1. Over the past several months the IMF mission has been engaged in an intensive policy dialogue with the Slovak authorities that led to an agreement in March on a program that will be monitored by IMF staff. This program contains the economic objectives and policies of the government for the next several years, with an emphasis on the measures required during 2001 to achieve these objectives. A Statement of Economic Policies containing the main macroeconomic parameters for 2001 and the policies for the period ahead was endorsed by the cabinet in March. The government has already begun to implement these policies, and performance under the IMF staff-monitored program has been favorable (Table 1). In this note we take stock of developments since the last Article IV consultation, assess risks to the economic outlook in Slovakia, and provide policy recommendations. The mission would like to express its gratitude for the cooperation it has received, and the collegiality and quality of the discussions. It is always a pleasure to engage in policy discussions with the Slovak authorities, and the mission wishes them continued success.

2. The authorities‘ efforts to stabilize the economy and accelerate structural reforms are paying off. Impressive gains were made during the last year. Macroeconomic imbalances were further reduced, mainly due to a tight fiscal stance for most of 2000 and significant increases in administered prices. Strong export expansion supported real GDP growth of 2.2 percent in 2000, while declining inflation and a manageable fiscal deficit allowed the National Bank of Slovakia (NBS) to ease monetary policy in a series of modest interest rate cuts. Meanwhile, the most recent available data has been encouraging: in the first few months of 2001, retail sales, industrial production, and construction were up significantly, and inflation continued to fall. Restructuring and privatization of state-owned banks has advanced, and a number of other structural reforms are on track.

3. The government needs to build on this success and ensure that recent gains are not lost. There is a broad consensus in the government and in society that the most immediate challenges are to:

4 achieve the government’s fiscal targets, which will require inter alia expenditure restraint and strong efforts to improve tax collection while adhering strictly to the government’s plans for structural reforms in the fiscal area;

4 reduce unemployment, which has taken center stage politically;

4 keep inflation low while avoiding a sharp real appreciation that does not reflect productivity gains, which will require careful management of the macroeconomic policy mix; and,

4 strengthen the financial system-including through the adoption of a proactive approach in bank supervision-which will be critical to prevent a re-emergence of banking sector problems.

4. The mission has identified a number of risks that the government will need to address forcefully:

4 The attainment of the 3.9 percent of GDP deficit for the general government in 2001 is at risk. Revenues during the first four months of the year were not as strong as expected and there have been discussions about further reducing taxes. Expenditure trends, notably on social benefits, are much higher than anticipated.

4 The financing of a number of government initiatives in 2001 could be at risk because of delays in the privatization of SPP. If the government were to go ahead with these initiatives using alternative financing, it should coordinate very carefully with the NBS the source and timing of this financing to avoid disruption of financial markets.

4 The external current account deficit is widening and may turn out to substantially exceed 5 percent of GDP in 2001, larger than projected under the program. In these circumstances, although inflation remains subdued, there is not much room for further monetary easing.

4 The global slowdown also presents some downwards risks for Slovakia. Over the next several months there could be a significant deceleration in Slovakia’s export market growth, particularly in western Europe. This may require some policy adjustments in the period ahead.

4 A delay in much needed improvement of banking supervision could weaken the financial system. An upgrade of the quality of banking supervision staff, and an enhancement of on-site supervision should not be delayed any longer.

Macroeconomic Framework

5. The economic outlook for 2001 is encouraging and is based on a projected pickup in real GDP growth to over 3 percent, with domestic demand being the main source of growth. The strength of domestic demand reflects a recovery in both private consumption and investment, and is underpinned by strengthening real household incomes, low real interest rates, and a somewhat expansionary fiscal policy. Inflation is forecast to continue its downward trend, falling close to the bottom of the authorities‘ target range of 6.7-8.2 percent for end-December 2001.

6. A surge in the trade deficit and a potential widening in the current account deficit, however, raise concerns. In recent months imports have surged rather sharply, reflecting domestic demand pressures, while exports have continued to increase at a slower pace. As a result, the merchandise trade deficit in the first quarter of 2001 increased significantly, and the external current account deficit could widen to about 51 percent of GDP for the year. Although this deficit is expected to be financed largely by foreign direct investment, which could reach 12 percent of GDP depending on the timing of the SPP privatization, the widening of the current account increases external vulnerability.

