Mission Concluding Statements
Slovak Republic and the IMF
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Slovak Republic — 2002 IMF Article IV Consultation Mission
Preliminary Conclusions, May 22, 2002
1. Over the past 12 months, the Slovak economy has been recovering and inflation has fallen. GDP growth—3.3 percent in 2001—is on track to reach around 4 percent in 2002. Fixed investment has grown especially strongly, supported by increased profitability and enterprise restructuring; and buoyant private consumption has been underpinned by rising real wages and employment, as well as expansionary fiscal policy. Headline and core inflation rates eased last year, and are headed to about 4 percent by end-2002.
2. This favorable performance has come against the background of an adverse external setting, with demand for Slovak exports slowing down noticeably. While the current upturn is now being led by consumption, the recovery also reflects years of solid macroeconomic management and important steps on privatization and financial sector reform. All this, together with foreign direct investment, have strengthened the economy.
3. However, the sustainability of the current expansion is threatened by the widening of the external current account deficit in 2001—and its large projected size in 2002. There are some temporary factors, amounting to over 1 percent of GDP, behind the increase in the external deficit, and thus this deficit may narrow in the period ahead. This narrowing would also be consistent with an increase in exports supported by a recovery in demand from Europe and, on the supply side, by the recent investment boom—the boom itself being part of the reason for the underlying external deficit. There is a risk, however, that the deficit will remain at an unsustainable level, or may even increase, because of excessive domestic demand pressures, which reflect too expansive a fiscal policy. This policy is adding to strong private sector demand, and most of the resulting additional aggregate demand is being covered by imports. Without corrective policy action, the external current account deficit is headed towards a deficit of over US$2 billion, equivalent to 9 percent of GDP.
4. A deficit of this size is not sustainable over the medium term (the mission estimates that an external current account deficit of some 6-7 percent of GDP would be sustainable1 over the coming years under the assumption of strong FDI prospects, dynamic rates of growth, and the trend appreciation of the koruna). While privatization receipts are huge—thus mitigating risks in the immediate future—the substantial improvement in international reserves and other vulnerability indicators may prove temporary if the current account deficit is not reduced in the next few years. Against this background, the most immediate key challenge is to transform the positive momentum of the Slovak economy into sustained growth and a durable increase in living standards on the way to EU accession. Over the medium term, another challenge is to maximize the benefits of accession to the EU while minimizing integration costs.
5. How can policies best respond to these challenges in the near future, while positioning Slovakia for early—and successful—EU accession?
6. In order to reduce external vulnerability, policies should be geared to contain domestic demand pressures: in line with our advice last mission, we believe that a fiscal tightening is necessary to meet the government's targets. A fiscal tightening is strongly preferable to a monetary tightening, as the latter could exert upward pressure on the exchange rate, harm competitiveness, and crowd out private activity. Together with credible fiscal consolidation and disinflation, the successful positioning for EU accession and convergence to EU living standards will also require the reinvigoration of structural reforms—which appear to have lost momentum recently.
7. The authorities have targeted a general government deficit of 3.5 percent of GDP in 2002, somewhat below the 2001 level, but the actual fiscal stance is more expansionary.2 The mission estimates that, unless corrective measures are taken, the deficit of the general government could reach Sk 55.5 billion in 2002 (5.3 percent of GDP), primarily on account of expenditure overruns in the social area and shortfalls in nontax revenues. And under current policies, including already legislated increases in wages and social benefits, the general government deficit would reach around Sk 66 billion in 2003, equivalent to 5.7 percent of GDP, compared with 3 percent of GDP committed under the EU accession process.
8. This expansionary fiscal policy is unwarranted under current circumstances. While in the medium term Slovakia has the potential to grow at 4-5 percent a year, compared with 4 percent projected for 2002 and 2003, the present apparent slack in the labor market masks supply-side constraints typical of an economy that still needs substantial restructuring. In this situation, the fiscally-fuelled increase in aggregate demand is having adverse effects on the external current account deficit, and therefore calls for an early adjustment of policies.
9. Against this background, the government needs to go back to the path of fiscal consolidation that began in 1999, but started to slacken towards the end of 2001. The mission still regards the government's original target of 3.5 percent of GDP for 2002 as appropriate, being consistent both with a sustainable external current account deficit and medium-term fiscal consolidation. Nevertheless, the deficit of 4.5 percent of GDP currently contemplated by the government need not endanger macroeconomic stability provided that strong adjustment measures are taken in connection with the 2003 budget.3 In order to achieve both the 2002 government target and the appropriate fiscal stance in 2003, the authorities would need to take additional measures, some of which are already under consideration by the government. Most of these measures would be on the expenditure side, consistent with the government's medium-term fiscal strategy. The authorities should also forcefully implement tax administration reform with measures to reduce tax arrears and reform the VAT refund system to complement the introduction of the Large Taxpayer Unit, in line with IMF technical assistance recommendations.
10. Were a strong program of adjustment not to be implemented, the economic costs would include a depreciated currency and higher inflation, higher interest rates, lower investor confidence, and a potential setback in Slovakia's ambitions for EU accession.
