INTERNATIONAL MONETARY FUND

Slovak Republic—Staff Visit
Concluding Statement, May 27, 2004

1.     	Slovakia’s accession to the European Union (EU) took place amidst promising economic prospects. Despite an adverse external environment, output has continued to expand strongly and exports have shown remarkable vigor. These positive developments reflect a number of factors—a strong competitive position vis-à-vis western Europe and neighboring countries, the coming on-stream of past (mainly foreign) direct investments, skillful macroeconomic management, and improvements in the business climate reflecting the privatization of public enterprises, a strengthened legal framework, and labor market reform. Building on these successes to sustain growth will be essential to the job creation that is needed. 
2.     	EU membership provides additional impetus to deal with the economic challenges ahead. Slovakia can only benefit from staying the course with bold policies that have served it so well. The main challenge now is to pursue a policy mix that will lead to a sustainable fiscal position and disinflation—both needed for durable growth and investment, but also required for a successful experience in ERM2 and the euro area. Such a policy together with the completion of the unfinished structural reform agenda—particularly in the areas of health care, education, legal framework, and devolution of fiscal responsibilities—would reinforce good economic prospects and confirm Slovakia as one of the most promising new members of the European Union. To succeed in these challenges, the government will need to show the same determination on the pending reforms as it has shown to date in implementing its ambitious agenda to stabilize and reform the economy.
The Macroeconomic Outlook
3.     	The outlook remains for strong macroeconomic performance in 2004, with the composition of growth shifting gradually to domestic sources. Growth of 4.2 percent in 2003 was driven by good performance of the export sector, which offset a significant decline in domestic demand. Fiscal tightening (especially indirect tax and administered price increases) and the associated fall in real wages dampened private sector consumption; and fixed investment, which had grown strongly in the past, declined modestly. Signs of a turnaround in domestic demand have emerged in the first few months of this year, and with an improving outlook for Europe as well, we project growth of about 4 percent in 2004. Consumption is expected to recover, supported by higher disposable income, and investment should also pick up in an increasingly favorable business environment. Underlying inflationary pressures have been mostly absent and should remain contained on present expectations of restraint in wage settlements and still-high unemployment. We project core inflation at just under 3 percent this year. After a much larger than expected narrowing in the external current account deficit in 2003, the deficit is expected to widen slightly to just over 2 percent of GDP this year, well within sustainable levels. Risks to this outlook are balanced. On the upside, domestic demand may be stronger than projected reflecting higher disposable income. On the other hand, a more restrained recovery in the EU and delays in large export-oriented investment projects would dampen growth through their effect on exports.  
4.     	The positive underlying trends of this year should continue in the period ahead. Consumption growth should be boosted by employment creation in the fast-growing and most productive sectors of economy, and increasing real wages. Recent FDI decisions and a sustained favorable business environment (including the tax reform) should provide the basis for further increases in productivity and rates of growth of over 5 percent in the medium term. Continued fiscal consolidation is needed in the coming years to make room for higher private investment and also maintain the external current account deficit within sustainable bounds. 
Fiscal Policy
5.     	The 2004 budget target is well within reach, with favorable prospects for overperformance. The budgeted deficit (4 percent of GDP) would represent some expansion from last year’s outcome of 3½ percent of GDP, which was justifiable in light of the observed cyclical weakness of domestic demand and the stronger than expected external current account performance in 2003. Moreover, two additional considerations would validate the current fiscal stance: (i) the overperformance in 2003 (1½ percentage points of GDP) was largely due to transitory factors, while the permanent elements—in particular, the curbing of spending in the health sector and savings from measures to reduce abuse of social benefits—have been appropriately reflected in this year’s budget; and (ii) the need to accommodate the fiscal impact of EU accession. Fiscal developments so far this year have  been positive, assisted by the change in trend on domestic demand; and we project that the general government deficit target should be met with a comfortable margin, assuming no new unbudgeted expenditures. In our view, the government should take advantage of the opportunity to speed up the pace of fiscal consolidation—especially in light of the robust economic expansion—and allow some room for dealing with remaining risks surrounding the full impact of the tax reform which will not be known until early next year. Thus, we recommend that the government use any revenue overperformance for reducing the deficit rather than increasing expenditure.
