## 1svkea2019001

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### Context and recent performance
- Per capita income rose from around 45 percent of the EU average to 75 percent over two decades.
- Real GDP growth reached 4.1 percent in 2018.
- Wage growth has surpassed productivity growth for the last 5 years, pushing core and headline inflation rates to above 2 percent in 2018.
- Recent expansion drivers: strong household credit growth, labor market dynamics, and investments in the automotive industry.
- The economy is highly export-dependent and concentrated: the top four product categories and EU destinations account for over 80 percent of total exports.
- GVC-related exports account for close to 90 percent of gross exports; Slovakia remains mainly engaged in assembly activities with limited forward linkages and value-added.

### Vulnerabilities and risks
- External concentration risks:
  - Heavy dependence on exports and concentrated export structure heighten sensitivity to external developments.
  - Rising automation and shifts in automotive demand (including toward electric cars) risk eroding the comparative advantage based on low-cost vocationally-trained industrial workers.
- Institutional perception:
  - Unfavorable perceptions of institutional quality could become more detrimental if not addressed.
- Financial and household vulnerabilities:
  - Declining lending margins led banks to expand mortgage lending aggressively, including to riskier segments.
  - Mortgage loan growth: 10.9 percent in March 2019 (remains the highest in the EU).
  - Household debt has nearly doubled relative to disposable income since 2009.
  - Mortgage borrowers are relatively more concentrated in the low-income segment; household financial assets are among the lowest in the EU.
- External position and imbalances:
  - Current account deficit deteriorated in 2018 to 2½ percent of GDP, largely due to a temporary spike in imports related to automotive investments.
  - The cyclically-adjusted CAD is slightly above the norm estimated at 1 percent, implying a marginal overvaluation of 1 percent of the real effective exchange rate.
  - The estimated policy gap is 2.5 percent, mostly driven by health expenditure.
- Sectoral exposure:
  - Transport, electrical and machinery, chemicals, and metals sectors account for over 80 percent of exports and affect 30 percent of domestic employment and 40 percent of output.

### Outlook and downside scenarios
- Near-term growth:
  - Real GDP growth projected to moderate to 3½ percent in 2019 as large automotive investment projects complete; robust wage and credit growth will support private consumption.
- Medium term:
  - Growth projected to moderate to potential as domestic demand slows; net exports contributions are projected to improve due to recent capacity expansion in the automotive sector.
  - Headline and core inflation expected to remain above 2 percent in the near term.
- Labor market:
  - Employment grew by 1.7 percent annually in 2018: Q4; unemployment rate fell to 6.1 percent.
  - Measures to ease hiring of foreign workers have begun to stabilize firm-reported labor shortages; higher labor force participation and moderating growth projected to slow wage growth.
- External balances:
  - Higher exports projected to narrow the CAD to a balanced position over the medium term; gross external debt roughly unchanged relative to GDP; net international investment position improves.
- Downside scenario:
  - Escalating trade tensions and a no-deal Brexit could reduce real GDP growth by 1 percentage point in the near term relative to the baseline.
  - Scenario assumes imposition of 25 percent tariffs on European cars and car parts by the US and hard Brexit.

### Risks (summary)
- External downside risks: trade tensions, no-deal Brexit, structural changes in the automotive sector (shift to electric vehicles, potential reshoring).
- Domestic downside risks: continued high credit growth raising household and banking sector vulnerability.
- Upside risk: higher and more effective absorption of EU funds could boost investment and domestic demand.

### GVC integration, constraints, and policy priorities
- GVC findings:
  - Strong GVC integration delivered productivity and process innovation gains and improved export quality.
  - Integration concentrated in assembly (backward linkages) with limited forward linkages; share of transport equipment exports feeding into final products assembled elsewhere has declined since 2000.
  - Slovakia is a net importer of car parts (relative export-to-import ratio low); value of exports going to skilled workers is low relative to peers.
- Policy priorities to retain export competitiveness:
  - Skills and innovation:
    - Remove disincentives to enter dual vocational education; ensure steady supply of skilled labor and investment in innovation.
    - Address shortage in engineering and mathematical skills; increase synergy between higher education and future skill needs.
    - Strengthen science-business linkages; consolidate fragmented public research system.
    - Ensure full use of EU funds for R&D.
  - Institutional quality and business environment:
    - Increase regulatory predictability; create competitive and transparent public procurement; raise judiciary independence; minimize conflicts of interest; use impact assessments prior to regulatory changes.
  - Transport and digital infrastructure:
    - Invest in transport and digital infrastructure to diversify trade partners and products and meet just-in-time requirements of global firms.

### Labor market, demographic pressures, and inclusion
- Demographics:
  - Population set to experience fast ageing; initiatives to improve utilization of domestic labor force are critical.
- Measures and recommendations:
  - Reintegration of long-term unemployed through customized counselling and profiling; complement with active labor market policies and better absorption of EU funds.
  - Expand commuting and relocation allowances; increase availability of affordable childcare to improve female participation.
- Roma integration measures (2019 package):
  - Employment, education, healthcare, housing; pilot activation strategies with additional wage support and peer mentorship; legal provision for debt relief; proposal to make schooling mandatory at age five and expand childcare; dedicated health assistants fluent in Romani; multi-stage social housing scheme funded through EU grants.

### Authorities’ views (highlights)
- Education:
  - Top priority: improve quality of primary and lower secondary education by increasing attractiveness of teaching (higher salaries, more training, better working conditions).
  - New law linking remuneration and career promotions to teacher quality; support for professional bachelor’s degree programs; accreditation agency expected operational in 2020.
- Research and Innovation:
  - Improve selection of government-funded research projects; plan to increase R&D tax allowance to 150 percent of qualifying expenditure in 2019 and to 200 percent in 2020.
  - Authorities see small size of domestic firms as key obstacle to upward movement in value chains.
- Institutions:
  - Anti-corruption strategy adopted; new government unit to coordinate anti-corruption; contemplating expanding Special Prosecutor’s mandate to include money laundering; establishing a specialized office to protect whistleblowers.
  - Requirement for public procurement contracts processed through electronic invoices beginning in 2021.

### Fiscal policy, FRA constraints, and options
- Recent fiscal performance:
  - Headline deficit narrowed to 0.7 percent in 2018.
  - Consolidation drivers: higher social security contributions, savings from pension and health reforms, lower non-wage current spending, falling debt service costs; offset by higher public wage bill and capital spending.
  - A change of methodology for certain expenditures of up to 0.3 percent of GDP is under review by Eurostat and may revise the 2018 fiscal deficit upward.
- 2019 target and staff assessment:
  - Authorities target a balanced budget in 2019; staff supported target but highlighted need for additional measures.
  - Staff’s baseline projections for 2019 show a deficit of 0.3 percent of GDP, mainly due to lower non-tax revenues and rising public sector wage bill.
  - Achieving a balanced budget would require containing expenditure on subsidies and goods and services and possibly higher excise taxes on tobacco and energy products.
  - Staff cautioned against pro-cyclical loosening and introducing any new discretionary expansionary measures.
- 2020 outlook and package risks:
  - Staff’s preliminary baseline projection shows a close to balanced budget in 2020.
  - A package under discussion (to be submitted in June) includes measures on family benefits and tax reductions; incomplete details but could noticeably increase the fiscal deficit in 2020 if implemented as currently designed.
  - Several proposed measures seem regressive and counter to social inclusion objectives.
  - No need for fiscal stimulus when growth is significantly above potential and fiscal space still needs to be rebuilt.
- Fiscal Responsibility Act (FRA) features:
  - MTO relaxed from a structural deficit of ½ percent of GDP to 1 percent of GDP starting 2020.
  - FRA escape clause allows sanctions to be suspended only in the event of a very severe recession (a decline in nominal GDP growth rates of at least 12 percentage point over two fiscal years).
  - Less drastic shocks (for example a drop in real GDP growth rate by 3 percentage points, equivalent to one standard deviation) could trigger pro-cyclical consolidation because of the debt brake.
- Options within FRA to create policy space:
  - Recalibrate the growth-related escape clause to accommodate less drastic shocks.
  - Introduction of multi-year expenditure ceilings set for a 4-year cycle based on forecasted structural revenues targeting a long-term public debt-to-GDP ratio of 40 percent while ensuring, at a minimum, fulfillment of the MTO.
  - Proposed expenditure ceilings could anchor medium-term planning but require a transparent and parsimonious framework consistent with the SGP and FRA.

