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Slovak Republic

Author(s):
International Monetary Fund
Published Date:
July 2007
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I. Introduction

1. Slovakia has become one of Central Europe’s strongest economic performers over the past few years. Sound macroeconomic management, a wide range of structural reforms, and increasing integration with the European Union (EU) have led to progressive strengthening of economic growth. However, regional inequalities have not diminished, and long-term unemployment remains high among the low-skilled and in the less-advanced regions.

2. Slovakia entered ERM2 in November 2005, and the new coalition government formed following the June 2006 elections is committed to adopting the euro in January 2009. The prospect appears feasible. Notwithstanding the government’s emphasis on higher social spending, the 2007–09 budget framework aims at meeting the Maastricht fiscal deficit criterion in 2007 and achieving further fiscal consolidation thereafter. The near-term inflation outlook has improved, and the Maastricht reference rate seems within reach. Slovakia already meets the Maastricht criteria for long-term interest rates and the public debt ratio.

Slovak Republic: The Maastricht Criteria
200520062007
CriterionActualCriterionActualCriterionForecast
Average HICP inflation (percent) 1/2.52.82.94.33.11.6
Long-term interest rate (percent) 2/5.43.56.24.46.44.2
General government deficit
(in percent of GDP) 3/3.02.83.03.43.02.9
General government debt
(in percent of GDP)60.034.560.030.760.029.5
Sources: Eurostat and IMF staff estimates.

1.5 percentage points above the three lowest inflation rates in the EU. For 2007, criterion based on WEO projections.

Two percentage points above the rates in the three lowest inflation rate countries in the EU. For 2007, criterion is based on WEO projections and forecast represents the actual rate in March 2007.

ESA 95 basis, including the second-pillar pension costs. For 2007, the forecast represents the deficit target in the budget.

Sources: Eurostat and IMF staff estimates.

1.5 percentage points above the three lowest inflation rates in the EU. For 2007, criterion based on WEO projections.

Two percentage points above the rates in the three lowest inflation rate countries in the EU. For 2007, criterion is based on WEO projections and forecast represents the actual rate in March 2007.

ESA 95 basis, including the second-pillar pension costs. For 2007, the forecast represents the deficit target in the budget.

One concern, however, is the considerable strengthening of the koruna since October 2006 and the persistence of appreciation pressure, prompted by a favorable economic outlook and positive investor sentiment toward the region. This could potentially pose a threat to competitiveness as well as, in the event of a sudden change in investor sentiment, complicate meeting the test of exchange rate stability under ERM2.

3. The main challenges ahead are to manage the potential vulnerabilities in the process of euro adoption and to implement policies that will sustain strong performance in the monetary union. Accordingly, the consultation discussions concentrated on: coping with the appreciation pressures in the foreign exchange market; ensuring greater fiscal and labor market flexibility for absorbing asymmetric shocks in the absence of a national monetary policy; and continuing with structural reforms to sustain growth and to address the high unemployment problem and regional inequalities.

II. Background

4. Economic growth picked up further in 2006, bringing output close to its estimated potential. Real GDP growth accelerated to 8¼ 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. Over four-fifths of the deficit was covered by foreign direct investment (FDI) inflows (Figure 1; and Tables 1, 2, and 3).

Figure 1.Slovak Republic: Economic Indicators, 2000–07

Sources: National Bank of Slovakia; Statistical Office of the Slovak Republic; World Economic Outlook; and IMF staff projections.

1/ New EU-8 include Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia.

2/ Employment is measured on ESA 95 basis data, and unemployment data is from Labor Force Survey.

Table 1.Slovak Republic: Selected Economic Indicators, 2002–07
200220032004200520062007
Proj.
(Percent change, period average)
Real sector
Real GDP4.14.25.46.08.38.8
Output gap (in percent of potential GDP)-0.2-0.5-0.5-0.3-0.10.0
Gross industrial output (constant prices)-1.39.111.54.79.9
Consumer prices
CPI (period average)3.38.57.52.74.52.3
CPI (end of period)3.49.35.93.74.22.0
HICP (period average) 1/3.58.47.52.84.31.8
HICP (end of period) 1/3.29.45.83.93.71.6
Wages
Nominal wages9.36.310.29.28.07.1
Real wages5.8-2.12.46.33.34.7
Employment (ESA 95 basis)-0.51.8-0.31.42.32.0
Unemployment rate (annual average, in percent) 2/18.617.518.116.213.311.8
(In percent of GDP)
Public finance (ESA 95 basis)
General government balance 3/-7.7-2.7-3.2-2.8-3.4-2.9
Structural general government balance 3/-7.5-2.4-3.0-2.6-3.4-2.9
General government debt43.342.441.534.530.729.5
(Percent change, end of period, unless otherwise indicated)
Money and credit
Broad money 4/3.45.615.07.815.3
Credit to enterprises and households 4/14.814.86.226.022.9
Interest rates (in percent, end-of-period)
NBS policy rate (two-week repo rate)6.506.004.003.004.75
Lending rate (floating rate and up to 1 year initial rate fixation)4/7.57.25.45.87.8
Deposit rate (up to one month) 4/4.54.63.62.74.6
(In billions of U.S. dollars, unless otherwise indicated)
Balance of payments
Merchandise exports14.421.827.632.041.753.2
Merchandise imports16.522.529.234.544.855.4
Current account balance-1.9-2.0-3.3-4.1-4.6-3.7
(in percent of GDP)(-8.0)(-6.0)(-7.8)(-8.6)(-8.3)(-5.3)
Official reserves, end-period9.212.114.915.513.417.6
(in months of imports of goods and nonfactor services)(5.8)(5.7)(5.5)(4.8)(3.2)(3.5)
Gross external debt, end-period13.118.123.827.132.233.9
(in percent of GDP)(49.4)(50.4)(52.4)(59.9)(55.6)(48.5)
Short-term debt (in percent of GDP, original maturity basis)16.021.723.033.626.923.2
Short-term debt (in percent of GDP, remaining maturity basis)26.929.530.636.929.625.5
Official reserves to short-term debt (percent, remaining maturity basis)128.9114.7107.492.978.098.7
Exchange rate
Slovak koruna per U.S. dollar
Period average45.336.832.331.029.7
End of period40.032.928.531.926.2
Slovak koruna per euro
Period average42.741.540.138.637.2
End of period41.741.238.837.834.6
Nominal effective exchange rate (percent change, period average)5/-0.65.44.01.62.6
Real effective exchange rate (percent change, period average) 5/
CPI-based0.812.89.22.36.5
ULC-based8.9-0.88.4-3.7-1.7
Memorandum item:
GDP (current prices, Sk billions)1,1111,2131,3551,4711,6361,822
Sources: Statistical Office of the Slovak Republic; Ministry of Finance; National Bank of Slovakia; and IMF staff calculations.

The harmonized index of consumer prices (HICP) is an internationally comparable measure of inflation calculated by each member state of the European Union.

ILO definition as in Labor Force Survey.

In 2004, includes forgiveness of domestic debt claims on the health sector falling due, equivalent to 0.8 percent of GDP. From 2005 onward, includes second pillar pension costs.

There is a break in the series in 2004. Data for 2004–2006 are in accordance with European Central Bank methodology.

Trade-weighted. Partner countries comprise Austria, Czech Republic, France, Germany, Hungary, Italy, Netherlands, Poland, United Kingdom, and United States.

Sources: Statistical Office of the Slovak Republic; Ministry of Finance; National Bank of Slovakia; and IMF staff calculations.

The harmonized index of consumer prices (HICP) is an internationally comparable measure of inflation calculated by each member state of the European Union.

ILO definition as in Labor Force Survey.

In 2004, includes forgiveness of domestic debt claims on the health sector falling due, equivalent to 0.8 percent of GDP. From 2005 onward, includes second pillar pension costs.

There is a break in the series in 2004. Data for 2004–2006 are in accordance with European Central Bank methodology.

Trade-weighted. Partner countries comprise Austria, Czech Republic, France, Germany, Hungary, Italy, Netherlands, Poland, United Kingdom, and United States.

Table 2.Slovak Republic: Macroeconomic Framework, 2002–09
20022003200420052006200720082009
Staff Projections
(In percent of nominal GDP)
Consumption78.277.277.075.375.573.272.371.7
Nongovernment57.956.757.855.455.454.354.254.4
Government20.320.519.219.920.118.918.117.3
Gross capital formation29.024.626.029.228.928.828.829.0
Nongovernment25.522.223.626.827.127.327.527.8
Government3.52.42.42.41.81.51.31.2
Fixed investment27.325.024.126.826.426.426.426.6
Foreign saving 1/8.36.67.88.68.35.34.23.5
Gross national saving20.818.018.220.621.223.624.725.5
Nongovernment22.919.319.621.523.125.426.326.9
Of which: Households4.95.14.14.34.44.44.34.2
Government-2.1-1.3-1.4-1.0-1.9-1.9-1.7-1.5
Households’ gross saving (percent of disposable income)7.98.46.97.07.37.37.27.2
General government balance (ESA 95 basis) 2/-7.7-2.7-3.2-2.8-3.4-2.9-2.4-1.9
(Percentage change in real term)
GDP4.14.25.46.08.38.87.57.0
Households’ disposable income4.90.62.17.36.66.96.66.7
Domestic demand4.1-1.36.28.66.26.26.26.3
Consumption5.21.23.65.05.65.65.95.8
Nongovernment5.20.13.87.26.36.86.86.8
Government5.23.92.0-0.64.12.33.12.7
Gross capital formation1.3-8.014.318.67.77.57.17.3
Fixed investment0.3-2.35.017.57.38.07.67.7
Change in stocks (contribution to GDP growth) 3/0.3-1.62.30.60.40.00.00.0
Exports of goods and non-factor services4.715.97.913.820.720.613.010.9
Imports of goods and non-factor services4.67.68.816.617.817.611.910.3
(Percentage change)
Memorandum items:
Inflation (CPI, period average)3.38.57.52.74.52.32.02.0
Inflation (HICP, period average) 4/3.58.47.52.84.31.82.02.0
GDP deflator4.64.76.02.42.72.32.22.2
Employment (ESA 95 basis)-0.51.8-0.31.42.32.01.51.3
Nominal wages9.36.310.29.28.07.17.06.7
Real wages5.8-2.12.46.33.34.74.94.6
Productivity4.72.35.84.65.86.75.95.6
Unit labor costs4.43.94.14.42.00.41.11.1
Unemployment rate (percent, annual average) 5/18.617.518.116.213.311.811.010.5
Gross domestic product (Sk billion, current prices)1,1111,2131,3551,4711,6361,8222,0012,187
Sources: Statistical Office of the Slovak Republic; and IMF staff estimates and projections.

