Slovak economy digested global crisis well and continues to outpace EMU growth
Low debt, moderate deficit, current account balance surplus
But change in government carries uncertainties
Euro membership a blessing or a curse?
Slovak bonds are interesting for buy-and-hold purposes given the yield pick up
Primary market is best way to acquire bonds, due to illiquid secundary market
Economy grew solidly in 2010/2011
Following a difficult period of adverse economic fortunes around the turn of the century, Slovakia reformed its economy profoundly and reaped the fruits from 2001 onwards. Taking into account the global crisis in 2009, when the economy contracted by 4.9%, the Slovak economy still grew on average by 4.4% annually in the period 2000 to 2011 with a growth peak in 2007 (10.5%). The period of strong growth allowed the country to catch up rapidly with the more wealthy countries in Europe. Whereas the Slovak per capita GDP in PPP terms was 50% of EU-27 in 2000, it had climbed to 73% of EU-27 in 2010, the last year for which official data are available. The pace of catching up in the past decade was the fastest of the four main Central European countries.
The export-oriented Slovak economy recovered markedly from the recession that hit the country in 2009 and grew again by 4.2%, in 2010, driven by a revival of exports. The growth momentum has slowed slightly since, driven by a slowdown in the economy of its main trading partners, resulting in a3.3%increase of GDP in 2011.
The Slovak economy, however, still expanded by 3.4 % Y/Y in the fourth quarter of 2011, following an increase by 3.0 % Y/Y in the third quarter of 2011. External demand was again the main driving factor as the export of products and services increased by 7.5% Y/Y. Especially the automotive sector fared well, as some new product lines became operational. At the same time, imports declined by 1.0% Y/Y, due to a modest decline in domestic consumption (- 0.4% Y/Y), while consolidation efforts of the government resulted in a negative contribution of government spending (-3.7% Y/Y). Besides net exports, investments positively surprised, as gross fixed capital formation accelerated from 5.9% Y/Y in Q3 to 8.4% Y/Y in Q4.
The economy surprised again positively in the first quarter of 2012 with the above consensus growth of 3.1% Y/Y according to the flash estimate of the Slovak statistical office. No details about the composition of growth are available yet, but most likely net export was again the main driving factor, while investments should have held up well.
… outlook positive, but fiscal adjustment restrains growth pace…
The Ministry of Finance increased its 2012 GDP growth forecast in mid-March to 2.3% from 1.1% previously. KBC forecasts growth at 1.5% in 2012 and 2.2% in 2013, but various factors made us recently more optimistic, which might lead to an upward revision in the short term. Which are these factors? Firstly, the strong trade results in the first months of the year and an encouraging GDP growth figure for the first quarter of the year. Secondly, there is anecdotal evidence that the car sector plans to produce 925k cars this year. This is ambitious as car sales are declining in Western Europe, but Slovak producers might increase their market share or gain new share on Asian markets (export to China).
However, the 2012-2013 fiscal package will again negatively influence the domestic consumption unless it is done through the revision of the current pension system.
Besides the negative impact of the fiscal package, the main threat to growth in the next 18 months is a recession at Slovak’s main trading partners. However, the strong competitiveness position of the country will soften the blow of such a potential external shock, allowing the Slovak economy to continue growing, albeit at a slower pace.
Inflation no problem for now
The Slovak inflation started decreasing in December 2011 and continues this downward trend also in 2012. The headline CPI inflation peaked at 4.6% Y/Y in November and gradually went down to 3.6% Y/Y (April 2012). We expect a further deceleration towards or even below 3% Y/Y by the end of the year, which would result in a yearly average of about 3.1% in 2012 and 2.3% in 2013. However, the less predictable prices of food and fuel are still the main risk for this year. A higher unemployment rate keeps wage growth subdued and as productivity remains strong, it guarantees that underlying inflation remains subdued. The fiscal package should not increase the price pressures as the government does not envisage hiking indirect taxes (VAT or consumption taxes), which have a strong influence on the price level. It rather plans to increase the income taxes, which has a negative impact on the purchasing power of households. Therefore, it could even dampen the potential demand led inflation pressures in 2013.
Current account in surplus!!