### Fiscal needs, efficiency measures, and quantified estimates
- Fiscal needs:
  - Significant new investments and higher maintenance spending needed to expand and improve transport infrastructure.
  - Realigning and improving education quality and integrating disadvantaged groups will require public resources.
  - Constitutional law passed in March 2019 reversing earlier pension reforms will raise long-term pension expenditure (capping retirement age at 64 for men, with early retirement options for women with children).
- Staff estimates on fiscal space creation:
  - Measures can create additional fiscal space of up to 3 percent of GDP over the medium term to accommodate growth-enhancing social and infrastructure investment.
  - Full absorption of the EU funds programmed for education and infrastructure for the current programming period would make available an additional 2 percent of GDP in funding for priority spending.
- Revenue efficiency measures:
  - New tax reliability index, e-filing, and pre-filled tax returns expected to improve corporate taxpayer compliance.
  - Planned adoption of online-electronic cashiers expected to improve VAT collection efficiency.
  - Strengthen audit capacity via upskilling staff and better identification and assessment of non-compliance risks; anticipated Unified Analytical Center expected to help.
- Expenditure efficiency measures:
  - Thematic expenditure reviews of two-thirds of public spending under the Value for Money program identifying total savings.
- Quantified estimates from staff (Text Table 3):
  - 0.9 0.7 Increasing public investment efficiency
  - 1.7 1.4 Reducing the VAT gap
  - 1.4 1.1 Total
  - 4.0 3.2 Full EU funds absorption in education and transport
  - 2.6 2.1 Grand total
  - 6.5 5.3 Source: IMF staff calculations.
  - Note: Full absorption assumption: 95 percent ESIF funds allocated to educational and vocational training and network infrastructures and transport and energy will be absorbed; amounts shown net of what is already budgeted and of needed co-financing.

### Value for Money and public investment efficiency
- Identified savings composition (Percent of GDP):
  - Healthcare, 0.4
  - IT, 0.0
  - Environment, 0.1
  - Labor & Social Policies, 0.1
  - Education, 0.1
  - Public wage bill, 0.2
- Implementation to date:
  - Limited to health sector: central procurement of prescription drugs and medical equipment delivered cost savings, but rising operational costs of public hospitals remain unaddressed.
  - Strengthening the mandate of the Value for Money implementation unit would help reforms gain traction.
- Public investment efficiency:
  - PIMA suggests a broadly effective framework with room for improvement in project selection, procurement practices, and oversight of SOEs that carry out half of public investment.
  - Recommendations: create an integrated pipeline of major projects monitored by a dedicated central unit; establish a specialized unit to strengthen financial oversight of major SOEs; strengthen administrative capacity in project planning and public procurement to reduce investment volatility and improve EU funds absorption.

### Financial sector: macroprudential framework, vulnerabilities, and recommendations
- Macroprudential measures (Text Table 4 summary):
  - LTV limits introduced 2014–2015 non-binding (Maximum: 100 %; Share of 90+: 10 %; Additional limit for 80+: 40 %); 1st revision 2016–2017 binding (Maximum: 90 %; Share of 80%+: 20%).
  - DSTI limit introduced 100 %; 1st revision 80 % (phase-in applies); 2nd revision (2018-2019): No change.
  - Interest rate sensitivity test: introduced Applies to new loans only; 1st revision Applies to all customeŕ s loans with variable interest rates.
  - Maturity limit: RRE-secured loans: 30Y (excep. 10 %); Unsecured loans: 8Y (phase-in applies).
  - Amortization rule: Mandatory amortization with annuity (no change).
  - DTI: Not set initially; Share of 8+: 10% (phase-in applies) in later revisions.
  - Source: National Bank of Slovakia
- Household and mortgage indicators:
  - Mortgage loan growth: 10.9 percent in March 2019.
  - Household debt nearly doubled relative to disposable income since 2009.
  - Household financial assets among the lowest in the EU.
- Banking sector stability and risks:
  - Overall NPL ratio declined to 3 percent at end-2018 (post-crisis low).
  - Less systemic banks and building societies show higher average NPL ratios and lower coverage ratios; these institutions constitute roughly a fifth of banking sector assets.
  - Staff analysis: if NPL ratios of less systemic institutions double (average NPL ratio becomes 17 percent), these institutions could lose all or a large part of capital buffers.
  - Profitability robust (around 10 percent average return on equity) but faces risks from compressed lending margins, parent company pressures, intense competition, declining risk-weight estimates, low credit risk spreads, regulatory cap on early repayment penalties introduced in 2016, and strong role of mortgage brokers.
  - Liquidity position comfortable; banks largely rely on deposits for funding.
- Policy considerations and staff recommendations:
  - Reduce NPLs of less systemic institutions: require NPL reduction strategies; require building societies to increase NPL coverage ratios; complement regulatory caps with a cap on share of uncollateralized loans.
  - Enhance capital buffers of weaker banks: support incremental use of CCyB and Pillar II requirements; consider imposing non-zero Pillar II capital guidance for less systemic institutions in 2019.
  - Allow the bank levy to expire in 2021 as legislated to help banks safeguard profitability and accumulate buffers (initial target EUR 750 million already collected).
  - Better internalize mortgage credit risks: introduce a risk weight add-on on housing loans and consider a floor on risk weights; be vigilant about mortgage brokers facilitating loosening lending standards.
  - Consider taxation and housing market reforms: remove preferential tax treatment of housing-related capital gains and link real-estate taxation to market value; streamline regulatory procedures for construction permits; introduce more balanced landlord-tenant regulation to support long-term rental market (currently around 10 percent of the housing market).

### Housing market and rental housing strategy
- Authorities set up a working group to draft a strategy by 2020 to develop the rental housing market.
- Strategy elements should include:
  - seek more balanced regulations for tenants and landlords;
  - expand public rental houses.
- Authorities expressed reservations on removing preferential treatment of capital gains from housing investment.
- Staff recommendation: consider reducing preferential tax treatments for housing investment and removing obstacles to develop the rental housing market.

### AML/CFT, supervisory cooperation, and implementation
- AML/CFT:
  - Efforts made to transpose EU 4th AML Directive in 2018.
  - Authorities preparing the AML/CFT Action Plan 2019–22 based on the National Risk Assessment 2017–18.
  - Sustained efforts needed to improve disciplinary processes, step-up bank employee trainings, strengthen anti-corruption support measures, and enhance operational independence and effectiveness of the Financial Intelligence Unit.
- Home-host cooperation and regulatory gaps:
  - Dominance of foreign banks requires strong home-host cooperation and close engagement in Joint Supervisory Teams in SSM.
  - With limited domestic capacity to absorb bail-inable bonds, encouraging banks to have higher non-regulatory capital buffers may help meet MREL.
  - Domestic regime should require banks to obtain authorities’ pre-approval in acquiring qualifying holdings of non-bank entities and to periodically report ultimate beneficial owners of their qualifying holdings.

