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Bratislava, May 29, 2012
Slovakia enjoyed one of the strongest recoveries in the region, reflecting its sound economic fundamentals and prudent policies. However, the economic outlook is clouded by spillovers from the euro area crisis. Policies should focus on mitigating risks and promoting growth. The government’s commitment to fiscal consolidation is welcome, but durable adjustment will require complementary reforms. Continued strong financial oversight is essential. Boosting employment is a top priority. The government’s economic program now being elaborated provides an opportunity to put in place the needed reforms to promote vibrant and inclusive growth.
1. The economy is expected to continue growing at a healthy pace. Buttressed by strong external demand, real GDP expanded by 3.3 percent in 2011—among the highest growth rates in the region—despite a sizable fiscal consolidation. Strong growth continued into the first quarter on the back of expanded auto production. Amid a worsened external environment, growth in 2012 is projected to slow to 2.6 percent. This relatively benign slowdown reflects strong trade linkages with Germany, continued external competitiveness, a still-moderate government debt ratio, and a sound banking system. Growth is projected to pick up to about 3½ percent over the medium term as the external environment strengthens and rising domestic demand closes the output gap.
2. However, risks to this outlook are mostly to the downside. Externally, an intensification of the euro area crisis would reduce demand for Slovak exports and increase bond spreads, reducing growth and weakening banks’ balance sheets. Working together with European partners in creating a more complete monetary union would help allay this risk. Domestically, a loss of market confidence in government’s commitment to fiscal consolidation would increase funding costs and result in tighter credit conditions. An early parliamentary approval of durable deficit reduction measures would reassure markets.
3. Policies should focus on mitigating risks and building a foundation for a strong and inclusive growth. Durable fiscal consolidation would put public finances on a sustainable footing. Continued strong oversight of the financial sector and close cross-border supervisory cooperation would maintain financial stability. Mutually reinforcing structural reforms to the labor market, education, and the business climate would boost employment and promote more inclusive growth.
Durable fiscal consolidation to promote sound public finances
4. The significant fiscal retrenchment in 2011 is welcome, but further adjustment will be needed to ensure debt sustainability. In 2012, adjustment stalled amid the election cycle and expenditure overruns, and the deficit is expected to remain broadly unchanged at 4¾ percent of GDP. In the absence of further fiscal consolidation, public debt ratio will remain on a rising trajectory and become increasingly vulnerable to shocks. Stabilizing the debt at 40 percent of GDP in the long run—a level that would leave room for the expected increase in ageing-related costs and other priority spending—would require a structural fiscal effort of about 2½ percent of GDP relative to 2011.
5. While the government’s deficit reduction plans are appropriate, policies should be prepared to let automatic stabilizers work fully. Though the details are still being worked out, it appears that the planned measures would be sufficient to lower the deficit to below 3 percent of GDP in 2013, while not unduly constraining growth. If growth turns out lower than expected, policies do not need to counterbalance the resulting revenue shortages, but should instead be allowed to operate automatically (for example, through higher unemployment compensation and social assistance), thereby limiting the effects on the economy. At the same time, if growth surprises on the upside, the higher revenue should be saved to facilitate the adjustment.
6. The focus of the planned adjustment mainly on boosting revenues is broadly appropriate. Following a sizable expenditure-based consolidation in 2011, the room for additional spending cuts without fundamental public sector reforms is limited, necessitating focus on revenue measures in the short run. These include shifting pension contributions from the second to the first pillar, introducing a progressive personal income tax, increasing the corporate income tax rate, extending the bank levy on corporate deposits to retail deposits, as well as broadening social insurance and income tax bases.
7. However, complementary reforms are essential to ensure a durable fiscal consolidation. The planned shift of pension contributions brings with it increased future government pension obligations. We therefore welcome the authorities’ plans to combine it with a parametric reform of the first pillar. The reform should be underpinned by an actuarial analysis to ensure the system’s financial solvency. The proposed increase in direct taxes may reduce incentives to invest, underscoring the need for a more welcoming investment climate. The envisaged numerous changes to the tax system could raise collection risks, while the bank levy could discourage financial intermediation.
