Mission Concluding Statement 

Slovak Republic—2010 Article IV Consultation Concluding Statement of the Mission

July 19, 2010

Slovakia is quickly rebounding from a deep recession, but faces difficult fiscal and labor market challenges in the wake of the crisis. The underlying fiscal position has weakened considerably, and a large fiscal consolidation is essential to reduce the deficit to below 3 percent of GDP by 2013. A fiscal adjustment package of around 2½ percent of GDP for 2011, combined with an expenditure growth norm for subsequent years could anchor the fiscal consolidation strategy. Long-term unemployment is high and entrenched, and reducing it will require addressing structural labor market obstacles. Measures could include investing in public infrastructure, strengthening the orientation of education and training towards labor market needs, enhancing active labor market policies, and easing the wage cost of low skill workers while strengthening their incentives to work.

The outlook: a robust recovery, but significant challenges remain

Slovakia is quickly emerging from a deep recession. A large export-oriented manufacturing sector exacerbated the impact of the global downturn, but it has also produced considerable gains from the current recovery in global export demand. After collapsing in the first quarter of 2009, year-on-year growth in the first quarter of 2010 was near 5 percent, and industrial production has almost returned to pre-crisis levels. Inflation at 0.7 percent in June 2010 was among the lowest in the euro zone, alleviating concerns that euro adoption would raise inflation. However, the fiscal deficit widened to 7¼ percent of GDP in 2009, and the unemployment rate surged to about 15 percent in the first quarter of 2010.

Growth this year will be among the highest in the European Union. Real GDP is projected to expand by about 4 percent in 2010. A rebound in external demand will be the main driving force, with some firming of investment (including inventories build-up) and private consumption. Aided by relatively strong fundamentals, including an overall sound banking sector, growth is projected modestly to increase further to about 4¼ percent in the coming years.

Notwithstanding the upbeat outlook, downside risks are substantial. In particular, external developments, especially in the rest of the euro area, could be less favorable than expected. Domestically, sluggish bank lending, a further decline in real estate prices, and loss of fiscal credibility could also have a negative impact.

In the aftermath of the crisis, fiscal and labor market challenges have intensified. The underlying fiscal position has deteriorated sharply in tandem with the crisis, and a large fiscal consolidation is vital to reduce the general government deficit to below 3 percent of GDP by 2013. Long-term unemployment, particularly among low skill workers and in certain regions, is expected to remain above already high pre-crisis levels. To improve employment prospects, structural labor market obstacles, including wage costs and work incentives, have to be addressed.

The policy agenda: fiscal consolidation and structural reforms

Fiscal policy: a multi-year, front-loaded adjustment effort to achieve the Maastricht norm by 2013

The underlying fiscal position has weakened considerably. Spending continued to expand at its fast pre-crisis pace during the crisis, while revenue fell by even more than output. The revenue loss and corresponding widening of the fiscal deficit are mostly structural in nature. The economic rebound will help reduce the headline deficit somewhat, but will leave the crisis-induced deterioration in the fiscal position intact.

With the recovery under way, a widening of the deficit in 2010 is not warranted by economic conditions. Accommodation of the steep revenue drop and some discretionary stimulus were appropriate in 2009, in view of the extraordinarily large downturn. However, the increase in the general government deficit to 8 percent of GDP which we project for 2010 is excessive. To the extent still possible, efforts to rein in the deficit, including strict expenditure control, should be pursued. Nevertheless, the scope for policy interventions in the remainder of the year is limited, and the focus now should be on 2011.

The 2011 budget should initiate a front-loaded, multi-year fiscal consolidation. Without measures, the 2011 general government deficit would decline only modestly to a worrisome 7¼ percent of GDP. A large fiscal adjustment therefore is imperative. Anchoring the adjustment within a credible consolidation strategy aimed at reducing the deficit to below 3 percent of GDP by 2013 will help spread the adjustment burden, while bringing the negative debt dynamics to a halt in 2013. Without a large adjustment and credible medium-term fiscal anchor, however, markets could lose confidence and possibly prompt adoption of immediate and potentially disruptive deficit cuts.

For 2011, an adjustment package of about 2½ percent of GDP would be appropriate. This would offer a proper balance between the dual objectives of ensuring fiscal sustainability and not impeding the recovery. An adjustment of the recommended magnitude will be challenging, and require a combination of expenditure and revenue measures. Steps to curb expenditures could include temporarily freezing, in nominal terms, public sector wages, pensions, and some social benefits, and restraining local government outlays. So far, spending on these items has continued to grow at pre-crisis rates which crowd out other government spending and absorb an ever-larger share of GDP. With regard to revenue, the authorities could consider hiking rates—the VAT rate, which is low relative to neighboring countries, in particular. Other steps could include broadening the tax base; eliminating exemptions in the corporate and income taxes, VAT and social contributions; and lifting the income ceiling on social security contributions. Such measures would help restore some of the drop in tax revenue, to the extent it exceeded the output contraction. To increase stability and reduce uncertainty in the tax environment facing businesses, tax policy changes should be concentrated in 2011.

