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Since the introduction of reforms, monetary policy played a key role in the economic stability of the Czech Republic throughout the transition.
Inflation remained surprisingly low (though relatively high in 1989 and
1990), exchange rates were relatively stable (after initial fluctuations), and external reserves stayed strong throughout the period (spurred by unusual and unexpected outside interest in the Czech Republic as the first reformer to prove its success).

What is perhaps most impressive are the obstacles Czech officials overcame in developing an effective monetary policy. First, the entire CMEA trading block was virtually dismantled. Reform and transition would be difficult even with stable trading partners. In the CMEA, all of the countries were experimenting with and adjusting prices, exchange rates and policies. It was very difficult to set monetary conditions correctly, in real or absolute terms.

Second, within just a few short years, the CSFR itself broke apart for economic and political reasons. This was largely unexpected and proved difficult in the policy making arena. As the break-up drew near, officials had a difficult time determining which policies should be enacted based upon which of many scenarios might occur in the CSFR.

Third, after finally establishing the terms of the CSFR split and negotiating a seemingly effective customs and monetary union between the two new countries, the monetary union failed miserably. Within a few months, the union caused significant drains on much needed foreign reserves in both countries and had to be abandoned.

Finally, the Czech tax system had to be completely overhauled.
Additionally, the banking system needed massive reform. Large spreads in interest rates were common and overall the banks were simply reluctant to lend on any long term basis, a major impediment to domestic investment and growth.

All of these massive changes occurred within just a few years. Throughout these developments, monetary policy remained extremely tight. At the onset of the reform period, it was at its tightest, with a minor break late in
1991, once the political economic dust had settled. Otherwise, the next monetary reprieve didn’t occur until the second half of 1993. By 1994, broad money grew at 30 percent compared with growth of 15 percent a year earlier. More important than doubling growth figures is that the economy was able to withstand this growth by 1994!

Interest rates were high throughout the period, and continue to remain high by most western standards (over 9 percent). Interest rates were not directly controlled but were subject to central bank reserve requirements and discount rate announcements. Liquidity was further controlled through regular auctions of treasury bills.

Bank reform focused primarily on establishing the legal framework for transactions between the central bank and newly established commercial banks. Weaknesses still remain in reporting and accounting and the reluctancy for banks to lend. Several commercial banks have had to come back under government control to prevent major economic problems.

Macro Economic Stability 1992 - present

By 1992, the CSFR began to show significant signs of success. Though they were in fact more disadvantaged than many other countries in the CEE, they fared well. Their export market consisted almost entirely of former members of the Council for Mutual Economic Assistance (CMEA) who were in the same transitional position as the CSFR, impeding efficient trade. Fortunately, inflation on the whole in the CSFR remained remarkably low when compared to the rest of the CMEA, as did external debt. Inflation did jump just before the CSFR breakup into the Czech and Slovak Republics. Experts suggest this occurred in part due to the fear of instability during the breakup and in part due to an anticipated VAT. As expected, in 1993 (in the Czech
Republic), inflation rose again after introduction of the VAT.

In 1993, free from its less advantaged Slovak counterpart, the Czech
Republic better targeted its economic recovery plan. The plan encompassed three main elements:

1) A balanced state budget that encompassed sweeping tax reform;
2) A tight monetary policy to reduce the inflation caused by VAT and other lesser effects (which also improved its external position for trade and investment); and
3) Moderate wage increases (adjusted to inflation) and a stable exchange rate.

This reform policy was backed by an IMF “stand by” arrangement as a precautionary measure. The IMF would assist if the Czech Republic needed financial assistance. This happened once early in 1993 and Czech officials repaid the loan before it came due (much to the delight of the IMF).

Unemployment remained remarkably low in the Czech Republic at 3 percent in
1993, while Poland’s figures (another major success story in CEE) still remain in double digits. Low, virtually non-existent unemployment certainly contributes to greater political and popular acceptance of the above fiscal and monetary policies.

Many attribute a major setback in the Polish “Shock Therapy” reform efforts to the political demands of the labor unions. The Polish President, Lech
Walesa, understood the need to keep wages low to implement the reform. But he feared for his political power and caved in to labor pressures by granting wage increases. By doing so he nearly destroyed the entire economic reform process. He claimed that had he not, the entire political reform process would have crumbled.

Czech officials didn’t face this obstacle as unemployment throughout the transition remained low. The political reform process was slightly segregated from the economic reform process. The small Czech population
(roughly 10 million) was easier to organize than Poland’s 40 million.
Regional differences were less and political factions less pronounced.
Regardless, by 1993, the Czech Republic had a very cohesive popular political support base which facilitated the economic reforms.

By 1994, foreign trade increased substantially, with much of the growth occurring between EU member nations. Tourism in Prague, now a “must see” on any European vacation, contributed to increased trade to maintain a strong balance of payments and a surplus in the current account. Though FDI by
1994 had decreased (after very high initial investments in 1992 and 1993), the

capital account maintained high inputs due to the rise in borrowing of
Czech firms (which proved even better for Czech long term economic success).

GDP began to rise slightly after a period of decline from 1991-1993 of nearly 20 percent. Privatization entered its second round in 1994 for enterprises being privatized through voucher programs. The first wave of privatization is considered a remarkable success (a model to be used farther east). As this first wave ended in 1993, the Prague stock exchange began trading and the banking system went though increased and improved reforms. The Czech Republic was a leader in the CEE in trade and investment. Economic reform efforts, coupled with the above mentioned political support, put the Czechs at the forefront of CEE success.

Industry

Industrial output by 1993 declined by nearly 21 percent compared with 1991 figures. This can partially be explained by increases in the service sector, as investment soared in service sectors and dropped dramatically in the industrial sector. Also, the industrial sector was the most inefficient sector in the former centrally planned economy and much of those inefficiencies were corrected with the introduction of market reform. Most industries produced less as consumption dropped. And they did so more efficiently as output based economic plans were no longer used.

It is significant to note that the Czech Republic does not have an industrial policy. They feel the state does not have enough information or resources and thus it is most efficient to allow the private sector complete control. Government could assist with exemptions and subventions, but the market should determine winners and losers.

However, the Czech government continued, through 1994, to bail out state- owned enterprises, mostly due to their economic (employment) and political leverage. In essence, this hurts struggling smaller, private, firms that are unable to compete with giants, let alone subsidized giants. These large industrial subsidies are all but gone in most industries today, however they still exist for politically sensitive or economically vital industries. In some cases the government reluctantly returned to subsidies as not all of the initial privatization efforts proved successful. Some large enterprises were not effectively dismantled and the resulting giant enterprises were simply too large and inefficient for the new market economy. It took several years, in some cases, to learn this lesson.

Prices

Consumer price inflation by 1993, after the initial shocks of the VAT, stabilized at 18 percent. Experts estimate the VAT added 7 percent to inflation during 1993 and an additional 2 percent can be attributed to government administered price regulations. Price regulations remained mostly in the utilities sector. Adjustments from 1994-1995 increased prices in several key areas including gas, oil, transportation, medicine and telecommunication tariffs.

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