Fiscal Policy and Structural Fiscal Reforms

7. The mission believes that with continued expenditure restraint, the government should be able to meet its target for the deficit of the general government of 3.9 percent of GDP in 2001. Monetary data on the position of the government indicate that the deficit target for the first quarter under the staff-monitored program was met comfortably (see Table 1), while preliminary data for the state budget and the state funds confirm that the indicative sub-ceilings for expenditure were also met.

8. There are, however, as noted, potential pressures on the public finances during the rest of the year that need to be addressed. The mission understands that there could be overruns in social benefits associated with recent changes in the legislation for the housing and child allowances, as well as with the possible adjustment in the subsistence minimum income and higher-than-assumed unemployment. Additional pressures could materialize if an increase in pensions is enacted before confirmation of a trend on better-than-expected collection of contributions. As these expenditures would represent obligations of the state and thus cannot be delayed or avoided without incurring arrears, the government should adhere to the general government expenditure targets agreed under the staff-monitored program through cuts in non-statutory expenditure if required. In this connection, it will be important to ensure, as envisaged in the government’s program, strict adherence to the expenditure ceiling and that additional non-statutory expenditure be undertaken only as long as the deficit target for 2001 is met. In particular, the mission recommends that the timing and financing of highway construction be made contingent on better-than-budgeted tax revenue and/or on cuts in other non-statutory expenditure. Finally, the government should pursue a cautious wage policy to avoid exceeding budget targets, and to give signals of wage moderation to the private sector.

9. In addition, proposals for reducing taxes could compromise short-term fiscal targets and the medium-term objective of continued fiscal consolidation. Regarding the corporate income tax, in particular, following the recent reduction in the tax rate to 29 percent, the scope for further reduction is quite limited. In the current circumstances of high unemployment, a reduction in payroll taxes would probably have more priority. The mission, however, recommends a very cautious approach to tax policy at this stage, including postponing of further tax cuts until improvements in tax collection as a result of better administration and the broadening of the tax base are well-established.

10. The mission supports the government’s intention to target a general government deficit of no more than 31 percent of GDP in 2002. Such a deficit would be consistent with the government’s medium-term objectives and would inter alia help promote private sector activity and contribute to external stability. The mission welcomes the improvements in the efficiency of the budgetary process and the increased transparency of general government operations, including through the early preparation of the budget and the integration of state funds into it.

11. It believes that the current and projected favorable economic setting-with the economy on the upswing and poised to follow a strong growth path-provides an excellent opportunity to move forward with some important fiscal reforms. The government should intensify efforts to reform tax administration in line with recommendations provided by Fund technical assistance missions, strengthen public finance management and enact legislation to control borrowing by local and regional governments, and establish a medium-term strategy to address inefficiencies in the health system and improve the quality of health care services. Other urgent priorities are to improve the financial situation of the pension insurance system and prepare it for comprehensive reform, to ensure control over budgetary support to state-owned enterprises, and to tighten eligibility criteria for state and social assistance benefits, and streamline their administration.

12. In the short term, there is also an urgent need to better coordinate the domestic debt placements of the Ministry of Finance and the sterilization operations of the NBS. These operations, if left uncoordinated, could have adverse implications for the financing of the budget and potentially disrupt financial markets. Therefore, close coordination between the ministry and the NBS will be key. The mission understands that as a first step the Ministry of Finance has invited an NBS staff member to participate in the ministry’s auction committee. This is welcome, and hopefully foreshadows an intensification of cooperation across a broad range of issues between the two institutions.

Monetary and Foreign Exchange Policies

13. The mission believes that the current monetary policy stance should be maintained because a further easing could put in jeopardy the external objectives of the program. It concurs with the NBS that as long as fiscal restraint is maintained, anchored by strict adherence to the expenditure ceiling, and wage increases remain moderate, there should be no significant pressures on inflation and the exchange rate in the period ahead. Data for the first quarter of 2001 suggest that this is so far the case: year-on-year inflation was 0.1 percentage point below the lower limit of the indicative band, and since mid-January the exchange rate has been stable against the euro without intervention. Nevertheless, present trends in the current account that reflects domestic demand pressures suggest that a further easing of monetary policy is not advisable at this time.

