Commission Report 2002 (Slovakia)

The existence of a functioning market economy

A relatively broad-based coalition government largely maintained political consensus on macroeconomic stabilisation and structural reforms throughout its four years in office. The government steered a steady reform course, although political considerations occasionally caused some reform deceleration. The government managed to bolster its economic policy efforts by agreements with international financial institutions, in particular a Staff Monitored Programme with the International Monetary Fund and an Enterprise and Financial Sector Adjustment Loan with the World Bank. Important commitments have also been made in the Pre-Accession Economic Programme (PEP) submitted to the Commission in 2001 and updated in 2002. It reflects good progress in institutional capacity building. Nevertheless, the methodology and co-ordination for budgeting and medium-term fiscal planning need to be further advanced, as intended by the government.

Real GDP growth has steadily been accelerating after the government's stabilisation policy had caused a temporary slowdown. By 1997-1998, the relatively fast growing Slovak economy had run into unsustainable external imbalances, which had predominantly been caused by delays in structural reforms, a sizeable but largely unproductive increase in investment spending and by unsustainable fiscal expansion. This led the government to complement the already tight monetary policy with a fiscal stabilisation package. The restrictive effect of this policy mix was alleviated by strong external demand but still induced a growth slowdown to 1.3% in 1999. Since then, GDP growth has been accelerating and reached 3.3% in 2001. The external contribution to growth became negative and was replaced by a broad-based revival of domestic demand. Real fixed investment grew by 9.6%, spurred by increased profitability and a reduced corporate income tax rate. Private consumption expanded by 4% and was stimulated by an incipient employment increase, higher real wages, a personal income tax cut, and the redemption of privatisation bonds. Public consumption grew by 5.1%. In the first quarter of 2002, growth accelerated further to 3.9% and was predominantly driven by household and government consumption, which grew by more than 5%, whereas fixed investment had a slightly negative and external demand a small positive impact.

Starting from levels close to 10% of GDP, the current account deficit more than halved in 1999-2000, but doubled again in 2001. In the period from 1996 to 1998, the current account deficit had reached unsustainable levels of close to 10% of GDP. The following restrictive policy mix, coupled with strong external demand, more than halved the deficit to below 4% of GDP. However, in 2001, the current account deficit surged back up to 8.6% of GDP as a result of a strong revival of domestic demand and the concurrent slowdown in Slovakia's major export markets. Nevertheless, Slovakia can still easily finance its current account deficit and, in addition, has recently considerably increased its foreign currency reserves as a consequence of very high privatisation revenues from foreign direct investors. Moreover, at least in 2001, the current account deficit was to a considerable extent driven by an expansion of investment, which should be much more productive now than in the pre-1999 period - as suggested by several structural improvements discussed below. However, consumption has become stronger as well and is now dominating economic growth, with corresponding implications for the size and composition of imports and the sustainability of the current account deficit.

Unemployment has risen sharply over the reference period. Enterprise restructuring and the temporary economic slowdown caused unemployment to mount from 11.8% in 1997 to 19.4% in the first quarter of 2002 (labour force survey data). It has stayed at this high level in spite of accelerating growth as an array of structural shortcomings has been hampering the labour market's capacity to reabsorb the redundant workforce. Employment started to increase in 2001 (by 1%). In the first quarter of 2002, employment was 0.2% higher than in the same period of 2001.

Inflation has been reduced to the single-digit range again, with its hikes over the reference period being mainly caused by administered price adjustments. Primarily as a consequence of price deregulation, consumer price headline inflation rose from an annual average of around 6.5% in 1997-1998 to a peak of 12.3% in 2000. In 2001, it was reduced to an average 7.3% and in July 2002 it fell to a record low of 2.0% year-on-year. The low 2002 figures are due to a virtual halt in administered price adjustments. Although these adjustments are expected to resume in 2003, the National Bank of Slovakia should be in a good position to keep the inflation rate well below the two-digit level. Core inflation, which abstracts from changes in administered prices and indirect taxes, also reached a record low of 1.2% in June and July this year.

