DBRS Morningstar Downgrades Slovak Republic to “A”, Trend Changed to Stable

DBRS Ratings GmbH (DBRS Morningstar) downgraded the Slovak Republic’s Long-Term Foreign and Local Currency – Issuer Ratings to “A” from A (high). At the same time, DBRS Morningstar downgraded the Slovak Republic’s Short-Term Foreign and Local Currency – Issuer Ratings to R-1 (low) from R-1 (middle). The trends on all ratings have been changed to Stable.

KEY RATING CONSIDERATIONS
The downgrades to the ratings reflect DBRS Morningstar’s assessment that Slovakia’s medium-term macroeconomic performance will be weaker than previously expected. Slovakia’s economic performance will likely remain constrained by the series of recent global shocks. Elevated inflation and interest rates challenge the domestic environment, while higher costs and weaker external demand weigh on the country’s external position. The worsening of Slovakia’s potential growth projections hamper the government’s strategy to balance its fiscal accounts and to meaningfully reduce the public debt ratio. Under current assumptions, Slovakia’s structural deficit remains wide over the forecast period and its debt-to-GDP ratio remains well above pre-pandemic levels. These assumptions are further complicated by uncertainty linked to this year’s early election. Deteriorations in DBRS Morningstar’s “Economic Structure and Performance” and “Fiscal Management and Policy” building blocks are the key factors for the downgrade.

The “A” ratings and Stable trends reflect the country’s sound macroeconomic features. Slovakia attracts high-quality foreign investment and is well integrated into the European supply chain. The country’s credit profile also benefits from its European Union (EU) membership and deep integration with major Eurozone (EZ) economies, particularly Germany. These factors have been key to Slovakia’s economic catchup process in the years since joining. The country’s credit strengths offset structural weaknesses, including its small economy, high reliance on exports, regional disparities, and adverse demographics.

RATING DRIVERS
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. Alternatively, the ratings could be downgraded if there is evidence of structural deterioration in Slovakia’s economic performance, and/or a further and material weakening of the government’s commitment to rebalance the public finances over the medium term.

RATING RATIONALE
Slovakia’s Economic Recovery Has Been Slow And Medium-Term Prospects Have Deteriorated

Slovakia’s small and open economy centred around manufacturing exports has proven vulnerable to disrupted supply-chains and to increased costs of energy and capital linked to the pandemic and Russia’s war on Ukraine. The country’s historically near-complete reliance on gas imports from Russia has meant the nature of recent shocks weakens the performance of Slovakian industry. Slovakia’s external sector is exposed to the performance of its partners, notably Germany, whose economic recovery has also been sluggish. Though goods exports have recovered above pre-crisis levels, the terms of trade shock from higher prices left the trade balance negative last year for the first time since 2008. The difficult external environment has also affected domestic demand. Despite subsidised prices, the rapid rise in energy costs and the pass through to food prices and nominal wages from Slovakia’s tight labour markets caused inflation to average 12.1% last year. High inflation and eroded real wages slowed private consumption and investment. Following its comparatively mild 3.4% contraction of real GDP in 2020, flash estimates indicate Slovakia’s GDP at the end of 2022 was 1.2% higher than the pre-crisis 2019 level.

Looking ahead, Slovakia’s medium-term economic performance is likely contingent on the evolution of the energy crisis and the country’s ability to successfully absorb the inflow of EU funds. Authorities have been effective at replacing some of the gas dependency on Russia and at filling Slovakia’s large gas storage capacity, yet risks remain of energy supply shortages. To help offset challenges from abroad, Slovakia is one of the largest recipients of funds from the EU’s Multiannual Financial Framework (MFF). The previous MFF funding round ends in 2023, and together with the Next Generation EU grants (6.2% of GDP) the country has an opportunity to direct significant capital over the next few years to support productivity enhancing investments. However, Slovakia has a poor track record of absorbing EU funds and the growth-enhancing effects of the funds on the economy remain unclear. Adverse demographics and regional economic disparities are additional structural challenges. The European Commission (EC) projects economic growth to average 1.8% in 2023-24, roughly in line with its 1.6% estimate of output potential growth. The EC’s estimate of potential growth in 2019 was 2.4%, and it averaged 3.6% over the preceding twenty years.

