DBRS Ratings GmbH (DBRS Morningstar) changed the trend on the Slovak Republic’s (Slovakia) Long-Term Foreign and Local Currency – Issuer Ratings to Negative from Stable and confirmed the ratings at A (high). At the same time, DBRS Morningstar changed the trend on Slovakia’s Short-Term Foreign and Local Currency – Issuer Ratings to Negative from Stable and confirmed the ratings at R-1 (middle).
KEY RATING CONSIDERATIONS
The trend change reflects DBRS Morningstar’s expectation of a weaker macroeconomic performance for the Slovak economy in the medium term, which could be further constrained by (1) the possible full stoppage of Russian gas supplies along with (2) lower external demand for Slovak exports. These factors might have structural implications for the country’s economic prospects and weigh on the government’s fiscal rebalancing strategy. The public debt ratio rose by 15 percentage points during the Coronavirus Disease (COVID-19) pandemic to 63.1% of GDP in 2021 and the National Bank of Slovakia (NBS) projects that it will remain above 60% of GDP in coming years. Latest government estimates point to weaker-than-anticipated growth compared with pre-invasion of Ukraine with GDP expected to expand by only 1.9% and by 2.6% in 2022 and 2023, respectively, versus 4.2% and 5.0% as anticipated in last year’s draft budgetary plan. The slowdown in economic growth might be further exacerbated if Russia’s gas delivery stops, which would likely cause rationing in the important manufacturing sector, further boost inflation, and hamper external demand. In this context, implementing a structural improvement in the fiscal accounts will likely be more challenging. Moreover, tensions within the ruling coalition are intensifying and this will likely weigh on policymaking.
Slovakia’s A (high) ratings reflect the country’s historically good track record of sound macroeconomic performance and its relatively 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 European Union (EU) membership and deep integration with major Eurozone economies, particularly Germany. These factors have been key in the economic catchup process that, however, has slowed over the last years. Slovakia’s credit strengths offset structural weaknesses, including its small economy, high reliance on exports, rising household debt in the context of low financial net wealth, regional disparities, and unfavourable demographics.
An upgrade of the ratings is unlikely in the near term. Over time, DBRS Morningstar could upgrade the ratings if a substantially improved budget position and sustained economic growth lead to a significant reduction in the public debt ratio. DBRS Morningstar could also change the trend back to Stable if the current economic headwinds, including the possible stoppage of Russia’s gas supply, do not alter Slovakia’s sound macroeconomic framework.
Ratings could be downgraded due to one or a combination of the following factors: (1) evidence of a structural deterioration in Slovakia’s economic performance; and/or (2) a further and material weakening of the government’s commitment to rebalance the public finances in the medium term.
Medium-Term Prospects Deteriorated Significantly and Prolonged Inflation and a Full Cut in Russian Gas Supply are Key Risks
Since Slovakia joined the EU, it has experienced rapid economic growth supported by high integration in the EU, strong domestic demand, and a large influx of foreign investment. These factors have supported the country’s growth model. Despite being a small economy, Slovakia benefits from EU membership that has contributed to fast growth in its GDP per capita income level in purchasing power terms, which stood at 68% of the EU 27 average in 2021, up from 59% in 2004. However, over the last years, the income convergence trend has slowed. DBRS Morningstar anticipates no further significant improvements in coming years, reflecting the economic impact associated with Russia’s invasion of Ukraine in the context of high inflation and prolonged supply-side disruptions.
While the economic slump during 2020 was relatively mild, with GDP falling by 4.4% in Slovakia compared with 5.9% in the EU, the country has struggled to register a quick recovery and GDP remains below pre-pandemic levels. This reflects persistent supply-side disruptions, which continue to weigh on the important car sector, and have been intensified by Russia’s invasion of Ukraine.
The increasing likelihood of a cut in Russia’s gas supply heightens Slovakia’s recessionary risk in the context of higher than Eurozone inflation and weaker external demand. This reflects both the large reliance on Russian gas for Slovakia’s energy mix when alternatives are limited and take time to develop. Moreover, its high economic openness makes the country highly exposed to a worsening in trade partners‘ growth, notably Germany. In June 2022, the government markedly revised its economic projections to 1.9% for GDP in 2022 and to 2.6% in 2023 compared with 4.2% and 5.0% in the last draft budgetary plan 2022 forecast. Against this background, a cut in Russian gas supplies and weaker external demand could hamper Slovakia’s economic fundamentals and weigh on fiscal rebalancing.
