Slovak Republic -- 2009 Article IV Consultation, Concluding Statement of the IMF Mission
May 25, 2009
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.
Slovakia has been among the best economic performers in central and eastern Europe in recent years. During 2004–08, the country enjoyed a period of rapid economic growth guided by sound macroeconomic and structural policies, and buoyed by a vibrant export sector. Real GDP grew by an average 7.4 percent, which helped reduce the difference in GDP per capita between Slovakia and the EU average substantially. At the same time, the unemployment rate dropped by 8½ percentage points.
The broad-based economic expansion did not instigate imbalances or unsustainable dynamics. Inflation remained relatively low, credit expansion was high but consistent with the underlying convergence process, and wage growth in line with productivity helped maintain competitiveness. Public debt has dropped to the point where it does not pose major concerns. The current account deficit has declined gradually to a level consistent with convergence. It was mainly financed by FDI, and hence external debt remains low. These favorable factors have facilitated, despite the global financial turmoil, a smooth transition to the Euro in January, which in turn enhanced stability and confidence—manifested in the highly successful placement of a Eurobond in mid-May.
The financial sector’s focus on traditional prudent banking activities and reliance on retail funding has helped it weather the global financial crisis well thus far. Data through the first quarter suggest that the sector remained overall sound, profitable, liquid and well capitalized. Nonetheless, there are signs that the economic downturn is beginning to impact asset quality.
Slovakia is highly influenced by external economic developments, however, and the global economic slump has substantially affected its economy. Strong economic fundamentals, prudent macroeconomic policies, and a sound financial sector contributed to maintaining the country’s high growth throughout 2008. But the magnitude and extent of the global slump, particularly the pronounced economic weakening in the euro area, led to a sharp decline in Slovak economic activity in the first quarter of 2009. The unemployment rate soared, and inflation decelerated rapidly.
In response to this sharp deterioration in the economic environment, the government has taken various policy initiatives to support domestic demand, employment, and low-income earners. A reallocation and rationalization of spending under an unchanged budgetary expenditure envelope created some room for employment subsidies and a negative income tax for low income earners. An increase in the utilization of EU transfers as envisaged by the authorities could add to the stimulus. The authorities also acted commendably to ensure the stability of the financial sector, notably by stepping up bank monitoring and by strengthening domestic coordination mechanisms and cross-border supervisory arrangements.
Against the projected frail economic conditions in the euro area through 2009, real GDP is projected to shrink significantly this year—around 4½ percent. Although the collapse of external demand is at the origin of the downturn, a drop in confidence and employment and tighter lending conditions will also dampen private consumption and investment. Downside and upside risks around the forecast are broadly balanced. They mainly relate to external developments and are unusually large, in part because of the ambiguity about the timing and scope of a global recovery.
Reflecting the broad economic downturn, the unemployment rate is projected to exceed 12 percent by end-2009, notwithstanding wage moderation, supportive government policies, and responsible social partners. The fiscal deficit is forecasted to swell to slightly above 5 percent of GDP, mainly on account of a revenue shortfall, while inflation will remain subdued.
By 2010, we expect that the economic environment will improve. Supported by the projected rebound in the euro area, real GDP growth is forecasted to reach about 2 percent in 2010 and accelerate to 4–5 percent from 2011 onward, still significantly below the exceptional 2004–08 performance. The unemployment rate will remain high through 2010, before starting to ease in 2011. Assuming no policy adjustments, the budget deficit will remain at a high level of around 5 percent of GDP during 2010–11.
The key challenge for fiscal policy will be to anchor an accommodating fiscal stance in the short run within a credible medium-term consolidation strategy aimed at reducing the deficit and improving the quality of public finances. Under the current unprecedentedly weak economic conditions, letting the deficit widen in 2009 as a result of falling revenue is appropriate and should not raise investor concern—particularly in view of the low government debt-to-GDP ratio and the overall prudent fiscal policy track record of recent years. However, the 2004–08 growth acceleration translated into expenditure patterns that, if maintained over the medium term, could result in persistent deficits in excess of the Maastricht ceiling.
The fiscal strategy should aim at bringing down the deficit to about 4 percent of GDP next year and to below 3 percent of GDP by 2011. Taking into account the projected recovery, this adjustment trajectory would help support investor confidence in the authorities’ underlying commitment to sound fiscal policies and help meet SGP requirement. The recommended deficit targets will require a discretionary fiscal effort of about 1 percent of GDP each year in 2010–11.
