Mission Concluding Statement 

Slovak Republic -- 2007 Article IV Consultation Discussions

March 13, 2007

1. Slovakia has become one of Central Europe's strongest economic performers over the past few years. The new government's demonstrated commitment to the continuation of prudent policies aimed at ensuring euro adoption in January 2009 has secured investor confidence and should help sustain this status.

2. Slovakia is well poised to adopt the euro, but challenges lie ahead. The near-term inflation outlook has improved, and the Maastricht inflation criterion seems within reach. The 2007-09 budget framework is aimed at meeting the euro zone entry objective, but there is a risk of slippage in the fiscal performance of local governments. Another key challenge will be to satisfy the test of exchange rate stability under ERM2 as the evolution of the koruna is influenced not only by economic fundamentals but also by swings in investor sentiment toward the region. Also, to ensure a successful experience in the euro area, policies must be suitably oriented toward enhancing the ability of the economy to deal with shocks. In particular, appropriate adjustment mechanisms—wage and labor market flexibility and the capacity to run countercyclical fiscal policy—ought to be in place prior to adopting the euro. A political consensus that recognizes the pay-off from a continued focus on fiscal prudence and structural reforms will remain essential. These aspects are elaborated below.

Recent developments and outlook

3. Economic growth accelerated in 2006 to 8.3 percent, supported by strong productivity gains. Domestic demand growth remained robust, albeit slowing in momentum, while the contribution of net foreign demand rose. Exports increased sharply, as exports of cars and durable consumer goods speeded up, and outpaced imports. However, owing to a deterioration in the terms of trade, the external current account deficit narrowed only slightly to 8¼ percent of GDP from 8½ percent of GDP in 2005. The bulk of the deficit was covered by foreign direct investment inflows. Favorable GDP and export developments together with a rebound of positive investor sentiment toward the region prompted a progressive strengthening of the koruna from October onward.

4. Inflation was on an upward path for much of 2006, but this trend was reversed in the fourth quarter. At end-2006, headline inflation (HICP basis) stood at 3.7 percent, compared with 3.9 percent at end-2005. Inflation developments during the year were heavily influenced by trends in world energy prices, a pick up in food price inflation, and the base effects of the large regulated price increases of October 2005. With real wage increases moderating and lagging productivity gains, wage-push inflationary pressure was absent.

5. The fiscal outturn in 2006 was better than envisaged in the budget, but still the stance was expansionary. The general government deficit, including the cost of the second pension pillar, is officially estimated at 3.4 percent of GDP, compared with 4.2 percent of GDP envisaged in the budget and an outturn of 2.8 percent of GDP in 2005. Accounting for net transfers from the EU, the fiscal stimulus in 2006 amounted to 1½ percent of GDP. Collections of tax and nontax revenues and social insurance contributions exceeded the budgeted levels by about 2½ percent of GDP, owing to stronger-than-expected growth in the underlying bases and one-time special factors. There also was some underspending in co-financing of EU-funded projects because of shortfalls in drawdown of funds from the EU budget. These gains were mostly offset by higher outlays on goods and services, an increase in entitlements for pensions and health benefits, and larger subsidies to the transport sector.

6. There were significant differences between various levels of general government in the fiscal performance relative to the budgeted levels. The fiscal outturn was better than envisaged for the state budget and the Social Insurance Agency. But, the outturn for the other levels of general government in the aggregate was 0.6 percent of GDP worse than budgeted. Most of this slippage occurred in the municipalities.

7. Looking ahead, economic growth prospects appear to have shifted to a higher plateau. The economy is likely to expand at rates above those assumed in the 2007-09 budget framework. Real GDP growth is projected by the mission to rise to 8¾ percent in 2007 and to moderate to 7 percent in 2009. The projected expansion is in line with the mission's estimates of potential growth that takes into account capacity increases. The commencement of production and increasing capacity in several export-oriented projects, especially in the automotive and electronic industries, and increased downstream integration with domestic supply chains will be the main engines of growth. Associated capital deepening and technological enhancements should sustain robust productivity growth and corporate profitability. Investment is expected to be buoyed by strong profits and FDI-financed projects in the pipeline and under negotiation. Private consumption growth should maintain momentum, supported by real wage increases, continuing employment gains, and favorable expectations triggered by prospective euro adoption. In the mission's view, competitiveness remains satisfactory. Accordingly, the contribution of net exports is foreseen to strengthen in 2007 and remain positive in subsequent years, fueled by growing exports of cars and electronic products. Accordingly, the external current account deficit is projected to narrow progressively to about 3½ percent of GDP in 2009. Slovakia's improved economic outlook and favorable prospects for euro adoption may create a tendency for upward pressure on the currency with the potential for overshooting.

