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 remain Stable.

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS Morningstar’s view that a sound macroeconomic performance should continue to sustain Slovakia’s economy in the medium term, facilitating an improvement in the fiscal trajectory. The erosion in fiscal space brought about by the Coronavirus Disease (COVID-19) pandemic has been material and the public debt ratio rose to 60.6% in 2020 from 48.2% registered in 2019, reflecting the GDP decline as well as the large increase to around 8.0% of GDP in the cash buffer. Nevertheless, debt affordability remains strong and interest costs are expected to continue to decline. DBRS Morningstar anticipates that the country will benefit from the European Union (EU) funds in the coming years, contributing to a return to a solid GDP growth rate. However, the elevated structural deficit remains a challenge to public sector debt stabilisation in the medium term. According to the International Monetary Fund (IMF), the public debt ratio will peak at 65.0% of GDP in 2022, before gradually declining to approximately 62.4% in 2026.

Slovakia’s A (high) ratings reflect its good track record of sound macroeconomic performance and its relatively low, albeit rising, level of public debt. The country attracts high-quality foreign investment and is well integrated into the European supply chain. Its credit profile benefits from its EU membership and deep integration with major Eurozone economies, in particular with Germany. 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

Ratings could be upgraded due to one or a combination of the following factors: (1) a faster than expected 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 material reduction in public debt in the medium term.

Ratings could be downgraded due to one or a combination of the following factors: (1) a significantly weaker economic recovery leading to a further deterioration in fiscal accounts and to a substantial and prolonged increase in the debt-to-GDP ratio in the medium term; (2) signs that banking sector vulnerabilities are materially increasing as a result of a prolonged deterioration in credit quality.

RATING RATIONALE

Medium-Term Perspectives Remain Solid although Delta Variant Spread Poses Some Uncertainty In The Near Term

Slovakia’s ratings are underpinned by its solid macroeconomic performance. Supported mainly by strong domestic demand, robust economic activity has contributed to a rapid income convergence towards the EU average since the country joined the bloc. Slovakia’s GDP per capita level based on purchasing power has risen significantly to around 74% of the EU average in 2020, up from 57% in 2004. The pandemic is expected to have interrupted only temporarily the robust economic growth the country has been experiencing over the last two decades. GDP per capita income is projected to continue to rise moderately and the gap with the EU average should narrow going forward. However, this will likely be dependent on external demand as the economy is small and highly reliant on exports.

Last year’s economic recession was milder than expected and despite the uncertainty over the spread of the Delta variant, Slovakia is projected to recover solidly this year. In 2020, the rapid rebound in car exports during the summer months along with the government support measures contributed significantly to mitigating the negative effect of the pandemic-related restrictions. After GDP expansion of 2.5% in 2019, GDP contracted by 4.8% in 2020, less than the EU average of 6.0%.

The impact of the second wave of infections led the government to reimpose restrictions, which weighed on the pace of recovery. However, after contracting by 1.4% quarter-on-quarter in the first quarter of 2021, GDP growth rebounded by 2.0% in Q2. According to the latest forecast from the European Commission (EC), the pre-pandemic output level should be achieved in the third quarter of this year, reflecting an improvement in confidence leading to higher consumption after the easing of restrictions, along with a recovery in exports. Slovakia’s GDP is projected to expand by 4.9% in 2021, before accelerating to 5.3% in 2022. Nevertheless, risks are tilted to the downside due to the input shortage which is temporarily constraining manufacturing activity and the slow vaccination progress. So far, only 39% of the population has received full vaccination which compares unfavorably with the EU average of approximately 56%. Moreover, inflation as in other countries is accelerating and could dampen the recovery in consumption to some extent. The consumer price index has started to accelerate since May and increased to 3.3% year-on-year in July, the highest level in eight years, from 0.8% in February. Nevertheless, so far the main inflation drivers are external – largely the disruption of supply chains, and are expected to be transitory.

Slovakia’s EU membership is a key factor of its credit strength, both in terms of financial support and in terms of preferential access to trade and financial markets. EU funds from the previous Multiannual Financial Framework (MFF), to be spent until 2023, provided a sound absorption rate is achieved, are expected to provide a significant stimulus. Moreover, the country remains one of the largest receivers of funds in the current MFF. These resources, together with the Next Generation EU (NGEU) grants, which are estimated at 6.5% of GDP, will likely support economic growth in the medium-term and facilitate an improvement in the fiscal trajectory.

Regional Disparities and Unfavourable Demographics Remain Key Challenges

Besides the economic challenges that come from being a small economy that is highly reliant on exports, Slovakia faces structural challenges. These include low employment rates among low-skilled and disadvantaged groups and low female labour force participation, all of which are further amplified by regional disparities. Underdeveloped infrastructure, lower educational attainment, and low labour mobility have held back development of the Eastern and Central regions of the country. In addition, Slovakia’s demographics are one of the most adverse in Europe with its old-age dependency ratio expected to increase to 60.4% in 2060 from 24.5% in 2020 according to Eurostat. After the pension reform in 2019 that removed the automatic adjustment of the statutory retirement age to life expectancy and introduced the retirement age cap of 64 years, the parliament reversed the cap in December 2020. The automatic adjustment of the statutory retirement age, as it is currently proposed in the reform of the pension system, will positively affect debt sustainability from 2031. The statutory retirement age set by the current legislation will be valid until 2030, when the retirement age reaches 64 years. Pension expenditure in the coming years, instead, is expected to continue to rise, particularly if the proposed parental bonus is approved. This would likely require further fiscal reforms to improve debt sustainability.