Negative of current account balance. For historical periods, foreign saving implied by national accounts data differs from the current account deficit reported in BOP statistics. The discrepancy is mainly due to different exchange rates employed in the calculations.

From 2005 onward, includes second pension pillar costs. In 2004, includes forgiveness of domestic debt claims on the health sector falling due, equivalent to 0.8 percent of GDP.

Includes statistical discrepancy.

The harmonized index of consumer prices (HICP) is an internationally comparable measure of inflation calculated by each member state of the European Union.

ILO definition as in Labor Force Survey.

Sources: Statistical Office of the Slovak Republic; and IMF staff estimates and projections.

Negative of current account balance. For historical periods, foreign saving implied by national accounts data differs from the current account deficit reported in BOP statistics. The discrepancy is mainly due to different exchange rates employed in the calculations.

From 2005 onward, includes second pension pillar costs. In 2004, includes forgiveness of domestic debt claims on the health sector falling due, equivalent to 0.8 percent of GDP.

Includes statistical discrepancy.

The harmonized index of consumer prices (HICP) is an internationally comparable measure of inflation calculated by each member state of the European Union.

ILO definition as in Labor Force Survey.

Table 3.Slovak Republic: Balance of Payments, 2002–06(In millions of U.S. dollars, unless otherwise indicated)
20022003200420052006
Prelim.
Current account balance-1,959-1,971-3,298-4,090-4,562
Trade balance-2,151-637-1,536-2,450-3,083
Exports, f.o.b.14,47821,84327,62132,02641,696
Imports, f.o.b.-16,629-22,480-29,157-34,476-44,778
Services balance456237268320664
Receipts2,7863,2863,7254,4075,404
Payments-2,330-3,050-3,458-4,087-4,740
Income balance-456-1,816-2,198-1,976-2,088
Receipts3439339991,6201,955
Payments-800-2,748-3,197-3,597-4,043
Of which: Interest-634-536-353-413-545
Current transfers19324516915-55
Official-12-1358210279
Private205258111-195-334
Capital and financial account balance5,1781,7774,9305,1611,036
Capital account107101137-18-41
Foreign direct investment 1/3,9636473,0521,9513,797
Of which: Reinvested earnings01,4761,5351,2191,275
Portfolio investment554-543866-9821,561
Other investment5511,5588584,245-4,119
Short-term5241,8971,1765,258-4,747
Long-term27-339-318-1,014628
Financial derivatives21517-34-162
Errors and omissions4261,8811,130-5031,410
Overall balance3,6451,4931,8262,212-3,220
Financing
Gross reserves (negative indicates increase)-3,645-2,954-2,763-5682,116
Memorandum items:
Current account balance (in percent of GDP)-8.0-6.0-7.8-8.6-8.3
Trade balance (in percent of GDP)-8.8-1.9-3.7-5.2-5.6
Terms of trade (percent change)0.9-0.2-0.3-0.3-1.4
Gross official reserves (US$ million)9,19612,14914,91215,48013,364
In months of imports of goods and services5.85.75.54.83.2
Total external debt13,10718,09023,76427,05232,206
(in percent of GDP)49.450.452.459.955.6
Short-term external debt (original maturity basis)4,2377,78210,44815,20215,556
(in percent of GDP)16.021.723.033.626.9
Short-term external debt (remaining maturity basis)7,13310,59113,88716,65817,129
(in percent of GDP)26.929.530.636.929.6
Reserves/short-term debt (percent, remaining maturity basis)128.9114.7107.492.978.0
External debt service/Exports of goods and services (percent)11.314.310.811.74.7
Sources: National Bank of Slovakia; and IMF staff estimates.

In 2006, direct investment includes about US$1,050 million of privatization proceeds from the sale of shares in the domestic electricity company, Slovenske Elektrarne.

Sources: National Bank of Slovakia; and IMF staff estimates.

In 2006, direct investment includes about US$1,050 million of privatization proceeds from the sale of shares in the domestic electricity company, Slovenske Elektrarne.

Contributions to Growth, 2003–06(Percentage points, unless otherwise indicated)
2003200420052006
Real GDP growth4.25.46.08.3
Domestic demand-1.36.38.86.5
Of which:
Private consumption0.02.13.93.5
Fixed investment-0.61.34.42.1
Change in stocks-1.62.30.60.4
Net foreign demand5.5-0.9-2.81.7
Memorandum items:
Real growth of exports (in percent)15.97.913.820.7
Real growth of imports (in percent)7.68.816.617.8
Terms of trade (percent change)-0.2-0.3-0.3-1.4
Current account balance (in percent of GDP)-6.0-7.8-8.6-8.3
Foreign direct investment (in percent of GDP)6.57.24.47.6
Output gap (in percent of potential GDP)-0.5-0.5-0.3-0.1
Sources: Statistical Office of the Slovak Republic; and IMF staff estimates.
Sources: Statistical Office of the Slovak Republic; and IMF staff estimates.

5. The strength of the economy boosted employment, but wage pressure was subdued and profitability continued to rise. Employment gains were concentrated in construction and market services. The unemployment rate fell sharply to 13 percent, though long-term unemployment remained stuck at around 8 percent of the labor force. Despite strengthening demand for labor, real wage increases moderated and lagged productivity gains. Thus, the share of profit in value added of non-financial enterprises rose to nearly 18 percent in 2006 from 13¾ percent in 2005. The rise in profit share was broad-based.

Unemployment Rate, 2002–06(In percent)
20022003200420052006
Unemployment rate (total)18.517.418.116.213.3
Short-term (less than 1 year)7.46.87.15.23.6
Medium-term (1 to 2 years)3.93.43.13.02.0
Long-term (more than 2 years)7.27.27.98.17.7
Source: Statistical Office of the Slovak Republic, Labor Force Survey.
Source: Statistical Office of the Slovak Republic, Labor Force Survey.

Real Wages and Productivity for Overall Economy, 1999–2006

(year-on-year change, in percent)

Sources: Statistical Office of the Slovak Republic; and IMF staff calculations.

Profits of Non-financial Enterprises, 1999–2006

(percent of value added)

Source: Statistical Office of the Slovak Republic.

6. Inflation was on an upward path for much of 2006, but this trend reversed in the fourth quarter. Harmonized consumer price (HICP) inflation reached 5 percent (year-on-year) in July-August 2006 but declined thereafter to 2 percent in February-March 2007. Inflation developments were heavily influenced by trends in world energy prices, the unwinding of the base effects of the large increases in several regulated utility prices in October 2005, and decreases in regulated prices in January 2007 that were in part attributable to margin compression by distributors under pressure from the government.

Headline and Core Inflation (HICP basis), 2001–07

(percent change, year-on-year)

Source: Eurostat.

Regulated Items and Fuel Inflation, 2001–07

(CPI basis, percent change, year-on-year)

Source: Statistical Office of the Slovak Republic.

1/ Regulated items comprise close to a quarter of the CPI basket. Major regulated items are electricty, gas, and heating, which have a combined weight of about half the regulated items.

7. Financial market trends were influenced by mutually reinforcing domestic and global developments. During May-July 2006, negative investor sentiment on emerging markets as well as concerns about the election outcome and course of policies led to depreciation pressures on the koruna and increases in long-term koruna rates and default risk premium on government bonds. In subsequent months, global risk aversion toward emerging markets decreased and Slovak financial assets received an extra boost as the new government affirmed its commitment to euro adoption and a flow of new information pointed to stronger-than- expected economic fundamentals. Thus, financial derivatives reverted to pricing in interest rate convergence with the euro area, and the koruna resumed an appreciation trend at a faster pace than other regional currencies (Figure 2).

Figure 2.Visegrad-4 Countries: Financial Market Indicators, 2004–07

Sources: Bloomberg and Haver.

1/ Difference between 5-year local currency interest rate forward and similar euro-denominated interest rate forward.

2/ Credit default swap spread is the annual premium to be paid in return for full payment by a third party in the event of default by the bond issuer.