Nevertheless, the country has started to diversify its energy supply, but reducing its dependence on Russia’s fossil fuel imports will take time. Pre-invasion, Russia accounted for around 85% of Slovakia’s gas imports in 2020 and its important manufacturing sector could be highly exposed to rationing, despite efforts to increase storage levels and to diversify supplies. This would likely lead to even higher inflation, further hampering private consumption. The government aims to reduce Russian gas dependency by increasing imports from Norway and from use of liquefied natural gas tankers, and plans new investments in other sources. Gas reserves have increased to around 76% as of 22 August 2022 and, in case of a cut in the Russian gas supply, could contain the impact even though the country might struggle to refill the storage capacity next summer.
As a small and open economy, Slovakia is particularly vulnerable to a weaker external environment. Russia’s invasion of Ukraine is clouding the foreign trade outlook with a drop in trade with Russia and Ukraine as well as lower demand from key EU trading partners. Furthermore, inflation is expected to remain in double-digits at least until 2023, which would weigh on households’ real incomes and on private consumption.
That said, 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 recipients of funds under the current MFF. These resources, together with the Next Generation EU (NGEU) grants estimated at 6.2% of GDP, will likely support economic growth in the medium term and mitigate the slowdown in activity.
Unfavourable Demographics Despite the Upcoming Pension Reform Might Require Additional Measures
Besides the economic challenges that Slovakia faces as a small economy that is highly reliant on exports, the country also faces structural challenges. The Slovak total employment rate among low-skilled workers is among the lowest in the EU, which stood at 28.9% compared with 56.1% in the EU as of Q1 2022, 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 in the eastern and central regions of the country, which show higher unemployment rates compared with the Bratislava area. In addition, Slovakia’s demographics are among the most adverse in Europe with its old-age dependency ratio at 24.5% in 2022 and expected to increase to 60.4% in 2060, about 6% higher than the EU average according to Eurostat. The automatic adjustment of the statutory retirement age, as currently proposed in the pension system reform, by removing the cap to the statutory age at 64 years, will positively affect debt sustainability but only after 2030 compared with the current legislation. That said, the link between the statutory retirement age to life expectancy if not embedded in the constitution might be more subject to a reversal. Instead, pension expenditure in the coming years is expected to continue to rise, with the parental bonus generating additional fiscal costs in the coming years. This would likely require further fiscal reforms to improve debt sustainability.
Public Finances Will Likely Improve in the Near Term, but Fiscal Consolidation is Key to Structural Improvement Over the Medium Term
Public finances in Slovakia have been highly affected by the pandemic and the related fiscal support. Despite the approval of the multiannual expenditure ceiling, the fiscal accounts repair trend is highly uncertain due to the economic consequences of the conflict in Ukraine as well as the impact of high inflation on current expenditures. The budget deficit peaked last year at 6.2% of GDP and a cyclical improvement is underway on the back of the recovery, the winding down of the COVID-19 support measures, strong inflation and improved tax collection. But structural improvements are challenging.
The conflict in Ukraine complicates implementing a consolidation strategy in DBRS Morningstar’s view. While the fiscal deficit will likely continue to cyclically improve this year after the spike in 2021, further structural measures, including the pro-family stimulus in response to the increase in inflation and the rise in public wages are adding fiscal pressure to public finances in the medium-term. The deficit this year should decline to 3.7% of GDP benefiting from the reduction in the pandemic-related expenditures along with higher revenues, that should more than compensate for the additional cost of refugees, the war and support for the higher cost of living. Nevertheless, there is uncertainty with regard to the following years.
DBRS Morningstar views positively the fact that the government passed legislation on the expenditure ceiling in March this year but the weaker economic environment complicates the consolidation effort. The government now envisages a slower annual structural consolidation path (0.5% of GDP vs 1.0%) compared with the draft budgetary balance and the parliament passed a pro-family stimulus that includes support for up to EUR 1.0 billion (about 1.0% of GDP) since 2023 which is not expected to be budgetary neutral. Risks are tilted to the upside as new additional measures could be implemented in the case of prolonged inflation and/or should the recession risk intensify. Fiscal revenue flows are expected to be supportive thanks to inflation and to contribute to a deficit decline particularly this year. But over the medium term public wages and pension increases along with additional expenditures on goods and services may not be compensated. This would make it more challenging to implement a fiscal consolidation strategy.
Russian Invasion of Ukraine Has Intensified Higher Import Prices and Supply-Chain Disruptions, Which Further Weigh on Slovakia’s External Position
The country benefits from robust integration in EU value chains and a high flow of foreign direct investment as well as EU funds, However, near-term negative pressure from the prolonged impact of the supply-side bottlenecks, high import prices, and lower demand from trading partners weigh on the current account balance. With around 91% 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.
