Slovak Republic--November 2002 IMF Staff Visit, Concluding Mission Statement
November 20, 2002
1. A Fund mission conducted discussions with the Slovak authorities over the period November 6-19, focused on fiscal and monetary policies, in particular for 2003. We thank the authorities for the usual close cooperation with the mission, their generous hospitality, and for the stimulating discussions. This note presents the mission's assessment of the current economic situation and lays out policy recommendations.
2. The economic recovery has gained further momentum compared with the situation at the time of the last staff visit in May, and inflation has remained low. Real GDP grew by 3.9 percent in the first half of 2002 compared with the first half of 2001, and partial indicators for the third quarter have been strong. Slovakia escaped the worst of the severe regional flooding in August 2002, and growth is expected to remain robust in 2003. However, the unemployment rate remains high at around 18 percent. The 12-month core inflation rate fell to 1.7 percent at end-October, well below the National Bank of Slovakia's (NBS) indicative lower bound of 3.2 percent for end-2002. Although this outcome partly reflects temporary factors including lower-than-expected food and fuel prices, inflation is still very low given the stage of the economic recovery. Headline inflation has fallen below 3 percent, but will rise sharply in early 2003 when deferred adjustments of key administered prices are implemented.
3. The large external current account deficit remains a concern. Exports have begun to recover strongly in recent months (growing at around 19 percent in volume in the year to June-September), but the external deficit is projected at close to 8 percent of GDP in 2002-still too large, despite some narrowing from 2001. Domestic demand pressures have been transmitted directly into the external accounts, without significantly affecting prices. However, substantial privatization receipts in 2002-around 16 percent of GDP-have boosted international reserves and reduced near-term vulnerability.
4. Fiscal consolidation has been on hold so far this year. The staff projects the general government deficit at around 5½ percent of GDP in 2002, compared with a revised official target of 4½ percent of GDP (excluding costs of bank restructuring and called guarantees). On an ESA95 basis, this deficit could exceed 7 percent of GDP. The wider deficit reflects mainly arrears in the health system and overruns on social assistance spending, despite better-than-budgeted tax collections.
5. Although inflation has been low, monetary policy has been complicated by the wide external current account deficit, and, more recently, by the surge in capital inflows. Following the elections, the koruna strengthened sharply, fully unwinding the depreciation that had taken place earlier this year. The NBS reduced its policy rate by 25 basis points effective early November. A surge in capital inflows over the past two weeks prompted the NBS, first, to intervene in the foreign exchange market to resist appreciating pressures on the koruna, and, second, to reduce its policy rate by an additional 150 basis points on November 15.
In this context, Slovakia faces a number of challenges:
· To strike the right balance in the short run between monetary and fiscal policies, and exchange rate flexibility to address the surge in capital inflows prompted primarily by "convergence plays"1 of foreign investors.
· To reduce the external current account deficit and maintain the course of disinflation. The external deficit remains above sustainable levels, which are estimated as high as 6-7 percent of GDP, and the recent reduction in official interest rates could lead to a further widening of the external current account deficit, and risk exacerbating underlying inflation.
· To achieve sustainable fiscal consolidation. This consolidation would address these challenges, and also help meet the Maastricht convergence criteria.
· To implement all of these without hindering reforms to promote convergence to EU living standards-a key objective over the period ahead.
These considerations motivate the mission's recommendations.
Monetary, exchange rate, and supporting policies
6. The NBS faces perhaps the most challenging policy environment of the last four years. The substantial interest rate differential with the euro zone-in part reflecting the higher inflation expectations in Slovakia-and the expectation that the Slovak koruna will appreciate over the coming years as Slovakia moves towards adopting the euro, have made Slovak financial assets more attractive. This is especially the case after most of the political uncertainty existing before the elections was eliminated by the inauguration of a new, fairly homogeneous, and pro-reform government. Because foreign investors have a tendency to discover these opportunities more or less at the same time, such situations tend to be accompanied by surges in short-term capital inflows, as witnessed in recent days in Slovakia.