6.     	The draft 2005-07 budget framework represents a decisive and welcome step toward further fiscal consolidation. The preparation for the first time of a three-year budget framework should give a higher degree of predictability to fiscal policy, strengthen its credibility, and promote macroeconomic stability. We believe that the framework is also an effective vehicle to bring together a critical mass of reforms envisaged by the government or already underway. The welfare reform to rationalize benefits and improve incentives for job search and employment creation contributes to the envisaged restructuring of expenditure. Continued health sector reform and the planned pension reform are also essential for medium- and long-term fiscal sustainability. Although the projected reduction of the deficit is fairly gradual (3 percent of GDP by 2007), it represents a considerable effort, particularly in light of the adverse near-term fiscal effect from the pension reform.  
7.     	Revenue projections are realistic, but achieving the deficit targets will require the full implementation of difficult envisaged expenditure policies. Compared to the projected outcome for 2004, the approved three-year budget framework implies a reduction of 1 percentage point of GDP in revenues to 36½ percent of GDP in 2007, primarily reflecting revenue losses from the first pillar of the pension system, as pension reform takes effect. In our view, tax revenues have been projected realistically, with some upside risks on value-added tax collections. The budget framework also envisages a reduction of 1½ percentage points of GDP in expenditure to 39½ percent of GDP in 2007. Savings will hinge on strict restraint of the public sector wage bill, and relatedly, measures to continue streamlining public sector employment, especially in the education sector. Adherence to the indexation of state benefits as envisaged in the budget framework will also be important.
8.     	Beyond 2007, the mission believes that a considerably smaller deficit would be a prudent medium-term goal, including in light of the authorities’ objective of early euro adoption. Slovakia’s Convergence Programme envisages achieving fiscal balance by 2010. Such a strengthening of the fiscal position would provide a cushion to allow automatic stabilizers to work during cyclical downturns, and help keep public debt at a moderate level. The authorities plan to adopt the euro by 2009. We believe that this timetable is ambitious but feasible, although first meeting the Maastricht fiscal deficit criterion with a safety margin would help minimize Slovakia’s vulnerabilities in ERM2.
9.     	Finally, the mission is heartened by the continued efforts to improve fiscal management and transparency. Besides the introduction of a three-year fiscal framework, we also welcome the strengthening of the analytical capabilities at the Ministry of Finance, the enhanced reporting of public debt information, and progress in introducing ESA-95 fiscal reporting. To strengthen fiscal discipline, an important feature of the new fiscal framework should be the introduction of three-year expenditure ceilings that would be submitted to parliament for approval. In particular, this would entail specifying sub-ceilings on the key components of public spending that need to be reined in, and identifying measures to underpin these medium-term efforts.
Monetary Policy
10.     	In a challenging policy environment, we believe that the present monetary policy stance is appropriate. The main policy interest rate is at 5 percent following the gradual reduction by 150 basis points since September 2003, in response to weak domestic demand and, more recently, significant short-term capital inflows, in a context of low core inflation. In our view the reduction in interest rates reflected appropriately the balance of risks facing the economy at the time, particularly the perceived poor prospects for domestic demand combined with koruna appreciation.
11.     	Going forward, the National Bank of Slovakia (NBS) should maintain a cautious approach. Although supply is likely to be increasing with recent and projected large investments, rising domestic demand could diminish the slack in some sectors of the economy and start exerting upward pressure on prices over the period ahead. On current trends, real disposable income is set to grow by about 3 percent this year and support the recovery in consumption, while investment is also expected to grow strongly. Unless the koruna further appreciates markedly (tightening monetary conditions), the NBS should avoid additional easing because the lagged effects from earlier interest rate reductions are still in the pipeline and are supportive of growth. 
12.     	If capital inflows turn out to be strong—and threaten competitiveness—any further monetary easing should be accompanied by further fiscal tightening. In this case, a tighter fiscal policy and wage moderation would be essential both to secure disinflation and to support external competitiveness. This reinforces the need to safeguard any fiscal overperformance this year—particularly if domestic demand recovers faster than expected. On wages, the government has already signaled restraint in the public sphere, and it is important to make every effort to adhere to this policy, which in turn could give a signal to wage settlements in the private sphere. The NBS could also play an important role by enhancing its communications to the public regarding guidance on inflation.
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We wish the authorities every success in their efforts. We also would like to express our sincere appreciation for the usual high quality of the discussions, the cooperation received, and the generous hospitality extended to us.