DBRS Morningstar Confirms Slovak Republic at “A”, Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Slovak Republic’s Long-Term Foreign and Local Currency – Issuer Ratings at “A”. At the same time, DBRS Morningstar confirmed the Slovak Republic’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that the economic recovery is ongoing, despite the pandemic-related disruptions, and the energy price and interest rate shocks. Strong expansion of investment, low unemployment, government support, and easing supply bottlenecks have supported economic activity. However, the momentum will likely slow in the second half of the year due to still elevated, albeit moderating, inflation rates, tighter financing conditions, and weak external demand. On public finances, measures aimed at mitigating high energy prices and increased social spending is expected to keep the fiscal deficit elevated and the debt-to-GDP ratio above the pre-pandemic level. Slovakia holds parliamentary elections this year, and the many political parties near the threshold to enter parliament obscure the election outcome and cloud the medium-term fiscal outlook.

The ratings confirmation reflects 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 EU. The country’s credit strengths offset structural weaknesses, including its small economy, high reliance on exports, regional disparities, and adverse demographics.

CREDIT 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.

CREDIT RATING RATIONALE
Fragmented Politics Could Complicate The Next Government’s Ability To Pass New Legislation And Amendments To Debt Brake Rule

Slovakia holds an early parliamentary elections on September 30, 2023, and polls suggests another fragmented political outcome. Most recent polling by Politico shows persistent improvement by the Direction – Slovak Social Democracy (Smer) party led by former Prime Minister Robert Fico. Smer would collect 21% of prospective voters, up from a low of 8% in November 2020. Progressive Slovakia and Voice – Social Democracy trail with 16% and 14% of the potential vote. An additional six other parties are currently polling above the five percent threshold for parliamentary representation, suggesting another multi-party coalition government that could struggle to amend the Constitutional Act of Budgetary Responsibility, including the debt break rule, or make additional progress with justice reform and the anti-corruption effort. Slovakia is a weaker performer compared with its peers on rule of law and corruption perception indices. Police recently arrested high profile officials from the intelligence and security services allegedly for corruption and links to organized crime. Improvement in this area, among many benefits, could enhance the country’s historically low capacity to absorb EU funds. DBRS Morningstar does not expect Slovakia’s fragmented political environment to dramatically weigh on the progress necessary to receive Next Generation EU funding, but implementation delays could occur.

Vulnerable To External Shocks, Structural Improvement To Slovakia’s Economy Is Likely Contingent On EU Funds

Slovakia’s small and open economy centred around manufacturing exports was vulnerable to the pandemic and Russia’s invasion of Ukraine. The country’s historically near-complete reliance on gas imports from Russia, the disruption to supply-chains, and the higher costs of energy and capital have meant the nature of recent shocks weakened the performance of Slovakian industry. That said, the recovery in Slovakia’s automotive sector has surprised to the upside in the first half of the year, despite the economy’s exposure to its partners, notably Germany, whose recovery has been sluggish. Domestic consumption has been weighed down by still high inflation. The rapid rise in energy costs and the pass through to food prices and nominal wages from Slovakia’s tight labour market caused inflation to average 12.1% last year, though the rate fell below double digits to 9.7% in July 2023 compared to a year earlier. Following its comparatively mild 3.3% contraction of real GDP in 2020, Slovakia’s GDP was 1.2% higher than the pre-crisis level at the end of last year, and the European Commission (EC) expects 1.3% growth in 2023.

The strength of Slovakia’s medium-term economic performance is likely contingent on the evolution of energy prices, inflation and interest rates, the external environment, and the country’s ability to successfully absorb the inflow of EU funds. 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’s absorption capacity of EU funds is among the lowest in the EU, according to the EC 2023 Slovakia Country Report, and the growth-enhancing effects of the funds on the economy remain unclear. Adverse demographics and regional economic disparities are additional structural challenges. The EC projects annual economic growth to average 1.8% in 2023-24, roughly in line with its average estimate of output potential growth during 2023-2027. The EC’s estimate of potential growth in 2019 was 2.5%, and it averaged 3.6% over the preceding twenty years.

