The Czech banking sector is expanding. Total assets of all commercial banks in the Czech Republic grew by some 30 per cent in 1995-96 (to reach roughly US$74 billion as of 30 June 1996). Deposits by clients increased by 25 per cent (to US$34 billion), total credits and loans to clients by 15 per cent (to US$35 billion). Total equity of commercial banks increased by approximately 24 per cent and reached US$2.8 billion.

Rectified by the inflation rate, the real annual financial growth of the Czech banking sector can be estimated at nine to ten per cent.

The total number of banks at its peak at the beginning of 1995 reached 59, of which seven banks (including specific institutions like the Consolidation Bank or the Czech Export Bank) were partly owned by the State. The remaining 52 fully private banks include 11 with minority foreign ownership, 13 with majority or full foreign ownership and ten branches of foreign banks. All banks were established as universal banks, and a few of them developed a specialised profile.

Behind this statistical picture of seemingly unchanging trends, strong features, signalling a step from a phase of quantitative expansion into a completely different phase of structural ripening, started to emerge. While the years 1990 to 1993 epitomised a baby-boom period and a time of extensive growth, sometimes accompanied by inaugural entrepreneurial euphoria, the years 1995/1996 turned into a period when the banking sector began to be confronted with tough efficiency challenges. Some banks had to face constraints on the access to resources, weaknesses in their credit portfolio and stronger competition on the financial market. Also the expansion in lending, prompted by major and small privatisation, started to take its toll smaller banks. Twelve banks were visibly affected by this process, mostly in the course of the last two years. Seven of them disappeared from the market. Some of the banks found solutions in mergers with bigger partners.

The share of banks, which in one way or another signalled difficulties in the past two years, in total banking business is roughly ten per cent, the total sum of losses is in the order of two to four per cent of total assets. The sector as a whole proved to be strong enough to cope with this uneasy period.

The experience of the last two years prompted efforts to improve the efficiency of surveillance over the financial market, both on the side of banking and capital market supervision, and encouraged attempts to improve overall 'market discipline'. The increasing involvement of banks as players on the capital market underlined the need for a scheme able to measure and regulate risks in the securities business.

Two other factors played a significant role in the development of the banking sector. Almost five years after the introduction of the internal-convertibility regime of the Czech koruna (CZK), a new Foreign Exchange Act, effective from 1 October 1995, established legally the external convertibility of the CZK. This was followed by an official application by the Czech Republic for admission to the European Union. Particularly this latter move strengthened efforts to adapt to the legal and regulatory regime of EU financial markets and to adjust to the full impact of the competition of West European banks.

At the beginning of 1996 an intention was revived to accomplish the privatisation of the few remaining Czech banks in which the State was a co-owner. Withdrawal of the State from its position as a significant shareholder in these banks is going to be a step-by-step process and the State will very likely wish to retain at least a minority stake in some of these banks.

The macroeconomic framework, in which the commercial banking sector operates, has been characterised by the completion of all relevant privatisation waves. A renewed growth of industrial production and labour productivity improvement resulted in an increase in the gross domestic product and a more dynamic investment in industry. Also important was an inflow of direct foreign investment. Domestic demand was revitalised considerably. The drawbacks have been inadequate liquidity and lack of capital in enterprises. A worsened balance of payments, particularly a high trade deficit, were further unfavourable features. An optimistic prediction of the inflation rate decreasing to eight per cent did not materialise. The 17 per cent growth of nominal wages was, however, sufficient to result in a pronounced increase in real wages, which increased domestic demand and favourably influenced savings by households. Domestic currency deposits outpaced in growth the foreign currency deposits. A relevant factor behind this is a continuing interest rate differential between the CZK and foreign currency accounts, to the benefit of CZK deposits. A tendency towards short-term deposits also continues. The domestic capital formation in relation to high capital need is, however, low and foreign capital keeps its important role in financial sources.

The unemployment rate is low (around three per cent), with a large proportion of labour force released from industry and agriculture being absorbed by the tertiary sphere.

A slight deficit of the State budget emerged as a new element in 1996, despite more optimistic original expectations. The main reasons for the deficit are inadequate tax returns, an exclusion of privatisation revenues from budgetary sources and, to a certain extent, the costs of the consolidation of the banking sector.

External financial relations are influenced primarily by a growing trade deficit, which is estimated at US$5.2 billion in 1996. Its major cause is a slow-down of growth of exports (five to six per cent in constant prices), and high import growth. Export efforts, oriented towards developing countries, and engineering exports are supported by export insurance, including the subsidising of insurance tariffs. Other kinds of support, however, are below current requirements, while the principal incentive - an undervalued CZK - has already exhausted its potential.

Foreign exchange reserves, which thanks to an inflow of foreign capital (direct investment and short-term capital, placed on the secondary market) into the Czech Republic, reached a record level of US$15.6 billion (in the whole banking sector) or US$12.6 billion (in the Central Bank - as of 30 April 1996), are now relatively constant and have undoubtedly a favourable effect on the stability of the CZK exchange rate, which remained stable even after an extension of the exchange rate fluctuation span from +/- 0.5 per cent to +/- 7.5 per cent.

In an effort to curtail inflationary pressures, the Central Bank took a number of radical steps in mid-1996: the discount rate increased from 9.5 per cent to 10.5 per cent and the Lombard rate from 12.5 per cent to 14 per cent. Most perceptible for commercial banks is an increase in the obligatory minimum level of reserves from 8.5 per cent to 11.5 per cent. This measure, aimed primarily against credit expansion, may also be viewed as a step towards a strengthening of the banking market.

Dr Ivan Angelis was born and educated in Prague. He graduated from Charles University (Law) and from the Technical University of Prague (Economics). His professional career includes posts in the sector of international trade, international economics and finance. His experience includes trade negotiations in GATT, activities in the UN Economic Commission for Europe, UNCTAD, UNIDO and others. He was appointed Secretary-General of the Association of Banks in 1992. Before, he was managing director of the Research Institute for Foreign Economic Relations. He is an author of numerous articles and co-author of three books on international economics.