8. The National Bank of Slovakia (NBS) has been following a hybrid monetary framework focused on restraining inflation and on maintaining the exchange rate within ERM2 requirements. Concerns about a negative inflation outlook prompted the NBS to increase its key policy interest rate in four steps in the first three quarters of 2006 by a total of 175 basis points to 4.75 percent. In July 2006, the NBS intervened heavily in the foreign exchange market to stem depreciation pressures when the koruna dropped below the central parity under ERM2. In end-December, as the koruna approached the upper edge of the ERM2 ±15 percent band, the NBS began countering appreciation pressures through verbal and direct interventions and prolonged rejection of bids during regular repo auctions, driving down interbank interest rates below policy rates. Eventually in mid-March 2007, with appreciation pressures persisting, the central parity was revalued with the approval of the EU member states by 8.5 percent to Sk35.44—below the prevailing market rate. The NBS has continued to counter appreciation pressures since the parity revaluation and has held the koruna at around 6 percent above the new central parity. With inflation coming down markedly in the first quarter of 2007 and judging upside risks to be low, the NBS lowered its policy rate by 50 basis points in two steps since end-March (Figure 3). Because of the large capital outflows and NBS interventions to stem depreciation pressures in mid-year, gross official reserves declined in 2006 and fell further below the stock of short-term debt (Table 4). However, the reserve position has improved in 2007 owing to interventions aimed at countering appreciation pressures.

Figure 3.Slovak Republic: Exchange Rate and Interest Rate Developments, 2002–07

Sources: Slovak authorities; Bloomberg; and IMF staff calculations.

Table 4.Slovak Republic: Vulnerability Indicators, 2002–06(In percent of GDP, unless otherwise indicated)
20022003200420052006
Financial indicators
Public sector debt 1/43.843.142.634.530.5
Broad money (percent change, 12-month basis) 2/5.07.115.07.815.3
Private sector credit (percent change, 12-month basis) 2/14.814.86.226.022.9
Of which: credit to households (percent change, 12-month basis) 2/18.138.841.635.932.0
BRIBOR (six months, end-of-period, in percent) 3/
Nominal5.85.83.73.24.7
Real2.4-2.5-3.60.40.2
External indicators
Merchandise exports (percent change, 12-month basis in US$)14.551.925.715.831.7
Merchandise imports (percent change, 12-month basis in US$)12.636.229.017.931.6
Terms of trade (percent change, 12-month basis)0.9-0.2-0.3-0.3-1.4
Current account balance-7.8-0.8-3.6-8.6-8.3
Capital and financial account balance21.65.37.511.91.9
Capital account0.40.30.30.0-0.1
Foreign direct investment16.92.03.03.76.9
Portfolio investment2.3-1.72.1-2.12.8
Other investment2.14.72.010.4-7.5
Net foreign assets (NFA) of commercial banks (in US$ billions)0.3-1.1-2.3-5.5-2.7
Gross official reserves (in US$ billions)9.212.114.915.513.4
Net international reserves (NIR) (in US$ billions)8.811.114.815.313.0
Central bank short-term foreign liabilities (in US$ billions)4/0.00.90.00.00.0
Central bank foreign currency exposure (in US$ billions)6.18.010.412.38.8
Short-term foreign assets of commercial banks (in US$ billions)1.00.90.80.81.7
Short-term foreign liabilities of commercial banks (in US$ billions)1.02.33.96.84.4
Foreign currency exposure of commercial banks (in US$ billions)0.3-1.1-2.3-5.5-2.7
Official reserves in months of imports of goods and services5.95.75.54.83.2
Broad money to gross official reserves (percent)168.6150.2184.8171.1241.6
Total short-term external debt to gross official reserves (percent) 5/77.687.293.1107.6128.2
Total external debt49.450.452.459.955.6
Of which: public sector debt14.114.715.212.413.3
Total external debt to exports of goods and services (percent)75.972.075.874.368.3
Total external debt service payments to exports of goods and services (percent)11.314.310.811.74.7
External amortization payments to exports of goods and services (percent)7.711.59.09.43.1
External interest payments to exports of goods and services (percent)3.62.71.92.31.6
Exchange rate (per US$, period average)45.336.732.331.029.6
Real effective exchange rate (CPI-based, period average)0.812.89.22.36.5
Real effective exchange rate (ULC-based, period average)8.9-0.88.4-3.7-1.7
Other indicators
Stock market index140.0177.6326.6413.3415.6
Foreign currency debt rating (Moody’s)A3A3A3A2A1
Sources: Data provided by the Slovak authorities; and IMF staff estimates.

General government.

There is a break in the series in 2004. Data for 2004–2006 are in accordance with European Central Bank methodology.

Bratislava Interbank Offered Rate

Includes short-term liabilities of the government.

Includes medium- and long-term debt due next year.

Sources: Data provided by the Slovak authorities; and IMF staff estimates.

General government.

There is a break in the series in 2004. Data for 2004–2006 are in accordance with European Central Bank methodology.

Bratislava Interbank Offered Rate

Includes short-term liabilities of the government.

Includes medium- and long-term debt due next year.

9. With rising interest rates, credit growth eased slightly in 2006. Credit growth in Slovakia was broadly similar to that in the slower growing neighboring countries but well below that in the Baltic countries. Unlike in several other new EU-members states, lending by Slovak banks is mainly funded by domestic deposits and is predominantly denominated in domestic currency.

Selected New EU Member States: Credit Developments, 2004–06
200420052006
Credit to the private sector(Percent change)
CEEC-5
Czech Republic15.822.323.3
Hungary19.218.817.3
Poland2.912.624.3
Slovakia6.226.022.9
Slovenia21.023.625.7
Baltic countries
Estonia44.666.562.1
Latvia47.064.364.0
Lithuania40.356.151.4
Foreign currency loans to private sector(Share in total loans, percent)
CEEC-5
Czech Republic10.29.49.9
Hungary39.045.949.6
Poland23.925.827.0
Slovakia22.828.227.1
Slovenia36.751.256.9
Baltic countries
Estonia80.479.978.1
Latvia60.970.070.9
Lithuania58.365.852.8
Sources: International Financial Statistics; national authorities; and IMF staff estimates.
Sources: International Financial Statistics; national authorities; and IMF staff estimates.

Loans and Deposits of Commercial Banks, 2003–2007

(billion koruny, end of period)

Source: National Bank of Slovakia.

10. The fiscal outturn in 2006 was better than envisaged in the budget, but still the stance was expansionary. The general government accounts were in a deficit of 3.4 percent of GDP, compared with 4.2 percent targeted in the budget and an outturn of 2.8 percent of GDP in 2005 (Table 5). The outturn for the state budget and Social Insurance Agency was better than envisaged, but there was slippage in the performance of other levels of general government, especially the municipalities. Accounting for net transfers from the European Union (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 2 percent of GDP, owing to stronger-than-expected growth in the underlying bases and one-time special factors. There also was some underspending in cofinancing 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, and increase in entitlements for pensions and health benefits, and larger subsidies to the transport sectors.

Table 5.Slovak Republic: Fiscal Operations of the Consolidated General Government, ESA 95 basis, 2005–09(In millions of koruny)
20052006200720082009
EstimatesBudgetPrel.BudgetBudgetBudget
Total revenue544,372568,793589,032624,413655,928700,264
Tax revenue269,815268,803279,969306,917326,857347,824
Personal income tax39,38840,18442,21147,02852,35558,009
Wage tax33,76734,84536,14040,26045,15350,263
Self-employment tax5,6215,3396,0716,7687,2027,746
Corporate profit tax40,59138,30845,83949,35154,08559,246
Withholding tax on capital income3,8554,4704,8594,2144,4244,687
VAT117,332121,417124,102134,599142,550151,401
Excises54,46651,29048,26257,73159,26460,087
Import duties, property tax and other14,15013,13414,69613,99414,17914,394
Social contributions186,246206,010212,520223,491234,265249,592
Grants and transfers20,17235,01225,17933,59437,67446,044
Of which: from European Union16,85534,18521,85032,03636,98245,050
Other revenue68,13958,96871,36460,41157,13256,804
Of which: interest6,2054,56611,5817,3666,8666,567
Total expenditure576,367613,203626,201656,977680,255715,032
Current expenditure511,849549,724559,536602,681625,533665,687
Gross wages100,714109,564109,467119,827123,477130,044
Wages75,72181,78382,09588,20791,68896,506
Employer social security contributions24,99327,78127,37231,62031,78933,538
Goods and services 1/82,16282,61291,63094,300109,518126,626
Subsidies and transfers303,202327,888332,357353,057356,646372,831
Agricultural subsidies12,42914,73213,38817,67117,25622,441
Transport subsidies11,64611,02713,69512,26212,36412,238
Health insurance companies67,54871,72775,00780,00082,67088,256
Sickness benefits4,9665,3435,5325,7196,0036,298
Old-age and disability pensions104,601111,039115,133124,614130,813136,683
Active labor market policies3,3884,7293,8883,0131,348258
Unemployment benefits2,4403,7401,9282,5882,7432,828
State benefits and social assistance29,76732,49832,56132,79933,03833,334
Social security contributions on behalf25,86332,59933,20838,29437,45839,801
of certain groups
Transfers to the EU12,76714,10514,66417,29617,79318,064
Other subsidies and transfers27,78726,34923,35318,80115,16012,630
Interest25,77129,66026,08235,49735,89236,186
Capital spending64,51863,47966,66554,29654,72249,345
Capital assets34,93029,89238,12127,68526,15820,884
Capital transfers 2/29,58833,58728,54426,61128,56428,461
Revenue loss to the second pillar pensions9,25920,20018,24620,19922,49825,012
Fiscal balance-41,254-64,610-55,415-52,763-46,825-39,780
Memorandum items:
Nominal GDP1,471,1311,531,4001,636,2631,794,6631,919,0752,050,499
Deficit excluding second pillar pension costs-31,995-44,410-37,169-32,564-24,327-14,768
Source: Ministry of Finance.