### External Debt Sustainability Analysis (Annex IV) — key figures and baseline dynamics
- Baseline external debt (in percent of GDP): 115.
- Historical scenario external debt (in percent of GDP): 157.
- Shock box figures (baseline 115):
  - Interest-rate shock box figure: 117.
  - Non-interest current account shock box figure: 121.
  - Combined shock box figure: 123.
  - Real depreciation shock (30% depreciation) box figure: 127.
  - Growth shock box figure: 124.
- Baseline external debt by year (in percent of GDP):
  - 2014: 90.0
  - 2015: 84.9
  - 2016: 90.8
  - 2017: 111.0
  - 2018: 113.3
  - 2019: 113.8
  - 2020: 114.5
  - 2021: 115.1
  - 2022: 115.5
  - 2023: 115.5
  - 2024: 115.0
- Debt-stabilizing non-interest current account (long-run constant balance): -5.1 (in percent of GDP).
- Change in external debt (annual, in percent of GDP) 2014–2024: 7.9, -5.1, 5.9, 20.2, 2.4, 0.5, 0.7, 0.6, 0.3, 0.0, -0.5.
- Identified external debt-creating flows (2014–2024): -4.3, -2.3, -1.1, -3.3, -5.4, -3.1, -3.3, -3.4, -3.9, -4.2, -4.4.
- Selected components (2014–2024):
  - Current account deficit, excluding interest payments: -3.3, -0.2, 0.3, 0.3, 0.8, 0.0, -0.6, -0.9, -1.0, -1.3, -1.7.
  - Exports (in percent of GDP): 91.3, 90.9, 93.0, 95.1, 95.6, 98.2, 97.2, 97.4, 97.4, 97.6, 98.0.
  - Imports (in percent of GDP): 87.4, 89.4, 90.4, 93.2, 94.7, 96.5, 94.9, 94.5, 94.2, 94.3, 94.0.
  - Net non-debt creating capital inflows (negative): -1.1, -1.1, -1.1, -1.3, -1.2, -1.1, -1.0, -1.1, -1.2, -1.2, -1.3.
- Automatic debt dynamics (annual contribution) 2014–2024: 0.1, -1.0, -0.3, -2.2, -5.0, -2.0, -1.8, -1.5, -1.7, -1.7, -1.4.
  - Contribution from nominal interest rate: 2.2, 1.9, 1.9, 1.7, 1.7, 1.7, 1.6, 1.7, 1.3, 1.3, 1.3.
  - Contribution from real GDP growth: -2.2, -4.3, -2.6, -2.7, -4.1, -3.7, -3.4, -3.2, -3.0, -3.0, -2.7.
- Residual, including change in gross foreign assets (2014–2024): 12.2, -2.8, 7.0, 23.4, 7.8, 3.6, 4.0, 4.0, 4.2, 4.2, 4.0.
- External debt-to-exports ratio (2014–2024): 98.6, 93.3, 97.7, 116.7, 118.5, 116.0, 117.8, 118.2, 118.5, 118.3, 117.3.
- Gross external financing need (in billions of US dollars) 2014–2024: 32.4, 35.2, 32.7, 39.4, 65.1, 68.3, 72.8, 77.9, 82.8, 88.1, 93.3.
- Key macro assumptions (selected sequences as presented):
  - Real GDP growth (in percent): 2.8 4.2 3.1 3.2 4.1 2.3 2.9 3.4 3.1 2.9 2.7 2.7 2.5.
  - GDP deflator in US dollars (change in percent): -0.1 -16.6 -0.7 3.3 6.8 -1.0 7.1 -0.6 3.3 2.9 2.8 2.5 2.7.
  - Nominal external interest rate (in percent): 2.7 1.8 2.3 2.0 1.7 2.6 0.9 1.6 1.5 1.5 1.2 1.2 1.2.
  - Growth of exports (US dollar terms, in percent): 0.2 -13.5 4.6 9.0 11.8 3.6 13.1 5.5 5.6 6.1 5.7 5.5 5.7.
  - Current account balance, excluding interest payments (in percent of GDP): 3.3 0.2 -0.3 -0.3 -0.8 0.3 2.5 0.0 0.6 0.9 1.0 1.3 1.7.

### Box 1 — Revenue cyclicality and buffers under the Fiscal Responsibility Act (key findings and simulation)
- Method:
  - Disaggregated econometric model estimated growth elasticities of VAT, PIT, CIT and SC to real GDP using annual data over 1997-2018.
  - Model form: 훥푇_푖푡 = 푐_푖푡 + 훥푌_푡 + 훥휋_푡 + 훥휌_푖푡 + 훥휆_푖푡 + 휖_푖푡; adjustments made to CIT and SC series to filter one-offs.
- Findings:
  - CIT and PIT have higher elasticities compared to VAT and Social Contributions (SC).
- Scenario simulation:
  - DSA growth shock: fall in growth rate by one standard deviation of GDP growth rates in past 10 years lowering real GDP growth by 3 percentage points in 2019 and 2020 before rebounding.
  - Additional spending on automatic stabilizers of about 1 percent of GDP assumed over 2019-20.
- Simulation outcomes:
  - Structural balance remains broadly in line with the MTO of -1 percent of GDP.
  - Overall balance weakens to -3½ percent of GDP by 2020 reflecting full revenue loss and automatic stabilizers.
  - Public debt projected to be 12 percentage points above the baseline trajectory by 2022, exceeding the third debt brake and mandating a public wage freeze and other consolidation measures.
  - Observation: FRA debt ceilings are invariant to the cycle and set to decline over time; pro-cyclical consolidation could prolong slowdown, lower public investment, and worsen debt dynamics.
- Shock assumptions:
  - Shock described as a 3 p.p. shock to real GDP growth based on 1 standard deviation over past 10 years; inflation lowered by 1 percent; no active consolidation assumed; does not include impact of expansionary package planned for 2020.

### Box 2 — Profitability and pressures from lending margin compression
- Overall profitability and distribution:
  - Slovak banks recorded around 10 percent of average return on equity during post-crisis years.
  - Profitability particularly strong for systemic foreign bank subsidiaries; smaller banks face strong downward pressures.
- Key drivers of margin compression:
  - High reliance on interest income; parent bank pressure to expand portfolios; low credit costs and lower risk-weights; dominant role of mortgage brokers (over half of mortgage loans intermediated by brokers).
- Sensitivity analysis:
  - A decline in loan interest rate by about 108 basis points (2014–17 experience) would reduce operating profits per asset by between 0.6–0.8 percentage points, all else equal.
- Potential mitigation:
  - Smaller banks’ profitability pressures may ease if their relatively high deposit interest rates decline along with lending rates.

*Source: IMF staff report excerpt for the Slovak Republic country consultation (content unit 1svkea2019001).*

### 1. Revenue Cyclicality and Buffers Under the Fiscal Responsibility Act ___________________________ 29

### 1. Revenue Cyclicality and Buffers Under the Fiscal Responsibility Act ___________________________ 29

### Context and recent performance
- Slovakia experienced sustained income convergence over two decades, with per capita income rising from around 45 percent of the EU average to 75 percent.
- Real GDP growth accelerated in recent years reaching 4.1 percent in 2018.
- Wage growth has surpassed productivity growth for the last 5 years, pushing both core and headline inflation rates to above 2 percent in 2018.
- Growth drivers in the recent expansion included strong household credit growth, labor market dynamics, and investments in the automotive industry.
- The economy is highly export-dependent and concentrated: the top four product categories and EU destinations account for over 80 percent of total exports.
- GVC-related exports account for close to 90 percent of gross exports, but Slovakia remains mainly engaged in assembly activities with limited forward linkages and value-added.

### Vulnerabilities identified
- External concentration risks:
  - Heavy dependence on exports and concentrated export structure heighten sensitivity to external developments.
  - Rising automation and shifts in automotive demand (including toward electric cars) risk eroding the comparative advantage based on low-cost vocationally-trained industrial workers.
- Institutional perception:
  - Unfavorable perceptions of institutional quality could become more detrimental if not addressed.
- Financial and household vulnerabilities:
  - Declining lending margins led banks to expand mortgage lending aggressively, including to riskier segments, leaving households and banks vulnerable to labor and property market downturns.
- External position and imbalances:
  - The current account deficit deteriorated in 2018 to 2½ percent of GDP, largely due to a temporary spike in imports related to automotive investments.
  - The cyclically-adjusted CAD is slightly above the norm estimated at 1 percent, implying a marginal overvaluation of 1 percent of the real effective exchange rate.
  - The estimated policy gap is 2.5 percent, mostly driven by health expenditure.
- Sectoral exposure:
  - Transport, electrical and machinery, chemicals, and metals sectors account for over 80 percent of exports and affect 30 percent of domestic employment and 40 percent of output.

