Is the Czech Economy Running Out of Steam?


Long stereotyped as a giant assembly plant for foreign manufacturers, Czechia is aware of the need to upscale its economy and invest in higher added-value sectors. But the richest country in Central Europe may have missed its chance to shine.

The Czech Chamber of Commerce sounded the alarm bell as the summer break came to an end. In a study published at the end of August, the business lobby group said that after exhausting previous growth drivers that had been boosting the country’s wealth since the 1990s, Czechia was now facing a moment of economic reckoning and was bound, if nothing was done to correct the trajectory, to fall into the so-called “middle-income trap”.

Having been unable to transform its labour-intensive and relatively low added-value manufacturing sector towards more innovative, higher-value production, the Czech economy faces the risk of losing its competitive edge, falling into long-term stagnation, and suffering from a sustained slowdown in wage growth and living standards, the report warned.

“This discussion has been there for years,” Krystof Krulis, a research fellow at the Prague-based Association for International Affairs (AMO) and co-author of a paper on the topic, tells BIRN. “But warnings like this are important to remind politicians of the problem.”

While admitting the concept of the “middle-income trap” is more commonly applied to Asian economies, Krulis insists “it does touch on something important about the path Czechia needs to take”.

“We’re really talking about the long-term transformation of the Czech economy,” he warns.

Low-hanging fruit

Coined in 2007 by economists Indermit Gill and Homi Kharas when examining East Asian countries, “the middle-income trap refers to a situation whereby a middle-income country is failing to transition to a high-income economy due to rising costs and declining competitiveness,” the World Bank says – a definition that might ring true to anyone following Czechia’s recent economic woes.

And while including the Czech Republic, whose GDP per capita stands at about 87% of the EU average, as “a middle-income country” is somewhat problematic, according to Krulis, economists agree the concept can prove useful in helping to diagnose the long-term ills of the Czech economy.

For the past decades, Czech prosperity and convergence with Western living standards was based “on massive [foreign direct investment] inflows from abroad, building export-oriented capacities, especially in the manufacturing sector benefiting from an initially cheap and available labour force, an advantageous location, openness to external trade, and overall macroeconomic stability,” Petr Kral, executive director of the Monetary Department of the Czech National Bank, tells BIRN.

The country’s EU accession in 2004, with its attendant large inflows of funds and profitable customs-free export opportunities, further boosted Czech growth, while cementing its dependence on exterior factors, especially neighbouring Germany’s own manufacturing industry.

“This growth model has become exhausted over time, the low-hanging fruit has been collected, and there is a risk that the country may get caught in the middle-income trap,” Kral argues, further warning against inflating the “miraculous” nature of Czech economic growth over the past 30 years.

“While the Czech Republic has converged towards more advanced countries in the long term, it still lags significantly behind them,” he points out, noting that the country’s ability to reach the level of other countries in terms of GDP per capita was partly driven “by the underperformance of southern European countries” after the 2008 financial meltdown and 2012 European debt crisis.

“At the same time, the growth of the Czech economy has not been that exceptional in terms of Central and Eastern European countries,” he explains.

Over the past decade, the Czech Republic’s annual real GDP growth averaged 2.2 per cent, below Slovakia’s 2.3 per cent and far behind Poland and Romania’s at 3.8 per cent and 3.5 per cent respectively.

Losing its edge

Relying for too long on its previous growth drivers also made the Czech economy more exposed to the external shocks experienced since 2020, especially the COVID-19 pandemic and war in Ukraine.

The Czech Republic’s all-mighty export-driven, Germany-dependent and energy-intensive manufacturing sector has made it particularly vulnerable to the global production and supply chains disruptions of the past three years, as well as to the recent energy crisis.

“The economy’s real gross domestic product has not yet reached the pre-COVID level of late 2019, making the Czech Republic an exception within the EU,” Kral says, forecasting a return to economic growth in 2024 after stagnation, or a possible recession, this year.

With growth slowly picking up from next year and inflation already slowing, the Czech economy could soon recover from the current slump. But looking at the bigger picture, the trap might already be closing, prompting uneasiness among business and financial circles.

Last year, citing labour shortages, a relatively small market, higher wages and the currency volatility risk, the Czech National Bank warned that the country was losing its attractiveness to foreign investors, many of whom are now seeking greener, bigger and cheaper pastures in other CEE countries.

“It doesn’t make much sense [for foreign investors] to locate new plants here when they would have a hard time finding labour or would have to pay significantly higher wages,” confirmed economist Veronika Hedija, signalling a shift from just a few years ago when Czechia was still considered the most attractive and competitive economy in the region.

In its report, the Czech Chamber of Commerce assessed that the Polish economy could plausibly overtake its neighbour to the south in the next few years, highlighting just one of many scenarios that could put Czechia in a weaker position to compete with larger markets in the region.

No silver bullet

Czech authorities have long grappled with a conundrum that consecutive crises have, until recently, largely pushed into the background.

Talking in front of a cohort of Czech economic diplomats in June, Foreign Minister Jan Lipavsky noted that the prosperity of the Czech Republic depends on “our ability to create products, services and software with high added value”, moving up the European and global production chains from assembly to design, diversifying export markets and making the most of the green transition.

A few months later, in early September, Prime Minister Petr Fiala unveiled the “Restart Czechia” program aimed at modernising the Czech economy within the next ten years and increasing investments in high added value innovative sectors – an initiative somewhat reminiscent of the “Industry 4.0” (Prumysl 4.0) project adopted by a previous government in 2016.

“Transport, energy infrastructure, nuclear power, lithium, chips and trends in information technology: these are six concrete fields that have enormous potential to change our country,” Fiala listed. “A major part of our strategic investment must go into these areas.”

Indicative of the government’s efforts not to be left behind in high-growth sectors, “the fact that the Prime Minister presented his vision is partly tied to the fact that the Czech business community is very worried about the state of the Czech economy,” political scientist Jiri Pehe surmised on Czech Radio.

“I think that top businessmen in the Czech Republic are really afraid that the economy is stalling, not just now, it may be a long-term development, because there is really no vision for the Czech economy,” he said.

With “no one-size-fits-all solution” to overcoming the middle-income trap, the Czech Republic will have to come up with its own formula to support short-term growth in a volatile economic context while unlocking new potential for the future.

From automation and digitisation to the green transition, biotechnologies or cybersecurity, prospects abound. It’s money, however, that could prove scarce as the government finalises its new austerity package, especially as such sectors commonly need sizeable upfront investments and a specialised workforce, both of which appear to be currently lacking in Czechia.

From a strong industrial tradition to a qualified workforce, near-full employment and relatively healthy public finances, the Czech Republic still has more than one string to its bow to face its uncertain economic future with mild confidence.

But for experts, who point to the low levels of public and private spending in R&D, innovation and education as the main culprits, the main question remains as to whether authorities will show the strategic foresight – and political will – to open the next chapter in Czechia’s economic development.

Source : Balkaninsight