The Fiscal Deficit Widens This Year And Gradually Narrows Over The Forecast Period

Slovakia’s public finances continue to be 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. Despite the costs associated with the energy shock in 2022, the fiscal deficit narrowed to 2.0% of GDP last year due to the unwinding of COVID-19 support measures, strong inflation, and improved tax collection. This improvement is expected to reverse once again this year, to 6.3% of GDP according to the government’s Stability Programme (SP), due to energy cost mitigation and increased social spending. As the EU ends its Stability and Growth Pact escape clause, the government’s SP forecasts the fiscal deficit will narrow to 2.2% of GDP by 2026, although Slovakia’s central bank expects a 5.3% deficit by mid-decade.

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 in 2022 as 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 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 at 3.6% of potential growth in 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 48.0% prior to the pandemic to 61.0% 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 57.8%. Assumptions in the government’s SP shows the debt ratio increasing gradually over the forecast period but remaining under the 60% threshold. The wide structural deficits and gradual economic recovery prevents debt dynamics from more firmly improving. 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 view as positive for the credit 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 Terms Of Trade Shock Negatively Affected Slovakia’s External Position; Risks To External Sector Appear Contained

Supply bottlenecks and the deterioration in the terms of trade resulted in a current account deficit of 8.2% of GDP in 2022, according to the National Bank of Slovakia (NBS), from the small surplus recorded in 2020. Trade data improved in the first half of the year, as global value chain disruptions eased and energy imports stabilised. The NBS expects the deficit to narrow back towards balance by 2025. Prior to Russia’s invasion of Ukraine, Slovakia imported roughly 85% of its gas from Russia. The government says it now draws in roughly 43% of gas from Russia, according to Ardal. 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 2022 negative net international investment position (NIIP) of 62.1% 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, by way of higher prices and interest rates, 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 second quarter of 2023. A high level of uncertainty remains over the second-round effects of high inflation on Slovakian corporates. 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 in a context of higher rates. However, residential property prices contracted in the second quarter yoy by 6.4%. Risks are also mitigated by low household debt at 48.3% of GDP as of the fourth quarter of 2022, limited variable rate mortgages, and the NBS’s strong macroprudential framework. Likewise, DBRS Morningstar views banks operating in Slovakia, 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.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Social (S) Factors
The Human Capital and Human Rights factor significantly 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 20,881 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 is a significant consideration for Slovakia’s ratings. DBRS Morningstar considered this factor in the Political Environment building block. Slovakia ranked poorly in the corruption perceptions index (49th out of 180 countries) in 2022 according to Transparency International, and has relatively low scores for the rule of law (74.5 percentile rank) and voice and accountability (76.8 percentile rank), according to the World Bank. The Institutional Strength, Governance, and Transparency factor is a relevant considerations but does not significantly affect the ratings for Slovakia. The government effectiveness score (69.2 percentile rank) and public perception of judicial independence remain low compared to other EU countries, according to the European Commission 2022 Rule of Law Report. This reflects 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 (4 July 2023) https://www.dbrsmorningstar.com/research/416784/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/419952.

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 (29 August 2022) https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. 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/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for this rating include the Statistical Office of the Slovak Republic, Slovakia Ministry of Finance (Stability Programme 2023, Policy Brief – June 2023), Národná Banka Slovenska (Financial Stability Report – May 2023, Economic and Monetary Developments – Summer 2023), European Commission (Summer Forecast 2023, 2023 Rule of Law Report Country Chapter in the Rule of Law in Slovakia – July 2023, Update Maximum financial Contribution RRF Grants – June 2022), Transparency International, The Social Progress Imperative, The Council for Budget Responsibility of Slovakia, Ardal (Investor Presentation May 2023), IMF (World Economic Outlook – April 2023, International Financial Statistics, 2022 Article IV Consultation 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, these are unsolicited credit ratings. These credit ratings were 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 credit 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 credit 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://registers.esma.europa.eu/cerep-publication/. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/419950.

These credit ratings are 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: February 24, 2023

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