Most of the EU-related spending of the 2nd program period (2007-13) funds is allocated under goods and services.

In 2005, includes debt forgiveness (mainly to Sudan, Afghanistan, and Syria) amounting to Sk 13,658 million.

Source: Ministry of Finance.

Most of the EU-related spending of the 2nd program period (2007-13) funds is allocated under goods and services.

In 2005, includes debt forgiveness (mainly to Sudan, Afghanistan, and Syria) amounting to Sk 13,658 million.

Table 5.Slovak Republic: Fiscal Operations of the Consolidated General Government, ESA 95 basis, 2005–09(In percent of GDP)
20052006200720082009
Estimates.BudgetPrel.BudgetBudgetBudget
Total revenue37.037.136.034.834.234.2
Tax revenue18.317.617.117.117.017.0
Personal income tax2.72.62.62.62.72.8
Wage tax2.32.32.22.22.42.5
Self-employment tax0.40.30.40.40.40.4
Corporate profit tax2.82.52.82.72.82.9
Withholding tax on capital income0.30.30.30.20.20.2
VAT8.07.97.67.57.47.4
Excises3.73.32.93.23.12.9
Import duties, property tax and other1.00.90.90.80.70.7
Social contributions12.713.513.012.512.212.2
Grants and transfers1.42.31.51.92.02.2
Of which: from European Union1.12.21.31.81.92.2
Other revenue4.63.94.43.43.02.8
Of which: interest0.40.30.70.40.40.3
Total expenditure39.240.038.336.635.434.9
Current expenditure34.835.934.233.632.632.5
Gross wages6.87.26.76.76.46.3
Wages5.15.35.04.94.84.7
Employer social security contributions1.71.81.71.81.71.6
Goods and services 1/5.65.45.65.35.76.2
Subsidies and transfers20.621.420.319.718.618.2
Agricultural subsidies0.81.00.81.00.91.1
Transport subsidies0.80.70.80.70.60.6
Health insurance companies4.64.74.64.54.34.3
Sickness benefits0.30.30.30.30.30.3
Old-age and disability pensions7.17.37.06.96.86.7
Active labor market policies0.20.30.20.20.10.0
Unemployment benefits0.20.20.10.10.10.1
State benefits and social assistance2.02.12.01.81.71.6
Social security contributions on behalf1.82.12.02.12.01.9
of certain groups
Transfers to the EU0.90.90.91.00.90.9
Other subsidies and transfers1.91.71.41.00.80.6
Interest1.81.91.62.01.91.8
Capital spending4.44.14.13.02.92.4
Capital assets2.42.02.31.51.41.0
Capital transfers 2/2.02.21.71.51.51.4
Revenue loss to the second pillar pensions0.61.31.11.11.21.2
Fiscal balance-2.8-4.2-3.4-2.9-2.4-1.9
Memorandum items:
Deficit excluding second pillar pension costs-2.2-2.9-2.3-1.8-1.3-0.7
Public debt, ESA 95 basis34.530.729.528.126.2
Source: Ministry of Finance.

Most of the EU-related spending of the 2nd program period (2007-13) funds is allocated under goods and services.

In 2005, includes debt forgiveness (mainly to Sudan, Afghanistan, and Syria) equivalent of 0.9 percent of GDP.

Source: Ministry of Finance.

Most of the EU-related spending of the 2nd program period (2007-13) funds is allocated under goods and services.

In 2005, includes debt forgiveness (mainly to Sudan, Afghanistan, and Syria) equivalent of 0.9 percent of GDP.

Fiscal Outcome, 2005–06(In percent of GDP)
2006
BudgetActualBudgetPrel.
Fiscal balance, including second pillar pension costs-3.8-2.8-4.2-3.4
Fiscal balance, excluding second pillar pension costs-3.4-2.2-2.9-2.3
Primary fiscal balance, excluding second pillar pension costs 1/-1.4-0.1-1.3-1.4
Cyclically adjusted primary fiscal balance-1.3-0.1-1.4-1.5
Net transfers from the EU1.30.31.30.4
Fiscal impulse including the impact of net transfers from the EU 2/0.9-1.32.41.5
Memorandum items:
Real GDP growth (percent)4.56.05.48.3
Fiscal balance of state budget-4.1-3.0-3.5-2.3
Fiscal balance of municipalities0.00.20.0-0.3
Source: Ministry of Finance.

In 2005, excludes debt forgiveness (mainly to Sudan, Afghanistan and Syria) equivalent of 0.9 percent of GDP.

Change in the cyclically adjusted primary balance plus the change in net transfers from the EU. Receipts from the EU budget generally have counterparts on the expenditure side. Thus, there is no effect on the fiscal deficit but there is an expansionary impact since the receipts do not withdraw resources from the private sector like normal revenue. Payments to the EU budget raise the measured deficit but do not increase domestic demand.

Source: Ministry of Finance.

In 2005, excludes debt forgiveness (mainly to Sudan, Afghanistan and Syria) equivalent of 0.9 percent of GDP.

Change in the cyclically adjusted primary balance plus the change in net transfers from the EU. Receipts from the EU budget generally have counterparts on the expenditure side. Thus, there is no effect on the fiscal deficit but there is an expansionary impact since the receipts do not withdraw resources from the private sector like normal revenue. Payments to the EU budget raise the measured deficit but do not increase domestic demand.

III. Macroeconomic Outlook

11. Economic growth prospects appear to have shifted to a higher level. There was consensus that the economy would likely expand faster than the 5–7½ percent assumed in the 2007–09 budget framework and the latest Convergence Programme update. Staff project real GDP growth to rise to 8¾ percent in 2007 and to moderate to 7 percent in 2009. The commencement of production and increasing capacity in several export-oriented projects, especially in the automotive and electronics 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 enterprise 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. The contribution of net exports is foreseen to strengthen in 2007 and remain positive in subsequent years, fueled by growing exports of cars and electronics products. Allowing for some increase in the import propensity of domestic demand, the external current account deficit is projected to narrow progressively to about 3½ percent of GDP in 2009—less upbeat than the official and consensus forecasts.

Contributions to Growth, 2006–09(Percentage points, unless otherwise indicated)
2006200720082009
Staff Projection
Real GDP growth8.38.87.57.0
Domestic demand6.56.46.36.2
Of which:
Private consumption3.53.73.63.6
Fixed investment2.12.22.12.1
Change in stocks0.40.00.00.0
Net foreign demand1.72.51.20.7
Memorandum items:
Real growth of exports (in percent)20.720.613.010.9
Real growth of imports (in percent)17.817.611.910.3
Terms of trade (percent change)-1.40.40.00.0
Current account balance (in percent of GDP)-8.3-5.3-4.2-3.5
Foreign direct investment (in percent of GDP)7.64.13.53.1
Output gap (in percent of potential GDP)-0.10.00.00.0
Sources: Statistical Office of the Slovak Republic; and IMF staff projections.
Sources: Statistical Office of the Slovak Republic; and IMF staff projections.
Slovakia: Comparison of Real GDP and Current Acccount Forecasts
2006200720082009
ActualProjections
Real GDP growth (in percent)
IMF staff8.38.87.57.0
National Bank of Slovakia8.38.97.46.9
Ministry of Finance 1/8.37.45.25.1
Consensus Forecast 2/8.38.66.7
Current account balance (in percent of GDP)
IMF staff-8.3-5.3-4.2-3.5
National Bank of Slovakia-8.3-4.3-2.7-0.9
Ministry of Finance 1/-8.3-3.8-2.7-2.1
Consensus Forecast 2/3/-8.3-4.0-2.5
Sources: National Bank of Slovakia, Ministry of Finance, Consensus Economics, and IMF staff projections.

Official forecast of the 2007–09 budget framework.

Consensus forecast is the mean of the forecasts of 11 institutions comprising market participants and thinktanks. Compiled in March 2007.

Nominal forecast for current account is converted to ratio of GDP using IMF staff’s nominal GDP projection adjusted for the Consensus Forecast for real GDP growth.

Sources: National Bank of Slovakia, Ministry of Finance, Consensus Economics, and IMF staff projections.

Official forecast of the 2007–09 budget framework.

Consensus forecast is the mean of the forecasts of 11 institutions comprising market participants and thinktanks. Compiled in March 2007.

Nominal forecast for current account is converted to ratio of GDP using IMF staff’s nominal GDP projection adjusted for the Consensus Forecast for real GDP growth.

12. Staff’s growth outlook is subject to balanced risks. On the upside, consumption demand could be higher if real wage increases and demand-side impetus financed by bank credit were greater than assumed in the staff scenario, and if household saving propensity started to fall. In the event of stronger domestic demand, the current account deficit could exceed staff projections. Downside risks to growth are a significant slowdown in major markets and higher oil prices. There should be no negative implications for the euro adoption goal if economic growth turns out lower than the staff projection since the budget is based on conservative growth assumptions.

13. In a context of strong growth prospects and external outlook, external debt sustainability is not a concern. Slovakia is likely to remain an attractive destination for foreign investors and record large surpluses in the financial account (Table 6). In addition, the anticipated rise in corporate saving is likely to limit debt financing. Thus, in the baseline scenario, external debt relative to GDP is projected to decline by about 13 percentage points to 43 percent in 2012. Various stress tests indicate that Slovakia’s external debt dynamics should remain manageable. Even under the most adverse scenario, the debt would settle at around 63 percent of GDP over the medium term (Table 7).