### Outlook and projections
- Near-term growth:
  - Real GDP growth is projected to moderate beginning this year to 3½ percent in 2019 as large automotive investment projects complete, while robust wage and credit growth will support private consumption.
- Medium term:
  - Growth is projected to further moderate to its potential level as domestic demand slows; contributions from net exports are projected to improve due to recent capacity expansion in the automotive sector.
  - Both headline and core inflation are expected to remain above 2 percent in the near term.
- Labor market:
  - Employment grew by 1.7 percent annually in 2018: Q4, and the unemployment rate fell to 6.1 percent.
  - Recent measures to ease hiring of foreign workers have begun to stabilize firm-reported labor shortages; higher labor force participation (including from expansion of childcare facilities) and moderating growth are projected to slow wage growth going forward.
- External balances:
  - Higher exports are projected to narrow the CAD to a balanced position over the medium term, improving the net international investment position and keeping gross external debt roughly unchanged relative to GDP.
  - Despite acceleration in wage growth, productivity-adjusted average compensation remains roughly in line with peers and the CPI-based real effective exchange rate is comparable to peers.
- Downside scenario:
  - Escalating trade tensions and a no-deal Brexit could reduce real GDP growth by 1 percentage point in the near term relative to the baseline.
  - The downside scenario assumes imposition of 25 percent tariffs on European cars and car parts by the US and hard Brexit, with additional impacts if supply chains are disrupted.

### Risks (summary)
- External downside risks:
  - Escalating trade tensions, a no-deal Brexit, and structural changes in the automotive sector (including the shift to electric vehicles and potential reshoring) could materially weaken growth and competitiveness.
- Domestic downside risks:
  - Continued high credit growth raises household and banking sector vulnerability to labor and property market downturns.
- Upside risk:
  - Higher and more effective absorption of EU funds could boost investment and domestic demand.

### Policy discussion — Structural reforms and GVC integration
- Gains and limits from GVC integration:
  - Strong GVC integration delivered sizable productivity and process innovation gains and improved export quality (notably higher-end car production).
  - However, Slovakia’s integration is concentrated in assembly (backward linkages) with limited forward linkages; the share of transport equipment exports that feed into final products assembled elsewhere has declined since 2000.
  - Slovakia is a net importer of car parts (relative export-to-import ratio low), and the value of exports going to skilled workers is low relative to peers.
- Policy priorities implied by analysis:
  - Reap fuller benefits of GVC integration by shifting toward activities with higher value-added and stronger forward linkages.
  - Address institutional governance perceptions to sustain FDI attractiveness and competitiveness.
  - Strengthen policies that mitigate household and banking sector vulnerabilities associated with rapid mortgage and credit expansion.

*Source: IMF staff report excerpt for the Slovak Republic country consultation.*

### 13.      Continued success in the GVC-led growth model hinges on expanding activities

### 13.      Continued success in the GVC-led growth model hinges on expanding activities beyond assembly and developing competitive domestic firms

### GVC-led growth model: challenges and prerequisites
- Making an inroad in GVC is a difficult task; successful cases are scarce (Annex II).
- The automotive value chain requires heavy investments, high demand for technical expertise, and a long product development cycle.
- Options for small open economies:
  - Become an assembly hub with relatively low domestic value-added activities (example: Slovakia).
  - Develop domestic suppliers to move up the value chain and directly serve global lead firms.
- Successful moves up the value chain require a confluence of factors: a highly-educated workforce, strong innovative capacity, top-notch connectivity, high domestic investment, and an active government role providing strategic direction and a supportive environment for exporters.
- Institutional quality is highlighted by empirical literature as important for upgrading within GVCs.

### Recommendations to retain export competitiveness
- Skills and Innovation
  - Removal of disincentives to enter dual vocational education has substantially increased the number of apprentices.
  - Policies should ensure a steady supply of skilled labor and investment in innovation to counter automation risks and facilitate upward movement in GVCs.
  - The share of tertiary graduates in Slovakia is comparable to peers, but there is a shortage in engineering and mathematical skills.
  - Actions recommended:
    - Greater synergy between higher education and future skill needs.
    - Strengthen science-business linkages.
    - Consolidate the fragmented public research system to improve coordination.
    - Ensure full use of EU funds for R&D to improve capacity to absorb technology.
- Institutional quality and business environment
  - Implementation of the new Civil Service Act expected to improve human resource management in the civil service.
  - Recent measures to build administrative capacity in public procurement (training and technical support) are welcome.
  - Going forward, focus on:
    - Increasing regulatory predictability.
    - Creating a more competitive and transparent public procurement system.
    - Raising the independence of the judiciary.
    - Minimizing conflict of interest in public administration.
    - Greater use of impact assessment tools prior to adoption of regulatory changes.
- Transport and digital infrastructure
  - Slovakia ranks relatively unfavorably to peers in the efficiency of customs clearance, timeliness of shipments, and the quality of trade and transport-related infrastructure.
  - Staff underscored the need to invest in transport and digital infrastructure to diversify trade partners and products and to meet just-in-time requirements of global firms.

### Labor market, demographic pressures, and inclusion
- Recent initiatives to improve utilization of the domestic labor force are critical given projections for rapid population ageing.
- Authorities’ measures and recommended complements:
  - Reintegration of long-term unemployed through customized counselling and profiling is appropriate.
  - Complement with active labor market policies to invest in skills and increase employability of the long-term unemployed, including better absorption of EU funds.
  - Expand allowances for commuting and relocation to support labor mobility and reduce regional disparities.
  - Increase availability of affordable childcare to improve participation of women in the labor force.
- Roma integration measures (2019 package)
  - Comprehensive measures in employment, education, healthcare, and housing.
  - Pilot activation strategies: additional wage support and peer mentorship programs are delivering results.
  - Legal provision for debt relief to help indebted Roma workers pursue employment without wage garnishment.
  - Legislative proposal to make schooling mandatory at age five and expansion of childcare facilities closer to Roma communities.
  - Facilitating participation in early childhood education to increase educational integration of Roma children.
  - Dedicated health assistants fluent in the Romani language to improve access to healthcare.
  - Multi-stage social housing scheme funded through EU grants intended to support desegregation of Roma households.

### Authorities’ views (highlights)
- Education
  - Top priority: improve quality of primary and lower secondary education by increasing attractiveness of teaching (higher salaries, more training, better working conditions).
  - New law on pedagogical and expert employees links remuneration and career promotions to teacher quality.
  - Support for professional bachelor’s degree programs, including financial incentives for universities.
  - Newly created accreditation agency expected to become operational in 2020 to improve tertiary education quality.
- Research and Innovation
  - Improve selection of government-funded research projects via tighter standards and more involvement of foreign experts in selection committees.
  - Plan to increase the R&D tax allowance for companies to 150 percent of qualifying expenditure in 2019 and to 200 percent in 2020.
  - Authorities see small size of domestic firms as a key obstacle to upward movement in the value chain.
- Institutions
  - Adopted an anti-corruption strategy and established a new government unit to coordinate anti-corruption within ministries.
  - Contemplating expanding the Special Prosecutor’s mandate to include money laundering.
  - Establishing a specialized office to protect whistleblowers.
  - Requirement for public procurement contracts to be processed through electronic invoices beginning in 2021 to improve transparency.

