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 remain Stable.

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS Morningstar’s view that a sound macroeconomic performance should continue to sustain Slovakia’s economy in the medium term despite the erosion in fiscal space brought about by the Coronavirus Disease (COVID-19) pandemic. Substantial government support is cushioning the impact of the restrictions albeit at the cost of a severe deterioration in the fiscal deficit to 6.7% of GDP in 2020. A strong recovery in exports mitigated the fall in GDP last year, but the public debt-to-GDP ratio is expected to have risen above 60% from 48% registered in 2019. Nevertheless, debt affordability continues to improve thanks to the European Central Bank’s (ECB) purchasing programme. DBRS Morningstar anticipates that the country will benefit from the large amount of European Union (EU) funds in coming years contributing to a return to a solid GDP growth rate. However, the elevated structural deficit remains a challenge to public sector debt stabilisation in the medium term.

Slovakia’s A (high) ratings reflect its good track record of sound macroeconomic performance and its relatively low albeit rising 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, in particular with Germany. 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 failure to return to solid growth leading to a further deterioration in fiscal accounts and to a material increase in the debt-to-GDP ratio 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

The Fiscal Deterioration Makes a Credible Plan for a Gradual Fiscal Consolidation Key

Prior to the coronavirus outbreak, Slovakia’s good track record of fiscal management and buoyant cyclical conditions had contributed to a stabilisation in the fiscal deficit slightly above 1.0% of GDP since 2017 from 3.1% in 2014. However, the pandemic as well as pre-electoral measures resulted in a marked deterioration in the fiscal deficit in 2020. Despite some temporary initiatives that will peter out in 2021, deficits are likely to remain elevated as the government faces the challenge of reining in spending while not impeding a rapid recovery. DBRS Morningstar is concerned with the permanent character of some measures including wages, social benefits, and an increase in the tax allowance, all of which largely affect the structural deficit and prevent a rapid improvement of the fiscal accounts. Nevertheless, the government has started to implement some consolidation measures, including the abolishment of VAT exemption, an increase on the excise duties on tobacco, as well as a reduction on compensation in the public sector and on intermediate consumption.

The government implemented a sizeable support package to provide relief to the economy and this includes discretionary expenditures for around 3.1% of GDP as well as up to 2.4% of public guarantees for liquidity needs in 2020. For this year the government could count on 1.1% of GDP of reserves for the impact of the pandemic. According to the government, the combination of automatic stabilisers which translated into a fall in revenues and higher expenditures, and the discretionary measures are likely to result in a record deficit of 9.7% in 2020. However, the latest projections from the Council for Budget Responsibility (CBR) point to a significantly softer fiscal deterioration thanks to higher tax revenues, lower expenditure execution, and an improvement in Slovakia’s economic performance in 2020. The CBR estimates the budget deficit to have increased to 6.7% of GDP in 2020, but project it to rise again to 7.0% this year before declining to around 5.8% and 6.0% in 2022 and 2023, respectively.

DBRS Morningstar expects the temporary measures, including the short-time work scheme as well as public guarantees, to be extended and to be phased out only when the situation normalises. Nevertheless, the substantial deterioration in the structural deficit, estimated to have increased to 4.4% in 2020 from 2.3% in 2019 by the CBR and to further rise to 5.4% in 2021, is a point of concern. Nevertheless, latest macroeconomic data suggest the deficit could be lower, but additional government efforts would be needed to improve the fiscal trajectory. Should this not materialise, the stabilization in the public debt-to-GDP ratio could be delayed.

A Rapid Vaccine Rollout Along With EU Funds Support a Fast Recovery and a Return To a Solid Growth Path

Slovakia’s ratings are underpinned by its solid macroeconomic performance. Supported mainly by strong domestic demand, robust economic activity has contributed to a rapid income convergence towards the EU average since the country joined the bloc. Slovakia’s GDP per capita level based on purchasing power has risen significantly to around 73% of the EU average in 2020, up from 57% in 2004. Despite a more moderate economic growth since the Global Financial Crisis (GFC), Slovakia remained among the top growth performers in the EU, with GDP growth averaging 3.0% on an annual basis from 2010 to 2019.

A rapid recovery in car exports and a less severe decline in household consumption resulted in a significant rebound in economic activity after the first lockdown. However, the second COVID-19 wave of infections and the subsequent restrictions have been negatively affecting Slovakia’s recovery which would likely weigh on early 2021 economic performance. Nevertheless, as the pandemic shock fades, the large support of EU funds is expected to contribute to Slovakia’s return to a solid economic performance.