Slovakia abandoned its exchange rate peg in the face of exchange market pressure in 1998. Against the backdrop of Slovakia's macroeconomic imbalances, the pressure on Slovakia's exchange rate peg vis-à-vis a deutschmark/US dollar basket surged in August-September 1998 due to political uncertainties, the crisis in Russia, and the build-up of post-election devaluation expectations. The National Bank of Slovakia (NBS) floated the Slovak crown on 1 October 1998. This led to a sharp depreciation, which basically continued until mid-1999 and was partly reversed in the second half of that year. The exchange rate against the euro remained relatively stable during 2000 and 2001. The NBS has been limiting interventions to the moderation of rapid movements and to the smoothing of strong fluctuations. To this end, it resumed interventions this year for the first time since January 2001, as the Slovak crown started to show signs of weakening due to pre-election uncertainties and re-emerged economic imbalances. After it had strengthened since the beginning of 2002, the crown depreciated from around SKK 41.5 per euro in mid-April to lows of almost SKK 45 per euro in June and July but has appreciated again since.

Monetary policy has successively been geared towards inflation benchmarks. Since the exchange rate peg was abandoned, monetary policy has been using interest rates as its main operating instrument to pursue its inflation goals. Accompanying the government's fiscal stabilisation policy, interest rates were channelled down until March 2001 to 7.75% (repo rate). They were left unchanged until April this year, when the National Bank felt compelled to react to a lack of fiscal consolidation in the pre-election period and to increased external imbalances by an interest rate increase of half a percentage point. Real interest rates dropped over the reference period and were partly negative. With inflation low, they have been rising this year. In spite of lower interest rates, bank lending contracted in real terms during bank restructuring and privatisation and has only very recently started to recover. Given the status of financial market development and the important role of direct corporate foreign financing, the transmission of interest rate changes is still weak.

After the implementation of its stabilisation package, the government's fiscal stance has become increasingly expansionary again and now deviates from the consolidation path targeted in the pre-accession economic programme. Based on harmonised EU standards (ESA95), Slovakia notified a general government deficit for the years 1997 to 2001 which fluctuated between roughly 4.5% and 6.5% of GDP - except for the year 2000 when it spiked to 12.7% of GDP. For 2002, planned net borrowing amounts to 5.3% of GDP but includes one-off receipts of 0.5% of GDP from the sale of telecommunication licences. Starting in 1999, and in particular in 2000, the figures have been heavily influenced by the sequencing of the exceptional operations in connection with Slovakia's bank restructuring. Abstracting from bank restructuring costs and called-on guarantees (and on a GFS-basis), Slovakia had followed a restrictive fiscal stance and had reduced its general government deficit by roughly 1.5% of GDP between 1997 and 1999. Since 2001, the fiscal stance has become increasingly expansionary again, in spite of accelerating growth. In particular, the government has deviated from its PEP commitment for the general government deficit for 2002 and revised its deficit target upward by 1% of GDP, with a risk of a higher fiscal slippage remaining. In addition, the continuation of current policies would suggest a further deficit expansion in 2003. A reversal of these developments and a reduction of the fiscal pressure on the current account is contingent on decisive and rapid fiscal policy measures, including a more vigorous continuation of structural public expenditure reforms.

Government debt has substantially increased over recent years, mostly as a consequence of the bank restructuring operation. Government gross debt increased from 29.7% of GDP in 1997 to 44.1% of GDP in 2001. The government has largely excluded the use of privatisation revenues for current expenditure and committed itself to using the record privatisation revenues in 2002 for debt retirement and for financing the transition cost of the envisaged pension reform. Contingent liabilities in the form of government guarantees amount to roughly 15% of GDP.