The Fiscal Deterioration Makes a Credible Plan for a Gradual Fiscal Re-balancing Key

Slovakia’s good track record of fiscal management and buoyant cyclical conditions had contributed to a stabilisation in the fiscal deficit slightly above 1.0% of GDP since 2017 from 3.1% in 2014. However, the impact of pandemic-related restrictions, the cancellation of the bank levy as well as pre-election measures resulted in a marked deterioration in the fiscal deficit to 6.1% of GDP in 2020. This year, the government is extending and expanding supportive measures including the short-time working scheme as well as spending in the healthcare sector. The latest estimate from the government points to a deficit of 8.8% of GDP in 2021, lower than the 9.9% envisaged in the Stability Program as economic growth is performing better than expected although risks are tilted to the downside.

The structural deficit is expected to continue to rise in 2021 and fiscal consolidation will start only in 2023 but additional details will likely be provided only in the Autumn budget. According to the Stability Programme, the structural deficit will rise to 5.5% of GDP in 2021 from 2.7% in 2020 and remain stable in 2022 as the government aims to continue to support the recovery due to still high uncertainty about the pandemic development. Starting from 2023 the structural deficit is estimated to improve by 1.0% of GDP annually but details are not yet known. DBRS Morningstar projects a cyclical improvement in the headline fiscal balance but views as key a credible structural fiscal consolidation plan to stabilise the public debt to GDP ratio in the medium term.

Temporary Disruption in Semiconductor Supply To Have a Limited Impact on Slovakia’s Export Performance in the Medium-Term

Slovakia’s external position is good and benefits from high integration in EU value chains particularly through the automotive sector, and a high flow of foreign direct investment as well as of EU funds. However, with around 82% of total exports as a share of GDP, Slovakia is one of the most open economies in Europe and this, along with a low export diversification base, makes the country highly exposed to external demand. Provided that disruption in semiconductor supply weighs only temporarily on the vehicle industry, trade performance should continue to remain sound in the medium term. The country’s external performance should benefit from higher production capacity in the auto sector going forward.

The recovery of foreign demand since the second half of last year contributed to the rebound of export performance. The improvement in the goods balance to 0.7% of GDP in 2020 from a deficit of 1.1% in 2019, along with low returns on past foreign investment, helped the current account deficit narrow to 0.4% of GDP in 2020 from 2.7% in 2019. Once the economic recovery is fully underway, the current account deficit will likely widen again reflecting higher import demand and high public investment. The latest projections from the IMF point to a deficit rising to 0.6% and to 1.6% in 2021 and 2022, respectively.

Slovakia’s negative Net International Investment Position (NIIP), although large at 63.1% of GDP in Q1 2021, is less of a concern. Despite a large share of government debt being 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, along with an expected resilience of export performance, positively weighed on DBRS Morningstar’s qualitative assessment of the “Balance of Payment” building block.

Public Debt Ratio Likely to Continue to Rise Before Stabilising but the Debt Profile Remains Sound

The sizeable deterioration in the fiscal deficit led to a large rise in the public debt which is projected to peak in 2022 before gradually declining. Slovakia was one of the few European countries with a debt ratio below 60% of GDP entering the crisis, but a sharp deterioration in the fiscal deficit and the conservative build-up of a cash buffer caused the debt to increase to 60.6% in 2020 from 48.2% in 2019. The government’s decision to extend further fiscal support to the economy will translate into further pressure on public debt which is likely to peak at 65.0% of GDP in 2022. The improving debt affordability due to declining interest costs along with a likely solid growth in the medium term should contribute to a decline in the debt ratio. However, further fiscal consolidation measures remain key to stabilising and then returning the public debt ratio to a steady downward trajectory. The debt brake rule was suspended because of the past elections and the pandemic, but will likely be replaced by a new debt framework based on expenditure limits corresponding to the planned structural balance, and on sanctioning thresholds linked to net government debt. This would improve flexibility in the management of the cash reserves as well as mitigate pro-cyclicality.

DBRS Morningstar continues to positively view Slovakia’s public debt profile and debt affordability which benefits from the European Central Bank’s (ECB) expansionary policy and credibility as well as a sound state debt cash buffer. This is currently estimated at around EUR 8 billion (8.0 % of GDP) but it will likely decline going forward. Slovakia’s State government debt is almost all long term and at a fixed rate. 96.48% is denominated in euros and the remaining foreign currency debt is fully hedged. The average maturity of government debt at a comfortable level of 8.5 years as of end-July 2021 reduces refinancing risk.

