Public Information Notice No. 01/77

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the Slovak Republic

August 1, 2001

On July 27, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Slovak Republic.¹

Background

Although the Slovak economy rebounded quickly from the economic disruption caused by abandoning central planning and declaring independence—with the economy growing on average 5 percent in 1993-98—macroeconomic imbalances brought the Slovak economy under a cloud of vulnerability in 1998. At the same time, despite high growth, the unemployment rate never fell below 12 percent.

The present government assumed office in October 1998 amidst signs of vulnerability, including a substantial depreciation of the currency upon its forced flotation. It embarked on policies to restore macroeconomic balances and lay the basis for sustainable economic growth. An ambitious fiscal plan introduced in 1999 was based on expenditure cuts, and increases in indirect taxes and administered prices. At the same time, the authorities began a serious effort to reform the financial sector, another source of vulnerability.

The fiscal tightening, a reduction in households' purchasing power and hardening budget constraints led to a sharp declines in domestic demand in 1999 and 2000, but a strong improvement in net trade performance partly offset their impact on aggregate demand, and GDP grew around 2 percent per year in 1999-2000. In these circumstances, balance of payments difficulties eased considerably: the external current account deficit narrowed to 3.5 percent of GDP in 1998 from 10 percent of GDP in 2000 and official reserves increased. An unwelcome side effect of the slow growth in 1999-2000 has been a further rise in unemployment, to close to 18 percent in early 2001.

Data for the first half of 2001 suggest that economic growth was picking up, the budget was on track, and inflation still subdued, although the current account deficit started to widen. The tentative recovery of domestic demand at the end of 2000 seemed to have carried over into 2001, and although the unemployment rate remained high in the first quarter, employment increased year-on-year for the first time since 1997. Data for the first months indicate that headline and core inflation remained within the indicative band set by the NBS for 2001, which aims at headline inflation of 6.7-8.2 percent by end-2001.

On the structural side, the authorities have gone ahead with their plans to privatize the main state-owned banks, and prepare for privatization the large state-owned enterprises. The government divested itself of substantial holdings in the banking sector, and has made progress toward the restructuring and divesture of the gas and electricity companies, the oil transportation company, and remaining holdings in the banking sector. The government's agenda for the future includes reforms in the health, pension, and social benefits systems, as well as in the tax system, and public enterprise restructuring. The authorities' strategy to deal with high unemployment centers around increasing labor market flexibility, rationalizing the social benefits system, and improving the employability of vulnerable groups.

Executive Board Assessment

Directors commended the authorities for the progress made over the last two years in reducing large macroeconomic imbalances, observing that balance of payments difficulties have eased considerably and fiscal discipline is being restored. They considered that the challenge in the period ahead was to implement the strategy of fiscal consolidation, disinflation, and structural reform in a determined fashion. In this connection, Directors welcomed the authorities' adoption of an ambitious economic program—to be monitored by the staff²—that addresses comprehensively the main weaknesses of the Slovak economy and will allow a successful completion of the EU accession process. Directors urged the authorities to implement the program in a forceful and timely fashion.

In order to relieve external current account and inflation pressures, Directors encouraged the authorities to make every effort to achieve their fiscal deficit targets for 2001 and 2002. They supported the authorities' emphasis on restraining expenditures, and encouraged them to resist pressures for additional spending in the run-up to the September 2002 elections. In particular, Directors stressed the need to contain the wage bill and social transfers, reduce transfers and state guarantees to enterprises, and strengthen control over investment expenditure. On the revenue side, Directors advised the authorities to resist calls for tax cuts until improvements in tax collections from better administration were established. While welcoming the decentralization of fiscal responsibilities planned by the Slovak government, Directors stressed the importance of imposing controls to limit local government borrowing and of improving these governments' administrative capacity prior to the devolution of fiscal responsibilities from the central government.

Directors expressed concern that the large anticipated flows of privatization revenues could lead to nontransparent uses, loss of financial control, and an expansionary fiscal stance. Therefore, they recommended that the authorities adopt legislation to ensure that privatization receipts will be used exclusively to retire debt and reform the pension system, and to monitor the uses of privatization revenues closely.

Directors agreed that to strengthen the credibility of policies aimed at securing macroeconomic balance and the inflation targets, a clear medium-term path for fiscal consolidation was essential. They commended the authorities for announcing targets for the overall fiscal deficit through 2005 that should make room for private investment without straining the current account. Given that these targets are to be achieved primarily through expenditure restraint, Directors noted the need for advancing technical preparation for expenditure cuts as part of a well-articulated plan of fiscal reforms. They therefore urged the authorities to prepare a detailed multiyear fiscal plan, building on their commitments under the staff-monitored program.

Directors supported the authorities' intention to use published inflation benchmarks to guide their monetary policy decisions. They agreed that the koruna remains appropriately competitive, and, given the government's anti-inflationary stance, considered that the exchange rate should continue to float freely, with only exceptional intervention by the central bank to avoid sharp oscillations in the koruna. In order to bring inflation down further, Directors agreed that, along with fiscal consolidation, monetary policy should aim at keeping real interest rates significantly positive over the medium term. Looking ahead, Directors pointed out that tensions may arise between a fiscal policy supportive of domestic activity and a monetary policy targeted on disinflation. Should these arise, they should be resolved by tightening fiscal policy, so as not to crowd out private investment and weaken external competitiveness.

Directors welcomed recent progress in strengthening the banking system, including efforts to privatize the state-owned banks and to strengthen banking supervision. They emphasized the importance of completing this process, and of moving ahead with enhancing the supervisory and regulatory framework of the banking system to avoid a recurrence of the bad loan problem. They cautioned that further delays in deciding on an appropriate institutional set-up for banking supervision might raise questions about the authorities' determination to enhance such supervision.

Directors welcomed the government's focus on increasing the role of the private sector and of foreign direct investment, including through recent efforts to accelerate enterprise restructuring and privatization. They urged the authorities to adhere to their plans to privatize assets in the energy sector, which should be reformed to improve efficiency and develop a competitive environment.

Directors noted with concern the persistently high level of unemployment. While the closure of nonviable enterprises and the elimination of redundancies was responsible for the jump in unemployment in the early years of transition, Directors considered that this situation could have been ameliorated over time by job creation in the new private sector. However, private enterprise hiring has been rather sluggish, reflecting, to a large extent, rigidities in the labor market, notably an inflexible labor code and still-high payroll taxes. Thus, Directors welcomed the authorities' efforts to increase labor market flexibility, but recommended more decisive steps to simplify hiring and dismissal procedures. They also noted the need to limit the generous social assistance in order to reduce the disincentives to job search, and to rationalize and better target the social safety net. Over the medium term, as the fiscal situation permits, a reduction in payroll taxes would help boost labor demand.

Directors were encouraged that the Slovak Republic subscribes to the Special Data Dissemination Standard, and commended the authorities for the good quality of the data.