### Fiscal policy: creating adequate space
- Recent fiscal consolidation and performance
  - Headline deficit narrowed to reach 0.7 percent in 2018.
  - Consolidation drivers:
    - Revenues: higher social security contributions driven by strong wage and employment growth and earlier reforms.
    - Expenditures: savings from earlier pension and health reforms, lower non-wage current spending, and falling debt service costs offset higher public wage bill and capital spending.
  - Note: A change of methodology for certain expenditures of up to 0.3 percent of GDP is under review by Eurostat and may result in an upward revision of the 2018 fiscal deficit.
- 2019 fiscal target and staff assessment
  - Authorities target a balanced budget in 2019; staff supported the target but highlighted need for additional measures.
  - With a positive output gap, maintaining a balanced budget is appropriate.
  - Staff’s baseline projections for 2019 show a deficit of 0.3 percent of GDP, mainly due to lower non-tax revenues and rising public sector wage bill.
  - Achieving a balanced budget would require containing expenditure on subsidies and goods and services and possibly higher excise taxes on tobacco and energy products.
  - Downside risks: lower growth, possible upward revision of the 2018 fiscal deficit, and higher spending ahead of March 2020 Parliamentary elections.
  - Staff cautioned against pro-cyclical loosening and introducing any new discretionary expansionary measures.
- 2020 outlook and planned package risks
  - Staff’s preliminary baseline projection shows a close to balanced budget in 2020.
  - A package under discussion (to be submitted in June) includes measures on family benefits and tax reductions; incomplete details but could noticeably increase the fiscal deficit in 2020 if implemented as currently designed.
  - Several proposed measures seem regressive and counter to social inclusion objectives.
  - No need for fiscal stimulus when growth is significantly above potential and fiscal space still needs to be rebuilt.
  - To achieve a balanced budget, any package size would need to be quite small; reducing capital spending would not be appropriate.
- Fiscal Responsibility Act (FRA) constraints and escape clause
  - Fiscal consolidation created modest fiscal space given strict FRA provisions.
  - Declining and low fiscal deficit, single-digit gross financing needs, and stable access to financing support debt sustainability and leave adequate fiscal space to maneuver in downturns without violating the SGP rules (Annex III).
  - Authorities’ medium-term budgetary objective (MTO) relaxed from a structural deficit of ½ percent of GDP to 1 percent of GDP starting 2020.
  - FRA escape clause allows sanctions to be suspended only in the event of a very severe recession (a decline in nominal GDP growth rates of at least 12 percentage point over two fiscal years).
  - Less drastic shocks (for example a drop in real GDP growth rate by 3 percentage points, equivalent to one standard deviation) could trigger pro-cyclical consolidation because of the debt brake.
- Options within the FRA to create policy space
  - Consider recalibrating the growth-related escape clause to accommodate less drastic shocks to avoid pro-cyclical consolidation.
  - Authorities contemplating introduction of multi-year expenditure ceilings set for a 4-year cycle based on forecasted structural revenues targeting a long-term public debt-to-GDP ratio of 40 percent while ensuring, at a minimum, fulfillment of the MTO.
  - Proposed expenditure ceilings could anchor medium-term planning, but require a transparent and parsimonious framework to ensure effective monitoring and consistency with the SGP and FRA.

### Fiscal needs and options to raise resources
- Considerable fiscal resources needed for social and infrastructure investment and higher pension spending:
  - Significant new investments and higher maintenance spending needed to expand and improve transport infrastructure.
  - Realigning and improving education quality and integrating disadvantaged groups will require public resources.
  - Constitutional law passed in March 2019 reversing earlier pension reforms (capping retirement age at 64 for men, with early retirement options for women with children) will raise long-term pension expenditure.
- Staff estimates on creating fiscal space via revenue and expenditure efficiency
  - Staff estimates that measures can create additional fiscal space of up to 3 percent of GDP over the medium term to accommodate growth-enhancing social and infrastructure investment.
  - Full absorption of the EU funds programmed for education and infrastructure for the current programming period would make available an additional 2 percent of GDP in funding for priority spending.
- Revenue efficiency measures
  - New tax reliability index, e-filing, and pre-filled tax returns expected to improve corporate taxpayer compliance.
  - Planned adoption of online-electronic cashiers expected to improve VAT collection efficiency.
  - Strengthen audit capacity in core tax areas via upskilling staff and better identification and assessment of non-compliance risks; anticipated Unified Analytical Center expected to help.
  - IMF staff assessment shows improving fiscal institutions, including tax compliance, helps improve control of corruption.
- Expenditure efficiency measures
  - Authorities completed thematic expenditure reviews of two-thirds of public spending under the Value for Money program identifying total savings.

### Quantified estimates from staff (Text Table 3 as presented)
- 0.9 0.7 Increasing public investment efficiency
- 1.7 1.4 Reducing the VAT gap
- 1.4 1.1 Total
- 4.0 3.2 Full EU funds absorption in education and transport
- 2.6 2.1 Grand total
- 6.5 5.3 Source: IMF staff calculations.
  - Note: Full absorption of EU funds assumption: 95 percent ESIF funds allocated to educational and vocational training and network infrastructures and transport and energy will be absorbed; amounts shown net of what is already budgeted and of needed co-financing.

*Source: 1svkea2019001 - Continued success in the GVC-led growth model hinges on expanding activities*

### 0.9 percent of GDP in 2019. So far,

### 1svkea2019001 - 0.9 percent of GDP in 2019. So far,

### Value for Money and Fiscal Efficiency
- Identified savings composition (Percent of GDP):
  - Healthcare, 0.4
  - IT, 0.0
  - Environment, 0.1
  - Labor & Social Policies, 0.1
  - Education, 0.1
  - Public wage bill, 0.2
- Implementation to date:
  - Implementation has been limited to the health sector, where central procurement of prescription drugs and medical equipment delivered cost savings, but rising operational costs of public hospitals remain unaddressed.
  - Strong political will is needed to push reforms in other sectors and to press for concrete action plans to be included in the budget.
  - Strengthening the mandate of the Value for Money implementation unit would help reforms gain traction.
- Public investment efficiency:
  - The Public Investment Management Assessment (PIMA) suggests a broadly effective framework with room for improvement in project selection, procurement practices, and oversight of state-owned enterprises (SOEs) that carry out half of public investment.
  - Recommendations include creating an integrated pipeline of major projects monitored by a dedicated central unit and establishing a specialized unit to strengthen financial oversight of major SOEs, including their annual budgets and investment plans.
  - Further strengthening administrative capacity in project planning and public procurement would help reduce volatility of investment and improve EU funds absorption, which remains weak relative to peers and last programming period.

### Authorities’ Views on Fiscal Policy
- Fiscal intentions and risks:
  - Authorities intend to reach a balanced budget this year.
  - Monthly data point to continued strength in revenue collections, including from the still-strong labor market.
  - Authorities agree fiscal space under the national FRA is limited and that sustained consolidation is key to building adequate space for counter-cyclical policy.
  - They intend to contain the cost of the coalition package to minimize its impact on the 2020 fiscal balance.
- Revenue-side measures:
  - Progress in lowering the VAT gap; need to reduce it further.
  - Ongoing work on a bottom-up approach for CIT gap assessment in collaboration with Fund staff, expected to be finalized in 2019: H2.
  - To strengthen the audit function: centralized selection of audit cases, increased share of spot investigations, and a new Act on Financial Administration effective July 2019.
  - Soft warning system for tax debtors implemented in 2018 has positively influenced compliance.
- Expenditure-side measures:
  - Commitment to follow through with implementation of measures identified in thematic expenditure reviews.
  - Recognition of challenges in inter-ministerial coordination and the absence of a direct link between reform progress and budgetary allocations.
  - Intention to sustain progress in the health sector to preserve realized cost-efficiency gains.

