Mission Concluding Statement 

Slovak Republic -- Preliminary Conclusions of the IMF Mission to Review the Staff-Monitored Program

March 13, 2002

Slovak Republic -- Preliminary Conclusions of the IMF Mission to Review the Staff-Monitored Program

March 13, 2002

1. In March 2001 the Slovak authorities concluded the preparation of an economic program that brought together the various elements of the government's economic strategy. This ambitious program has been monitored by International Monetary Fund (IMF) staff, and a mission has been in Bratislava for the past two weeks conducting the program's last review. While fiscal and monetary policies have been broadly as envisaged during 2001, other policies, particularly those related to structural reform, have been implemented less forcefully.

2. Against this background, and reflecting in part slow demand in Europe, Slovakia is facing a challenging situation. While the economy is recovering, macroeconomic imbalances have become increasingly evident over the past several months: the growth in domestic demand has continued to outstrip production growth, and on current trends the 2002 fiscal deficit is projected to exceed significantly the target agreed under the staff-monitored program. The external current account deficit widened to more than 9 percent of GDP in 2001-more than doubling with respect to the previous year-and is projected to remain large in 2002. Although the fiscal and external deficits should be financeable in 2002 even without recourse to the large expected privatization receipts, these deficits are not sustainable. The authorities should adhere to their commitment not to use privatization receipts for current spending, and implement policies that would bring the deficits to levels consistent with declining debt to GDP ratios.

I. Program Implementation, Developments, and Risks

3. Quantitative performance under the program was broadly in line with targets; however, only half of the structural benchmarks were met, including several with delay (Tables 1 and 2 (pdf file)). The end-December targets for net official international reserves and net domestic assets of the banking system were met. The revised target for the 2001 general government deficit of 3.7 percent of GDP and the corresponding expenditure ceiling were narrowly missed. Although the benchmark on external debt and guarantees was met, the outstanding stock of total guaranteed debt has not been put on the downward trend envisaged under the program. The authorities made substantial progress in privatizing banks and enterprises, reforming the financial and energy sectors, improving the transparency of fiscal operations, and some progress in other areas, including reforming the health sector. However, policy implementation remains incomplete in several areas, particularly those related to fiscal reform and banking supervision. There is also evidence that implementation of essential reforms has lost momentum in recent months.

4. External developments have been adverse, as noted, but the economy has continued to grow, and inflation is on a downward trend. Real GDP growth in 2001 is estimated at 3.3 percent. Fixed investment grew especially strongly, boosted by increased profitability and enterprise restructuring; solid growth in private consumption was underpinned by rising real wages and employment, as well as the redemption of National Property Fund bonds; and fiscal policy was expansionary. The resulting domestic demand boom led to an across-the-board surge in imports (11½ percent in real terms), with imports of capital goods especially strong. The impact of the European slowdown on exports-as well as Volkswagen Slovakia's temporary output slowdown reflecting restructuring works-exacerbated the increase in the trade deficit. As a consequence, Slovakia's external vulnerability increased. Inflation, however, has continued to fall steadily: headline and core inflation rates eased to 6.6 percent and 3.2 percent, respectively, at end-2001, in both cases below the benchmark range¹ of the National Bank of Slovakia (NBS), and inflation fell further in early 2002.

5. There are several risks in the outlook. Political uncertainty may delay planned greenfield foreign direct investment. Continued weak external demand over the next several months would adversely affect the manufacturing sector, further widen the external current account deficit, and, potentially, put off investment. These risks interact with policy slippages and policy-related uncertainties, foremost in the fiscal area, in ways that could affect business confidence and increase Slovakia's vulnerability. The large receipts expected from the privatization of SPP, the state-owned gas company, may give the false impression that needed policy adjustments have become less urgent. Nevertheless, whether risks are managed successfully will depend almost entirely upon the design and implementation of economic policies, particularly fiscal policy.

II. Macroeconomic Policies for 2002

6. In this environment, the task for policies in the remainder of 2002 is to address macroeconomic imbalances, diminish vulnerabilities, and keep Slovakia on its path towards sustainable growth.

