Slovak Republic -- Preliminary Conclusions of the IMF 2004 Article IV Consultation Mission
November 10, 2004
1. Slovakia's accession to the European Union on May 1 was a significant milestone as well as a recognition of important accomplishments. In the past few years, output has expanded and inflation has declined, while fiscal and external imbalances have narrowed substantially. Although unemployment remains high, Slovakia's growth record compares favorably with those of other Visegrad-41 countries, and output seems recently to have accelerated, supported by an expansion in capacity. These accomplishments reflect, in no small measure, sound macroeconomic management and an improved business climate, achieved through privatizing public enterprises, restructuring banks, simplifying procedures for establishing companies, and deregulating the labor market. The authorities envisage ERM2 entry by 2006 and euro adoption by January 2009; at end-2003 Slovakia already complied with the Maastricht criteria on interest rate and public debt.
2. Looking ahead, the authorities face the challenges of meeting the Maastricht criteria on inflation and the fiscal deficit, while increasing employment and growth. First, the inflation rate, though falling, is well above the euro area average and bringing it down to the Maastricht level will require further effort. Interest rate cuts and fiscal stimulus, combined with other factors, could lead to an increase in underlying inflation. Second, additional fiscal consolidation will become more difficult, particularly in light of the costs of the second-pillar pension reform. Third, further structural reforms remain essential over the medium term to reduce unemployment and ensure sustained income convergence to western European levels.
3. Economic growth has accelerated and broadened to the domestic sector, with macroeconomic policies accommodating. We expect the 2004 general government deficit target to be met with a margin, mainly due to lower-than-budgeted cofinancing of EU-funded projects, as well as somewhat better-than-budgeted tax revenues. However, taking into account cuts to direct taxation and the projected net transfers from the EU, the fiscal impulse could amount to about ¾ percent of GDP this year. Monetary policy has also accommodated economic activity through a reduction in policy rates by 200 basis points in the year through July, which cut the two-week repo rate to 4.5 percent. In addition, the National Bank of Slovakia (NBS) intervened in the foreign exchange market to limit exchange rate appreciation. These policies, together with real wage increases and sustained foreign investment, have boosted private domestic demand. We project the external current account deficit at about 3 percent of GDP in 2004, a slight widening from the previous year, but well below its sustainable range (which we estimate at around 6 percent of GDP). Overall, real GDP growth is projected at around 5 percent in 2004-05, with its composition continuing to shift to domestic sources. Sustained high energy prices and weaker-than-anticipated growth in western Europe represent downside risks.
4. The mission sees upside risks to the inflation outlook. Inflation remained high in 2004 (6½ to 7 percent projected by end-2004), driven by adjustments to indirect taxes and administered prices, and is projected to fall next year as these one-off effects wane. However, the mission's analysis suggests that output may be close to potential, and there is evidence of a pick-up in price and wage growth in the non-tradable sector. Inflationary pressures also arise from previous policy stimulus; and second-round effects of higher oil prices, regulated prices, and indirect taxes. We therefore see a risk that, on present trends, and without the somewhat tighter policies recommended below, CPI inflation in 2005 may exceed the top end of the latest published NBS target range (3.3 percent).
Monetary and Exchange Rate Policy
5. Monetary policy is constrained by euro adoption goals and the trend real exchange rate appreciation associated with income convergence. Substantial FDI has expanded export capacity, and additional investment is in the pipeline. The resulting increase in productivity and income growth in Slovakia relative to its trading partners will lead to sustainable real appreciation over the medium term, a process outside the control of the NBS. This real appreciation will have to take place through further nominal appreciation, higher inflation, or a combination of the two. While excessive nominal appreciation that is unmatched by productivity growth could hurt competitiveness, the trend real appreciation implies that a strategy of slowing down nominal appreciation could risk missing the Maastricht inflation criterion by 2007.
6. Monetary policy should thus be geared to disinflation. Since the expansion is gaining momentum, slack in the economy is diminishing, and the budget implies a small positive fiscal impulse in 2005, the scope for further reduction of interest rates in the period ahead has largely disappeared. Given the inflation outlook, only a further surge in inflows would justify a cut in rates as a last resort. Otherwise, the NBS should not resist a gradual appreciation of the koruna that would tighten monetary conditions. Besides, predictable intervention in the foreign exchange market can provide one-way bets to speculators, and thus be costly for the NBS. Further interventions would enlarge the NBS balance sheet and lead to additional sterilization and valuation losses.