14. The current level of the exchange rate is broadly appropriate and there seem to be no problems of competitiveness. The mission supports the policy of the NBS to intervene in the foreign exchange market exclusively to avoid short term oscillations in the rate of the koruna vis-a-vis the euro, while not opposing long-term trends of the Slovak currency. Slovakia’s floating exchange rate regime in conjunction with the absence of an explicit commitment by the NBS to a range for the exchange rate is consistent with the authorities‘ emphasis on inflation as the dominant consideration for monetary policy.

The Policy Mix and Risks to the Outlook

15. The significantly higher-than-expected merchandise trade deficit in the first quarter of 2001 raises the specter of high current account deficits, which in turn has renewed concerns about the appropriateness of the macroeconomic policy mix. In the context of buoyant domestic demand, which could be further accentuated by the repayment of National Property Fund bonds during the rest of the year , policymakers will have to guard against the reemergence of external and internal macroeconomic imbalances. Against this background and in light of external developments, NBS staff have indicated that it is reluctant to reduce interest rates further despite low inflation. Indeed, if domestic pressures intensify, including through a realization of the fiscal risks, and the current account widens further, a tightening of the monetary stance could be envisaged. However, with high unemployment and negligible inflation pressures, the mission’s view is that the onus of adjustment should be on fiscal policy. Pressures that could arise from the projected large capital inflows later this year or early in the next year would be exacerbated by a tighter monetary policy, potentially creating a vicious circle of more inflows, appreciation pressures stemming from the domestic spending of such inflows, and further monetary tightening. It will therefore be important that the policy response to external pressures caused by domestic demand center around a rebalancing of the policy mix towards a tighter fiscal stance, including by deferring the spending of privatization revenues.

16. Downward risks in the external environment could add to the challenges faced by the government, jeopardize the achievement of program targets, and complicate the policy response. As noted, Slovakia is vulnerable to a larger-than-expected slowdown in global economic activity. Under such a scenario, the mission recommends in the first instance to let the exchange rate depreciate and explore the scope for easier monetary policy. Although automatic fiscal stabilizers would be appropriate in this case, there is not much scope to let them operate as a more expansionary fiscal policy would exacerbate Slovakia’s vulnerability. In the short run, the uncertainty about financing sources increases the country’s vulnerability to external shocks in a weakening international environment. In this regard, possible delays in privatization-related FDI underscore the need for prudence. The government should therefore be particularly careful in not incurring expenditures on the expectation of revenues or financing that may not materialize or may only partially materialize.

Unemployment

17. The mission is concerned about the economic and social implications of the persistently high unemployment rate. After a decline in the second half of 2000, mainly attributed to the operation of temporary public works programs, the unemployment rate has returned to levels close to 20 percent, although official figures surely overstate the actual number of people without jobs. The staff has studied the unemployment problem and has noted that a significant part of unemployment is non-cyclical. The nature of unemployment reflects the collapse in output during the early years of transition when many enterprises lost their markets (e.g., heavy engineering and armaments), continued growth of the labor force, and also, to a large extent, distortions in the incentive structure (e.g., the small difference between wages and unemployment benefits for workers at the low end of the wage scale; the weak targeting and monitoring of eligibility for social transfers; and high payroll tax rates). The mission would like to emphasize that a major disincentive to hiring labor remains the high rate of social security contributions, an issue to be dealt with over the medium term. While discouraging formal employment of workers, these high contributions have also encouraged work in the gray economy, reducing the capacity of the government to collect taxes and adding financial strain on social expenditure.