The current account balance developments of countries recently got a lot more attention than previously, as the euro debt crisis showed that also inside a currency union, persistently high current account deficits might be relevant as an indicator of a loss of competitiveness. However, the current account deficits should be interpreted in a broader context. Indeed, economic theory learns that the flow of capital towards emerging countries is a healthy development. Investors are looking for higher returns and thus allocating capital in the most efficient way, often by sending it to emerging countries. The necessary corollary of high(er) capital flows (surpluses) is a high(er) current account deficit. The main question is whether these capital inflows, the driver of current account deficits, are used in a productive way or whether they simply finance too much consumption.
In the past, Slovakia accumulated current account deficits as had most other Central European countries. The profound restructuring of the economy around the turn of the century, the prospect of and later on the entry in EU (and EMU) triggered a lot of capital looking for higher returns. In the case of Slovakia, the money largely found its way to sound investment opportunities that strengthened the fabric of the economy.
The period of high current account deficits, which amounted to more than 8% of GDP in 2005-2006, is over for now. In 2009, the recession year, the deficit amounted to 3.6% of GDP, down from 6.3% of GDP in 2008. However, despite a rather strong recovery of the economy in 2010, the deficit stabilized and this year even a small surplus may be registered. No new deterioration is expected in 2013. There may have been a cyclical component in the shrinkage of the current account deficit, but more important also a structural component is at work. High investment, productivity growth and restraint wage growth improved the competitiveness. This favoured exports and consequently higher trade surpluses. The car sector is a good example as it continues to export more despite a difficult car market in Europe (see higher).
It is not completely excluded that the shrinkage of the current account deficit was partially driven by lower capital inflows (deleveraging W-Europe). In this case, the future trend growth may be somewhat lower than in the past decade, as foreign investment would slow down. However, at the current juncture, the current account balance should be regarded as a positive feature, suggesting healthy fundamentals. In this respect, the EU in a recent report (macro-economic imbalance procedure) published a list of 12 EU countries with structural imbalances that needed to be addressed. Slovakia didn’t appear on this list.
Public finances need consolidation
The government deficits were relatively high before 2001, but a more orthodox fiscal policy reduced deficits during the subsequent years. In 2007 and 2008, the government deficit amounted to 1.8% and 2.1% respectively. Of course, the strong growth pace made it easier to contain the deficits.
However, the sharp crimp in activity during the crisis unsurprisingly unveiled an unsustainable fiscal position. The deficit rose to 8% of GDP in 2009 and shrank subsequently to 7.7% in 2010 and 4.8% in 2011.
The combination of higher deficits and slowing nominal GDP growth resulted in a rapidly rising debt-to-GDP ratio. From 41% of GDP in 2004, Slovak debt first fell to about 28% in 2008, but jumped to 35.5% in 2009, 41% in 2010 and 43.3% in 2011. If the consolidation efforts of government finances won’t be continued rigorously, the debt ratio may soon reach 50% of GDP. Otherwise, the debt-to-GDP ratio may stabilize slightly below 50% in the next couple of years, which is the most likely outcome.
The official MoF debt to GDP forecast expects the debt to rise from 43.3% in 2011 to 50.9% in 2012. The MoF forecast is probably too pessimistic. Growth close to or higher than 2% could help to stabilize debt under the 50% threshold.
The projection of the outgoing government (see higher) might be perceived as the potential pressure on the New Leftist government to implement needed fiscal consolidation steps. According to the new Fiscal Act (Constitution Law) a debt to GDP ratio above 50% might trigger debt brakes.
Constitution debt breaks
At the end of last year, a constitutional law on budgetary responsibility, or so-called debt brake law, was passed in the Slovak parliament. If the public-finance debt exceeds 50%, the finance minister will have to write a letter to parliament explaining the reasons and proposing remedial steps. If the debt reaches 53%, the government will be obliged to adopt a package of measures and freeze its own salaries. At 55%, it will be impossible to increase expenditures for the following year. At 57%, the government will have to prepare a balanced budget. If these measures don't work and the debt reaches the 60% ceiling, the government must initiate a vote of confidence. The upper limit will gradually decline to 50% from 2017 onwards.
Parliament approved the constitutional act creating an independent Fiscal Council and binding strict fiscal rules (see higher). The act reduces the room for fiscal excesses, as the change or abolition of the Act requires a 2/3 majority in parliament. In addition, the Macroeconomic committee and Tax forecasting committee will produce governmentindependent forecasts. This is a step forward from the situation where the Ministry of Finance produced its own forecasts. So, while the new Smer government constitutes a risk for eventual adventurous policies, the new constitutional act should prevent excesses.
