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Slovak Republic-Preliminary Conclusions of the Mission to
November 4, 2001
1. In May 2001 the Slovak authorities concluded the preparation of a coherent economic program aimed at achieving sustained economic growth, reducing inflation further, and strengthening the external position. This program brought together the various elements of the government's strategy that have been part of Slovakia's reform agenda for some time. The government's strategy would be based on actions to attain sustained fiscal stability. These actions would be focused on achieving a more efficient tax system, and reforms to ensure continued financial discipline, including reforms of the health, pension, transport, and education systems, and better targeting of social policies. In addition, the strategy called for accelerating financial sector reforms, strengthening bank supervision, restructuring and privatizing the main state enterprises, and increasing labor market flexibility. The government would also improve governance through the enhancement of the transparency of fiscal operations and corporate activities. The program was described in the authorities' Memorandum of Economic Policies of May 29, 2001, and its implementation has been monitored by IMF staff. The purpose of this visit has been to review the implementation of the staff-monitored program through September 2001, and to discuss policies for 2002.
2. In many respects, the program's initial results have been positive. Economic activity has continued to expand while inflation fell modestly, and fiscal and underlying monetary performance were in line with the program through September. On the structural front, most benchmarks for end-June and end-September were met, although clearly there have been implementation delays. While structural reform is moving in the right direction, it is doing so at a slower pace than envisaged under the program, and a concerted effort by the government is required to accelerate reform.
3. Two striking developments since the program began are a substantial widening of the external current account deficit, and a completely different external economic environment, particularly a pronounced deterioration of economic activity in Europe. The widening of the current account deficit has resulted from an expected slowdown in exports combined with the much stronger growth of imports than anticipated. It is true that part of the increase in imports reflects higher investment, but the available evidence shows that there has been an across the board increase in imports, including of consumption and intermediate goods. In the present environment, the mission believes that the risks over the next several months are skewed toward the downside and that there is therefore a need for a policy response that addresses the macroeconomic imbalance reflected in the external accounts.
4. In the mission's view-which is shared by the authorities-this policy response should be centered on fiscal policy, with a more limited role for monetary policy to avoid a possible loss of competitiveness through effects on the exchange rate. Therefore, we are recommending that the National Bank of Slovakia (NBS) maintain the policy interest rate unchanged for the time being while some measures are taken on the fiscal side to save part of the revenue overperformance in 2001. The mission is at this stage evaluating and discussing with the authorities the implications of current developments for the budget and the fiscal stance in 2002.
I. Policy Implementation and Developments Through Septeber 2001
Real Sector and External Developments
5. The economy has continued to grow based on a strong recovery of domestic demand—in the first half of 2001 real GDP was 2.9 percent higher than a year earlier—and the mission projects real GDP to grow by 2.7 percent in 2001. The European slowdown has taken its toll on exports, which grew in volume by only 7 percent over a year ago in the second quarter, compared with 13 percent in the first quarter. More recent data indicate that exports have continued to slow. Reflecting strong domestic demand and the removal of the import surcharge, import volume increased by 15½ percent in the first half of 2001. Consequently, the external current account deficit is projected to widen to almost 9 percent of GDP in 2001, compared with about 5 percent of GDP under the program. Although the unemployment rate has remained high, the domestic demand recovery combined with wage moderation has been positive for employment. The mission expects that unemployment will continue to decline.
6. Fiscal performance in the first nine months of 2001 was in line with the program, and the government is on track to meet its fiscal deficit target of 3.9 percent of GDP for the year (Table 1). The end-September benchmark on the general government deficit was met, as tax revenues exceeded budget projections and the government has shown spending restraint. The government has spent a substantial part of the revenue overperformance on highway construction. In the broader public sector, some expenditure pressures have emerged, notably on the payments of state and social assistance benefits, which are projected to be higher than envisaged. The general government expenditure ceiling for end-June was met as was the end-September expenditure sub-ceiling for the state budget.
7. Despite having missed the relevant targets on international reserves of the NBS and net domestic assets of the banking system by small margins, underlying monetary developments have been in line with the program. While demand for broad money grew by less than envisaged, net banking system credit to both the government and the private sector was below projections. Although increases in credit to the private sector and to the general government were significant in the third quarter, overall aggregates continue to develop in line with the program. The NBS has kept interest rates unchanged since March 2001.
8. The record on implementation of structural policies has been mixed (Table 2). The mission is encouraged that steps have been taken in a number of areas, but clearly there have been delays in implementing several structural reforms. The government has introduced measures to improve labor market flexibility and restrict the informal hiring of workers and approved a timetable for the gradual increase of the retirement age. Progress was slower in introducing incentives to contain costs in the health system and defining the appropriate scope for the health care system. Steps were taken to adopt a new approach to bank supervision, but most of the work in this area remains to be done. In order to strengthen fiscal control the program envisaged the elimination of most state funds by end-September, and this remains under discussion in Parliament.
9. It is regrettable that administered prices will not be adjusted in 2002-with the exception of the gas price for enterprises. This will provide a sense of false relief on the inflation front but accumulate pressures that are likely to become evident after 2002. In addition to complicating the management of monetary policy down the road, the decision not to increase administered prices for households has sent a message of political expediency over needed adjustments, and, importantly, could affect adversely the sale price of some state assets, notably the gas company.
