Council opinion of 12 February 2008 on the updated convergence programme of Slovakia, 2007-2010
Date: 2008-02-12
Institutions: Council of the European Union
Subjects: Slovakia, budget estimate, economic convergence, economic forecasting, public finance, stability programme

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Official Journal of the European Union

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COUNCIL OPINION

of 12 February 2008

on the updated convergence programme of Slovakia, 2007-2010

(2008/C 49/11)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveil-
lance of budgetary positions and the surveillance and coordination of economic policies (1), and in particular
Article 9(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

On 12 February 2008, the Council examined the updated convergence programme of Slovakia,
which covers the period 2007 to 2010.

Slovakia is currently experiencing a period of strong growth induced by wide-range structural reforms
introduced in previous years combined with substantial inflows of FDI, especially into the manufac-
turing sector. Although consequential to growth employment picked up as well and the unemploy-
ment rate fell substantially, certain segments of the population concentrated in eastern regions do not
seem to take part in this economic expansion.

Apart from constituting a drag on public finances and a social problem, the low employability of
certain segments of the labour force limits the country's potential output growth and thus hampers
the catching-up process. This unevenness in the distribution of economic activity across population
groups and regions would call for an increase in the quality of public education and some reallocation
of government expenditure to education, R&D and innovation and infrastructure development.
Following a predominantly restrictive budgetary policy in previous years, the fiscal stance turned
expansionary in 2006, while monetary conditions tightened on the back of increased policy rates and
continued exchange rate appreciation which however, as testified by the strong growth in exports and
falling current account deficit, does not seem to have affected external competitiveness of the Slovak
economy. As a Member State with a derogation and an ERMII participant Slovakia should gear its
macroeconomic and structural policies towards achieving sustainable convergence. Although inflation
has decelerated markedly in 2007, it is expected to pick up again on the back of rising food and
energy prices, strong growth, a tightening labour market and a fading effect of the strong exchange
rate appreciation in 2006-2007. In order to meet the inflation targets set out in the programme —
which assumes euro area membership from 2009 — and to contain possible inflationary pressures
after the disinflationary effect from past substantial exchange rate appreciation fades out, further
structural reforms are necessary and the government should stand ready to adopt a tighter fiscal
stance than that envisaged in the programme.

(3)

The macroeconomic scenario underlying the programme envisages that real GDP growth will drop
from 8,8 % in 2007 to 5,0 % in 2010. Assessed against currently available information (2), this
scenario appears to be based on plausible growth assumptions until 2009 and cautious ones for
2010, as the exceptional export performance recorded in 2007 induced by the launch of new
production capacities in the manufacturing sector is not expected to be repeated in the coming years.
The programme's projections for inflation appear to be on the low side as they are based on more

(1) OJ L 209, 2.8.1997, p. 1. Regulation as amended by Regulation (EC) No 1055/2005 (OJ L 174, 7.7.2005, p. 1). The

documents referred to in this text can be found at the following website:
http://ec.europa.eu/economy_finance/about/activities/sgp/main_en.htm

(2) The assessment takes notably into account the Commission services' autumn forecast and the Commission assessment of

the October 2007 implementation report of the national reform programme.

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favourable external assumptions than the Commission services' autumn 2007 forecast and on a
different assumption on the fading out of the effect of past exchange rate appreciation.

(4)

(5)

(6)

(7)

For 2007, the general government deficit is estimated at 2,7 % of GDP in the Commission services'
autumn 2007 forecast, against a target of 2,9 % of GDP set in the previous update of the convergence
programme and of 2,5 % of GDP in the current update. This improvement was enabled by a
revenue over-performance outweighing higher-than-budgeted expenditure. Given that the estimated
2007 deficit outturn is lower (by 0,2 % of GDP) than previously targeted both in nominal and struc-
tural (i.e. cyclically-adjusted net of one-off and other temporary measures) terms, the Slovak authori-
ties have partly responded to the invitation in the Council opinion of 27 February 2007 on the
previous update of the convergence programme (1) which called for a strengthening of the structural
adjustment in order to ensure the correction of the excessive deficit in 2007 with a larger margin.

The main goal of the budgetary strategy is to reach the medium-term objective (MTO) for the
budgetary position of a structural deficit of just below 1 % of GDP by 2010. The programme foresees
the general government deficit to decrease from 2,5 % of GDP in 2007 to 0,8 % of GDP in 2010 in
nominal terms, with the primary balance improving from a deficit of 1,0 % of GDP in 2007 to a
surplus of 0,5 % of GDP in 2010. The adjustment in both structural and nominal terms is back-
loaded towards the end of the programme period. Compared to the previous update, the new update
broadly confirms the planned adjustment against a more favourable macroeconomic scenario. Fiscal
consolidation is envisaged to be expenditure-based (especially cuts in social payments and compensa-
tion of public employees) as the expenditure ratio is planned to be reduced by 3 percentage points of
GDP over the programme horizon while the revenue ratio would decline by half this amount.

