Fiscal consolidation and reduction of borrowing needs in the pipeline for the Czech Republic

The June state budget result showed a reversal of the negative trend for the first time this year. The improvement is higher than we expected, but still this year's budget will be a risk both ways for Czech government bond (CZGB) issuance. The story remains the same from the beginning of the year. While spending is on track for the Ministry of Finance (MinFin), tax revenues are lagging. In detail, we see that personal and corporate income tax is in line with the plan or even slightly higher. On the other hand, indirect taxes such as VAT and consumption tax are lagging behind the plan, confirming the slump in domestic demand in recent quarters.

Looking ahead, we can expect the deficit to deteriorate again in July and then improve in August and September due to the incoming historically record dividend from the state-owned energy company and the windfall tax. So the picture will be mixed for the rest of this year. We leave our deficit forecast for this year unchanged at CZK320bn, versus the MinFin's plan of CZK295bn. This, together with the surplus of other sectors of the public finances, should result in a public deficit of 3.8% of GDP. However, we may still see some changes here from the government, which wants to assess this year's state budget during the summer and perhaps introduce some savings measures for this year.

For next year, the government recently approved a CZK235bn state budget deficit and is targeting a public deficit of 1.8% of GDP, which includes the approval of a savings package. This is starting to be discussed in parliament, however, we expect this to be an issue in the autumn months. Given that the government has a majority in both houses of parliament, we expect the key parameters to be approved.

Since the beginning of the year, the MinFin has covered about 54% of this year's CZGBs issuance, according to our calculations, assuming the higher state budget deficit we forecast vs the MinFin plan. This is less than CEE peers Poland and Romania but still fully under control and well positioned for the second half of the year when we can expect lower CZGB yields. For the rest of the year, we expect the monthly supply of CZGBs to be about the same or only slightly lower than the first half average. This is confirmed by the indication for July of CZK19bn, with the MinFin traditionally trying to avoid lower summer liquidity.

Elsewhere on the supply side for this year, we no longer expect any euro-denominated bond issuance, as we assumed in our CZGBs outlook at the beginning of the year. The MinFin is currently in discussions with the European Commission to extend the Recovery and Resilience Facility plan and we expect this year's FX needs to be covered fully by European Union money. On the other hand, we do not expect EU money to be involved in covering CZK needs this year.

The MinFin recently published an updated funding strategy that didn't bring much new for this year. However, the figures for next year confirmed our earlier calculations of a drop in borrowing needs next year to around 60% of this year's level. This is due to the year-on-year decline in the state budget deficit, but also to low redemptions next year. This should translate into a significant drop in the supply of CZGBs next year. Moreover, the government may involve more money from the EU and supranational institutions, which may further reduce the supply of CZGBs next year.

Given CZGBs supply dynamics, which are trending towards pre-Covid levels, and fiscal consolidation, which is a positive outlier among CEE peers, we expect the asset swap spread (ASW) to return to negative territory, a historically usual level for the spread vs the interest rate swap (IRS) curve. On the CZGBs side, we expect the government's consolidation package to take the main spotlight in late summer/early fall and later the MinFin to start focusing on CZGBs supply for next year, which should be positive for bonds. Moreover, on the IRS side, the market is already pricing in a near return of the Czech National Bank rate to the equilibrium level of 3% at this point, which should limit the further decline of the long-end in the IRS curve. Overall, we are positive on CZGBs and see a case for significant ASW tightening in the second half of the year.