### Financial Sector: Macroprudential Measures and Vulnerabilities
- Macroprudential framework changes (Text Table 4 overview):
  - LTV limit:
    - Introduction (2014–2015, non-binding): Maximum: 100 %; Share of 90+: 10 % (phase-in applies); Additional limit for 80+: 40 % (phase-in applies)
    - 1st revision (2016–2017, binding): Maximum: 90 %; Share of 80%+: 20% (phase-in applies)
  - DSTI limit:
    - Introduction: 100 %
    - 1st revision: 80 % (phase-in applies)
    - 2nd revision (2018-2019): No change
  - Interest rate sensitivity test:
    - Introduction: Applies to new loans only
    - 1st revision: Applies to all customeŕ s loans with variable interest rates
    - 2nd revision: No change
  - Maturity limit:
    - RRE-secured loans: 30Y (excep. 10 %)
    - Unsecured loans: 8Y (phase-in applies)
  - Amortization rule: Mandatory amortization with annuity (no change)
  - DTI: Not set initially; Share of 8+: 10% (phase-in applies) in later revisions
  - Source: National Bank of Slovakia
- Household and mortgage indicators:
  - Mortgage loan growth: 10.9 percent in March 2019 (remains the highest in the EU).
  - Household debt has nearly doubled relative to disposable income since 2009.
  - Mortgage borrowers in Slovakia are relatively more concentrated in the low-income segment.
  - Household financial assets are among the lowest in the EU.
- Banking sector stability and risks:
  - Overall NPL ratio declined to a post-crisis low of 3 percent at end-2018.
  - Less systemic banks and building societies show higher average NPL ratios and lower coverage ratios; these institutions constitute roughly a fifth of banking sector assets.
  - Staff analysis: if NPL ratios of less systemic institutions double (average NPL ratio becomes 17 percent), these institutions could lose all or a large part of capital buffers.
  - Profitability robust but faces risks from compressed lending margins due to low interest rates, parent company pressures, intense competition, declining risk-weight estimates, low credit risk spreads, regulatory cap on early repayment penalties introduced in 2016, and strong role of mortgage brokers.
  - Liquidity position comfortable; banks largely rely on deposits for funding.
- Policy considerations and staff recommendations:
  - Reduce NPLs of less systemic institutions:
    - Require banks with high NPL ratios to develop NPL reduction strategies.
    - Require building societies to increase NPL coverage ratios.
    - Complement regulatory caps on long-maturity loans for building societies (20 percent for loans with 20–30 years of maturity and 10 percent for loans with 25–30 years of maturity) with a cap on the share of uncollateralized loans in total loans.
  - Enhance capital buffers of weaker banks:
    - Support incremental use of the counter-cyclical capital buffers (CCyB) and supervisory (Pillar II) capital requirements.
    - Consider imposing non-zero Pillar II capital guidance for less systemic institutions in 2019, taking into account supervisory stress test results.
  - Allow the bank levy to expire:
    - Bank levy imposed on liabilities (less equity) of banks weighs heavily on unprofitable banks—sometimes claiming more than 30 percent of pre-tax income.
    - The initial targeted amount (EUR 750 million) has already been collected; the levy should be allowed to expire in 2021 as legislated to help banks safeguard profitability and accumulate buffers.
  - Better internalize mortgage credit risks:
    - Introduce a risk weight add-on on housing loans and consider a floor on risk weights on housing loans to discourage excessive risk taking.
    - Be vigilant about risks that mortgage brokers may facilitate loosening lending standards.
  - Consider taxation and housing market reforms:
    - Remove preferential tax treatment of housing-related capital gains and link real-estate taxation to market value to curb investment demand and add fiscal revenues.
    - Streamline regulatory procedures for construction permits to improve housing supply.
    - Introduce more balanced regulation of landlord-tenant rights to support development of the long-term rental market (currently around 10 percent of the housing market) and reduce demand for home ownership from over-leveraged or low-income households.

### Anti-money laundering, Supervisory Cooperation, and Implementation
- AML/CFT:
  - Efforts made to transpose EU 4th AML Directive in 2018.
  - Authorities preparing the AML/CFT Action Plan 2019–22 based on the National Risk Assessment 2017–18.
  - Sustained efforts needed to improve disciplinary processes, step-up bank employee trainings, strengthen anti-corruption support measures, and enhance operational independence and effectiveness of the Financial Intelligence Unit.
- Home-host cooperation and regulatory gaps:
  - Given dominance of foreign banks, strong home-host cooperation and close engagement in Joint Supervisory Teams in SSM is critical.
  - With limited domestic capacity to absorb bail-inable bonds, encouraging banks to have higher non-regulatory capital buffers may help meet MREL.
  - Domestic regulatory regime should require banks to obtain authorities’ pre-approval in acquiring qualifying holdings of non-bank entities and to periodically report ultimate beneficial owners of their qualifying holdings.

*Source: 1svkea2019001 - 0.9 percent of GDP in 2019. So far,*

### 36.      The authorities are considering broad measures to expand rental housing market. They

### 36.      The authorities are considering broad measures to expand rental housing market.

### Housing market developments and policy measures
- Authorities broadly agreed with staff’s assessments on housing market developments.
- A working group has been set up to draft a strategy by 2020 to develop the rental housing market.
- The strategy should include measures to:
  - seek more balanced regulations for tenants and landlords; and
  - expand public rental houses.
- Authorities expressed reservations on removing preferential treatment of capital gains from housing investment, arguing that it is inefficient to change the national tax-regime to address possible house price overvaluations in large cities.
- Staff recommendation: consider reducing preferential tax treatments for housing investment and removing obstacles to develop the rental housing market (see also macroprudential and fiscal recommendations).

### Banking sector risks and supervision
- Authorities acknowledged strong profitability pressures on smaller banks and rising risks.
- For the moment, authorities did not see material flaws in internal models of systemic foreign bank subsidiaries.
- Authorities showed interest in the mission’s assessment that:
  - compressed default risks in large banks’ internal models, together with
  - strong intermediation roles of mortgage brokers,
  - are contributing to build-up of risks; and indicated they would analyze these issues further.
- Key vulnerabilities identified:
  - prolonged period of low interest rates;
  - too benign credit risk assessments by banks;
  - the regulatory cap on mortgage refinancing fees; and
  - strong market intermediation role of mortgage brokers.
- Consequences:
  - compression of the lending margin;
  - nearly doubled household debt relative to disposable income due to sustained high credit expansion, especially to low income segments;
  - rapidly rising flat prices in urban areas and appreciating house price-to-income ratio indicating growing vulnerabilities, particularly for smaller banks with less capital buffers.
- Macro- and micro-prudential policy actions noted or recommended:
  - incremental use of CCyB and supervisory capital requirements to ensure adequate capital buffers;
  - strong vigilance of smaller banks, including reduction of NPLs;
  - potential further increase in capital buffers for smaller banks given higher vulnerability;
  - allow the bank levy to expire as scheduled in 2021 to help smaller banks build capital buffers;
  - given historically low default rates, consider imposing add-on risk weight on mortgage loans to ensure better internalization of credit risks.

### Macroeconomic outlook, growth drivers, and risks
- With one-off effects of investment in the automotive industry tapering off, growth is projected to decelerate and gradually converge to its potential.
- Domestic demand, supported by robust wage and credit growth, is expected to propel economic activity.
- Contributions from net exports are expected to improve on the back of recent capacity expansion in the automotive sector.
- Major downside risks: continued international trade tensions and a no-deal Brexit to Slovakia’s export-led economy.
- With still-high credit growth, households and banks are vulnerable to possible labor and property market downturns.
- Slovakia’s export-led growth success depends on capturing higher-value activities; recommended complementary policies include:
  - ensure adequate supply of qualified teachers and strengthen dual-track vocational training;
  - improve quality of tertiary education and align higher education with technical skills needs;
  - improve coordination of public research system and strengthen linkages between businesses and universities;
  - ensure full use of EU funds for R&D;
  - foster a more predictable and enabling business environment, competitive and transparent public procurement, independent judiciary, and well-developed infrastructure and logistics networks.

### Labor market and demographic pressures
- Population set to experience fast ageing; efforts to ensure optimal use of the domestic labor force are appropriate.
- Constraints:
  - insufficiently inclusive education system;
  - lack of affordable early childcare facilities contributing to a high gender gap and regional disparities in labor market participation.
- Welcomed measures:
  - legislative proposal to make schooling mandatory starting at age 5;
  - efforts to reintegrate the long-term unemployed into the labor market;
  - increasing availability of affordable childcare.
- Recommended complements:
  - active labor market policies to invest in skills and increase employability of marginalized groups;
  - better absorption of EU funds.