7. Accepting gradual appreciation in the period ahead would avert a sharper, disruptive appreciation down the road. Estimating equilibrium exchange rates with confidence is not easy and involves a degree of judgment; therefore we do not point to a particular level of the nominal exchange rate as being appropriate in the short term. Nonetheless, persistent inflows—in spite of historically low interest rate differentials vis-à-vis the euro area—indicate that nonresidents expect the koruna to appreciate in the period ahead. A number of factors suggest that the real exchange rate will appreciate over the medium term. First, while the external current account deficit may temporarily widen in 2005-06, it is likely to remain below Slovakia's sustainable level in the medium term. Second, Slovakia's wages are below those of its main competitors, even when adjusting for productivity. Third, and relatedly, the Slovak price level is still less than half of euro area prices, which is low even when allowing for Slovakia's level of income. Monetary policy will therefore need to accommodate real appreciation through a gradual nominal appreciation in the period ahead, to maintain inflation on a downward path.
8. The NBS should enhance its communications to the public to guide inflation expectations and promote more forward-looking wage-setting behavior in the private sector. Firms should also look at the NBS's inflation target to anchor forward-looking inflation expectations in wage negotiations. The public sector can contribute to wage moderation by signaling the importance it attaches to this goal through its own wage policy.
9. A tightening of monetary conditions should be supplemented by further fiscal consolidation. Given the strong economic expansion, a somewhat tighter fiscal stance in 2005 would be preferable, and, at a minimum, strict budget implementation will be crucial. The 2005 deficit target of 3.8 percent of GDP—close to the likely 2004 outcome—reflects second-pillar pension reform costs of close to ½ percent of GDP and higher EU-related expenditure. Once net transfers from the EU are taken into account, and pension reform costs are excluded, the budget implies a fiscal expansion of about ¼ percent of GDP. We understand that reopening budget discussions and finding additional structural spending measures would be difficult at this stage, given the extent of reforms recently implemented. That said, collections of social contributions have been disappointing in 2004, and remain a risk in 2005. In these circumstances, it will be essential to take measures to offset this risk. In any case, expenditure should be restricted to budgeted levels. Any additional revenue from positive growth surprises should be saved, while lower revenue from slower-than-expected growth or other causes should be offset by curbing spending. This asymmetry would also help to not delay fiscal adjustment to 2006 (an election year) or 2007, when a substantial share of adjustment is scheduled to take place.
10. We recommend adopting a more ambitious deficit target for 2007, and bringing forward some of the expenditure savings from 2007 to 2006, to avoid an excessive back-loading of adjustment. Beyond 2005, the three-year budget framework aims to reduce the deficit to 3 percent of GDP—the Maastricht level—by 2007. But because 2007 is the test date for euro adoption, targeting a deficit with no margin with respect to the Maastricht criterion is risky. Unless the authorities target a lower deficit (say 2½ percent of GDP), the criterion may be missed in case of even relatively minor shocks.
11. Achieving the needed deficit reduction may require a stronger fiscal framework. Fiscal policy faces the major task of combining additional consolidation with welcome pension reform, cuts to direct taxation, and higher spending on EU-financed projects. This requires a durable reduction in real primary spending growth at the general government level from current annual rates of about 6 percent—albeit with this figure higher because of newly available resources from the EU—to about 1 percent per year (to meet the recommended target for 2007). The elaboration of a medium-term fiscal framework based on binding expenditure ceilings as well as nominal balance targets is likely to be necessary to achieve fiscal consolidation objectives. A system based on primary expenditure ceilings will put a premium on durable fiscal savings measures—and force the discipline of elaborating the appropriate policies. Strengthening cooperation between central and local governments will also be important for the success of this process.
12. The required streamlining in primary spending should rely on continued reforms and focus on promoting economic growth. The reforms to the benefits system—including the introduction of the activation allowance—are expected to contain spending and provide incentives for higher labor force participation. Additional savings in these areas could be obtained from phasing out early retirement privileges, reevaluating disability pension schemes, containing abuse, and improving management of the Social Insurance Agency. Health care reform is expected to stop the accumulation of arrears in the system although public spending in health care will increase significantly in 2005. This increase will need to be stemmed in the medium term by improving administration of the system and limiting the basic free universal benefit package. We understand that the government intends to cut waste in all the chapters of the budget, but more policy elaboration is needed to clarify the source of further durable expenditure savings in 2006 and 2007. To support growth, these savings should be in areas that preserve the implementation of EU-funded projects, and rely on the continued restructuring of inefficient sectors, such as the railways. Moreover, we would urge a careful review of spending on subsidies that seem unlikely to enhance potential economic growth, particularly agricultural subsidies.