II. Policies for the Remainder of 2001 and 2002
10. The widening of the external current account deficit and delays in the implementation of the government's structural reform program cast a shadow over an economic outlook that otherwise on the whole remains positive. Thus, in the mission's view, the government needs to address both these issues decisively. On the external deficit, the mission believes that in light of a substantially riskier external environment in the near term the fiscal stance should be tightened compared to program, and the government should stand ready to take additional measures in 2002 as needed. This is important to ensure that-at a minimum-fiscal policy does not add to the current pressures on the balance of payments. On structural reforms, it is essential that the government implement its program as envisaged. This will require an across the board effort to accelerate reform.
11. The authorities now estimate that revenue collections for 2001 will be about Sk 7.5 billion higher than budgeted. The goal of fiscal policy for the remainder of 2001 should be to save about Sk 2.5 billion of this overperformance, which is necessary to counter macroeconomic imbalances reflected in a wider external current account deficit. The authorities have identified a number of areas in which these savings can be achieved: enforcement of tighter eligibility criteria for state and social assistance benefits, lower subsidies to agriculture, control of housing subsidies extended to building society plans, and expenditure restraint in the State Road Fund. These savings are reflected in the new expenditure ceiling agreed with the authorities for end-2001. As a result, the general government deficit for end-2001 would be contained below 3.7 percent of GDP compared with 3.9 percent of GDP under the program. The government's commitment in the fiscal area should go some way to addressing the external imbalance caused by domestic demand pressures.
12. The draft 2002 budget as submitted to Parliament envisages revenue collections for the general government of Sk 369 billion and expenditures of Sk 407 billion. The resulting deficit of Sk 38 billion (3.5 percent of GDP) would imply a modest tightening of the fiscal stance in 2002. A deficit of 3.5 percent of GDP seems appropriate but the mission has reservations about the inclusion of some projected receipts of the Consolidation Bank (Sk 160 billion) as budget revenue. These are one-off receipts that should be used to retire the debt resulting from the bank restructuring operation. Moreover, as the costs of this operation have not been included in the budget deficit it appears logical to exclude from the budget any related revenues. Once revenues are corrected, and including some further expected increase in arrears to the health insurance funds, the budget deficit in 2002 would amount to about 4 percent of GDP. The mission is also concerned about the wage policy for 2002-which contemplates an increase of over 14 percent for public sector employees-because of its effects on wages in general, competitiveness, and the external accounts. This increase is too large in light of a projected headline inflation of 4-5 percent. The mission thus recommends that the authorities reconsider the government's wage policy for 2002, with the aim of giving average wage increases of no more than 8 percent-which would still result in a real wage increase of up to 4 percent.
13. It is essential that the use of privatization receipts be restricted to retiring state debt and financing pension reform, with very few exceptions. As these receipts are one-off they should not be used for recurring expenditure, even indirectly, otherwise spending plans will be unsustainable. The mission recommends that emphasis be placed on retiring external debt rather than domestic debt, to contain the monetary sterilization required from the NBS and improve Slovakia's external debt indicators. Moreover, to facilitate monetary management and ensure transparency, privatization receipts should be deposited in full at the NBS, rather than at commercial banks.
14. A final point on fiscal issues. In the current environment there is no room for further reductions in taxes in the near term. The macroeconomic outlook is too fragile to put at risk the important goal of fiscal consolidation. When the time comes for further tax reductions, efforts should focus on the reduction of taxes on labor (social contributions) to promote legal employment, and reduce the existing wedge between taxes on labor and capital.
Monetary and Exchange Rate Policies
15. At the current juncture-when inflation developments are favorable and credit to the private sector is still subdued-the "wait-and-see" approach to interest rate policy is suitable assuming that the fiscal stance is appropriately tight. With a fall in inflation expected, this policy implies a modest monetary tightening. Nevertheless, it is hard to foresee a reduction in rates in the near term with an external current account deficit that is approaching 10 percent of GDP.
16. In the mission's view the current level of the exchange rate is appropriate, and there is no evidence that the slowdown in exports is related to competitiveness problems. Nonetheless, the current pressures on the balance of payments have resulted in a reduction of the official reserve coverage of imports and the concomitant deterioration in some vulnerability indicators. Although the almost freely floating exchange rate system provides a degree of automatic adjustment, if this deterioration were to continue, the authorities will need to consider seriously an overall tightening of the policy stance.
17. This is perhaps one of the areas most at risk in an election year, but it remains essential for continued economic progress in Slovakia, and in more ways than one is the backbone of the whole program. Without structural reform, gains in stabilization could prove temporary. An overhaul of bank supervision-which is underway-remains key for the strengthening of Slovakia's financial system. Reform of the health, transport (particularly railways), and social assistance systems are priorities in the government's agenda that should be pursued vigorously to ensure fiscal sustainability. Strengthening tax administration and reforming the pension system should also be an important part of this agenda. Finally, efforts to improve labor market flexibility will remain central to building a more resilient Slovak economy, and public finance reform-including the elimination of most state funds-should be accelerated.
III. Concluding Remarks
18. Bringing durable economic stability to Slovakia and the concomitant improvement in living standards for its citizens will require a coordinated effort of fiscal, monetary, and structural policies. The policies envisaged by the staff-monitored program comprehensively address the main problems in the Slovak economy, and the time frame for reforms is appropriately ambitious. Execution of the program is broadly satisfactory, but there is a risk that if reforms are implemented in a piecemeal fashion-and with delay-the benefits of the policies will be extremely slow to come, and perhaps not be durable. We recognize that the authorities remain committed to implementing the program as a whole and in a timely fashion. Nevertheless, the coming period-with elections looming-will be a test of the resolve of the Slovak society to advance reform. This resolve, however, will be rewarded by Slovakia's transformation into a modern economy with high living standards. We trust that the Slovak society and its government will persevere and attain this goal.