11. The fiscal stance in 2002 and 2003 will be affected by the use of privatization receipts. It is essential that these receipts be used only to retire state debt-aside from those funds reserved for pension reform. While this would be our advice in general, this advice holds even more strongly because of the need to avoid additional fiscal pressures on the external accounts. We are aware of the intentions of the government to use privatization receipts to retire primarily domestic debt. Nevertheless, in line with past advice, the mission recommends that emphasis be placed on retiring external rather than domestic debt, to contain the monetary sterilization required from the central bank and improve Slovakia's external debt indicators.
12. Another—less visible but pervasive—factor affecting the fiscal stance is the extension of government guarantees. Although some progress was achieved, these guarantees, already amounting to about 15 percent of GDP, continue to be granted too liberally—in some cases in lieu of budget transfers to cover the operating losses of certain public enterprises. Moreover, the mission is concerned that the extension of guarantees may reflect the absence of hard budget constraints in key public enterprises. We urge the government to review carefully its policy in this area, with the aim of increasing sharply the service of loans by borrowers, ensuring hard budget constraints across the economy, and lowering the stock of guarantees. Otherwise, these contingent liabilities represent over time a substantial transfer from taxpayers to financially unsound public enterprises—as they become actual liabilities of the budget.
13. In the end, fiscal sustainability will depend on the concerted and sustained implementation of key reforms. In some respects, implementation has only just begun. Mixed progress in reforming the health and education systems, and in restructuring the railways, have resulted in the continued accumulation of debts, which eventually end up being assumed by the budget. Additional steps will be necessary to contain healthcare costs, particularly pharmaceutical costs, but we are encouraged by the steps so far in the reform of the health system. The effects on the public finances of the still-pending pension reform remain uncertain, but given the long-term difficulties facing the pension system, the introduction of a multi-pillar system remains a crucial reform. Although it is appropriate to use privatization receipts to finance the transition costs from the introduction of the second pillar, we should warn the authorities that the earmarking of these receipts could result in too expensive a pension reform being undertaken because the earmarked receipts could set a floor for the cost of the reform. We encourage the authorities to use technical assistance in this area available from the World Bank, and strive to generate a cost-effective pension reform. The authorities should also move ahead with planned reforms to streamline social assistance, improve public finance management, and restructure the civil service.
Monetary and Exchange Rate Policies
14. The mission supports the central bank's policy of allowing the continued float of the koruna and gearing monetary policy toward lowering underlying inflation and protecting international reserves. Inflation developments have been favorable in 2002, and the central bank should be able to meet its inflation targets despite substantial wage settlements. The projected growth of M2 in the monetary program—which assumes a decline in velocity—is consistent with these targets. Going forward, during tripartite wage negotiations the National Bank of Slovakia (NBS) should promote more analysis so that the parties take into account the effects of wages on prices during their negotiations.
15. The recent 50 basis point increase in interest rates by the central bank is an appropriate signal in response to external imbalances and insufficient action on the fiscal front. The main question for the NBS over the coming months will be how to react if there is no fiscal adjustment, and external pressures do not abate. The mission does not see a need to counter the recent depreciation (3 percent since end-March) of the exchange rate through intervention in the foreign exchange market or further increases in interest rates because this depreciation is unlikely to threaten the inflationary targets of the NBS. Moreover, it can help improve external competitiveness and promote external adjustment, as long as wage and price pressures are held in check. However, if depreciation of the koruna continues unchecked and threatens the achievement of the inflationary targets, the NBS would need to increase interest rates in order to achieve these targets.
16. There is no doubt that monetary policy is not the best instrument to address the large external current account deficit. While further increases in interest rates would dampen domestic demand, they might also strengthen the koruna excessively, weakening competitiveness at a time when exports have been stagnant for a while. To be sure, the sensitivity of the exchange rate to interest rates is limited, given the still modest interest-sensitive capital flows in Slovakia. But, in the absence of fiscal measures, the large increases in interest rates that would be required to generate a sizable effect on domestic demand would certainly have an impact on the koruna as well as on firms' interest costs. All this underscores once more the urgent need to adopt additional fiscal measures that would contain the pressures on the external accounts.
Medium-Term and Structural Policies
17. While an adjustment to macroeconomic policies along the lines suggested above remains the priority in the near term, the current situation in Slovakia also reflects the need for further structural reforms. EU accession—and eventual adoption of the euro—requires continued credible disinflation and fiscal consolidation, and reforms to enhance robustness and flexibility of the economy and financial markets. The government's medium-term and structural reform agenda then should be based on three pillars: (i) promoting real convergence to the EU; (ii) developing and implementing fiscal, monetary, and exchange rate frameworks that support EU accession; and (iii) giving priority to reforms that would make the Slovak economy more flexible and resilient—thus avoiding the recurrence of very large external imbalances that have characterized the recent past.
