Mission Concluding Statement 

Slovak Republic: Staff Concluding Statement of the 2015 Article IV Mission

November 3, 2015

Growth is accelerating due to strong domestic demand. Well-designed fiscal measures would help support policies to reduce still-high joblessness and regional disparities, while enhancing room for maneuver under fiscal rules. Vigilant application of macroprudential policies would help guard against potential risks from rapid household credit growth.

1. Growth is picking up as domestic demand strengthens further. Against a backdrop of accommodative monetary conditions and low oil prices, higher capacity utilization and a concerted push to spend expiring EU Funds are boosting investment, while job creation and real wage growth are fueling private consumption. Exports remain strong, but imports have risen even faster, reflecting healthy domestic demand. Growth is forecast to reach 3.2 percent this year, and 3.5 percent in 2016–17 as further expansion of the auto industry is expected, before settling at a little over 3 percent in the medium term. Although inflation should be near zero this year due to falling energy costs, prices should rise in 2016 as the output gap closes.

2. Given Slovakia’s integration into the global economy, the strong outlook remains vulnerable to external risks. Resilience to shocks is bolstered by a sound and liquid banking sector, low private sector leverage, and limited public debt. If, however, growth were to falter among key trading partners such as Germany—whether due to weakness in the euro area itself, a slowdown in China or other emerging market economies, or tensions between Russia and Ukraine—Slovakia’s important export sector would be affected. On the domestic side, rapid household credit growth could lead to financial sector risks, while high long-term unemployment could erode human capital, undermine growth, and exacerbate demographic challenges.

Boosting Investment and Reducing Unemployment

3. High joblessness, especially long-term and among youth and women, as well as sharp regional differences, remain key challenges. Rising growth has led to welcome job creation. Nonetheless, the unemployment rate remains in double digits, and some groups are especially affected: more than 60 percent of the unemployed have been jobless for longer than a year; youth unemployment has declined but remains near 25 percent, and the share of young people not in education, employment, or training is one of the highest in the EU; and Slovakia compares unfavorably with European peers in terms of female labor force participation. Further, substantial disparities in terms of income, employment, and infrastructure remain between Bratislava and other regions; there are few job opportunities in high unemployment areas.

4. Spurring job-rich growth in less dynamic regions while addressing longer-term labor market and demographic challenges calls for a comprehensive approach:

• Enhancing road and railway infrastructure, including through effective use of EU Funds, would help promote investment in lagging regions, a priority recognized in recent government initiatives. Better transport links as well as a shift in budget resources toward rental housing programs could promote labor mobility. More broadly, strengthening the business climate (e.g., improvements to the legal and procurement systems to address governance weaknesses) could encourage private investment.

• Lowering the labor tax wedge, especially for low-wage or part-time workers, would foster labor force participation and help reduce disincentives to hiring. In this spirit, the reduction in the health contribution allowance to offset the impact of the early 2015 minimum wage increase was a welcome step. The draft budget’s moderate increase in the childcare allowance and funding for kindergarten facilities go in the right direction to raise female labor force participation.

• Strengthening education and training would allay skill shortages and mismatches that are becoming more apparent. Effective implementation of the recently launched dual system for vocational education and job experience is essential to help meet workforce requirements. Efforts to improve elementary and secondary education, especially for marginalized populations such as Roma where integration needs are substantial, should also be a high priority.

• Comparatively low levels of active labor market policy (ALMP) spending should be raised and sustained, and the planned evaluation of the various ALMPs should be completed to help maximize effectiveness.

Careful Fiscal Consolidation to Preserve Policy Space and Support Growth

5. Further fiscal consolidation is needed to ensure room for policy maneuver. After a substantial narrowing of fiscal imbalances through 2013 to exit the EU’s Excessive Deficit Procedure, the deficit has remained between 2.5 and 3 percent of GDP. While high unemployment, large infrastructure needs, subdued inflation, and favorable borrowing conditions could argue for a supportive fiscal stance, the output gap is now closing rapidly. Moreover, there is limited room under a Fiscal Responsibility Act (FRA) debt brake that would require spending cuts, and the FRA thresholds will be lowered by one percentage point per year starting in 2018, putting even more pressure on deficit targets in the medium term. To create the headroom necessary for fiscal policy to be able to play a counter-cyclical role in the event of shocks, a debt ratio safely below FRA debt brakes is necessary.

