3) Moderate wage increases (adjusted to inflation) and a stable exchange rate.
This reform policy was backed by an IMF “stand by” arrangement as a precautionary measure. The IMF would assist if the Czech Republic needed financial assistance. This happened once early in 1993 and Czech officials repaid the loan before it came due (much to the delight of the IMF).
Unemployment remained remarkably low in the Czech Republic at 3 percent in 1993, while Poland’s figures (another major success story in CEE) still remain in double digits. Low, virtually non-existent unemployment certainly contributes to greater political and popular acceptance of the above fiscal and monetary policies.
Many attribute a major setback in the Polish “Shock Therapy” reform efforts to the political demands of the labor unions. The Polish President, Lech Walesa, understood the need to keep wages low to implement the reform. But he feared for his political power and caved in to labor pressures by granting wage increases. By doing so he nearly destroyed the entire economic reform process. He claimed that had he not, the entire political reform process would have crumbled.
Czech officials didn’t face this obstacle as unemployment throughout the transition remained low. The political reform process was slightly segregated from the economic reform process. The small Czech population (roughly 10 million) was easier to organize than Poland’s 40 million. Regional differences were less and political factions less pronounced. Regardless, by 1993, the Czech Republic had a very cohesive popular political support base which facilitated the economic reforms.
By 1994, foreign trade increased substantially, with much of the growth occurring between EU member nations. Tourism in Prague, now a “must see” on any European vacation, contributed to increased trade to maintain a strong balance of payments and a surplus in the current account. Though FDI by 1994 had decreased (after very high initial investments in 1992 and 1993), the
capital account maintained high inputs due to the rise in borrowing of Czech firms (which proved even better for Czech long term economic success).
GDP began to rise slightly after a period of decline from 1991-1993 of nearly 20 percent. Privatization entered its second round in 1994 for enterprises being privatized through voucher programs. The first wave of privatization is considered a remarkable success (a model to be used farther east). As this first wave ended in 1993, the Prague stock exchange began trading and the banking system went though increased and improved reforms. The Czech Republic was a leader in the CEE in trade and investment. Economic reform efforts, coupled with the above mentioned political support, put the Czechs at the forefront of CEE success.
Industry
Industrial output by 1993 declined by nearly 21 percent compared with 1991 figures. This can partially be explained by increases in the service sector, as investment soared in service sectors and dropped dramatically in the industrial sector. Also, the industrial sector was the most inefficient sector in the former centrally planned economy and much of those inefficiencies were corrected with the introduction of market reform. Most industries produced less as consumption dropped. And they did so more efficiently as output based economic plans were no longer used.
It is significant to note that the Czech Republic does not have an industrial policy. They feel the state does not have enough information or resources and thus it is most efficient to allow the private sector complete control. Government could assist with exemptions and subventions, but the market should determine winners and losers.
However, the Czech government continued, through 1994, to bail out state-owned enterprises, mostly due to their economic (employment) and political leverage. In essence, this hurts struggling smaller, private, firms that are unable to compete with giants, let alone subsidized giants. These large industrial subsidies are all but gone in most industries today, however they still exist for politically sensitive or economically vital industries. In some cases the government reluctantly returned to subsidies as not all of the initial privatization efforts proved successful. Some large enterprises were not effectively dismantled and the resulting giant enterprises were simply too large and inefficient for the new market economy. It took several years, in some cases, to learn this lesson.
Prices
Consumer price inflation by 1993, after the initial shocks of the VAT, stabilized at 18 percent. Experts estimate the VAT added 7 percent to inflation during 1993 and an additional 2 percent can be attributed to government administered price regulations. Price regulations remained mostly in the utilities sector. Adjustments from 1994-1995 increased prices in several key areas including gas, oil, transportation, medicine and telecommunication tariffs.
Wages
Wage restraints through a “tax based income policy” was an important feature of the CSFR. Wage restraints ended in 1993, but had to be brought back by the end of the year by the Czech government. The rational behind bringing the restraints back was that market forces were not yet adequate to control wage increases. Wage increases had to remain close to increases in consumer prices to avoid inflationary difficulties. Therefore, as late as 1995, up to 100 percent tax rates were applied to wage increases over allowable limits, effectively keeping wages at desired rates.
Monetary Policy: 1993
By 1993, Czech monetary policy began to stabilize in conjunction with political and economic indications of success. The basic aims of monetary policy at this point were simply to maintain internal and external currency stability. Officials kept the Czech crown pegged to stable European currencies and prevented inflation from rising above 10 percent. In a somewhat disguised blessing, foreign capital flowed into the Czech Republic at high rates in 1994 causing officials to raise reserve requirements from 9 to 12 percent to insure inflationary stability. The banking system, though still flawed, was able to withstand the pressures. The economy certainly welcomed the increased capital.
By 1993 and even more so by 1994, monetary policy was less of a political tool in the reform process. Stability in many respects had been achieved. The nature of further reform and continued stability relied almost entirely upon fiscal decision-making. To fully understand and appreciate the political economics of reform from 1993 onward, both fiscal and monetary, an examination of the Czech budget is helpful. Defining the role of the state in the new market oriented economy is critical. Two main issues must be examined, the resources and informational capabilities of the state. Both are limited and both are not independently effective. The budget and the political issues surrounding its passage are important in understanding the Czech approach to stability now that much of the transition has been rather successfully completed.
Intergovernmental Financial Relations
Before the budget analysis, a brief overview of intergovernmental financial relations may be helpful. The Department of Finance makes budgetary estimates for the Ministry of Economy. They regulate spending and essentially decide which organizations and institutions receive the much sought after government subsidies. They are also responsible for government accounting, financial management and regulation of wages. The Department of Finance is classified under the Ministry’s “Administration and Finance” section.
The Foreign Economic Relations Department, the European Affairs Department and the Economic and Social Policy Department are all included under the Ministry’s “Economic Policy.” They all report to the Ministry and are essentially charged with the difficult task of improving and encouraging economic development both home and abroad. The Ministry also supports a wide variety of business development departments; Small Business, Business Promotions, Tourism, etc. Though their interactions, cooperation and communication are limited, they all follow somewhat coordinated general policy initiatives of the Ministry.
The 1993 Budget
The following budget summary is based on the 1993 budget because that was the first budget elaborated as the independent Czech Republic. Before the transition, Czech had one of the more state dominated economies in the CEE. The state controlled almost all economic activity with government expenditures reaching as high as 65 percent of GDP in 1989.
The 1993 budget focused on a more developed private sector. The budget is fundamentally influenced by tax reform which will be discussed in the following chapter.
Revenues
The 1993 budget is based on three main revenues: the value added and excise taxes (36.9 percent), income tax from legal entities (25 percent) and social insurance (28.5 percent). The new tax system (and total restructuring of public finance to benefit local budgets) reshaped the revenue system and forced budget developers to complete more in-depth estimates of revenue flows. They were forced to make more accurate revenue predictions.
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