Surgical Manoeuvres

Ministers of the caretaker government were assigned some homework last week: to go through their accounts and find several billion crowns that could be saved in the collapsing budget. Even though the politicians have so far pretended to not be engaging in this, they will have to find ways to save dramatically after the elections. Debts are spinning out of control, and the state bankruptcy of the Czech Republic is becoming possible.

Vladimír Špidla

was a nice, pleasant labour minister and later prime minister. He did not shout or swear or pretend to know what was best all of the time. He did not holiday with the lobbyists. His subordinates considered him a hard worker and passionate debater who was capable of listening to others at long meetings. Put simply, he was a politician of the sort that come few and far between in the Czech Republic. Let us hope, nonetheless, that nobody like him will lead this country again. The answer of this ambiguity can be found in an analysis of the numbers that make up the state budget. That is where Špidla's legacy is so strong that, because of it (though not only because of it of course), Czechs are in the same trouble that the Hungarians are staggering in and the Latvians can be found in a more advanced state of.

The problems are the threat of state bankruptcy and the need for the drastic cuts that, in the case of Latvia, can be found in lowering the salaries of state employees by 50%. The Czech Republic is still significantly better off; economists, however, warn that, unless politicians turn a switch, the Hungarian or even Latvian route will be inevitable. "The speed of the growing debt is terrifying: Nobody expected it to go this fast," says former ČSSD Finance Minister Jiří Rusnok, a member of the National Economic Council (NERV). The Czech state currently owes CZK 1.25 trillion, more than the entire budget for this year, to various international institutions, its citizens and investors. This year, therefore, some CZK 46 billion – half of the education budget – will be used to pay off debts.

What can be done? To understand today's "Czech problem" let us stay in the office of Vladimír Špidla for a while. He inscribed his name onto today's situation in two ways. First, as a ČSSD shadow minister and social affairs expert in the 1990s, he refused to admit even a hint of any problem. Ageing population? Nonsense. Social benefits too generous? We can make do. When Klaus's cabinet endorsed a later retirement age in 1995, Špidla promised to withdraw if he became minister. When Klaus' cabinet pushed through the direct payment of child bonuses and other social benefits, Špidla said again that he would cancel that as the benefits were "children's entitlement".

This was not only about the social reforms: Špidla and his politics left an imprint on public finance that is still causing headaches. Until 1998, Klaus' centre-right cabinets used to push through (though not always successfully) well-balanced budgets, and a law enforcing these was even considered. With the ascent of the ČSSD into the cabinet, an utterly new approach to public finance was introduced: Each state budget leaves a debt of dozens of billions of crowns. Špidla as prime minister geared up and ended up with the debt of CZK 100 billion, something unheard of before. The last month of the ČSSD-Christian Democrat- Unie svobody reign in 2006 ended by a 30% increase in social benefits that represented an extra CZK 15 billion in the budget.

In the last seven years, the volume of company and household loans doubled and the politicians, instead of following the economic principle of lowering the debts and going against the tide in order to prepare the country for more sparse times, continued to feed this boom by placing the burden on the state coffers (national debt grew on average by 13% per year, while the economy increased only 6% in the very best span). It was only after 2006, in Topolánek's cabinet, that the trend turned toward moving the state debt back to budgets that could comfortably ensure the country's eurozone accession. We can see today, though, how big a role exceptional growth played in this as the current global economic crisis is bringing the idea of healthy finances down again. We can suddenly see that Czechs have practically no public finance reserves and that high social spending could only be kept through the combination of debts and the exceptionally good conditions of the European economy and ensuing investments. "I do not expect a similarly favourable situation to return any time soon," Rusnok said.

From where to borrow?
The slump in public finances is remarkable, particularly in contrast to the way Czechs grew richer in the last 10 years. Topolánek's cabinet, for example, managed in 2008 almost double the money (in nominal value) that Miloš Zeman's cabinet did 10 years ago. What did we get for that? In broad terms: It was mainly spent on agricultural subsidies, dozens of kilometres of new motorways, social benefits and the police. Science funding also grew slightly. Education and defence were left out.

