Morningstar DBRS Confirms Ratings on Slovakia at “A”, Negative Trend

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

KEY CREDIT RATING CONSIDERATIONS
The Negative trend on the long-term credit ratings reflects the risks related to Slovakia’s structurally large fiscal deficit, and it remains unclear whether the new governing coalition will prioritise the rebalancing of public accounts. Despite economic headwinds, including tighter financial conditions and weaker performance from Euro area peers, the economy overperformed European neighbours last year thanks to investment spending linked to EU funding. Recovery in private consumption and a pick-up in external demand are expected to keep economic output above trend growth this year and next. Considerable downside risk stems from the large fiscal deficit, having widened in recent years due to measures aimed at mitigating high energy prices and by new permanent spending commitments. The European Commission (EC) forecasts deficits in 2024-2025 to average 5.7% of GDP. In the absence of more budgetary adjustments, the public debt ratio remains on an upward path over the forecast period.

The confirmation of the credit ratings 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 membership of the European Union (EU) and its deep integration with major Euro Area (EA) 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. The government’s inability to rein in budget deficits in recent years has emerged as an increasingly evident challenge to credit quality. Authorities have signalled their intention to deliver a fiscal consolidation plan later this year.

CREDIT RATING DRIVERS
The trend could revert to Stable if the government introduces a credible medium-term consolidation plan. Over time, Morningstar DBRS could upgrade the credit ratings if a substantially improved budget position and sustained economic growth lead to a significant reduction in the public debt ratio and the deteriorating trend in government effectiveness is reversed. Alternatively, the credit ratings could be downgraded if measures are not introduced to rein in high budget deficits and stabilise the public debt ratio, or if there is evidence of structural deterioration in Slovakia’s economic performance.

CREDIT RATING RATIONALE

The Fiscal Deficit Remains Structurally Wide, Government Medium-Term Plan Is Forthcoming

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. The deficit narrowed to 2.0% of GDP in 2022 due to the unwinding of COVID-19 support measures, strong inflation, and improved tax collection. This improvement reversed once again in 2023, widening to 4.9% of GDP, due mainly to the indexation of social benefits and measures to mitigate the economic and social impact of the increase in energy prices. The 2024 budget plan extended energy support and other measures to increase social spending towards pensions, an increase in a child tax credit, and defence spending. Higher expenditures are not fully offset by new revenues, and due to the more permanent nature of the newly adopted measures, the EC expects the deficit to reach 5.9% this year and 5.4% in 2025.

Despite welcome changes to Slovakia’s medium-term fiscal policy framework, its structural deficit remains much larger in the years to come than it was before the latest crises. The passage of the expenditure ceiling and pension reform in 2022 is favourable. The new expenditure 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 reducing the deficit. Likewise, features of pension reform, principally the parental bonus, increase current spending over the next decade. As a consequence, the National Bank of Slovakia (NBS) projects the structural deficit of 4.6% of potential output in 2026, limiting the government’s shock absorbing capacity. Morningstar DBRS anticipates the release later this year of the government’s consolidation plan, which it intends to follow in order to achieve its budgetary deficit target of 3% of GDP by 2027. Reaching the target would constitute a roughly 1 percentage point of GDP adjustment each year for three years.

The Public Debt Ratio Gradually Increases Over The Forecast Period

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. The cyclical economic recovery and high inflation deflated the debt ratio in 2022, though the NBS forecasts it to rise from 56.0% in 2023 to 60.4% in 2026. The wide structural deficits prevent 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 of 8.4 years and low debt servicing costs at 1.85% of GDP in 2023, and a conservative cash buffer of around 7-10% of GDP.

Slovakia’s Economy Has Proven Comparatively Resilient To External Shocks, Structural Improvement Is Likely Contingent On EU Funds

Slovakia’s small and open economy centred around manufacturing exports has been challenged in recent years from reoccurring shocks. The country’s historically near-complete reliance on gas imports from Russia, the disruption to supply-chains, weaker economic performance of the German economy, and the higher costs of energy and investment have meant the nature of recent disruptions weakened the performance of Slovakian industry. Domestic consumption has also 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 10.9% in 2023, though the rate fell to 2.4% in June 2024 compared to a year earlier. Despite the cyclical challenges, the economy expanded by 1.6% in 2023, well above the EU’s 0.4% average growth. The overperformance was in large part due to the windfall investments linked to the exhaustion of the previous funding round of the EU’s Multiannual Financial Framework (MFF).

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 performance of trading partners, and the country’s ability to successfully absorb the inflow of EU funds. Slovakia is one of the largest recipients of funds from the next round (2020-2027) of the EU’s MFF (11.0% GDP), 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, 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 forecasts annual economic growth to average 2.6% in 2024-25, roughly in line with its estimate of potential growth in 2019, though below the economy’s average growth trend of 3.6% over the preceding twenty years.