Slovakia has started important structural public expenditure reforms, but the bulk of measures required to achieve fiscal sustainability still lie ahead. Important reform steps have been instituted in the health system but expenditure remains comparatively high and the sector is still far from being financially sound. Parametric reforms, such as relatively modest increases in the retirement age, have been initiated in the pay-as-you-go pension system but are not sufficient to brace it for the looming demographic pressures in the medium and long term. A decision on the introduction of a mandatory funded pension pillar has been taken and encompasses the use of substantial privatisation revenues for the financing of the transition costs. However, the legislation for the second pillar is not yet in place and many critical design questions remain open. Social assistance and benefits offer additional opportunities for savings without compromising their basic functions, in particular by improved targeting. In addition, the reform of education financing is not yet completed. Restrictions on the granting of subsidies and guarantees to enterprises still lack sufficient effectiveness. Considerable scope for savings also exists in connection with the civil service reform.

Tax reforms and tax reductions have been implemented but the strengthening of tax compliance has to continue. The corporate income tax rate has been reduced from 40% to 25% in two stages. The personal income tax rates have also been cut back and the number of tax brackets reduced. In addition, an import surcharge, which had been introduced temporarily in 1999, was phased out again in 2000. Reforms in tax administration have taken place but some elements, such as the implementation of a new organisational structure, have not yet been fully completed. Measures to reinforce tax compliance, in particular for VAT, are also needed. The government is creating the administrative infrastructure for the improved collection of social security contributions. The efforts to resolve tax and social contribution arrears need to be further strengthened.

Improvements in budgeting and public finance management have been introduced. The government has taken important steps to enhance the transparency and management of public finances, such as the abolition of almost all extra-budgetary funds; changes in the budgeting procedures and in budget classification; initial steps towards medium-term and programme budgeting; and towards the gradual build-up of a modern treasury system and a debt management agency. The measures are being implemented in the context of a phased fiscal decentralisation.

Although a more balanced policy mix had been reached in the stabilisation period of 1999-2000, monetary policy and tight credit conditions have been the main adjustment forces since, while fiscal policy has become more and more expansionary again. As mentioned above, monetary policy became increasingly tight during 1997-1998 but a narrowing of the unsustainable external deficits occurred only when fiscal policy became more restrictive and balanced the policy mix through the implementation of a stabilisation package in 1999-2000. In the meantime, fiscal policy has become expansionary again and has contributed to the re-emergence of external imbalances.

The free interplay of market forces has been strengthened. Several major price deregulation packages have successively been implemented since 1999, mainly in transport, energy, and housing. They enhanced cost recovery in these sectors. Administered prices rose by 38% in 1999, 21% in 2000, and 17% in 2001. The share of administered prices in the CPI now amounts to roughly one fifth. Among other measures, the liberalisation of the electricity and the gas market has begun and a Regulatory Office for Network Industries, responsible for gas, heating and electricity, started operations in October 2001.

The privatisation of non-financial public enterprises has substantially advanced. Since 1998, privatisation has avoided the deficiencies of the methods chosen in the earlier waves and has made significant further progress. As in the financial sector and in a clear break with the past, the government has been conducting its privatisation operations through transparent and competitive tenders. The major state-owned non-financial enterprises bequeathed to the new government were concentrated in the communication, utilities and transport sectors. In the meantime, most of these enterprises have been fully or at least partly privatised. The most prominent examples are the sale of a 51% stake in Slovak Telecom and of 49% stakes (with management rights) in the oil pipeline operator Transpetrol and the Slovak gas company to foreign strategic investors. The proceeds of the latter transaction amounted to around 12% of GDP. 49% stakes have also been sold in the three regional Slovak power distributors and in several bus transport companies. The private sector share in GDP now reaches around 85%. Most of the envisaged further privatisation projects are relatively small - except for the power producer Slovak Electricity, which has already been tendered and is scheduled to be privatised before the end of 2002, and the transport operating part of Slovak Railways.

The government has dismantled barriers to market entry and strengthened market exit rules, but effective implementation still needs to be reinforced. Steps have been taken to facilitate, streamline and shorten the market entry process for new enterprises, although there is scope for further progress. Financing for new entrants is still a constraint but should be facilitated by recently adopted collateral legislation, which includes pledges on moveable assets. On market exit, the government introduced a reform of the bankruptcy framework with a view to enhancing creditor rights, accelerating procedures, and making restructuring a more realistic option. Although these were significant steps, the creation of an adequate and operational rehabilitation and exit framework is not yet finished as, for example, highlighted by the lack of trustee and judicial implementation capacity.

