May 23, 2018

As the Slovak economy continues to enjoy robust growth, policies need to address long-standing challenges. With historically-low unemployment, labor and skills shortages are weighing on future growth prospects. Gaps in education, infrastructure and institutional quality are additional drags. Addressing these challenges will require multi-faceted structural reforms, but also fiscal resources which should be created through increased revenue and spending efficiency building on recent fiscal consolidation achievements. A sustained period of strong credit growth has increased household indebtedness. Macroprudential policies are appropriately addressing risks to households and banks.

The Slovak economy is enjoying consecutive years of favorable performance. Per capita real income grew by around 3 percent annually during the last five years supported by strong labor market dynamics and credit growth. The unemployment rate is at a historically low level, while external sector performance is in line with economic fundamentals. Looking ahead, real GDP growth is expected to reach 4 percent in 2018 and accelerate further in the medium term supported by investments in the automotive sector.

Robust growth and policy efforts are helping to improve fiscal balances and create policy space. The overall fiscal deficit is estimated to have improved significantly during the last two years reaching 1 percent of GDP in 2017. The consolidation has been supported by higher social security contributions, lower interest payments, and lower social benefits and non-wage current spending. In the absence of further discretionary measures or large wage hikes, the overall fiscal balance is projected to improve further, reaching a deficit of 0.8 percent of GDP this year and a balanced position by 2020. This would create sufficient fiscal buffers to withstand unforeseen macroeconomic shocks, even under the constraints of the Fiscal Responsibility Law.

The positive medium-term outlook is not without risks. On the downside, there are risks from rising protectionism in international trade and skills shortages in the domestic labor market that could weigh on Slovakia’s export-dependent economy. In addition, a sudden downturn in the economy and the property market can negatively impact households—which have become increasingly vulnerable after a decade of double-digit mortgage credit growth. On the upside, stronger growth in the Euro area and higher public investment from a pick-up in the absorption of EU funds could boost growth further.

In addition, long-standing weaknesses are posing challenges to potential growth. In line with peer countries in Central Europe, post-crisis labor and total factor productivity growth rates have been less than half of their pre-crisis levels and are likely to face further headwinds from intensifying labor and skills shortages. Relatively weak education and institutional quality compared to EU peers and the projected decline in the workforce because of rapid population aging, if left unaddressed, will also dent productivity and labor supply growth, challenging the prospect of sustained convergence to EU income levels.

Structural Reforms: Lifting Productivity Growth

Labor and skills shortages are becoming more acute. The share of survey respondents reporting labor shortages increased by five folds over the last five years in the industrial sector where the problem is most acute. However, with policy effort, there is scope to increase the domestic labor pool over time through higher participation of disadvantaged groups and women. Slovakia has a persistently higher gender gap in labor force participation and employment than EU peers, driven mostly by a lack of adequate early childcare facilities. In addition, long-term unemployment rate remains high among disadvantaged groups due to inadequate marketable skills and limited training opportunities.

Weak education quality and institutions are additional drags to productivity growth. Difficulties in finding qualified workers, in addition to restraining expansion of production, may also limit technology adoption and productivity growth. While the share of labor force with secondary education is high, low PISA scores across subjects indicate quality gaps particularly for vulnerable communities. Vocational training is widespread, but it is not well connected with work opportunities, resulting in many vocational school graduates pursuing work that is not in their field. In addition, there is scope for improving economic efficiency by strengthening judiciary independence, reducing anti-competitive practices in public procurement, improving coordination between government ministries, and simplifying administrative procedures.

The mission welcomed the authorities’ policy efforts to address structural weaknesses and recommended complementary measures. On the labor market, recent measures to facilitate procedures for issuing work permits to foreigners are steps in the right direction and should be strengthened by finalizing the list of occupations and further simplifying administrative procedures. Plans to expand formal childcare services, especially for young children, are expected to help increase female labor force participation and should be complemented by encouraging greater gender flexibility in the use of childcare-related leave. On education, measures to increase attractiveness of the teaching profession and strengthen collaboration between vocational schools and employers are appropriate. These should be complemented by teachers’ training, mandatory pre-school education targeting improvement in vulnerable communities, optimization of regional school network and a forward-looking higher education strategy that takes into account rapidly changing demand for skills. On governance, effective implementation of the recently approved Civil Service Act and the Anti-Offshore Law are important. Together with measures to increase competition in the public procurement system and improve tax compliance, these reforms are expected to improve governance.

