This Selected Issues paper and Statistical Appendix examines external competitiveness and the exchange rate for the Slovak Republic. The paper describes two simple types of competitiveness indicators: (i) real effective exchange rate measures, which examine underlying fundamentals thought to influence external performance; and (ii) indicators of actual export performance. The results suggest that the unfavorable outcomes in the merchandise trade balance and the current account from 1996 to 1998 reflected, at least in part, competitiveness problems. The paper also presents an assessment of banking conditions and the supervision system in the Slovak Republic.

Abstract

This Selected Issues paper and Statistical Appendix examines external competitiveness and the exchange rate for the Slovak Republic. The paper describes two simple types of competitiveness indicators: (i) real effective exchange rate measures, which examine underlying fundamentals thought to influence external performance; and (ii) indicators of actual export performance. The results suggest that the unfavorable outcomes in the merchandise trade balance and the current account from 1996 to 1998 reflected, at least in part, competitiveness problems. The paper also presents an assessment of banking conditions and the supervision system in the Slovak Republic.

IV. External Current Account Performance in the Slovak Republic: A Brief Retrospective81

A. Introduction

137. The large external current account deficit in Slovakia has been a major economic concern. The deficit exceeded 10 percent of GDP each year from 1996 to 1998, and must be reduced significantly if the risks of a balance of payments crisis are to be reduced significantly. With negligible inflows of non-debt-creating capital, the deficit has been financed primarily by large external borrowings, which has led to explosive foreign debt dynamics. Moreover, the persistently high current account deficits and fiscal deficits that have accompanied them have adversely affected the market’s assessment of Slovakia’s credit risk. Over the past 12 months or so, all the major credit rating agencies have downgraded Slovakia’s sovereign debt to below investment grade. This has reduced Slovakia’s access to international financial markets, and made borrowing more expensive. Moreover, other vulnerabilities in the economy, such as the weaknesses in the banking and enterprise sectors, have further impeded capital inflows, thereby making it all the more imperative to deal with the external current account problem.

138. Reflecting expansionary macroeconomic policies, Slovakia’s output growth in the 1995–98 period was driven by domestic demand, instead of by exports as in the early phase of the transition process. This made Slovakia’s economy one of the fastest growing among transition economies (GDP increased annually by more than 6½ percent in the 1995–1997 period, and by a still high 4.4 percent in 1998), but also led to high current account deficits. Strong domestic demand growth reflected lax fiscal policy, and the activities of public enterprises, as well as strong investment growth in the private sector. Although high investment rates are usually viewed as desirable, investment in Slovakia was partly driven by distortionary incentives created during the privatization process, and most investment apparently did not take place in the tradable goods sector.

139. The counterpart to the boom in domestic demand was rapid import growth, while export performance was mixed. The latter was comparatively weak during 1996–97, and accompanied by a loss of external competitiveness resulting mainly from labor market developments. In 1998, export growth recovered. Moreover, the koruna depreciated in real effective terms, reflecting productivity gains in manufacturing sector, the slowdown in wage growth, and the nominal depreciation of the currency.

140. The rest of this paper is organized as follows: Section II outlines some key aspects of external current account developments in Slovakia. Section III demonstrates the need for policy adjustments using a simulation analysis of debt dynamics. Finally, Section IV provides concluding remarks.

B. Key Aspects of Current Account Developments

141. This section first discusses the various factors that have contributed to the current account deficits recorded in 1996–98. Booming investment was clearly one key factor. But while high investment to GDP rates usually at least lessen concerns about current account deficits, the investment record in Slovakia has not been fully reassuring in this regard. In particular, a relatively small proportion of investment was undertaken in the tradable goods sector; for various reasons discussed below, actual investment may have been smaller than what is recorded in the official statistics; and of the investment that took place, little of it benefited from foreign participation and know how.

Rapid domestic demand growth and saving-investment behavior

142. Domestic demand, which contracted in the early years after independence (1993–94), surged by 11 percent in 1995 and by 18 percent in 1996, led primarily by investment (Table IV-1). The jump in investment—from 23 percent of GDP in 1994, to 28 percent in 1995, and to an exceptionally high level of 39 percent of GDP in 1996—was reflected in the deterioration of the external current account balance from small surpluses in 1994–95 to a deficit of more than 10 percent in 1996 (Table IV-2). Investment remained near 39 percent of GDP in 1997 and 1998. Meanwhile, the ratio of economy-wide saving to GDP was little changed during 1995–98. The ratios of both investment and saving to GDP were substantially higher than in other central European economies (Table IV-3).

Table IV-1.

Slovak Republic: Gross Domestic Product Composition and Growth

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Sources: Slovak Statistical Office; and staff estimates.

Comparable data are not available due to a change in methodology in the compilation of trade data.

Table IV-2.

