DBRS Morningstar Confirms Slovak Republic at A (high), Stable Trend

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

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS Morningstar’s view that a sound macroeconomic performance should continue to support Slovakia’s economy in the medium-term despite the erosion in fiscal space brought about by the coronavirus (COVID-19) pandemic. As a small and open economy Slovakia has been affected severely by the fall in foreign demand, in particular in the automotive sector, but signs of a recovery are visible as containment measures have been relaxed. Higher government spending, the fall in revenues and the sharp recession will result in a record fiscal deficit and a rise in the public debt-to-GDP ratio to above 60% in 2020 from 48% in 2019. Going forward, phasing out government support to rein in spending without damaging the recovery might be a challenge for the new cabinet, but DBRS Morningstar expects a gradual prudent strategy eventually to emerge. Moreover, European Union (EU) budget resources allocated to Slovakia are expected to mitigate against the risk of a prolonged weak recovery, facilitating an improvement in the debt trajectory, a reduction in the fiscal deficit and the implementation of reforms.

Slovakia’s A (high) ratings reflect its good track record of sound macroeconomic performance, conservative fiscal management and its low level of public debt. The country attracts high-quality foreign investment and is well integrated into European supply chains. Its credit profile benefits from its EU membership, and deep integration with major Eurozone economies. These factors have been key in the economic catch-up process. These credit strengths offset structural weaknesses including Slovakia’s small economy, high reliance on exports, rising household debt in a context of low financial net wealth, regional disparities and unfavourable demographics.

RATING DRIVERS

For the time being, upward rating action is unlikely, but ratings could be upgraded due to one or a combination of the following factors: (1) a faster than expected income convergence toward the EU average; (2) progress in diversifying the economy as well as reducing regional disparities that constrain GDP potential; (3) once the immediate crisis has passed a renewed effort to strengthen fiscal discipline combined with a reduction in public debt. Ratings could be downgraded due to one or a combination of the following factors: (1) a further significant worsening in the economic outlook and/or a failure in fiscal consolidation leading to an upward trend in public debt in the medium-term; (2) signs that banking sector vulnerabilities are materially increasing as a result of a prolonged deterioration in credit quality.

RATING RATIONALE

Deficit Will Rise to a Record Level and A Credible Plan for a Gradual Fiscal Consolidation Becomes Key

Prior to the coronavirus outbreak, Slovakia’s good track record of fiscal management and buoyant cyclical conditions had contributed to a stabilization in the fiscal deficit slightly above 1.0% of GDP since 2017 from 3.1% in 2014. Policy efforts to collect taxes and reduce tax fraud were accompanied by buoyant revenue growth related to strong wage dynamics. However, the impact of the pandemic as well as pre-electoral spending are likely to result in a record deficit this year. The new cabinet, appears committed to a conservative fiscal policy, but it likely will be challenged to rein in higher government expenditures without damaging the recovery. This risks delay in the implementation of a prudent fiscal plan in the medium-term.

In response to the pandemic shock leading to a severe GDP contraction the new cabinet introduced several support measures. These mostly include short-time work schemes, a deferral in health insurance and social security contributions, extensions of nursing benefit schemes, tax deferrals, cancellation of the bank levy and the implementation of state guarantee schemes and debt moratoria. Moreover, the impact of automatic stabilizers and a significant tax shortfall because of the downturn and extra stimulus for local governments are expected to contribute to a rise in the deficit to 11.6% of GDP in 2020 up from 1.3% in 2019, according to the July estimates from the government. However, as the economy recovers, the deficit figure for 2020 could be lower. According to the latest forecast from the Council for Budget Responsibility (CBR), the budget deficit could reach 8.8% of GDP if the government does not adopt additional measures. The stability program envisaged a consolidation to a deficit below 3% of GDP in 2023, but more clarity on a prudent fiscal plan is key, along with a reform agenda to be submitted to the European Commission (EC) as part of the Next Generation EU programme.

Early Signs of Recovery are Visible but Momentum Could Weaken Towards the End of the Year

Slovakia’s ratings are underpinned by its solid macroeconomic performance in past years. Supported mainly by strong domestic demand, robust economic activity has contributed to a rapid income convergence toward the EU average since the country joined the bloc. Slovakia’s GDP per capita based on purchasing power has risen to around 74% of the EU average in 2019, up from 57% in 2004. A more moderate economic growth since the Global Financial Crisis (GFC) has not prevented Slovakia from remaining among the top growth performers in the EU, with GDP growth averaging 3.0% over the last ten years.

