February 11, 2005

The Slovak authorities are grateful for the extensive consultations and discussions with the staff and for the well written and balanced Staff Report and the Selected Issues Papers.

Introduction

The continuation of consistent macroeconomic policies, supported by comprehensive structural reforms, has borne fruit. The fiscal deficit shrank from 5.7 percent of GDP in 2002 to 3.4 percent in 2003, while the external current account deficit fell from 8.0 percent of GDP to 0.9 percent during the same period.

A broad-based privatization program, a sharp reduction of government expenditure on subsidies and transfers, radical reforms to the pension and healthcare systems, and the adoption of a single tax rate for personal and corporate income taxes and VAT, earned Slovakia recognition as the World Bank’s “top reformer of the year” in 2004.

May 1, 2004 was the historic date on which Slovakia and other advanced transition countries joined the European Union. Accession took place during a period of strong economic growth largely resulting from prudent macroeconomic stabilization policies and a broad-based framework aimed at medium-term sustainability.

In December 2004, Standard and Poor’s upgraded Slovakia’s sovereign rating to A-, with a positive outlook. In January 2005, Moody’s upgraded Slovakia to A2.

Real Sector Development

Slovakia is one of the fastest growing economies in Central and Eastern Europe. The higher-than-expected growth of about 5.3 in 2004 was driven by strong domestic demand, higher wages, a vigorous export performance, and high nonprivatization FDI. The authorities’ medium-term projection for GDP growth is around 5 percent in the period 2005-2007.

Last year, the external current account deficit widened by more than 2 percentage points. This deterioration was due mainly to strong investment inflows and strong outflows of profits being repatriated to foreign companies operating in Slovakia. The authorities expect that in 2005, imports connected with the construction of Peugeot, Kia, Ford, and other greenfield investments will increase the external current account deficit to 5 percent of GDP, but this will be fully financed by FDI inflows. For 2006, the authorities project a current account deficit of about 4.5 percent of GDP. In 2007-2008, the current account deficit is expected to be less than 2 percent of GDP.

To make the economy more competitive, the authorities have adopted the Lisbon Strategy and will implement it through 2010. They are convinced that the only way to guarantee Slovakia’s long-term competitiveness is to create the structural conditions essential for developing a knowledge-based economy. In particular, the authorities intend to concentrate their efforts on four areas: improving education and human resources, ensuring that Slovak citizens develop information technology skills, ensuring the development of Slovakia’s scientific potential, and continuing to develop a business environment that promotes market competition.

Fiscal Policy

With a view to adopting the euro as soon as possible, the authorities succeeded in building support for their plans to meet the Maastricht criteria. A first step towards that goal was bringing the ESA-95 (European System of Accounts) general government deficit below 4 percent of GDP in 2004.

The overall fiscal deficit in 2004 turned out better than budgeted and is estimated at 3.8 percent of GDP. The authorities agreed with the staff that further consolidation will be needed. But given the election cycle, it will be difficult to reduce the deficit faster than the authorities already envisage in their Convergence Programme.

The update of this program covers the period 2004 to 2007 and provides indicative projections until 2010. The budget plans for 2005 and 2006, as specified in the three-year fiscal policy framework, are in line with the Convergence Programme. Based on this framework, the authorities target the general fiscal deficit for 2005 and 2006 to be 3.8 percent and 3.9 percent of GDP, respectively. The target for 2007 is to reduce the fiscal deficit to 3 percent of GDP reference value, which the European Council of Ministers supported in their statement of December 2004.

Monetary Policy

Slovakia’s strong competitive position vis-à-vis other EU members, strong capital inflows, and EU membership have caused the Slovak koruna to strengthen vis-à-vis the euro and the US dollar. In response, the National Bank of Slovakia (NBS) cut interest rates by a cumulative 250 basis points and intervened substantially in the foreign exchange markets in 2004. Nevertheless, the appreciation in 2004 exceeded 6 percent vis-à-vis the euro, which was much higher than the NBS’s expectation.

In 2004, headline inflation dropped to 5.9 percent and core inflation to 1.5 percent. This was significantly lower than the inflation in 2003, but still relatively high because of administered price increases toward cost-recovery levels and indirect taxes.

In December 2004, the National Bank of Slovakia approved the monetary program and the new monetary policy framework for 2005-2008. Within this framework, monetary policy will focus primarily on inflation, and the NBS has announced explicit inflation targets for 2005-2008. This conforms to the authorities’ strategy for euro adoption. The inflation targets are 3.5 percent within a ± 0.5 percent range for 2005, and below 2.5 percent for 2006, and below 2 percent thereafter.

