The Slovak authorities appreciate the candid and useful discussions with the IMF team during the 2015 Article IV Consultation meetings. The staff report and the informative Selected Issues paper cover well the developments of and the outlook for the Slovak economy, and provide a fair picture of the policy challenges facing the authorities.

Overview

The Slovak economy has been performing well in a weak external environment, comparing favorably with the Eurozone as well as the European Union. Following 2.5 percent growth in 2014, economic activity has been accelerating in the course of 2015, reaching 3.7 percent in the third quarter (y/y) with robust domestic demand, and most notably public investment providing key contributions. Public investment accelerated particularly with respect to the end of the availability of EU funds within the 2007-13 programming period.

A major positive development has been the continued improvement in major labor market indicators throughout 2015 as employment increased by 2.6 percent in the first three quarters and the unemployment rate declined to 11.3 percent in the third quarter against 12.9 percent a year ago. The stagnating overall price level (with a modest decline into negative territory in the second half of 2015) due primarily to declining energy prices helped push real wage growth to over 3 percent in the third quarter, supporting private consumption.

The 2016 state budget is based on the assumption of 3.1 percent growth of GDP to be driven by the acceleration of private consumption while export growth is expected to weaken reflecting the slow growth in the main trading partners. Inflation is expected to pick up only modestly to 0.9 percent. Both real wage and employment gains should positively contribute to consumption growth with a somewhat lower saving rate providing additional impulse. While an acceleration of investment in the private sector is expected in 2016 it will merely compensate for the lower public investment due to the base effect of 2015. The Ministry of Finance projects further increases of GDP growth to 3.6 percent in 2017 and 2018. The negative output gap, estimated at 0.8 percent in 2015, should decline to 0.4 percent in 2016 and be closed in 2017. The risks to the outlook primarily stem from the external environment.

Unlike in the staff report, the government’s GDP growth projections are conservative in the sense that they do not include the envisaged positive impact of the now confirmed investment of the fourth car manufacturer (Jaguar-Land Rover) which thus presents an upside risk to actual growth and should also lift potential growth currently estimated by the Ministry of Finance at 2.6 percent.

Fiscal Policy

The solid economic performance and the effectiveness of the measures aimed at tax revenue efficiency helped bringing tax revenues to above the budgeted levels in both 2014 and 2015.

However, higher revenues have not fully counter-balanced the increase in investment spending, healthcare outlays and the negative effect of the correction of EU funds in 2015. This is expected to result in an end-2015 general government deficit of 2.7 percent of GDP, slightly higher than the budgeted 2.5 percent of GDP.

The Slovak government remains committed to fiscal consolidation to ensure the sustainability of public finances. The path envisaged under the approved 2016-18 general government budget targeting the gradual reduction of the headline deficit to 1.9 percent of GDP in 2016, to 0.4 percent in 2017 and to zero in 2018, is ambitious but feasible. It is also in line with Slovakia’s EU commitments and the domestic fiscal responsibility act. The structural deficit should decline from 2.1 percent in 2015 to no more than 0.5 percent of GDP in 2017, thus meeting Slovakia’s medium-term objective (MTO). General government debt is expected to gradually decline from 52.8 percent of GDP at the end of 2014 to 48.9 percent of GDP in 2018. The envisaged adjustment relies primarily on the spending side, with intermediate consumption accounting for the bulk of the adjustment. The ongoing “ESO” reform, seeking more efficient public administration and the improvement in public procurement should be the key sources of the savings.

The authorities are aware that credible fiscal adjustment is essential for maintaining a high credit rating and favorable market financing terms and for preventing the materialization of the risk linked to the high share of non-resident holdings of Slovak government debt. At the same time, the authorities have been pursuing policies towards economic and social goals in line with the program manifesto and the National Reform Program. The measures included in several “social packages”, including the reduction of the VAT from 20 to 10 percent on selected staple foods in effect since January 1, aim at spreading the benefits of solid economic performance particularly to the lower-income groups and lagging regions. In addition, measures such as higher day care allowances or investments in public day care capacities are also expected to support female labor market participation.

