DBRS Confirms Slovakia at A (high), Stable Trend

DBRS Ratings Limited (DBRS) confirmed the Slovak Republic’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). At the same time, DBRS confirmed the Slovak Republic’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The trends on all ratings are Stable.

KEY RATING CONSIDERATIONS

Slovakia’s A (high) ratings reflect its strong macroeconomic performance and deep integration with major Eurozone economies. Over the last decade, Slovakia has been among the top growth performers in the EU. Following a 3.4% expansion in 2017, growth is expected to remain strong in the medium-term, primarily led by private consumption and automobile exports. Slovakia also attracts high quality foreign investment and is an integral part of global supply chains.

Slovakia’s credit profile benefits from its track record of conservative fiscal management and low public debt. The government also expects the deficit to fall further from 0.8% of GDP in 2017 to 0.6% in 2018 enabling Slovakia to meet its medium-term budgetary objective of a balanced budget in 2020.

Despite these strengths, the ratings are constrained by relatively low productivity, regional disparities, and unfavorable demographics. While Slovakia has a healthy banking sector, DBRS is also monitoring the vulnerabilities related to rapid household credit growth. Nonetheless, the confirmation of the stable trend reflects DBRS’s assessment that risks to the ratings currently are broadly balanced.

RATING DRIVERS

DBRS views that the Slovak Republic is well placed in the A (high) rating category. Upward rating drivers include: (1) strong investment that enhances productivity; (2) progress in reducing regional disparities that increases potential growth; and (3) a reduction in the structural deficit combined with a steady decline in public debt, beyond our current expectations. Downward rating drivers include one or a combination of the following: (1) a deterioration in growth prospects contributing to a reversal of the declining fiscal deficit and public debt ratio trajectory; (2) signs that banking sector vulnerabilities are materially increasing due to a prolonged and significant rise in household credit growth; or (3) disruptive political developments severe enough to derail the economic and fiscal outlook.

RATING RATIONALE

Slovakia’s Strong Growth Momentum Benefits from EU Membership and Global Supply Chains

Slovakia’s ratings are underpinned by its solid macroeconomic performance. It has been among the top growth performers in the EU during the last decade, with growth averaging 3.7%, led by both consumption and investment. As a result, Slovakia’s economic convergence based on purchasing power has risen to 78% of the EU average. Following 3.4% growth in 2017, real GDP growth is expected to increase to 4% in 2018 and 4.2% in 2019. Current growth trends have been driven primarily by domestic demand. Consumption has been supported by rising employment, real wages, and favorable credit conditions. Slovakia is among the biggest beneficiaries of EU fund transfers, which has benefited public sector investments. Private sector investments have been supported by accommodative ECB policies and improving lending conditions. In addition, with Slovakia being a key hub for auto manufacturers - Volkswagen, Peugeot-Citroën, Kia and Jaguar Land Rover - growth is likely to be aided by a rise in exports driven by rising car production, both in new and upgraded facilities.

Slovakia’s EU membership is a key component of its credit strength, both in terms of financial support and in preferential access to trade and financial markets. Slovakia has been a major beneficiary from the European Structural and Investment Funds. It is scheduled to receive in total EUR 15.3 billion for the period 2014-2020, equivalent to 2.6% of GDP on an annual basis. Financial conditions have improved largely due to the ECB’s accommodative policies. Strong competitiveness resulted in Slovakia’s export market share in the EU more than doubling. The rise in exports has been supported by foreign direct investment inflows and Slovakia’s growing participation in global value chains in the auto industry. Investment into Slovakia is driven by European and other international firms taking advantage of lower labor costs and proximity to Europe’s main population centers.

Strong Government Balance Sheet and Prudent Fiscal Management

Slovakia has a strong track record of fiscal consolidation. Measures taken after the financial crisis resulted in a five-percentage point reduction in the deficit, from a high of 8% of GDP in 2008 to 2.8% in 2013. This enabled Slovakia’s exit from the EU’s Excessive Deficit Procedure (EDP). The deficit has declined further to 0.8% in 2017 and the government expects the deficit to fall further to 0.6% in 2018 enabling Slovakia to meet the objective of a balanced budget in 2020. In addition to a favorable economic backdrop, the improvement in Slovakia’s public finances has been driven by policy initiatives impacting both revenues and expenditures. On the revenue side, the government’s comprehensive anti-tax-avoidance program and measures to enhance tax administration efficiency has substantially reduced the compliance gap from 40% in 2012 to 26.3% in 2017. On the expenditure side, the authorities’ ‘value for money’ program, which is a comprehensive expenditure review of key sectors, has effectively reined in expenditure.

