- High economic growth and lowest EU unemployment rate
- Risk of overheating through tight labour and housing markets
- The economy is highly dependent on the European economy (mainly Germany) and the automotive and machinery and equipment sectors
- Rising protectionism could be a significant threat
Strong economic growth
When looking at economic indicators, the Czech economy is doing very well. First, it has the lowest unemployment rate of the European Union (hitting bottom at 2.3% in April 2018) with a strong participation rate. Then, the real GDP growth is broad-based and although it was higher in 2017, it is expected to remain at high level to reach 3.7% in 2018 and 3.2% in 2019. Also, the inflation rate of 2018 (2.3%) is 10 basis points lower than in 2017 and remains around the central bank’s target, after a three-year period during which inflation rate was close to 0%. In addition, the public debt to GDP ratio has been declining for years and is expected to remain low in 2018 (below 35%), well below the Euro convergence criteria. Finally the real wage growth was significant in 2017 (4%) and should continue to support domestic consumption.
Risk of overheating
Still, the Czech economy seems to face some structural headwinds. Firstly, with such a low unemployment rate combined with a declining active population (due to aging) the labour market is very tight and businesses find difficulties to hire. This puts an upward pressure on nominal wages as shown by the nominal wage growth of 8.5% in the first half of 2018. Although wage growth supports domestic demand, it also results in a decline in competitiveness compared to neighbouring countries as well as in an increased demand for foreign products through an intensification of imports, which finally affects the current account balance that is still in surplus but expected to turn into a deficit this year. After a period of appreciation after the authorities abandoned the exchange rate floor in April 2017 (cf. graph 1), the Czech Koruna was not immune from the 2018 EM turbulences despite its strong external position. Should the Czech Koruna further appreciate, it could further weigh on external competitiveness and thus on the current account balance.
Secondly, the property market is overheating as house prices grow faster than income rise. The increase in real wages has made housing more accessible to residents, which has increased the demand for real estate leading to an increase in prices in this market. Especially, in the Prague area prices have risen faster than elsewhere. As a result, household debt growth has been very rapid in recent times and is coinciding with the increase in mortgage lending, putting the financial stability of households in a risky position. Especially since the time of "easy money" seems to be over with rising domestic and international interest rates. Highly indebted household may suffer the most in the event of a slowdown in the economy or rising interest rates. The current state of the economy suggests that the situation will continue for some time.
Trade war should impact the Czech economy
Besides, some headwinds are also coming from the outside. A rise in protectionism leading to a decline in global trade poses a significant risk for the Czech economy. Indeed, the small open economy relies on external demand, mainly from EU countries that stand for 84% of all Czech exports. More specifically, Germany is its key trade partner. Indeed, more than one third (39%) of goods exports goes to Germany. The largest segment of Czech exports to their German neighbour is in the vehicle and car parts sector (e.g. vehicles motors and other parts and accessories) and represents 21% of all exports to Germany.
Other sectors like the machinery and equipment or iron and steel sectors are also tightly linked to the German economy. If it were to slow down, it would severely damage the Czech economy through its exports channels.
Now, the tariffs that the US President Donald Trump would pose, could affect some sectors beside the steel and aluminium sectors. In fact, just as he has imposed 25% on European steel and aluminium for national security reasons, he could do the same for European cars. This would do a lot of damage in the German car industry and, indirectly, in the Czech industry.
However, and it is quite paradoxical, a new burst of American tariffs against the EU could ward off the threat of overheating. Indeed, if tariffs would weaken the car industry, these would also strongly affect Czech employment given the importance of this sector. And, higher unemployment would ease the pressure on wages and thus decrease the risk of overheating.
In conclusion, the Czech Republic, as an open and export-driven economy, benefits from the strong economic performance of its trade partners. However, it shows signs of overheating, mainly through its labour and housing markets. Boosting potential growth and/or rising interest rates faster than expected could help the Czech Republic to slow down the economy that runs at breakneck speed…before trade war does it for it.
Analyst: Matthieu Depreter – email@example.com