The Czech Republic
USSR to EU
Public finance policy issues during the political
economic transition from centrally planned socialist
economics to free market democratic capitalism.
V550 Dr. Mikesell
November 20, 1996
Rick Ferguson email@example.com
Eric Martin firstname.lastname@example.org
Dmitri Maslitchenko email@example.com
Table of Contents
II. Political Summary: Restructuring for Transition
III. Transition to Market Economy: 1990 - 1991
IV. Problems of Transitional Monetary Policy and the Financial Sector: An Overview
V. Macro Economic Stability: 1993 - present
VI. Monetary Policy: 1993
VII. Intergovernmental Financial Relations
VIII. Budgetary Overview: 1993 - present
IX. Tax Reform
X. Current Political Economic Considerations: 1996
XI. The EU and NATO
In 1989, after nearly 40 years of Soviet control, Czechoslovakia once again became an independent nation, the Czech and Slovak Federalist Republic. This transition from Soviet socialism to democracy culminated throughout Central and Eastern Europe with the literal collapse of the Berlin Wall in East Germany, the heroic Gdansk Shipyard Strikes in Poland. The student and worker protests in Prague and Budapest were no less important.
The Czechoslovakian revolution took place peacefully and over a much longer period of time than events in other former Soviet Union or Warsaw Pact nations. Hints of major reform in Czechoslovakia began as early as 1968. Czechoslovakian officials, under Soviet power, moved incrementally to begin the long road towards decentralization and independent Czechoslovakian rule. Their increasingly effective efforts became known as the Prague Spring, a time of growth, change and development.
Success was, of course, neither immediate nor easy to achieve. The Cold War reached a pinnacle in the Eighties and the winds of change began to blow in Central and Eastern Europe. The CEE nations endured many hardships. Soviet oppression, though waning by this time, became largely unbearable. Change in Czechoslovakia came from the ground up; dissidents quietly began to return to popular power. The revolution gained momentum by 1989. ‘Revolutionists’ began to demand sweeping economic and political reform. They were backed by well organized and very timely strikes and protests. After a two hour general strike on November 27, 1989, proving the immediate and widespread power and cohesion of the revolution, the Soviet controlled authorities finally agreed to negotiate.
Through the negotiation process and threat of further massive general strikes, former dissidents assumed officially sanctioned ‘concessional’ positions. Within months, they gained near complete (and very real) control of the Federal Assembly. On December 29, 1989, Mr. Havel, a very famous and popular Czech dissident, became President of Czechoslovakia (renamed the Czech and Slovak Federalist Republic).
This initial political victory represents only half of the nation’s success. Within the first three years of self rule, harsh economic (and subsequent political) realities forced the nation to divide once again. The nation as a whole was unable to accommodate the vast discrepancies between the western Czech and eastern Slovak regions. Massive economic reforms brought this to the popular agenda as Slovakia suffered greatly while their Czech counterparts seemed to benefit from reform.
The government in Prague wished to move swiftly to further reform efforts. Slovakia hindered Czech success and in turn suffered greatly by this Czech-led reform. Slovakia simply could not move as rapidly toward a market economy due to the economic configuration left to them by years of Soviet planned economics.
Political Overview: Restructuring for Transition
In 1992, Vladimir Meciar, a very strong nationalist was elected prime minister of the Slovak Republic, while Vaclav Klaus, a moderate federalist, was elected in the Czech Republic. Unfortunately, these two leaders were unable to agree on common economic and political strategies to govern the CSFR. Klaus’s reform plans, now legendary, were simply inappropriate for the fledgling Slovak regions. Slovakians felt alienated from the government reform in Prague. Within a short time it was very clear that the Czech regions could not completely support their Slovak countrymen through the transition. The two leaders agreed to divide the Czech and Slovak Federalist Republic (CSFR) into the Czech and Slovak Republics on January 1, 1993.
Federal assets and liabilities were split between the two nations in a two to one ratio. The Czech Republic received the larger portions reflecting both size and population. Again, the split was achieved peacefully, without massive debate. The two countries agreed to form a customs union. They implemented identical foreign policies with respect to third countries, and forbid tariffs or ‘bans’ between themselves. They also formed a temporary monetary union, which collapsed within months as both countries unexpectedly experienced a massive drain on foreign reserves during this time. To more fully understand the current developments in the Czech Republic, one must examine the historical economic decisions made before the break-up in 1993 as outlined below.
