Slovak Republic -- Concluding Statement of the IMF Staff Visit, July 2005
July 14, 2005
1. Slovakia's successful first year of EU membership positions it well for dealing with the challenges ahead. Growth remained robust despite a difficult external environment, inflation declined notwithstanding higher oil prices, and foreign investors' interest in the country continued to increase. Although unemployment remains high, trends in employment and unemployment are improving. These achievements provide a solid basis for pursuing the government's goals to enter ERMII in the first half of 2006 and adopt the euro in January 2009. The authorities' timetable to join the euro area is feasible but requires that they stay the course with fiscal consolidation and disinflation, while continuing with structural changes to make the Slovak economy more flexible. This statement highlights the main fiscal and monetary policy considerations for the period ahead.
2. Economic activity is buoyant, helped by strong domestic demand. Although easing from the 5½ percent growth in 2004, data for the first quarter of 2005 confirmed that economic activity remains strong. GDP growth in that quarter was 5.1 percent year-on-year, and we expect it to be about 5 percent for the year as a whole. In line with trends observed in 2004, growth is being supported by FDI-driven fixed investment and robust private consumption growth, with the latter reflecting higher disposable incomes. The negative contribution of net exports to growth is projected to increase as FDI brings with it substantial capital imports. Strong imports will contribute to a widening of the current account deficit to about 6½ percent of GDP for 2005 as a whole.
3. The general government deficit was better than targeted in 2004, and, despite strong growth, year-on-year inflation has fallen. Excluding a one-time unbudgeted payment of health sector debt amounting to 0.8 percent of GDP, the fiscal deficit was 3.3 percent of GDP against the 4 percent of GDP budgeted. Year-on-year inflation declined in the first half of 2005 reflecting primarily base effects from one-off increases in indirect taxes and regulated prices last year, but also falling food prices, strong retail competition, and koruna appreciation. Despite high oil prices in 2005 compared to the previous year, we project end-year CPI inflation at 2.7 percent, below the NBS's indicative target range.
4. Changes to the monetary policy framework introduced this year focus policies on inflation goals. The National Bank of Slovakia's (NBS) new inflation-targeting framework is expected to increase transparency and contribute to more forward-looking inflation expectations, hopefully breaking the inertia observed so far in nominal wage increases. We support the new framework and welcome the increasing role of inflation models in the NBS's decisions. The publication of inflation projections was an important step in making monetary policy more transparent and improving communications. However, it has been limited to quarterly inflation averages while NBS targets refer to end-year inflation. Thus, to improve transparency, NBS publication of its quarterly forecasts should be extended to end-year forecasts, in line with the definition of its targets. Also, the NBS should continue with efforts to make private sector wage-setting more forward looking.
5. Increases in fuel and regulated prices, as well as demand pressures, could challenge monetary policy in the year ahead. Unemployment and remaining economic slack should curtail second-round effects on wages, and koruna appreciation is expected to further constrain price increases. Thus, we expect end-2006 inflation at close to, but slightly exceeding the NBS ceiling of 2½ percent. However, we see upside risks to inflation arising from a rapidly-diminishing economic slack, possible further oil price increases, and the danger that rapid wage growth will exceed productivity increases. Thus, the NBS should remain vigilant to detect signs of, and react appropriately to, any second-round effects of fuel price increases and demand pressures.
6. Fiscal policy should support disinflation efforts. Significant koruna appreciation has played an important role in bringing inflation down over the past year. However, further fast appreciation could start to bite into competitiveness, and policies need to preserve competitiveness in the run-up to ERMII as well as to ensure price stability. In this spirit, fiscal policy should play a more active role to ease the burden on monetary policy in bringing inflation down.
7. The projected fiscal stance in 2005 provides appropriate support to disinflation objectives. We expect the general government deficit in 2005 to reach about 3.4 percent of GDP (4.2 percent of GDP including second pillar costs), in line with the budget. Higher-than-expected participation in the second pillar pension system has doubled pension cost estimates and overall social security contribution collections will fall short of budget due to administrative difficulties. However, tax collections are in line with the budget, savings are expected on the expenditure side, and net EU transfers are projected below budget (½ percent of GDP instead of the budgeted 1⅓ percent). Should this happen, the budgeted neutral stance will turn into a negative fiscal impulse for the year as a whole.
8. However, it would be preferable if the projected fiscal stance came from further systemic reform rather than lower net EU transfers. Several options are available in this regard. The health care system and the Social Insurance Agency remain a drag on the budget because of poor revenue collections, and efforts should continue to reduce wasteful spending across the board. Addressing these issues would allow taking full advantage of EU funds to improve key aspects of the economy while avoiding cyclically ill-timed demand pressures.
9. A tighter fiscal stance is needed in 2006 to support disinflation objectives and enhance the credibility of the 2006-08 fiscal framework. The government has released parameters for the 2006 draft budget implying a general government deficit of 2.9 percent of GDP (4.2 percent of GDP including second pillar pension costs). This lower deficit compared to 2005 would imply a broadly neutral fiscal stance because of the effect of net EU transfers. With growth running above potential for the past two years and the inflation target at risk, we believe that a reduction of the targeted general government deficit by about ½ percent of GDP would be desirable. Adjustment of the fiscal stance should rely on permanent expenditure reduction, including curtailing subsidies that are unlikely to enhance growth potential, such as those to agriculture and housing savings programs. A more ambitious deficit target would support disinflation, strengthen the country's position during the first year in ERMII, and provide margins to deal with negative shocks, which will be critical once Slovakia enters the euro area. Bringing forward adjustment to 2006 would also spread more evenly the fiscal effort, which is now back-loaded to 2007, thus bolstering the credibility of the authorities' plans.
10. The NBS has made significant progress in strengthening banking supervision. We welcome institutional improvements that have enhanced the capacity of the banking supervision department to assess risks in the banking system, relying in part on a stress-testing framework. The merger of financial supervisors scheduled for January 1, 2006 ought to strengthen supervisory capacity, but the process should not be allowed to distract from effective oversight of the financial sector. The risk-based supervision approach developed by the NBS should be extended swiftly to the merged supervision unit to permit unified monitoring of the sector. The fast growth of second pillar pension funds underscores the importance of close monitoring of risks in this evolving sector of the market.
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We thank the authorities for their usual generous hospitality and excellent cooperation.