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DE RUEHPG #0683/01 3031659
ZNR UUUUU ZZH
P 291659Z OCT 08
FM AMEMBASSY PRAGUE
TO RUEHC/SECSTATE WASHDC PRIORITY 0790
INFO RUEHZL/EUROPEAN POLITICAL COLLECTIVE PRIORITY
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RUEHBS/USEU BRUSSELS PRIORITY
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UNCLAS SECTION 01 OF 04 PRAGUE 000683 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: EFIN ECON PREL EZ
SUBJECT: CZECH REPUBLIC: GLOBAL FINANCIAL CRISIS 
CONTRIBUTING TO SLOWDOWN OF ECONOMIC GROWTH 
 
REF: PRAGUE 501 
 
(U) This cable is Sensitive but Unclassified.  Please protect 
accordingly. 
 
¶1. (SBU) Summary: The Czech Republic has so far escaped the 
worst of the global financial crisis.  The conservative Czech 
banks remain relatively healthy, with significant capital and 
liquidity, despite disruptions to the interbank lending and 
government bond markets.  The global crisis is, however, 
contributing to a slowdown of Czech economic growth, mainly 
by depressing demand in Western Europe for Czech exports. 
Banks are also tightening lending rules making mortgages and 
loans harder to obtain.  The small, underdeveloped stock 
market has fallen 45 percent in the past 30 days.  Delays in 
privatizations of Prague Airport and Czech Airlines as well 
as declines in FDI are also possible (although not certain). 
Nevertheless, analysts still expect around four percent real 
GDP growth in 2008 and roughly two and half to three percent 
in 2009 (following three years of over six percent growth). 
 
 
¶2. (SBU) Believing that panic poses the greatest threat, 
Czech authorities continue to reassure the public that 
although the recent period of "extraordinarily good times is 
over" there is nothing to fear.  The GoCR has introduced a 
bill to increase the amount of deposits guaranteed by the 
state to cover 97 percent of all Czech deposits.  One of the 
GoCR's biggest concerns, however, is that international 
investors will fail to distinguish the Czech economy from its 
less healthy neighbors and pull their money out of the region 
en masse.  The USG should likewise distinguish the Czech 
economy from others in the region.  End summary. 
 
Czech Banks Remain Relatively Healthy 
-------------------------------------- 
¶3. (SBU) The Czech Republic experienced a significant 
financial crisis from 1997-2002 that cost around 20-30 
percent of GDP to fix.  The result was a consolidation of the 
banking market and fairly conservative banks.  Because Czech 
banks concentrate almost exclusively on the domestic market, 
they have had little or no exposure to U.S. mortgage-backed 
securities or credit default swaps.  (Note:  While a few of 
the banks had some exposure to Icelandic banks and funds this 
exposure appears relatively small.  A few local 
municipalities also had Icelandic investments.  End note.) 
Local analysts and government officials continue to report 
that Czech Banks have significant liquidity and are well 
capitalized. 
 
¶4. (SBU) According to Patria Finance's David Marek, deposits 
are the main source of funding for the banking system.  The 
average bank's loan to deposit ratio is under 75 percent, 
providing it with significant liquidity and making it less 
dependent on the interbank lending market or other forms of 
funding.  Banks mainly offer loans and are not generally 
involved with more sophisticated and opaque debt instruments. 
 According to Czech National Bank Board member Eva 
Zamrazilova, the level of household indebtedness is also low, 
under 20 percent of GDP, of which 12 percent of GDP is from 
mortgages.  Unlike elsewhere in the region, Czech households 
borrow almost exclusively in Czech crowns from Czech banks. 
Czech corporate debt is similarly low, while general 
government debt is only 28.1 percent of GDP.  The level of 
non-performing loans is 2-3 percent of mortgages and 6-8 
percent of consumer credits.  Although the Czechs have a 
significant trade surplus (5.4 percent of GDP in the second 
quarter), they have a modest current account deficit (1.9 
percent of GDP in 2007 and 2-2.5 percent of GDP forecast for 
2008) thanks to the high level of dividends paid on FDI.  On 
September 30, the CNB had roughly USD 37 billion in foreign 
reserves. 
 
