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 Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The trends on all ratings are Stable.

KEY RATING CONSIDERATIONS

The confirmation of the Stable trend reflects DBRS’s view that economic growth, primarily supported by private consumption and automobile exports, will remain strong over the 2019-2020 period, despite some headwinds stemming from the European economy’s slowdown. Moreover, Slovakia has made progress with fiscal consolidation, and its deficit declined to 0.6% of GDP in 2018. Further improvements are expected to be largely cyclical rather than structural. Although some fiscal easing is likely ahead of the next year’s parliamentary elections, public debt-to-GDP is projected to continue to decline to around 44% of GDP in 2020. Moreover, recent macroprudential policies should mitigate the rising vulnerabilities stemming from the household sector because of strong retail credit growth.

Slovakia’s A (high) ratings reflect its strong macroeconomic performance and deep integration with major euro-zone economies. The country attracts high-quality foreign investment and is well integrated in European supply chains. Its credit profile benefits from its European Union (EU) membership, its track record of conservative fiscal management and low public debt. These credit strengths offset structural weaknesses including relatively low productivity, regional disparities and unfavourable demographics.

RATING DRIVERS

DBRS views that the Slovak Republic is well placed in the A (high) rating category. Upward rating drivers include: (1) continued investment that enhances productivity and fuels income convergence toward the EU average; (2) progress in reducing regional disparities that increases potential growth; or (3) continued fiscal discipline combined with a sustained decline in public debt. 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 as a result of a prolonged and significant rise in household credit growth.

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. Over the last four years economic growth averaged 3.7%, led by both consumption and investment. As a result of this sustained economic performance, the country’s GDP per capita based on purchasing power has risen to 78% of the EU average. Following a 4.1% growth rate in 2018, real GDP is expected to grow at a similar pace in 2018 before moderating to 3.5% in 2020 because of the fading boost from increasing car production. Current growth trends have been driven primarily by domestic demand. Consumption has been supported by rising employment, real wage growth, and favourable credit conditions. Private sector investments have been sustained by accommodative European Central Bank (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 in 2019.

Risks of potential higher tariffs on the European auto sector could affect output. However, strong domestic demand should compensate for a less supportive external environment. Slovakia’s unemployment rate is trending down from the peak registered at 14.2% in 2013 and is projected to decline to 6.0% in 2020. This should contribute to a further boost in wage growth in light of a tighter labour market.

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. The country has been a major beneficiary from the European Structural and Investment Funds. In total, it is scheduled to receive EUR 15.3 billion for the period 2014-2020, equivalent to around 2.5% of GDP on an annual basis on average. The high integration in European value chains has also contributed to an improvement in the country’s export performance. The rise in exports has been supported by foreign direct investment inflows. Investment into Slovakia is driven by European and other international firms taking advantage of lower labour costs and proximity to Europe’s main population centres.

There is some uncertainty related to the European Commission (EC)’s proposal for the 2021-2027 EU Budget to reduce funds to the Cohesion Policy (CP) and Common Agriculture Policy (CAP) for Eastern European EU members, including Slovakia, which have relied significantly on the EU budget to sustain their development. Although the cut in the allocation of funds could be sizeable at around 22% and 26% for the CP and CAP, respectively, in DBRS’ view near- to medium-term growth prospects are unlikely to be affected as funds under the 2014-2020 multiannual financial framework (MFF) are likely to be available until 2023 (T+3 rule).

Current Account Deficit Set to Narrow Although Risks to External Performance Are Intensifying

The current account deficit will likely narrow, but the global trade slowdown poses some risks to the export outlook. The new Jaguar Land Rover plant is projected to boost car exports and to partially offset the negative contribution of the primary balance because of the substantial outflow of dividends. According to the International Monetary Fund (IMF), the current account deficit is expected to shrink to 0.9% this year from 2.5% of GDP in 2018. However, trade tariffs on the auto sector pose a risk to Slovakia’s export performance which could be also affected by the indirect slowdown of Slovakia’s key European trading partners. Slovakia’s negative Net International Investment Position (NIIP), although large at 65.9% of GDP as of Q3 2018, is less of a concern. Despite a growing share of government debt held by foreign investors, this is mainly composed of foreign direct investment in the form of equity and intercompany lending, and there is limited private sector reliance on foreign credit.