To anchor the fiscal consolidation strategy after 2011, expenditure growth should be capped. Based on the recommended policies for 2011 and the projected real GDP growth path, and with a view to reducing the general government deficit to below 3 percent in 2013, a ceiling that from 2012 would cap annual real expenditure growth at 2 percent or less could be adopted. Such an expenditure growth ceiling would have to be incorporated in the multi-year budget to be presented to Parliament in the fall.

Further fiscal institutional reforms remain a priority. The recommended expenditure growth ceiling could help align the annual budget process and medium term spending priorities. Setting out detailed and realistic plans for the main spending categories within a medium-term budget framework and enhancing program budgeting would facilitate achieving strategic expenditure policy priorities. Among these priorities, structural reforms that address unsustainable expenditure dynamics in health care in line with recommendations from the IMF, the OECD and the World Bank will be a key. Other important fiscal institutional reform goals include improving public investment planning and implementation, including through a re-evaluation of PPPs as a financing mechanism; strengthening the capacity to absorb EU funds; and unifying the collection of taxes and social security contributions. Finally, a stable legal and regulatory environment to match the objectives of the second pillar pension funds should be created.

Labor market and other structural reforms: reducing long-term unemployment, and improving education and the business environment

Unemployment is expected to decline overall, but long-term unemployment will remain high. The rebound in growth is projected to bring down conjunctural unemployment, in manufacturing in particular. The absorption of cyclically unemployed will be facilitated by the flexibility of Slovakia’s labor market legislation and practices, which is overall rather high by the standards of that in neighboring countries.

A number of factors contribute to the high long-term unemployment. Public infrastructure gaps and lack of proper education and training for labor market purposes are important structural impediments to employability. But wage costs of low skill workers appear to be an important obstacle as well, particularly in some regions with high unemployment where the minimum wage could exceed 50 percent of the average wage.

Tackling long-term unemployment will require a multi-pronged effort. Expediting EU funds absorption and improving capital expenditures in high-unemployment regions, and strengthening the orientation of education and vocational programs towards labor market needs will help ease structural impediments. Targeted and well-monitored active labor market policies could contribute to the activation of long-term unemployed and offer additional job-related training. To address wage cost and work incentives issues, a scheme that for low skill workers combines reduced social security contributions for employers with some in-job benefits for employees could be considered. When well designed, the fiscal costs of such scheme would be limited. In addition, the minimum wage’s role as reference for other wage setting and the mechanism for annual increases in the minimum wage could be reexamined.

More general educational reform and steps to improve the business environment will help support medium-term growth and rapid convergence. Improving the scope and quality of tertiary education and strengthening professional training at the tertiary level are priorities. As to enhancing the business environment, public sector governance issues, which receive wide attention and rank among the most significant problems for doing business in Slovakia, figure prominently. Deficiencies with respect to public procurement need to be addressed in particular.

Financial sector: continued vigilance

The financial sector is weathering the global financial crisis overall well. Reflecting a focus on traditional domestic banking activities and cautious lending practices, Slovak banks, mostly subsidiaries of foreign banks, hold no toxic assets and have limited exposure to sovereign risk in peripheral euro zone members. In the aggregate, they have maintained a loans-to-deposit ratio significantly lower than one and have continued to be profitable. Furthermore, with encouragement of the supervisory authorities, banks have increased their capital and liquidity ratios, including by limiting dividend payouts. The deterioration in asset quality, while pronounced, has stabilized and provisions are adequate. Nonetheless, new lending activity remains weak, in the corporate and commercial real estate segments in particular.

The relative resilience of the banking sector is manifested in the most recent stress tests. They indicate that the banking system can absorb a variety of domestic shocks, including a severe decline in output and employment. If sovereign risk elsewhere in the euro zone were to materialize, Slovak banks will be in a position to deal with spillovers from exposed parent banks. Nevertheless, further losses on lending to the corporate and real estate sectors need to be carefully monitored.

With mostly foreign-owned banks, strong cross-border supervisory cooperation will continue to be the key. Slovak supervisory authorities will have to help ensure effective cooperation and coordination with to-be-established EU-level supervisory institutions in particular. However, it will be important that the authorities also continue to strengthen regulation and supervision at the national level. Both the supervisory authorities and the banks will have to prepare for new provisions in the Basel III and Solvency II frameworks, which could be costly or restrictive for some banks, depending upon their particular business model.

¹ The mission would like to thank the Slovak authorities for their hospitality and the open discussions.