Slovak Republic -- 2005 Article IV Consultation Discussions, Preliminary Conclusions of the IMF Mission
December 14, 2005
1. Sound macroeconomic management and a wide range of fundamental structural reforms over the past few years have facilitated Slovakia's successful entry into ERM2 on November 25, 2005. Policy makers should now focus on laying the ground for a smooth transition under ERM2 to euro adoption, planned for January 2009, and for strong performance in the monetary union. Although the economy is well poised in many respects (in particular, Slovakia already meets the Maastricht criteria for long-term interest rates and the public debt ratio), risks and challenges remain. The immediate challenges are to reduce inflation and the fiscal deficit to levels that meet the Maastricht criteria, satisfy the test of exchange rate stability under ERM2, and reduce the risk of an overly strong conversion rate when the euro is adopted. With the economy on course to grow at or above estimates of potential in the period ahead and given upside risks to inflation, a tighter fiscal stance than envisaged in the 2006-08 budget is necessary to minimize tensions between the inflation and exchange rate objectives. A political consensus that recognizes the pay-off from continued focus on fiscal prudence will remain essential. These aspects are elaborated below.
Recent developments and outlook
2. Robust economic growth has continued in 2005, and its pace (forecast by the mission at around 5½ percent for the year as a whole) has surpassed expectations. Private consumption and fixed investment demand have strengthened appreciably, but have been accompanied by inventory rationalization. A large positive swing in net exports has occurred in the second half of the year. Still, mainly reflecting developments in the first half, the external current account deficit is projected to widen to 5.6 percent of GDP by year-end, but much of it is covered by foreign direct investment inflows.
3. The downward trend in headline consumer price inflation since early 2005 was partially reversed in the fourth quarter on account of increases in regulated prices in October. Inflation at end-2005 is forecast at around 4 percent, compared with 5.9 percent at end-2004. Koruna appreciation, falling food prices due to a good harvest, and increased competition at the retail level subsequent to EU membership have dampened inflation pressures. Despite real wage growth gathering pace and exceeding productivity gains, the increase in prices of non-tradables has slowed.
4. Fiscal performance thus far in 2005 has been better than expected. Tax revenues have been boosted by stronger growth in their underlying bases (wages, employment, consumption, and enterprise profitability) and should exceed the budgeted levels. In addition, there have been savings in interest payments. Assuming that these additional resources are saved and are not matched by increased spending in the last few weeks of the year, and taking into account forgiveness of certain foreign debt claims, the mission projects a general government deficit of 3.1 percent of GDP compared with 3.4 percent of GDP envisaged in the budget (excluding the cost of the second pension pillar). The projected outturn implies a slight withdrawal of fiscal stimulus in 2005, which is appropriate.
5. Looking ahead, a strengthening of economic growth and the external current account position can be expected. The composition of growth is likely to shift toward net exports, with the commencement of production at new plants in the automobile industry and the associated pick up in exports. Private consumption growth is projected to moderate somewhat, on the assumption that real wage growth will slow (as it resumes to lag productivity growth) and that household saving propensity will remain stable. Some easing of investment growth is likely with the completion of several large FDI-financed projects, and further inventory rationalization is anticipated. Accordingly, the mission projects real GDP growth to increase to about 5¾ percent in 2006 and 6½ percent in 2007, and moderate to 5¼ percent in 2008. The projected expansion in the next two years is at or above the mission's estimates of potential growth, and is higher than that assumed in the recently approved budget. The external current account deficit is projected to narrow progressively to 3¼ percent of GDP in 2008.
6. National Bank of Slovakia's inflation targets for end-2006 and end-2007 are ambitious, especially when measured against the structural influences stemming from the catching-up process, and their achievement may be subject to risks. The HICP inflation target for end-2006 (2.5 percent) is likely to be breached on account of the unanticipated further adjustments in regulated prices scheduled for January 2006. Though, it may be feasible to achieve headline CPI inflation of 2.5 percent by end-2006, provided second-round effects from the impact of regulated price increases are absent. In the mission's assessment, there are uncertainties about lowering inflation further to the end-2007 target (2.0 percent, HICP basis). Although its impact has been muted thus far, the risk of inflationary pressures from declining economic slack cannot be discounted. Moreover, if the historical relationship of similar nominal wage growth in tradable and non-tradable sectors is sustained, a pick up in growth driven by the tradable sector is likely to result in higher unit labor costs in the non-tradable sector and could feed through to inflation. The effect could, however, be tempered if retail competition continues to intensify as it has in the recent past. Based on these considerations, the mission forecasts headline CPI inflation remaining about 2.5 percent in 2007.
