Divided views over budget deficit and debt threat

The Czech budget deficit and overall public debt have been thrust into the spotlight. Caretaker Prime Minister Jan Fischer repeated this week he would only stay on until the middle of next year if a tax raising and cost cutting budget is passed. But while headlines warning of a ballooning budget deficit and meltdown in international confidence abound, not everyone agrees about the nature of the threat and urgency needed to tackle it.

Caretaker Prime Minister Jan Fischer was suddenly dealt a stronger political hand last week when politicians unexpectedly shrunk away from early autumn elections. The stop gap Prime Minister now found he was expected to stay on until the middle of 2010 and upped the stakes if he was to do that. One of his conditions was that Minister of Finance Eduard Janota’s proposed budget for 2010 should be accepted.

Jan Fischer, Eduard Janota (right), photo: CTK
The government is now backing around 90 billion crowns in spending cuts and tax rises to pin next year’s public deficit to around 155 billion crowns or around 5.0 percent of Gross Domestic Product. It was on course 230 billion crowns, or more than 7.0 percent of GDP.

Leaders of the two main left and right-wing parties refused to discuss a similar proposal before the summer. They thought the budget would be dealt with by whatever government followed the expected October polls. But while the polls are history, the budget is still very large and present. And the Finance Ministry is warning that a stop-gap provisional budget for next year with an expected 230 billion deficit will not only damage investor confidence in the country but could also disqualify it from pumping huge amounts in European Union funds.

But the nature of the budget deficit and overall public debt threat is itself a matter for debate. And there are many economists and analysts who believe that the Ministry of Finance has painted an over gloomy picture of both in order to help push through Mr Janota’s budget package in the face of political foot-dragging.

Pavel Mertlík
Former Social Democrat minister of finance Pavel Mertlík, now chief economist at Raiffeisenbank’s Czech operations, says the threatened 7.0 budget deficit should be put into context.

“I do not think it is a catastrophe. But I think it is not a good situation. If we look at international comparisons, Germany, for example, will this year have a deficit of 7.0 percent as well and there are certainly governments that will have higher deficits.”

The Czech Republic was not hit that badly by the international financial crisis, there were no big bank failures of threats of failures which have pushed up state borrowing and debt for example in the US or Britain.

David Marek is chief economist at Prague-based Patria Finance. He points out that international investors have not yet taken fright or shown signs are likely to because of local budget worries.

“We can see that the financial markets are not worried enough to sell Czech crowns, Czech bonds or Czech shares. I do not think the situation is critical just now. We still have time to solve it, but that is not for example in five or 10 years. We should solve it in the next four years.”

He adds that the Ministry of Finance has contributed to creating a darker picture of the deficit and debt problem by predicting hardly any economic growth at all next year. The ministry expects growth of just 0.1 percent. Patria, however, puts Czech growth for 2010 at around 2.0 percent — and this is far from the most optimistic scenario.

Mr Mertlík says his current successor is only doing his job by steering public finances according to very conservative predictions.

“Basically, I think he is rather approaching his task with a sort of standard fiscal conservatism. If we have, let’s say, a medium, negative and positive projections for next year, if you are constructing a budget you should rather take the negative one. However, according to our own forecast, we expect the eurozone to grow by hardly much faster than 1.0 percent year on year next year. The Czech Republic will grow a little bit faster by a few tenths of a percent point, so something like 1.3 to 1.5 percent. So basically all we expect is not a real recovery but rather stagnation with a lot of structural changes.”

In its parting shot last week, the government’s own economic team of advisors, NERV, highlighted a series of factors that make any predictions about even the near term economic outlook hazardous. As well as the speed of an economic recovery there are also questions whether some of the foreign financial owners of some the Czech Republic’s biggest banks will not face problems because of their exposure to risky loans. This could in turn influence local banks’ willingness to start lending again to small and medium-sized business and help boost growth.

