DBRS Confirms Slovak Republic 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.

The confirmation of the Stable trend reflects DBRS’s view that economic growth, although decelerating from 4.1% recorded last year, because of intensifying headwinds stemming from the European economy’s slowdown, is set to remain sound at around 2.5% on average in the 2019-20 period. Moreover, Slovakia has made progress with fiscal consolidation, and its deficit declined to 0.7% of GDP in 2018. Further improvements, however, are expected to be largely cyclical, rather than structural and dependent on the volatility of the economic performance. Some fiscal easing is likely ahead of the next year’s parliamentary elections, but public debt-to-GDP is projected to continue declining. According to the European Commission (EC), the public debt ratio will fall to around 46.0% of GDP in 2020 from 48.9% in 2018. Moreover, recent macroprudential policies are projected to mitigate the rising vulnerabilities stemming from strong retail credit growth in the household sector.

Slovakia’s A (high) ratings reflect its strong macroeconomic performance, its track record of conservative fiscal management and low public debt. 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, and deep integration with major euro-zone economies. These credit strengths offset structural weaknesses including Slovakia’s small economy, high reliance on exports, 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) substantial progress in income convergence toward the EU average; (2) progress in diversifying the economy as well as reducing regional disparities that constrain GDP potential; (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

Weaker External Environment is Weighing on Slovakia’s Growth, but Domestic Demand to Remain Supportive

Slovakia’s ratings are underpinned by its solid macroeconomic performance. The country has been among the top growth performers in the EU. Over the last four years, economic growth averaged 3.7%, mainly 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 from 57% in 2004. Due to the less favorable external environment, GDP growth is likely to decelerate this year, and is projected at 2.5% on average in 2019-20 period compared with 4.1% registered in 2018. Risks to Slovakia’s outlook are tilted to the downside as the country’s reliance on the auto sector, makes Slovakia vulnerable to potential higher tariffs on the European auto sector. At the same time, lower economic growth in Germany, the main trading partner, clouds Slovakia’s outlook. However, domestic demand, driven by buoyant private consumption, is expected to remain supportive due to rising real wage growth and to favourable credit conditions. Signs of a tight labour market are starting to emerge and shortages of labour are likely to further contribute to inflation remaining elevated at around 2.4% this year.

Slovakia’s EU membership is a key component of its credit strength, both in terms of financial support and in terms of preferential access to trade and financial markets. The country has been a major beneficiary of European Structural and Investment Funds. In total, it is scheduled to receive EUR 15.3 billion for the period 2014-2020, equivalent to an average of 2.5% of GDP on an annual basis. Slovakia’s high level of integration into European value chains has also contributed to an improvement in the country’s export performance over the last decade. 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 centers.

Slovakia, along with other Eastern European members of the EU, have relied significantly on the EU budget to sustain its development. Consequently, a potential reduction of funds for the Cohesion Policy (CP) and Common Agriculture Policy (CAP) may have an impact on growth. Although the cut in the allocation of funds could be sizeable at around 22% and 27% for the CP and CAP, respectively, in DBRS’ view near- to medium-term are unlikely to be materially affected by lower funds. Under the 2014-2020 multiannual financial framework (MFF) EU funds are likely to be available until 2023 (T+3 rule).

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

While the Slovak economy with around 85% of total export as a share of GDP is vulnerable to external shocks, its sizeable Net International Investment position (NIIP) is less of a concern. Since 2011 the current account position has improved substantially, shifting from a deficit of around 5% of GDP to small surpluses registered over the period 2012-2014. Due to strong import demand of investment goods and a more negative primary balance as result of dividend outflows on foreign investments, the current account balance has moved back to deficit and in 2018 stood at around 2.5% of GDP. Against this backdrop, risks to the Slovak export performance are intensifying because of the weaker foreign demand, protectionist trade policies and the potential disorderly U.K.’s departure from the EU. However, DBRS expects the increased production capacity of the auto sector to contribute to narrowing the current account deficit in the medium term. According to the EC, the Slovak current account is forecast to shrink to 1.8% of GDP in 2020. Slovakia’s negative Net International Investment Position (NIIP), although large at 65.5% of GDP as of Q1 2019, is less of a concern. Despite a growing share of government debt held by foreign investors, the NIIP 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, mitigating risks to capital outflows.

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

Slovakia has a strong track record of fiscal consolidation over recent years and public debt is lower than the lowest limit prescribed by the national Fiscal Responsibility Act. Measures taken after the financial crisis, along with strong nominal growth, have resulted in a steady decline in the budget deficit from a high of 7.8% of GDP in 2009 to 0.7% last year. This reflects a combination of cyclical improvement and policy initiatives, including the improvement in VAT collection efficiency. Robust job growth has resulted in higher taxes and social contributions over recent years. On the expenditure side, savings stemming from the health sector and the pension reform, and lower interest costs, more than compensated for higher state wages and investment.

DBRS anticipates a more gradual fiscal consolidation than the one outlined in the latest Stability Programme in April 2019, when the government projected a budget balance from this year. Lower GDP growth, some fiscal slippage ahead of the of parliamentary elections in 2020 and the significant public wage increases over 2019-2020 by around 10% annually, will make meeting the government’s target more challenging. The EC forecasts a budget deficit declining to 0.5% of GDP this year and 0.6% in 2020. The government’s new measures focusing on reduction of tax burden and increase in social spending if not offset by compensatory policies, are expected to hamper the consolidation effort. All in all, the improvement expected might be more cyclical than structural and dependent also on the volatility of the economic performance.