The Terms Of Trade Shock Temporarily Deteriorated Slovakia’s External Position

Supply bottlenecks and the deterioration in the terms of trade resulted in a current account deficit of 7.3% of GDP in 2022, according to the NBS, from the small surplus recorded in 2020. Trade data improved last year, as global value chain disruptions eased and energy imports stabilised. The NBS expects the deficit to have narrowed to 1.6% in 2023 and expects a similar result this year. Prior to Russia’s invasion of Ukraine, Slovakia imported roughly 85% of its gas from Russia, and now draws in roughly two-fifths. Alternative trade and financial links with Russia are modest. Slovakia also appears well positioned to manage the transition of its auto industry to electric vehicles. The external sector from a stock perspective is less concerning than the negative net international investment position (NIIP) of 54.4% of GDP in 2023. 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 Morningstar DBRS’ 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 net interest 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 2.5% of total loans in 2023 were still historically low. Likewise, banks operating in Slovakia have capitalisation and coverage ratios above the EU average, and are therefore equipped to absorb losses if the economic environment were to deteriorate.

Risk stemming from the housing market is worth monitoring. Higher savings during the pandemic fuelled strong housing demand and double-digit growth in mortgage lending. Limited household net financial savings and high inflation weakened household debt affordability in a context of higher rates. The rise in the cost of borrowing caused residential property prices to contract. The property price index declined by 10.7% from the third quarter of 2022 through to the first quarter to 2024. The financial system, nonetheless, has strong risk mitigating factors. Property prices are still up 44.9% between the first quarter of 2020 until first quarter of 2024. Risks are also moderated by low household debt at 46.8% of GDP in 2023, limited variable rate mortgages, and the NBS’ strong macroprudential framework. Last year’s increase of the countercyclical capital buffer rate from 1.0% to 1.5% also reinforces bank capital. These factors contribute to the positive qualitative assessment of the “Monetary Policy and Financial Stability” building block.

The Volatility Of Slovakia’s Politics And The Weakening Of Key Governance Scores Limit Policy Continuity

Slovakia held an early parliamentary election on September 30, 2023, which resulted in another fragmented political outcome. The Direction – Slovak Social Democracy (SMER-SD) party emerged as the largest party by winning 42 seats, followed by Progressive Slovakia (PS - 32 seats) and Voice – Social Democracy (HLAS-SD - 27 seats). The coalition government formed by SMER, HLAS, and Slovak National Party (SNP – 10 seats) and led by Prime Minister Robert Fico was sworn in on October 25, 2023.

Slovakia is a weaker performer compared with its peers on rule of law and corruption perception indices. Its World Bank Government Effectiveness percentile rank score of 63.7 in 2022 has persistently worsened over the years from its peak score of 75.0 in 2014. Slovakia ranked poorly in the corruption perceptions index (47th out of 180 countries) in 2023 according to Transparency International, and has relatively low percentile rank scores for the rule of law (70.3) and voice and accountability (75.4), according to the World Bank. These trends negatively affect Morningstar DBRS’ qualitative assessment of the “Political Environment” building block. Improvement in these areas, among many other benefits, could enhance the country’s historically low capacity to absorb EU funds. Morningstar DBRS does not expect Slovakia’s divided political environment to dramatically weigh on the progress necessary to receive Next Generation EU funding, but implementation delays could occur.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
ESG Considerations had a significant effect on the credit analysis.

Social (S) Factors

The following Social factors had a significant effect on the credit analysis: 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 24,336 in 2023 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 following Governance factors had a significant effect on the credit analysis: 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 (47th out of 180 countries) in 2023 according to Transparency International, and has relatively low scores for the rule of law (70.3 percentile rank) and voice and accountability (75.4 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 (63.7 percentile rank) and public perception of judicial independence remain low compared to other EU countries, according to the European Commission 2024 Rule of Law Report. This reflects perceptions of interference or pressure from the government and politicians.

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

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://dbrs.morningstar.com/research/437707.
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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030 in its consideration of ESG factors.

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

The sources of information used for these credit ratings include the Statistical Office of the Slovak Republic, Slovakia Ministry of Finance (Stability Programme 2024, Budget 2024), Národná Banka Slovenska (Financial Stability Report – May 2024, Economic and Monetary Developments – Summer 2024), European Commission (Spring Forecast 2024, 2024 Slovakia Country Report, 2024 Rule of Law Report Country Chapter in the Rule of Law in Slovakia – July 2024), Transparency International, The Social Progress Imperative, The Council for Budget Responsibility of Slovakia, Ardal (Investor Presentation April 2024), IMF (World Economic Outlook – April 2024, International Financial Statistics), European Central Bank, Eurostat, Bank for International Settlements, World Bank, and Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings 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: YES
With Access to Management: NO

Morningstar DBRS 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. Morningstar DBRS’ outlooks and ratings are under regular surveillance.

For further information on Morningstar DBRS 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 Morningstar DBRS 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://dbrs.morningstar.com/research/437706.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Jason Graffam, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: April 22, 2016
Last Rating Date: February 09, 2024

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