Following Improvement To The Fiscal Deficit In 2022, The Public Sector Imbalance Likely Widens Again In 2023

Slovakia’s public finances have been adversely affected by the compounding macroeconomic shocks since 2020. Following the 1.2% of GDP deficit in 2019, the negative public balance widened to an average of 5.4% in 2020-21 to accommodate pandemic-related government support measures designed to protect public health, firms, jobs, and households. Despite the costs associated with the energy shock in 2022, the deficit is estimated to have narrowed to 3.5% of GDP last year due to the unwinding of COVID-19 support measures, strong inflation, and improved tax collection. This improvement will likely reverse this year as expansionary policy – linked to the energy crisis, recent legislation to increase pro-family social spending, and costs associated with integrating war refugees – is combined with weak economic activity. The government’s 2023 budget projects the deficit to widen to 6.4% of GDP this year and gradually decline thereafter.

Despite welcome changes to Slovakia’s medium-term fiscal policy, its structural deficit remains much larger than it was before the crises. DBRS Morningstar views the government’s passage of the expenditure ceiling and pension reform last year as a favourable. The new fiscal rule is designed to contain spending growth each year, while pension reform removes the cap on the statutory retirement age and links retirement to life expectancy. Both could over time help improve public finance outcomes. That said, the government legislated the spending cap when deficits were high, lengthening the time it will take before the new rule has a durable effect on the balance. Likewise, features of the pension reform, principally the parental bonus, increase current spending over the next decade. As a consequence, fiscal policy is now structurally more expansionary than it was prior to the crisis. Slovakia’s Council for Budget Responsibility (CBR) forecasts Slovakia’s structural deficit widens to 4.6% of potential growth by 2026, above its 1.9% estimate in 2019.

The Public Debt Ratio Is Not Expected To Return To Pre-Pandemic Levels Soon

Slovakia’s gross government debt-to-GDP ratio increased from 48.2% prior to the pandemic to 62.2% in 2021 as a result of large fiscal measures to support the public and the economy, and a sizeable increase in liquid assets. Last year’s cyclical economic recovery and high inflation deflated the debt ratio to 58.9%, but the CBR expects it to again rise above 60% of GDP by 2026 as deficits remain wide and economic growth only slowly recovers. Despite this, debt management in Slovakia has favourable features. The country benefits from a comparatively moderate level of public debt, a sound debt profile with long average maturities (8.5 years) and low debt servicing costs (1.31% of GDP) in 2022, and a conservative cash buffer (around 7-10% of GDP). DBRS Morningstar would welcome the passage of the new debt brake rule. It would target net, rather than gross, government debt and is designed to improve the management of treasury cash reserves, mitigate procyclicality, and enhance predictability.

The Crises Have Negatively Affected Slovakia’s External Position; External Sector Risks Appear Contained

Supply bottlenecks and strong domestic demand over the last few years resulted in a current account deficit of 5.5% of GDP in 2022, from the small surplus recorded in 2020. Slovakia’s national bank expects the deficit to narrow back towards balance by 2024 as global value chain disruptions ease and energy imports stabilise. Prior to Russia’s invasion of Ukraine, Slovakia imported roughly 85% of its gas from Russia. DBRS Morningstar assumes Slovakia now draws in roughly half of that amount of gas from Russia, though data on the origins of energy imports is scarce. Alternative trade and financial links with Russia are modest. Slovakia also appears well positioned to effectively manage the transition of its auto industry to electric vehicles. The external sector from a stock perspective is less concerning than the IMF’s forecast for Slovakia’s 2022 negative net international investment position (NIIP) of 67.0% of GDP. This comprises mostly of foreign direct investment in the form of equity and intercompany lending. There is limited private-sector reliance on foreign credit which mitigates risks of capital outflows, and large inflows of EU funds lessen risk to the current account refinancing. These factors positively affected DBRS Morningstar’s qualitative assessment of the “Balance of Payment” building block.