The government is committed to the continued improvement of tax collection efficiency and tax compliance as a key source of additional revenue. The authorities appreciate the very useful technical assistance provided by the FAD in 2012 on the assessment on the VAT Gap and the design of the action plan of 50 measures to mitigate tax evasion, particularly in VAT, by strengthening prevention and control, and stricter penalties. Recognizing the developing nature of tax fraud the government approved in 2015 the amended action plan with further 30 measures. With a substantial segment of fraud linked to cross-border activities the authorities recognize the need for the effective frameworks for international cooperation and exchange of information. Besides revenue collection, tax policy measures also aim at improving the business environment, e.g. introduction of a reverse charge for VAT payments in construction (liability of the buyer rather than the seller for the VAT) or the cash accounting scheme (VAT payment liability upon receipt of payment rather than at the time of invoice issuance) for small enterprises; and shortening of VAT refund periods. The government is also committed to improving the quality of spending by introducing the comprehensive and regular expenditure reviews to promote a value-for-money concept across all budgetary chapters. The pilot expenditure reviews have been launched, also with the support from the FAD for the Ministry of Education and the Ministry of Finance.

Financial Sector

The Slovak banking sector remains healthy and resilient to potential stresses, with solid levels of key indicators regarding capital, liquidity, asset quality and profitability.

At the same time, the authorities are aware of the developments that could create vulnerabilities, particularly with respect to the continued strong growth of household credit (over 13 percent in the first three quarters of 2015). After a three-year stagnation, corporate credit started to pick up modestly in mid-2015.

The National Bank of Slovakia (NBS), as the banks’ regulator and supervisor in the framework of the Single Supervisory Mechanism (SSM), regards the existing prudential rules, including the recommendations guiding the maximum loan-to-value (LTV) levels on new housing loans, limits on new loans with very long maturity, and stress-testing the housing loan portfolios to an increase in interest rates and the deterioration of macroeconomic situation, as sufficient at the current juncture. In addition, the recently adopted act on housing loans which will come into effect in March 2016 tightens lending standards, mandating the banks to assess the borrowers’ repayment capacity including at the time of significant loan top-up, disregarding the value of collateral. However, the NBS intends sending a stronger signal to the market by incorporating the recommendations into binding legislation and possibly tightening the prudential limits in 2016 should the strong growth continue. In addition, such legislation would also enable the introduction of debt-to-income (DTI) limits if needed. The NBS also recognizes the rising need for an increase of the counter-cyclical capital buffer from its current zero level, particularly if corporate credit growth shows signs of excessive growth as well.

Despite the adverse impact on the protracted period of low interest rates on insurance companies the sector remains relatively stable. The NBS currently does not see the need for macroprudential measures for insurance companies at this juncture, but stresses the importance of their prudent behavior, particularly with respect to payment of dividends in cases of weakening solvency.

Structural Issues

Despite the improvement in headline labor market indicators the Slovak authorities consider the significant structural challenges as well described in the staff report, particularly the high long-term and youth unemployment rates as well as the low labor participation of women. A set of measures has been adopted to improve incentives on both the demand and supply side of the labor market including a health contribution allowance for low-income workers, subsidies for the creation of jobs for the youth or re-training programs. The recent internal staff reallocation in labor offices has led to the improved ratio of clients to the contact point employees. The government is planning to comprehensively assess the efficiency of the all active labor market policies to further improve the system. The dual education scheme, aiming at better matching vocational education with the needs of businesses, has been off to a good start and the participation of businesses and students is expected to gradually increase.

Recognizing that private sector investment and economic activity are central to employment creation, the Slovak authorities put strong emphasis on the further enhancement in transport infrastructure, particularly the completion of the motorway and expressway network, improvement in the business environment, including by lowering the administration burden on entrepreneurs, as well as support to start-ups and research activities.