Slovak Republic: Saving-Investment Balance, 1995-98

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Sources: Slovak authorities; and staff estimates.

Includes Post, Telecommunications, Railways, and Electricity.

Excluding the military equipment shipped from Russia in exchange for a reduction of Slovak claims, equivalent to 1.5 percent of GDP.

Table IV-3.

Slovak Republic: Regional Comparison of Selected Economic Indicators

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Sources: WEO, Slovak authorities, EBRD, and staff estimates

Includes 1.5 percent of GDP of military equipment shipped from Russia in exchange for a reduction of Slovak claims, which is captured in the BOP accounts as imports but not in the national accounts.

Wages, deflated by productivity index.

In the manufacturing sector.

143. The reasons behind the investment boom are not fully understood. Some contributing factors were the following: (i) the pro-investment stance of the government, including special incentives created under the privatization process, which may have contributed (as discussed below) to some overrecording of investment; (ii) the government’s initiation of huge road and power infrastructure projects; and (iii) the modernization drive in the large industrial base of the country, after the newly acquired access to western technology.

144. The absence of an effective wage policy contributed to domestic demand growth, in particular during 1996–97. In those years, real wages increased by about 7 percent each year. A wage control law, introduced in the second half of 1997 with the aim of reducing wage growth, particularly in loss-making enterprises, turned out to be ineffective, and was revoked in November 1998.

145. Monetary policy was fairly ineffective in containing domestic demand pressures because of the easy access of Slovak enterprises to foreign borrowing in the 1996–98 period. Monetary policy, which had been expansionary until mid-1996, was tightened thereafter, as evidenced by the rise in the average one-month interbank lending rate from 10 percent in the first half of 1996, to 24 percent in 1997, and 19 percent in 1998. While the ensuing high real interest rates—the inflation rate remained stable, at about 6 percent—imposed strains on domestic banks and enterprises, domestic demand pressures were not contained. For example, when domestic credit growth slowed down from 18 percent in 1996 to about 2 percent in 1997, Slovakia’s enterprises took advantage of their easy access to international capital markets, and increased their foreign borrowing, some of which was supported by a program of government guarantees.

146. From a saving-investment standpoint, the government’s fiscal policy and the operations of some large public enterprises accounted for most of the large saving-investment gap of the Slovak economy. The general government deficit deteriorated dramatically in the 1996–98 period, switching from a surplus of 0.2 percent of GDP in 1995 to a deficit of 6 percent in 1998. Moreover, public enterprises substantially contributed to the shortfall of savings compared with investment. As Table IV-2 suggests, almost all of the savings-investment gap in the nongovernment sector (which includes the private sector and the state-owned enterprises) in 1997 and 1998 came from four large state enterprises, reflecting in addition to high investment, their very low or negative profitability.82

Merchandise trade performance

147. Against the background of rapid domestic demand, export performance weakened in 1996 and 1997. As shown in Table IV-4, Slovakia’s export growth in these two years was among the lowest of the central and eastern European transition economies. Moreover, Slovakia’s share in EU imports (the EU is Slovakia’s most important export market) more than doubled from 0.11 percent in 1993 to 0.29 percent in 1998, but was stagnant in 1996 and 1997. In these two years, the cumulative appreciation of the real effective exchange rate, based on unit labor costs (ULCs), was 23½ percent.83 The real appreciation largely reflected the strong nominal wage growth and a slowdown in productivity growth in those years. The ULC effects in 1997 were reinforced by nominal effective appreciation of the Slovak currency of about 6 percent.

Table IV-4.

Slovak Republic: Central and Eastern Europe Exports of Goods

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Sources: IMF Direction of Trade Statistics; and staff estimates.

148. Export performance improved substantially in 1998. Export volume growth was an estimated 12 percent, compared with 1½ percent in 1997 and 6 percent in 1996. As noted above, Slovakia also increased its share in the EU market. In addition, the appreciation of the ULC-based real effective exchange rate was reversed because of the slowdown in wage growth, a strong recovery in productivity growth, and nominal exchange rate depreciation.

149. Slovakia’s exports have been heavily concentrated in a narrow industrial base. This makes Slovakia’s exports sensitive to the performance of a few large exporters. The export base includes steel, basic chemicals, fuels, and machinery and equipment. Iron and steel, for example, constitute more than 14 percent of total exports, almost all of it produced by Slovakia’s largest private company, Vychodoslovenske Zelezarnie, A.S. (VSZ). When the company experienced financial difficulties in 1998, as a result not only of a glut in the global steel market, but also of internal inefficiencies and high indebtedness, this substantially affected a large share of Slovakia’s exports. In a similar vein, it appears that several large exporters of chemicals and chemical products, which contributed about 10 percent to total exports in 1998, have recently been experiencing financial difficulties as a result of incomplete restructuring, which has also adversely affected their export capabilities. On the other hand, foreign greenfield investments in some large projects have increased export capacity of the Slovak economy, particularly in automobile sector, and substantially contributed to export growth in 1998.