Table 6.Slovak Republic: Medium-term Balance of Payments, 2005–09(In millions of U.S. dollars, unless otherwise indicated)
20052006200720082009
Staff Projections
Current account balance-4,090-4,562-3,673-3,289-3,110
Trade balance-2,450-3,083-2,230-1,819-1,640
Exports, f.o.b.32,02641,69653,17363,10672,624
Imports, f.o.b.-34,476-44,778-55,403-64,924-74,264
Services balance320664852928978
Receipts4,4075,4046,2906,9867,677
Payments-4,087-4,740-5,439-6,058-6,698
Income balance-1,976-2,088-2,297-2,455-2,593
Receipts1,6201,9552,1192,2712,434
Payments-3,597-4,043-4,417-4,726-5,028
Of which: Interest-413-545-787-790-758
Current transfers15-55357145
Official210279357432543
Private-195-334-354-375-397
Capital and financial account balance5,1611,0367,9305,8535,905
Capital account-18-4112811
Direct foreign investment 1/1,9513,7972,7422,6862,613
Of which: Reinvested earnings1,2191,2751,4421,5321,663
Portfolio investment-9821,5611,8711,9051,917
Other investment4,245-4,1193,3051,2541,365
Short-term5,258-4,7472,622600658
Long-term-1,014628684654706
Financial derivatives-34-162000
Errors and omissions-5031,410
Overall balance568-2,1164,2582,5642,795
Financing
Gross reserves (negative indicates increase)-5682,116-4,258-2,564-2,795
Memorandum items:
Current account balance (in percent of GDP)-8.6-8.3-5.3-4.2-3.5
Trade balance (in percent of GDP)-5.2-5.6-3.2-2.3-1.9
Terms of trade (percent change)-0.3-1.40.70.00.0
Gross official reserves (US$ million)15,48013,36417,62120,18522,980
In months of imports of goods and services4.83.23.53.43.4
Total external debt27,05232,20633,92836,83339,365
(in percent of GDP)59.955.648.546.644.7
Short-term external debt (original maturity basis)15,20215,55616,26417,03217,743
(in percent of GDP)33.626.923.221.520.1
Short-term external debt (remaining maturity basis)16,65817,12917,84618,78320,224
(in percent of GDP)36.929.625.523.822.9
Reserves/short-term debt (percent, remaining maturity basis)92.978.098.7107.5113.6
External debt service/Exports of goods and services (percent)11.74.74.23.83.9
Sources: National Bank of Slovakia; and IMF staff projections.

In 2006, direct investment includes about US$1,050 million of privatization proceeds from the sale of shares in the domestic electricity company, Slovenske Elektrarne.

Sources: National Bank of Slovakia; and IMF staff projections.

In 2006, direct investment includes about US$1,050 million of privatization proceeds from the sale of shares in the domestic electricity company, Slovenske Elektrarne.

Table 7.Slovak Republic: External Debt Sustainability Framework, 2002–12(In percent of GDP, unless otherwise indicated)
ActualProjections
20022003200420052006200720082009201020112012
I. Baseline ProjectionsDebt-stabilizing

non-interest

current account 6/
External debt49.450.452.459.955.648.546.644.743.943.243.0-3.3
Change in external debt-3.10.92.07.5-4.2-7.2-1.9-1.9-0.8-0.6-0.2
Identified external debt-creating flows-14.3-1.5-5.9-1.5-6.4-7.9-4.5-3.9-2.9-2.7-1.7
Current account deficit, excluding interest payments5.53.96.56.96.13.22.52.11.41.31.6
Deficit in balance of goods and services6.91.23.04.54.42.01.20.80.2-0.1-0.4
Exports70.276.074.576.785.485.188.991.491.891.893.2
Imports77.177.377.581.289.887.290.192.292.091.792.8
Net nondebt creating capital inflows (negative)-16.2-2.1-7.0-4.4-6.9-3.9-3.4-3.0-2.6-2.6-2.5
Automatic debt dynamics 1/-3.6-3.3-5.3-4.0-5.5-7.1-3.6-3.1-1.7-1.4-0.9
Contribution from nominal interest rate2.42.11.41.72.22.01.71.41.61.51.4
Contribution from real GDP growth-1.9-1.8-2.4-2.8-4.3-4.1-3.2-2.9-2.5-2.1-1.4
Contribution from price and exchange rate changes 2/-4.1-3.5-4.4-2.9-3.4-5.1-2.0-1.6-0.9-0.9-0.8
Residual, incl. change in gross foreign assets11.22.47.99.02.20.72.62.02.12.11.5
External debt-to-exports ratio (in percent)70.466.270.378.065.156.952.448.847.847.146.2
Gross external financing need (in billions of euros)3/6.98.912.913.922.423.023.524.524.925.426.2
in percent of GDP26.630.338.036.451.110-Year

Historical

Average
10-Year

Standard

Deviation
43.439.437.034.833.032.3
Key macroeconomic assumptionsProjected

Average
Real GDP growth (in percent)4.14.25.46.08.34.22.48.87.57.06.05.03.56.3
Nominal external interest rate (in percent)5.34.73.23.74.24.70.84.43.93.43.93.73.53.8
Growth of exports (current euros, in percent)8.221.613.516.028.416.39.920.517.414.18.57.27.212.5
Growth of imports (current euros, in percent)7.212.516.218.027.514.810.717.316.213.67.86.86.911.4
Current account balance, excluding interest payments-5.5-3.9-6.5-6.9-6.1-5.22.3-3.2-2.5-2.1-1.4-1.3-1.6-2.0
Net nondebt creating capital inflows16.22.17.04.46.95.84.73.93.43.02.62.62.53.0
II. Stress Tests for External Debt RatioDebt-stabilizing

non-interest

current account 6/
A. Alternative scenarios
A1. Key variables are at their historical averages in 2008–12 4/48.548.748.247.947.446.4-7.7
A2. Reduction in real GDP growth (relative to baseline) 5/48.548.147.547.547.346.8-3.9
B. Bound tests
B1. Nominal interest rate is at historical average plus two standard deviations in 2008 and 2009.48.547.746.946.145.445.1-3.4
B2. Real GDP growth is at historical average minus two standard deviations in 2008 and 2009.48.550.251.450.349.448.9-3.9
B3. Change in euro GDP deflator is at historical average minus two standard deviations in 2008 and 2009.48.550.952.851.650.650.0-4.0
B4. Non-interest current account is at historical average minus two standard deviations in 2008 and 2009.48.553.858.957.656.556.0-3.6
B5. Combination of B1-B4 using one standard deviation shocks.48.557.265.964.563.462.9-4.3
B6. One time 30 percent nominal depreciation in 2008.48.564.961.359.658.357.3-4.8

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in U.S. dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Real GDP growth drops to 4 percent throughout 2008–12.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and both non-interest current account and nondebt inflows in percent of GDP) remain at their levels of the last projection year.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in U.S. dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Real GDP growth drops to 4 percent throughout 2008–12.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and both non-interest current account and nondebt inflows in percent of GDP) remain at their levels of the last projection year.

14. Barring major shocks, inflation is likely to moderate in the near term and meet the Maastricht reference rate. The regulated utility price decreases of January 2007 will result in a significant dampening of inflation. Given the latest World Economic Outlook energy price projections and assuming that wage increases continue to lag productivity gains, staff considers the NBS’s inflation projections for end-2007 (1.6 percent) and end-2008 (1.9 percent) to be realistic.1 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. Upside risks to inflation are higher consumer spending, against the backdrop of zero slack in the economy, and wage pressures induced by a tighter labor market. The authorities stressed that the impact of the downward adjustments in regulated prices was sustainable in that they would not negatively affect cost recovery and the ability of the utility companies to maintain and renew their infrastructure.

IV. Policy Discussions

15. The authorities are giving priority to euro adoption but are also committed to socially inclusive growth. They were concerned about the rapid pace of exchange rate appreciation and the risk of an overly strong conversion rate when the euro is adopted. They emphasized that fiscal consolidation was a key objective and that increases in social spending would be effected within the limits imposed by the deficit targets. However, the authorities were inclined to devote additional revenues resulting from faster economic growth to meeting social welfare goals. They also have taken a number of labor market policy initiatives aimed at spreading the gains from growth to low-income earners. Staff highlighted the risk of the public expenditure structure and the labor market becoming less flexible and, to ensure a successful experience in the euro area, encouraged the authorities to orient policies toward enhancing the ability of the economy to deal with shocks.

16. Over a number of years, the authorities have implemented policies generally in line with the Fund’s advice.

A. Monetary and Exchange Rate Policy

17. The authorities noted that the revaluation of the central parity of the koruna was justified by Slovakia’s improved economic fundamentals. The productivity growth differential vis-à-vis the euro area had widened in 2006, and a sizeable part of the upward pressure on the exchange rate reflected productivity-driven equilibrium real appreciation. The authorities recognized that the parity revaluation entailed risks. It increased the room for further appreciation within the ERM2 band and could induce additional speculative inflows. It also increased Slovakia’s vulnerability to investor sentiment turning bearish, as the cushion for accommodating depreciation had become smaller relative to that before the parity adjustment. However, the authorities were optimistic that investors would increasingly decouple the koruna from regional influences. Staff regards parity revaluation to be a pragmatic strategy, given the reasons for the upward deviations and the objective of keeping the exchange rate within the ERM2 band.