Transition to Market Economy Overview: 1990-1991
CSFR economic reformers went to work immediately following the collapse of Soviet rule. The reform package included near complete liberalization of prices, a complete reversal of former exchange and trade systems and an impressive preparation for massive and rapid privatization. These efforts were supported by financial policies including a “pegged” exchange rate, currency devaluations, and restrictive fiscal, monetary and wage policies.
Although monetary policy is discussed in a separate section, it needs to be briefly addressed here to understand the conditions in which the transition occurred. Monetary policy in the initial stages of transition ensured that inflation remained in control throughout currency devaluations and price liberalizations. The CSFR devalued its currency by 20 percent in 1991 after several smaller devaluations before hand. Taken as a whole, these devaluations reduced the value of the currency by half within six months. Generally, monetary policy remained tight throughout the entire period.
Undoubtably, the goals of the CSFR economic reformers were to drastically reduce government spending. The former centrally-planned, output-driven economic policies were no longer effective for the new capitalist democracy. Restructuring government expenditures was a key component of reform. The main changes, aside from massive privatization discussed below, forced reduced subsidies wherever possible. Every sector of society, with the exception of health, welfare and education, saw an abrupt end to government subsidies. In 1991 alone, for example, officials reduced government spending by 12 percent to reach 47 percent of GDP. This trend continued throughout the transition. Massive government spending, a hallmark of socialism, ended virtually overnight.
Areas where government spending remained high would remain so throughout the reform process. Health and welfare for poor, elderly, unemployed and children is a very difficult situation in any government, especially one in transition. Reformers focused primarily on industry and energy in the initial stages, leaving the areas of greater uncertainty to be dealt with in a more stable political environment.
As an almost immediate measure, subsidies to foodstuffs and energy were reduced by nearly 50 percent. Retail prices for most household items increased by nearly 25 percent literally overnight. By the end of 1991, the Czech government controlled only 6 percent of prices in the country as compared with 85 percent in early 1990. Only basic necessities, oil, and agricultural products remained under state control. To offset some of these shocks, wages increased, though only slightly and not nearly enough to meet the increased cost of living. Politically powerful trade unions prevented the passage of even more drastic reform measures. Plans in 1991 to increase the price of electricity, heating oil and coal by nearly 400 percent and rent by 300 percent were delayed until 1992 and 1993.
Foreign Trade and Investment
After an initial currency devaluation of nearly 50 percent, the government adopted an adjusted exchange rate connected to a “basket” of convertible hard currencies. Internal convertibility of hard currencies was established in 1991. These two measures combined to foster trade and investment. Initially, the CSFR set a 20 percent surcharge on imports coupled with a 5 percent tariff. These obstacles soon ended as major provisions were passed to more actively encourage trade and investment. Initial steps toward private property rights and the dissemination of publicly owned lands further enhanced the investment environment.
Privatization is by far the most critical and complicated development the CSFR had to address. Speed was critical. The ‘default mechanism’ ensured that current managers and persons of powers would assume control and create their own joint venture agreements with foreign entities.
State firms that were nearly completely vertically integrated needed to be desegregated by form and function. And the process had to be done well, for flailing industries would simply increase state expenditures. Failures did not decrease expenditures in compliance with the transitional reform strategy. The CSFR privatization plan was threefold. Small-scale privatization was the easiest. Retail stores, restaurants and small service or industrial workshops were sold to the highest bidders in weekly public auctions. Where no CSFR buyers were found, a second round of auctions allowed foreigners to bid.
Property restitution was more difficult. The government needed to equitably redistribute land that had been taken nearly 40 years earlier. This is a difficult and involved issue. CSFR citizens are allowed to claim land taken from them, though the burden of proof is on them. Where no proof exists, special arrangements can be made for state assistance. In areas of conflict, the issue will be brought to the courts. A large part of the country was not in private hands before Soviet rule. Some of this land can be used as an offering to parties where disputes over ownership exist. Also, lands that have been improved (shops, developments, houses, etc.) are sold at specially determined rates to the former property owners. Prices and possible alternative compensation for those owners who do not wish to purchase these ‘improvements’ are again settled by a special court arrangement.
