Mission Concluding Statement 

Slovak Republic: Staff Concluding Statement of the 2023 Article IV Mission

December 18, 2023

Washington, DC: An International Monetary Fund mission, led by Magnus Saxegaard, and comprising Farid Boumediene, Fuad Hasanov, and Shinya Kotera, conducted discussions for the 2023 Article IV consultation with Slovak Republic during November 30–December 14, 2023. At the conclusion of the visit, the mission issued the following statement:

Economic Developments, Outlook, and Risks

The Slovak economy has remained resilient despite significant headwinds from the war in Ukraine, soaring commodity prices, and supply chain disruptions . Growth is expected to have weakened to 1.1 percent in 2023 from 1.8 percent in 2022. Private consumption fell as higher social transfers and energy support that led to a widening fiscal deficit only partially offset the impact of a decline in real wages, while government investment (financed in part by EU grants) grew strongly. Inflation has declined from record-high levels in 2022 and early 2023 but remains among the highest in the euro area.

The economy is projected to grow by 2.2 percent in 2024.Household consumption is set to recover as the decline in the pace of price increases relative to wages boosts real incomes and supports demand. Improved global supply chain conditions will continue to support a recovery in exports, offsetting somewhat weaker foreign demand. Headline inflation is projected to keep falling, but core inflation is expected to be stickier due to the ongoing recovery of wages. Adverse demographic trends and lower productivity growth imply that medium-term growth is projected to be significantly lower than the pre-pandemic average, resulting in slower income convergence.

Risks are tilted firmly to the downside. In the near term, a global slowdown would weaken exports. Commodity price shocks could also keep inflation in the euro area high and require further monetary policy tightening. Domestically, delays in fiscal consolidation, slow implementation of structural reforms, and failure to absorb EU grants effectively could increase government borrowing costs and lower potential growth. A sharp real estate market downturn could depress domestic demand and trigger losses for financial institutions. Finally, continued strong nominal wage growth or an increase in profit margins could keep inflation elevated and undermine competitiveness.

Fiscal Policy

Fiscal consolidation is needed to safeguard the sustainability of public finances. The fiscal deficit increased by 4.5 percentage points of GDP in 2023 compared to the 2022 outturn on account of temporary energy measures, a permanent increase in family benefits (child allowances and tax credits), more generous pensions, and the effect of past inflation on expenditures. For 2024 the authorities have proposed a budget that targets a reduction in the headline deficit of 0.5 percentage points of GDP (relative to 2023) while committing to further consolidation efforts in 2025 and 2026. The IMF mission welcomes the authorities’ resolve to improve public finances, but further efforts are needed to put debt on a downward path, rebuild buffers for potential shocks, and prepare for the increase in aging-related spending.

• The approximately €800 million (0.6 percent of GDP) in net measures included in the 2024 budget are estimated to be sufficient to reduce the deficit to 6 percent of GDP in 2024 from 6.5 percent of GDP in 2023. However, even with 0.6 percent of GDP in measures, the structural fiscal deficit (excluding energy support and other one-off policies) is projected to widen by 0.9 percentage point to 5.3 percent of GDP in 2024, reflecting a combination of the lagged effect of high inflation on expenditure, the incomplete indexation of certain taxes to inflation, more generous pensions, an increase in defense spending and higher interest costs. The mission recommends taking additional structural fiscal measures beyond those already envisaged in the 2024 budget to keep the structural deficit in 2024 unchanged relative to the projected 2023 outcome. Moreover, to help the consolidation effort any revenues above those projected in the budget or lower-than-anticipated expenditures on energy support should be saved. While a tighter fiscal policy stance may lower growth next year, it will reduce the need for an even larger fiscal consolidation in the future.

• For 2025-26 the 1 percentage point annual reduction in the headline fiscal deficit targeted in the 2024 budget is appropriately ambitious, though concrete fiscal measures are needed to increase the credibility of the envisaged consolidation. Beyond 2026, the mission recommends reducing the structural balance by at least 0.5 percentage points per year. The goal should be to reduce the headline deficit to around 2 percent of GDP by 2028 from 6.5 percent in 2023, putting debt on a downward trajectory (reaching about 58 percent in 2028) and start creating space for the increase in aging-relating spending. Beyond the forecast horizon, the required consolidation will depend on reforms to boost medium-term growth.

A credible consolidation path will require specifying additional revenue and expenditure measures beyond those introduced in the 2024 budget, as well as reforms to strengthen the fiscal framework. Staff estimate that a cumulative 3.7 percent of GDP in structural fiscal measures will be needed over 2024-28 to achieve the recommended consolidation. These measures should be designed in a way that is consistent with supporting Slovakia’s long-term growth and climate objectives.

