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 trend 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. DBRS Morningstar does not expect the current supply side bottlenecks or the structural changes in the automotive sector to hamper the competitiveness of the Slovak economy in the coming years. However, Slovakia’s near term economic performance might be hindered by higher and more persistent than expected inflation which might be also amplified by current developments in the energy market due to consequences of the Russia/Ukraine situation. Following a 3.5% expansion in 2022, stronger exports and funds from the European Union (EU) will likely help the economy experience a pick-up in activity to 5.3% in 2023, according to the government. This should help to improve the fiscal trajectory which had deteriorated in the aftermath of the Coronavirus Disease (COVID-19) outbreak. Strong fiscal support along with a material rise in liquidity assets caused the public debt-to-GDP ratio to increase from 48.2% of GDP in 2019 to an estimated 61.9% at end-2021, but it will likely gradually decline to around 55% of GDP in 2024. DBRS Morningstar projects further macroprudential measures in the coming years to mitigate the resurgence of risks in the housing market.

Slovakia’s A (high) ratings reflect its good track record of sound macroeconomic performance and its moderately low 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, particularly Germany. These factors have been key in the economic catch-up process. Slovakia’s credit strengths offset structural weaknesses including being a 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 improving its resilience to external shocks; (3) significant progress in fiscal consolidation combined with a material reduction in the public debt-to-GDP ratio 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) evidence that banking sector vulnerability significantly increases as a result of a material rise in the housing market risks.

RATING RATIONALE

Medium-term Prospects Remain Solid but Supply Chain Disruptions and Prolonged Inflation Are Key Risks

Despite being a small economy, sound macroeconomic fundamentals support Slovakia’s ratings. Since the country joined the EU bloc it has experienced rapid income convergence towards the EU average on the back of solid domestic demand, a large inflow of foreign direct investment, and dynamic exports. This led Slovakia’s GDP per capita level based on purchasing power to rise significantly to around 71% of the EU average in 2020, from 57% in 2004. Over the last years and because of the pandemic the catch-up process has somewhat stalled, but medium-term economic prospects remain sound.

Current semiconductor shortages, as well as the impact of the pandemic, are constraining economic recovery in the near term. Activity started to slow last year from the third quarter, reflecting more intense supply bottlenecks leading to production suspension, which, in turn, hampered exports. In parallel, the spread of the Delta variant caused the government to tighten restrictions in a context of a low vaccination rate. According to the Ministry of Finance’s latest projections, Slovakia’s economic activity has only partially recovered the pandemic losses, with GDP expanding 3.1% last year after contracting 4.4% in 2020. The first months of 2022 will likely be marked by still persistent supply disruptions and the impact of the spread of the Omicron variant on consumption. This would likely delay the recovery to later this year when bottlenecks are expected to ease. Nevertheless, the impact of inflation remains uncertain, which on average is expected to rise 6.0% this year and 4.7% in 2023 and could constrain more than anticipated the recovery in private consumption. Moreover, if geopolitical tensions between Russia and Ukraine continue to escalate, higher energy prices will likely fuel inflation further in Slovakia, which is highly reliant on gas and oil from Russia. Slovakia, where storage levels are low, imports all its gas requirements from Russia. At around 27%, gas remains among the largest source together with oil to produce energy, making it vulnerable to possible lower or more expensive imports.

In DBRS Morningstar’s view, however, the fundamental macroeconomic profile of the Slovak economy will not be altered in the medium term. The economy is expected to gradually adapt itself to the pandemic and the export outlook, provided the bottlenecks are addressed, remains sound. GDP is expected to accelerate this year to 3.5% before peaking at 5.3% in 2023, underpinned by a recovery in exports and a large inflow of EU funds. 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) are likely to be significant in 2023 due to the end of the programming period. Moreover, the country remains one of the largest receivers of funds also 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.

Unfavourable Demographics Despite the Upcoming Pension Reform Might Require Additional Measures

Besides the economic challenges that come from being a small economy that is highly reliant on exports, Slovakia faces structural challenges. The total employment rate among low-skilled workers is among the lowest in the EU and it is further amplified among disadvantaged groups, and 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 which show higher unemployment rates compared with the Bratislava area. 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. 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 but only from 2031. This is because the current legislation set a statutory age of 64 years until 2030. 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.

