Full rating report of Slovak Republic

ACRA revised the ratings of the Government of the Slovak Republic (hereinafter, Slovakia) under the international scale in September 2021. As of the publication of this report, the issuer had the following ratings:

• Long-term foreign currency credit rating at A and local currency credit rating at A;

• Short-term foreign currency credit rating at S1 and local currency credit rating at S1.

The outlooks on the long-term foreign currency credit rating and the local currency credit rating are Stable.

Positive rating assessment factors

• Relatively high level of welfare.

• Moderate public debt with good structure, and large European market for placements of issues.

• Debt market support institutions in the Eurozone, and the euro’s reserve currency status.

Negative rating assessment factors

• Small size and very high openness of the economy.

• Poorly diversified industrial sector.

• Accumulated relative lag in education and R&D investments.

• Moderately negative demographic prospects.

Long-term foreign currency credit rating structure

key assessment factors

The A long-term sovereign ratings of Slovakia are based on the final scores of the following analytical blocks: Macroeconomic Position — bbb, Public Finance — bbb+, External Position — aa, and Institutional Framework — a+.

MACROECONOMIC POSITION

The final score of the Macroeconomic Position analytical block is bbb, which is two notches lower than the core score of a-.

Core score factors. ACRA expects the real GDP of Slovakia to grow by 3.5–4.5% in 2021–2022 after a 4.4% contraction in 2020. The downside risks to this scenario are fading considerably due to the rising share of the vaccinated individuals: as of November 14, 2021, more than 46% of the population had received at least one dose of a COVID-19 vaccine. If this pace is maintained, the probability of further lockdowns and other restrictions on economic activity by the end of 2021 will be negligible in both Slovakia and its main trade partners. This is why all of ACRA’s scenarios consider 2022–2023 as years of GDP growth, which, on average, will exceed the potential of around 3%. This will not have a major impact on the small size of the country’s economy in the global context (it amounts to less than 0.15% of the global economy, and is the EU’s 22^nd largest economy, Fig. 1) or the relative level of welfare. In general, for Slovakia the level of welfare is high globally, but compared to most other EU countries this indicator is low (Fig. 2).

Inflation in Slovakia and the Eurozone as a whole are generally similar (temporary deviations usually do not exceed 1.5 pps). Since 2008, average annual growth of the harmonized CPI has fluctuated from -0.5% to 4.0% amid a target of 2%, which indicates that the ECB’s monetary policy with regard to Slovakia and the National Bank of Slovakia (NBS) is relatively successful. ACRA expects average annual inflation to be below 3.5% in 2021, reach its peak in winter and then gradually decline in 2022 from levels around 5% to 1-2%.

Modifiers. In the long-run, the country’s GDP growth outlook is a source of concern, primarily due to the economy’s high concentration on the automotive industry (15% of output, 4% of direct employment, and 33–34% of exports). This increases the dependence of the country’s economic activity on industry-specific risks and risks associated with global trade tensions in general and environmental policies in particular. Moreover, Slovakian carmakers can expect to encounter further major changes in the industry, given the growing popularity of electric vehicles, self-driving cars, and car sharing. A potential delayed response of Slovakia’s car manufacturers to these challenges¹ may have a considerable negative impact on the country’s economic growth and employment in the long term. The economy’s small size and considerable openness may exacerbate these risks.

In addition, the country’s economic potential is constrained by the declining size of the labor force and a potential decline in its quality. The labor force will shrink due to negative demographic trends. The UN expects a 7.5% contraction in the population aged 20–74 in 2020–2035, which will only be partially offset by an increase in the length of citizens’ active life and the period of their employment. Factors that may negatively affect the quality of labor force are brain drain, a weaker education system than CEE peers, and insufficient R&D spending. All this could compromise the country’s competiveness.

The Sustainability of Economic Growth modifier was applied (-2) in light of the abovementioned concerns. No other modifiers were applied in this block.

¹During 2018-2020, the average share of hybrid and electric cars in total vehicle exports from Slovakia grew roughly in line with the global average (reaching ~30% in 2020). Nevertheless, high concentration still poses a risk in the future.

PUBLIC FINANCE

The final score of the Public Finance analytical block is bbb+, which is three notches higher than the core score of bb+.