The outgoing central-right government made the fiscal consolidation its policy priority, following the outspoken slippage in 2009/2010. Accordingly, the budget deficit fell from 7.7% of GDP in 2010 to 4.8% of GDP in 2011 including the hidden unaccounted debt created in 2008-09 (railway companies and healthcare system).
…but change of government creates uncertainty
Early Parliamentary elections took place on March 10. The left-wing Smer party defeated the rightist coalition that ruled the country less than two years. Smer gathered 44.41% of votes or 83 out of 150 seats in the Parliament. The clear majority will lead to a single-party government for the first time since the Velvet revolution in 1989. Smer invited all parties to start talks about collaboration, but all right wing parties rejected the invitation. The outgoing government committed itself (towards the EU Commission) for a decline of the deficit to 2.9% of GDP in 2013. After the government change the new government will have to continue the consolidation process. Otherwise, it might trigger a negative reaction of financial markets (higher yields) and a financial penalty of up to 0.2% of GDP from the EU Commission (€140M)
The new government will have the difficult task to bring the deficit to 2.9% of GDP by the end of 2013, which will need a deficit reduction by approximately €1B and the implementation of unpopular measures. Smer announced typical leftist measures like higher taxes for wealthy people, banks and highly profitable corporate companies. They promised investment support for local entrepreneurs and a return of highway PPP (Private-Public Partnership) projects. This alone will be not enough to consolidate public finances and spending cuts will need to be part of the effort.
The new fiscal adjustment plans are still on the drawing table and should be announced during the summer. There are some risks the Smer government would follow as rigorously as the outgoing government the austerity path agreed with the EU Commission. However, this shouldn’t be overrated though, as the new government might use the second part of its tenure to follow a more relaxed budgetary policy, after taking the needed measures in the 2012/2013 period. EU pressures and constitutional brakes are other factors that minimize risks of fiscal slippage.
The policies of the new government are important from another longer term angle. They may slow the trend growth of the economy, which is a long time negative for Slovak debt.
Strong financial sector
The Slovak banking system is strong and has very well coped with the 2009 financial en economic crisis and the ongoing euro debt crisis, just like its neighbor Czech Republic. The Slovak banks are profitable and wellcapitalized. They didn’t need government support in the crisis. The capital adequacy ratio of Slovak banks is over 12%, well above the likely future threshold of 9%. The loanto- deposit ratio of 90% would allow Slovak banks to cope relatively well with eventual future shocks. They have no meaningful foreign exchange loans in their portfolio, as is for instance the case for Hungarian or Polish banks. The NPL declined to 6% at the end of March 2012 from 6.2% one year earlier and is well below levels reached in most other Central European and in crisis-hit euro countries.
Despite the strength of the banking system, bank taxes and the dependence from foreign parent banks are risks, albeit modest ones. Regarding the former, the net profit of the banking sector decreased by 18% Y/Y in Q1 2012, mainly due to the negative impact of a newly implemented bank tax (0.4% of the adjusted balance sheet). Regarding the latter, Slovak banks are for more than 90% owned by foreign banks. These may reduce lending to their subsidiaries to bring their own core tier 1 capital ratio to the minimum required 9%, triggering a credit crunch in Slovakia.
However, the profitability of the Slovak banks and European actions like the Vienna initiative make it unlikely that these risks will materialize. So, from a sovereign debt perspective, the situation of the banking sector causes little reason for concern.
Euro, a blessing or a curse?
In light of the current economic problems in the eurozone, it isn’t obvious whether euro membership is a blessing or a curse. The examples of countries like Portugal, Spain or Greece immediately pop up.
These countries gradually lost competitiveness and after a credit-induced rapid catching up of living standards, they risk now a long period of hardship that may stall the improvement of living standards or worse may reverse the progress made in the first decade of euro membership. Slovakia, as a late entrant, has the advantage it can draw lessons from the crisis. The loss of the currency as a policy tool means that Slovakia needs a flexible economy. In this respect, the country made big progress in the last ten years. The labour market is very flexible and product markets are reasonably flexible too. Also the low taxation of income is a structural positive feature.