Banking Sector

Slovakia’s banking sector has been successfully restructured and brought in line with EU and Basel requirements. The World Bank has supported an Enterprise and Financial Sector Adjustment Loan which has supported the re-capitalization and privatization of formerly state-owned banks, and the overhaul of the legal frameworks for banking, insurance and the securities market. Slovakia’s banking sector is now on a sound footing: it is profitable, the best capitalized banking sector in the region, and is almost fully owned by foreign partners.

To improve supervision in the financial sector as a whole, the authorities and the NBS have decided to integrate the Financial Markets Authority into NBS’s Banking Supervision Department in 2006.

Foreign Direct Investment

Overall, today’s stable macroeconomic framework, supported by strong and comprehensive structural reforms, an improved investment climate, in particular the tax reform, have created an environment attractive to foreign investors. This environment is now further strengthened by EU membership, which provides a powerful stimulus for private sector development. New greenfield investments, particularly in the automotive industry, will make Slovakia the largest per capita car producer in the world by 2007.

Reform Agenda

The ambitious reform agenda has been almost fully implemented within the first two years of this government’s term (the next election will take place in September 2006). The only item still outstanding is the reform of the education system, and the authorities expect that this part of the agenda will be discussed again in parliament within the next two or three weeks.

Tax Reforms

A comprehensive tax reform was introduced in 2004 to improve incentives for entrepreneurship and work by making the tax system more transparent and reducing distortions caused by exemptions and double taxation. The reform is based on a single flat rate of 19 percent for all personal and corporate incomes taxes and also for VAT. In addition, almost all tax exemptions have been eliminated, and the estate transfer, gift, and inheritance taxes have been abolished.

Social Protection

The Government has established a modern, cost-effective, and efficient social protection system. In particular, reforms in 2004 corrected the disincentives to work, while still providing needed assistance to poorer Slovaks. This includes a multi-pillar pension reform, improvements in the collection and administration of social contributions, and strengthening the institutional capacity of the Ministry of Labor, Social Affairs and the Family, and of the Social Insurance Agency and the National Labor Office.

Public Finance

The Public Finance reform has strengthened the institutional capacity for budgetary and financial management of government operations, and has improved the macro-economic analysis and forecasting capabilities of the Ministry of Finance. In addition, a Debt Management Agency and the State Treasury System have been established.

Pension Reform

The pension reform applicable from 2004 has enhanced the public pay-as-you-go (PAYG) balances by gradually increasing the statutory retirement age from the previous 60 years for men and 55 years for women to 62 for both genders. A fully-funded second pillar was introduced in January 2005.

Health Sector

A comprehensive health sector reform was launched to promote the sector’s fiscal sustainability while maintaining the quality of health care and increasing the capacity of the health sector.

Legal and Judicial Systems

All aspects of the legal and judicial systems and institutions have been assessed by the World Bank, and their strengths and weaknesses identified, and the Ministry of Justice has begun implementing the World Bank’s recommendations. Despite considerable progress in this area, weaknesses remain. The authorities are committed to addressing these weaknesses and strengthening the business, and legal environment.

Unemployment

The authorities agree with the staff that notwithstanding the amendment of the Labor Code reform in July 2003, unemployment is still a major concern. Unemployment is still relatively high, even by regional standards, although some improvement is visible.

With a view to reducing unemployment by improving labor mobility, the World Bank approved a Human Capital Technical Assistance Project for the Slovak Republic on January 25, 2005. This project will help the government to strengthen its ability to promote employment, education, and social cohesion by establishing an effective policy infrastructure to implement, manage, and evaluate reforms in the Ministry of Labor, Social Affairs and Family, and in the Ministry of Education. The authorities intend to address the issue of skills and regional mismatches pointed out by staff through improvements in the education system and infrastructure development that gives priority to the less-developed regions in the country.

Euro Adoption

In anticipation of euro adoption, the authorities approved an updated Convergence Programme in November 2004. It is expected that Slovakia will join ERM-II during the first half of 2006, and will adopt the euro in 2009. Moreover, the Ministry of Finance envisages having the general government finances in balance by 2010. The authorities are strongly committed to fulfilling all Maastricht criteria for euro adoption in a timely manner. This goal is also supported by the opposition parties.

Conclusion

The generally positive trend of recent economic developments and favorable outcomes of structural reforms, observed in the Slovak Republic since the last Article IV consultation (concluded in July 2003), would not have been possible without the broad-based technical assistance, useful advice, and strong support provided by both the Bretton Woods institutions. This does not mean that Slovakia considers reforms and adjustments it needs as being already complete. But the authorities are confident that they can complete the remaining part of their agenda: Reforming the education system, reducing unemployment, strengthening the judiciary and law enforcement, and improving the knowledge-based economy. And the main medium-term challenge for the Slovak Republic is still to fulfill all of the criteria for adoption of the euro.