7. For fiscal policy, the government should ensure that-at a minimum-it does not add to current pressures on the balance of payments. This means adhering to a general government deficit of 3½ percent of GDP, excluding bank restructuring costs and called guarantees, as envisaged under the staff-monitored program. On current policies the deficit could exceed 5 percent of GDP, reflecting expenditure overruns in the social area, shortfalls in nontax revenue, and the reclassification of some revenue items. With efforts to tighten spending relative to the budget and to current trends, the government's deficit target of 3½ percent of GDP should be feasible. Such a deficit would represent modest progress towards the objective of medium-term fiscal consolidation, while appropriately supporting the continued economic recovery.

8. Given projected revenues, curtailing public expenditure growth is critical for meeting these objectives, and measures amounting to 1½ percent of GDP will be needed. With the understanding that the Slovak authorities are better placed to assess appropriate measures, the mission offers the following suggestions:

● Public sector wage bill: the mission is concerned about the public sector wage policy for 2002 because of its effects on the budget; on wages in general, and thus competitiveness; and on the external accounts. The proposed increase in the wage bill by about 15 percent was based on expected inflation of 6.7 percent in the budget, and perhaps excessive under that inflation assumption. The current expectation of the NBS for inflation in 2002 is only 4-4½ percent, and a more modest increase in the wage bill, of say, 9 percent, would save 0.2-0.3 percent of GDP and still provide for a sizable real wage increase.

● Capital spending: spending on highway construction is budgeted to increase by almost 40 percent in 2002. We recognize that improving road infrastructure is a government priority. Nevertheless, a reduction in the 2002 budgeted amount of around Sk 2 billion (0.2 percent of GDP), with some budgeted spending deferred to 2003, would still allow for an increase of about 10 percent in spending on roads in 2002.

● Social assistance benefits: the government should monitor carefully spending on social assistance and state benefits, and seek to prevent the expenditure overruns seen in recent years.

● Other expenditure: in the health care sector, recent steps are facilitating expenditure restraint; yet effective expenditure control and the prevention of fresh arrears will require the implementation of measures both on the supply of services and on the demand side, notably for pharmaceuticals. As the health system becomes financially self-sustaining, all expenditure obligations should be settled in a timely fashion, not least to avoid additional financial costs. There also remains room for curtailing subsidies, including on pharmaceuticals, mortgages, and agriculture.

● Expenditure control: the government should reintroduce the tighter quarterly expenditure ceilings, as employed in 2001.

9. Tax policy and administration should support the objectives of fiscal consolidation in 2002. There is no room for further cuts to corporate and personal income taxes given the priority of containing the fiscal deficit. Indeed, with the latter in mind, the government should consider adjusting some excise taxes, such as those on petroleum and petroleum products, and alcohol. The government should accelerate tax administration reform, which has not progressed as envisaged under the program, with measures to reduce tax arrears and reform the VAT refund system to complement the introduction of the Large Taxpayer Unit, in line with recent recommendations of an IMF technical assistance mission.

10. It is essential that the use of privatization receipts be strictly limited to retiring state debt-aside from those funds that will be used for pension reform. While this would be our advice in general-privatization receipts are one-off and hence should not be used for recurring expenditure, even indirectly, because spending plans can otherwise become unsustainable-this advice holds even more strongly because of the need to avoid additional fiscal pressures on the external accounts. The mission recommends that emphasis be placed on retiring external debt rather than domestic debt, to contain the monetary sterilization required from the NBS and improve Slovakia's external debt indicators. Moreover, the government should establish a plan for early retirement of debt instead of waiting for maturity of the various sovereign bonds that are traded in the market. To facilitate monetary management and ensure transparency, privatization receipts should be deposited in full at the NBS, rather than at commercial banks.

11. Turning to monetary policy, the NBS should help foster sustainable economic growth by pursuing its inflation benchmarks, as well as containing excessive demand pressures. In this light, the NBS's "wait and see" approach to interest rate policy remains appropriate. Nevertheless, in the absence of timely fiscal measures, the NBS would be forced to review monetary policy and may have to adopt a tighter policy stance. In the mission's view the current level of the exchange rate remains appropriate and there is no evidence that the slowdown in exports is related to competitiveness problems. The mission supports the NBS policy of basically abstaining from intervention in the foreign exchange market.