7. In the face of these inflows, the NBS has broadly three options (or combination thereof): (a) large-scale sterilized or unsterilized intervention to avoid koruna appreciation; (b) letting the koruna appreciate, intervening only sparingly to avoid sharp oscillations of the exchange rate; and (c) reducing interest rates, perhaps drastically.
· Sterilized intervention:2 The NBS may be concerned that inflows are temporary-carrying the risk of a reversal of any appreciation or initial fall in interest rates when capital flows out of the country following the realization of capital gains-and thus may intervene in the foreign exchange market to prevent a koruna appreciation that could go too far too fast. Although the premise for the intervention is not unreasonable, the mission is of the view that sustained sterilized intervention is self-defeating. To the extent that the policy reduces the risk of reversal by maintaining Slovak assets undervalued, it justifies investor behavior and leads to continued inflows. This in turn leads to an expansion of the NBS's balance sheet and its exposure to foreign exchange risk, and increased sterilization costs.
· Letting the koruna appreciate: While a koruna appreciation would certainly reduce the dividends of any future convergence play-lessening the incentive for short term inflows-and cool down aggregate demand, it carries the risk of going too far, affecting the competitiveness of the Slovak economy, especially if wage costs are not sufficiently contained. In turn, this could have adverse consequences for existing and prospective investors in productive activities.
· Reducing interest rates: Reducing rates would lessen the incentive for convergence plays somewhat, but at the cost of promoting the overheating of an economy that is growing at close to potential, risking a widening of an already large external current account deficit and higher inflation. Some view interest rates as not a very powerful tool in this situation because the surge in inflows is based on the belief that the euro conversion must be much higher than the current market exchange rate (upon eventual euro adoption) and any interest rate reduction can only partially offset this effect.
8. What to do? There is no easy way out from a situation such as the one faced by the NBS. Ironically, it is the price of too much perceived success and the near certainty of foreign investors that Slovak assets will appreciate in value. The NBS cannot fundamentally alter this process, and it should convey this message clearly to the government, the public, and investors. Nevertheless, there are actions that the NBS and the government can take to smooth the process and minimize the disruption caused by volatile capital flows.
9. First, the policy mix should be further reoriented towards a tighter fiscal policy and easier monetary policy, in that order, so as not to endanger the disinflation process or the external accounts. The NBS has moved very quickly to reduce interest rates drastically in response to the surge in capital inflows but before parliamentary approval of the 2003 budget that will tighten fiscal policy substantially. This approach carries risks-particularly of overheating-that need to be minimized: following the NBS's recent policy shift, the government should move very quickly to tighten fiscal policy, even beyond the 5 percent of GDP deficit projected under the 2003 draft budget. The implementation of tighter fiscal measures preferably should start in the remainder of 2002, as suggested below. In addition, wage restraint should accompany fiscal policy, to unburden monetary policy and support the achievement of inflation objectives. Public sector wage restraint should take the lead in this regard. To the extent that fiscal policy is tightened making room for an easier monetary stance, the NBS could intervene in the foreign exchange market to avoid sharp oscillations of the exchange rate.
10. Second, the risk of a reversal of any koruna appreciation or initial fall in interest rates can be minimized by accelerating preparations for joining the euro zone. All this, in the mission's view, underscores the need for the government to review the fiscal stance in the period ahead, with a view to further tightening. The implementation of durable fiscal and structural reforms is also critical to promote the growth in productivity that would be required to maintain competitiveness.
Fiscal policy and reforms
11. Against this background, the mission urges maximum use of the available flexibility in fiscal policy over the remainder of 2002, by:
· Controlling and cutting discretionary spending, especially on goods and services.
· Reviewing the implementation of the capital budget, and, if possible, restricting capital expenditure, by postponing some recently committed projects until the macroeconomic situation becomes clearer.