The legal framework for a market economy has broadly been established, although the enforcement of legal rules needs further upgrading. The government has considerably progressed in instituting the legal rules for a market economy. However, the capacity to enforce these rules lags behind. The most constraining factor is the judicial system, which needs substantial further reform. It still suffers from numerous problems, in particular a lack of human and technological resources, of managerial efficiency and of insulation against corruption.

The restructuring and privatisation of the Slovak banking sector has basically been completed. The government restructured its three largest state-owned banks (with a combined asset share of almost 50%) by injecting capital (around 2% of GDP) and carving out bad loans (around 12 % of GDP) in 1999-2000. In the course of 2001, it successfully privatised them to foreign direct investors. State-owned small and mediumsized banks have also been almost completely privatised and some insolvent small and medium-sized institutions have exited. The share of foreign-owned banks in total bank assets exceeds now 90%. The state-owned work-out institutions, to which the bad loans had been transferred, were merged this year, with the Slovak Consolidation Agency now being the only collection agency. The debt work-out is being conducted through different market-based methods and the agency is currently looking for a foreign joint venture partner to bring in additional expertise.

The banking sector is now much better placed for expansion and the fulfilment of its intermediation role. Without the bad loans transferred to work-out institutions in the course of bank restructuring, domestic credit to the private sector stood at 35% of GDP at end-2001, while deposits amounted to 62% of GDP. Bank restructuring and privatisation were accompanied by credit contraction in real terms, but recent developments suggest that lending activity to companies and households is picking up. The potential for expansion is large and will be encouraged by improvements in the legal operating environment. It will be based on the considerably enhanced stability of the sector. The aggregate capital-adequacy ratio based on Slovak accounting standards, for example, was almost 20% at end-2001 in comparison with less than 1% before bank restructuring (June 1999). Similarly, the ratio of non-performing loans to total loans dropped from almost 40% before bank restructuring to roughly 13%. Profitability remains low. The widespread presence of foreign direct investors is likely to enhance competition and efficiency and to improve corporate governance and risk management, including of the indirect risk arising from corporate customers with high foreign currency debt.

The intermediation role of the non-bank financial sector remains minor, although steps have been taken to facilitate its development. The government has strengthened the legislative framework for securities markets so as to achieve, inter alia, better protection of shareholder rights. A new securities law and commercial code have been adopted. Nevertheless, both capitalisation of and activity in securities markets remain very low. The bond market is dominated by government paper. A substantial reform of the framework for debt issuance and management and of the domestic debt market is still outstanding. In the insurance sector, the state-owned Slovak Insurance Company, with a market share of close to 50%, was sold to a foreign investor. Institutional investors invest mostly in bank deposits and government paper. Implementation of the envisaged pension reform and the ongoing growth of the insurance sector could help to enlarge the institutional investor base and to foster financial sector development.

The legal basis for financial sector regulation and supervision has been substantially enhanced but the upgrading of the implementation capacity to international standards has only recently gained momentum. Important legal improvements were, for example: the amendments to the NBS law and the Slovak constitution, which strengthened the power and accountability of the NBS banking supervision department; the introduction of a new banking law; a new securities act; a new insurance act; and the legislation underlying the creation of the new Financial Market Authority. However, many legal improvements have not yet been matched by satisfactory implementation, including in the area of accounting standards and auditing. Sufficient regulatory and supervisory implementation capacity is a pre-condition for keeping pace with the quantitative and qualitative expansion of an increasingly competitive and potentially more risk-inclined financial sector. The implementation of measures to create adequate banking supervisory capacity has recently gained strong momentum. Concerning non-bank financial institutions, the legal basis for their new supervisor, the Financial Markets Authority, has just been reformed and the agency's operational capacity is not yet fully established. A strategy for better co-ordination and for unification of financial market supervision within the NBS by 2005 is being drawn up and gradually implemented.

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