Crisis Depressing Demand for Czech Exports 
------------------------------------------ 
¶5. (SBU) The crisis's greatest impact to date has been to 
contribute to the current slowdown of Czech economic growth, 
mainly by depressing demand for Czech exports.  The global 
financial crisis did not cause this slowdown, it was already 
occurring.  The Czech business cycle peaked in 2007, tax 
changes that went into effect January 1 blunted a growing 
real estate boom and a strong crown hurt exports, investment 
and tourism (ref a).  The global crisis, however, is 
contributing to the slowdown's severity. 
 
¶6. (SBU) The Czech economy has one of the largest 
manufacturing sectors in the EU. Most Czech manufacturer 
goods are exported.  In 2007, the export to GDP ratio was 
 
PRAGUE 00000683  002 OF 004 
 
 
70.8 percent.  In 2007, 85.3 percent of Czech exports went to 
other EU countries, 30.8 percent to Germany alone.  As a 
result, the Czech economy is especially sensitive to any 
Western European economic downturn. 
 
Credit Drying Up 
---------------- 
¶7. (SBU) Banks are also tightening their lending practices in 
an effort to maximize liquidity and protect against any 
future difficulties.  As a result, loans and mortgages are 
reportedly becoming much more difficult to obtain.  Some 
families and businesses who would have qualified for loans 
earlier this year are no longer eligible.  During the first 
three quarters of 2008, mortgage lending has fallen 15.4 
percent year on year.  (Note:  A significant part of this 
decline is attributable to a tax change that went into effect 
January 1, which increased the VAT on real estate from five 
to nine percent.  Despite the drop, mortgage lending is still 
well above 2006 levels.  End note.)  While some non-bank 
financial companies have reportedly emerged to try to fill 
the void, the shortfall in available credit is likely to be 
another drag on future growth. 
 
Stock Exchange Down 60 Percent; Not Main Source of Capital 
--------------------------------------------- ------------- 
¶8. (SBU) The Prague Stock Exchange Index has fallen nearly 60 
percent since June and 45 percent over the past 30 days.  The 
index is now at it lowest level since the Czech Republic 
acceded to the EU in May 2004.  The market has moved largely 
in parallel with world markets, not due to local 
fundamentals.  Some stocks reportedly have a PE ratio as low 
as two to one.  Stock mutual funds have experienced similar 
drops. 
 
¶9. (SBU) Although significant, local analysts warn not to 
exaggerate the markets, importance. Czech companies have not 
traditionally used the market as a major source of capital, 
preferring bank loans instead.  Few major companies are 
listed.  Ordinary Czechs are generally not invested in the 
market, either directly or through mutual funds, although 
they do have some exposure through pension funds.  According 
to the CNB's Zamrazilova, the stock market only accounts for 
around 10 percent of Czech's savings. (Note: On October 22, 
the Vienna Stock Market (Wiener Borse) purchased a majority 
stake in the market for an undisclosed sum.  The sale had 
been planned for some time and reported suitors included 
NASDAQ.  End note.)  Money market funds have also experienced 
losses of around 2 percent on average.  So far in October, 
Czechs have withdrawn a record net 10.2 billion CZK from 
money market funds, most of which has been deposited in local 
bank accounts. 
 
Global Credit Crunch May Restrict FDI, Complicate 
Privatizations 
--------------------------------------------- --------------- 
¶10. (SBU) Other potential consequences of the global 
financial crisis could include less foreign direct investment 
into the Czech Republic as the global credit crunch restricts 
access to and increases the cost of international financing. 
Some analysts have speculated that the crisis may decrease 
interest in the GoCR's planned privatization of the Prague 
airport and Czech Airlines, driving down the price or even 
prompting delays. 
 
Businesses Feeling the Pain 
--------------------------- 
¶11. (SBU) Czech businesses, especially exporters are feeling 
the pain from the slowdown of the Czech economy.  Many Czech 
businesses, especially related to the automobile, crystal, 
real estate development, and high-end tourism sectors have 
reported significant drops in orders.  The automotive 
industry is the heart of the Czech economy and accounts for 
roughly 16 percent of Czech manufacturing.  The Czech 
Republic's largest company, Skoda, temporarily stopped 
production for several days due to lower orders and, for the 
first time in its history, dropped the base price on all of 
its cars.  Several automotive part suppliers have cut 
personnel.  Last month, a major crystal glass manufacturer 
declared bankruptcy after over a century in business, 
although it was having problems long before the recent 
slowdown. 
 