Preliminary estimates from the Slovak Statistical Office were better than expected and GDP contracted by 5.2% last year from an expansion of 2.3% registered in 2019. This compares favorably with the EU average, where GDP is estimated to have declined by 6.4% according to Eurostat. Government support cushioned the impact of business shutdown, lockdown measures, and travel restrictions that affected consumption and investment decisions. With the easing of the lockdown in May, the manufacturing sector benefitted from foreign demand that recovered swiftly while the service sector struggled to recover and continues to be affected by current confinement measures. The short-time work scheme has limited the increase in the unemployment rate to 7.5% of the workforce in December 2020 from 4.9% in February 2020. As uncertainty around the evolution of the pandemic remains, the short-time work scheme could be extended further this year. Vaccine deployment should enable the country to return rapidly to a solid growth rate and return to pre-pandemic levels by the end of 2021. The EC projects GDP to rise by 4.0% this year before accelerating to 5.4% in 2022. This should help partially mitigate risks to the public debt trajectory. However, uncertainty remains high and the risk of a spread of more aggressive COVID-19 variants could slow down the recovery.

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. Furthermore, Slovakia is expected to benefit greatly from the flow of EU funds. Unspent EU budgetary resources from the previous 2014-2020 Multiannual Financial Framework (MFF) and Next Generation EU (NGEU) grants, with the latter estimated at around 6% of 2019 GDP, could boost growth and facilitate fiscal consolidation.

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. After the pension reform in 2019 that removed the automatic adjustment of the statutory retirement age to life expectancy and introduced the retirement age cap of 64 years, the parliament reversed the cap last December. However, this will be affective from 2023, but it reflects government’s commitment to place pension expenditures on a more conservative path.

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

With around 85% of total exports as a share of GDP, Slovakia is one of the largest open economies in Europe. This along with a low export diversification base makes the country highly exposed to foreign demand. However, the competitive vehicle production sector together with surplus in the balance of services has supported the country’s external performance dynamism. With the outbreak of the pandemic, the shutdown of car production plants during the first wave had a toll on Slovakia’s external performance. Nevertheless, during the summer the rebound in the export of transport equipment boosted by Germany’s demand but also from non-EU countries was better than expected and Slovakia registered a large surplus in its foreign trade balance. The trade balance was EUR 2.7 billion in 2020, around EUR 1.7 billion higher than in 2019. This, however, will likely not prevent the current account to have remained in deficit in 2020. The latest projections from the OECD point to a narrowing of the deficit to 1.3% of GDP from 2.9% in 2019. In DBRS Morningstar’s view, as the recovery in foreign demand is still subject to uncertainty, Slovakia’s export momentum could cool in coming months, but the country’s external performance should benefit from the higher production capacity in the auto sector in the medium term.

Slovakia’s negative Net International Investment Position (NIIP), although large at 66.8% of GDP in Q3 2020, is less of a concern. Despite a large share of government debt being 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 along with a better than expected resilience of export performance positively weighed on DBRS Morningstar’s qualitative assessment of the “Balance of Payment” building block.

Public Debt Ratio Likely to Continue to Rise in Coming Years but Debt Profile Remains Sound

Slovakia was one of the few European countries with a debt ratio below 60% of GDP entering the crisis. The debt-to-GDP ratio which had been on a gradual declining trend from the peak of 54.6% in 2013 has likely increased to over 60% last year from 48% in 2019. This reflects the large increase in the deficit along with the fall in GDP as well as the conservative build-up of a cash buffer. According to the latest projections from the Slovak Council for Budget Responsibility (CBR), in the absence of a fiscal consolidation effort for the period 2022-23, the public debt ratio will continue to rise in coming years to 65.3% in 2023. The debt brake rule was suspended because of the past elections and the pandemic but will likely be followed by a new debt framework based on both a multiannual expenditure rule on the planned structural balance and on sanctioning thresholds linked to net government debt. This would improve flexibility in the management of the liquidity cash reserves as well as on mitigating pro-cyclicality.

DBRS Morningstar continues to positively view Slovakia’s public debt profile and debt affordability which benefits from the European Central Bank’s (ECB) expansionary policy and credibility as well as a sound state debt cash buffer, estimated at around EUR 8 billion (9.0 % of GDP) in 2020. Slovak government debt is almost all long term, at a fixed rate and 96.4% is denominated in euros. The remaining foreign currency debt is fully hedged. The average maturity of government debt at a comfortable level of 8.3 years as of end-January 2020 reduces refinancing risk.