18. The very high unemployment rate has brought into sharp focus the importance of labor market issues in the short- and medium-term, and it is reassuring that the authorities have discussed possible ways to deal with unemployment and have taken measures to reform the labor market and restrict illegal work. Although economic growth and structural policies that encourage private sector development will have a positive impact on employment, they may be insufficient to make a serious enough dent in unemployment. In the short run, unemployment is likely to remain high, though it is also likely that the unemployment rate has peaked. The mission assesses positively the employment strategy contained in the National Plan of Employment. Given the largely structural nature of unemployment, the emphasis on improving the employability of groups at risk is appropriate, and so is the attention to the development of small and medium-size enterprises. At the same time, the mission would suggest more decisive steps toward improving the flexibility of the labor market. The procedures for hiring and dismissing workers should be simplified, and differentiation of social benefits (and minimum wage) across regions, in line with the cost of living, would create incentives for job creation in the poorer regions. Measures to restrict illegal work are welcome but the mission is concerned that they may provide insufficient incentives to switch from informal to formal employment.

Bank Soundness and Banking Supervision

19. Bank soundness continues to be a source of concern. According to information provided by the NBS, the ratio of nonperforming loans to total loans amounted to over 15 percent at end-2000 based on the NBS’s classification criteria. Although 67 percent of nonperforming loans are covered by provisions, the amount of nonperforming loans might be higher according to international standards. In addition to endangering bank soundness, this persistent asset quality problem could have future fiscal implications.

20. The mission welcomes the draft new Banking Act, which should contribute to moving Slovakia’s legal framework closer to EU standards. The draft Act incorporates improvements that reinforce supervisory powers by introducing a „prompt corrective action“ provision, enhance board governance, improve the definition of connected parties, expand the concept of consolidated supervision, and add risk management provisions. The authorities recently finished a diagnostic review of banking supervision based on the Basel Core Principles. To enhance the effectiveness of banking supervision, however, prudential regulations should be improved further by discontinuing the accrual of interest on non-performing loans, and improving loan classification, capital adequacy regulations, and accounting standards.

21. While the authorities have taken positive steps towards restructuring the large state-owned banks and strengthening the regulatory system, many challenges remain. Implementation of effective banking supervision has been very weak due mainly to insufficient legal enforcement power and shortage of qualified supervision resources. Bank supervision has relied heavily on off-site monitoring based on the quantitative analysis of figures reported by banks, which are likely to be distorted. On-site examination has been inadequate partly reflecting resource constraints (13 on-site examiners). This problem, coupled with lack of vigorous use of enforcement actions, resulted in a more costly and disruptive resolution process. It is, therefore, very important for the NBS to reinforce on-site examinations considerably, with a focus on an early detection of problem banks in order to prevent accumulation of nonperforming loans.

22. Finally, efforts to strengthen banking regulation and the enforcement powers will not achieve their objective unless supported by improvements in skills, techniques, and resources of bank supervisors. Therefore, the authorities should implement forcefully and without delay the Supervisory Development Plan that has been agreed with the World Bank, and should provide the necessary operational independence and allocate additional financial and human resources to the supervision function.

Privatization, Governance, and the Legal Framework

23. Completion of bank restructuring and privatization, and continued restructuring and privatization of public enterprises are essential for the sustainability of reform. The mission welcomes further progress in the privatization of banks and urges the authorities to complete the sale of VUB, move forcefully on IRB, adhere to its schedule for the privatization of SPP and Transpetrol, and proceed quickly with the reform of the electricity sector with the aim of transforming the sector before privatizing its assets.

24. The mission welcomes the authorities‘ efforts to improve the legal framework and the quality of corporate governance. The amendments to the Bankruptcy Law have made it easier to initiate bankruptcy proceedings, set time limits for the resolution process, granted creditors a stronger voice in the process, and given more prominence to restructuring as opposed to liquidation. The mission urges speedy progress in bringing Slovak Accounting Standards in line with the International Accounting Standards, reforming the collateral regime, amending the Commercial Code, and drafting a new Securities Law. These measures will not only stimulate domestic entrepreneurial activity but also encourage foreign direct investment.

Statistical Issues

25. The authorities need to address remaining weaknesses in the Slovak statistics and to implement recommendations of the recent multisector IMF mission. The most serious weaknesses pertain to the consistency and quality of real sector data. There is also a need for greater transparency and coordination in the fiscal accounts, especially among budgetary and extra-budgetary units. In addition, the interaction between the compilers of sectoral statistics needs to be improved so as to ensure more frequent and timely consistency checks between external, fiscal, and monetary data. These statistical issues will become particularly important in the monitoring of the quarterly benchmarks under the staff-monitored program.