DBRS Confirms Slovakia at A (high), Stable Trend

DBRS, Inc. confirmed the Slovak Republic’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). At the same time, DBRS confirmed Slovakia’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The trend on all ratings is 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. Growth is expected to remain strong in the medium-term, primarily led by private consumption and automobile exports. In addition, Slovakia attracts high quality foreign investment, has a healthy banking sector, and adheres to a solid fiscal framework. Despite these strengths, the ratings are constrained by relatively low productivity, regional disparities, and unfavorable demographics. DBRS is also monitoring political developments following the resignation of PM Fico and its uncertain impact on economic policy and institutional quality. 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 relaxation of fiscal discipline (2) a deterioration in growth prospects contributing to a reversal of the declining public debt ratio trajectory, or (3) disruptive political developments severe enough to derail the economic and fiscal outlook.

RATING RATIONALE

EU Membership Supports Strong Growth Momentum

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. Consumption has been supported by rising employment, real wages, and favorable credit conditions. Slovakia is among the biggest beneficiaries of EU funds transfers, which has benefited public sector investments. Private sector investments have been supported by accommodative ECB policies and improving lending conditions. Growth prospects are likely to remain favorable in the medium-term, with the EC projecting growth at 4.0% in 2018 and 4.2% in 2019 (albeit lower than the National Bank of Slovakia’s forecast of 4.3% in 2018 and 4.7% in 2019). Higher growth reflects sustained domestic demand as well as higher automobile exports.

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 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, with the expansion 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.

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 8.1% 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. 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.

Slovakia’s demographics, coupled with low fertility, are one of the most adverse situations in Europe. 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. To address these challenges, Slovakia has proposed changes to its pension system, which include linking the statutory retirement age to life expectancy and a switch to inflation-based indexation starting from 2018. Implementation of reforms is key given Slovakia’s rapidly ageing population and low statutory retirement age (currently 62.5 years). However, this also reflects low life expectancy, which is the 5th lowest in the EU.

Strong Government Balance Sheet and Prudent Fiscal Management

Slovakia’s credit profile benefits from its track record of conservative fiscal management and low public debt. Measures taken following 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). 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. The deficit has declined further since 2015, falling to 2.2% in 2016 and is projected to have declined to 1.6% in 2017 supported by strong VAT and labor tax revenues due to the favorable economic backdrop. The government expects the deficit to fall further to 0.8% in 2018 enabling Slovakia to meet its medium-term budgetary objective of a balanced budget in 2020.

A key challenge on the fiscal front is Slovakia’s low revenue efficiency. Slovakia has one of the largest VAT gaps in Europe (29.4% v/s EU average of 12.8%) and lowest levels of corporate tax compliance. The recent improvement in VAT proceeds is encouraging, but at 48% the efficiency gap is high relative to its EU peers. The IMF estimates that a further increase in Slovakia’s value-added tax efficiency to the EU average (54%) could produce an additional 0.9% of GDP in revenues. Further, the convergence of property and environmental tax collections to EU average levels could increase revenues of up to 2% of GDP. These measures could create space to help address fiscal needs arising from ageing demographics. In order to meet its medium-term objective of a balanced budget in 2020, on-going efforts to increase tax efficiency and to address ageing problems related to pensions and healthcare are key.

Slovakia is among the few EU countries whose public debt-GDP ratio is below the Maastricht threshold of 60%. Its public debt-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 ratios stabilizing at 50.6% in 2017. Slovakia’s underlying debt dynamics point to a declining debt trajectory over the projected five-year horizon, reaching 43.6% in 2022. 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 7 years.

Private Sector Leverage Increases but Financial Stability Risks are Limited

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.
The trend most significant for financial stability in Slovakia continues to be household loan growth of 12.3% in December 2017, similar to trends seen during 2006-16. Mortgages remain the key driver of household credit, accounting for nearly 80% of total household loans. The rise in private sector leverage is amongst the highest in the EU over the last 10 years, with the stock of household debt amongst the highest in Eastern Europe. This is largely attributed to the low interest rate environment and favorable domestic macro developments, including the introduction of a statutory cap on housing loan repayment fees.

Given the interlinkage of the Slovak banking sector to the property market, the increase in loan growth is a concern. 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 has approved a further increase in the countercyclical buffer to 1.25% effective 1 August 2018. The NBS also recently harmonized regulatory differences between consumer and housing loans, chiefly by requiring a financial buffer for consumer loans. Without this requirement, borrowers have been able to use the financial buffer required for a housing loan to service a consumer loan, thereby rendering the regulation ineffective. As in the case of housing loans, the buffer is set at 15% of the difference between the applicant’s net income (deducting all debt servicing) and total minimum subsistence amount. The NBS expects that phasing in the buffer requirement will avert shocks to the consumer loan market.

Corruption Issues Continue to Impact Institutional Quality

The deaths of journalist Jan Kuciak and his fiancée in February 2018 triggered the biggest anti-government protests since those of the 1989 anti-communist Velvet Revolution. As a result, Prime Minister Fico - the head of Slovakia’s three-party coalition and his cabinet members, all resigned. With the junior coalition parties deciding to stay in the coalition, President Andrej Kiska swore in a new Cabinet led by Peter Pellegrini, who previously was the deputy prime minister. However, political uncertainty continues as Fico remains the head of the center-left party, SMER-SD (a member of the three-party coalition that also includes the far-right Nationalist Slovak National Party and the Minority Oriented Most-Hid).

Even before the recent unrest, Slovak firms identified corruption and inefficient government bureaucracy as the main obstacles to doing business. Slovakia scores below the EU average in areas relating to the government’s responsiveness to the needs of small and medium enterprises. There remain concerns on the business environment linked to the slow process of approving construction permits, relative difficulty in enforcing contracts, and costs of insolvency resolution. Thus, while Slovakia has seen an uptrend in foreign investment in the auto sector (Volkswagen, Peugeot-Citroën, Kia and Jaguar Land Rover) and the electronic space (Samsung and Foxconn), there is low participation by domestically-owned companies in the global supply chain.

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, housing market and credit trends, fiscal performance, debt trajectory and the political environment.

KEY INDICATORS

Fiscal Balance (% GDP): -1.6 (2017); -1.0 (2018F); -0.2 (2019F)
Gross Debt (% GDP): 50.6 (2017); 49.9 (2018F); 47.2 (2019F)
Nominal GDP (EUR billions): 84.9 (2017); 90.1 (2018F); 95.4 (2019F)
GDP per Capita (EUR): 15,630 (2017); 16,592 (2018F); 17,535 (2019F)
Real GDP growth (%): 3.4 (2017); 4.0 (2018F); 4.2 (2019F)
Consumer Price Inflation (%): 1.4 (2017); 2.2 (2018F); 2.0 (2019F)
Domestic Credit (% GDP): 132.5 (2016); 136.7 (Sept-2017)
Current Account (% GDP): 0.2 (2017); 0.4 (2018F); 1.3 (2019F)
International Investment Position (% GDP): -62.4 (2016); -63.9 (2017)
Gross External Debt (% GDP): 90.9 (2016); 110.8 (2017)
Governance Indicator (percentile rank): 76.4 (2016)
Human Development Index: 0.85 (2015)

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.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve-month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.
Lead Analyst: Rohini Malkani, Senior 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: November 3, 2017

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.