Mission Concluding Statement 

Slovak Republic: Staff Concluding Statement of the 2019 Article IV Mission

May 17, 2019

Slovakia is an economic success story. Sizable productivity gains from strong integration with global value chains over the past two decades have delivered sustained income convergence toward the EU average. But as the economic cycle turns and structural shifts reshape the automotive industry—the core engine of Slovakia’s export-led economy—policies should seek to re-energize the country’s growth model by strengthening institutions, improving public sector efficiency and investing in infrastructure and skills. Strong fiscal discipline and vigilant micro- and macroprudential measures are needed to ensure continued fiscal and financial stability.

A virtuous cycle is past its peak

The economy grew briskly over the past five years. This was supported by strong household credit growth, robust labor market dynamics, and new investments in the automotive industry. Job creation has been particularly strong, driving unemployment to its lowest level and bidding up wages in both private and public sectors. This has filtered into consumer prices with inflation rising above 2 percent although the economy has preserved its competitiveness relative to trading partners.

With one-off effects of investment in the automotive industry tapering off, the mission projects growth to decelerate. Real GDP growth is projected at 3½ percent for 2019 and is expected to moderate further toward its potential over the medium-term. Domestic demand is expected to propel economic activities supported by robust wage and credit growth, albeit at a slower pace than in the recent past. Also, contributions from net exports are projected to improve on the back of recent capacity expansion in the automotive sector more than compensating weaker external demand.

The softer economic outlook faces significant uncertainties. A turning economic cycle is unmasking several structural vulnerabilities. Slovakia’s heavy dependence on exports and a concentrated export structure render the economy highly sensitive to ongoing global trade tensions and risks of a no-deal Brexit. Any negative shock originating in the export sector is likely to be amplified through ripple effects on a vast network of domestic firms that are linked to this sector and confidence effect on consumers. This may be further compounded by a decade of strong credit growth that has significantly raised household indebtedness and made banks vulnerable to economic downturns. Sufficient fiscal policy space and financial sector buffers are needed to insure against possible cascading effects from adverse shocks.

Structural policies: Tapping into full benefits of the global value chains

Leveraging its location and availability of low-cost qualified labor, Slovakia has attained a very high level of integration with the global value chains. This has proved pivotal to exports growth and income convergence. However, more than two decades after the initiation of this export-led growth strategy, Slovakia remains engaged mostly in the assembly of the final products. With rising automation of assembly jobs in the industrial sector, and shortage of skilled labor, the country is at risk of losing its comparative advantage. The automotive industry, which is heavily invested in combustion-engine cars, faces an additional risk over the medium term from the ongoing shift in global demand toward electric cars that may give rise to reshoring of production.

Slovakia’s continued success in exports hinges on capturing higher-value activities. This can be attained by providing an enabling environment for domestic firms to rise up as suppliers of key intermediate inputs and taking part in process and product innovations. To this end, government support for skills development and innovation could be instrumental. Recent policy efforts to ensure an adequate supply of qualified teachers, including through higher remuneration and pedagogical development, and strengthen dual-track vocational training are welcome. These should be complemented by improving quality of tertiary education and aligning higher education with technical skills needs to support movement to higher value-added activities. Consolidating the fragmented public research system to improve coordination, strengthening linkages between businesses and universities, and ensuring full use of EU funds for R&D would help enhance the capacity to absorb technology more effectively and innovate.

Better institutions and trade logistics would provide invaluable support. To ensure retention of high-skilled workers and generation of higher value added by domestic firms, a more efficient public sector, improved business environment and well-developed infrastructure and logistics networks are important. The authorities have undertaken commendable efforts in recent years to diagnose weaknesses in the public sector and increase transparency. Going forward, focus needs to be on the implementation of reforms to ensure a more efficient and enabling government through increasing regulatory predictability, instilling a more competitive public procurement system, raising independence of the judiciary, and minimizing conflict of interest in the public administration.

With the population set to experience fast ageing, Slovakia needs to ensure optimal use of its domestic labor force. Recent efforts to reduce administrative requirements and processing time for hiring of foreign workers have eased labor shortages. However, to counter impending ageing impact, expected to be among the fastest in the EU, Slovakia needs to adopt policies to fully utilize its domestic labor force. An insufficiently inclusive education system combined with a lack of affordable early childcare facilities are contributing to the still-high gender gap and regional disparities in labor market participation. The legislative proposal to make schooling mandatory starting at age 5 is welcome and will help increase integration of Roma population. This should be complemented by active labor market policies to invest in skills and facilitate job placement to increase participation of the marginalized groups who constitute a sizable share of the population, including through better absorption of EU funds. Recent initiatives to expand availability of affordable childcare will help improve participation of women in the labor force and should be accompanied by more gender-neutral parental leave policies.

