Slovak Republic -- Concluding Remarks of the IMF Staff Visit
October 3, 2006
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
Slovak Republic -- Concluding Remarks of the IMF Staff VisitOctober 3, 2006
1. The IMF mission supports the authorities' goal of euro adoption in January 2009 and the emphasis on socially inclusive economic growth. Over the past few years, Slovakia has become one of Central Europe's strongest economic performers. Euro adoption, properly prepared, should strengthen this status as it is likely to bestow further substantial net benefits that will feed into sustained high growth. At the same time, spreading the gains from growth to all segments of the population will promote social cohesion and ensure broad-based political support for economic policies.
2. Achieving these goals is inherently challenging in that it will require a judicious balance of policies. For euro adoption, policies must be suitably oriented toward not only meeting the Maastricht criteria but also enhancing the ability of the economy to deal with shocks. To ensure strong performance in the monetary union, appropriate adjustment mechanisms—wage flexibility and the capacity to run countercyclical fiscal policy—ought to be in place prior to adopting the euro. The increased social orientation of policies will need to be carefully meshed into this framework. A consensus among senior policy makers that recognizes the pay-off from a continued focus on fiscal prudence and structural reforms will remain essential. A consistent and credible policy framework also will be key to strengthening and sustaining the confidence of financial market participants who are watching the actions of the new government closely.
3. The details of the new government's economic policy framework are still being crafted. Thus, the mission's observations are necessarily selective and preliminary. A more comprehensive assessment of policies and economic outlook will be undertaken during the next Article IV consultation discussions planned for February 2007.
4. Political transition in Slovakia is taking place at a time of cyclical upswing. Economic growth in 2006-currently forecast at around 6½ percent—has strengthened more than anticipated in the 2006-08 budget framework and the last Convergence Programme update. A further pick up in real GDP growth to about 7 percent is expected in 2007, with the impetus coming from higher exports as new automobile plants commence production. Thereafter, growth is likely to ease from this peak, and the pace over the medium term would depend on the orientation of macroeconomic and structural policies. The key to sustaining growth at the 5 percent rate envisaged in the last Convergence Programme update is to steer a course that stimulates investment and job creation, preserves competitiveness, and encourages diversification of the production structure.
5. The general government deficit in 2006 is likely to be smaller than envisaged in the budget, but still the fiscal stance will be slightly expansionary and the expenditure structure will turn more rigid. The deficit, including the cost of the second pension pillar, is officially projected at 3.6 percent of GDP, compared with 4.2 percent of GDP envisaged in the budget and a 3.5 percent of GDP outturn in 2005. Collections of tax revenue are running ahead of expectations, owing to stronger-than-expected growth in their underlying bases, and some scaling back of capital expenditure is anticipated. However, a part of this cushion will be offset by increases in social spending and other transfers. The share of non-discretionary current spending (excluding interest payments) in total expenditure is thus projected to rise from 70 percent in 2005 to 74 percent in 2006.
6. Both headline inflation and core inflation (HICP basis) have been on an upward path since September 2005, but a downturn is expected in the fourth quarter of 2006. The rising trend to date reflects the impact of rising world energy prices, a turnaround in food price inflation, and a faster increase in prices of non-tradables. Regulated price increases that are in the pipeline are expected to be modest compared with the increases in the previous round, which should result in significant gains in disinflation. Given the latest unofficial estimates of upcoming regulated price increases and on the assumption that international energy prices remain around the present level, the staff projects inflation to fall to around 4 percent at end-2006 (well above National Bank of Slovakia's (NBS) original target of 2½ percent). The mission's baseline inflation scenario shows an average annual inflation of around 2¾ percent during the assessment period for compliance with the Maastricht criteria (April 2007-March 2008)-slightly under the currently projected reference rate, which is subject to uncertainty.
7. Although the Maastricht inflation criterion seems within reach, there are clear upside risks to inflation. First, there were signs of incipient wage pressures in the second quarter of 2006, and this may intensify on account of backward-looking indexation to inflation and the knock-on effect of the recently announced increase in the minimum wage. Second, the expansionary fiscal stance in 2006 (much of which derives from additional current spending) could exert upward pressure on inflation in 2007. In addition, there are uncertainties surrounding the evolution of world energy prices. Given that the inflation criterion will likely be interpreted strictly (as evidenced in Lithuania's recent experience of missing the criterion by a whisker) and that the reference rate itself is uncertain, it would be important to insure against the risks and uncertainties and aim at a lower inflation rate to provide a higher safety margin.
8. Responsibility for meeting the Maastricht criterion on inflation (and the related one on exchange rate stability) cannot be assigned exclusively to the NBS. Similarly, the Ministry of Finance on its own cannot deliver on the fiscal deficit criterion. Rather, coordinated and concerted efforts will be required by all government bodies. In view of the transmission lags, early and decisive policy actions are necessary in a number of areas, including regulated prices, monetary and fiscal policies, and wage-setting.
