Country Report Slovakia
Economic growth in Slovakia decelerated from 3.2% in 2011 to 2.2% in 2012. Strong foreign demand for Slovak cars and foreign direct investment, the latter primarily by foreign car producers, were the main drivers of growth. Although the dominance of the car industry has boosted growth in recent years, it also causes a risk, as it results in a low level of diversification of the economy. Internal demand remained weak in 2012, due to austerity measures and a high unemployment rate. For 2013, we expect economic growth to decelerated further to roughly 1%, as foreign direct investment and foreign demand for cars will boost growth less than in previous years. Furthermore, additional austerity measures have become active in 2013. The latter signals that prime minister Fico is willing to bring down the budget deficit, which has come somewhat as a surprise, as the deficit rose sharply during Fico’s previous term in office. Finally, the banking sector is strong and well capitalized. There is however a chance that in case parent banks in Austria and Italy run into problems, Slovak banks will lose a safety line, which may lead to higher funding costs.
Introduction and update
While economic growth in Slovakia decelerated from 3.2% in 2011 to 2.2% in 2012, Slovakia still outperformed most of its neighbors. Figure 1 clearly shows that net exports was the main driver of economic growth, as internal demand remained weak. The positive contribution of net exports was related to the good performance of the important car industry. Also for 2013, we expect economic growth to be externally driven, although the contribution of net exports will be lower. The latter is caused by the fact that foreign car companies will not invest in a further expansion of the car production capacity and an increase in foreign demand for Slovak produced cars is also not expected. Internal demand will remain weak, due to a high unemployment rate (figure 2), relatively low wealth levels and additional austerity measures. The government led by prime-minister Robert Fico has implemented austerity measures to lower the budget deficit, which stood at 4.4% of GDP in 2012. All in all, we expect the economy to grow by roughly 1% this year.
New government, but a familiar face
After spending less than two years in opposition, Robert Fico became in April 2012 for the second time prime-minister of Slovakia. His center-left party, Smer-SD, gained 83 seats in the 150-member parliament at the elections held in March 2012. Thus, Smer-SD became the first party since the breakup of Czechoslovakia to win an absolute majority. This was seen as a mixed blessing. On the one hand, a one-party government could enhance political stability and increase the government’s effectiveness in battling the country’s economic woes.
However, at the same time, it was feared that Fico would repeat the anti-austerity and anti-business policies of his first term. The opposition criticized both the crisis measures Fico intended to implement and Fico’s fiscal policies during his first time in office. Then, the budget deficit worsened to 8% of GDP in 2009. Although we should keep in mind that the economy contracted that year by 4.9% due to the global financial crisis, we note that Slovakia already had a budget deficit in the boom years that preceded the crisis. Fico’s anti-business stance during his first term is clearly illustrated by the introduction of the Strategic Enterprises Law in 2009. This law gave the government the power to acquire companies in financial difficulties as long as these companies considerable influence on a specific "strategic" region or industry. The law was in force only until the end of 2010, but triggered strong criticism from both investors and opposition parties.
The relative good economic growth figures for 2012 (+2.2%) have not enabled the government to bring down its budget deficit considerably, as the deficit fell only from 4.9% in 2011 to 4.4% of GDP in 2012. This was mainly the result of lower than expected tax revenues, as domestic demand was weak. However, fears that Fico would ‘repeat’ the anti-austerity policies of his first term turned out partly unfounded, as Fico introduced new austerity measures in 2013 to reach the 3% of GDP budget deficit target set by the Excessive Deficit Procedure of the European Union. However, it remains questionable whether the government will meets this target. The implemented austerity measures include among others an increase of the corporate income tax rate to 23% and of the income tax rate for individuals earning more than EUR 3,300 a month to 25%. Thus, the Smer-SD made an end of the flat tax system that had been in place since January 2004, when Slovakia set most taxes at 19%.