The proportion of the so-called mandatory expenses in the budget grew alongside the debts. Those include the aforementioned social benefits and state employees' salaries. As a result, the state is paying out 82% of the budget on mandatory expenses this year and that significantly curbs political decisions about investment. The percentage of mandatory expenses grows every year, just like the debts do. There is the realistic threat that within several years the state will collect taxes only to cover debt payments, public servants' salaries, and health insurance for children and pensioners, and distribute the rest in social benefits. All that right up to the point when the Czech Republic, just like Latvia now, would stop being trustworthy enough to get loans with reasonable interest rates abroad.

How far are we from such a moment? According to Jiří Rusnok, the "turning point" that will change the Czech path into the Hungarian one cannot be determined in advance. The stumbling block is the trust of the financial markets, which is rather unpredictable, as well as the Czech political determination to address the situation.

Before, for instance, Latvia got into its current problems, its government debt was one of the lowest in Europe and the country was described as the star among post-communist states. "A number of factors can play a role here: the sentiment on bourses, the political situation or, for example, a bad rating from international agencies," said Pavel Kohout, another NERV member and a former advisor to both right- and leftwing finance ministers. "But what is certain is that we cannot do without more loans now. The system would collapse without more loans."

Bond is the key word in this game. More specifically: 10-year government bonds that are traded on stock exchanges all around the world. Other countries also solve their problems with a shortage of money by issuing bonds. However, like trading in shares, this game involves certain risks as well; the key question is at what price will investors buy Czech bonds. And the present situation, actually, is far from perfect. "Dozens of countries are currently putting their bonds onto the market owing to the crisis," Kohout said. "There is a surplus of bonds, and it is hard to predict what happens with the Czech ones. The German and French ones may appear as a much more certain investment." He added that backers are presently only willing to lend money for Czech debts at high interest. The rate has recently climbed from below 3.5% to the current 5.5%, and accrual alone pushes the Czech government debt further up.

In the aforementioned Latvia, interest rates also gradually soared to 5%, then to 7% and to 9%, and shortly after that remained fallow. "In a certain instant, investors completely lose confidence that a troubled country can pay its money back and they simply do not want its bonds any longer," said Aleš Michl, an analyst with Raiffeisenbank who runs the verejnydluh.cz website, where Czechs can follow the rise in government debt (it grows by CZK 6,500 per second). The consequences are fatal. "Such a country then loses confidence in the eyes of other investors and businesses as well, which means that its development slows for many years." The only salvation then is a loan from the International Monetary Fund or – as partly happened in the Baltic region, Hungary and Romania – from the European Union. Such a way does not mean any victory for the nation's self-confidence because this saviour requires compliance with strict rules.

Choosing between taxes or allowances – or both
"It is clear that the jig may be up,"Jiří Havel said, shrugging his shoulders. "One day simply the innkeeper comes and does not give us anything on credit." This man, who is now responsible for the Social Democratic economic policy, looks relaxed and natural. It might also be because the ČSSD's chief economic expert will soon be heading to Brussels as an MEP. But before he leaves, he says, he wants to complete one important mission: to make the Czech budget ready for tough times. "Nobody is underestimating it any longer," he said.

The information available, however, so far does not look much like a solution to the budget problem: The Social Democrats have come up with a proposal that the opposition and commentators have described as a "fundamental threat" to the Czech budget and so supplied estimates upon its release predicting several billions of crowns in additional expenditures. The Social Democrats are proposing to contribute as much as CZK 3,500 to people who commute to work; give pensioners an extraordinary 13th pension increase, to the extent of CZK 2,500; and pay companies up to one-fifth of costs incurred for job creation. They are also proposing state guarantees for mortgage loans and relief for businesses that don't cut jobs.

The list looks dramatic, but the measures might cost less than they seem. The extraordinary pension is a symbolic one and should actually serve as a substitute for the consumer price index. Contributions for new employees and for commuting – yes, but only under strict conditions and only for those on whom the state is going to save money on by not having to pay unemployment benefits. "In the end, it means no extra costs," Havel said, and he may even be right. Apart from that, he makes it clear that his party is planning no additional pouring of money into social benefits – as it did before the 2006 elections.

The proposal, however, is not going to make any cuts in social benefits either. So how would the ČSSD fix the giant hole in the state coffers?

"We want to choose solely the method of tax hikes,"

Havel said.

"It should be only a moderate increase, but almost all rates will have to be revised."

Nonpartisan economists would raise the objection that higher taxes would make investors angry and hamper economic growth, and so would not bring in extra money. The ČSSD claims the opposite, and that's where the debate ends for the moment.