The Russian invasion of Ukraine is intensifying supply-side disruptions, input shortages, and causing import prices to increase. This, along with lower exports because of weaker external demand and shutdowns in production, particularly in the auto sector, places pressure on Slovakia’s trade balance. Following a small surplus in 2020, the current account balance shifted to a deficit of 1.9% of GDP last year driven by strong domestic demand while supply-side bottlenecks constrained the export rebound. The current account deficit will likely continue to widen to 5.5% of GDP this year compared with 1.9% in 2021 driven by higher energy prices, before narrowing to 2.3% in 2023 with a balanced position only in 2024 according to the NBS. Global value-chain disruptions are projected to ease by 2023, but there is considerable uncertainty such as to the possible loss of competitiveness as a result of a higher inflation in Slovakia and weaker external demand from EU trading partners, notably Germany. Trade and financial links with Russia are modest, even though the high fossil fuel reliance is elevated and a complete stoppage in Russia gas supply could put additional pressure on import prices. Moreover, a prolonged shortage on key inputs, provided mainly by Russia and Ukraine, could be detrimental to Slovakia’s car manufacturing sector. DBRS Morningstar continues to see Slovakia as relatively resilient to the structural transition to electric vehicles, with the negative effects associated with deglobalisation risk still contained. This is reflected in the strong investment commitment from parent car manufacturing companies in Slovakia.
Slovakia’s negative net international investment position (NIIP), although large at 62.8% of GDP in Q1 2022, is less concerning. 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 EU funds should mitigate risks to the current account refinancing lowering in parallel to the country’s external liabilities. These factors positively affected DBRS Morningstar’s qualitative assessment of the “Balance of Payment” building block.
Risks to a Declining Public Debt Ratio Trajectory are Increasing as Economic Growth Weakens and Fiscal Consolidation Strategy Complicates
Slovakia’s ratings benefit from a moderate level of public debt in comparison with international standards, a sound debt profile with a low total cost of debt, 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 peaked at an all-time high of 63.1% last year. In 2021 liquid assets continued to increase mainly due to the deposit inflows in the state treasury accounts from non-government entities.
The International Monetary Fund (IMF) anticipates a gradual decline in the public debt ratio to 56.3% of GDP in 2023, which should reflect still-favourable interest growth dynamics, a lower deficit, and high nominal GDP growth because of high inflation. Moreover, liquid assets will decline and higher rates will contribute to an outflow in deposits in the state treasury accounts from nongovernment entities. DBRS Morningstar projects weak real economic growth as well as slower fiscal consolidation, which could hamper the public debt decline. According to the NBS, the Slovak public debt ratio could remain above 60% of GDP in the medium term. DBRS Morningstar views future debt developments as highly influenced by Slovakia’s economic performance as well as the constitutional passage of the new debt brake rule. This new rule would be based on sanctioning thresholds linked to net government debt which would also improve flexibility in the country’s management of its cash reserves as well as mitigate procyclicality, enhancing debt trajectory predictability.
Slovakia currently enjoys a sound debt profile coupled with low interest costs. The Euro system, which holds a large share of Slovak debt estimated at around 50% of marketable debt, has contributed to improve public debt affordability despite the sharp rise in the debt stock in 2020. However, the change in the European Central Bank’s (ECB) monetary stance and high inflation are putting pressure on yields. The total weighted-average interest yield at issuance, after reaching the lowest historical level of 0.24% last year, rose significantly to 1.55% as of mid-June 2022 and could continue to rise. Nevertheless, the total cost of debt that is currently at around 1.24% of GDP is expected to rise moderately and only gradually over the coming years, benefitting from mostly fixed rate debt and a comfortable residual maturity of 8.5 years at the end of July 2022. Moreover, contingent liabilities are limited also due to the large share of foreign-owned banks and less than 1.0% of the state debt is denominated in foreign currency and fully hedged. The sizeable cash reserves, which the Statistical Office of the Slovak Republic estimated at 11.5% of GDP as of the end of 2021, mitigates the liquidity risks.
Second-round Implications from the Conflict in Ukraine and Rapid Housing Loan Growth Are Mitigated By Low Household Debt And Strong Banks’ Resilience
Slovakia’s ratings benefit from a well-capitalised, stable and profitable banking system that has remained resilient during the pandemic. So far, the phaseout of COVID-19 relief measures has not translated into a significant deterioration in credit quality, and non-performing loans have remained contained. But there is a high level of uncertainty over the second-round effects of Russia’s invasion of Ukraine. The banking sector exposure to Russia and Ukraine is limited and lower trade will likely negatively affect mainly large and diversified firms. Nevertheless, those firms facing higher energy costs and lower turnover could be highly affected, which will likely translate into a deterioration in credit quality. DBRS Morningstar views Slovak banks, which benefit from a high level capitalisation and coverage ratios, well equipped to absorb losses stemming from a deterioration in the economic environment.