Strong Government Balance Sheet and Prudent Fiscal Management Bode Well for Debt Sustainability

Slovakia has a strong track record of fiscal consolidation. Measures taken after the financial crisis along with strong nominal growth resulted in a steady decline in the fiscal deficit from a high of 7.8% of GDP in 2008 to 0.6% last year. This reflects a combination of cyclical improvement and policy initiatives affecting both revenues and expenditures. On the revenue side, the government’s comprehensive anti-tax-avoidance programme and measures to enhance tax administration efficiency have substantially reduced the compliance gap to 26.3% in 2017 from 40% in 2012. On the expenditure side, the authorities’ ‘value for money’ programme, which is a comprehensive expenditure review of key sectors, has reined in expenditure effectively.

The government aims to achieve an almost balanced budget this year. However, some fiscal slippage is likely to occur ahead of the of parliamentary elections in 2020 and wages are expected to increase over the period 2019-2020 by around 10% in each year. DBRS anticipates a slower fiscal consolidation path with the budget deficit declining to 0.3% of GDP this year versus the government’s projection of 0.1%. Moreover, the improvement in the budget balance appears to be mainly cyclical and therefore dependent on the volatility of economic performance. On the other hand, a potential ceiling on expenditure in the future, currently under discussion in parliament, will likely provide more predictability to the budgetary process and increase discipline.

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 because of the countercyclical stimulus and lower growth, reaching a high of 54.7%. A reduction in the deficit and a pick-up in growth have resulted in the debt ratio declining to the estimated 48.8% of GDP in 2018. According to the latest IMF WEO of October 2018, 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 favourable debt composition. Slovakia’s government debt is all long term, with 95% denominated in euros. The remaining foreign currency debt is fully hedged. The average maturity of government debt has risen to the comfortable level of 8.8 years in 2018 from 4.9 years in 2009, which is in line with the Organisation for Economic Co-operation and Development (OECD) average.

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

Slovakia records a rapid increase in household debt as a result of sustained retail credit in a context of high share of home ownership and rapid economic convergence. Loan growth to households, although on a moderating trend recently, has been substantial for a decade and it has averaged at 11.4% year-on year in 2018 compared with 2.6% in the Euro Area. The rise in private sector leverage in Slovakia has been amongst the highest in the EU. At 42% of GDP as of Q3 2018, it is also amongst the highest in Eastern Europe, even though it is below the EU average of 53%. Within household loans, mortgages remain the key driver of household credit, accounting for a large share 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 loan-to-value ratio is a point of attention. The vulnerability of the Slovak household sector is further accentuated by a high concentration of housing loan among low-income households and by households’ financial assets-to-liabilities ratio, which at 38% of GDP is the lowest in the EU. Against this background a potential loss of employment over a long period of time will likely affect household debt service affordability.

However, despite rapid loan growth, the banking sector has strong fundamentals and loan portfolios remain relatively healthy. The healthy banking sector in Slovakia reflects sound profit growth (albeit on a declining trend), adequate levels of capitalisation, and good asset quality. The main banks are foreign subsidiaries, but their reliance on external funding is limited. The banking sector 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 has led the National Bank of Slovakia to implement a series of measures including an increase in the countercyclical buffer and a gradual tightening in the regulatory lending standards since the second half of 2018. In DBRS’s view, in addition to the gradual phase-in of further stricter lending standards a potential market saturation and demographic developments should contribute to mitigate the risks stemming from housing loan growth.