Market confidence is also as much about sentiment and sporadic temporary factors as about the facts and figures at the hands of the international dealers in debt or currencies or the ratings agency expects who can affect how a country’s economic performance is perceived.

Mr Mertlík says it is difficult to draw a line where international investors will start finding the Czech deficit and debt situation unacceptable. In the current climate, he says even a higher budget deficit next year of around 7.0 percent would now seem okay.

“I think there is no real threshold, or rather, one can say that it is varying in time because sometimes investors are more optimistic, sometimes they are more risk adverse. Currently, the degree of risk adversion globally is decreasing and I think that 7.0 percent is for most investors okay. Not as a long-term development, but for 2010 when everyone understands this will be a particularly difficult year for public finances. On the other hand, what investors would like to see is that for 2011 and the following years the government takes steps to ensure that the fiscal situation does not continue in that way.”

As Patria’s Mr Marek point out, the Czech Republic also suffers from being sporadically cast alongside other less financially secure and stable countries in the region, such as some of the Baltic states, Hungary or Romania.

“Lots of people from developed countries looked at the whole region as a whole. So, in the worst phase of the financial crisis they simply did not compare the situation in Lithuania, the Czech Republic, Poland, Hungary or Slovakia. They saw some problems in this region and sold off all their securities and bonds in the region.”

While the situation has improved now and some distinctions seem to be made, Marek says there is no guarantee the tendency to clump Central European countries in the same bag will not return with all the damage that could do for evaluations of the Czech Republic’s risk factor.

While both top economists distance themselves from the Ministry of Finance’s immediate and gloomy budget and debt warnings. They concede that the Czech Republic faces bigger problems sustaining higher deficits and debt in the future.

With so many governments borrowing more to boost their economies and bail out problem banks and financial institutions over the last year, the overall amount of government debt has ballooned and so will the borrowing needed to service it.

The debt burden of the club of rich and developed countries in the OECD is expected to rise from 70.0 percent of GDP now to around 100 percent of GDP in 2010. Such levels of borrowing are almost inevitably going to mean that governments will have to offer higher interest returns for their debt in the future. That means a higher burden for servicing debt for those countries that build it up. Patria’s Marek again:

Eduard Janota, photo: CTK
“Our costs of servicing state debt can increase quite significantly. Next year it could be 70 billion crowns, several years ago it was half of that.”

Raiffeisen’s Mertlík warns that the market will effectively put a cap on the amount of new borrowing and debt that will be allowed after the recent surge.

“For the future, the rate of growth of global debt cannot be as fast as it was in recent years. So reforms should be everywhere and the safe levels [of debt] probably will be rather decreasing.”

Another factor in strengthening calls for lower state borrowing in the longer term is the growing burden that an ageing population will increasingly start putting on state finances and those paying into the state coffers rather than taking out. While the Czech Republic is far from alone here, it does stand out for having failed to take any meaningful steps to tackle the problem so far.

But there are also wider questions which impinge upon the budget not just for next year but for decades to come. If the country really wants to make the transition from a largely manufacturing economy into a knowledge-based and innovation economy that would take some considerable state investment into education and research. Mr Mertlík says that with current levels of tax around Anglo-Saxon levels of a third of GDP, there is room for more tax and spend to emulate the successful policies of other countries like Finland. Taxes to fund the public sector there accounts for 44 percent of GDP. But that is a big political decision.

In the shorter term, Mertlík believes the finance minister will get his way on at least part of his deficit slimming package.

“I am not sure if it will be exactly what Mr. Janota is proposing, maybe with some modifications. The second point is that the cuts will not finally be so big. What Mr Janota is offering is something like 2.0 percent of GDP. I think if it is one half of that it is a quite radical change. So I think it will be modified and the package will be smaller.”

There is, he says, still time and leeway for follow up action when the discussions have died down about the 2010 budget. But that will demand politicians take some big decisions about where the country is going. And at the moment they are on what amounts to a long-term pre-election holiday.