18. The authorities expressed the view that an overshooting of the koruna from the equilibrium level was likely to undermine the competitiveness of traditional manufacturing firms as well as small and medium-sized enterprises, where productivity gains were lower. However, staff noted the inherent difficulties of measuring equilibrium rates in transition economies and observed that competitiveness remained satisfactory according to most indicators. Strong productivity growth kept the unit labor cost-based real effective exchange rate broadly stable in 2006. Moreover, with increases in real product wages lagging productivity gains, profitability rose and continued to outpace trading partners (Figures 4 and 5). Significantly, profitability of sectors experiencing slower export growth was comparable to that of sectors with faster export growth. Slovakia’s export market share has increased for all sectors in recent years, and its exports have moved up the technology ladder at a faster pace than most regional peers (Figures 6 and 7). The pace of export market penetration is likely to be sustained over the medium term on account of commencement of production and expansion of capacity in several export-oriented projects.

Figure 4.Slovak Republic: Exchange Rate Indicators, 1998–2007

(1998q1=100) 1/

Citation: 2007, 226; 10.5089/9781451835557.002.A001

Sources: Eurostat; International Financial Statistics; and IMF staff calculations.

1/ Trade weights based on 1999–2001 data for exports of goods. Partner countries comprise: Austria, Czech Republic, France, Germany, Hungary, Italy, Netherlands, Poland, United Kingdom, and United States.

2/ Unit labor costs in trading partner countries relative to those in Slovakia, adjusted for manufacturing producer price inflation—a rough indicator of developments in relative profitability. An increase represents gain in competitiveness, vis-a-vis trading partners, assuming similar capital-labor ratios.

Figure 5.Slovak Republic: Wages, Productivity, and Product ULC in Manufacturing, 1998–2006 (1998q1=100) 1/

Sources: Statistical Office of the Slovak Republic; and IMF staff calculations.

1/ Trade weights based on 1999–2001 data for exports of goods. Partner countries comprise: Austria, Czech Republic, France, Germany, Hungary, Italy, Netherlands, Poland, United Kingdom, and United States.

2/ Defined as the ratio of nominal wages to producer price index.

3/ Defined as the ratio of real product wages to productivity.

Figure 6.Competitiveness Indicators and Export Market Shares of Slovak Republic and Selected New EU-Member States, 1998–2006

Sources: Statistical Office of the Slovak Republic; United Nations Comtrade database; Direction of Trade Statistics; and IMF staff calculations.

1/ 4-quarter moving average. Calculated as the share of exports of each individual country in the combined total world imports.

2/ The methodology used in the classification of exports is explained in the accompanying selected issues paper.

Figure 7.Selected New EU Member States: Technological Composition of Exports, 1994–2005

(Share in percent of country exports)

Sources: United Nations Comtrade database; and IMF staff calculations. Methodology is detailed in IMF Country Report 06/414.

19. The NBS has persisted with foreign exchange intervention and rejection of repo bids in open market operations for containing appreciation of the koruna. However, these efforts have succeeded in easing pressures for only limited duration. Staff encouraged the NBS 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. Given the favorable inflation outlook, staff recommended that the NBS lower its policy interest rates. Staff also saw merit in NBS officials communicating to market participants that the terminal conversion rate could be different from the prevailing market rate, as had been the case for Greece, Ireland, and Finland.

B. Fiscal Policy

20. The authorities noted that the 2007–09 budget framework was aimed at meeting the euro zone entry objective. It envisaged a general government deficit (including the second pillar pension costs) of 2.9 percent of GDP in 2007 and consolidation thereafter of ½ percent of GDP annually to 1.9 percent of GDP in 2009. Taking into account net transfers from the EU, this would imply a marginally contractionary stance every year. Fiscal consolidation would rely mainly on a reduction in expenditure in relation to GDP. However, the authorities planned higher expenditure on health care, pensions and other social spending, and agriculture. The budget incorporates marginal changes to the flat tax system that are not unduly distortionary—the VAT rate on medicine and medical devices has been lowered from 19 percent to 10 percent, and standard deductions have been reduced for higher income earners.

Fiscal Outlook, 2006–09(In percent of GDP)
2006200720082009
BudgetPrel.Budget
Fiscal balance, including second pillar pension costs-4.2-3.4-2.9-2.4-1.9
Fiscal balance, excluding second pillar pension costs-2.9-2.3-1.8-1.3-0.7
Primary fiscal balance, excluding second pillar pension costs-1.3-1.4-0.20.20.7
Cyclically adjusted primary fiscal balance-1.4-1.5-0.40.20.7
Net transfers from the EU1.30.40.81.01.3
Fiscal impulse including the impact of net transfers from the EU 1/2.41.5-0.6-0.4-0.2
Memorandum items:
Real GDP growth (percent) 2/5.48.37.45.25.1
Source: Ministry of Finance.

Change in the cyclically adjusted primary balance plus the change in net transfers from the EU. Receipts from the EU budget generally have counterparts on the expenditure side. Thus, there is no effect on the fiscal deficit but ther is an expansionary impact since the receipts do not withdraw resources from the private sector like normal revenue. Payments to the EU budget raise the measured deficit but do not increase domestic demand.

For 2006, forecast of the 2006–08 budget framework. For 2007–09, forecast of the 2007–09 budget framework.

Source: Ministry of Finance.

Change in the cyclically adjusted primary balance plus the change in net transfers from the EU. Receipts from the EU budget generally have counterparts on the expenditure side. Thus, there is no effect on the fiscal deficit but ther is an expansionary impact since the receipts do not withdraw resources from the private sector like normal revenue. Payments to the EU budget raise the measured deficit but do not increase domestic demand.

For 2006, forecast of the 2006–08 budget framework. For 2007–09, forecast of the 2007–09 budget framework.

21. Staff recommended a more ambitious fiscal consolidation than envisaged in the budget framework, given the strong growth outlook and challenges in fending off appreciation pressures. This 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. The strategy to achieve additional fiscal consolidation would not necessarily require scaling back on budgeted expenditure. Revenues are likely to exceed the budgeted levels as economic growth is anticipated to be stronger relative to the budget assumptions. Accordingly, staff encouraged the authorities to save the revenue overperformance and ensure a better fiscal outturn. This would entail adhering to the nominal expenditure targets specified in the budget framework.

22. Ministry of Finance officials recognized the merits of a stronger counter-cyclical fiscal policy, but drew attention to the political constraints. Given the emphasis in the government’s manifesto on enhancing welfare state measures, there would be pressure for using additional revenues resulting from faster economic growth for socially-oriented current spending. Ministry officials noted that the state budget law for 2007 limited the extent to which revenue overperformance could be spent without resorting to a supplementary budget—only up to 1 percent of the budget baseline expenditure. While this could potentially help obtain a lower-than-envisaged deficit in 2007, they did not rule out the possibility of an upward revision of the original expenditure ceilings for 2008 and 2009 when the 2008–10 budget framework is prepared on the basis of updated macroeconomic projections.

23. Fiscal management at local government levels will have to be made consistent with the national fiscal consolidation strategy. The authorities explained that the slippage in the fiscal performance of municipalities in 2006 was election related, and considered the risk of it recurring in 2007 to be small. However, fiscal rules applicable to local governments are based on ceilings related to their debt stock, which are currently non-binding. They do not prevent revenue overperformance from funding additional spending and do not ensure operation of automatic fiscal stabilizers. Also, there is no satisfactory mechanism in place for monitoring fiscal developments of local governments. Accordingly, staff recommended that fiscal rules applicable to local governments be amended with the aim of strengthening expenditure control and enhancing fiscal flexibility. Until these measures became effective, staff suggested use of moral suasion to avoid any borrowing for expenditures beyond the budgeted levels and to save any revenue overperformance.

24. The expenditure program in the 2007–09 budget framework does not identify how the announced policy priorities will be sustained beyond 2007. Some of the new social expenditure policy initiatives are not fully funded, and their full implementation would cost 0.4–0.5 percent of GDP more annually than provided for in the budget framework. The authorities indicated that higher expenditure on social policy priorities would be accommodated through efficiency gains in government spending, streamlining public administration, and stronger revenue performance. They acknowledged that a key challenge was to contain costs in the health care system.2 However, they downplayed staff’s concern about possible increase in demand for doctor’s consultations and outpatient contacts following the recent elimination of co-payments. The authorities stated that the details of public administration reform and a comprehensive medium-term expenditure program would be elaborated in the 2008–10 budget framework.

25. Staff expressed concern that the rising share of non-discretionary expenditure would reduce budgetary flexibility. Creating space for the growing co-financing of EU-funded projects as well as fiscal adjustment in the event of shocks would become more difficult. While acknowledging that capital expenditure can also help achieve social welfare goals, the authorities did not foresee a quick shift in the composition of expenditure.

26. The drawdown of EU funds has fallen short of the budgeted levels. While Slovakia compares favorably with neighboring countries in the overall absorption of EU funds, it fares poorly in the utilization of cohesion funds. The authorities noted that the current legislation on land acquisition and procedures for construction permits hindered drawdown of EU funds for infrastructure projects and needed to be urgently reviewed.