Fiscal policies: Build policy space by safeguarding fiscal discipline and raising efficiency

The fiscal position has improved in recent years. Thanks to strong job-rich growth and measures that supported tax collections and boosted social and health contributions, overall fiscal deficit is estimated to have decreased to 0.7 percent of GDP in 2018. Earlier pension and health sector reforms helped deliver savings in spending despite notable increases in public sector wages. The public debt level, at 49 percent of GDP in 2018, is below the lower limit of the national Fiscal Responsibility Act (FRA). However, fiscal space created by the recent consolidation may not be sufficient to cushion significant economic downturns. While under the EU fiscal rules, there is adequate flexibility to counter sizable economic shocks, fiscal room is much more limited under the national FRA. The mission’s analysis suggests that a sizable drop in real GDP growth may trigger pro-cyclical fiscal consolidation in order to stay within the FRA limits.

Sustained fiscal consolidation is important to create adequate policy space to counter shocks. With growth expected to remain above potential, a balanced budget target is appropriate for 2019 and in the medium term. However, the fiscal deficit is projected to be 0.3 percent of GDP in 2019 requiring additional measures to offset costs of rising public sector wages. For 2020, the package of measures currently under discussion by coalition partners could significantly increase the fiscal deficit. The mission recommends refraining from expansionary measures beyond what is already budgeted. In this context, the authorities’ proposal to introduce multi-year expenditure ceilings linked to the long-term debt target would prove useful in anchoring fiscal discipline; a transparent and parsimonious framework would be critical for full consistency with the Stability and Growth Pact and the FRA.

Fiscal space is also needed to accommodate growth-enhancing social and infrastructure investment. Significant new investments and higher spending on maintenance are needed to expand and improve Slovakia’s infrastructure, which falls behind EU peers given its size and population. This needs to be done in line with value for money principles. Realigning and improving the quality of the education system to meet the future needs of the labor market and increasing the inclusion of disadvantaged groups will also require sizable public resources. Meanwhile, the reversal of earlier pension reforms through the passage of the retirement age cap is expected increase long-term costs of aging.

Resources for investment needs should be raised through higher revenue and spending efficiency and better absorption of EU funds. The authorities’ continued efforts to raise tax efficiency, including through the implementation of e-filling system and the planned adoption of online electronic cashiers, are welcome and should be sustained through further strengthening of the audit capacity in all core tax areas. Meanwhile, adequate ownership of the reforms outlined in the spending reviews and the political will to push through their implementation will be important to materialize identified savings, including in the health care sector where progress should be sustained. A more robust public investment framework is required to improve the efficiency of public investment and absorption of EU funds. In particular, a consolidated pipeline of appraised projects managed by a central unit would improve project selection and prioritization at a national level. Strengthening financial and operational oversight of state-owned enterprises—which execute half of the capital budget— and addressing residual weaknesses in public procurement are important.

Financial Policies: Insure against vulnerabilities

The banking sector is stable and well-capitalized, but strong competition is eroding profitability, especially in smaller banks. A prolonged period of low interest rates together with a business model that relies mostly on lending in a small market have produced severe competition among banks. The competition has been further exacerbated by too benign credit risk assessments by banks, the regulatory cap on the mortgage refinancing fee, and the strong market intermediation role of mortgage brokers. The result has been rapid expansion of banks’ mortgage portfolio and strong compression of the lending margin, both being the largest in the EU. Consequently, smaller banks with weaker asset quality and lower profitability are left highly vulnerable to economic downturns.

Households and banks are vulnerable to labor and property market downturns. During the last decade, a sustained period of high credit growth has nearly doubled household debt relative to disposable income. Compared to EU members, banks in Slovakia have extended a higher share of mortgages to low-income households. Though the property market on average remains broadly in line with economic fundamentals, rapidly raising flat prices in urban areas and an appreciating trend of house prices-to-income ratio may indicate accumulating imbalances in the housing market and rising vulnerabilities of households and banks to possible downturns in the property market.

Proactive macro-prudential measures have moderated credit growth, and the mission sees merit in additional measures. These macro-prudential measures have also contained credit risks of new lending through tightening of banks’ credit standards. Furthermore, recognizing vulnerabilities of the household sector, the authorities have increased the countercyclical capital buffers and supervisory capital requirements to enhance resilience of the banking sector. The mission strongly supports these measures and the authorities’ readiness to further raise capital buffers as necessary. Notwithstanding, strong vigilance of smaller banks is needed given their higher vulnerability to economic downturns. Given historically low default rates, more forward-looking assessment of credit risks is warranted. Allowing the bank levy to expire as scheduled in 2021 should help the smaller banks build more capital buffers.

The IMF mission would like to thank the authorities and other counterparts for the frank and thoughtful discussions and kind hospitality.