Interview: Zdenek Tuma, central bank governor

Financial Times: What is your view on how the country did during the crisis?

Zdenek Tuma: If you asked me three or four years ago whether I could imagine that the economy would be falling at 4 per cent per annum and I would still be happy, I would not believe you. But it's true that in relative terms the Czech economy has been doing relatively well.

It is an open economy and the exposure to the European Union and eurozone is very high, so it is not surprising that the Czech economy has been hit quite hard. But on the positive side, this is the first test of at least two institutional features of the Czech economy.

One regards monetary policy and inflation targeting and how that performed in these extreme situations. I believe monetary policy has been able to maintain credibility.

The second point is the relationship between home and host banking sectors. Multinational groups which have Czech subsidiaries – which are systematically important institutions – are incorporated here in the Czech Republic and have to comply with Czech regulations and the Czech legal framework. It is not in the interest of parent companies to withdraw liquidity and capital.

I dare to say that the relationship has been working quite well between parent companies and their local subsidiaries. If there is any excess of capital and the parent company would like to use it elsewhere, I do not see any problem. But we have always insisted on keeping enough capital at local subsidiaries so that they can withstand even the stress scenarios.

The banking sector is in pretty good shape. Without any doubt, the pressure will continue. The crisis is not over despite the fact there are the first signs that the economy has been recovering slightly. But the pressure on companies and households will continue, default rates will go up, households will feel more stress in the coming months.

Without a doubt, more provisions will need to be created. But all stress tests indicate that the banking sector and the financial sector in general should be able to go through relatively smoothly.

FT: What is the level of non-performing loans?

ZT: In the corporate sector it is going up relatively quickly, in the household sector the rise is more gradual. That is also why we expect to reach the peak in corporate loans sooner, and regarding households the pressure will continue for the whole of 2010. The point is the banking sector has enough capital to withstand the pressure without any government intervention.

FT: Did you feel that outsiders were not differentiating among the various parts of central Europe during the crisis?

ZT: It was not only the media. I would also blame some international institutions, including the International Monetary Fund and the European Bank for Reconstruction and Development. Unfortunately, these institutions were speaking about the region of central and eastern Europe and didn't differentiate among the different countries.

I believe today people differentiate better than at the height of the financial crisis. Without any doubt, the position of Poland and the Czech Republic is better than, for instance, Latvia and some others.

There is a number of specific features of the Czech economy, one of the most important is a low foreign exchange exposure – Czechs did not borrow in foreign currencies. The second one certainly is that the banking sector can finance its activities primarily from domestic sources. And unlike some other central banks, we did not have to pump any liquidity into the system.

In the end, the banking sector is a net creditor not a net debtor, which contributes to the stability of the financial system.

FT: What is the situation regarding inflation, and is deflation a serious worry?

ZT: We reached negative inflation in the past – in 2003 – but at the time we knew it was temporary. But today's situation is somewhat different.

This time, there is a concern that the economy could end up in deflation. The baseline forecast for headline inflation should be close to our inflation target of 2 per cent in 2010. The increase will be fuelled by an increase in value added tax.

Looking at inflation without the influence of taxation, it would be relatively close to zero. Nevertheless, we expect it will go up at the end of 2010 as well. It is true that for most of 2010 it will be close to zero, so that concern about deflation is certainly relevant.

The consensus is that there are risks on both upside and downside. Ultimately, however, I would not be overly concerned about deflation. After all, our interest rates are still relatively high – 1.25 per cent – so I do believe that there remains some room for manoeuvre.

FT: What is your view of the fiscal situation?

ZT: The problems are big and the outlook is not very good.

For at least 10 years, commentators, analysts and some politicians have been saying that the development of public finances is not sustainable in the long term, that there is a growing structural deficit.

The fiscal situation stabilised between 2005 and 2007, but that stabilisation was primarily due to higher revenues than expected and very robust growth of the Czech economy.

Back then, we had already pointed out that when the boom was over, the problems would bounce back. The fact is that the structural deficit is higher than it was in the past. The share of mandatory expenditure is very high. The social system is too generous for the present state of development.

Everybody seems to accept that the pension system is not sustainable: that it requires changes such as the postponement of the retirement age; that the ratio of pensions to wages should be lower in the future, etc.

Without any doubt, the stabilisation of public finances today is not feasible without using both sides of the budget, which means higher taxation as well as expenditure cuts.

FT: Will the finance minister's plans to reduce the deficit next year affect economic growth?

ZT: We are one of the first countries to address the issue of an exit strategy. We must be one of the first, because unlike some AAA-rated countries such as France and the UK, which are able to borrow for a longer time with higher deficits, I don't think we would be able to borrow at reasonable costs with a budget deficit of 10 or 15 per cent gross domestic product and debt at 60-70 per cent of GDP.

Our thresholds are lower, so we have to be more disciplined than some of the bigger boys. It is quite rational of this government to slam on the brakes. This is a reasonable trade-off to rein in the ballooning deficit. The impact on the economy will not be fatal.

We have gone up with our forecasts for real GDP growth: for 2010 it is seen at 1.4 per cent and at 2.2 per cent in 2011. I believe we will maintain higher economic growth than more developed countries in the EU over the medium term, by 1 or 2 percentage points.

FT: What is your view on a time frame for euro entry?

ZT: From the economic perspective, monetary policy cannot accelerate output growth over the longer term. There are pros and cons to adopting the euro, but my long-standing view has been that in the end it is a political decision. But given the exposure of the Czech economy to the eurozone, it is a must for the Czech Republic to join, sooner or later.

At the moment, joining is complicated by the fiscal situation: obviously we don't comply with the Maastricht criterion on the budget deficit.

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