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Slovakia’s economy among the EU’s top performers

Tom Nicholson and Beata Balogoá

	The car industry is helping to keep the economy strong.
	SITA

Thanks to its robust macro-economic growth in recent years and preparation for euro adoption, Slovakia, an OECD member, is well equipped to graduate in 2008 from World Bank borrowers to the ranks of developed countries that provide developmental aid. The World Bank upgrades countries that reach a certain gross national income per capita, which for 2006 stood at $6,275, and are able to sustain long-term development without the bank’s support. Slovakia’s gross national income per capita in 2006 stood at $7,950, with good access to capital markets.

Standard & Poor's Ratings Services on March 3, 2008 confirmed Slovakia's country rating at A/A-1 and revised its outlook from stable to positive. The rating service also raised the transfer and convertibility assessment on Slovakia to AA+ from AA. Positive development of the public finances and the government's commitment to cut the public finance deficit in the future contributed to the move.

It has not always been this way

After the split of the Czechoslovak federation in 1993, Slovakia entered an era of massive privatisation, when state property was transferred to private hands. Some analysts characterise the era between 1994 and 1998 as the era of “crony capitalism” and irresponsible fiscal policies.

In 1994, economic growth in Slovakia stood at 4.9 percent, which accelerated to 6.9 percent the following year, but much of that economic growth was fuelled by government spending, such as on freeways.

Public spending was sharply cut after the September 1998 elections. The incoming Mikuláš Dzurinda government introduced reforms to close a trade deficit of over 10 percent of GDP and reduce above 30 percent interest on government debt. The economic growth in 1999 slowed down to 1.3 percent. The impact of the restrictive measures gradually wore off, however, and the subsequent growth in domestic demand returned GDP growth to 4.6 percent in 2002, creating a basis for medium-term sustainable growth.

While the pace of GDP growth was similar in 2003, the Slovak economy was posting the most dynamic growth in Central Europe by 2004, standing at 5.5 percent and launching its reputation as a “regional tiger”. In 2006, the growth rate jumped to a record 8.3 percent as the new car plants of PSA Peugeot Citroen and Kia Motors came on line and began exporting.

The economy grew at a record rate of 10.4 percent in 2007. The growth was mainly fuelled by the muscular automotive industry, production of engines and transportation means and production in the electro-technical industry. Market watchers expect that the growth will slow slightly, but still remain an EU leader.

Jobless rate still troubling

Slovakia has kept its gloomy standing near the top of the European Union's jobless rankings. But 2007 has brought some reason for optimism, with the lowest jobless figures in more than 10 years. The registered unemployment rate in Slovakia reached 7.84 percent at the end of February 2008, with labour offices reporting a total of 237,017 job seekers.

The sharpest climb of unemployment in the country was recorded in the first years of economic transformation in 1991, when 240,000 people were put out of work. The year 1994 was one of the worst years for unemployment, which reached 14.4 percent (366,200 people). The overwhelming majority of jobless people had less education than the national average and had been out of work for more than a year.

After the Dzurinda government took over in 1998, unemployment swelled to over 20 percent, giving Slovakia one of the highest jobless rates in Europe. The rate remained high until January 2003, when job creation helped to push it down to 15.2 percent. Slovakia’s entry to the EU in May 2004 has also helped, as almost 200,000 Slovaks are believed to be working in countries that scrapped barriers to the free movement of labour, especially Ireland and the UK.

This trend accelerated in 2006 and 2007 as two major car industry investments - PSA Peugeot Citroen in Trnava and Kia Motors in Žilina – launched production and generated indirect employment through suppliers.

Labour market watchers suggested the lower numbers might be the first sign of a slowdown of the outflow of Slovaks taking jobs abroad. However, Slovakia has also found itself in the middle of a troubling employment paradox. While the country has been struggling to create jobs for its long-term unemployed some major investors are finding it difficult to fill some of the new jobs they have created, and the World Bank has suggested importing workers from other countries as an option.

Average monthly wages increased by 7.2 percent between 2006 and 2007, to Sk20,146 in early 2008. Market watchers attribute the increase to robust economic growth and the growth of labour productivity which last year went up by 8.1 percent, compared to only 6.1 percent in 2006.

The average wages were highest in the financial services sector, standing at Sk38,632 in 2007, while the electricity, gas and water supply sectors paid average monthly salaries of Sk35,490.

Euro within reach

After a years-long marathon, Slovakia is finally on the home stretch toward adoption of the EU currency.

In order to qualify for the euro, the country’s general government deficit must be less than 3 percent of the GDP. Long-term interest rates should be no more than 2 percentage points above the average for the three EU countries with the lowest long-term interest rates. The public debt must not exceed 60 percent of the GDP. The country also has to keep its currency’s exchange rate within the European Exchange Rate Mechanism (ERM) II for at least two years, and the harmonised inflation rate must stay within 1.5 percentage points above the average for the three EU countries with the lowest inflation rates.