Household Leverage Continues to Rise, but Risks Are Mitigated by the Slovak Banks’ High Capitalisation

Slovakia’s excessive household credit growth in the context of rising house prices and low savings pose some concerns for the country’s financial stability, but the banking system’s high capital buffers provide comfort. So far, the level of impaired loans has remained low thanks to the combination of government support measures as well as the resilience of the Slovak private sector, but uncertainty remains around the economic recovery. In DBRS Morningstar’s view, the high level of banks’ capitalisation is an important buffer to cushion the deterioration in credit quality once the consequences of the pandemic unfold.

Household debt has increased rapidly over the past decade to 43.6% in Q1 2021 from 24.1% of GDP in Q1 2010, and while the ratio is still below the EU-27 average of 50.1%, households are vulnerable due to low savings in financial assets. This trend reflects a sustained growth of credit lending in a context of a high share of home ownership, favourable labour markets, low interest rates, and high banks’ competition. Macroprudential policies implemented so far have translated into a gradual slowdown in credit lending for housing to around 8.6% in February 2021 from the peak of 15.4% in March 2017, but recent months have seen a reversal in the trend. As of June 2021, credit growth for home purchases accelerated to 10.3% year-on-year, likely reflecting higher confidence and liquidity, and it is still substantially higher than the Eurozone average of 5.4%. A prolonged acceleration in credit lending for home purchases could require further initiatives from the Slovak authorities.

The impact of COVID-19 on credit quality has been contained so far but uncertainties over the medium term remain. Slovakia’s households, benefitting from government income support, have shown some resilience. The increase in the unemployment rate has been moderate and loans subject to moratoria that have become distressed after the end of the measures represented only 0.7% of total retail loans according to the Národná banka Slovenska (NBS) as of end-April 2021. Although the interest margin continues to structurally weigh on profitability, the improvement in the economic outlook will likely lead Slovak banks to reduce substantially provisions this year, after a sizeable increase in 2020. This would contribute to a rise in profits in 2021 after the decline by one quarter registered last year. However, the pandemic is not over and negative medium-term consequences on credit quality could intensify depending on the recovery. Against this background, DBRS Morningstar views the banking system’s high levels of capitalisation as an important buffer to absorb future losses. As of March 2021, both the common equity tier 1 (CET) and the coverage ratio at 17.4% and 66.6%, respectively, are high. These factors contribute to the positive qualitative assessment of the “Monetary Policy and Financial Stability” building block.

Despite the Government’s Reshuffle, Commitment Remains High on The Anti-Corruption Strategy and on Improving Slovakia’s Institutional Framework

The coalition government has been making progress in tackling corruption as well as with the rule of law, and the government reshuffle is not expected to undermine the political agenda or cause snap elections. After taking office in March 2020, the government, led by the OlaNO party, which was elected on an anti-corruption platform, has been able to put forward important measures to improve the judicial system and to limit corruption. Although the country ranks poorly in the corruption perception index compared with its peers, the overhaul in the judicial system is expected to improve the perception of the independence of judges and the efficiency of the system. Coalition frictions over the vaccine procurement as well as the management of the pandemic, led the former Prime Minister, Igor Matovic, to step down and he was replaced by the former Finance Minister, Eduard Heger in April 2021. The government reshuffle should not affect the political agenda although further tensions may complicate policy implementation. At this stage, the risk of snap elections remains low.

ESG CONSIDERATIONS
The Human Capital and Human Rights (S) and the Bribery, Corruption and Political Risks and Institutional Strength, Governance and Transparency (G) were among the key ESG drivers behind this rating action. Despite progress with narrowing the EU income gap, Slovakia’s per capita GDP is low at $19,070 in 2020 compared with its European peers. According to World Bank Governance Indicators 2019, Slovakia ranks in the 71.2nd percentile for Rule of Law and in 74th percentile in the government effectiveness. These factors were taken into consideration within the following building blocks: “Economic Structure and Performance”, “Fiscal Management and Policy” and “Political Environment”.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/383538.

EURO AREA RISK CATEGORY: LOW

Notes:
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

All figures are in Euros (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 https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

The sources of information used for this rating include Statistical Office of Slovak Republic, Slovakia Ministry of Finance (Stability Programme - April 2021, Report on expected reality for the year 2021 compared to approved public administration budget for 2021– June 2021), Národná banka Slovenska (Financial Stability Report – May 2021), European Commission (Summer Forecast – July 2021, Recommendation for a Council Recommendation delivering a Council opinion on the 2021 Stability Programme of Slovakia – June 2021, Assessment of the final national energy and climate plan of Slovakia - October 2020, 2021 Rule of Law Report Country Chapter in the Rule of Law in Slovakia – July 2021), Transparency International, The Social Progress Imperative, Our World in Data, Ardal, International Monetary Fund (IMF, Article IV Consultation Press Release Staff Report - June 2021), UNDP, Organisation for Economic Co-operation and Development (OECD), European Central Bank (ECB), Eurostat, Bank for International Settlements (BIS), World Bank, World Economic Forum, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

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 12-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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/383539.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
Lead Analyst: Carlo Capuano, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: April 22, 2016
Last Rating Date: February 26, 2021

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