DBRS Morningstar Confirms Slovak Republic at A (high), Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Slovak Republic’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). At the same time, DBRS Morningstar 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

The confirmation of the Stable trend reflects DBRS Morningstar’s view that although risks to economic growth have increased because of a weaker external environment, Slovakia’s macroeconomic performance should remain sound with GDP growth around 2.4% on average in 2020-2021. The impact of COVID-19 including the slowdown of the Eurozone and lower activity due to potential domestic restrictive measures could likely affect Slovakia. In this scenario, DBRS Morningstar expects a negative impact on the economy, although it could be short-lived and mitigated by potential supportive government measures. Slovakia’s fiscal position has improved over the last years, but the budget balance is now expected to deteriorate, mainly due to lower growth and higher pre-electoral public expenditures. DBRS Morningstar expects that both the EU and the national constitutional fiscal framework, along with a more prudent strategy from the new government, will contain the rise in the fiscal deficit. Risks to debt sustainability appear limited because of sound nominal GDP growth and low funding costs. The public debt-to-GDP ratio is projected by the European Commission (EC) to gradually decline to below 47.0% of GDP in 2021, from an estimated 48.1% in 2019.

Slovakia’s A (high) ratings reflect its sound macroeconomic performance, its good track record of conservative fiscal management and its low public debt. The country attracts high-quality foreign investment and is well integrated into European supply chains. Its credit profile benefits from its European Union (EU) membership, and deep integration with major Eurozone economies. These factors have been key in the economic catch-up process. These credit strengths offset structural weaknesses including Slovakia’s small economy, high reliance on exports, rising household debt in a context of low financial net wealth, regional disparities and unfavourable demographics.

RATING DRIVERS

DBRS Morningstar 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) a renewed effort to strengthen 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 substantial reversal in the public debt-to-GDP ratio’s declining trajectory (2) lower government commitment to fiscal prudence resulting in a sustained increase in the public debt ratio; (3) signs that banking sector vulnerabilities are materially increasing as a result of a prolonged and significant rise in household debt.

RATING RATIONALE

Pre-electoral Measures Require the New Government to Strongly Commit to Fiscal Consolidation

The victory of the Ordinary People Party (OĽaNO) paves the way for a shift from a previous nationalist government to a more pro-EU coalition. Ongoing discussions point to a four-party government coalition including as junior partners the Freedom and Solidarity Party, For the People and We are Family. DBRS Morningstar views positively the focus on improving the healthcare and education system as well as addressing corruption and respect for the Rule of Law, including the implementation of the reform of the judicial system. However, with a coalition comprising of different parties, to some extent the government might be potentially more fragile and subject to internal divisions.

Over the last few years a good track record in fiscal management and buoyant cyclical conditions have contributed to a stabilization in the fiscal deficit level. The combination of policy efforts to collect taxes and reduce tax fraud have been accompanied by strong revenue growth on the back of solid wage growth, with the deficit stabilizing at around 1.0% of GDP on average since 2017, from 3.1% recorded in 2014.

However, the slowdown in economic performance along with the impact of pre-electoral social spending is placing higher pressure on the budget. The fiscal deficit target of 0.5% of GDP this year following an estimated 0.9% in 2019, will likely be revised upwards by the new government. Recent projections from the Slovak fiscal council point to a deficit deteriorating to 1.8% of GDP in 2020 if no compensating measures are implemented. At the same time, the approval of the thirteenth pension payment adds another 0.5% of GDP in 2020 with the deficit rising towards 3.0% of GDP in 2022. In this scenario, the new coalition government will face the challenge of adopting more prudent measures to contain public expenditure at a time when the risks to economic growth are tilted to the downside. Nevertheless, in the absence of further economic slowdown, DBRS Morningstar expects a prudent fiscal stance and gradual containment of the rising budget deficit. The adherence to the EU fiscal framework as well as the constraints of the debt brake rules reduce the risk of a sharp deterioration in the deficit.

A 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 2.9%, 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 around 78% of the EU average, up from 57% in 2004.

Following strong growth in 2018 when the economy expanded by 4.0%, Slovakia’s real GDP growth rate declined to 2.3% last year, with export growth suffering from weaker external environment and low private consumption in the first quarter. Although DBRS Morningstar anticipates a recovery in exports in the medium-term, current uncertainty on the impact of the COVID-19 virus on global value chains clouds the Slovak economic outlook. At the same time, some more restrictive measures might be implemented by the government, should the number of new cases rise exponentially. DBRS Morningstar, however, expects a not negligible negative impact on the economy, although short-lived. The economy is projected to bottom out this year at 2.2% and to expand by 2.6% in 2021, supported mainly by domestic demand which will benefit from resilient consumption, higher investment and public consumption. However, risks remain tilted to the downside due to Slovakia’s reliance on export growth, as well as to the economic performance of the Eurozone.

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.