• Revenues: Several of the revenue measures in the 2024 budget, including the increase in health insurance contributions, increase in taxes on tobacco and sugar, a minimum tax for domestic companies, and a minimum tax for multinational companies, are welcome. In addition, already during 2024 there is scope to raise significant additional revenue by increasing the basic VAT rate to the EU average and reducing the number of items subject to a reduced VAT rate. These measures could deliver up to 0.6 percent in deficit reduction in 2024 and about 1.3 percent of GDP thereafter. Beyond 2024, raising property taxes by transitioning to a market value based system would generate an additional 0.3 percent of revenue. Environmental taxes could be raised to the EU average, generating around 0.3 percent in revenue and supporting the green transition. In addition, the authorities should ensure that excise tax rates are adjusted for inflation to prevent the erosion in structural revenues over time.

• Spending: The government’s intention to keep public sector wages constant in 2024 is appropriate given the significant increases in 2023. In addition, implementing already-identified Value for Money initiatives (e.g. a reduction in subsidies) and making the 2023 package of family benefits more targeted could yield savings of about 0.5 percent of GDP already in 2024. Temporary energy support measures to households should not be extended beyond 2024 as they are costly, untargeted, and discourage energy conservation. In addition, reversing the recent increase of the 13 ^th pension and eliminating the parental pension would yield about 0.4 percent of GDP in savings. [1] Finally, eliminating the recently introduced early retirement option could yield fiscal savings over the long-term.

• Fiscal framework: The multiyear expenditure limits which entered into force in 2022 and become binding in 2024 have helped strengthen the fiscal framework. Enshrining the expenditure ceiling framework in the constitution with details of parameterization in an ordinary law would help prevent their reversal in the future while preserving flexibility to amend the calibration of the limits and related sanctions. For the expenditure ceilings to be effective it is also important to preserve the capacity and independence of the Council for Budgetary Responsibility, and to ensure the processes of preparing the expenditure ceilings and the government budget are aligned. At the same time, the mission recommends reforming the debt brake before it comes into effect in 2026, including by lowering the thresholds that trigger the escape clause to avoid the risk of a large procyclical fiscal consolidation during economic downturns. A reform of the debt brake would also be an opportunity to align debt brake sanctions with the expenditure ceilings as well as the EU’s revised fiscal framework.

The mission welcomes the government’s objective to increase absorption of EU funds . EU funds absorption during the 2014-20 programming period has been low relative to other EU countries, but establishment of a public investment authority within the Ministry of Finance and amendments to the procurement law have improved absorption capacity. However, a strengthening of human resources and digitalization of processes is needed to further improve project management, while introducing a system to monitor progress would strengthen project implementation. In addition, stronger financial oversight of state-owned enterprises (SOEs) would help improve public investment efficiency given the large amount of public investment carried out by SOEs.

Financial Sector Policy

The Slovak banking sector has sizeable capital and liquidity buffers . Domestic lending rates have increased with the ECB policy rate, and credit growth has declined. The housing market has also started to cool due to rising mortgage rates and lower real wages. Capital ratios are broadly stable at 20 percent of risk-weighted assets, supported by an increase in profits, as higher interest rates have boosted banks’ net interest margins. Liquidity buffers are also ample. The quality of the credit portfolio has continued to improve and NPLs are close to historical lows with adequate provisions.

Higher interest rates and an unexpected deterioration in the macroeconomic outlook could put pressure on credit quality moving forward, while risks are elevated in the commercial real estate (CRE) sector. Thus far, household finances have been resilient to high inflation, but an increase in unemployment would impair their repayment capacity. Firms with the largest cost increases have seen a deterioration in their financial position, though the impact on asset quality to date has been limited. However, high for long interest rates could put pressure on households given that less than 10 percent of mortgages have been reset to the current market rate. In addition, the CRE sector, to which Slovak banks have a significant exposure, is particularly sensitive to high interest rates.

Close monitoring of banks’ credit portfolio is warranted. The authorities should ensure that banks continue to adequately provision for expected losses and emerging risks, especially in vulnerable segments including the CRE sector. In addition, the authorities should continue to update stress tests to assess the resilience of the banking sector to adverse macro-financial shocks and identify pockets of vulnerability. Efforts should be made to strengthen the resilience of the financial system to cyber-attacks in line with the EU’s Digital Operations Resilience Act.

The new bank levy, used to in part to finance a mortgage subsidy scheme, will weigh on banking sector profits. The levy could prevent the build-up of bank capital buffers, stifle credit growth, and put upward pressure on mortgage rates.Furthermore, the mortgage subsidy weakens the monetary policy transmission mechanism and could lead to more sustained high inflation.