Concerns Regarding Household Leverage Rise, but Slovak Banks are Well Equipped to Face the Impact of the Pandemic

Slovakia’s excessive household credit growth in the context of tight financial conditions, rising house prices and low savings pose some concerns for the country’s financial stability. This could be further exacerbated by the consequences of COVID-19, but in DBRS Morningstar’s view, the combination of government support measures along with the high level of banks’ capitalisation, 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 47.0% in Q3 2020, and while the ratio is still below the EU average of 53.1%, households are vulnerable due to low savings in financial assets. This trend reflects a sustained growth of credit lending in a context of a high share of home ownership, favourable labour markets, and low interest rates. COVID-19 has only slightly dampened retail credit growth, that despite the fall in household disposable income, has remained sustained. As of December 2020, credit growth for home purchases at 9.0% year-on-year was still double the euro area average of 4.4%, but macroprudential policies implemented in the past few years have translated into a gradual slowdown of housing loan growth from the March 2017 peak of 15.4%.

In spite of the rapid debt growth, Slovakia’s households benefitting from government income support have shown some resilience. The increase in the unemployment rate has been moderate and the latest survey conducted by the central bank in October last year suggests that only 0.6% of indebted households are concerned with servicing their debt. This is equivalent to just 0.76% of the total retail loan book. The current restrictive measures are likely to result in an increase in both vulnerable households and weak small and medium-size enterprises but banks are well positioned to counteract the rise in delinquency rates. Higher provisioning would likely weigh on Slovak banks’ profitability which is already constrained by high competition and low interest rates. Nevertheless, high levels of capitalisation are expected to cushion the impact of the pandemic on their balance sheets. As of September 2020, both the common equity tier 1 (CET) and the coverage ratio at 16.7% and 69.2%, respectively, are high. These factors contribute to the positive qualitative assessment of the “Monetary Policy and Financial Stability” building block.

The Government Focuses on an Anti-Corruption Agenda and on Improving Slovakia’s Institutional Framework

DBRS Morningstar positively views the anti-corruption agenda and the pro-EU sentiment of the coalition government led by the OlaNO party. Slovakia ranks poorly in the corruption perception index compared with its peers but the overhaul in the judicial system is expected to improve perceptions of the independence of judges and of the efficiency of the system. Slovakia is carrying out a large number of COVID-19 tests but the deployment of the vaccine remains slow so far, as in other European countries. The share of people who received at least one dose stood at 5.5% as of 25 February 2021.

ESG CONSIDERATIONS
The Human Capital and Human Rights (S) and the Bribery, Corruption and Political Risks and Institutional Strength, Governance and Transparency (G) were among the key ESG drivers behind this rating action. Despite progress with narrowing the EU income gap, Slovakia’s per capita GDP is low at $18,700 in 2020 compared with its euro system peers. According to World Bank Governance Indicators 2019, Slovakia ranks in the 71st percentile for Rule of Law and in 74th percentile in the government effectiveness. These factors were taken into consideration within the following building blocks: “Fiscal Management and Policy”, “Economic Structure and Performance” and “Political Environment”.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at: https://www.dbrsmorningstar.com/research/373262

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/374376.

EURO AREA RISK CATEGORY: LOW

Notes:
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

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 (July 27, 2020). Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings: https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

The sources of information used for this rating include Statistical Office of Slovak Republic, Slovakia Ministry of Finance (Draft Budgetary Plan - October 2021, Macroeconomic forecast – February 2020, 2020 National Reform Programme), Národná banka Slovenska (Financial Stability Report – November 2020), European Commission (Winter Forecast – February 2021, Assessment to the Draft Budgetary Plan of Slovakia – October 2020, Country Report Slovakia – February 2020, Assessment of the final national energy and climate plan of Slovakia - October 2020, 2020 Rule of Law Report Country Chapter in the Rule of Law in Slovakia – September 2020), Central office of Labour, Social affairs and Family, Transparency International, Vision of Humanity, Social Progress Index, CBR (Addendum to the Evaluation of the General Government Budget for 2021-2023 – December 2020), Our World in Data, Ardal, IMF, UNDP, OECD, ECB, Eurostat, World Bank, BIS, UNDP, World Economic Forum, 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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/374378

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Carlo Capuano, Vice President, Sovereign Global Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-head of Sovereign Ratings, Sovereign Global Ratings
Initial Rating Date: April 22, 2016
Last Rating Date: September 4, 2020

DBRS Ratings GmbH, Sucursal en España
Paseo de la Castellana, 81
Floors 26 & 27
28046 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.