Public Information Notice No. 99/69

Public Information Notice: IMF Concludes Article IV Consultation with Slovak Republic

August 4, 1999

On July 21, 1999, the Executive Board concluded the Article IV consultation with Slovak Republic.¹

Background

While important economic strides have been made since independence-including rapid growth and low inflation-Slovakia's economy has also recorded large macroeconomic imbalances and experienced increasing strains on the banking and enterprise sectors. These developments were symptoms of an unbalanced policy mix, in which too lax a fiscal policy was combined with a relatively tight monetary stance, as well as delays in addressing key structural weaknesses in the economy. This was ultimately reflected in strong exchange rate pressures in August and September 1998, the abandonment in October 1998 of the former exchange rate band, and a subsequent currency depreciation up to May 1999.

Persistently large external current account deficits have been a key risk factor of the Slovak economy in recent years. The current account deficit was about 10 percent of GDP in 1998, the third straight year of deficits of 10 percent of GDP or more. The continuing external imbalance in 1998 reflected strong domestic demand, driven primarily by fixed capital investment in the first half of the year and private consumption in the second half. With little foreign direct investment, the persistence of large current account imbalances resulted in a rapid increase in external debt.

Lost external competitiveness has also been a cause for concern, but one that became less pressing in 1998. From 1995 to 1997, the koruna appreciated in real effective terms by about 25 percent (unit labor cost based, year-average figures). However, much of this loss in competitiveness was offset by the real depreciation that started in 1998, and by the additional nominal depreciation of the koruna in early 1999.

Despite the large external imbalance, fiscal policy eased further in 1998 and fell short of stated objectives. The overall deficit of the general government widened to 6 percent of GDP in 1998, compared with 5.2 percent of GDP in 1997 and an official target of 2 percent of GDP for all of 1998. The main reasons for overshooting the official target were an expansion in extrabudgetary investment in the period preceding the elections in September 1998, cost overruns in the public health sector, and a deterioration in tax compliance. The shortfall of saving over investment of public enterprises also contributed to keeping the external current account deficit high. Poor control over costs and delays in increasing administrative prices, as well as high levels of investment contributed to the saving-investment gap of the enterprises.

With an insufficiently tight fiscal stance, the macroeconomic policy mix placed a heavy burden on monetary policy, at the same time that strains in the banking and enterprise sectors limited the National Bank of Slovakia's (NBS) perceived scope to tighten. Indeed, as evidenced by a gradual recovery in credit growth and declining short-term interest rates, monetary policy was less restrictive in 1998 than in 1997, which did little to encourage external current account adjustment. However, measured inflation has been relatively stable, reflecting most recently low food price increases, declining import prices, and the elimination in October 1998 of an import surcharge.

While the overall balance of payments position was stable through mid-1998, the currency came under strong pressure beginning in August. In the face of a large external current account deficit, severe exchange rate pressure was triggered in August-September 1998 by the combined effects of domestic uncertainties in the run-up to the September elections, widespread expectations of a post-election devaluation, and the crisis in Russia. The NBS lost about one-fifth of its international reserves in August and September 1998, and floated the koruna on October 1, 1998. Immediately after the float, the exchange rate dropped to 15 percent below its former central rate from 6 percent below that rate in September, and stabilized at about 10 percent below the former central parity in the four months to January 1999. Since end-January 1999, there have been renewed bouts of downward pressure on the exchange rate, reflecting unfavorable reviews by international ratings agencies, limited access to foreign funds, and an easing of monetary policy in mid-February 1999 to help the government lower its financing costs. The depreciation of the koruna against the central rate of the former exchange rate band was 17 percent from early August 1998 to the end of April 1999.

Against this background, and further financial market pressures in May 1999, the authorities announced at the end of that month a package of fiscal measures and administrative price adjustments. In May, the exchange rate depreciated by an additional 5 percent, notwithstanding about a doubling of short-term interest rates and moderate foreign exchange market intervention by the NBS in support of the currency. The fiscal package targeted a deficit of the general government of about Sk 20-25 billion in 1999 (3 percent of GDP or less), compared with a deficit of 6 percent of GDP in 1998. Reflecting their balance of payments concerns, the authorities decided to include in that package an import surcharge of 7 percent, to be reduced over time and phased out by the end of 2000.

