Via IMF (Den Internationale Valutafond)

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

May 17, 2019

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

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.

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Structural policies: Tapping into full benefits of the global value

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

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

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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

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

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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

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

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

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