To achieve the recommended deficit path, sustained efforts to further cut costs, better target social spending, and improve the quality of public spending will be essential the coming years and also in the remainder of 2009. Some laudable efforts to improve the efficiency and effectiveness of spending, including steps to merge smaller government agencies and centralize and streamline public procurement, are already under consideration, but more needs to be done. The expenditure dynamics in health care and financial losses in the hospital sector are of particular concern, and need to be addressed through structural reforms along the lines previously recommended by the IMF. At the same time, targeted social spending and investment outlays should remain a clear priority and be protected.
In the context of the 2010 budget, the authorities plan to broaden the base and simplify the rate structure of social security contributions. This is a welcome step and could provide up to ½ percent of GDP additional revenue with a relatively limited negative impact on economic activity. However, more will be required to bring down the deficit to around 4 percent of GDP next year, including through public sector wage moderation consistent with deteriorating labor market conditions and wage restraint shown by the private sector .
Additional adjustment will be necessary in 2011 to further narrow the underlying gap between expenditure and revenue trajectories and return the deficit to below the Maastricht ceiling. With the scope for savings from continued expenditure rationalization diminishing, this could be achieved through a combination of revenue-raising tax policy measures and some additional expenditure cuts.
The consolidation strategy should be supported by fiscal institutional reforms and enhanced fiscal transparency. The medium-term expenditure framework incorporated in Slovakia’s three-year rolling budget should be strengthened to better align the annual budget process with the medium-term spending priorities. This will require the government to articulate clear spending priorities and set out detailed and realistic plans for the main spending categories over a multi-year horizon. In addition, investment planning and the capacity to accelerate the absorption of EU funds need to be improved. And fiscal risks and contingent liabilities related to government financial support to state-owned and private enterprises or associated with Public-Private Partnerships should be properly monitored and disclosed.
The financial system appears to be well prepared to absorb an inevitable increase in credit risk. In response to the more challenging environment, banks have tightened lending standards, limited dividend payouts, and increased capital. Still, the decline in economic activity will hurt banks’ asset quality and profits. In addition, profits will be negatively affected by the reduction in foreign exchange transactions following euro adoption. It is encouraging, in this regard, that stress tests indicate that banks are resilient to a range of possible adverse shocks and that it would take an exceptionally severe economic downturn—which is currently not envisaged—to push capital and liquidity positions into danger zones.
The National Bank of Slovakia’s proactive vigilance is commendable. The recent measures to strengthen bank monitoring and cross-border coordination have been well received by the private sector and have helped shore up financial sector confidence and stability. In the face of expected asset quality deterioration, continued close supervision and vigilance will be required. The response of the banking sector to pressures on profits and incentives for more consolidation related to euro adoption also needs to be monitored. Legislation under consideration to allow preemptive government financial intervention under well-defined criteria will strengthen the authorities’ capacity to act swiftly and decisively if needed. To minimize moral hazard, plans to provide budgetary support to borrowers facing financial difficulties such as newly unemployed should be well designed, sufficiently restrictive, have adequate safeguards in place, and be communicated clearly to the public. In due course, the deposit insurance arrangement should be reconsidered in line with EU-wide initiatives.
Euro adoption has reduced Slovakia’s exposure to foreign currency and related risks, but also heightened the importance of competitiveness and flexibility. In particular, the adoption has largely eliminated currency mismatches on the banking sector’s balance sheet. Risks of overheating and excessively rapid credit growth as observed in earlier euro adopters have lost near-term relevance in the current economic environment. However, real exchange rate appreciation continues to require close attention, as Slovak inflation is projected to remain above the euro area average. In this regard, increases in labor productivity that can offset the negative impact of real exchange rate appreciation on competitiveness remain key to successful performance in the monetary union. As independent exchange rate and monetary policy instruments are no longer available, it is also essential to enhance the underlying capacity of the economy to respond flexibly to shocks.
Productivity-enhancing structural reforms, wage discipline, and labor market flexibility should remain policy priorities. To boost productivity, the government should continue to improve the business environment and place special focus on strengthening the education system, which will also encourage new FDI. In terms of wage discipline, the recently reached tri-partite agreement to maintain real wage growth in line with productivity growth in 2009 will help maintain competitiveness, and similar arrangements should be envisaged for the coming years. Labor market reform measures announced in the 2008-10 National Reform Programme, notably the development of a national flexicurity system, will contribute to improved labor market flexibility.
We would like to thank the authorities for their exemplary hospitality, excellent cooperation, and open and productive discussions.