Regional Disparities and Unfavourable Demographics Remain Key Challenges

Despite strong growth, Slovakia faces important challenges. While overall unemployment levels have seen a cyclical improvement to 6.1% in 2018 of the workforce from 14.2% in 2013, structural challenges remain. These include high unemployment among low-skilled and Roma population and low female labor force participation of women with small children. These issues are amplified by regional disparities. Unemployment in Eastern Slovakia remains high at 12% compared with Bratislava where the unemployment rate is 4.2%. Underdeveloped infrastructure, lower educational attainment, and low labour mobility have held back the Eastern and Central regions. This has been translated into a sizable part of the population be unemployed or outside the workforce affecting also productivity growth and in turn the economy’s potential. In other areas, falling unemployment coupled with faster job creation and past emigration have led to labour shortages with some signs of overheating. However, recently, inflows have increased also because of high number of Slovaks returning from abroad.

Slovakia’s demographics, coupled with low fertility, are one of the most adverse in Europe with its old-age dependency ratio expected to increase from 21% in 2016 to 56.8% in 2070 based on the latest European Commission's 2018 Ageing report. In this context, the potential constitutional change to put a cap to the general statutory retirement age at 64 years following the progress achieved with the pension reform in 2012-2013, will likely negatively impact the fiscal sustainability. However, this constitutional change requires a supermajority of 60% and it seems unlikely to pass at the moment. On the other hand, 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.

Weak Government Coalition Will Make Progress On the Reform Agenda More Challenging

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-sized enterprises. The coalition government, comprising centre-left party SMER-SD, the conservative 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 last year, the government appears weaker and the risk of a snap election has increased owing also to differences among the coalition partners and the slim majority, despite the lack of a cohesive opposition. This might complicate making progress with the reform agenda ahead of the elections scheduled in March next year.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (high) –A(low) range. The main points discussed during the Rating Committee include progress with economic convergence to the EU average, household debt and financial stability, regional disparities, fiscal consolidation.

KEY INDICATORS

Fiscal Balance (% GDP): -0.8 (2017); -0.6 (2018E); -0.3 (2019F)
Gross Debt (% GDP): 50.9 (2017); 48.8 (2018E); 46.4 (2019F)
Nominal GDP (EUR billions): 84.8 (2017); 90.2 (2018E); 96.7 (2019F)
GDP per Capita (EUR): 15,593 (2017); 16,567 (2018E); 17,762 (2019F)
Real GDP growth (%): 3.2 (2017); 4.1 (2018); 4.1 (2019F)
Consumer Price Inflation (%): 1.4 (2017); 2.6 (2018E); 2.6 (2019F)
Domestic Credit (% GDP): 138.9 (2017); 143.8 (Sept-2018)
Current Account (% GDP): -2.0 (2017); -2.5 (2018); -0.9 (2019F)
International Investment Position (% GDP): -65.6 (2017); -65.9 (Sep-2018)
Gross External Debt (% GDP): 110.0 (2016); 115.6 (Sep-2018)
Governance Indicator (percentile rank): 75.0 (2017)
Human Development Index: 0.86 (2017)

EURO AREA RISK CATEGORY: LOW

Notes:

All figures are in euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Fiscal balance (EC), Gross debt (EC), Nominal GDP (EC), GDP per Capita (EC), Real GDP Growth (Slovakia Ministry of Finance/EC), Inflation (EC), Domestic Credit (NBS/SOSR/Haver), Current Account (Slovakia Ministry of Finance/IMF), International Investment Position (NBS/SOSR/Haver), Gross External Debt (NBS/SOSR/Haver). 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, Statistical office of the Slovak Republic (SOSR), ARDAL, National Bank of Slovakia; Eurostat, European Commission, IMF, UNDP, OECD, European Commission 2018 Ageing Report, 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.

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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:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Carlo Capuano, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: April 22, 2016
Last Rating Date: October 12, 2018

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