Mission Concluding Statement 

Bratislava, June 17, 2014

A welcome recovery in domestic demand will support stronger and more balanced growth. Identifying high-quality and growth-friendly fiscal measures would help sustain the adjustment progress achieved in recent years and enable support for actions to reduce very high unemployment and large regional disparities. Steps to improve the business environment would also advance efforts to address joblessness and boost growth.

1. Growth is gathering pace and becoming more balanced. Strong exports have supported economic activity in the Slovak Republic in recent years and made it one of the more dynamic economies in Europe, but a weakening external environment contributed to slower growth in 2013. A pick-up in domestic demand after two years of declines and more favorable conditions among Slovakia’s trading partners are expected to result in growth of nearly 2½ percent in 2014, rising to 3 percent in the medium term. Stronger domestic consumption and investment, against the backdrop of further ECB easing, should support moderate inflation in 2014 after falling prices early in the year.

2. Slovakia’s economy faces upside and downside risks. The recent rise in domestic demand could enhance confidence and spur further investment, potentially supported by Slovakia’s healthy banking system. Market sentiment and the economic outlook in key trading partners in Europe have been improving and could benefit further from recent ECB decisions. On the other hand, there are still risks to the recovery in Europe and from the possibility of protracted slow global growth. If geopolitical tensions involving Russia and Ukraine intensify, Slovakia could be affected by energy supply shocks as well as through trade channels, where indirect effects might be more significant.

High-quality fiscal measures to strengthen government finances and address joblessness

3. Despite significant progress, fiscal policy challenges remain. Slovakia’s strong fiscal commitment is evident. Since 2009, the budget deficit has been reduced by about 5 percentage points to 2.8 percent of GDP in 2013—just below the threshold for exiting the EU’s Excessive Deficit Procedure. Slovakia’s debt remains manageable and market conditions have allowed an extension of maturities at lower interest rates. However, durable fiscal measures are needed to prevent debt from continuing to rise, in part because of reliance on temporary measures to achieve adjustment.

4. The budget framework calls for early action. With economic output still below potential, subdued inflation, high unemployment, and infrastructure and other needs, gradual adjustment would be advisable. However, since government debt exceeded 55 percent of GDP in 2013, Slovakia’s Fiscal Responsibility Act (FRA), calls for some spending cuts already in 2014 and submission of budgets with partial spending freezes while debt remains above the threshold, with potentially negative effects on growth (sharper adjustment risks could come from submission of a balanced budget at the 57 percent of GDP threshold). Further impetus for adjustment comes from EU commitments, although these take into account whether economic output is above or below potential. After additional experience under the FRA, and in light of the evolving EU fiscal framework which overlaps with the FRA, the government might consider whether there is scope for a more streamlined set of fiscal rules that are clearer, less pro-cyclical, less biased toward expenditure cuts, and more reflective of debt vulnerabilities (e.g., cash balances push up gross debt but reduce short-term rollover risks). Changes in how government debt is defined can also create challenges for the framework.

5. Expenditure-based adjustment will be difficult. Consistent with the FRA’s emphasis on spending cuts, the government’s medium-term budget plan targets much lower outlays (a drop of more than 4 percentage points of GDP between 2013 and 2017). Making the government more efficient (e.g., the ESO initiative) would help achieve expenditure savings. But challenges in controlling the public wage bill and substantial cuts to investment spending in recent years, as well as the need to fund priority items to address unemployment and regional disparities (described below), suggest reliance on spending cuts could be difficult to sustain and undesirable in terms of key objectives.

6. Strengthening revenue collection should be a top priority. To reduce risks from over-reliance on expenditure cuts and avoid short-changing worthwhile outlays, revenue performance should be improved. Early progress in strengthening revenue collection and reducing evasion, especially steps to raise low efficiency in VAT collection, is welcome. The current VAT rate of 20 percent should be maintained. A property value-based real estate tax could yield substantial revenue, and efforts to strengthen data on real estate values in the cadastre should be accelerated. Apart from standard revenue measures, privatization of state assets would help reduce debt levels in a growth-friendly way. The recent increase of the state role in a key energy company runs in the opposite direction and could imply fiscal costs if energy price increases are not passed on.

Comprehensive approach to reduce unemployment and regional disparities

7. Wide-ranging policy actions are needed to tackle very high unemployment and regional disparities. Slovakia has been among the fastest growing economies in Europe, but nonetheless has very high unemployment (14 percent overall and much higher levels for youth, the long-term jobless, and marginalized groups), and wide gaps between Bratislava and other regions in terms of income, employment, and infrastructure. Policy and budget priorities should focus on coordinated actions to encourage investment and job creation, reduce financial disincentives to working and hiring, enhance skills, and help people enter or return to the labor market:

• Given very low vacancies in regions with high unemployment, strengthening infrastructure, especially highways, is critical to promoting investment and job creation in lagging regions. Increased absorption of EU Funds in this area could help.

• Improving aspects of the business climate such as contract enforcement (e.g., to promote timely payments among firms), procurement practices, governance, and high energy costs for businesses, as well as avoiding actions to make the labor environment more restrictive, could also encourage investment, including by small- and medium-sized enterprises.

• Reducing the high tax wedge that makes it unattractive for firms to hire and for people with low skill levels to work should be a high priority in the budget. Incentives under the benefit structure might be improved (e.g., consideration might be given to tapering general social benefits over time while continuing to provide some benefits when beginning work). A differentiated minimum wage also might be considered given regional disparities.

• Efforts to strengthen education and training should seek to improve curriculums to better match workforce needs, support teacher quality, and create an effective dual system of vocational training, based on close cooperation with businesses to ensure substantial practical experience in workplaces.

• The effectiveness of active labor market policies (ALMPs) and the public employment service should be boosted. ALMP spending, which is very low compared to peers, should be raised, including by drawing on EU Funds. Recent initiatives to focus on youth unemployment might be complemented by greater attention to the long-term unemployed and marginalized groups.

Maintaining a healthy financial sector

8. Continued prudence will maintain the strength of the banking system. Sound capital levels and liquidity buffers, rising profits, and deposit-based funding contribute to the strength of the banking system, make it resilient to shocks, and should facilitate corporate lending as demand picks up, complementing strong household lending growth. Consistent with Slovakia’s membership in the euro area, key banks will take part in the comprehensive assessment in preparation for the Single Supervisory Mechanism, and the supervisory and regulatory framework will be strengthened through implementation of the Basel III framework via the Capital Requirements Regulation/Capital Requirements Directive IV, including regarding macroprudential policy. While risks from rising loan-to-value (LTV) ratios are moderate at this stage and house prices remain flat, a recommendation on maximum LTV levels would be appropriate, and should cover both traditional mortgages and other housing loans. The relatively high bank levy should be decreased and replaced once the system for contributions to the Single Resolution Fund is implemented, and revenues from the levy should be placed in a more well-defined resolution fund.

9. Actions could help support non-bank finance and credit to small firms. Reducing high taxes on investment income and lowering transaction fees by establishing a more efficient central depository would address some of the factors that have contributed to very limited capital market activity. There could also be opportunities for cooperation with more established stock exchanges in the region. Prospects for small businesses could be enhanced by efforts to facilitate access to finance, such as through the JEREMIE initiative, in addition to steps to strengthen the business environment.

The staff team would like to thank the authorities and other counterparts for their hospitality and the good discussions.