Moreover, to strengthen the credibility of public finances, Slovakia introduced its Fiscal Responsibility Act in March 2012, specifying debt ceilings and adjustment measures to be implemented if ceilings were breached. Slovakia is among the few EU countries whose public debt-GDP ratio is below the Maastricht threshold of 60%. Its public debt-to-GDP ratio, which had averaged 40% prior to the global financial crisis, rose nearly 13% points during 2010-13 due to the countercyclical stimulus and lower growth, touching a high of 54.7%. A reduction in the deficit and a pick-up in growth have resulted in the debt ratio stabilizing at 50.9% in 2017. According to the IMF, Slovakia’s underlying debt dynamics point to a declining debt trajectory over the projected five-year horizon, reaching 40.5% in 2023. Near-term fiscal risks are mitigated by the benign interest rate environment and favorable debt composition. Slovakia’s government debt is all long-term, with 93% denominated in euros. The remaining foreign currency debt is fully hedged. Since 2009, the average maturity of government debt has risen from 4.9 years to 8.5 years in 2018.

Concerns Regarding Private Sector Leverage Rise, but Financial Stability Risks are Limited for Now

The trend most detrimental to financial stability in Slovakia is the increase in household credit. Loan growth averaged 13.3% in 2017, similar to trends seen in the last decade. The rise in private sector leverage in Slovakia is amongst the highest in the EU, with the stock of debt at 39.3% of GDP, amongst the highest in Eastern Europe. Within household loans, mortgages remain the key driver of household credit, accounting for nearly 80% of total household loans. Given the interlinkage of the Slovak banking sector to the property market, rapid loan growth coupled with a concentration of new loans with a higher LTV ratio is a concern. The vulnerability of the Slovak household sector is further accentuated by its financial assets-to-liabilities ratio, which is the lowest in the EU. The maturity mismatch between assets and liabilities reached an all-time high in 2017. This has reduced the capacity of distressed households to use their reserves for loan repayments. Furthermore, as the terms of loans are relatively long, there is little scope for rescheduling the debt of borrowers who get into financial difficulty. Current trends in liquidity could potentially increase domestic banks’ dependence on their parent groups.

However, despite rapid loan growth, the banking sector has strong fundamentals and loan portfolios remain relatively healthy. The banking sector in Slovakia has strong fundamentals as reflected in healthy profit growth (albeit on a declining trend), adequate levels of capitalization, and good asset quality. The main banks are foreign subsidiaries, but their reliance on external funding is limited. It is a traditional retail-oriented business model with stable domestic deposit-based funding.

However, while the banking sector is healthy, the combination of private sector leverage growth, coupled with rising property prices represents a risk. Nonetheless, repayment capacity is supported by the low interest rate environment, rising employment levels, and higher disposable income. Additionally, the National Bank of Slovakia (NBS) adopted macro-prudential measures which include limits to the maximum maturity of consumer loans at eight years, the introduction of a countercyclical buffer of 0.5%, and the imposition of a systemic risk buffer of 1% of their total risk-weighted exposures. The NBS Bank Board approved a further increase in the countercyclical buffer to 1.25% effective 1 August 2018.

Regional Disparities and Unfavorable Demographics Remain Key Challenges

Despite a strong growth story, Slovakia faces many challenges. While overall unemployment levels have seen a cyclical improvement from 14.2% of the workforce in 2013 to 7.7% in 2017, structural challenges remain. These include high unemployment among low-skilled and Roma population and low female labor force participation. These issues are amplified by regional disparities. Unemployment in Eastern Slovakia remains high at 12%, as compared to Bratislava where the unemployment rate is 4.2%. Underdeveloped infrastructure, lower educational attainment, and low labor mobility have held back the Eastern and Central regions, keeping a sizable part of the population unemployed or outside the workforce. In other areas, falling unemployment coupled with faster job creation and emigration have led to labor shortages. Although the positive balance of inflows is still driven by foreigners, recently the number of Slovaks returning from abroad is approaching the outflows from the country.