Budgetary Impact of New Expenditure Initiatives, 2006–09(In millions of koruny, unless otherwise indicated)
2006200720082009
Cost of new expenditure initiatives incorporated in the expenditure plan for 2007–09
Christmas bonus for pensioners1,614000
Disability pensions600960337342
Elimination of health care copayment1,9001,9001,900
Higher health contribution on behalf of vulnerable groups2,09300
Bonus for first born child288294300
Direct payments to farmers up to 70 percent of the EU-15 average3,73500
Investment incentives2,30000
Subsidies for mortgage loans50100120
Wage increases for teachers2,30000
Wage increases for judges154165173
Total
in millions of koruny2,21413,7802,7962,835
in percent of GDP0.10.80.10.1
Additional cost in case of full implementation of new expenditure initiatives
Christmas bonus for pensioners1,7001,7001,700
Higher health contribution on behalf of vulnerable groups 1/2,2362,391
Direct payments to farmers up to 70 percent of the EU-15 average 2/2,7841,418
Wage increases for teachers2,6653,169
Investment incentives 3/n.a.n.a.
Total (excluding n.a. item)
in millions of koruny1,7009,3858,678
in percent of GDP0.10.50.4
Source: Ministry of Finance.

The rate of health contribution on behalf of vulnerable groups is assumed to be kept at 4.33 percent in 2008 and 09—the same rate as in 2007.

Direct payments to farmers are assumed to be kept at 70 percent of the EU-15 average in 2008 and 09.

Not yet specified.

Source: Ministry of Finance.

The rate of health contribution on behalf of vulnerable groups is assumed to be kept at 4.33 percent in 2008 and 09—the same rate as in 2007.

Direct payments to farmers are assumed to be kept at 70 percent of the EU-15 average in 2008 and 09.

Not yet specified.

Drawdown of EU funds by categories, 2006
EAGGF 1/Structural

Funds
Cohesion

Fund
OthersTotalTotal

drawdown
(in percent of budgeted level)(in percent of GDP)
CEE-5 countries
Czech Republic88.446.749.958.662.51.1
Hungary95.547.544.655.766.01.7
Poland82.136.629.549.751.91.8
Slovak Republic86.0103.98.174.567.31.3
Slovenia75.566.737.199.276.51.4
Baltic countries
Estonia83.969.279.173.677.02.9
Latvia79.444.988.387.673.53.4
Lithuania96.625.236.567.759.63.1
Sources: Ministry of Finance of the Slovak Republic, and IMF Working Paper “EU Funds in the New Member States: A Primer” (WP/07/77).

European Agricultural Guidance and Guarantee Fund.

Sources: Ministry of Finance of the Slovak Republic, and IMF Working Paper “EU Funds in the New Member States: A Primer” (WP/07/77).

European Agricultural Guidance and Guarantee Fund.

27. Public debt sustainability is not a concern. At end-2006, general government debt stood at 30¾ percent of GDP. This is both within a safe range for an emerging market and below the Maastricht limit. Assuming the structural deficit trend specified in the latest Convergence Program update, the debt ratio is projected to decline by 7¾ percentage points to 23 percent of GDP by 2012. Aging-related fiscal pressure is anticipated only in the longer term, from 2020 onward. Vulnerability of debt to changes in inflation, interest rates, and the exchange rate is low (Table 8).

Table 8.Slovak Republic: Public Sector Debt Sustainability Framework, 2002–2012(In percent of GDP, unless otherwise indicated)
ActualProjections
20022003200420052006200720082009201020112012
I. Baseline ProjectionsDebt-stabilizing

primary

balance 10/
Public sector debt 1/43.342.441.534.530.729.528.126.225.224.122.9-0.6
o/w foreign-currency denominated13.611.510.99.67.37.87.97.67.67.57.3
Change in public sector debt-5.6-0.6-1.1-7.1-3.7-1.3-1.4-1.8-1.0-1.2-1.2
Identified debt-creating flows (4+7+12)-15.2-3.3-2.7-0.9-3.2-0.6-0.6-0.6-1.1-1.2-1.3
Primary deficit2.00.31.01.11.81.10.60.3-0.1-0.5-0.9
Primary (noninterest) revenue and grants38.836.734.636.434.933.332.232.130.129.929.8
Primary (noninterest) expenditure40.837.035.637.436.734.432.832.430.029.428.9
Automatic debt dynamics 2/-2.9-3.2-3.7-0.2-3.3-1.4-1.2-0.8-0.9-0.6-0.4
Contribution from interest rate/growth differential 3/-0.3-1.1-2.3-1.5-1.9-1.3-0.9-0.8-0.9-0.6-0.4
Of which contribution from real interest rate1.50.6-0.20.80.71.21.11.00.60.60.5
Of which contribution from real GDP growth-1.8-1.7-2.1-2.3-2.6-2.4-2.0-1.8-1.4-1.2-0.9
Contribution from exchange rate depreciation 4/-2.6-2.1-1.41.4-1.4-0.1-0.30.00.00.00.0
Other identified debt-creating flows-14.2-0.40.0-1.8-1.7-0.30.00.0-0.10.00.0
Privatization receipts (negative)-14.5-1.00.0-1.1-1.10.00.00.00.00.00.0
Recognition of implicit or contingent liabilities0.30.60.0-0.7-0.6-0.30.00.0-0.10.00.0
Other (specify, e.g. bank recapitalization)0.00.00.00.00.00.00.00.00.00.00.0
Residual, including asset changes (2-3)9.62.71.6-6.2-0.6-0.6-0.8-1.20.10.00.1
Public sector debt-to-revenue ratio 1/111.6116.4120.494.888.188.587.181.883.780.476.9
Gross financing need 5/14.313.114.111.29.18.47.66.75.65.04.4
in billions of U.S. dollars3.54.35.95.35.010-Year

Historical

Average
10-Year

Standard

Deviation
5.96.05.95.45.24.8
Key Macroeconomic and Fiscal AssumptionsProjected

Average
Real GDP growth (in percent)4.14.25.46.08.34.12.48.87.57.06.05.04.06.4
Average nominal interest rate on public debt (in percent) 6/8.26.35.74.65.17.41.96.76.46.24.44.44.45.4
Average real interest rate (nominal rate minus change in GDP deflator, in percent)3.61.6-0.32.22.42.12.64.44.24.02.42.42.43.3
Inflation rate (GDP deflator, in percent)4.64.76.02.42.75.32.02.32.22.22.02.02.02.1
Growth of real primary spending (deflated by GDP deflator, in percent)6.8-5.61.411.66.13.57.72.12.65.4-1.72.81.62.2
Primary deficit2.00.31.01.11.81.91.41.10.60.3-0.1-0.5-0.90.1
II. Stress Tests for Public Debt RatioDebt-stabilizing

primary

balance10/
A. Alternative Scenarios
A1. Key variables are at their historical averages in 2007–11 7/30.930.930.832.033.134.0-0.8
A2. No policy change (constant primary balance) in 2006–1130.330.129.630.431.332.5-0.9
B. Bound Tests
B1. Real interest rate is at baseline plus one standard deviations29.828.727.326.525.524.5-0.4
B2. Real GDP growth is at baseline minus one-half standard deviation30.229.729.329.830.431.3-0.5
B3. Primary balance is at baseline minus one-half standard deviation30.229.428.227.827.226.6-0.7
B4. Combination of B1-B3 using one-quarter standard deviation shocks30.129.428.227.727.126.5-0.4
B5. One time 30 percent real depreciation in 2007 9/33.431.829.928.727.326.0-0.7
B6. 10 percent of GDP increase in other debt-creating flows in 200739.537.635.634.132.731.3-0.9

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

8/ The implied change in other key variables under this scenario is discussed in the text.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

8/ The implied change in other key variables under this scenario is discussed in the text.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

C. Wage and Labor Market Issues

28. Recent labor market policy initiatives aimed at addressing income inequality could increase wage drift and undermine wage flexibility.

  • The authorities increased the minimum wage by 10 percent in October 2006, and the government manifesto calls for further increases in the minimum wage relative to the average wage. They are giving consideration to establishing formula-based guidelines for increases in the minimum wage. Staff urged the authorities to retain discretion for determining minimum wage increases and adopt a cautious stance, as the pace influenced wage negotiations in the private sector although a large part of wage setting was decentralized. Staff also noted 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.

  • In a reversal of the reform measure implemented in 2004, a recent amendment to the collective bargaining law has made sectoral wage agreements binding for all enterprises in the sector. Opposition parties and employer groups have petitioned the Constitutional Court on the validity of the amendment. Staff noted that the amendment would be particularly painful to smaller enterprises and would reinforce the negative effect of rapid exchange rate appreciation. It would also reduce the scope for regional wage differentiation that is desirable because of the large regional differences in employment rates. The authorities explained that the amended law allows individual firms to seek a waiver on socio-economic grounds. They also noted their intention to establish a tripartite Social Pact that would include a provision for wage moderation.

29. The government is seeking to amend the Labor Code with the aim of increasing employee protection and aligning it to the European social model. However, the draft legislation submitted to parliament does not have the full backing of the junior coalition partners and may be subject to change. Employers’ associations and major FDI-supported enterprises remain opposed to the proposed changes, arguing that they would increase labor costs and worsen the business environment.

30. Addressing regional disparities 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 employment growth has been small and the unemployment rate remains sticky around 20 percent. Active labor market policy (ALMP) schemes have been less effective 3 in the three lagging regions than in the rest of the country. The authorities indicated that new ALMP tools will be added from January 2008 to raise the employability of job seekers and to increase the incentives for employers to employ disadvantaged groups. They noted that the new scheme of investment incentives was aimed at supporting job creation in the underdeveloped regions. The authorities also plan to increase investment in infrastructure in these regions, strengthen the regional transport systems, and improve the quality of tertiary and vocational education, supported by contributions from the EU.