### Fiscal policy stance and public finances
- With above-potential growth, a balanced budget target for 2019 and 2020 is appropriate but will require additional efforts.
- Recent fiscal consolidation, driven by strong growth and policy efforts, has created some fiscal space under the SGP.
- Public debt trajectory is vulnerable to sizable economic downturns given strict escape clauses and debt brakes prescribed under the national FRA.
- Sustained fiscal consolidation will require fending off pressures to increase discretionary stimulus, which has absorbed a good part of the revenue windfall in recent years.
- Proposal to introduce multi-year expenditure ceilings to anchor budget planning and execution, while being consistent with the FRA and the SGP, would serve to instill durable fiscal discipline.
- Overly strict escape clauses may need to be revisited to avoid pro-cyclical fiscal tightening.
- Higher revenue and spending efficiency are needed to create resources for growth-enhancing social and infrastructure investment.
  - Planned measures to improve tax compliance through online electronic cashiers and electronic taxpayer services should be sustained and complemented by further strengthening of audit capacity in all core tax areas.
  - Strong political will and better inter-ministerial coordination are needed to push through reforms outlined in spending reviews.
  - Strengthen the mandate of the implementation unit and incorporate actionable measures in the medium-term budget to actualize savings.
  - A more robust public investment framework can improve efficiency of public investment and absorption of EU funds through better project selection and prioritization at a national level.
- Recommendation: next Article IV consultation with the Slovak Republic take place on the standard 12-month consultation cycle.

### Box 1 — Revenue cyclicality and buffers under the Fiscal Responsibility Act (key findings and simulation)
- Method:
  - A simple econometric model was used to estimate growth elasticities of different revenue categories while controlling for changes in revenue administration and the policy rate.
  - A disaggregated approach was used to estimate elasticities of each revenue category (VAT, PIT, CIT and SC) to real GDP.
  - The model is fitted using annual data over 1997-2018 in the following form: 훥푇_푖푡 = 푐_푖푡 + 훥푌_푡 + 훥휋_푡 + 훥휌_푖푡 + 훥휆_푖푡 + 휖_푖푡; where T is the log of specific revenue, Y is the log of real GDP, π is the log of GDP deflator, and ρ is the official tax/contribution rate. Parameter λ was introduced to disentangle the impact of GDP growth shocks from unobservable changes in tax administration or discretionary measures.
  - Adjustments were made to the CIT data series to filter the impact of special levies on industrial and financial sectors since 2012, and to the social contributions data series to offset large one-off collections in 2018.
- Findings:
  - Results suggest that CIT and PIT have higher elasticities compared to VAT and Social Contributions (SC).
- Scenario simulation:
  - A standard DSA growth shock was simulated: a fall in the growth rate by one standard deviation of GDP growth rates in past 10 years lowering real GDP growth rate by 3 percentage points in 2019 and 2020 before rebounding to baseline.
  - Estimated elasticities were used to simulate the impact on revenues, while baseline expenditure levels were maintained assuming no fiscal adjustment.
  - Additional spending on automatic stabilizers of about 1 percent of GDP was assumed over 2019-20.
- Simulation outcomes:
  - The structural balance remains broadly in line with the MTO of -1 percent of GDP.
  - The overall balance weakens to -3½ percent of GDP by 2020 reflecting the full revenue loss as well as the impact of automatic stabilizers.
  - The larger nominal deficit, together with adverse debt dynamics from lower nominal GDP growth, results in public debt being 12 percentage points above the baseline trajectory by 2022, exceeding the third debt brake and mandating a public wage freeze and other consolidation measures.
  - Observation: while the SGP’s fiscal rules are sensitive to the cyclical position, the FRA debt ceilings are invariant to the cycle and are set to decline over time. Pro-cyclical fiscal consolidation, either through FRA sanctions or efforts to avoid them, could prove self-defeating by prolonging the slowdown, lowering public investment, and worsening debt dynamics.
- Notes on chart and assumptions:
  - The shock is described as a 3 p.p. shock to real GDP growth based on 1 standard deviation of growth rates over the past 10 years; inflation is lowered by 1 percent; no active consolidation is assumed over the projection horizon; does not include the impact of the expansionary package planned for 2020.

*Source: IMF staff appraisal and related analysis contained in the provided content unit.*

### Box 2. Profitability and Pressures from Lending Margin Compression

### Box 2. Profitability and Pressures from Lending Margin Compression

### Overall profitability and distribution
- Overall profitability of the Slovak banking system has been robust.
- Slovak banks have recorded around 10 percent of average return on equity during post-crisis years.
- Profitability has been particularly strong for systemic foreign bank subsidiaries.
- Smaller banks face strong downward pressures on profitability due to drastic compression in the lending margin.

### Key factors driving lending margin compression
- Simple business model and small market size
  - High reliance on interest income made Slovak banks especially sensitive to the interest rate decline.
  - Pressured by parent banks, Slovak banks expanded portfolios aggressively to sustain profitability.
  - Low reliance of large corporates in Slovakia on domestic funding led banks to concentrate on household lending.
- Low credit costs
  - Historically low default rates compressed credit costs and risk-weights used in internal models.
  - Systemic banks used lower risk-weights to lower lending rates, putting pressure on smaller banks to offer even lower rates to gain market share.
- Dominant role of mortgage brokers
  - Over half of mortgage loans are intermediated with the help of brokers.
  - Mortgage brokers’ market power and detailed customer knowledge enabled them to negotiate lower lending rates as interest rates fell and refinancing surged after a regulatory cap on refinancing fee.

### Sensitivity analysis and projected impacts
- A further decline in interest rates could significantly reduce profit buffers of less-systemic banks and building societies.
- Sensitivity analysis result:
  - A decline in the loan interest rate by the same amount experienced during 2014–17 (about 108 basis points) would reduce operating profits per asset by between 0.6–0.8 percentage points, all other things being equal.
- Distributional impact:
  - Systemic foreign bank subsidiaries would remain the most profitable.
  - Smaller banks would feel more pressure on their profitability.
- Potential mitigation:
  - Profitability pressures facing smaller banks may be mitigated if their relatively high deposit interest rates declined further along with their lending rates.

### Selected related statistics from the box and nearby tables
- "around 10 percent" — average return on equity for Slovak banks in post-crisis years.
- "about 108 basis points" — loan interest rate decline during 2014–17 used in sensitivity analysis.
- "0.6–0.8 percentage points" — estimated reduction in operating profits per asset from that decline.
- "over half of mortgage loans are intermediated with the help of brokers."

*Sources: Fitch Connect; and IMF staff calculations.*

### Annex I. Slovak Republic's Global Value Chain Participation:

### Annex I. Slovak Republic's Global Value Chain Participation

### Stylized Facts — Integration and productivity
- Gross exports relative to GDP more than doubled since 2000.
- Links with global value chains (GVCs) accounted for close to 90 percent of all exports.
- Labor productivity has more than doubled since 1995, benefiting from technology transfer and automation.

### Stylized Facts — Export concentration and external exposure
- The export structure has become more concentrated with the top four export products accounting for more than 80 percent of total export in 2017.
- Slovakia’s critical trade connections are largely limited to Germany and Czech Republic, unlike some CEE peers (for example Hungary and Poland) which have more diversified critical connections including with countries outside the EU.
- The transport sector holds a larger number of critical connections relative to other sectors, although still with fewer connections than CEE peers.

### Definition and measurement notes
- A country’s bilateral trade is considered critical if it is large relative to the country’s other bilateral trade flows (above the 90th percentile of the distribution) and large relative to all bilateral trade flows in the world (above the 90th percentile of the worldwide distribution).
- Network visualizations referenced use only flows that are large relative to the country’s other bilateral flows (above the 90th percentile) and large relative to all bilateral flows in the world (above the 90th percentile).