Slovakia started meeting the most feared inflation criterion for adopting the euro in August 2007, when the country's inflation dipped thanks to cheaper clothing and food. In February 2008, the harmonised inflation in February stood at 2.1 percent, which is still under the critical 3.1 percent set by the inflation criterion.

Slovakia’s state coffers are in their best condition since 2000. Last year, the state budget deficit dropped to Sk23.53 billion, Sk15 billion lower than originally planned. Market watchers said the results boost Slovakia’s chances of keeping its public finance deficit under 3 percent of the country’s GDP. The public finance deficit for 2008 is planned at 2.3 percent, while the ambition is to have the deficit pushed down to 0.8 percent of GDP by 2010.

In the long term, Slovakia has had the fewest problems with the long-term interest rate and the general government debt-to-GDP ratio. As of mid-2007, the long-term interest rates stood at 4.3 percent, while the required threshold is 6.3 percent. The Slovak debt ratio was 30 percent of the GDP.

The currency target also seems reachable so far. Slovakia entered the Exchange Rate Mechanism II (ERM II) when it pegged the crown to the euro on November 25, 2005. The crown was originally pegged at the prevailing market exchange rate of Sk38.4550 to one euro. The crown was allowed to fluctuate in a band of plus or minus 15 percent.

A massive appreciation of the Slovak crown in late 2006 and early 2007 required Slovakia to revaluate its central parity in ERM II by 8.5 percent in March, to 35.4424 SKK/EUR. The exchange rate must now stay within 30.1260 SKK/EUR to 40.7588 SKK/EUR.

Foreign trade

Slovakia has a small, open economy, and therefore needs high export efficiency. After the fall of communism, Slovak companies had major problems selling their products abroad since restructuring and privatisation brought significant changes to the structure of the economy. However, the inflow of foreign capital in the 1990s and domestic private investment were not sufficient to resurrect the export sector, resulting in continuously high foreign trade deficits. The situation was especially critical in 1997 and 1998 when the balance of payments in the current account deficit exceeded 10 percent of GDP.

The year 2003 saw a remarkable turnaround in the Slovak trade deficit, which fell to 0.9 percent from 8 percent in 2002. But by mid-2004 the situation had again worsened, due to strong domestic demand and a drop in auto sector exports, as the VW factory near Bratislava reconfigured its lines for new production. The 2004 trade deficit was Sk47 billion, or 3.4 percent of GDP. As Slovakia’s new car manufacturers launched production in 2006, the trade deficit again worsened due to imports of technology and stockpiling supplies standing at Sk92.6 billion, or 7.2 percent of GDP.

In early 2008, cars and TV sets produced in Slovakia dragged the Slovak foreign trade from red numbers and Slovakia’s foreign trade balance stood at Sk6.6 billion in January 2008.

The country’s largest exports include cars, electronic equipment, chemicals, iron and steel. Main imports include crude oil and natural gas, iron ore and concentrates, and liquid crystal products. Slovakia’s largest trading partners are Germany, the Czech Republic, and Russia.

Business environment: friendly still has its aches

In 2004 and 2005 the business environment in Slovakia saw significant changes that were praised not only by Slovak entrepreneurs but also by international institutions such as the World Bank, which in 2004 listed Slovakia among the 10 most pro-reform countries in the creation of a positive business environment.

The most progressive steps introduced by the second Dzurinda administration from 2002-2006 included tax reform that created a 19-percent flat rate for VAT, income and corporate taxes. The government also simplified registration procedures for entrepreneurs, shortening the period for being entered into the commercial register to five working days, introduced more flexible labour market legislation and enacted clear rules for investors to gain state subsidies.

However, the business environment still has faces challenges, such as a high social security burden in the form of compulsory “payroll taxes” on employee wages paid into social security funds, complicated and fast-changing legislation, inefficient courts, low enforceability of the law and widespread corruption, the Business Alliance of Slovakia contends.

In early 2007, an Ernst & Young poll found that Slovakia had the best conditions for doing business in the Visegrad Four Central European region. However, the Business Alliance of Slovakia, which has been compiling a regular business environment index since 2001, downgraded the economy for the first time ever in the second half of 2006, after the Robert Fico government took power.

The alliance’s main criticisms were the new government’s decision to reduce the VAT rate on medicine from 19 to 10 percent and to raise the tax burden on people earning over about $2,000 a month, changes which it regarded as a violation of the flat tax principle.

The Fico team also came in for criticism for revising the Labour Code. Changes made to the legislation weaken the flexibility of the labour market and increase employment costs, reads the World Bank's Regular Economic Report on the new EU member countries, with a special focus on the labour market, released at the end of September 2007.

The last time Slovakia amended its Labour Code, in May 2003, it introduced the most far-reaching changes and the least rigid hiring regulations, placing the country next to Singapore and United States, according to the report.

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