The macroprudential stance is appropriate, but the authorities should consider introducing additional macroprudential tools to address emerging risks in the CRE sector. The increase in the countercyclical capital buffer (CCyB) in August 2023 was appropriate, despite the slowdown in credit growth since some new loans have risky attributes. However, the authorities should stand ready to release the CCyB if downside macro-financial risks materialize. Previously introduced borrower-based measures such as the debt-service-to-income (DSTI) and loan-to-value (LTV) limits have been effective at containing risks in the residential real estate market. In addition, the authorities should explore options to introduce targeted macroprudential measures, such as a systemic sectoral capital risk buffer, to build resilience against risks in the CRE sector, though care should be taken to ensure that any new measure does not stifle the flow of credit.

Improvements to the AML/CFT framework should be sustained. Remaining deficiencies should be addressed, including: (i) requirements to manage and mitigate instances of high ML/TF risks, (ii) beneficial ownership information, and (iii) procedures to mitigate risks posed by politically exposed persons. Continued progress in strengthening the AML/CFT framework will help manage reputational risks that may arise from sanctions evasion, particularly in the current geopolitical context.

Structural Policies

Structural reforms are needed to raise productivity growth and revive income convergence. The success of the auto sector has led to decades of strong growth and is likely to remain an important part of the economy for years to come. However, a more diversified and higher-value-added economy is needed to raise productivity growth and drive potential growth in the future. Diversification efforts could be boosted by raising very low spending on public R&D and supporting firms and startups via R&D tax credits and grants, as is currently envisaged in the new National Strategy on Research, Development and Innovation, and by strengthening research cooperation between universities and firms.

Slovakia’s Recovery and Resilience Plan (RRP) will help address these structural challenges. The mission welcomes the new government’s commitment to continue the impressive progress made so far, with Slovakia completing all the milestones necessary to request the first three RRP payments, and to increase the absorption of EU funds and speed up investments. Implementation of the RRP reforms, along with effective execution of the planned investments, will be instrumental in addressing Slovakia’s structural weaknesses and lifting the economy’s growth potential.

Targeted policies are needed to address regional income inequalities and stimulate inclusive growth. While there has been some convergence in the past twenty years, GDP per capita in Bratislava is over 3 times higher than in the East. The authorities should continue efforts to reduce regional inequality, including by boosting investment in physical and digital infrastructure and improving transportation links, increasing access to education and expanding vocational training, and increasing the housing stock in areas with less labor market slack. At the same time targeted measures, such as improving access to affordable housing, schooling, and vocational education, are needed to improve employment opportunities and foster social inclusion among the Roma community and other disadvantaged groups, a large share of whom live in the Eastern regions of Slovakia.

Tackling Slovakia’s demographic challenges will be crucial for sustaining medium-term growth and safeguarding fiscal sustainability. Slovakia’s working age population is expected to fall from 67 to 57 percent of the population by 2050, putting pressure on employment, growth, and potentially living standards.Reversing the impact of aging requires policies to increase fertility and the labor force participation of women, the elderly, and the disadvantaged. The relinking of the statutory retirement age to life expectancy in the 2022 pension reform will help, as will the increase in child support, though the latter should be made more targeted to reduce its fiscal cost. In addition, shortening the 3-year long maximum maternity leave period (one of the longest in the OECD) whilst improving the availability of child and elderly care and increasing options for flexible work arrangements would help raise employment rates among women, while tax credits for older workers and restrictions on early retirement would raise labor force participation among the elderly. Also, policies targeting the Roma community would allow Slovakia to unleash the potential of this untapped labor force. Visa programs targeted at foreign workers and integration programs for immigrants would further help address skill gaps and boost labor supply. Finally, strengthening healthcare, by modernizing the hospital network and improving access to primary care services in underserved regions, will help improve health outcomes and extend working lives.

Slovakia has made significant progress in reducing greenhouse gas emissions, but more efforts are needed. While greenhouse gas emissions have fallen by 44 percent since 1990, meeting Slovakia’s commitment to cut emissions by 55 percent by 2030 relative to 1990 levels will require further efforts. The planned replacement of two coal-fired blast furnaces in the steel industry with electric ones, which is being considered for after 2025, and the expansion of the EU’s ETS system to road transport and buildings from 2027 will support climate mitigation policies, though the carbon price in the new ETS sectors is expected initially to be lower than in the traditional ETS sectors. In addition, Slovakia’s RRP, which includes a RePowerEU chapter, earmarks about €2.5 billion for climate objectives, including building renovations, sustainable transport, and support for renewables. The authorities should also consider increasing the effective energy tax rate, including by introducing an explicit carbon tax in sectors not (yet) covered by the ETS system, including road transport, buildings, and agriculture, and phase out fossil fuel subsidies. Lastly, supporting environmental R&D and investment in green technologies would not only help with climate mitigation efforts but also support economic diversification.

The IMF team thanks the authorities and other interlocutors for their generous hospitality and constructive dialogue.