9. Regulated prices. The mission was informed that the government's initiative on regulated prices does not interfere with the principle of cost recovery, but is aimed at squeezing the profits of the natural monopolies and inducing them to achieve efficiency gains. It would be important to ensure that the anticipated moderation of regulated price increases is sustainable, does not entail cross-subsidization, and is in compliance with European Commission directives. The mission understands that changes are being considered in the regulatory mechanism. In this context, the transparency of the pricing formulas and the independence of the regulatory body should not be compromised.
10. Monetary policy. While the mission believes that there is scope for further interest rate hikes, a disinflation strategy centered around monetary policy alone has significant drawbacks. If the authorities were to rely primarily on monetary policy, it could increase speculative capital inflows and exchange rate volatility (which could threaten the test of exchange rate stability under ERM2). In the event of inconsistencies or lack of credibility in the policy framework, Slovakia's risk premium would likely increase and the effectiveness of monetary policy will be severely reduced.
11. Fiscal policy. Given the upside risks to inflation and with the economy growing at a faster rate than potential, a more ambitious fiscal deficit path for 2007-09 than currently envisaged would be desirable. The authorities' announced fiscal deficit targets for 2007-09 (3 percent of GDP in 2007, 2½ percent of GDP in 2008, and 2 percent of GDP in 2009) are aimed at meeting the Maastricht fiscal criterion in 2007 and conforming to Stability and Growth Pact guidelines. Together with the planned utilization of EU funds, the envisaged deficits imply a broadly neutral fiscal stance in 2007, a withdrawal of stimulus in 2008, and a neutral stance in 2009. The mission recommends a withdrawal of fiscal stimulus in 2007 when the inflation criterion is at risk. Toward this end and to provide a safety margin, a reduction of the targeted general government deficit in 2007 by about ½ percent of GDP to 2½ percent (and progressive lowering of the deficit thereafter) would be appropriate. To have a demonstrable effect on inflation during the assessment period, the additional fiscal restraint needs to be implemented up-front in the first half of the year.
12. Lowering the fiscal deficit target in 2007 as proposed by the mission would require scaling back outlays on planned new measures. Even so, consistent with the new government's goal, there would be room for higher social spending than anticipated in the 2006-08 budget framework of the previous administration. The mission would advise the authorities against seeking short-term budgetary savings by restraining capital expenditure as this would impair the long-term economic growth potential. Moreover, any revenue over-performance or saving in interest payments should be saved.
13. The overall fiscal framework, especially on the expenditure side, needs to be strengthened. The authorities have created room for some of the planned increase in social spending and other transfers by ad hoc across-the-board limits on discretionary expenditures rather than through efforts focused on addressing inefficiencies in the system. The mission is concerned about the possibility of emergence of quasi-fiscal deficits and corresponding debts which the central government might eventually have to absorb down the road—some agencies may be able to offset the reduced expenditure allocations by borrowing with government guarantees, and the budget constraint on health care providers has been weakened by the reversal of previous reforms. In a similar vein, there are uncertainties about the evolution of deficits of local governments as fiscal control is exercised through ceilings on their debt stock, which are currently non-binding. Another concern is that the authorities have not identified how the higher level of social spending and other transfers currently planned for 2007 will be sustained in subsequent periods when further fiscal consolidation is intended and revenue growth may slow down. As such, an increase in the share of non-discretionary expenditures in total spending would make the structure of the budget more rigid, making fiscal adjustment more difficult in the event of shocks.
14. Slovakia's simple and efficient tax system has become a hallmark of its recent economic success and an attraction for investors. The mission is therefore pleased to note that the only marginal adjustments to the existing tax system are planned and that these are not likely to create significant distortions. The mission would encourage the authorities not to expand the list of items subject to a lower VAT rate (which currently will apply only to medicine and medical tools) so as not to create opportunities for tax evasion and burden tax administration.
15. Wage policy. Wage moderation and flexibility in wage setting procedures will be important for containing inflationary pressure as well as for safeguarding competitiveness. Thus, the mission supports the government's intention to limit wages increases in the budgetary sphere to 5 percent per year during 2007-09. It would be important to ensure that this limit is not breached. The mission recommends that wage increases in the rest of the public sector also be limited to 5 percent per year during 2007-09. However, the mission is concerned that in the private sector the large (10 percent) increase of the minimum wage could have a knock-on effect on the entire wage structure, and that the large breach of the NBS's inflation target in 2006 could encourage backward-looking indexation of wages. The mission encourages the authorities to exercise moral suasion on the social partners to avoid such an outcome. Also, in the mission's view, the introduction of an earned income credit for low-income workers would be a better option to guarantee a minimum living standard than further increases in the minimum wage.
16. In the past few years, labor market flexibility in Slovakia has improved. This is evidenced in part by the decline in the Employment Protection Legislation and Rigidity of Employment indices. To foster employment creation and to prepare for EMU membership, it will be essential to further enhance labor market flexibility. Thus, the authorities should ensure that changes to the Labor Code under consideration provide the required support in this direction, by easing hiring and dismissal rules, promoting regional mobility and providing for flexible wage setting mechanisms.
It is a pleasure to have been welcomed by the new government so early in its tenure. We thank our interlocutors for their cooperation and wish them success in the job ahead.