### Domestic spillovers and sectoral centrality
- About 40 percent of Slovakia’s output is generated by the four main export products: transport equipment, machinery, metal, and chemicals.
- These four main export products account for a third of labor demand through direct and indirect employment.
- Transport and equipment and electrical and machinery sectors are among the most central sectors in terms of connectivity with other sectors in the economy.
- Chemical and metal products play a less central role in the domestic economy compared with transport equipment and electrical and machinery.
- Metal products and transport equipment sectors play a critical role for generating labor demand, whereas chemical and machinery sectors play a more peripheral role for labor demand.
- Centrality of a sector is measured by whether it provides demand for goods/labor to a large number of other sectors; intersectoral flows considered are those above the 50th percentile for each sector and above the 25th percentile for the economy as a whole.

*Source: IMF staff (Annex I, "Slovak Republic's Global Value Chain Participation").*

### Annex IV. External Debt Sustainability Analysis (DSA)

### Annex IV. External Debt Sustainability Analysis (DSA)

### Key findings from bound tests and scenario analysis
- Baseline external debt (in percent of GDP): 115.
- Historical scenario external debt (in percent of GDP): 157.
- Interest-rate shock box figure: 117 (baseline 115).
- Non-interest current account (CA) shock box figure: 121 (baseline 115).
- Combined shock box figure: 123 (baseline 115).
- Real depreciation shock (30% depreciation) box figure: 127 (baseline 115).
- Growth shock box figure: 124 (baseline 115).
- Notes on shocks and scenarios:
  - Shaded areas in figures represent actual data.
  - Individual shocks are permanent one-half standard deviation shocks (footnote 1).
  - Historical scenarios use ten-year historical averages to project debt dynamics five years ahead; a sharp increase in the debt-to-GDP ratio in the historical scenario is largely driven by more than 16 percent depreciation of euro against dollar, which makes the historical average of GDP deflator in USD negative (footnote 2).
  - Combined shock applies permanent 1/4 standard deviation shocks to real interest rate, growth rate, and current account balance (footnote 3).
  - Real depreciation shock is a one-time real depreciation of 30 percent occurring in 2010 (footnote 4).
- Gross financing need under baseline is shown on the right scale in the figures (label present).

### Baseline projections and debt dynamics (Slovakia: External Debt Sustainability Framework, 2014–24)
- Baseline: External debt (in percent of GDP) by year:
  - 2014: 90.0
  - 2015: 84.9
  - 2016: 90.8
  - 2017: 111.0
  - 2018: 113.3
  - 2019: 113.8
  - 2020: 114.5
  - 2021: 115.1
  - 2022: 115.5
  - 2023: 115.5
  - 2024: 115.0
- Debt-stabilizing non-interest current account (long-run constant balance): -5.1 (in percent of GDP).
- Change in external debt (annual, in percent of GDP): 7.9, -5.1, 5.9, 20.2, 2.4, 0.5, 0.7, 0.6, 0.3, 0.0, -0.5 (2014–2024).
- Identified external debt-creating flows (4+8+9): -4.3, -2.3, -1.1, -3.3, -5.4, -3.1, -3.3, -3.4, -3.9, -4.2, -4.4 (2014–2024).
- Components (selected):
  - Current account deficit, excluding interest payments: -3.3, -0.2, 0.3, 0.3, 0.8, 0.0, -0.6, -0.9, -1.0, -1.3, -1.7 (2014–2024).
  - Deficit in balance of goods and services: -3.9, -1.6, -2.6, -1.9, -0.9, -1.7, -2.4, -2.9, -3.2, -3.3, -4.0 (2014–2024).
  - Exports (in percent of GDP): 91.3, 90.9, 93.0, 95.1, 95.6, 98.2, 97.2, 97.4, 97.4, 97.6, 98.0 (2014–2024).
  - Imports (in percent of GDP): 87.4, 89.4, 90.4, 93.2, 94.7, 96.5, 94.9, 94.5, 94.2, 94.3, 94.0 (2014–2024).
  - Net non-debt creating capital inflows (negative): -1.1, -1.1, -1.1, -1.3, -1.2, -1.1, -1.0, -1.1, -1.2, -1.2, -1.3 (2014–2024).
- Automatic debt dynamics (annual contribution): 0.1, -1.0, -0.3, -2.2, -5.0, -2.0, -1.8, -1.5, -1.7, -1.7, -1.4 (2014–2024).
  - Contribution from nominal interest rate: 2.2, 1.9, 1.9, 1.7, 1.7, 1.7, 1.6, 1.7, 1.3, 1.3, 1.3 (2014–2024).
  - Contribution from real GDP growth: -2.2, -4.3, -2.6, -2.7, -4.1, -3.7, -3.4, -3.2, -3.0, -3.0, -2.7 (2014–2024).
  - Contribution from price and exchange rate changes: 0.1, 1.4, 0.4, -1.2, -2.6, .......... (projection line notes ellipses for later years).
- Residual, including change in gross foreign assets (2-3): 12.2, -2.8, 7.0, 23.4, 7.8, 3.6, 4.0, 4.0, 4.2, 4.2, 4.0 (2014–2024).
- External debt-to-exports ratio (in percent): 98.6, 93.3, 97.7, 116.7, 118.5, 116.0, 117.8, 118.2, 118.5, 118.3, 117.3 (2014–2024).
- Gross external financing need (in billions of US dollars) 4/: 32.4, 35.2, 32.7, 39.4, 65.1, 68.3, 72.8, 77.9, 82.8, 88.1, 93.3 (2014–2024).
- Gross external financing need (in percent of GDP): 32.1, 40.1, 36.4, 41.1, 61.1, 10-Year10-Year62.4,62.4,63.0,63.4,64.0,64.4 (note: table shows concatenated labelling for 10-Year statistics).
- Scenario with key variables at their historical averages 5/: 113.8, 122.0, 130.3, 139.2, 148.0, 157.4, 2.0 (presented as series in table).

### Key macroeconomic assumptions underlying baseline (as presented)
- Real GDP growth (in percent): 2.8 4.2 3.1 3.2 4.1 2.3 2.9 3.4 3.1 2.9 2.7 2.7 2.5 (sequence presented in table).
- GDP deflator in US dollars (change in percent): -0.1 -16.6 -0.7 3.3 6.8 -1.0 7.1 -0.6 3.3 2.9 2.8 2.5 2.7 (sequence presented in table).
- Nominal external interest rate (in percent): 2.7 1.8 2.3 2.0 1.7 2.6 0.9 1.6 1.5 1.5 1.2 1.2 1.2 (sequence presented in table).
- Growth of exports (US dollar terms, in percent): 0.2 -13.5 4.6 9.0 11.8 3.6 13.1 5.5 5.6 6.1 5.7 5.5 5.7.
- Growth of imports (US dollar terms, in percent): 0.9 -11.2 3.5 10.0 13.0 3.2 13.1 4.7 4.8 5.5 5.3 5.4 4.9.
- Current account balance, excluding interest payments (in percent of GDP): 3.3 0.2 -0.3 -0.3 -0.8 0.3 2.5 0.0 0.6 0.9 1.0 1.3 1.7.
- Net non-debt creating capital inflows: 1.1 1.1 1.1 1.3 1.2 1.1 0.1 1.1 1.0 1.1 1.2 1.2 1.3.

### Definitions, interpretations, and methodological notes
- Automatic debt dynamics formula and components: Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt (footnote 1).
- Contribution from price and exchange rate changes defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock; r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator) (footnote 2).
- For projection, the residual line includes the impact of price and exchange rate changes (footnote 3).
- Gross external financing need defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period (footnote 4).
- Key variables for the historical-average scenario include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP (footnote 5).
- Debt-stabilizing non-interest current account is the long-run, constant balance that stabilizes the debt ratio assuming key variables remain at their levels of the last projection year (footnote 6).

*Source: Annex IV. External Debt Sustainability Analysis (DSA), Slovakia: External Debt Sustainability Framework, 2014–24 (IMF staff report content provided).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1svkea2019001.pdf_