Employment and Unemployment by Region, 2001–06
200120022003200420052006
Employment rate(In percent of working population)
Slovakia, total56.556.757.656.957.759.1
Bratislava68.567.168.267.669.669.7
Trnava59.660.761.962.764.265.1
Trencin59.760.762.662.662.764.1
Nitra52.551.052.755.255.958.0
Zilina56.257.857.756.557.459.3
Banska54.552.653.151.052.854.2
Presov53.154.654.852.953.755.5
Kosice51.051.352.550.349.250.9
Unemployment rate(In percent of labor force)
Slovakia, total19.218.517.418.116.213.3
Bratislava8.48.66.98.25.24.3
Trnava18.016.113.212.510.48.8
Trencin13.411.39.28.68.17.0
Nitra23.123.823.420.317.713.2
Zilina18.917.317.117.415.211.8
Banska22.425.223.826.623.821.0
Presov22.720.120.422.821.418.0
Kosice24.824.123.025.224.620.2
Source: Statistical Office of the Slovak Republic, Labor Force Survey.
Source: Statistical Office of the Slovak Republic, Labor Force Survey.

Success Rate of Active Labor Market Policies in 2005 1/

(In percent)

Source: Ministry of Labor, Social Affairs and Family.

1/ Measured as a ratio of participants in active labor market policy programs who found a job to the total number of participants.

D. Financial Sector Issues

31. The banking system, which is almost entirely foreign-owned, is currently healthy. A recent FSAP update mission found that banks are adequately capitalized and profitable, and asset quality remains high (Table 9). Stress tests indicate that banks remain resilient to a range of possible adverse shocks.4 However, continued rapid credit growth has increased banks’ exposure to credit risk and their vulnerability to swings in the economic cycle. NBS officials deemed risk management practices of banks to be generally adequate. Noting that the lowering of policy interest rates to counter appreciation pressures may also provide additional impetus to credit growth, staff stressed the need to closely monitor bank loan portfolios and to tighten prudential requirements if necessary.

Table 9.Slovak Republic: Financial Soundness Indicators for the Banking Sector, 2002–06(In percent, unless otherwise indicated)
20022003200420052006
Capital Adequacy
Regulatory capital to risk-weighted assets21.322.418.714.813.0
Regulatory Tier I capital to risk-weighted assets18.521.618.915.014.2
Asset Composition and Quality
Nonperforming loans to gross loans1/7.93.72.65.03.2
Nonperforming loans net of provisions to capital6.04.23.16.47.9
Sectoral distribution of outstanding loans (in percent of total loans)
Individuals18.121.726.730.330.2
Governmet3.32.98.35.02.5
Agriculture1.71.61.61.61.3
Manufacturing23.821.115.814.611.1
Construction1.71.41.62.22.5
Wholesale and retail trade14.913.113.513.011.9
Transportation6.78.15.13.94.7
Financial services6.36.98.710.318.3
Other23.423.218.719.117.3
Earnings and Profitability
Return on assets (after tax)1.21.21.21.21.3
Return on equity (after tax)11.510.811.916.916.6
Interest margin to gross income76.680.773.365.466.4
Noninterest expenses to gross income63.770.061.269.158.3
Liquidity
Liquid assets to total assets 2/28.916.813.333.536.5
Liquid assets to short term liabilities81.355.940.340.345.6
Foreign Exchange Risk
Net open positions in foreign exchange to capital (on balance sheet)-42.0-59.0-80.0-14.4-1.2
Net open positions in foreign exchange to capital (off balance sheet)-35.06.040.0-24.244.2
Foreign currency-denominated loans (percent of total loans)17.120.722.828.227.1
Foreign currency-denominated liabilities (percent of total liabilities)15.619.019.328.022.3
Source: National Bank of Slovakia.

A decline in the NPL ratio in 2006 is partly due to a change in the methodology for calculating NPLs.

In 2006, liquid assets include government bonds in holding-to-maturity portfolio.

Source: National Bank of Slovakia.

A decline in the NPL ratio in 2006 is partly due to a change in the methodology for calculating NPLs.

In 2006, liquid assets include government bonds in holding-to-maturity portfolio.

32. In 2006, the NBS unified supervision of the entire financial sector. The non-bank financial sector is relatively small but growing rapidly. NBS officials indicated that the riskbased forward-looking approach of supervision was now fully operational in the non-bank financial sector. The FSAP update mission determined that the NBS is well prepared to cope with the challenges resulting from the implementation of the Basel II supervision framework from January 2007. NBS officials regularly interacted with home country supervisors at different levels, but they acknowledged the importance of improving coordination further. Staff encouraged the authorities to implement in a timely fashion the recommendations of the MONEYVAL report to improve the anti-money laundering regime.

V. Staff Appraisal

33. Slovakia is reaping the benefits of sound policies over the past few years. Reforms of the tax and welfare systems, financial sector, and the labor market have increased the incentives to work, improved the business climate, and enhanced the flexibility of the economy. These measures together with prudent macroeconomic management and large FDI inflows have supported progressive strengthening of economic growth and increasing export orientation, making Slovakia one of the top performers in the region. The new government’s commitment to the continuation of policies aimed at ensuring euro adoption in January 2009 has secured investor confidence and should help sustain this status.

34. Slovakia is well poised to adopt the euro, but challenges lie ahead. The near-term inflation outlook has improved and the Maastricht reference rate seems within reach. The 2007–09 budget framework is aimed at meeting the euro zone entry objective. However, a key challenge is to satisfy the test of exchange rate stability under ERM2, as the evolution of the koruna is influenced not only by Slovakia’s economic fundamentals but also by swings in investor sentiment in the region. Another challenge is to put in place adjustment mechanisms—wage and labor market flexibility and the capacity to run countercyclical fiscal policy—prior to adopting the euro. This will ensure that asymmetric shocks can be effectively absorbed in the absence of a national monetary policy. Thus, a continued focus on fiscal prudence and structural reforms will remain essential. The increased social orientation of policies that the authorities are also aiming for will need to be carefully meshed into this framework.

35. Monetary policy priorities have shifted to containing exchange rate appreciation and keeping the rate within the ERM2 band. 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 and volatility. The koruna’s recent firming does not appear to pose a significant threat to competitiveness. However, further rapid appreciation of the koruna could be disruptive for small and medium-sized exporters. The NBS should use its policy instruments in a manner that will limit opportunities for one-way bets in the foreign exchange market. Given the favorable inflation outlook, the NBS should lower its policy rates instead of persisting with the rejection of repo bids to contain appreciation pressures.

36. A tighter fiscal stance than envisaged in the budget is desirable, given the robust growth prospects and the persistence of appreciation pressures. Such a strategy would also facilitate the achievement of euro zone norms on a sustainable basis. Ensuring a better fiscal outturn will require safeguarding the revenue overperformance that is anticipated because of a stronger economic growth outlook, and adhering to the original medium-term expenditure ceilings. It will also be important to strengthen fiscal management of local governments and improve policy coordination across all levels of government.

37. The medium-term expenditure framework should be strengthened to reflect policy objectives clearly and to enhance fiscal flexibility. The authorities have initiated background work to increase spending efficiency and streamline public administration. It will be important to follow through with these plans in a decisive manner. However, increased socially-oriented current spending is likely to make the public expenditure structure more rigid. Capital expenditure can also help achieve social welfare goals while increasing the long-term growth potential and widening the discretionary scope for fiscal policy. More emphasis should be put on reducing income inequalities by channeling resources toward employment promotion and investment in infrastructure in underdeveloped regions. Priority should be given to eliminating the bottlenecks that hinder drawdown of EU funds for infrastructure projects, and space should be created for the growing co-financing of EU-funded projects.

38. Wage moderation and flexibility in wage setting procedures would contribute importantly to containing inflationary pressures and safeguarding competitiveness. In this regard, the recent legislation that extends sectoral wage agreements to all firms in the sector is worrisome. The authorities should avoid further large increases in the minimum wage as it would lead to wage drift and may harm employment prospects of low-skilled workers.

39. Slovakia continues to face considerable challenges in the labor market. Reforms implemented in 2003–04 and stronger GDP growth have contributed to a pick up in the employment rate, but the unemployment rate remains high among the low-skilled and in the less-advanced regions. Active labor market policy schemes have been relatively ineffective in lowering unemployment in these regions, and need to be improved. Consideration should be given to introducing earned income credit for low-income workers, with a view to stimulating job creation and further increasing incentive to work. The authorities should also ensure that the amendments to the labor code do not lead to higher labor costs and reduce labor market flexibility.

40. The financial system is in good health, but faces challenges. The increasing exposure of banks to credit risk requires close monitoring. Given the high foreign ownership of banks and the recent introduction of the Basel II framework, it will be important to strengthen cooperation and exchange of information with home country supervisors, and to develop arrangements for coordinated remedial actions for dealing with problem banks. The extension of a risk-based approach of supervision to non-bank financial institutions is welcome. The NBS is encouraged to address the remaining gaps in the anti-money laundering regime, taking into account the recommendations of MONEYVAL.

41. It is recommended that the Article IV consultation with Slovakia remain on the standard 12-month cycle.

Subsequent to the mission, in April, the NBS lowered the end-2007 inflation projection to 1.3 percent, taking into account recent price developments.

See the accompanying Selected Issues Paper for discussion of health care spending in Slovakia.

Measured in terms of raising exit rates from unemployment into employment following participation in a scheme.

See the accompanying Financial Sector Stability Assessment.

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