150. In the face of strong growth in domestic demand—and investment demand in particular—import growth was very high in 1996–98. Using the WEO estimate of import deflators, import volume growth averaged about 14 percent in those three years. Moreover, such a high rate of import volume growth occurred despite the imposition of import surcharges ranging from 7 to 10 percent in 1995 and 1996, and the reintroduction of a 7 percent surcharge in July 1997 (which was fully phased out October 1998).84 Real exchange rate appreciation in 1996 and 1997 also contributed to higher imports. High investment activity influenced the structure of imports, as evidenced by the increasing share of machinery in total imports from less than 30 percent in the 1993–95 period, to more than 35 percent in the 1996–98 period. In addition, higher imports were driven by autonomous components arising from greater consumer demand for product variety and the higher quality of foreign consumer goods, which had to be imported in the absence of production in importcompeting industries.

Investment related concerns

151. The investment that took place has been inward-looking in the sense that the tradable goods sector has not been the recipient of most investment activity. The manufacturing sector received only about 20 percent of total investment in the period 1994–98 (Table IV-5). At the same time, this sector accounted for almost 90 percent of total exports, while its share in GDP was about 25 percent in the period 1994–98. By contrast, recorded investment in nonmarket services (which includes government services such as public administration and defense) grew from 13 percent in 1994 to about 18 percent of total investment in 1998, while its share in GDP was only 13 percent in 1998.

Table IV-5.

Slovak Republic: Investment by Sector

(In percent of total investment)

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Sources: Slovak authorities; and staff estimates.

152. Slovakia’s export potential has benefited only modestly from foreign direct investment (FDI) in existing enterprises. With a highly educated and skilled labor force, and relatively low wages, privatization of Slovak companies could have attracted significant amounts of FDI had the government’s privatization policy not discriminated against foreign investors in favor of domestic managerial groups. As a result, FDI in Slovakia has so far been much lower than in other central European countries (see Table IV-3). For example, at the end of 1998, cumulative FDI on a per capita basis was only US$340, or about seven times less than in Hungary. This has prevented Slovakia from strengthening its export potential through larger capital injections from abroad, along with better management and technological know-how. Moreover, poor transparency of the privatization process, absence of legal protection for the rights of investors, weak market regulations, and reports of “cronyism” deprived Slovakia of all but a trickle of portfolio investment and deterred development of a well-functioning capital market.

153. Finally, the quality (and possibly the measurement) of investment in Slovakia was adversely affected by the peculiar incentives under the privatization program. Under the privatization scheme, investors were allowed to reduce their payments to the National Property Fund (NPF) for the acquired companies if these companies invested in fixed assets. Such incentives reduced the efficiency of investment, as the cost of investment was often effectively borne by the NPF. Moreover, since investments that could fall under this scheme were often not precisely specified, strict enforcement was made difficult. Therefore, it is possible that the total investment figures overestimate the underlying productive investment. Indeed, anecdotal evidence suggests that personal cars of company managers were claimed to be new fixed investment. Further, under pressure from the former government, the state banks often provided loans to sustain investment in inefficient enterprises; it is reported that in so doing, investments may have been diverted away from the most productive enterprises.

Implications of the large and persistent current account deficits

154. Foreign borrowing has been the main source of financing for Slovakia’s current account deficit, which has resulted in a rapid debt buildup. Gross external debt rose from only 22 percent of GDP in 1995 to almost 60 percent of GDP in 1998, the highest level among the transition economies in the region (Tables IV-3 and IV-6).85 Moreover, some 40 percent of the debt is short-term, which increases Slovakia’s vulnerability to crisis. The hefty foreign borrowings have imposed pressures on the cash flows of enterprises as their debt-servicing costs more than doubled from 1994 to 1996. Further, the high level of foreign debt has also made Slovak enterprises vulnerable to the depreciation of the koruna, as evidenced, for example, by reports of large losses and cash-flow problems in the last half of 1998.

155. The persistent current account imbalances have been a factor that has gradually made foreign borrowing more expensive and difficult for Slovakia. In downgrading Slovakia’s sovereign debt to below investment grade in the last 12 months or so, major credit rating agencies noted external (as well as internal) imbalances. In addition, the default on a US$35 million loan payment by VSZ in November 1998 appeared to signal problems underlying Slovakia’s enterprises.86 The Russian crisis in August 1998 also caused foreign investors to become even more cautious. With all these factors making it more difficult to attract foreign funds, large current account deficits became even more of a problem.