The government also implemented a new pension law, which reallocates the contribution to the first (pay-as-you-go-system) and second (mandatory funded private system) pillar. Until September 2012, people contributed 9% of their wage to both the first and the second pillar. From now on, 14% of the wage will go to the first pillar and 4% to the second. In the short run, this will have a positive effect on government finances, as it increases revenues by EUR 500 million. In the long run, it will probably worsen government finances, as due to the aging of the population more people will lay a claim on pension benefits. Besides, the retirement age was raised to 62 years. Before, women retired at 57 and men at 60. Furthermore, the retirement age is now linked to life expectancy, which means the retirement age is expected to increase by 50 days per year.
Figure 3: Public finances
Source: EIU, IMF, EC
The government also introduced a new labor market law, which is meant to strengthen the position of both employees and the labor unions. However, critics argue that the new law will make the labor market more rigid, which could have a negative impact on employment. Unemployment was 12.8% in 2012 and was thus already relatively high. Finally, the government introduced a bank tax (see last paragraph).
Dependence on car manufacturing
Slovakia has a very open economy, with exports and imports accounting for 98% and 94% of GDP respectively. However, Slovakia’s exports are not very well diversified, as cars made up around 30% of total exports in 2012 (up from 20% in 2011). Total car production capacity was enlarged by roughly 30% in 2012 thanks to investments by Kia. Slovakia’s dependence on the car industry is also illustrated by figure 4. In 2012 Slovakia produced 167 cars per 1,000 inhabitants, while only 14 cars per 1,000 inhabitants were sold on the domestic market.
In the last three years, Slovakia has benefitted from the strong performance of the car industry. Additional demand could be attributed to the car scrappage schemes in some European countries, but also to the launch of Volkswagens Up (which is produced in Slovakia). Production rose from 639,763 in 2011 to around 900,000 in 2012. This large increase had a positive effect on net exports, which stimulated economic growth. Car production is expected to remain flat, as it is unlikely that external demand for cars will rise further and no new production facilities will be opened.
As a result, car production will be much less important as a driver of growth, but the sector is likely to continue to contribute to Slovakia’s trade and current account surpluses. However, the openness of the economy and the low level of export diversification make Slovakia vulnerable to a strong fall in demand for cars.
The recent Cyprus bailout has led to renewed attention for weaknesses in banking systems. Slovak banks are generally strong and well-capitalized. Non-performing loan ratio’s for both households and corporations in Slovakia remained at moderate levels in the first six months of 2012. There are thereby large differences between sectors (figure 6). Halfway 2012 the non-performing loan ratio for households stood at 4.25%, down from 4.63% in December 2011, but seems to have increased in the second part of 2012. The corporate non-performing loan ratio fluctuated around 8% during the first six months of 2012. Exposure to Southern European countries, Slovenia and Hungary is rather limited, as Slovak banks had invested only 1.4% of their assets in these countries by mid-2012.
Figure 6: Bad loans per sector
Slovak banks are for 99% owned by foreign banks, mostly Austrian and Italian banks. Positive in this respect is that the Slovak banks have an extra safety line in case their financial position weakens. This may lower the chance that the Slovak government has to step in. Foreign ownership also results in some risks. In case the mother bank runs into trouble, two risks may materialize. First, the mother banks may withdraw money from its Slovak subsidiary. We consider the risk that this will happen as low, as regulators are likely to step in to stop the outflow of money. Second, in case the subsidiary relies strongly on the guarantees provided by the mother bank, the funding costs may rise due to the problems of the mother bank, which will at least have a negative impact on the profit margins. The chance that Slovak banks will run into difficulties are slim, as they are well capitalized themselves. However, in case mother banks of Slovak subsidiaries run into trouble, the impact of the problems of mother banks on Slovak banks should be monitored.
As we already mentioned, a bank tax was implemented. A tax on corporate deposits of 0.2% was introduced on January 2012 by the previous government. Per October 1st 2012, the tax base was extended to retail deposits, while the rate was raised to 0.4%. The tax has been imposed to finance a fund to cover the costs of a bail-out, in case one of the banks runs into trouble. When the fund has raised 500 million Euro’s, the tax rate will be halved and the tax will be abolished when 1 billion Euro’s has been collected. According to the Central Bank the profitability of the banking sector has fallen due to the levy.It is well possible that due to the tax hike interest rates will rise and/or the supply of loans will be restricted, which could hamper economic growth.