Financial Sector Challenges Are Mitigated By Strong Bank Resilience And Healthy Private Sector Balance Sheets

Slovakia’s banking system is stable, well-capitalised, and profitable. The recent rise in interest rates supports bank margins, and the combined threats to the domestic economy have until now not translated into a significant deterioration in credit quality. Non-performing loans at 1.9% of total loans were still low in the third quarter of 2022. A high level of uncertainty remains over the second-round effects of high inflation on Slovakian corporates. Firms facing higher energy costs and lower turnover could be most affected. Financial sector risk also stems from the housing market. Higher savings during the pandemic fuelled strong housing demand and double-digit growth in mortgage lending. Limited household net financial savings and high inflation weakens household debt affordability. However, low household debt at 49.4% of GDP as of the second quarter of 2022 and the NBS’s strong macroprudential framework help mitigate risks. Likewise, DBRS Morningstar views Slovak banks, whose capitalisation and coverage ratios are above the EU average, well equipped to absorb losses stemming from a deterioration in the economic environment. The NBS’s increase of the countercyclical capital buffer rate from 1.0% to 1.5%, effective August 2023, also reinforces bank capital. These factors contribute to the positive qualitative assessment of the “Monetary Policy and Financial Stability” building block.

Elections Later This Year Complicate New Legislation And Amendments To The Debt Brake Rule

Slovakia’s ruling coalition government was weakened when the Freedom and Solidarity (Sloboda a solidarita, SaS) party abandoned the coalition last year. The current minority government appears unlikely to pass any meaningful legislation prior to the early election scheduled for September 2023. Most recent polling by Politico shows the parties Voice – Social Democracy (HLAS) and Direction – Slovak Social Democracy (Smer) each garnering 19% of voting intentions as of February 2023, and six other parties polling above the five percent threshold. Depending on the election outcome, the next government could struggle to amend the Constitutional Act of Budgetary Responsibility or make additional progress with justice reform. Slovakia is a weaker performer compared with its peers on rule of law and corruption perception indices. High-profile officials have recently been prosecuted for corruption. Improvement in this area could increase the country’s capacity to absorb EU funds, which is historically low. DBRS Morningstar does not expect the fragmented nature of Slovakia’s political environment to dramatically weigh on the progress necessary to receive Next Generation EU funding, but implementation delays 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 20,600 in 2022 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 (49th out of 180 countries) in 2022 according to Transparency International. In comparison with other EU countries, Slovakia has a relatively low score for the rule of law (73.6 percentile rank), according to the World Bank. DBRS Morningstar considered this 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 Worldwide Governance indicators over the years, including the government effectiveness (69.2 percentile rank) and voice and accountability (76.8 percentile rank) scores, 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.

There were no Environmental factors that had a significant or relevant effect on the credit analysis

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 (May 17, 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://www.dbrsmorningstar.com/research/410266.

EURO AREA RISK CATEGORY: LOW

Notes:
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/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). In addition, DBRS Morningstar uses 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-andgovernance-risk-factors-in-credit-ratings (May 17, 2022) in its consideration of ESG factors.

The sources of information used for this rating include the Statistical Office of the Slovak Republic, Slovakia Ministry of Finance (Budgetary Plan – October 2022, Stability Programme – April 2022, Macroeconomic forecasts for years 2022 – 2026, February 2023), Národná Banka Slovenska (Financial Stability Report – November 2022, Economic and Monetary Developments – Winter 2022), European Commission (Winter Forecast – February 2023, 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 (Review 2022 and Outlook 2023), IMF (World Economic Outlook – October 2022, International Financial Statistics, Slovak Republic: 2022 Article IV Consultation-Press Release; and Staff Report – June 2022), European Central Bank, Eurostat, Bank for International Settlements, World Bank, Politico Poll of Polls, 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/410268.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Jason Graffam, 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 26, 2022

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