Monetary, exchange rate, and price policies
7. A hybrid monetary framework of inflation targeting and exchange rate targeting that is being followed by the NBS should be compatible with achieving the Maastricht inflation criterion and meeting ERM2 requirements, provided monetary policy is supported by strong fiscal policy and wage moderation. Since this eclectic approach is less transparent than pure inflation targeting, the authorities will need to communicate their policy strategy with as much clarity as possible.
8. An improvement in policy coordination with regard to adjustments in regulated prices is warranted. Unanticipated increases in regulated prices that lead to overshooting of the inflation target is likely to undermine the role of the NBS's inflation targets in anchoring inflation expectations. Plans for adjustments in regulated prices should be formulated in a multi-year framework, and the circumstances under which actual changes could deviate from the currently planned changes should be clearly specified. In this context, it would be useful to undertake a review to determine the scope for efficiency gains and commensurate cost saving in sectors subject to regulated pricing. Indeed, the impending privatization of the largest electricity producer and the six largest heating plants should contribute to higher efficiency.
9. The inflation goal will have to be met while ensuring a viable exchange rate. In this regard, the right choice of both the central parity at entry into ERM2 and the terminal conversion rate is critical. As the current level of the real exchange rate is estimated to be close to the real equilibrium exchange rate, the mission believes that setting the central parity at 38.455 koruny per euro—around the market exchange rate just prior to ERM2 entry—was appropriate. In the period ahead, the economic outlook (rising growth and narrowing external current account deficit) and the likely continued positive sentiment of rating agencies and foreign investors toward Slovakia make room for some nominal and real appreciation of the koruna but also creates the potential for overshooting. The mission understands that the EC and ECB recognize that structural factors can generate an appreciation of the real exchange rate in the new member states and are likely to take this into account in the assessment of exchange rate stability. However, it would be important to ensure that appreciation under ERM2 is not excessive (measured in relation to the equilibrium real appreciation), as this would bite into competitiveness and risk producing an overly strong conversion rate, with potential serious long-term consequences. In this context, the mission would like to note that Slovakia's competitiveness vis-à-vis neighboring new EU-member states has eroded in the past few years, judging on the basis of developments in bilateral real exchange rates and relative profitability indices. The mission's analysis also suggests that adjusting for labor productivity, average wages in the manufacturing sector in Slovakia are not uniformly lower than in the neighboring new member states. Thus, there is little room for complacency in maintaining competitiveness.
10. Fiscal policy should be oriented not only toward meeting the Maastricht deficit criterion, but also toward supporting the disinflation goal (including countering the upside risks to inflation as well as easing the burden on monetary policy). Support from fiscal policy will be crucial for ensuring exchange rate stability while preventing excessive appreciation. Also, the medium-term consolidation path should be consistent with ensuring long-term fiscal sustainability and meeting the requirements of the Stability and Growth Pact.
11. The recently approved 2006-08 budget is on track to meet the Maastricht fiscal criterion in 2007, but the implied evolution of the fiscal stance could complicate the achievement of the inflation and exchange rate objectives. Viewed against the expected fiscal outturn in 2005, the deficits envisaged in the budget (2.9 percent of GDP in 2006, 1.6 percent of GDP in 2007, and 1.3 percent of GDP in 2008, excluding the cost of the second pension pillar) imply an expansionary fiscal stance in 2006, a broadly neutral stance in 2007, and a withdrawal of stimulus in 2008.1 This pattern would be ill timed and, therefore, inappropriate. The substantial pro-cyclical stimulus implied by the 2006 budget should be avoided. In 2007, a withdrawal of stimulus would be desirable to counter the risks to the inflation goal.
12. The strategy to achieve the desired additional fiscal consolidation needs to include two elements:
• Safeguarding in all years the additional revenues arising from the carry-forward of the momentum of revenue over-performance in 2005 and from the anticipated stronger economic growth than assumed in the 2006-08 budget. In other words, the nominal expenditure targets specified in the budget should be adhered to even in the face of higher revenues. Any saving on interest payments also should be saved.