· Controlling housing subsidies extended by building society plans; reducing the interest rate subsidy for mortgage loans, especially in light of falling market interest rates; and strictly controlling, and possibly curtailing, subsidies to agriculture. If these subsidy measures are not possible in 2002, then they should be implemented in early 2003.
12. The 2003 budget aims appropriately at a substantial tightening of the fiscal stance. This is necessary to correct the slippages in 2002, make sufficient progress on the medium-term consolidation path to ensure the credibility of that path, unburden monetary policy, and help put the external current account deficit on the path to sustainability. In this context, the mission believes that the government's budget deficit target of 5 percent of GDP in 2003 (on an ESA95 basis) is appropriate. The target implies an underlying correction of around 2 percentage points of GDP with respect to the projected outturn in 2002.
13. The budget contains strong measures on both the revenue and the expenditure sides.
· On the revenue side, measures to more closely align the two VAT rates (pending their unification in 2004) and to increase excises on petroleum products and tobacco should increase revenues by around 1 percentage point of GDP.
· On the expenditure side, the main reductions compared to 2002 should come in the social areas and capital spending. In the health sector, reforms that reduce the rate of arrears accumulation should generate savings of ¼-½ percent of GDP. Savings of around ½ percent of GDP compared to 2002 should also be achieved from limiting untargeted spending on state benefits and social assistance. The capital budget will also be contained, mainly through restricting new motorway construction.
· The cancellation of the thirteenth wage for public sector employees will prevent additional expenditures of about ½ percentage points of GDP-but is not enough in itself to prevent the public sector wage bill from rising by 11.4 percent in 2003.
· Despite an increase in the budgeted subsidy bill from 2002, the increase broadly reflects the more transparent support to the railway companies; in 2002 such support was provided off-budget through the extension of government guarantees for commercial loans.
14. Nevertheless, the budget faces some risks that the authorities should be prepared to offset. The mission is concerned that any larger-than-targeted deficit would not only hinder the needed reduction of the external current account deficit but would also represent a second consecutive year of missed fiscal targets, undermining the authorities' credibility. The main downside risk is to corporate income tax collections, which could be overstated by some Sk5 billion. Also, the estimated Sk4.5 billion in new health sector indebtedness in 2003 can only be a rough guess in light of much larger arrears in the health system in 2002. These risks could be largely offset by higher VAT revenues and a lower interest bill. But if the downside risks materialize, the government should introduce measures elsewhere in the budget to ensure the attainment of the 2003 fiscal target.
15. The government should carefully review public sector wage spending. Against a background of substantial real wage increases in 20023 and consistent with an austerity budget, the public sector wage increase of 5 percent planned for July 2003 appears unwarranted. The mission recommends that any public sector wage increase be postponed to 2004, and that the associated fiscal savings not be spent. This measure would contribute to a tighter fiscal stance and help dampen wage growth in the economy-also providing appropriate signals of restraint to wage negotiations in the private sector.
16. The mission is encouraged by announced measures in the area of health spending, which should help contain the growth in the debt of the health sector. The measures aim to eliminate abuse in the system, control wasteful spending on pharmaceuticals through the introduction of small fees, and also introduce fees for hospital accommodation and non-emergency transportation. The planned corporatization of hospitals will also be an important step in imposing hard budget constraints in the health sector.
17. The decentralization process may assist reforms in several areas, including health and education, but also poses risks to expenditures if not monitored carefully. The central government is required to pay down the debts of institutions being transferred to subnational governments, such as schools and hospitals. The central government spent Sk0.5 billion to pay off old education sector debt in 2002, and Sk3.4 billion from the National Property Fund is budgeted in 2003 to write off the debt of hospitals being transferred to subnational governments. The government should take special care to minimize the cost of the decentralization process, and be vigilant for any near-term debt accumulation by institutions awaiting transfer. More generally, the authorities should make special efforts to track expenditures by subnational governments to avoid risking a loss of expenditure control.