Core score factors. High GDP growth and a gradually improving budget balance in the years prior to the coronavirus pandemic led to a decline in the general government consolidated debt to GDP ratio from 54% in 2013 to 48% in 2019 (calculated according to the definition applied in the EDP procedure, i.e. Maastricht debt). In 2020, both automatic stabilizers and discretionary anti-crisis expenses contributed to the growth of debt to more than 60% of GDP, which was one of the main reasons why ACRA downgraded the country’s sovereign credit rating from A+ (prior to September 3, 2021) to A, along with the impact of pension reforms in 2019 on the long-term budget balance. On the other hand, ACRA expects the debt load to stay below 65% of GDP until the end of 2023, which contributes to the rating’s Stable outlook. The structure of public debt will remain largely unchanged — around half of the holders of debt will be non-residents and all of the debt will be issued in EUR.

According to the Draft Budgetary Plan 2022, the government of Slovakia expects the general government balance to reach -7.9% of GDP in 2021 (the initial budget foresaw a level of -7.4% of GDP). ACRA expects that a substantial portion of deficit financing needs in 2021 will be covered by excess liquidity accumulated in the government’s accounts due to the front-loading of debt issuance in 2020–2021 (Fig. 3).

In the long term, the demographic trends described in the Macroeconomic Position block are expected to put substantial pressure on the structural balance of the government’s budget. The European Commission estimates that pension, healthcare and long-term care costs will increase by more than 10 pps of GDP by 2070 if economic policies are left unchanged. This puts Slovakia among the three most vulnerable EU countries in this respect. Potential future changes to pension system parameters, including, for example, relinking retirement ages to life expectancy, will be crucial to the long-term improvement of the general government’s budget balance.

Modifiers. Slovakia’s current fiscal rule framework proved to be effective in 2012–2020, but its parameters have become unrealistic due to the pandemic. Based on the Draft Budgetary Plan 2022 and proposed amendments to the Fiscal Responsibility Act, ACRA expects the multiannual expenditure ceiling to be introduced in 2022 (effective in 2023) and potentially a debt ceiling increase in the longer run. The downward trajectory of the debt ceiling will most probably persist in the future even if the levels are to change (Fig. 4). As a result, the fiscal rules will continue to have a beneficial effect on the long-term balance of the public sector. Historical adherence to the fiscal rule and adequate plans to revise it have been reflected in the application of the Fiscal Policy and Budget Flexibility modifier (+1).

Regardless of the growth in the debt burden in 2020–2021, ACRA does not expect significant deterioration of debt affordability associated, among other things, with an increase in borrowing costs. Slovakia is a member of the Eurozone, a monetary union whose currency has reserve status. Moreover, the ECB’s Outright Monetary Transaction Program potentially restrains interest rates on short-term and medium-term government bonds, as if there were a conditional guarantee on them — in crisis situations, the bank can redeem bonds issued by the government in the secondary market. Together with temporary the Pandemic Emergency Purchase Programme, this has a positive impact on borrowing costs. Although public debt is expected to grow significantly as a result of the pandemic and the interest rates in the Eurozone will rise slightly again, the growth of the government’s interest expenditures will be limited. This is a permanent consequence of belonging to the European institutional environment in which the Slovak government operates. ACRA takes this fact into account by applying the Debt Sustainability and Access to Markets and Funding Sources modifier (+2).

The overall contingent liability risks are contained. The size of direct public guarantees is traditionally one of the lowest among CEE peers. Contingent liability risks in the banking sector were mostly mitigated by its strong capital adequacy and high asset quality metrics prior to the coronavirus crisis. According to the NBS in its latest Financial Stability Report, in the stress scenario the potential share of loans to non-financial companies at risk of delinquency will amount to 6.5% at the end of 2021. In the retail loan portfolio, 3.6% of total loans may be at risk due to the coronavirus crisis.

In ACRA’s opinion, this is unlikely to trigger significant government support for the banking sector. Due to this, the Contingent Liabilities modifier was not applied or other modifiers of the block.

EXTERNAL POSITION

The final score of the External Position analytical block is aa, which is two notches higher than the core score of bbb+.

Core score factors. The economy of Slovakia is very open. In the absence of a recession or crisis, foreign trade turnover is consistently higher than 180% of GDP, which is significant both by EU standards (Fig. 5) and in the global context. In this regard, economic activity in Slovakia largely depends on the situation in the country’s trade partners. Export diversification is below the EU average, which is mainly due to the important role of the automotive industry in the Slovak economy.