Public Finances Will Likely Improve but Fiscal Consolidation is Key to The Structural Improvement

Following the pandemic-related deterioration in public finances, Slovakia’s fiscal position is expected to gradually improve. This is largely due to the phasing out of pandemic fiscal support, buoyant recovery, and a more prudent fiscal stance. In response to the pandemic, the government decided to further extend support last year that translated into a higher deficit, which is estimated at around 7.4% of GDP by the central bank (Národná banka Slovenska, NBS) compared with the 5.5% registered in 2020. This, however, is significantly lower than the 9.9% projected by the government in the Stability Programme in April 2021.

DBRS Morningstar foresees an improvement in the fiscal trajectory as the expenditure dedicated to support the economy should decline to 0.7% of GDP in 2022 from 3.4% in 2021. An improved inflow of tax revenues could also contribute to lowering the overall deficit below 4.0% in 2022, according to the latest estimates of NBS. While fiscal policy will likely be neutral in 2022, the government intends to start to consolidate public finances by 1.0% of GDP from 2023, bringing the headline deficit close to 3.0% next year. DBRS Morningstar, however, does not rule out a more gradual improvement in the fiscal trajectory as this remains dependent on the evolution of the pandemic along with risks related to how inflation might constrain consumption leading also to fiscal support measures. DBRS Morningstar expects also pressure on public finances in case of a possible high inflow of refugees from Ukraine should latest developments lead to a high number of people leaving the country. That said, DBRS Morningstar projects a cyclical improvement in the headline fiscal balance in the near term largely because of the recovery and lower pandemic support, with consolidation measures to reduce the structural deficit in the medium term. Compared with the 1.8% of GDP recorded in 2020 the structural deficit is estimated to have increased to 4.3% of GDP last year according to the government. At this stage, the extent of the fiscal consolidation measures remains uncertain as the amendment to the constitutional Fiscal Responsibility Act is yet be agreed in parliament. Nonetheless, DBRS Morningstar believes it unlikely the government will present a balanced budget or enact stable public expenditures for 2024 that would be a requirement under the current fiscal framework.

Disruptions in Semiconductor Supply Weigh on Slovakia’s Export Performance but Medium-term Prospects Remain Bright

Slovakia’s external position is good and benefits from a robust integration in EU value chains 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 its concentration in the automotive sector, makes the country highly exposed to external shocks.

Since the third quarter, semiconductor shortages are weighing on Slovakia’s export performance, translating into some production suspensions and weak foreign demand. As supply side disruptions subside, likely only later in 2022, and production recovers, exports are likely to regain momentum. In DBRS Morningstar’s view, unless a restructuring in the automotive supply chain occurs or/and the impact of the transition to electric and hybrid cars adversely affects vehicle production, the country is well positioned to experience a strong recovery in exports. Large investments from big manufacturing foreign companies are expected to mitigate this risk and DBRS Morningstar expects continuation of a flow of foreign direct investment. According to the NBS, the current account deficit could improve from 2.6% GDP estimated for 2021 to slightly below 0.8% on average from 2022 to 2024.

Slovakia’s negative Net International Investment Position (NIIP), although large at 63.2% of GDP in Q3 2021, is less of a concern. The NIIP mainly comprises foreign direct investment in the form of equity and intercompany lending and there is limited private sector reliance on foreign credit, mitigating risks of capital outflows. Moreover, the large inflow of the EU funds should mitigate risks to current account refinancing lowering in parallel the country’s external liabilities. 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 Peaked in 2021 Before a Gradual Decline on The Back of Sound Nominal Growth and Lower Liquid Asssets

Slovakia’s ratings benefit from a moderate level of public debt in comparison with international standards, a sound debt profile, and a conservative cash buffer. After sharply increasing by around 12 percentage points to around 59.7% of GDP in 2020, mainly as a result of the large fiscal package and the sizeable increase in liquid assets, the debt-to-GDP ratio is estimated to have peaked at an all-time high of 61.9% last year. This not only reflected the further extension of government support to mitigate the impact of the pandemic in 2021, but also government's liabilities to entities outside the general government sector. According to the NBS, negative interest rates on banks deposits encouraged the depositing of financial resources into the State Treasury accounts by public entities outside of the general government, amounting to around 1.8% of GDP. DBRS Morningstar anticipates a gradual decline in the debt ratio on the back of an improvement in the fiscal trajectory, lower liquid assets, and sound nominal growth rates, leading the debt ratio likely dropping close to 55% of GDP in 2024.