18. Promoting real convergence to EU living standards requires a concerted implementation of reforms to increase productivity in Slovakia. In addition to pending fiscal structural reforms that need to be accelerated for fiscal consolidation (primarily health and pension reforms), the government should focus on enhancing labor and enterprise flexibility, and strengthening further the financial sector:
· High unemployment calls for increased labor market flexibility and improved incentives to search and provide employment. Last-minute amendments to the new labor code have mitigated somewhat the increase in rigidities of this unhelpful code. However, more progress is needed to ensure adequate flexibility to employers and employees in reaching agreement on work practices and schedules. Such flexibility will be all the more important in the context of accession to the EU and ERMII. More progress is also needed in removing disincentives to work stemming from the welfare system.
· Enterprise reform needs to continue to strengthen the economy's supply response and reduce its dependence on imports. The inflexibility of enterprises to respond to changing demand conditions may have contributed to the recurring external current account deficits. For instance, many large enterprises have difficulties finding reliable good quality domestic suppliers and need to rely primarily on imported intermediate goods. Thus, enterprise restructuring and the development of flexible small- and medium-sized enterprises (SMEs) should remain a key priority. The access of these enterprises to external financing could be eased through further strengthening of the legal infrastructure and the insolvency framework, and suppressing credit diversion to large unsound public enterprises. Continued reduction of the administrative burden on SMEs is also essential.
· The financial sector requires further strengthening. The recent Financial Sector Assessment Program mission concluded that, although banks' direct vulnerability to interest and exchange rate shocks appears limited, they could be adversely affected by exchange rate shocks via the foreign exchange exposure of the corporate sector. Moreover, as banks enter new activities market risks will increase. Thus, market-risk supervisory capabilities should be enhanced, and reporting of exposure to market risk improved. Following its recent reorganization, the bank supervision department is now in a much better position to implement a more proactive supervisory policy, the first steps of which have already been taken. In anticipation of further consolidation in the banking industry, the authorities should review and, if necessary, rationalize policies that affect bank exit decisions.
19. The credibility of the medium-term fiscal consolidation targets needs to be strengthened. In the 2001 Pre-Accession Economic Program (PEP), the government envisaged reducing the general government deficit to 2.5 percent of GDP in 2004 and 2 percent of GDP in 2005, by continuing to reduce the expenditure to GDP ratio. We support this approach, but urge the authorities to state more clearly the medium-term objectives and policies under detailed multiyear expenditure and revenue plans, and frame all fiscal decisions in the context of this plan. In light of the fiscal pressures for 2003, this will be particularly important in the preparation of next year's budget, and should be considered in the preparation of any legislative initiatives that affect the budget. The tasks in the fiscal area over the coming years are all the more challenging because Slovakia still has to cover substantial costs related to EU accession, including on the needed upgrading of infrastructure. Given these pressures, the mission is not convinced that the authorities' objectives for 2003-04 are achievable by expenditure measures only—as contemplated in the PEP.
20. Monetary and exchange rate policies over the medium term should be geared to reducing headline inflation to Maastricht levels without hindering real convergence. This will be a key challenge, but it should be feasible within the current monetary policy framework. The convergence of Slovakia's relative price structure to that of the EU will require real appreciation of the koruna, probably through higher inflation than in the EU in the years to come. Therefore, we agree with the NBS that EU inflation levels should not be targeted before 2005. The postponement of the increase of some key administered prices from early 2002 to early 2003—which will cause an awkward jump in headline inflation in 2003—has increased the challenges for monetary policy. The central bank and the government will thus need to coordinate policies closely to mitigate the second-round effects of administered price increases—when they happen. In this context, a strong public commitment to a clearly defined inflation target path would support the credibility of disinflation, help anchor inflation expectations, and thus mitigate possible short-term costs of meeting Maastricht inflation criteria. Credibility of inflation targets would be enhanced if fiscal and monetary authorities were to use common inflation forecasts, and the authorities should take a firm stance in future public wage negotiations to keep wage increases in line with the inflation target and give appropriate signals of restraint to wage settlements in the private sector.
21. The government and parliament that emerge from the September 2002 elections will need to move promptly and decisively to continue with the extensive reform agenda. The authorities should recognize that delays, especially in those areas where there has been limited progress over the last few years (e.g. health care, civil service reform, state and social assistance benefits, and pension and labor market reform), would be harmful for Slovakia's ambitions for early EU accession and adoption of the euro. The mission wishes the authorities success with all the tasks ahead.
We would like to express our thanks to the authorities for the close cooperation with the mission, their generous hospitality, and for the stimulating discussions.
1 The external current account deficit is typically regarded as sustainable if the resulting ratio of net debt to GDP is not increasing, and is not "too high."
2 The fiscal deficit excludes the interest costs of bank restructuring and called government guarantees.
3 The general government deficit would be lowered to Sk 47 billion (4.5 percent of GDP) in 2002 and Sk 39 billion (3.5 percent of GDP) in 2003 under this scenario, which would achieve an external current account deficit of US$1.8 billion (8.6 percent of GDP) in 2002 and US$1.7 billion (7.3 percent of GDP) in 2003.
IMF EXTERNAL RELATIONS DEPARTMENT