Slovakia, along with other Eastern European members of the EU, has 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 discussions over the next 2021-2027 Multiannual Financial Framework are still ongoing, DBRS Morningstar anticipates a potential sizeable cut in the allocation of fund for Slovakia, however, the 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).

As External Risk Are Intensifying and the Current Account Improvement will Likely be Delayed

While the Slovak economy with around 86% of total exports as a share of GDP is vulnerable to external shocks, its sizeable Net International Investment position (NIIP) is less of a concern due to its composition. 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 a result of dividend outflows on foreign investments, as well as the slowdown in exports the current account balance has moved back to deficit and is currently hovering around 2.9% of GDP. Risks to Slovak export performance remain high because of a further slowdown in foreign demand, protectionist trade policies and the potential disorderly U.K.’s departure from the EU after the transition period. However, DBRS Morningstar expects the increased production capacity of the auto sector to contribute to narrowing the current account deficit in the medium-term. Slovakia’s negative Net International Investment Position (NIIP), although large at 65.7% of GDP as of Q3 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. This positively weighed on DBRS Morningstar’s qualitative assessment of the “Balance of Payment” building block.

Despite Low Growth and Fiscal Slippage, Risks to Public Debt Sustainability Remain Limited

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 an estimated 48.1% of GDP in 2019. However. the latest increase in social spending if not counterbalanced by compensating measures, along with the slowdown in the economy, are expected to result in a more gradual decline in the public debt ratio. The EC anticipates a public debt-to-GDP ratio to decline below 47% in 2021. Near-term fiscal risks are mitigated also by the benign interest rate environment and by the favourable debt composition. Slovakia’s government debt is almost all long-term, almost fully at a fixed rate and 96% 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 8.5 years as of end-January 2020 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 the context of accumulating imbalances in the residential property market pose some risks to financial stability. Household debt has increased rapidly over the last decade from 23.2% of GDP in Q3 2009 to 43.4% as of Q3 2019, and while the ratio is still below the EU average of 51.8% this makes households vulnerable because of low savings in financial assets. This trend reflects a sustained growth of retail credit in a context of a high share of home ownership, favourable labour markets and lingering low interest rates. Loan growth is on a gradual declining trend since early 2018 also related to the regulatory tightening implemented by National Bank of Slovakia (NBS). However, retail credit growth remains sustained and at around 8.5% on average over the last twelve months is well above the Euro area average of 3.0%. In this context, the recent NBS decision to tighten the maximum debt-service-to-income ratio (DSTI) limit to 60% from 80% is another step towards reducing excessive borrowing.

Given rising property prices, mainly because of a limited supply of houses, rapid loan growth coupled with a high loan-to-value ratio make households vulnerable. This is further accentuated by a high concentration of housing loans among low-income households and by total households’ net financial assets, which at 38.6% of GDP as of Q3 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 and the economy. In DBRS Morningstar’s view, however, further regulatory tightening, the gradual market saturation and demographic trend should mitigate risks stemming from the rapid loan growth.

The banking sector has strong fundamentals and loan portfolios remain relatively healthy. Slovak banks show adequate levels of capitalisation, and good asset quality even as profit margins are on a declining trend. The previous government decision to double the bank levy from 0.2% to 0.4%, might have a significant and negative effect on profitability, in particular in a sector with strong competition and declining interest margins. DBRS Morningstar does not rule out that this could have subsequent negative impact also on capitalization. Slovak banks are likely to face higher pressure on shifting from a traditional retail-credit model towards increasing fees, cost cutting and digitalization to improve efficiency and profit generating capacity.

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 5.9% in Q3 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. Underdeveloped infrastructure, lower educational attainment, and low labour mobility have held back the Eastern and Central regions of the country.

Slovakia’s demographics are one of the most adverse in Europe with its old-age dependency ratio expected to increase from 22.5% in 2018 to 58.8% in 2070 according to the EC. Moreover, the constitutional change passed in March last year to cap the general statutory retirement age at 64 years will further place pressure on public expenditures in the long-term.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.
http://www.dbrs.com/research/358012

EURO AREA RISK CATEGORY: LOW

Notes:

All figures are in Euro (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal 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 Slovakia Ministry of Finance, Statistical office of the Slovak Republic (SOSR), ARDAL, Národná banka Slovenska, Eurostat, European Commission, IMF, UNDP, OECD, Ageing Europe 2019, World Bank, BIS, and Haver Analytics. DBRS Morningstar 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 Morningstar had no access to relevant internal documents for the rated entity or a related third party.

DBRS Morningstar 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 Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar 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 GmbH are subject to EU and US regulations only.

Lead Analyst: Carlo Capuano, Vice President, Sovereign Global Ratings
Rating Committee Chair: Nichola James, Managing Director, Sovereign Global Ratings
Initial Rating Date: April 22, 2016
Last Rating Date: September 13, 2019

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