8. Barring major shocks, inflation is likely to moderate in the near term and meet the Maastricht criterion. Decreases in regulated utility prices will result in a significant dampening of inflation in 2007. Given the latest World Economic Outlook energy price projections and assuming that wage increases continue to lag productivity gains, the mission considers the NBS's HICP inflation projections for end-2007 (1.6 percent) and end-2008 (1.9 percent) to be achievable. The projections are subject to uncertainties related to developments in world energy prices and their domestic impact and to movements in the nominal exchange rate. There are risks that strong profitability and a tighter labor market could weaken firms' resistance to wage increases, and that increased confidence could generate higher consumer spending. The mission's understanding from the discussions with the authorities is that the impact of the recent downward adjustments in regulated prices is sustainable in that they will not negatively affect cost recovery and the ability of the utility companies to maintain and renew their infrastructure. The mission would recommend that future adjustments in regulated prices are undertaken transparently in accordance with established pricing formulas.

Monetary policy

9. In the mission's view, the current stance of monetary policy is appropriate for the achievement of the inflation objective. Interest rates should only be adjusted to the extent required to maintain an unchanged policy stance. The reliance on rejecting repo bids in open market operations and driving down market interest rates with the aim of discouraging speculative capital inflows should be strictly temporary. When circumstances warrant it, the mission would recommend that the NBS lower its policy interest rates instead of persisting with rejection of repo bids. Also, the NBS should aim to increase Slovakia's resilience to speculative capital inflows by using its policy instruments in a manner that would limit opportunities for one-way bets in the foreign exchange market.

Fiscal policy

10. The 2007-09 budget framework aims at meeting the Maastricht fiscal deficit criterion in 2007 and achieving further fiscal consolidation thereafter, but risks and challenges remain. One concern, as the experience of 2006 shows, is slippage in fiscal performance of municipalities and other levels of non-state budget that could jeopardize the achievement of the Maastricht criterion. Fiscal rules applicable to local governments are based on ceilings on their debt stock, which are currently non-binding. Also, there is no satisfactory mechanism in place for monitoring their fiscal developments. Steps should be taken to improve fiscal management of local governments and other levels of non-state budget and ensure the expenditure control necessary to achieve the fiscal consolidation objective. Fiscal rules for local governments should also be amended to ensure the operation of automatic fiscal stabilizers. In the interim period until these measures are effective, it will be important for the authorities to exercise moral suasion on local governments to avoid any borrowing to finance expenditures beyond the budgeted levels and to save any revenue overperformance.

11. A more ambitious fiscal consolidation than envisaged in the 2007-09 budget framework is desirable, given the strong growth outlook and the challenges in fending off appreciation pressures. A stronger counter-cyclical fiscal policy would ensure that the Maastricht criteria on inflation, the exchange rate, and the budget deficit are met by comfortable margins and in a sustainable manner.

12. The strategy to achieve additional fiscal consolidation would not necessarily require scaling back on expenditure foreseen in the budget. Revenues are likely to exceed the budgeted levels as economic growth is anticipated to be stronger relative to the budget assumptions. The mission would strongly encourage the authorities to save the revenue overperformance and ensure a better fiscal outturn. In other words, the nominal expenditure targets specified in the budget framework should be adhered to even in the face of higher revenues. Any saving on interest payments should also be saved.

13. The expenditure program in the 2007-09 budget framework is sketchy and does not identify how the announced policy priorities will be sustained beyond 2007. The mission understands that this deficiency will be corrected in the 2008-10 budget framework, the preparation for which will start shortly. We are encouraged to learn that the authorities intend to create room for the policy priorities through efficiency gains in government spending and streamlining public administration, and that the necessary background work has already been initiated. It will be important to follow through with these plans in a systematic and decisive manner. As noted above in ¶12, the mission would not recommend any upward revision of the expenditure ceilings for 2008 and 2009 when the 2008-10 budget framework is finalized on the basis of updated macroeconomic projections. The mission also would advise the authorities against reallocating capital expenditure or any underspending in co-financing of EU funded projects (arising from slower-than-envisaged absorption of EU funds) toward socially-oriented current spending and subsidies, as this would increase the rigidity of the public expenditure structure as well as impair the long-term economic growth potential. Capital expenditure also can help achieve social welfare goals. It would be more productive to reduce poverty and income inequalities by channeling resources toward employment promotion and investment in infrastructure in underdeveloped regions.