The ODS and TOP 09 have not revealed their election platforms yet, but have admitted cuts in social spending. "Taxes will not rise: It is possible to save money on the spending side," said former Labour and Social Affairs Minister Petr Nečas (ODS). "We have to solve problems solely on the side of expenditures," TOP 09 economic leader and former Finance Minister Miroslav Kalousek said. Both parties then gave lists of other measures that more or less copy recommendations by economists – across-the-board reduction of spending at individual ministries and the revision of some social benefits and state subsidies. They did not mention any specific steps for the time being. Both Kalousek and Nečas said that the details would become clear in September when the parties release their election programmes.

Commenting on this, independent economists say that the post-election condition of the Czech economy will be the deciding factor in further steps. If it is as bad as it is today, politicians will have to resort to both tax hikes and extensive budget cuts. And perhaps even crisis solutions will be put in place then. "Czech budgetary rules do not comprise any safeguards against rising debts,"Jiří Rusnok said. He is therefore proposing a law under which, once the debt reaches a certain degree (for example 55% to 60%), the budget would be approved based on crisis rules. It would mean for example a defined level of debt that future budgets would be forbidden to have written into them. The Finance Ministry is considering applying the British "golden rule" model, under which deficit money could be used for investment only, but not for mandatory expenditures. There are simply more ideas, and their implementation will depend on the degree of recession and on the strength of the government that will emerge from the elections.

WHERE TO CUT
Pensions are best suited for cuts as they make up the largest chunk of the state budget: CZK 336 billion this year, more than a quarter of expenditures. However, it's a politically touchy issue; the number of pensioners is high, retirement pay isn’t particularly, though, and those with solid incomes face a notable financial plunge once they've left the workforce. Not even the wildest reformer, then, dares to consider pension reform. No doubt, it is essential, yet it is merely meant to prevent a collapse 20 or more years from now, when the age of the Czech population is due to shift dramatically. It won’t generate savings right this moment – when the government needs them. Theoretically, changing the retirement age could immediately generate savings, though, politically, this is unthinkable. Even the latest relevant changes approved last year are due to come into action only in 10 years' time.

The regular valorisation of pensions, on the other hand, has the potential to generate savings. If politicians were to, for instance, agree to increase pensions by no more than the rate of inflation – the minimum level set by the legislature – in the coming years, they would save billions of crowns annually.

Social benefits (around CZK 80 billion) and the wages of state employees (around CZK 170 billion) definitely offer possibilities for curtailment, but they aren’t particularly grand. Child benefits, which became a symbol of social lavishing during Klaus’s tenure as prime minister (in that they were paid out to the rich), today add up to mere CZK 5 billion – hence, not even one-tenth of the stack of money for social support.

Cutting other benefits would also generate scant savings. For instance, ditching maternity grants could generate about CZK 2 billion, and those for the poorest could save up to CZK 10 million more. On the other hand, much can be saved on money paid for maternal or paternal leaves. MPs introduced this benefit prior to elections three years back; at the time, it was regarded as the appropriate appraisal for parental care as done in the west. But it also costs the state CZK 29 billion a year.

The same goes for benefits for people with disabilities – another welcomed change three years ago. The concept of paying benefits directly to the end users to allow them to independently select social services costs the state more than CZK 15 billion. Meanwhile, another CZK 7 billion in subsidies, said to be requested by regional lobbyist, trickles into institutions. State officials view this as another sector open to cuts by tightening payouts and partial converting them into coupons for social services (instead of purchasing care, receivers of benefits often keep the money to add to their pensions).

Resistance from the public is likely in this case as well. But, probably, any changes will meet a public protest, and it is solely up to the politicians’ courage to overcome this antipathy, because savings on mandatory expenses will require changes in legislation. Why not, for instance, cross off the benefit for building savings that today drains nearly CZK 15 billion from the state budget? Or why not trim the retirement benefits (CZK 2 billion this year) of those who have left the police ranks and are still active?

Within the clerical machine, experts have been pointing to possible savings for years. Estimates of potential administrative slenderizing sit between 10% and 20%. However, deeper reform, including audits of the needed and not-needed bureaus, would have to precede such tightening. It also wouldn’t be realistic to expect tens of million in savings, as the administrative workforce comprises a thin slice of state employees. By far the largest chunk belongs to teachers, who have been, in the long term, undervalued in their wages.