Delays in dealing with deep-seated structural problems have adversely affected the banking and enterprise sectors. Financial difficulties in the state-owned banks persist. Overall enterprise profits have been deteriorating in the face of poor management, weak governance, and reported asset stripping by managers of some companies. Moreover, some large enterprises that had borrowed abroad (often with government guarantees) are facing large financial losses as a result of the depreciation of the koruna. The authorities have decided to increase administrative prices, which, along with improved financial discipline, would help improve the financial performance of state enterprises. More generally, the new governments policy statement recognized the need to accelerate the pace of structural reforms, emphasizing that dealing with the weaknesses in the banking and enterprise sectors was essential, including through significant privatization involving foreign strategic investors and by improving the bankruptcy law and proceedings as well as other aspects of the legal and institutional framework.

Executive Board Assessment

Executive Directors noted the severe difficulties that the Slovak economy had faced in recent years. The external current account and fiscal deficits were large, and strains in the banking and enterprise sectors had become increasingly visible. These developments had put the Slovak Republic's achievements since independence at risk-including its good growth and low inflation record. Directors stressed that the key priority for macroeconomic policy in 1999 was to reduce the external current account deficit to a sustainable level, and that tighter fiscal policy would have to be the driving force behind the external adjustment.

Directors therefore commended the authorities' decision to substantially reduce the deficit of the general government to about 3 percent of GDP in 1999. They welcomed their announcement of a strong and courageous fiscal package in May, and looked forward to parliamentary approval of the few elements of the package that had not so far been adopted. However, Directors expressed regret over the imposition of the import surcharge, and urged that it be phased out quickly. A few Directors noted that if there were to be a further significant weakening of the economy, this could complicate the achievement of the deficit reduction target in the second half of the year. In that case, a reassessment of the policy stance could be called for. Directors encouraged the authorities to continue their close policy dialogue with the Fund.

Looking to next year, Directors observed that the setting of fiscal policy would need to take account of trends in the real economy and in the external accounts. However, they stressed the importance of attacking structural weaknesses in the budget, notably the high level of government spending and the tax burden relative to GDP, as well as the need to improve the quality of expenditure. Directors welcomed the authorities' plans to cut employment in the budgetary sector and implement further measures to rationalize the system of social benefits and pensions. In addition, they encouraged the authorities to strengthen their control over the operations of the general government outside the state budget.

Directors generally considered that, following the floating of the koruna in late 1998, monetary policy should be geared to protecting the country's international reserves and containing underlying inflation. They observed that international reserves were at an uncomfortably low level, and that a broadly stable exchange rate was important for achieving inflation objectives. They therefore considered that the National Bank of Slovakia (NBS) had to be prepared to raise interest rates in case of balance of payments pressures, and that monetary policy decisions should not be subordinated to concerns about government borrowing costs. Directors saw fiscal tightening as essential to help the NBS meet its objectives and to set the stage for a sustainable reduction in interest rates. Indeed, recent fiscal actions already appeared to have helped steady financial markets. Several Directors noted that the high level of investment by state enterprises may have been excessive. They considered that structural reforms to improve financial discipline could help address this problem and facilitate demand management.

Directors emphasized the importance of wage restraint in easing the burden on financial policies, and especially in maintaining external competitiveness. Some Directors also noted that it was unfortunate that the authorities were unable to extend the wage freeze from the budgetary sector to the state enterprise sector as originally intended.

Directors expressed concern over the rapid increase in nonperforming loans of the state-owned banks and over the fragile situation in the banking sector generally. They stressed that rapid implementation of a comprehensive bank restructuring program, including strong measures to cut banks' operating costs and reinforce their credit policies and loan recovery efforts, should be given high priority. In this context, they emphasized that the authorities should aim to privatize the state-owned banks, with the involvement of strategic investors. Directors welcomed the authorities' intention to cooperate closely with the World Bank on these issues.

Regarding the state-owned enterprises, Directors observed that weak financial performance, unwarranted wage increases, and recent difficulties in servicing debt were indications of weak governance. This problem should be addressed both in its own right and as a necessary complement to improving banking sector performance. Directors considered that strengthening creditor rights and improving bankruptcy procedures would help promote enterprise restructuring. They urged the authorities to accelerate and complete enterprise privatization, and, in the meantime, to strengthen enterprise financial discipline.