Public Information Notice No. 03/94

Public Information Notice: IMF Concludes 2003 Article IV Consultation with the Slovak Republic

August 5, 2003

On July 23, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Slovak Republic.¹

Background

Slovakia has emerged as one of the fastest growing European Union accession countries over the past two years against the backdrop of successful macroeconomic management and structural reforms since the late 1990s, including the curtailment of quasi-fiscal activities and restructuring and privatization of public sector enterprises; improvements in fiscal transparency and control; and inflation reduction. Lower trade barriers, substantial foreign direct investment, and financial sector reform added further impetus to growth. Recent reforms have culminated in an invitation to join the EU in May 2004, which was then ratified by a national referendum held in May 2003.

Despite significant progress, the Slovak economy continues to be hampered by structural weaknesses and related macroeconomic imbalances. The unemployment rate remains very high, both absolutely and by regional standards; large fiscal deficits have persisted; and substantial external imbalances have re-emerged since mid-2001.

Having won a second term in the September 2002 elections, the government of Prime Minister Dzurinda declared its intention to address these weaknesses through accelerated fiscal consolidation and structural reforms covering the tax system, the benefits system, pensions, labor markets, and the judiciary. The government and the National Bank of Slovakia (NBS) have also announced their intention to meet the requirements for euro adoption by 2006.

The economic expansion gained momentum in 2002 in the context of low core inflation and improving external accounts, but a widening fiscal deficit. Real GDP grew by a robust 4.4 percent, led by strong household consumption. Core inflation was only 1.9 percent at year-end, well below the indicative benchmark of the NBS. A combination of strong real export growth and declining import growth rate helped a slight narrowing of the current account deficit to 8.2 percent of GDP, while the general government deficit exceeded 7 percent of GDP (ESA95 basis). Foreign direct investment was a record 17 percent of GDP in 2002, owing largely to the sale of the state gas monopoly.

Buoyant-although slowing-economic activity so far in 2003 reflects a shift away from consumption, towards investment and exports. Indeed, despite the slowdown in Europe, exports continued to accelerate, led by strong expansion in the automotive sector. Price deregulation and indirect tax hikes have curtailed household consumption and fueled a rise in headline inflation to 8½ percent at end-June-but core inflation remained low, at 3 percent. Also, fiscal retrenchment was initiated in the context of a 2003 budget that targets a 2 percentage point reduction in the general government deficit from 2002.

Unemployment remained stubbornly high through end-2002, reflecting mainly structural factors including skills mismatches, regional disparities, high social contribution rates, and a benefit system that creates disincentives to work. But the registered unemployment rate fell by 3 percentage points in the first six months of the year, to less than 15 percent, reflecting a tightening of eligibility requirements and buoyant economic activity.

Since the fall of 2002, monetary policy has been challenged by the increasing conflict between reducing inflation and containing speculative capital inflows. The NBS has resorted to foreign exchange market intervention-most recently in May 2003-and cut interest rates by 150 basis points in November 2002. It has indicated its readiness to reduce interest rates further if warranted by market developments.

Executive Board Assessment

Executive Directors commended the Slovak authorities for their successful implementation over the past few years of policies that have resulted in brisk economic growth, falling unemployment, and notably resilient exports despite weak growth in Slovakia's major trading partners. The government's skillful economic management and commitment to reform have contributed to a major improvement in the perception of the Slovak economy abroad, and the recent announcements of major Foreign Direct Investment (FDI) projects have further bolstered the outlook for continued productivity gains, strong growth, and progress toward EU convergence.

Directors nevertheless agreed that, to sustain this favorable outlook, the authorities will need to take further decisive action to address the still-high unemployment, achieve a sustainable fiscal deficit reduction, and promote a further narrowing of the external current account deficit. They welcomed the government's wide-ranging reform agenda to address these challenges, and noted that full implementation of this ambitious agenda will also be key to prepare Slovakia's entry into the EU. They encouraged the authorities to build on the outcome of the recent referendum on Slovakia's EU membership and on its prospective accession in 2004 to press ahead with their reform plans.