18. The 2003 budget is only the first installment in a medium-term strategy of restructuring and consolidation of the public finances. The planned fiscal adjustment in 2003 will be achieved as much through increases in revenue as it is through spending measures. Going forward, the authorities' emphasis on expenditure reduction in the Pre-Accession Economic Program is appropriate. However, a more detailed multiyear plan, with concrete measures and a timetable, is needed to support the strategy for meeting the Maastricht fiscal deficit criterion. This plan should be based on a comprehensive review of the structure of expenditure, and for the desired adjustment to be sustainable, measures must be permanent and focus on some of the largest categories of spending, including social transfers and benefits, health spending, and public sector administration. Permanent measures should also affect spending on housing, transportation, and agricultural export subsidies. On the revenue side, any further reduction of the tax burden should await evidence of progress in fiscal consolidation and should give priority to reducing the very high payroll taxes.
19. Pension reform will be key to achieving a sustainable long-term fiscal position, although reform could entail significant costs. The postponement of the effectiveness of the new Social Insurance Act provides the opportunity to design a plan to closely integrate a reformed public pension system (first pillar) with a funded, mandatory system (second pillar), as well as to put the public system on a sounder financial footing-including through much faster increases in retirement ages than provided for in the approved Act. The planned second pillar could be a golden opportunity not only to reduce the burden on the first pillar, but also to promote old-age security by diversifying the sources of retirement income, and to assist the development of Slovak capital markets. But the second pillar could come with a price tag that should be taken into account in any decision to proceed:
· The administrative costs of individual accounts could be significant, especially on a per capita basis given Slovakia's small population.
· The large-scale diversion of contributions from the first to the second pillar could potentially complicate efforts to meet the Maastricht fiscal deficit criterion.
· An essential precondition for the introduction of the funded pillar will be to have in place a strong prudential framework, and an agency capable of supervising the second pillar companies and ensuring prudent and transparent asset management. This will require time, training, and additional financing whether it is done by a new regulatory agency or through the Financial Market Authority.
Other issues: unemployment and financial sector supervision
20. Unemployment remains Slovakia's most pressing social and economic problem, and measures to improve work incentives and promote labor market flexibility are critical. The authorities should concentrate their actions in two areas. First, measures should be introduced to redesign the social safety net to improve incentives to work as well as to reduce the burden on the budget. Government plans to control state and social assistance benefits strictly, through better enforcement of eligibility rules, means-testing, and improving the administration of benefits, clearly go in the right direction. Indeed, a fundamental rethinking of the benefits system is under preparation by the Ministry of Labor. Second, the mission is encouraged by government plans to revise the labor code to improve labor market flexibility, including the abolition of very rigid and specific regulations on work arrangements and schedules that strengthen incentives to evade compliance and move to the informal sector.
21. Financial sector supervision needs further strengthening. The new environment in the financial system, and the recent surge in capital inflows and lower interest rates, could boost the activities of commercial banks and change the risk profile of their operations. In this environment, a future deterioration of banks' portfolios is possible-particularly if banks play a substantial role in the intermediation of short-term capital inflows. In this light, progress in the supervision of banks and non-bank financial institutions has been slow, and perhaps insufficient, and a redoubling of efforts in this area is necessary.
22. Going forward, policies for both the short term and longer term need to be assessed on the basis of their consistency with the government's medium-term objectives of full integration into the EU. The mission believes that implementation of the policies recommended in this note would leave Slovakia well placed to achieve this worthy ambition. Developments in financial markets-which reflect widely held high hopes about the present administration-only underscore the need to deal promptly, decisively, and in a concerted way with the extensive reform agenda. The mission wishes the authorities success with the tasks ahead.
1 A convergence play involves foreign buying of Slovak assets in the expectation of their revaluation in foreign currency through the combination of a fall in interest rates and appreciation of the koruna.
2 Unsterilized intervention would be tantamount to a fall in market interest rates, particularly interbank rates if banks are intermediating the flows. This option is discussed below.
3 The public sector wage bill increased by nearly 15 percent while headline inflation is projected to be around 3 percent this year (against the 6.7 percent assumed in the 2002 budget).