Slovakia’s demographics, coupled with low fertility, are one of the most adverse situations in Europe with its old-age dependency ratio expected to increase from 19.7% in 2015 to 59.4% in 2060. Based on the latest European Commission's projections, there will be around 1.2 workers per old-age pensioner in 2060, compared to two at present. In response to adverse demographic trends, Slovakia has begun to implement changes to its pension system, which include linking the statutory retirement age to life expectancy and a switch to fully inflation-based indexation starting from 2018. Reforms are key given Slovakia’s rapidly ageing population and low general statutory retirement age (currently 62.38 years). To partially offset the demographic challenges, Slovakia has begun easing its policy on migrants. The amendment to the Act on Employment Services (effective from May 2018) simplifies conditions for employing foreigners from third countries, thus speeding up the whole process. There are currently over 62,000 foreign workers mainly from Central Eastern European countries.

Politics; Institutional Quality and the Upcoming EU Budget

Perceived corruption and inefficient government bureaucracy appear the main obstacles to doing business in Slovakia. Moreover, the country scores below the EU average in areas relating to the government’s responsiveness to the needs of small and medium enterprises. The coalition government, comprising center-left party SMER-SD, the far-right nationalist Slovak National Party and the minority oriented Most-Hid, is committed to improving the business environment with an emphasis on education, the legal system and anticorruption policies. However, following the resignation of Mr Fico as prime minister in March this year the government appears weaker. This might complicate making progress with the reform agenda, and new elections are scheduled in March 2020.

The EC’s proposal for the 2021-2027 EU Budget envisages a set of key issues including: higher contributions from the remaining EU27 members following the UK departure from the union; incremental spending on new priorities such as border control, security and defense; and a reduction in funds to the Cohesion Policy (CP) and Common Agriculture Policy’s (CAP). Eastern European EU members which have relied significantly on the EU budget to sustain their development might be hit by the new proposal. This impact is due to cuts to structural and investment funds, linking the rule of law to funding, and the increase in national co-financing. The Budget estimates a 20% reduction in funds to Slovakia. However, near- to medium-term growth prospects are unlikely to be impacted as funds under the 2014-2020 MFF are likely to be available until 2023 (T+3 rule).

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (high) – A (low) range. The main points of the Rating Committee discussion included the economic performance and structure, EU funding, the housing market and credit trends, the fiscal performance, the debt trajectory and the political environment.

KEY INDICATORS

Fiscal Balance (% GDP): -0.8 (2017); -0.6 (2018F); -0.3 (2019F)
Gross Debt (% GDP): 50.9 (2017); 49.0 (2018F); 46.6 (2019F)
Nominal GDP (EUR billions): 84.9 (2017); 95.4 (2018F); 96.9 (2019F)
GDP per Capita (EUR): 15,617 (2017); 17,536 (2018F); 17,793 (2019F)
Real GDP growth (%): 3.4 (2017); 4.0 (2018F); 4.2 (2019F)
Consumer Price Inflation (%): 1.4 (2017); 2.4 (2018F); 2.1 (2019F)
Domestic Credit (% GDP): 139.9 (2017); 139.7 (Mar-2018)
Current Account (% GDP): -2.1 (2017); -0.3 (2018F); 0.5 (2019F)
International Investment Position (% GDP): -61.7 (2017); -64.9 (Jun-2018)
Gross External Debt (% GDP): 110.8 (2016); 1114.1 (Jun-2018)
Governance Indicator (percentile rank): 75.0 (2017)
Human Development Index: 0.86 (2017)

Correction: On November 20, 2018, DBRS Ratings Limited corrected this press release originally issued on October 12, 2018 for the Slovak Republic to reflect that the rating is unsolicited, with participation by the rated entity, and that DBRS had no access to relevant internal documents. These disclosures were inadvertently omitted from the original press release.

Notes:
All figures are in EUR unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Slovakia Ministry of Finance; ARDAL, National Bank of Slovakia; Eurostat, European Commission, IMF, BIS, UNDP, OECD, World Bank, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve-month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
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Lead Analyst: Carlo Capuano, Assistant Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: April 22, 2016
Last Rating Date: April 13, 2018

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