Higher savings during the pandemic have fuelled strong housing demand, contributing to double-digit growth in mortgage lending growth since March 2021. In parallel, household indebtedness as well as property prices are rising, increasing the house prices correction risk in a weaker economic environment. Households in aggregate have limited net financial savings and with inflation increasing are likely to see a deterioration in the debt affordability. Nevertheless, despite the large surge in the past decade (26.0% of GDP in Q1 2012), household debt at 47.8% of GDP as of Q1 2022 remained lower than the EU average of 49.9%. Moreover, the NBS is proposing adjustments to the debt-to-income ratio limit for loans extending into retirement to mitigate the build-up of imbalances in the banks’ portfolio. DBRS Morningstar views the banking system’s high levels of capitalisation as an important buffer to absorb future losses. As of Q2 2022, both the common equity tier 1 and the coverage ratio at 16.7% and 70.0%, respectively, were higher than the EU average of 15.5% and 46.3%, respectively. Moreover, the NBS has decided to increase the countercyclical capital buffer rate from 1.0% to 1.5% with effect from 1 August 2023. These factors contribute to the positive qualitative assessment of the “Monetary Policy and Financial Stability” building block.
Frictions Within the Ruling Coalition Complicate Passing Legislation and Amending the Debt Brake Rule but Snap Elections are Still Unlikely
Political instability is rising in Slovakia and the Freedom and Solidarity (Sloboda a solidarita, SaS) party’s possible departure from the government coalition could lead to a minority government in the coming months, which will likely weigh on policymaking. The elevated political fragmentation, however, limits the appetite for snap elections, although the risk has increased. While the possible minority government could struggle to pass legislation as well as amend the Constitutional Act of Budgetary Responsibility, external assistance from other parties (including SaS) could support further progress with justice reform. The country ranks unfavourably in the rule of law and poorly in the corruption perception index compared with its peers, and some high-profile officials have been prosecuted for corruption. By tackling corruption, the government might also improve the absorption rate of EU funds, which is historically low. DBRS Morningstar expects that the current tensions within the ruling coalition will not dramatically weigh on the Next Generation EU (NGEU) progress due to its importance, but some delays in the implementation could occur.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Social (S) Factors
The Human Capital and Human Rights factor affects Slovakia’s ratings. Despite progress with narrowing the EU income gap since Slovakia joined the EU, the country’s per-capita GDP remained low at USD 21,053 in 2021 compared with its European peers, reflecting a lower level of competitiveness in its workforce. DBRS Morningstar considered this factor in the Economic Structure and Performance building block.
Governance (G) Factors
The Bribery, Corruption, and Political Risks factor affects the ratings. The country ranked poorly in the corruption perceptions index (56th out of 180 countries) in 2021 according to Transparency International. In comparison with other EU countries, Slovakia has a relatively low score for the rule of law (73.6th percentile rank), according to the World Bank. DBRS Morningstar considered the latter factor in the Political Environment building block. The governance factors have changed from the previous disclosure. In spite of some deficiencies in Institutional Strength, Governance and Transparency, some of these challenges are already reflected in the Bribery, Corruption and Political Risks factor. Despite a slight deterioration in the government effectiveness (71.6th percentile rank) and voice and accountability (74.9th percentile rank) Worldwide Governance indicators over the years, Slovakia’s institutional arrangements are relevant considerations but do not significantly affect the ratings. Public perception of judicial independence remains very low, reflecting perceptions of interference or pressure from the government and politicians.
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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/401879.
EURO AREA RISK CATEGORY: Low
All figures are in euros 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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).
The sources of information used for this rating include the Statistical Office of the Slovak Republic, Slovakia Ministry of Finance (Draft Budgetary Plan – October 2021, Stability Programme – April 2022, Current Macro Forecast of Economic Development – June 2022), NBS (Financial Stability Report – May 2022, Economic and Monetary Developments – June 2022, Macroprudential Commentary – June 2022 ), European Commission (Summer Forecast – July 2022, 2022 Rule of Law Report Country Chapter in the Rule of Law in Slovakia – July 2022, Update Maximum financial Contribution RRF Grants – June 2022), Transparency International, The Social Progress Imperative, The Council for budget Responsibility of Slovakia, Ardal, IMF (World Economic Outlook – April 2022, International Financial Statistics, Slovak Republic: 2022 Article IV Consultation-Press Release; and Staff Report – June 2022), ECB, Eurostat, Bank for International Settlements, 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: YES
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.
The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://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/401878.
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 25, 2022
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