Net investment position is negative and is one of the most significant in the EU (-66% of GDP in 2020). This, however, largely reflects the country’s FDI-intensive growth model rather than the inflexible negative trade balance. According to ACRA’s assessments, the trade balance will return to more usual levels of around -2% of GDP after temporarily growing to -0.4–1.1% of GDP during the pandemic. Another important factor that explains the negative investment position is deposits of foreign central banks held by the NBS that are related to the facilitation of settlements in the Eurozone.

The NBS practically foregoes accumulating international reserves because the country is part of the Eurozone — reserves cover less than a month’s worth of imports of goods and services and less than 20% of external general government debt. The NBS cannot independently set monetary policy, but is able to introduce macroprudential measures. The small size of reserves does not lead to additional risks in terms of the volatility of the effective exchange rate because Slovakia’s key trade partners are either part of the Eurozone or their currencies are very closely correlated with the euro. The NBS does not pursue an active exchange rate policy.

Modifiers. As the euro (Slovakia’s official currency) has reserve currency status, the country’s private external debt is mainly denominated in the local currency, as is public debt. This rules out the risks of significant foreign currency revaluation of external debt. In addition, the structure of external debt is dominated by relatively more stable components such as corporate debt to direct investors and central bank debt (Fig. 6).

Private debt, excluding debt to direct investors, makes up less than a quarter of total external debt. In order to reflect these factors, the External Debt Sustainability modifier was applied (+2). No other modifiers of the block were applied.

INSTITUTIONAL FRAMEWORK

The final score of the Institutional Framework analytical block is a+, which is the same as the core score of a+.

Core score factors. Institutional factors are above average on the global scale ACRA uses to assess countries, but lower compared to countries with the same level of creditworthiness, and lower than the EU average. The biggest constraint for Slovakia is its relatively low Control of Corruption score in the World Governance Indicators compiled by the World Bank. In addition, in 2020, Slovakia ranked 60^th in Transparency International’s Corruption Perception Index for 180² countries (fifth from last in the EU).

Despite the concerning trends described in the Macroeconomic Position block, the quality of human capital in Slovakia appears to have grown at average European rates in the recent past. Over the past 10 years, the corresponding index calculated by ACRA based on education and healthcare indicators grew by 8.3% for Slovakia, 8% for the EU, and 11% globally (unweighted average).

Modifiers were not applied for this block.

² 1^st indicates the lowest level of corruption.

KEY MACROECONOMIC INDICATORS

KEY ASSUMPTIONS

• An end to lockdowns in 2021.

• No plans to exit the Eurozone.

• High degree of utilization of money from European funds to finance investment in Slovakia.

POTENTIAL OUTLOOK OR RATING CHANGE FACTORS

A positive rating action may be prompted by:

• Introduction of measures to improve long-term budget sustainability, including those aimed at the pension system.

• Material improvement in governance and perception of corruption.

A negative rating action may be prompted by:

• Potentially serious external or industry-specific shocks and developments that may lead to volatile economic growth.

• Potential consequences for Slovakia due to the realization of redenomination risk in one of the Eurozone countries.

REGULATORY DISCLOSURE

The sovereign credit ratings have been assigned to the Slovak Republic under the international scale based on the Methodology for Credit Rating Assignment to Sovereign Entities under the International Scale and the Key Concepts Used by the Analytical Credit Rating Agency within the Scope of Its Rating Activities.

The sovereign credit ratings of the Slovak Republic were published by ACRA for the first time on October 25, 2019. The sovereign credit ratings and their outlooks are expected to be revised within 182 days following the publication date of the press release on the sovereign credit rating revision as per the Calendar of sovereign credit rating revisions and publications.

The sovereign credit ratings were assigned based on information from publicly available sources and ACRA’s own databases. The sovereign credit ratings are unsolicited. The Government of the Slovak Republic did not participate in the sovereign credit rating assignment.

In assigning the credit ratings, ACRA used only information, the quality and reliability of which was, in ACRA’s opinion, appropriate and sufficient to apply the methodologies.

ACRA provided no additional services to the Government of the Slovak Republic. No conflicts of interest were discovered in the course of the sovereign credit rating assignment.