Slovakia is among the few EU countries whose public debt-GDP ratio is below the Maastricht threshold of 60%. Following the global financial crisis its public debt-to-GDP ratio rose nearly thirteen percentage points during 2010-13, to a high of 54.7%, because of the countercyclical stimulus and lower growth. A reduction in the deficit and a pick-up in growth have resulted in the debt ratio declining to 48.9% of GDP in 2018. According to the latest IMF projections included in the July 2019 Article IV, Slovakia’s underlying debt dynamics point to a declining debt trajectory over the projected five-year horizon, falling to 41.7% 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, almost entirely at a fixed rate and 95% is 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 as of end-August 2019 from 4.6 years in 2009, which is in line with the Organisation for Economic Co-operation and Development (OECD) average.

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

Slovakia’s excessive credit growth to households in a context of accumulating imbalances in the residential property market poses some risks to financial stability. Household debt has increased rapidly over a decade to 42.3% of GDP as of Q1 2019, and while the ratio is still below the EU average of 52.3%, households are much more vulnerable to shocks. This trend reflects a sustained growth of retail credit in a context of high share of home ownership, rapid economic convergence and lingering low interest rates. However, signs of moderation have started to emerge also thanks to the phasing-in of the National Bank of Slovakia (NBS) regulatory tightening and the riskiness of new loans is decreasing. Nonetheless, loan growth which has averaged around 9.2% since January 2019, and remains well above the Euro area average of 2.8%. Mortgages remain the key driver of household credit and account for a large share of total household loans. Given rising property prices, mainly because of a limited supply of houses, rapid loan growth coupled with a concentration a high loan-to-value ratio represents a risk. The vulnerability of the Slovak household sector is further accentuated by a high concentration of housing loans among low-income households and by total households’ net financial assets, which at 38.2% of GDP as of Q1 2019 is the lowest in the EU. Against this backdrop, any potential economic downturn and subsequent job losses will likely hamper household debt service affordability.

Despite rapid loan growth, the banking sector has strong fundamentals and loan portfolios remain relatively healthy. The banking sector in Slovakia shows adequate levels of capitalisation, and good asset quality even as profit margins are on a declining trend. Although the main banks are foreign subsidiaries, their reliance on external funding is limited. The banking sector is a traditional retail-oriented business model with stable domestic deposit-based funding. However, rising private sector leverage coupled with rising property prices has led the NBS to implement a series of prudential measures in late-2018 such as an increase in the countercyclical capital buffer and a gradual tightening in the regulatory lending standards. In DBRS’s view, in addition to the gradual phase-in of further tightening of credit standards by the NBS a potential market saturation, and demographic developments should contribute to mitigating risks stemming from housing loan growth.

Regional Disparities and Unfavourable Demographics Remain Key Challenges

Despite strong growth, Slovakia faces important challenges beyond being a small economy that is highly reliant on exports. While overall unemployment levels have fallen to 5.7% in Q2 2019 from 14.2% in 2013, structural challenges remain, including high unemployment rates among low-skilled and disadvantaged groups and low female labour force participation. These issues are further amplified by regional disparities. Unemployment in Eastern Slovakia remains high at 10.1% compared to the Bratislava region where the unemployment rate was 2.9%. Underdeveloped infrastructure, lower educational attainment, and low labour mobility have held back the Eastern and Central regions of the country. In other areas, falling unemployment coupled with faster job creation and past emigration have led to labour shortages, and show signs of overheating. Recently, however, inflows have increased because of high number of Slovaks returning from abroad.

Slovakia’s demographics are one of the most adverse in Europe with its old-age dependency ratio expected to increase from 21.0% in 2016 to 56.8% in 2070 based on the latest European Commission's 2018 Ageing report. Moreover, the constitutional change passed in March this year to cap the general statutory retirement age at 64 years will further place pressure on public expenditures in the long-term. 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 citizens from third countries, thus speeding up the whole process.

A Fragile Government and A Fragmented Electorate Poses Risks to Pace of Reform Implementation

Perceived corruption and inefficient government bureaucracy appear the main obstacles to doing business in Slovakia. 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. Some progress has been made regarding a new system to identify and address corruption risk in the public sector, but additional effort may be required to strengthen transparency. However, following the resignation of Mr. Fico as prime minister in March last year, the government appears weaker and further progress might be limited. The government has a slim majority within the legislative body and coalition partners seem unlikely to overcome policy differences, despite the lack of a cohesive opposition. This might complicate progress with the reform agenda ahead of the elections scheduled in March next year, which could result in a complicated government formation process as the electorate appears more fragmented.

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 Slovak economic performance, progress with fiscal consolidation, retail credit growth, household debt.

KEY INDICATORS

Fiscal Balance (% GDP): -0.7 (2018); -0.5 (2019F); -0.6 (2020F)
Gross Debt (% GDP): 48.9 (2018); 47.3 (2019F); 46.0 (2020F)
Nominal GDP (EUR billions): 90.2 (2018); 96.1 (2019F); 101.8 (2020F)
GDP per Capita (EUR): 16,555 (2018); 17,615 (2019F); 18,636 (2020F)
Real GDP growth (%): 4.1 (2018); 3.8 (2019F); 3.4 (2020F)
Consumer Price Inflation (%): 2.5 (2018); 2.4 (2019F); 2.3 (2020F)
Domestic Credit (% GDP): 135.1 (2018); 133.9 (Mar-2019)
Current Account (% GDP): -2.5 (2018); -2.2 (2019F); -1.8 (2020F)
International Investment Position (% GDP): -67.3 (2017); -65.5 (Mar-2019)
Gross External Debt (% GDP): 113.0 (2018); 109.6 (Mar-2019)
Governance Indicator (percentile rank): 74.2 (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 (SOSR/Haver/EC), Real GDP Growth (EC), Inflation (EC), Domestic Credit (NBS/SOSR/Haver), Current Account (NBS, EC), 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.

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:
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: Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: April 22, 2016
Last Rating Date: March 22, 2019

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