The budgetary outcomes could be better in 2008 and worse in 2009 and 2010 than projected in the
programme. In particular, strong growth prospects, already adopted revenue-increasing measures
(broadening of the corporate tax base and increase in the maximum ceiling for social contribution
foreseen to generate additional revenue of some 0,3 % of GDP) and the likely outflow of participants
from the second pension pillar (2) (positive impact estimated at about 0,2 % of GDP) should allow for
a better-than-foreseen deficit outcome in 2008 if expenditure growth is kept more in check than
suggested by the programme as was the case in previous years. However, apparent risks exist for the
planned fiscal consolidation back-loaded to 2009 and 2010. In particular, there are no binding
expenditure ceilings, there is a lack of information on the measures that underpin the adjustment and
there are potentially some risks to expenditure related to planned partnerships with the private sector
notably as regards construction of motorways.

In view of this risk assessment, the budgetary stance in the programme seems broadly consistent with
a durable correction of the excessive deficit by 2007 as recommended by the Council. A sufficient
safety margin against breaching the 3 % of GDP deficit threshold with normal macroeconomic fluc-
tuations (estimated around a structural deficit of 2 % of GDP) would only be provided from 2010
onwards if the envisaged consolidation is strictly implemented (3). Moreover, the budgetary stance in
the programme seems insufficient to ensure that the MTO is achieved by the end of the programme
period, as envisaged in the programme. In 2008, only a slight improvement (0,25 % of GDP) in the
structural balance can be expected when good times are foreseen to occur.

The pace of adjustment towards the MTO implied by the programme in 2008 should be therefore
strengthened to be in line with the Stability and Growth Pact, which specifies that, for euro-area and
ERM II Member States, the annual improvement in the structural balance should be 0,5 % of GDP as
a benchmark and that the adjustment should be higher in good economic times. Moreover, budgetary
room needs to be created for the expected increase in inflows of EU funds in order to maintain the
restrictive fiscal stance planned for 2009-2010. The planned adjustment in the remaining years of the
programme — in line with the Pact — should be strictly implemented and, if necessary, backed up
with measures. Finally, should inflationary pressures emerge, a tighter fiscal stance than foreseen in
the programme would be required.

(1) OJ C 72, 29.3.2007, p. 1.
(2) In the first half of 2008 the second pension pillar will be temporarily opened, allowing current participants to leave and

new participants to join the scheme.

(3) The output gap estimates presented in the programme differ substantially from the Commission services estimates that are

based on the information in the programme using the common agreed methodology.

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(8)

(9)

Slovakia appears to be at medium risk with regard to the long-term sustainability of public finances.
The long-term budgetary impact of ageing is lower than the EU average, with pension expenditure
showing a more limited increase than in many other countries, notably thanks to the 2005 pension
reform. However, those projections hinge upon the assumption that a relatively low share of workers
will leave the mixed pension system in the first half of 2008, during which they will have the oppor-
tunity to do so. The budgetary position in 2007 as estimated in the programme with a structural
primary deficit constitutes a risk to sustainable public finances even before considering the long-term
budgetary impact of an ageing population. Consolidating the public finances, as planned in the
convergence programme, would therefore contribute to reducing risks to the sustainability of public
finances.

The convergence programme seems to be consistent to some extent with the October 2007 imple-
mentation report of the national reform programme. It confirms that the government's expenditure
priorities (healthcare, education and agriculture) continue to partly diverge from the key challenges
identified in the NRP (information society; R&D and innovation; business environment; and education
and employment). Moreover, it does not specify whether the national R&D expenditure target of
0,8 % of GDP will be met by 2010 while education spending tends to increasingly rely on EU Struc-
tural Funds. The programme does not contain a qualitative assessment of the overall impact of the
National Reform Programme within the medium term fiscal strategy but it provides systematic infor-
mation on the direct budgetary costs associated with the main reforms envisaged in the NRP
for 2008.

(10)

In terms of progress in implementing its ERM II commitments, the fiscal targets in successive conver-
gence programmes have been consistently overachieved but the targets themselves have turned out
not to be particularly ambitious given the better-than-originally-assumed initial fiscal position and
stronger-than-expected economic performance. As regards income policies, collective bargaining
agreements in the public sector have provided an important signal of wage moderation for the whole
economy. With a view to containing credit growth, the National Bank of Slovakia has closely moni-
tored risk management practices of banks and strengthened cooperation with home country supervi-
sors of banks operating in Slovakia.

(11) As regards the data requirements specified in the code of conduct for stability and convergence

programmes, the programme provides all required and most of the optional data (1).