• Durable expenditure saving. The mission would recommend that the authorities undertake durable expenditure restraint equivalent to about ½ percent of GDP in 2007. There appears to be scope for restraining expenditure through cutting waste, continued restructuring of inefficient sectors (such as the railways), and keeping real growth of subsidy expenditures (including to the agriculture sector) well below the growth of real GDP.
According to the mission's calculations, the proposed measures would yield a neutral fiscal stance in 2006, a withdrawal of stimulus of about 1 percent of GDP in 2007, and revert to a neutral stance in 2008. The proposed adjustment would also build a sufficient cushion against breaching the SGP limit of 3 percent deficit from a possible downturn in the future.
13. Saving the revenue over-performance will require the participation of all levels of government. The fiscal rules applicable to local governments do not prevent revenue over-performance from being utilized for additional spending. As such, the fiscal rules do not ensure operation of the automatic fiscal stabilizer. Non-adherence to the budgeted expenditure ceilings carries a risk of a cyclical increase in expenditure becoming permanently entrenched. The mission would encourage the authorities to take early and decisive steps aimed at improving fiscal management at the local government level and ensuring expenditure control necessary to achieve the fiscal consolidation objective and to enhance the flexibility of fiscal policy.
14. Wage moderation would be important in bringing down inflation, and greater wage flexibility would ensure that asymmetric shocks can be effectively absorbed in the absence of monetary policy following euro adoption. A slow down in the pace of minimum wage increases would be helpful, as this has a subsequent impact on the wage drift. The authorities also should keep a tight rein on public sector wages with the aim of signaling the importance of wage moderation. This would complement the NBS's communication efforts to make private wage bargaining adopt forward-looking adjustment to inflation. A large part of wage setting is already decentralized, but there is scope for further expanding enterprise-level wage bargaining and ensuring greater productivity-based wage adjustments.
Financial sector and other structural issues
15. Financial soundness indicators show that the Slovak banking system is currently healthy, but special attention should be paid to emerging risks. Credit to households has continued to grow rapidly, and there are signs of banks easing underwriting standards and providing loans to sub-prime clients in a competitive environment. Stress testing by the authorities suggests that at this point in time the banking system is resilient to increases in non-performing loans and to other macroeconomic shocks. Still, it would be desirable to ensure proper risk management at the bank level and prevent an excessive build-up of financial risks. Thus, the mission welcomes the efforts initiated by the NBS to improve data collection through new reporting forms and bank lending survey, to strengthen cross-border supervision, and to meet more frequently with banks. Supervisors also should pay particular attention to the risk assessment standards of banks during on-site inspections.
16. Improved supervision of non-bank financial institutions is a priority. The NBS's plan to apply a risk-based forward-looking supervision approach for these institutions under the unified supervision unit is appropriate. The fast growth of pension funds underscores the importance of close monitoring of risks in this evolving sector of the market. The mission would also encourage the authorities to develop a more unified and consistent approach to issues related to anti-money laundering and combating financial terrorism, as recommended by MONEYVAL examiners. The introduction of Basel II standards, planned for January 2007, should further strengthen financial sector surveillance. The IMF stands ready to review the Slovak authorities' plans for the transition to the Basel II regime and to assist in the development of a road map. The mission would also recommend that a FSAP update is undertaken in 2006 prior to the next Article IV consultation discussions.
17. Addressing the high unemployment problem is a continuing challenge. The introduction of earned income credit for low-income earners (currently under consideration), improvements in the focus of active labor market policy measures, the new investment incentive package that seeks to promote foreign investment in high unemployment regions, and the creation of a venture capital scheme for small and medium-sized enterprises should help increase employment opportunities and bring down the unemployment rate. The mission suggests that more attention be given to reducing the bureaucracy in the issuance of construction permits and to further speeding up enforcement of contracts at courts. With regard to the latter, Slovakia lags behind other EU countries.
We would like to thank the Slovak authorities for the close cooperation with the mission, their hospitality, and for the stimulating discussions.
1 The decline in the headline fiscal deficit envisaged in 2007 is mainly cyclical in nature, and a substantial stimulus arises from the anticipated higher EU-related spending.