The Slovak public debt currently enjoys a favourable debt profile with low interest costs. However, the latter will likely be affected by a less accommodative monetary policy stance. The Euro system, which holds a large share of the Slovak debt, has contributed so far to improving debt affordability despite the sharp rise in the stock of debt in 2020. Total weighted-average interest cost at issuance reached the lowest historical level of 0.24% last year, which compares well with the 1.5% registered in 2017. As monetary policy is anticipated to be less supportive, interest costs at issuance are expected to rise but debt affordability will likely remain sound, reflecting a government debt that is almost all long term and at a fixed rate. 96.62% of government debt is denominated in euros and the remaining foreign currency debt is fully hedged. The average maturity of government debt at a comfortable level of 8.3 years as of end-January 2022 reduces the refinancing risk. Moreover, the debt liquidity profile benefits from a large conservative cash buffer, estimated at around 10% of GDP as of end-2021, which mitigates further the risk of higher interest costs or a dramatic shift in demand.

In DBRS Morningstar’s view, future debt developments will likely be highly influenced by the not yet agreed new debt brake rule 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, enhancing debt trajectory predictability.

While Covid Consequences are Expected to be Limited, the Rapid Housing Loan Resurgence Remains a Risk to the Housing Market

The phasing out of the relief measures including the statutory moratoria is translating into a limited deterioration in credit quality. Both corporates and households are registering moderate nonperforming loan ratios, benefitting from sizable public support and reflecting sound resilience overall. Although some uncertainties surrounding the sectors adversely hit by the pandemic, as well as consumer credit, remain, credit provisions moderated in 2021 due to lower uncertainties.

The pandemic, however, has led to the resurgence of a rapid increase in retail credit growth, which in the context of rising household indebtedness and property prices, poses some concerns to overall financial stability. Higher savings during the pandemic have fueled strong housing demand contributing to a double-digit rebound in mortgage growth since March 2021. Structural housing market features, including high competition among lenders, high share of home ownership, and low interest rates also put pressure on housing loan growth, which stood at 11.5% in December 2021. In parallel, household indebtedness as well as property prices are rising leading to some overheating in the market and making households, which have in aggregate limited net financial savings, more exposed to risks. Nevertheless, despite the large increase in the past decade (24% in Q3 2010), household debt at 47.1% of GDP as of Q3 2021 remains lower than the EU average of 51.7%. Moreover, the macroprudential framework has played an important role in mitigating the mounting risks so far, but the current trends and the rise of loans among already indebted borrowers maturing often beyond the retirement age, will likely require new initiatives. Against this background, DBRS Morningstar projects further macroprudential measures to contain risks and views the banking system’s high levels of capitalisation as an important buffer to absorb future losses. As of September 2021, both the common equity tier 1 (CET) and the coverage ratio at 17.4% and 69.2%, respectively, are high. These factors contribute to the positive qualitative assessment of the “Monetary Policy and Financial Stability” Building Block.

Despite the Government 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 and improving the rule of law but more initiatives are needed. The April 2021 government reshuffle did not undermine the political agenda or cause snap elections and the government remains committed to putting forward important measures to improve the judicial system and to limit corruption. The country ranks unfavorably in the rule of law and poorly in the corruption perception index compared with its peers but the overhaul in the judicial system is expected to improve the perception of the independence of judges and the overall efficiency of the judiciary. DBRS Morningstar expects that by making further progress with tackling corruption the government might also improve the absorption rate of EU funds which is historically low. Frictions within the coalition partners over vaccine procurement as well as the management of the pandemic, led the former Prime Minister, Igor Matovic, to switch his position with the former Finance Minister, Eduard Heger in April 2021. The government reshuffle has not affected the political agenda so far, but further tensions may complicate policy implementation and some delays are likely. 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 was low at about USD 21,400 in 2021 compared with its European peers. According to the latest World Bank Governance Indicators, Slovakia ranks in the 73.6th percentile for rule of law, 74.9th percentile for voice and accountability and in 71.6th 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/392970.

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.

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 (Draft Budgetary Plan – October 2021, Current macro forecast of economic development – February 2022), Národná banka Slovenska (Financial Stability Report – November 2021, Economic and Monetary Developments – December 2021), European Commission (Winter Forecast – February 2022, Commission Opinion on the Draft Budgetary Plan of Slovakia – November 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, IFS, European Central Bank (ECB), Eurostat, Bank for International Settlements (BIS), World Bank, 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/392969.

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: August 27, 2021

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