14. Addressing the financial strains in the healthcare system is a priority. A key challenge is to improve the mix of intermediate resources. Reforms are needed to rationalize excess healthcare facilities, reduce pharmaceutical costs, and contain demand pressures for doctor's consultations and outpatient contacts. The incidence of doctors' consultations and outpatient contacts in per capita terms in Slovakia is more than double that in the EU-15 and more than the average for the new EU-member states. There is a risk that the demand for these services will increase following the recent elimination of co-payments. Another concern is that public hospitals are continuing to accumulate arrears, which the central government will eventually have to absorb. The operational inefficiencies in hospitals and the pricing of health care treatments need to be addressed.

15. Slovakia's simple and efficient tax system has become a hallmark of its recent economic success and an attraction for investors. The changes made to the system in 2007 were marginal, and the mission does not consider them unduly distortionary. The mission would encourage the authorities not to expand the list of items subject to a lower VAT rate (which currently applies only to medicine and medical tools) so as not to create opportunities for tax evasion and not to burden tax administration.

Wage and labor market issues

16. Wage moderation and flexibility in wage setting procedures will be important for containing inflationary pressures as well as for safeguarding competitiveness. In this context, the mission welcomes the authorities' intention to establish a tripartite Social Pact that would include wage issues. An agreement to keep wage increases below productivity growth would be appropriate as productivity gains are resulting from capital deepening and capital augmenting technological change. Expanding enterprise-level wage bargaining and ensuring greater productivity-based wage adjustments would promote wage flexibility. In this regard, recent legislation that extends sectoral wage bargaining agreements as the floor for wage adjustments in non-unionized firms is worrisome.

17. The authorities should adopt a cautious stance on the pace of minimum wage and public sector wage increases, as these influence wage negotiations in the private sector and because certain social benefits are linked to the minimum wage. It would be important to retain discretion for determining the increase in the minimum wage instead of establishing formula-based guidelines. The mission would like to stress that the introduction of an earned income credit for low-income workers would be a better option to guarantee a minimum living standard than further increases in the minimum wage. Implementation of this measure would enhance the incentive to participate in the labor market without having any negative impact on the demand for labor.

18. A more flexible labor market is needed to enhance growth potential and the economy's resilience to shocks, especially when eurozone membership eliminates the ability to use monetary and exchange rate policy. The mission would urge the authorities to incorporate amendments to the labor code, which are now being discussed in a public setting, only after undertaking a thorough analysis of their economic impact. It would be important to ensure that the amendments do not increase labor costs and reduce labor market flexibility.

Financial sector issues

19. According to the recent FSAP Update mission, the financial system is in a healthy state. Banks are well capitalized, profitable, and resilient to a range of possible adverse shocks. However, continued rapid credit growth has increased banks' exposure to credit risk and their vulnerability to swings in the economic cycle; this situation warrants close monitoring. The mission is pleased to learn that the risk-based approach of supervision is now fully operational in the non-bank financial sector as well. The main medium-term challenges are (i) improving coordination with home supervisors, especially regarding Basel II implementation, and (ii) addressing consumer protection concerns while avoiding conflicts with other financial sector policies. The mission would recommend that the responsibility for consumer protection be kept separate from financial sector supervision. The mission also would urge the authorities to implement all the recommendations of the MONEYVAL report to improve the AML/CFT regime in a timely fashion.

Other structural issues

20. Addressing regional inequalities and the high unemployment problem are continuing challenges. The benefits of rapid economic growth appears to have by-passed three regions in central and eastern Slovakia, where the general skill level of working-age population is low, employment growth has been small, unemployment remains sticky around 20 percent or more, and long-term unemployment is much higher than elsewhere in Slovakia. At the same time, there is a potential risk of shortage of skilled labor over the medium term in the other five regions of the country. Besides intensifying active labor market policies and providing investment incentives for underdeveloped regions, it will be important to increase investment in infrastructure in these regions, strengthen the transport and regional communication systems, and improve the quality of tertiary and vocational education. Priority should be given to eliminating the bottlenecks that hinder drawdown of EU funds for infrastructure and transport projects. Receptiveness to migrant labor can alleviate the medium-term shortage of skilled labor.

We would like to thank the Slovak authorities for the close cooperation with the mission, their generous hospitality, and for the stimulating discussions.