Large-scale privatization progressed swiftly. Some state-owned firms were sold outright to private interests while others remained under indirect state control until buyers were found, legal or economic concerns settled, or parliamentary debate resolved.
The strong tradition of labor unions and their political strength proved crucial to social security reforms throughout CEE. The CSFR was no exception. Labor unions were instrumental in keeping CSFR unemployment at very low levels and social safety net benefits quite high. Essentially the state guaranteed incomes at a minimal level to meet the ‘cost of living’ for the unemployed or the under-employed. Pensioners and parents of children received benefits adequately covering bare essentials. Further benefits for health care were distributed at the local level as the health system still remained under state control.
Problems of Transitional Monetary Policy and the Financial Sector
Since the introduction of reforms, monetary policy played a key role in the economic stability of the Czech Republic throughout the transition. Inflation remained surprisingly low (though relatively high in 1989 and 1990), exchange rates were relatively stable (after initial fluctuations), and external reserves stayed strong throughout the period (spurred by unusual and unexpected outside interest in the Czech Republic as the first reformer to prove its success).
What is perhaps most impressive are the obstacles Czech officials overcame in developing an effective monetary policy. First, the entire CMEA trading block was virtually dismantled. Reform and transition would be difficult even with stable trading partners. In the CMEA, all of the countries were experimenting with and adjusting prices, exchange rates and policies. It was very difficult to set monetary conditions correctly, in real or absolute terms.
Second, within just a few short years, the CSFR itself broke apart for economic and political reasons. This was largely unexpected and proved difficult in the policy making arena. As the break-up drew near, officials had a difficult time determining which policies should be enacted based upon which of many scenarios might occur in the CSFR.
Third, after finally establishing the terms of the CSFR split and negotiating a seemingly effective customs and monetary union between the two new countries, the monetary union failed miserably. Within a few months, the union caused significant drains on much needed foreign reserves in both countries and had to be abandoned.
Finally, the Czech tax system had to be completely overhauled. Additionally, the banking system needed massive reform. Large spreads in interest rates were common and overall the banks were simply reluctant to lend on any long term basis, a major impediment to domestic investment and growth.
All of these massive changes occurred within just a few years. Throughout these developments, monetary policy remained extremely tight. At the onset of the reform period, it was at its tightest, with a minor break late in 1991, once the political economic dust had settled. Otherwise, the next monetary reprieve didn’t occur until the second half of 1993. By 1994, broad money grew at 30 percent compared with growth of 15 percent a year earlier. More important than doubling growth figures is that the economy was able to withstand this growth by 1994!
Interest rates were high throughout the period, and continue to remain high by most western standards (over 9 percent). Interest rates were not directly controlled but were subject to central bank reserve requirements and discount rate announcements. Liquidity was further controlled through regular auctions of treasury bills.
Bank reform focused primarily on establishing the legal framework for transactions between the central bank and newly established commercial banks. Weaknesses still remain in reporting and accounting and the reluctancy for banks to lend. Several commercial banks have had to come back under government control to prevent major economic problems.
Macro Economic Stability 1992 - present
By 1992, the CSFR began to show significant signs of success. Though they were in fact more disadvantaged than many other countries in the CEE, they fared well. Their export market consisted almost entirely of former members of the Council for Mutual Economic Assistance (CMEA) who were in the same transitional position as the CSFR, impeding efficient trade. Fortunately, inflation on the whole in the CSFR remained remarkably low when compared to the rest of the CMEA, as did external debt. Inflation did jump just before the CSFR breakup into the Czech and Slovak Republics. Experts suggest this occurred in part due to the fear of instability during the breakup and in part due to an anticipated VAT. As expected, in 1993 (in the Czech Republic), inflation rose again after introduction of the VAT.
In 1993, free from its less advantaged Slovak counterpart, the Czech Republic better targeted its economic recovery plan. The plan encompassed three main elements:
1) A balanced state budget that encompassed sweeping tax reform;
2) A tight monetary policy to reduce the inflation caused by VAT and other lesser effects (which also improved its external position for trade and investment); and
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.