two years. That said, increases in social and wage spending have been the main expenditure items. This leaves less potential for more flexible management of the cost side of the budget.
Demand for Czech government bonds remains high and yields are relatively low compared to the short end of the curve. Foreign investors, who held 42% of all government bonds in CZK at the end of 2018, still show a great interest. They hold a relatively stable part of the market and tend to rollover their portfolios when their bonds have paid off, regardless of increased risks in emerging markets or rising credit premiums in the euro area.
End of the real estate boom?
The latest Eurostat house price data (+8.7% yoy) does not yet indicate any cooling off in the Czech residential real estate market. The data refer to Q3 2018, just before the introduction of tighter regulation by the Czech National Bank (CNB) for mortgage lending. Demand for mortgages and real estate, therefore, was peaking at the time. The continued strong price increase in Q3 can be explained by housing supply clearly lagging the increased demand for real estate. Supply is still below the level reached before the latest recession. Bureaucratic obstacles are responsible for the slow supply reaction to the demand. Obtaining planning permission and building permits in the Czech Republic is an exceedingly long and complicated process. According to World Bank data, it takes an average of 246 days to obtain a building permit, ranking the Czech Republic 156thin the world.
The rise in house prices is expected to ease significantly in 2019
to +3.5%, down from an estimated +8.0% in 2018. We see several reasons
for this. First, demand is becoming saturated. Excessive prices are
driving some potential buyers out of the market. Based on several
valuation measures, Czech residential property has become overvalued,
albeit not yet excessively so. Second, tighter mortgage regulations on
loan-to-values, debt-to-income and debt-service-to-income ratios will
weigh on price developments. In recent months, evidence of softer
price increases has already become clear from the price setting for
some new projects. The Czech real estate market hence requires further