Fiscal Policy: Raising Efficiency to Invest in Priority Areas

In recent years, the authorities’ fiscal policy efforts have focused on improving revenue and spending efficiency. Measures under the three-phase action plan to fight tax evasion have significantly reduced VAT compliance gaps. The authorities are in the process of formulating a new three-year strategic reform plan to address main weaknesses in revenue administration. At the same time, the multi-year thematic spending review program, called the Value for Money program, has completed reviews of six key ministries and is entering its third wave.

Continued policy efforts to improve efficiency could unlock significant resources. The VAT gap, despite notable improvement, remains sizable indicating room for further gains. The mission supports the authorities’ planned measures to combat tax evasion. On reform of tax administration, it highlights the following priorities: strengthening and broadening audit activities in all core tax areas, adopting a systematic approach to identification and assessment of compliance risks, increasing accessibility of information by tax payers and carrying out regular surveys to monitor public confidence. Strong political commitment is needed to fully capture savings identified in the spending reviews, as well as continued efforts to strengthen the capacity of the Implementation Unit in the Prime Minister’s office, and to integrate the findings of these reviews in the medium-term budget plans. Additionally, there is scope to save sizable resources in capital investment through strengthened project prioritization and improved public procurement system, which would also ensure timely and full absorption of EU funds.

These resources can be used for investments in infrastructure, education, and labor market to improve growth and inclusiveness. When compared to other EU countries, Slovakia shows significant gaps in motorway infrastructure measured relative to its population and size. Infrastructure sector also faces additional spending needs for maintenance of existing roads, modernization of railway and improvement of lower-class roads. As discussed above, sizable public resources are needed to align the education quality with future labor market needs of the economy, address disparities in opportunities faced by disadvantaged groups, and increase female labor force participation. Spending on active labor market policies is still one of the lowest in the EU and largely focused on job creation, despite rising job vacancies, rather than on employability.

Financial Sector: Preserving Stability

The banking sector is sound but vulnerable to adverse macroeconomic shocks. Banking sector profitability remains high supported by low operating costs. Notwithstanding high credit growth and declining net interest income, banks’ capital adequacy strengthened further in 2017 and non-performing loans remain low and adequately provisioned. However, banks have sought to maintain their profitability by expanding their loan volume to compensate for low interest rates, which has increased their sensitivity to adverse shocks including from lending to clients with higher indebtedness.

A sustained period of strong credit growth has increased household indebtedness. Low borrowing costs, robust employment growth, and rising property prices have supported strong demand from households and more recently from nonfinancial corporates. The stock of loans held by households, at around 40 percent of GDP, is now slightly above the level that is in line with economic fundamentals although overall private sector indebtedness is assessed to be appropriate. Average housing prices have increased but are still below their pre-crisis levels.

Pro-active tightening of macroprudential policies by the authorities is slowing down credit growth and building needed buffers. Sustained tightening of macroprudential measures over the last four years targeting risky and highly-indebted borrowers, including the introduction of binding limits on loan-to-value and debt-service-to-income ratios, appear to be slowing down household credit growth. The proposal to impose limits on debt-to-income ratios currently under consideration would complement existing borrower-based measures to dampen further the lending growth to highly-indebted borrowers. These measures appropriately balance the need to preserve access to credit for Slovak households with the need to safeguard financial stability, and should be approved without delay. To complement macroprudential policy efforts, consideration could be given to reducing tax subsidies for owner-occupied housing which arise from capital gains exemptions.

The IMF mission would like to thank the authorities and other counterparts for the frank and thoughtful discussions and kind hospitality.