As in other geographies, new cases of infections are rising rapidly and it has to been seen if this will falter the recovery both in Slovakia and in its major trading partners. The domestic lockdown between mid-March and the last week of April resulted in a fall in private demand and investment and, coupled with shutdowns in Slovakia’s trading partners, generated a sharp decline of exports. This was amplified by Slovakia’s high economic integration in the European supply chains, in particular in the automotive sector, generating a significant decline in manufacturing activity. A contraction in economic output of 5.2% quarter-on-quarter in Q1 will be likely followed by a deep recession in the second quarter. Preliminary estimates from the Statistical Office point to a further fall of 8.7% quarter-on quarter in Q2 GDP, leaving economic activity 12.1% lower compared with Q2 2019. The government expects the unemployment rate to rise to 8.2% in 2020 from 5.8% in 2019 largely due to physical distancing affecting the tourism, catering services, retail and transport sectors, and expects only a gradual decline thereafter.

Following a growth rate of 2.4% in 2019, the EC projects a severe economic contraction of 9.0% in 2020, worse than the Eurozone projected average of 8.7%, before a recovery of 7.5% in 2021. However, government support measures are providing some relief to the economy and with the resumption of economic activity, the Slovak economy has demonstrated signs of rapid recovery, in particular of exports. Despite the uncertainty, in DBRS Morningstar’s view, recent improvements suggest that economic performance could be better than expected should there be a successful containment of new infections. On the other hand, a rebound in the last quarter of 2020 might lose momentum should consumers start to build up precautionary savings in anticipation of a further worsening in the labour market. This could adversely affect demand, in particular for cars, also impacting the automotive sector.

Slovakia’s EU membership is a key factor of its credit strength, both in terms of financial support and in terms of preferential access to trade and financial markets. The country has been a major beneficiary of European Structural and Investment Funds in the current Multiannual Financial Framework (MFF), and these funds are likely to be spent up until 2023. DBRS Morningstar is of the view that depending on the ability of spending, new EU funds from the next MFF (2021-2027) and Next Generation EU, estimated to be around EUR 20 billion, are likely to mitigate against long-lasting implications on economic growth due to the COVID-19 shock.

Regional Disparities and Unfavourable Demographics Remain Key Challenges

Besides the challenges of a small economy that is highly reliant on exports, Slovakia faces structural challenges. These include low employment rates among low-skilled and disadvantaged groups and low female labour force participation, all of which are further amplified by regional disparities. Underdeveloped infrastructure, lower educational attainment, and low labour mobility have held back development of the Eastern and Central regions of the country. In addition, Slovakia’s demographics are one of the most adverse in Europe with its old-age dependency ratio expected to increase from 23.5% in 2019 to 60.4% in 2060 according to Eurostat. Moreover, the pension reform last year that removed the automatic adjustment of the statutory retirement age to life expectancy and introduced the retirement age cap of 64 years, will further place pressure on public expenditures in the long-term.

The Rebound in Car Exports Bodes Well for a Recovery but Uncertainty Remains around Slovakia’s Trade Performance

Slovakia is one of the largest open economies in Europe with around 85% of total exports as a share of GDP. While the pandemic-related containment measures have taken a toll on Slovakia’s external performance, the recent improvement bodes well for a recovery. Economic shutdowns in trading partners and the high reliance on vehicle production, representing around 29% of total exports, led to a suspension in production in the country causing exports to fall sharply in March and April. Since then goods exports have rebounded, but medium term uncertainties regarding Slovakia’s external performance remain due to its relatively low degree of export diversification and uncertainty around the evolution of the COVID-19 disease and its impact on foreign demand.

Slovakia’s current account has been in deficit since 2015 due to its imports of investment goods and a negative primary income balance related to dividend outflows on foreign investments. However, with the easing in restrictions and gradual improvement in the external environment, the deterioration in Slovakia’s external position might be less sharp than expected. Latest projections from the EC point to only a marginal increase in the current account deficit to 3.1% of GDP in 2020 compared with 2.9% in 2019. As the situation normalizes, DBRS Morningstar expects the higher production capacity of the auto sector to contribute to narrowing the current account deficit in the medium-term. Slovakia’s negative Net International Investment Position (NIIP), although large at 67.0% of GDP in Q1 2020, is less of a concern. Despite a large share of government debt held by foreign investors, the NIIP is mainly composed of foreign direct investment in the form of equity and intercompany lending and there is limited private sector reliance on foreign credit, mitigating risks to capital outflows. This positively weighed on DBRS Morningstar’s qualitative assessment of the “Balance of Payment” building block.

