Economic activity severely affected by the consequences of the Russia-Ukraine war
Despite solid growth in the first half of 2022 driven by the post-Covid recovery, Czech economic activity has since borne the brunt of the Russian invasion of Ukraine, the impact of which will continue to affect the Czech Republic's economy in 2023 as the country slips into stagnation mode. While industrial production (38% of GDP) remained relatively strong in 2022 due to a large backlog of orders following supply chain disruptions in 2021, industrial production is expected to falter in 2023. Driven by the automotive industry (10% of GDP, 25% of exports) and external demand, the country's industrial base will be weakened by the shortage of semi-conductors, high energy prices and the deteriorating economic outlook of the Czech Republic's main trading partners, especially Germany, which accounts for a third of the country's exports. Thus, despite the decrease in imports, the contribution of foreign trade to GDP growth will be negative. While the uncertain economic environment will also have a negative impact on private investment growth, public investment’s impact will be just the opposite, stimulated by support from European funds in the shape of EUR 7 billion (3.1% of GDP) in grants from now until 2026 under the European Union's Recovery and Resilience Facility (RRF).
Last, despite the robustness of the labour market (unemployment rate at 2.4% in early 2023) and government anti-inflationary measures to support households, private consumption will contribute negatively to the economic expansion, which has been weakened by high food and energy prices and negative real wage growth. After peaking at 18% in September 2022, inflation reached its highest level since the 1990s, forcing the Czech National Bank (CNB) to raise its policy rate by a cumulative 675 basis points to 7% between June 2021 and June 2022. While annual inflation will remain above the CNB's target of 2%, it could fall, spurred by the duo of falling domestic demand and easing energy markets.
Persistent twin deficits
The withdrawal of pandemic-related support measures was not enough to improve the Czech Republic's budget balance in 2022 as at the same time government spending remained high to support economic activity against the backdrop of the war in Ukraine. Despite the government's commitment to a fiscal consolidation programme aimed at reducing public spending by 0.9% of GDP by 2024 and reforming the pension system, the government deficit is expected to remain in 2023. Revenue increases that were made possible by the introduction of one-off taxes such as the windfall income tax from energy companies (1.1% of GDP) and banks (1.5% of GDP) will only partly offset the increase in expenditure. The latter will be largely related to household and business support measures to help them cope with rising commodity prices, with the government allocating CZK 72 billion (1% of GDP) to cap electricity and gas prices.
Despite rising borrowing costs, the government will easily finance its deficit by tapping sovereign debt markets and securing European funding under the RRF. However, while the Czech Republic's public debt-to-GDP ratio remains low relative to its peers, it will continue to rise slowly as successive budget deficits accumulate and interest rates rise. At the same time, the foreign currency share of public debt is increasing at a rapid pace given the higher bond yields on koruna-denominated debt (7.5% at the end of 2021 compared with over 20% in 2023).
The current account balance deteriorated in 2022, as the trade deficit widened due to rapidly rising energy import prices. Despite a smaller trade deficit, made possible by the drastic reduction in domestic demand and the fall in energy prices, the current account deficit is not expected to narrow in 2023. While the services surplus (1.5% of GDP) will remain unchanged, the primary income deficit (-2.9% of GDP) is expected to widen as dividend payments in the banking sector resume. While the Czech Republic has long been a favoured destination for foreign direct investment flows in the region, they have remained modest since the economic crisis stemming from the Covid-19 pandemic and will cover only a small share of the current account deficit in 2023. The considerable foreign exchange reserves will allow the Czech Republic to easily finance its current account deficit, after they comfortably covered 7.5 months of imports at the end of 2022 following CNB actions in the foreign exchange market to support the Czech koruna.
Strengthening the governing coalition in the face of war in Ukraine
Following his victory in the January 2023 presidential election, Petr Pavel, an independent candidate supported by the ruling centre-right coalition, was sworn in on 9 March 2023. His election paves the way for a closer union between the ministerial cabinet and the presidency. Since the October 2021 parliamentary elections, a five-party coalition has governed the country, led by Prime Minister and leader of the conservative Civic Democratic Party (ODS), Petr Fiala. The ODS, an ally of the Christian Democratic Union-Czechoslovak People's Party (KDU-CSL) and Top 09 in the Spolu coalition, formed an alliance with the progressive Pirate Party and the centrist Mayors Party. Together they control 108 of the 200 seats in the Chamber of Deputies. The opposition consists of former Prime Minister Andrej Babis' ANO party (72 seats) and the radical right-wing Freedom and Direct Democracy party (SPD, 20 seats). Russia's invasion of Ukraine has eased inter-party conflicts within the coalition and shifted the immediate political focus of the government to conflictual budgetary decisions. The political environment is thus expected to remain stable until the next parliamentary elections in 2025.
Czech-Russian relations were already strained before the war in Ukraine, and consequently the Russian invasion has deeply affected the Czech Republic's foreign policy. Petr Pavel has increased defence spending to the NATO target of 2% of GDP, up from 1.4% in early 2022. In addition, the Czech Republic has been heavily involved in supporting Ukraine, taking in refugees on a massive scale and providing significant humanitarian and military support.