• Marcin Malinowski

The Czech Republic Hunts for a New Source of Growth

After a quarter century of effective  economic change, the Czech Republic finds itself searching for a new growth model. Relative success, with per capita GDP nearly double compared to 1993  and households having 600% more in the bank than they did two decades, was built by a skilled workforce manufacturing at lower costs than western European competitors. “That model is exhausted,” says David Marek, chief economist with Deloitte in Prague.

Prague (CC By SA Nitin Vyas)

Over more than  20 years, Czech manufacturers transitioned from making heavy machinery to more value-added products integrated into European, and especially German, supply chains. Cars and car parts still drive exports and the economy generally—Škoda, a division of Volkswagen, is the country’s top exporter—and the chemical, metallurgy and other sectors follow similar models. However, robust growth peaked in the boom years of 2005-2006, and since then growth has been much more sluggish. The country suffered a post-crisis double-dip recession, and growth this year is expected to come to 2.5% and 2.7% in 2015, according to Eurostat. Those rates are higher than in most of western Europe, but not enough to make much progress in catching up to the richest half of the continent.

The problem is that the country’s notoriously conflicted politicians seem unable to break through reform fatigue and propose solutions that would boost growth. A further complication are the original sins of the 1990s, which saddled the economy with ongoing inefficiencies.

Amid a variety of flawed regional models, then-Prime Minister Václav Klaus’ laissez-faire friendly governments decided on voucher privatisation. In theory, this was meant to give Czechs the opportunity to own parts of formerly state-owned companies as they traded their coupons in for shares. The idea was to give everyone a stake in economic reform, and to make up for the lack of local capital thanks to the general pauperisation that was a legacy of communism. In practice, big investment funds gobbled up majority stakes, then delisted the companies from the stock market—or worse.

Now wanted and resident in the Bahamas, Viktor Kožený, the so-called “Pirate of Prague” was a prime practitioner of a wholly original type of fraud that emerged during this era. Tunnelling, as it came to be known, saw majority stakeholders sell off assets from a publicly traded company—at bargain prices—to their own offshore firm. Meanwhile minority shareholders, hailing from the largely financially illiterate general public, were left holding shares in the original, now hollowed-out company. “Main Street got almost nothing from the wave of privatisation,” Mr Marek says.

Beyond crippling confidence in the post-communist economic system, such developments hindered the development of domestic equity markets. The Prague Stock Exchange remains small, with listings and volume of trades shrinking. Today, most Czech companies still opt for bank loans when they need a cash infusion to grow.

There have been other bumps along the way too. The Czech crown crashed in 1997 amid what Mr Marek calls “a banking crisis and a credit crunch”, both terms to be revisited a decade later. The government slashed spending and the economy contracted in 1998 and 1999. Reforms would gain new momentum as the country pursued European Union membership and with entry into the trading bloc in 2004 exports boomed. By December 2005 monthly exports had jumped 63% as compared to two years earlier.

The 1997 domestic banking crisis proved a minor blessing in disguise as Czech banks translated those lessons into cautious lending policies that saw them fare better than foreign counterparts during the global downturn that began in 2008. Yet, much like the Chinese proverb about living in interesting times, such blessings can also prove a curse. In a market where firms are overly dependent on bank loans to fuel growth, tight-fisted lenders mean capital and growth potential lie dormant.

“Our biggest strength is macroeconomic stability with low debt, relatively low unemployment. People call it a boring economy,” says Vladimír Dlouhý, an advisor to Goldman Sachs who was also economy minister in the first post-communist Czechoslovak government starting in December 1989. “The problem is we don’t have growth.”

Most agree that future growth necessitates home-grown innovation capable of taking market share from western European firms, rather than supplying them with anonymous parts. Less clear, especially politically, is how to get there. Some advocate a shift away from direct taxation – especially a reduction in social security contributions, which as a percentage of tax collected are the highest in the EU – and a move toward consumption taxes. Many of the same people are critical of social policies that in certain income brackets still make it more sensible to collect benefits than take on work.

Ideologically-charged as they are, major changes to taxation and social benefit policies do not appear to be on the agenda of the centre-left government of Prime Minister Bohuslav Sobotka, but there are things that left and right can agree on, including boosting investment in research and development (R&D). The Czech Republic spends 1.88% of GDP on R&D, according to Eurostat. While strong for Central Europe, it is below the EU average and far behind eurozone leader Finland’s 3.55%. If the state is unable to invest directly, tax incentives well short of a tax code overhaul could draw private funds.

Other changes seem capable gaining consensus too. While not quite as Kafkaesque as it once was, Czech bureaucracy is tortuous. It takes nine steps to register a new business as compared to Slovenia where it takes just two. The Czech Republic comes in 44th in the World Bank’s annual Doing Business ranking, lower than many CEE peers like Poland and Slovakia. Starting a  business, getting a construction permit and paying taxes are big problems. And though the Czech National Bank’s present weak crown policy is providing a temporary boost to the economy, that will eventually end as joining the eurozone is “inevitable”, Mr. Marek says.

The Czech Republic’s current growth outpaces the EU average, but it is still much lower than what Mr Klaus must have  hoped for during his heyday. There is no doubt that the country is significantly wealthier than it was when protestors took to Prague’s cobblestoned streets in 1989 to overthrow the communist regime – but there is also a sense that the Czech Republic has lost its way.

“If you had showed me today’s Czech Republic back then, I would say we achieved immense success,” Mr Dlouhý says. “If you also had showed me how unhappy people would be, I would have a feeling that we failed.”

Benjamin Cunningham is a Prague-based writer and journalist. He covers Central Europe for The Economist, Time, The Christian Science Monitor and others. In 2014, he was a visiting fellow at the Institute for Human Sciences (IWM) in Vienna.


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