Directors emphasized that fiscal consolidation to increase national savings, improve the policy mix and reduce external imbalances should remain the top priority in the period ahead. They supported the authorities' plan to meet the Maastricht deficit criterion of 3 percent of GDP by 2006 as well as their intermediate objective to reduce the general government deficit to 5 percent of GDP in 2003. They urged the authorities to pursue steadfast policy implementation to avoid future fiscal slippages, and to carefully design and sequence the expenditure and revenue measures needed to help achieve the fiscal objectives.

Directors agreed that fiscal consolidation will hinge on expenditure reduction. They supported the authorities' plans to streamline health sector and welfare spending, and urged them to continue to seek savings in other areas. Directors stressed the importance of reducing public employment and of a prudent wage policy, including to help ensure economy-wide wage discipline and continued competitiveness. Carefully prioritized expenditure reductions will also be essential to create room for the infrastructure development needed to support real convergence to EU living standards. Directors encouraged the authorities to carry on with their plans to develop a comprehensive medium-term expenditure framework to support progress towards their fiscal objectives and ensure spending discipline at all levels of government.

Directors agreed that the forthcoming tax reform will support economic performance, reduce distortions and improve tax administration and compliance through enhanced transparency and simplicity. Given the uncertainties surrounding the revenue impact of the reform, Directors urged the authorities to stand ready to take all necessary measures to achieve their fiscal targets should downside risks to revenue materialize. They were encouraged that the authorities already demonstrated their commitment in this regard. Some Directors suggested close monitoring of the distributional impact of tax reform proposals.

Directors highlighted the importance of pension reform for underpinning a sustainable fiscal position in the longer term. They recognized that the authorities face a difficult decision on whether to introduce a mandatory, funded pillar to the pension system given the potential implications for the timely observance of the Maastricht deficit criterion. Directors encouraged the authorities to press ahead in any event with the reform of the existing public pension system. The priority should be to achieve a sufficiently ambitious increase in retirement ages and to strengthen the relationship between benefits and contributions.

Directors commended the NBS for its skillful management of monetary policy, with core inflation remaining low notwithstanding increases in administered prices and indirect taxes. They noted that monetary policy will continue to face a delicate balancing act between further progress on disinflation and the need to safeguard competitiveness in the face of surges in capital inflows, without leaning against exchange rate appreciation that would be in line with economic fundamentals. Given the still relatively high level of headline inflation, some Directors suggested that priority should be given to further disinflation efforts. Directors welcomed the NBS's efforts to improve inflation forecasts, which would support a more forward-looking monetary policy with greater emphasis on core inflation benchmarks. They also stressed that closer coordination between the government and the NBS on public communications would help guide market expectations.

Directors welcomed the authorities' strategy for euro adoption, and saw their plans to meet the Maastricht criteria by 2006 as feasible. They stressed, however, that this will require the full implementation of the planned fiscal consolidation and structural reforms to ensure that the Maastricht criteria are met in a sustainable manner prior to the adoption of the euro. Directors therefore encouraged the authorities to continue to make strong progress on their structural reform agenda. In particular, they saw a need for further efforts to enhance product and labor market flexibility and improve the benefits system, to address the still-high unemployment, reduce regional disparities, and facilitate the adjustment of the economy to adverse shocks.

Directors also stressed the importance of continued efforts to strengthen the resilience of the financial sector against the possibility of increased capital flows. They welcomed the recent strengthening of banking supervision-including the reorganization of the NBS's banking supervision department-and the increased cooperation among financial market regulators, and encouraged the authorities to implement fully the Supervisory Development Plan to improve on-site and off-site banking supervision.

Directors commended the authorities' focus on developing entrepreneurship, including recent efforts to comply with the Organization for Economic Cooperation and Development anti-bribery convention. They welcomed the progress made on improving the quality of economic statistics, increasing transparency, and complying with international standards, including in the areas of fiscal transparency and management. They looked forward to further improvements in line with the original Reports on the Observance of Standards and Codes recommendations.