Public Debt Ratio likely to Exceed 60% of GDP but Debt Profile Remains Sound

Slovakia was one of the few countries with a debt ratio below 60% of GDP entering the crisis. The debt-to-GDP ratio had commenced a gradual declining trend from the peak of 54.7% in 2013 but it is expected to exceed 60% this year from 48% in 2019. Sanctions and consolidation fiscal measures related to the debt brake rule are likely not to be activated until 2024 due to the nature and the size of the shock. Furthermore, a new elected government is expected to be formed again in 2024, triggering a transitional period of another 24 months. This makes it pivotal to have a credible fiscal plan to reduce the deficit in coming years along with a possible new fiscal responsibility act that would strengthen Slovakia’s fiscal framework.

DBRS Morningstar continues to positively view Slovakia’s debt profile as government debt is almost all long-term, at a fixed rate and 96.3% is denominated in euros. The remaining foreign currency debt is fully hedged. The average maturity of government debt remains at a comfortable level of 8.2 years as of end-August 2020 well above the 4.6 years in 2009, which is in line with the Organisation for Economic Co-operation and Development (OECD) average. At the same time, interest cost are expected to remain contained.

Concerns Regarding Household Leverage Rise, and could be Intensified because of the Pandemic Shock

Slovakia’s excessive household credit growth in the context of tight financial conditions and low savings pose some concerns for the country’s financial stability. This could be further exacerbated by the pandemic, but in DBRS Morningstar‘s view, the combination of government support measures along with the high level of banks’ capitalization, should alleviate risks stemming from a deterioration in credit quality.

Household debt has increased rapidly over the past decade from 24.1% of GDP in Q1 2010 to 43.5% in Q1 2020, and while the ratio is still below the EU average of 50.4% this makes households vulnerable due to low savings in financial assets. This trend reflects a sustained growth of retail credit in a context of a high share of home ownership, favourable labour markets and low interest rates. In this context, the impact of COVID-19 on households’ financial positions could be severe. At the same time, if the economy does not recover quickly, sectors most exposed to physical distancing measures could see a tightening in lending conditions should banks become more risk adverse. However, DBRS Morningstar positively views the government’s measures such as guarantees and debt forbearance.

The banking sector has strong fundamentals and loan portfolios are relatively healthy. Slovak banks are adequately capitalized, and have good asset quality despite declining profit margins. While the new government’s decision to cancel the bank levy has provided some relief to profitability, Slovak banks continue to face the challenge of shifting from a traditional retail-credit model towards increasing fees, cost cutting and digitalization to improve efficiency and profit generating capacity.

The New Government Focuses on an Anti-corruption Agenda and On Improving Slovakia’s Institutional Framework

DBRS Morningstar positively views the anti-corruption platform and the pro-EU sentiment of the new cabinet. Slovakia ranks low in the corruption perception index compared with its peers and an overhaul in the judicial system is expected to improve perceptions of the independence of judges and of the efficiency of the system. The parliamentary election saw the victory of the Ordinary People Party (OĽaNO) on the 29th February 2020 and the formation of a four-party coalition including the Freedom and Solidarity Party, For the People and We are Family. The cabinet is expected to be more pro-EU than the former ruling Smer-SD party, but supported by a coalition to some extent subject to internal divisions because of different parties.

ESG CONSIDERATIONS
Human Rights and Human Capital (S) and Institutional Strength, Governance, & Transparency (G) were among the key ESG drivers behind this rating action. Slovakia’s per capita GDP is low at $19,500 in 2019 compared with its euro system peers. According to World Bank Governance Indicators 2018, Slovakia ranks in the 70th percentile for Rule of Law. These factors were taken into consideration within the following building blocks: “Economic Structure and Performance” and “Political Environment”.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.
https://www.dbrsmorningstar.com/research/366407

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in Euros (EUR) 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: https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (27 July 2020)

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include Statistical Office of Slovak Republic, Slovakia Ministry of Finance (Stability Programme of the Slovak Republic for 2020 to 2023), Národná banka Slovenska (Financial Stability Report May 2020), European Commission (Summer Forecast 2020, Assessment to the Stability programme of Slovakia), Transparency International, CBR, ECB, Ardal, IMF, UNDP, OECD, Ageing Europe 2019, Eurostat, World Bank, BIS, UNDP, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was 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 rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and 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:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/366408

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Carlo Capuano, Vice President, Sovereign Global Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: April 22, 2016
Last Rating Date: March 13, 2020

DBRS Ratings GmbH, Sucursal en España
Calle del Pinar, 5
28006 Madrid
Spain
Tel. +34 (91) 903 6500

DBRS Ratings GmbH
Neue Mainzer Straße 75
60311 Frankfurt am Main Deutschland
Tel. +49 (69) 8088 3500
Geschäftsführer: Detlef Scholz
Amtsgericht Frankfurt am Main, HRB 110259

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.