¶12. (SBU) Four and five star hotels in Prague are reporting 
occupancy rates down as much as 30 percent from last year. 
While there is no real estate index, real estate developers 
are already reporting drops in property prices between 10 and 
20 percent.  (Note: the drop in occupancy rates and property 
prices is also a result of an increase in supply.  More new 
 
PRAGUE 00000683  003 OF 004 
 
 
retail property became available in 2008 than in any year 
before.  Several new luxury hotels opened this year.  End 
note.)  Retail spending was down in August for the first time 
in months.  Again, this slowdown was not caused by the global 
crisis, although the crisis is contributing to its severity. 
 
2009 Growth Still Expected at 2.5 to 3 Percent 
--------------------------------------------- - 
¶13. (SBU) Despite the challenging economic environment, 
analysts continue to expect the Czech economy to grow roughly 
4 percent in 2008 and between 2.5-3 percent in 2009 (the 
government's estimates are slightly higher.)  Inflation, 
which is currently an unusually high 6.6 percent (partly due 
to one time tax changes that went into effect January 1), is 
expected to fall to roughly 3 percent in 2009.  Unemployment, 
which has been at historic lows of around 5 percent (around 2 
percent in Prague), is gradually increasing and is expected 
to reach around 6.5 percent by the end of 2009.  Over the 
past few years, many businesses had been reporting that the 
shortage of labor, both qualified and manual, was the single 
most significant barrier to further economic expansion in the 
Czech Republic. 
 
¶14. (SBU) The Czech Crown (CZK), which floats freely, has 
depreciated slightly over the past month, falling from 
roughly 24 to the Euro on September 22 to 26.2 on October 21, 
only to rebound up to 24.7 on October 28.  Against the dollar 
the Crown has fallen from 16.2 in mid September to 19.8 
today.  Exporters and analysts have welcomed the weakening of 
the crown as a needed correction.  Earlier this year the 
Crown was the fastest appreciating currency in the world, 
reaching a peak in July of 23 CZK to the Euro and 14.4 to the 
USD, prior to a interest rate cut in August.  The CNB did not 
participate in the coordinated rate cuts on October 8, but 
did hint that a cut was likely at the November 6 CNB meeting. 
 Czech interest rates are among the lowest in Europe. The 2W 
repo rate and discount rate are 3.5 and 2.5 percent 
respectively. 
 
Panic Seen as Greatest Threat 
------------------------------ 
¶15. (SBU) Both analysts and the government believe that panic 
is the greatest threat.  They believe that the conservative 
Czech financial system and the inward-looking, conservative 
Czech population will muddle through, although as the Finance 
Minister put it, "the extremely good times are over" and the 
Czechs "will get rich more slowly."   Should there be 
significant panic and bank runs, however, all bets are off. 
Thus the government has sought to reassure the public that it 
has nothing to fear. 
 
¶16. (SBU) The GoCR has also submitted a bill to parliament 
that will increase the level of the guarantee of bank 
deposits to the equivalent of 50,000 Euro, which according to 
Finance Minister Kalousek will cover 97 percent of all Czech 
deposits.  (Currently only the first 90 percent of deposits 
up to the equivalent of 25,000 Euro is guaranteed).  Critics 
note, however, that while Czech individuals and companies 
have around 1.6 trillion CZK in deposits, the deposit 
insurance fund reportedly contains only 10 billion CZK -- not 
enough to cover all the deposits in even one of the larger 
banks.  While there have been some isolated reports of Czechs 
transferring their money to countries offering 100 percent 
deposit guarantees, this does not appear to have been 
widespread. 
 
European Ownership of Banks: Possible Channel of Contagion 
--------------------------------------------- ------------- 
¶17. (SBU) The European ownership of 97.6 percent of Czech 
banking assets also creates a potential channel for 
contagion, although fire walls exist.  All of the major banks 
are owned by European banking groups: CSOB by the Belgian KBC 
Group, Ceska Sporitelna by the Austrian Erste, Komercni Bank 
by the French Societe Generale, UniCredit Bank by the Italian 
UniCredit Group, GE Money Bank by GE, and Raiffeisenbank by 
the Austrian Raiffeisenbank.  Citibank and ING also have 
branch banks which have a small but still significant part of 
the market. 
 
