Important economic reforms have been implemented since the currency crisis of 1997, gradually improving conditions for doing business. Attracted by privatisation, tax incentives and prospects of EU accession, large amounts of foreign direct investment (FDI) have flowed in, helping to modernise the productive capacity. Nevertheless, the Czech economy has remained burdened for longer than other transition countries with a large number of poorly performing enterprises, suffering from weak corporate governance, which had been kept alive by soft loans from state-dominated banks. The major challenge in this context is to overcome the dualism between the prospering FDI sector and the still considerable part of Czech industry in need of further restructuring. Broadening the FDI boom requires the reallocation of resources -- mainly labour -- to more productive uses. In order to prevent unavoidable layoffs from turning into permanent withdrawals from the labour market, and to preserve the inherited high participation and employment rates, new reforms should improve the demand for labour and strengthen the incentives to take up work. This requires a market framework that facilitates large-scale reallocation of labour among firms and sectors through low hiring and firing costs. On the macroeconomic front, the Czech Republic faces the difficult task of rebalancing the policy mix so as to create conditions for greater financial stability and avoid a loss of external competitiveness through excessive wage increases and overshooting exchange rates. A substantial fiscal adjustment is needed, first of all to claw back the excessive fiscal loosening over the period 2002-03, but beyond that to deal with social-security spending pressures and to create room for tax cuts and growth-enhancing expenditure increases in areas like infrastructure investment, education and business-relevant public services. The probable Czech entry into the European Union next year will strengthen the framework for conducting broad ranging economic reforms, but also further increases the need to stay on such a reform path.

As with other countries in the region, the Czech Republic continues to face far-reaching structural transformations, which bear directly on macroeconomic performance. The economy has not yet reached a level at which a business cycle is firmly established. Potential output is not yet following a regular trend, but continues to reflect to a larger extent the impact of restructuring efforts in the wake of legal reforms and ownership changes.

A well-established inflation-targeting regime co-exists with a budget stance that has loosened beyond automatic stabilisers. This imbalance in the policy mix has unwelcome consequences for Czech macroeconomic conditions and must be resolved by a closer co-operation of monetary and fiscal policy. Monetary conditions have tightened considerably through till mid-2002 as a consequence of strong currency appreciation. The pace of appreciation was partly19 due to the government dissaving being in part financed by privatisation sales to foreign investors. As the pace of appreciation went beyond its recent average, in order to contain the mounting shocks on competitiveness and output, monetary and fiscal authorities agreed to moderate appreciation pressures by slowing down the conversion of privatisation proceeds and to convert at least part of the proceeds directly in the CNB, out of the foreign exchange market. This agreement softened somewhat the monetary conditions from the second half of 2002, but the fiscal drift continues and financial market tensions -- which would normally result from crowding out -- have only been avoided up to date because of subdued domestic business investment. The conflict between ambitious monetary objectives and a large structural deficit is not sustainable, and a more radical fiscal consolidation than currently envisaged is needed.

The responsibility of the state to provide free, universally accessible and high quality health care for the entire population enjoys an even higher social and political consensus than observed in other OECD countries. A dense network of general practitioners, hospital and ambulatory services, maternity care and generous distribution of drugs and medical aids, all funded by public resources, provides wide health coverage. This has helped to achieve a remarkable improvement in the health status of the population since the early years of transition, at a pace unmatched in the region with the exception of Slovenia. However, cost pressures generated by the system threaten its sustainability. Policymakers’ understandable efforts to make state-of-the-art medical technologies accessible on a universal basis, the future impact of the ageing of the population on demand of services (and its structure), and pressure from health professionals and pharmaceutical companies to align their wages and prices with those in Western Europe are the main forces threatening the fiscal stability of the system.

The first chapter presented recent economic developments, highlighting the ongoing dualisation of the economy, the relatively slow pace of productivity advance and the continued high employment rate. If the current trends continue, the OECD medium-term baseline (scenario I) described in the same chapter implies a modest improvement in living standards over the next five years. There are significant risks associated with this scenario that could easily generate an alternative outcome characterised by a more rapid productivity growth but also high and persistent structural unemployment (scenario II). A resolute pursuit of structural reforms advocated in this chapter would probably result in less spectacular productivity growth but higher and more sustainable employment and living standards (scenario III).