Cablegate: Czech Republic: Global Financial Crisis

DE RUEHPG #0683/01 3031659
P 291659Z OCT 08



E.O. 12958: N/A


(U) This cable is Sensitive but Unclassified. Please protect

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

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

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

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
--------------------------------------------- ---------------
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

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

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

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.

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

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.

© Scoop Media

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