8. In the medium term, considerable savings could be achieved by improving tax administration and expenditure efficiency. Removing nonstandard exemptions and strengthening VAT administration could generate some 1½ percent of GDP in additional revenue. The planned unification of revenue collections would aid in this regard. International comparisons suggest that increasing efficiency in health spending could generate some 1¾ percent of GDP in savings. The planned reform of public administration could result in additional efficiency gains. The generated savings could be used to further reduce debt, to improve the quality of public sector outcomes, and to finance improvements to public infrastructure in less developed regions of the country.
9. The recently adopted fiscal responsibility legislation (FRL) is welcome, but there is scope to further strengthen the fiscal framework. The Slovak FRL is broadly in line with best international practices: it enhances transparency and accountability, covers a broad definition of government, and includes appropriate enforcement mechanisms. However, making the FRL fully operational requires anchoring the budget in a sound medium-term fiscal framework. Moreover, collecting and publishing in the budget financial information of public entities, including hospitals, would improve the monitoring of fiscal risks.
Strong oversight and cross-border cooperation to maintain financial stability
10. Slovakia’s banking system is sound. Strong fundamentals and effective supervision have helped the sector weather the crisis well. Banks are liquid, well-capitalized, and largely funded by domestic deposits.
11. Nevertheless, risks call for continued supervisory vigilance. The largely foreign-owned banking system is exposed to risks stemming from potential renewed stress in Europe and deleveraging by parent banks. Sizable holdings of Slovak government bonds leave banks’ balance sheets vulnerable to a widening of bond spreads. Close cooperation with home supervisors is essential to mitigate cross-border risks. Recent steps by the National Bank of Slovakia to strengthen bank capital and liquidity buffers are welcome.
12. A speedy resolution of nonperforming loans (NPLs) would support an expansion of credit. NPLs have been slow to come down, particularly in the corporate sector. Removing tax obstacles—such as allowing loan losses to be tax deductible in the year they were incurred—would reduce delays in loan write-offs and free up capital. In this regard, recent amendments to the Act on Bankruptcy and Restructuring would encourage timely restructuring and speed up NPL resolution by allowing creditors to take a more proactive role in bankruptcy proceedings.
13. Curtailing risks in housing lending would further strengthen banks’ balance sheets. The less-stringently regulated “other housing loans”—which are not subject to the regulatory limit on the loan-to-value (LTV) ratio and not financed by mortgage bonds—have surged, driving up the average LTV ratio. Subjecting all types of housing loans to the same LTV limit would ensure loan quality and help prevent excessive risk-taking.
14. Promoting deeper financial markets would bring economic gains by enhancing investment efficiency and broadening access to finance. This could be facilitated by further relaxing investment restrictions for the Pillar II pension funds and by developing a secondary market for government bonds.
Structural reforms for a vibrant and inclusive growth
15. Boosting employment should be a top priority. Unemployment remains in double digits, largely unaffected by the improvements in output. Effective implementation of the reformed Labor Code should help reduce unemployment over the longer run. Better-targeted vocational training through occupationally-oriented curricula, informed by cooperation with employers, would reduce skill mismatches. A sharper focus on market needs in tertiary education would spur innovation and increase productivity.
16. Addressing persistent regional economic imbalances calls for mutually reinforcing structural reforms. Regional development could be enhanced through policies to expand and improve infrastructure. Consideration should also be given to increasing employment incentives by differentiating labor costs by region according to the cost of living, including by supplementing future lower increases in minimum wages in less developed regions with means-tested social benefits and targeted reductions in social insurance contributions. Measures to enlarge the rental housing market, including by easing rental regulations, could help address shortages that inhibit mobility. Addressing lingering corruption and weak property and contract rights enforcement would reinforce ongoing efforts to improve business climate.
The mission would like to thank the authorities for their warm hospitality and cooperation.
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