III. Structural Policies

12. Looking forward, policy decisions that could have a major effect on the public finances and on the economy in 2003, and beyond, are as important as prudent macroeconomic policies in 2002. These decisions pertain to policies on wages, and in the areas of health spending, unemployment benefits, active labor measures, and other social policies, including pensions. We have strong reservations about the merit of any measures that would have large implications for policy not explicitly considered in the context of a medium-term expenditure plan. Thus, we believe that the government should review policies in the context of a medium-term framework that is consistent with its commitment on government spending under the Joint Assessment for EU accession. The authorities should also reiterate their intention to adhere to the fiscal deficit objectives under this Assessment.

13. In this framework, monitoring and control of noncentral government expenditure will also be essential. The mission is encouraged that the decentralization process appears to be proceeding as envisaged under the program, especially in terms of safeguards needed for financial discipline. However, there is a need to build administrative capacity at the municipal and regional level, which may be a source of expenditure pressures. In this light, the experience in other countries suggests that forceful implementation-not just the framework-would be critical for the ultimate success of the policy on borrowing by municipal and local governments. The central government should maintain a vigilant control of the overall indebtedness of municipalities and regions. A successful decentralization will also require the strengthening of accountability and commitment to financial soundness by the different fiscal authorities, accompanied by timely and transparent information on fiscal operations of all entities.

14. We note that in the past sizable expenditure commitments have been incurred outside the normal budget process, complicating fiscal control, and government guarantees have been granted too liberally. The problem of unbudgeted expenditures has been partly addressed by the welcome abolition of most extra-budgetary funds, but new pressures have arisen given plentiful privatization receipts. As noted, these receipts should not be used to pay extra-budgetary expenditures. All expenditures should be fully integrated into the government's medium-term expenditure program, and be publicly recorded in a transparent multi-year framework, including in the context of the annual budget. Moreover, the mission is concerned that the continued extension of government guarantees-amounting to about 4 percent of GDP in new and rolled over guarantees during 2001-may reflect the absence of hard budget constraints in key public enterprises. We urge the government to review carefully its policy in this area, with the aim of increasing sharply the service of loans by borrowers. Otherwise, government guarantees represent over time a substantial financial transfer from taxpayers to financially unsound public enterprises.

15. The persistently high unemployment rate indicates that there are rigidities in the labor market. Unfortunately, the new labor code to take effect from April 1, 2002 is likely to exacerbate these rigidities. We strongly urge the government to postpone the implementation of this code until revisions are made to allow greater flexibility to employers and employees in reaching agreement on work practices and schedules. In addition, the new labor framework should minimize the bureaucratic burden on enterprises, especially small enterprises, and permit greater use of fixed-term contracts. The government should also limit unemployment and other social assistance benefits that stifle job search. Investment in education and training programs should be directed toward reducing the mismatch between the skills of labor market entrants and the requirements of new jobs being created.

16. Slovakia's banking system is being strengthened but implementation of banking supervision enhancements has been delayed. A significant restructuring of the banking sector with assistance from the World Bank is virtually complete. Bank supervision, however, has been fairly weak so far because of insufficient legal enforcement powers and a shortage of qualified supervision resources. The legal framework is being reinforced but the implementation of the supervisory development plan (SDP) agreed with the NBS has been delayed substantially. Following its recent reorganization, the banking supervision department is now well positioned to implement the SDP, and we urge the authorities to do so swiftly and forcefully.

17. The delay in the planned multi-pillar pension reform is regrettable, given the long-term difficulties facing the existing pay-as-you-go system. While it is appropriate to use privatization receipts to finance the transition costs from the introduction of the second pillar, we should warn the authorities that the earmarking of these receipts could result in too expensive a pension reform being undertaken because the earmarked receipts could set a floor for the cost of the reform. We encourage the authorities to use technical assistance in this area available from the World Bank, and strive to generate a cost-effective pension reform.

18. Slovakia faces major challenges in the coming months. Careful management of economic policies, particularly fiscal policy, will be necessary to achieve full growth potential without compromising macroeconomic stability. The mission has suggested policies that would make this possible, and we urge the authorities to coordinate policies closely and pursue needed changes with determination. If this is done, the prospects for redressing macroeconomic imbalances and sustaining long-term growth and stability are bright.

We would like to express our thanks to the authorities for the close cooperation that the mission has received and for the stimulating discussions.

¹ This was also a consultation band under the staff-monitored program.