The overall conclusion is that the programme is consistent with a correction of the excessive deficit by
2007. Thereafter,
it envisages back-loaded progress towards the MTO in a context of strong growth
prospects; in 2008, the envisaged structural improvement is not in line with the Pact and should be more
ambitious. Given risks to the budgetary targets from 2009 onwards, the MTO may not be achieved by 2010
as planned in the programme and therefore additional efforts might be required. Moreover, should infla-
tionary pressures emerge, a tighter fiscal stance than foreseen in the programme would be required along
with further structural reforms to improve the labour market performance. As regards the long-term sustain-
ability of public finances, Slovakia appears to be at medium risk. With respect to medium-term challenges,
the programme does not envisage any progress in reallocating expenditure towards R&D and innovation
while it states that education spending should increasingly rely on EU funds.

In view of the above assessment and the recommendation under Article 104(7) of 5 July 2004 and also
given the need to ensure sustainable convergence and a smooth participation in ERM II, Slovakia is invited
to:

(i) exploit the strong growth conditions to strengthen the pace of structural adjustment towards the MTO
in 2008 and strictly implement the envisaged structural consolidation thereafter backed up, if necessary,
by additional measures as well as more binding medium-term expenditure ceilings; and

(ii) introduce further structural reforms to improve the labour market performance and stand ready to
adopt a tighter fiscal stance, in particular in order to contain possible inflationary pressures, especially
after the disinflationary effect of past substantial exchange rate appreciation fades out.

(1) In particular, the data on the functional classification of government expenditure (COFOG) for 2010 are not provided.

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Comparison of key macroeconomic and budgetary projections

2006

2007

2008

2009

2010

Real GDP
(% change)

HICP inflation
(%)

Output gap (1)
(% of potential GDP)

Net lending/borrowing
vis-à-vis the rest of the
world
(% of GDP)

General government
balance
(% of GDP)

Primary balance
(% of GDP)

Cyclically-adjusted
balance (1)
(% of GDP)

Structural balance (3)
(% of GDP)

Government gross debt
(% of GDP)

CP Nov 2007

COM Nov 2007

CP Dec 2006

CP Nov 2007

COM Nov 2007

CP Dec 2006

CP Nov 2007

COM Nov 2007 (2)

CP Dec 2006

CP Nov 2007

COM Nov 2007

CP Dec 2006

CP Nov 2007

COM Nov 2007

CP Dec 2006

CP Nov 2007

COM Nov 2007

CP Dec 2006

CP Nov 2007

COM Nov 2007

CP Dec 2006

CP Nov 2007

COM Nov 2007

CP Dec 2006

CP Nov 2007

COM Nov 2007

CP Dec 2006

8,3

8,3

6,6

4,3

4,3

4,4

– 0,5

– 0,8

– 0,9

– 8,4

– 7,8

– 6,4

– 3,7

– 3,7

– 3,7

– 2,2

– 2,2

– 1,9

– 3,5

– 3,4

– 3,4

– 3,1

– 3,4

– 3,5

30,4

30,4

33,1

8,8

8,7

7,1

1,7

1,7

3,1

1,8

1,0

1,0

– 3,4

– 4,2

– 3,1

– 2,5

– 2,7

– 2,9

– 1,0

– 1,2

– 0,9

– 3,0

– 3,0

– 3,2

– 3,0

– 3,0

– 3,2

30,6

30,8

31,8

6,8

7,0

5,5

2,3

2,5

2,0

2,3

1,3

1,6

– 1,9

– 2,7

– 2,5

– 2,3

– 2,3

– 2,4

– 0,9

– 0,8

– 0,6

– 3,0

– 2,7

– 2,9

– 3,1

– 2,7

– 2,9

30,8

30,7

31,0

5,8

6,2

5,1

2,6

3,0

2,4

2,1

0,8

1,9

– 1,1

– 1,6

– 2,0

– 1,8

– 2,4

– 1,9

– 0,3

– 0,9

– 0,2

– 2,4

– 2,6

– 2,5

– 2,4

– 2,6

– 2,5

30,5

30,6

29,7

5,0

n.a.

5,0

2,7

n.a.

2,6

1,4

n.a.

2,4

– 0,4

n.a.

– 1,6

– 0,8

n.a.

n.a.

0,5

n.a.

n.a.

– 1,2

n.a.

n.a.

– 1,2

n.a.

n.a.

29,5

n.a.

n.a.

Notes:
(1) Output gaps and cyclically-adjusted balances according to the programmes as recalculated by Commission services on the basis of the

information in the programmes.

(2) Based on estimated potential growth of 6,4 %, 6,7 %, 6,7 % and 6,7 % respectively in the period 2006-2009.
(3) Cyclically-adjusted balance excluding one-off and other temporary measures. One-off and other temporary measures are 0,4 % of GDP
in 2006 — deficit-increasing and 0,1 % of GDP in 2008 — deficit-reducing according to the most recent update of the programme.
There are no one-off measures in the Commission services' forecast.

Sources:
Convergence programme (CP); Commission services' autumn 2007 economic forecasts (COM); Commission services' calculations,