6. Broadening the tax base, enhancing revenue collection, and achieving spending efficiencies would help secure needed fiscal adjustment while funding key priorities. Better revenue administration has anchored efforts to contain deficits in recent years, but there have also been cuts in investment spending and some reliance on temporary measures. An aggressive push to use EU Funds this year may help fill some infrastructure gaps. Spending discipline will be needed in 2016 to offset costs from higher wages, a reduced VAT rate for basic foods, and other social outlays. Fiscal policies should focus on five key areas:

• Enhancing revenue collection and broadening the tax base. Further improvements in VAT efficiency after substantial progress in recent years and development of relatively growth-friendly revenue sources such as a market value-based real estate tax would help achieve adjustment and create space for key priorities (see below). It will also be important to ensure that introduction of a reduced VAT rate does not undermine compliance.

• Identifying spending efficiencies, potentially in health and public order and safety, as part of planned efforts to improve value-for-money in the budget, and undertaking a comprehensive review of social benefits.

• Funding priorities to address labor market challenges and regional disparities such as infrastructure investment (including by making effective use of EU Funds in the new programming period), a lower labor tax wedge, ALMPs, education and training, childcare, and kindergartens.

• Using privatization proceeds for debt reduction (e.g., those realized recently from the sale of Slovak Telekom), refraining from increasing public ownership of companies, and undertaking further privatization of still sizeable state shareholdings.

• Strengthening long-term finances. Going beyond recent pension reforms is likely to be necessary to address rising retirement and healthcare costs due to population aging, while reopening of the second pension pillar has increased future government liabilities and undermined development of institutional investors and domestic capital markets (see below).

7. In light of experience so far, FRA modifications should be considered. Using net rather than gross debt thresholds could facilitate debt management; more gradual implementation of adjustment called for by the FRA—spending cuts or a balanced budget—would lessen potential pro-cyclicality; escape clauses could be better tailored to the size and nature of growth or other shocks Slovakia might face; and there could be less of a bias toward expenditure cuts. In addition, the debt thresholds might be kept at their current levels rather than lowered over time, although—as noted—policies should aim to maintain a safe margin below debt thresholds to avoid the need for procyclical policies during downturns.

Safeguarding Financial Stability to Promote Sustainable Lending

8. Additional supervisory measures would help guard against risks from rapid credit growth. Accommodative monetary policy and robust domestic demand have contributed to household debt climbing at one of the fastest rates in Europe, although corporate borrowing has only picked up recently. While household debt remains limited and banks enjoy sound capital and liquidity buffers, fast credit expansion could sow financial stability risks, mainly due to potentially lower debt affordability in the future. The National Bank of Slovakia (NBS) appropriately introduced macroprudential measures. Although the impact on credit growth has been limited so far, these measures have contributed to improved overall lending practices. With the planned transposition of its recommendations into law, the NBS should consider lowering the loan-to-value (LTV) limit to 85 percent, which would be more in line with those of peers, and accelerating the move to tighter exceptions to the limit. Issuing clear guidance on a maximum debt-to-income ratio would enhance the effectiveness of the LTV limit. If above-trend credit growth continues and broadens to the corporate sector, raising the counter-cyclical capital buffer to at least 0.5 percent (from zero percent currently) would be warranted. In the near term, more targeted measures such as raising risk weights and imposing stricter loss-given-default assumptions on real estate-related exposures should be considered, in combination with regular stress testing, timely implementation of new European standards for loan classification, and mandatory bank verification of external appraisals of collateral.

9. Preparation will help ensure the effectiveness of the bank resolution framework. Although there are no immediate risks on the horizon, tests of the feasibility of resolution tools and cross-border coordination would facilitate readiness under the new European framework, especially given the large deposit base and the important role of foreign-owned banks. Proceeds from the bank levy should be placed in a dedicated resolution fund by the end of the year to finance the national contribution to the EU’s Single Resolution Fund.

10. Quantitative easing (QE) by the European Central Bank may pose challenges and warrant closer monitoring of non-bank financial activities. Relatively low levels of government debt and financing needs, as well as the large share of hold-to-maturity portfolios among banks, could make it harder for the NBS to meet its asset purchase targets as part of the Eurosystem. Also, with low interest rates, investment returns have fallen for life insurance companies and the present value of their long-term liabilities has risen, potentially undermining the viability of guarantee-based products. The authorities should explore the possibility developing an industry-funded policyholder protection scheme, especially in the absence of a resolution mechanism for non-bank financial institutions.

11. Capital market development and integration could improve access to financing. A better functioning capital market could offer firms alternative financing sources such as equity issuance, provide additional investment options for savers, and make it easier for banks to issue long-term debt such as covered bonds to diversify funding sources and overcome rising asset-liability mismatches. Targeted efforts underway to promote financing of small and innovative firms are welcome and could be further supported by an EU Capital Markets Union. Plans to reduce high taxes on investment income and transaction fees, including through establishment of a new central depository, are important first steps toward financial market development; potential links to other stock exchanges in the region should also be explored to promote market access.

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