156. The country also exhibits additional economic vulnerabilities, which can further aggravate risks caused by the large current account deficits. The weak banking and enterprise sectors, relatively low reserves compared with other transition economies in the region, and the large stock of both short-term external debt and broad money relative to official reserves could further discourage foreign capital inflows, thereby compounding Slovakia’s financing problems.87 However, even if the country were able to borrow abroad at spreads near their levels prior to the debt downgrade, the debt dynamics would still have to be reversed in order to bring the debt ratios to sustainable and stable levels.

C. Sustainability of the External Current Account

157. This section presents results of a simulation exercise on current account and debt sustainability that was carried out to demonstrate the medium- and long-term implications of Slovakia’s current account deficits continuing at their recent levels. Current account deficits in the simulation period are assumed to be almost completely financed by foreign borrowing, as nondebt-creating flows in the absence of adjustment would likely remain at low levels. The country would have to pay interest rates much above benchmark rates, because of the inherent and perceived risks by lenders. As a result, as Table IV-7 indicates, debt servicing would begin to use up about one quarter of the export earnings by 2005; and the ratio of debt to GDP would clearly reach unsustainable levels. Thus, such debt dynamics would have to be reversed, either by policy measures, or because financing would become unavailable. Indeed, if external financing under such vulnerable economic conditions were to dry up, the country would need to run a current account surplus, which would likely be accompanied by harsh economic and social consequences.

Table IV-6.

Slovak Republic: Capital Flows and Debt Indicators

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Sources: National Bank of Slovakia; and staff estimates.

Includes the effects of so-called “window dressing” operations in 1997 and 1998, to the tune of about US$2 billion, undertaken in response to the NBS’ monetary regulation on banks’ net foreign asset positions (now abolished), which led commercial banks to increase both short-term external assets and liabilities.

Includes a small percentage of municipalities’ debt, which is not itemized.

Table IV-7.

Slovak Republic: Different Scenarios on Debt Sustainability

(In percent of GDP, unless otherwise specified)

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Source: Staff estimates.

158. To reverse the debt dynamics—which would also help to attract greater non-debt-creating inflows—the external current account deficit would need to be reduced substantially from its current level. In the adjustment scenario shown in Table IV-7, net interest payments fall rapidly, the debt ratios decline, and the external current account deficit falls to about 2½ percent of GDP in the year 2000, and declines further thereafter, to a level that could easily be financed by non-debt-creating sources. As a result, the debt-to-GDP ratio would be reduced to about 38 percent of GDP by the year 2005. With declining interest costs, additional resources would be released for productive uses, helping to achieve faster and more sustainable economic growth. Further, structural improvements in the enterprise and banking sectors, benefiting also from higher FDI, would lead to more efficient production and higher profitability, which in turn is reflected in improved external competitiveness. The required reduction in the current account deficit would also benefit from macreoeconomic adjustment, led by continued fiscal consolidation and a restrained wage policy.

D. Concluding Remarks

159. Significant actions must be taken to reduce Slovakia’s external current account deficit from its high levels of the past three years. Such an adjustment effort is all the more important in circumstances in which external financing prospects have worsened, and the past investments that helped to generate the external imbalances may not have contributed to enhancing the future performance of the tradable goods sector in a significant enough way. Without such an effort, the external current account deficit and the unfavorable debt dynamics associated with it would clearly leave Slovakia in a very vulnerable position.

160. Thankfully, concerns about this vulnerability have diminished. The recovery of exports in 1998 and the recent gains in external competitiveness are welcome. The government’s intention to reduce significantly the deficit of the general government in 1999, continue with fiscal consolidation in later years, and accelerate structural reforms will, when fulfilled, be important ingredients in bringing the external current account and associated debt dynamics to sustainable levels. All this will help lay the basis for durable economic growth.

APPENDIX

Table A1.

Slovak Republic: Gross Domestic Product - Current Prices

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Sources: Slovak Statistical Office; and staff estimates.

Adjusted for exceptional military imports.

Table A2.

Slovak Republic: Gross Domestic Product - Constant Prices

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Sources: Slovak Statistical Office; and staff’ estimates.

Adjusted for exceptional military imports.

Table A3.

Slovak Republic: Gross Domestic Product by Sectors, Constant Prices

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Sources: Slovak Statistical Office; and staff estimates.

Imputed banking services charges, indirect taxes, and own supplies.

Table A4.

Slovak Republic: Gross Domestic Product by Sectors, Current Prices

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Sources: Slovak Statistical Office; and staff estimates.

Imputed banking services charges, indirect taxes, and own supplies.

Table A5.

Slovak Republic: Investment by Sector

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Source: Statistical Office of the Slovak Republic.

Preliminary data.

Table A6.

Slovak Republic: Employment by Sector

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Sources: Slovak Statistical Office; and staff estimates.

Average number of people, including persons employed by entrpreneurs and entrpreneurs themselves, less women on maternity leave, apprentices and armed forces.

In 1997, for enterprises with 20 or more employees.

Until 1996, for enterprises up to 24 employees.

Estimate.