¶18. (SBU) To insulate the subsidiaries from the parent 
companies, the Czech banks are limited, by law, in the amount 
of funds they can loan to their parent company at 20 percent 
of their capital (this does not apply to branch banks such as 
ING or Citibank upon which there are no restrictions).  Ceska 
Sporitelna has already reportedly lent at least 12 percent of 
its capital to Erste.  According to Patria Finance's Marek, 
the major Czech banks are sound enough financially that they 
could survive on paper even if their parent company were to 
 
PRAGUE 00000683  004 OF 004 
 
 
collapse.  Major problems at a parent bank, however, could 
cause panic and trigger a run on its Czech subsidiary. 
 
Banks Hoarding Cash; Disrupting Bank Lending and Government 
Bond Markets 
--------------------------------------------- --------------- 
¶19. (SBU) Although the banks remain relatively healthy, they 
are accumulating reserves of cash and other liquid assets to 
guard against any possible future problems.  Several IT 
providers have told us that the banks have cut their IT 
budgets significantly and are looking for other ways to cut 
costs.  As mentioned above, they have also tightened their 
lending practices, making loans much more difficult to 
obtain.  This desire to ensure maximum liquidity has also 
caused significant disruptions in the interbank lending 
market as banks stopped lending to each other for periods of 
over 24 hours.  The CNB has downplayed the significance of 
this, noting the banks rarely lent money to each other prior 
to the global crisis.  Nevertheless the CNB has stepped in to 
fill the gap.  Starting October 15, it began to permit banks 
to borrow from it for periods up to 14 days using government 
bonds or other rather illiquid assets as collateral.  Prior 
to this, the CNB was regularly removing significant amounts 
of excess liquidity from the market. 
 
¶20. (SBU) The Czech banks have also been trying to unload 
Czech government bonds viewing them as largely illiquid, 
causing a significant drop in the price of these bonds.  The 
GoCR canceled two planned bond emissions in an effort not to 
further disrupt bond prices.  The GoCR did go forward with a 
bond emission on October 22.  Despite offering a higher 
interest rate, the GoCR was reportedly able to sell only a 
little over half of the planned amount.  Finance Ministry 
officials claim that the GoCR can easily forego this income 
until early next year.  The price drop, however, is limiting 
the growth of Czech pension funds, which as a rule have only 
minimal exposure to the Czech stock market and are heavily 
invested in Czech government bonds.  According to 
Zamrazilova, many of the banks now believe they have 
increased their liquidity enough to deal with the new 
situation, and thus we may soon see improvements in the 
interbank lending and bond markets. 
 
Comment: 
-------- 
¶21. (SBU) There are a number of obstacles the Czechs will 
need to continue to avoid.  International investors could 
panic and leave the region en masse, failing to distinguish 
between the Czech Republic and some of its more economically 
challenged neighbors.  The difficulties of a European parent 
bank, could lead to a run on a Czech subsidiary.  The banks, 
desire for maximum liquidity could cause a significant credit 
crunch, leading to an increase in bankruptcies.  Should one 
of the major property developers collapse, the property 
market could be thrown in chaos.  Nevertheless, the Czechs 
believe, with reason, that thanks to their economy's strong 
fundamentals and their conservative, inward looking banks and 
people, they are well-positioned to ride out the worst of the 
storm, although growth will continue to slow and harder times 
are ahead.  More long term challenges include diversifying 
their economy away from an over-reliance on the automotive 
sector as well as the fiscal imperative for significant 
pension and health care reforms to cope with an aging 
population. 
 
¶22. (SBU) Domestically, the global crisis has yet to have had 
much political resonance.  We do not anticipate the global 
crisis to affect our relations with the GoCR, which will 
continue to remain a strong U.S. ally.  We need to be careful 
to avoid any statements or actions concerning the Czech 
Republic that could lead to the panic the GoCR is so 
assiduously trying to avoid.  To this end, the USG should 
avoid publicly lumping the Czech Republic together with the 
region's more vulnerable economies, and, if asked, should 
express cautious optimism that the Czech economy can weather 
the world's current financial difficulties. 
Graber