13. We welcome ongoing improvements to fiscal management, but the new extrabudgetary fund is a setback to fiscal transparency. The new Debt and Liquidity Management Agency is already generating significant savings on government debt, and the recently established State Treasury is also making an important contribution to fiscal control, notwithstanding some temporary gaps in state budget expenditure data. However, we regret parliament's recent decision to re-establish an extrabudgetary environmental fund. The absorption into the state budget at end-2001 of most extrabudgetary funds—including the previous environmental fund—had been vital for transparency, particularly for parliament's oversight of government expenditure. We hope that the new environmental fund will not set a precedent for further reversals of fiscal transparency.
14. The macroeconomic policies recommended above are preconditions for successful participation in ERM2. The responsibility for meeting the goals of the euro adoption strategy lies not just with the NBS but also with the government. The credibility of the strategies for meeting both the inflation and fiscal criteria will be vital; missing any Maastricht criteria would result in a longer, and probably more difficult, stay in ERM2. Continuing to introduce structural expenditure savings to keep the fiscal deficit on the firm downward path discussed above is essential to allay market concerns that the Maastricht deficit criterion might be missed. Moreover, sustained structural efforts should continue to boost the resilience of the economy to shocks, including by bolstering the flexibility of the labor market. This will be especially important after Slovakia loses the exchange rate instrument.
Structural and Financial Sector Issues
15. Dealing with unemployment—a core social problem—requires a comprehensive approach encompassing education, enhanced labor mobility, and changes in taxation. Recent reforms to the labor code and the benefit systems are clearly steps in the right direction. They are expected to encourage employment in the period ahead through reducing restrictions on part-time employment, easing separation arrangements, and containing the scope for abuse of unemployment benefits. However, additional policies are needed to significantly lower unemployment. First, the quality and relevance of tertiary education should be improved, and vocational education should be reformed to meet evolving labor market demands. We welcome recent cooperation among the private sector, universities, and the Ministry of Education to tailor the training of graduates to market needs. The scope of these efforts should be broadened, as market needs are bound to continue changing at a brisk pace. Second, housing availability is hampering labor mobility; the government could encourage the development of more affordable housing in areas that are showing strong employment growth. Third, priorities for developing the transportation infrastructure should also take into account the need to link eastern regions with high unemployment to the centers of economic activity. Fourth, the government will need to keep searching for ways to reduce taxation on labor. While reducing distortions, encouraging investment, and improving tax administration, the recent tax reform also shifted the tax burden away from capital and toward labor, boosting incentives for more capital-intensive activities rather than employment growth.
16. An efficient and predictable legal environment is needed to attract small- and medium-sized enterprises—which are an engine of job creation in most countries. We therefore welcome the new commercial registry act, which has considerably shortened, standardized, and simplified firm registration procedures. We also welcome the new bankruptcy law being discussed in parliament, which would overhaul current bankruptcy procedures by speeding up their processing, improving creditor rights, reducing discretion by bankruptcy judges, and randomizing the allocation of cases to judges to reduce the potential for corruption. The task ahead is to improve the functioning of the courts to reap the benefits of the improved legal framework. The government intends to attract a new wave of investment, particularly in disadvantaged regions, through significant fiscal incentives. While investment incentives are widely used by other countries in the region, they should be designed to ensure that they are cost-effective and promote investment that would not have otherwise taken place.
17. Available indicators show that Slovakia's banking sector is sound, but emerging risks should be carefully monitored. Bank profitability is solid, non-performing loans are declining and well provisioned, and bank lending is rebounding—led by credit to households. However, this growth in household credit exposes the financial sector to new risks, which are amplified because available statistics do not capture the additional credit granted by nonbank institutions. Broadening data coverage is therefore important to enhance supervisory capacity. In particular, the NBS will need to collect comprehensive data on household assets and liabilities. We welcome institutional improvements that have enhanced the efficiency of banking supervision—as demonstrated by the completion of examinations of all banks over the past two years. Bank supervision should now react appropriately and in a timely fashion to examination findings, and should enhance its capacity for effective consolidated supervision. The integration of the Financial Markets Authority into the NBS in 2006 is expected to bring synergies, but should not distract from effective oversight of the financial sector.
18. The government's plans to finalize privatization will contribute to better resource allocation, and progress on product market reform will also provide an impetus to growth. The envisaged sale of Slovenske Elektrarne would successfully conclude major privatizations. The electricity and gas markets should be opened to competition, as planned, and the government should ensure a balanced relationship between the current providers, buyers, and alternative suppliers of these goods. Although in theory the market is already open for large consumers, the tariff structure offered to consumers appears to be discouraging real competition between current and prospective suppliers.
Slovakia has introduced an extraordinary range of reforms; completing and sustaining them will require continued determination. Confronting this challenge in the period ahead will be essential for successful participation in the eurozone. We wish the authorities well in this endeavor, and thank them for their close cooperation with the mission and their generous hospitality, and for stimulating discussions.
1 Czech Republic, Hungary, Poland, and Slovakia.