The European fiscal pact and the constitutional changes on the debt level are obviously benefits for the sovereign debt holder. There are less coercive measures on a European level to cope with eventual imbalances in the private sector that may ultimately mutate into a sovereign debt problem. However, the monitoring of imbalances on European level and flexibility of the Slovak economy go some way in soothing fears of future imbalances in the private sector.
To conclude, while it isn’t yet clear euro membership is a positive or a negative for bondholders, there are no specific indications yet of potential problems brewing. Rules on deficits and debts and peer pressures inside EMU diminish risks of political adventures.
Rating downgrades due to euro crisis!!
During the first two years of the century, the three major rating agencies upgraded the Slovak rating to investment grade. Until 2009 the Slovak rating gradually increased (catching up with the Czech Republic), supported by a decade-long track record of economic and fiscal reforms and a relatively low external debt. Joining the EU (2004) and the prospect of euro adoption (2009) were also supportive. However, the latter came back with a vengeance during the crisis. Since the outburst of the sovereign debt crisis, Slovakia was downgraded both by S&P and Moody’s (early 2012; more details see below). Currently Slovakia is rated on average similar to Slovenia (whose rating deteriorated more rapidly however since the recent crisis) but below the neighboring Czech Republic (which has the best rating in the CEE region). Slovakia is rated A+ at Fitch and one notch lower at S&P (A) and Moody’s (A2; negative outlook).
Rating agency Moody’s downgraded Slovakia’s government bond rating from A1 to A2 (negative outlook) on February 13. One of the reasons of the downgrade was the uncertainty over the euro area’s prospects for institutional reform and over the resources that would be made available to deal with the crisis. This reason was thrown up for all 9 European sovereigns that were downgraded that day. However, Moody’s also pointed to two domestic factors. First of all, there is Slovakia’s exposure to the deteriorating regional macroeconomic environment given Rating agency Moody’s downgraded Slovakia’s government bond rating from A1 to A2 (negative outlook) on February 13. One of the reasons of the downgrade was the uncertainty over the euro area’s prospects for institutional reform and over the resources that would be made available to deal with the crisis. This reason was thrown up for all 9 European sovereigns that were downgraded that day. However, Moody’s also pointed to two domestic factors. First of all, there is Slovakia’s exposure to the deteriorating regional macroeconomic environment given the dependence of the economy on external demand. Secondly, the fragile external environment increased financial event risk and at the same time political event risk had been heightened (following the collapse of the Slovak government). Downward pressure on the rating could develop if Slovakia's economic growth prospects deteriorate significantly or in case of a sharp intensification of the euro area crisis
Rating agency S&P downgraded Slovakia’s government bond rating from A+ to A (stable outlook) earlier on the year (January 13). S&P downgraded 9 EMU countries that day, also partly for reasons of an insufficient handling of systemic stresses in the euro zone. The high degree of openness of the Slovak economy and political situation were also mentioned. The stable outlook reflects the expectation that Slovakia’s government will reduce its currently high fiscal deficit and stabilize government debt as a share of GDP.
ISSUE CALENDAR
The Slovak Authorities planned to issue around €7.5-8B this year mainly through the sale of government bonds at the beginning of the year. Currently, ARDAL (Slovakia’s Debt and Liquidity Management Agency) has almost fulfilled its financing needs for this year (approximately around 90%). This year’s issued amount of bonds and T-bills stands at €7.2B so far. The local banks are still the main buyer of the Slovak government debt , reason why Ardal decided to diversify its existing portfolio of investors and reach out to non-local investors from within and outside the euro area.
Therefore, it issued T-bonds in Czech koruna, Swiss franc and U.S. dollar.
In the 2012 issue calendar, ARDAL planned to open at least three new government bond lines, depending on market conditions. ARDAL eyed one line with maturity up to 3 years, one with 10 years to maturity and finally, a bond line with 5+ years to maturity.
These three issues have already been completed in the meantime. In January, Ardal issued a 5-yr SLOVGB via syndication (€1B Jan2017). In March they issued CZK 12.5B 3-yr bonds (ca €0.5B Sep2015) and in mid-May they sold $1.5B 10-yr debt (ca €1.15B May2022). This means that there will most likely be no more benchmark issues this year.
At the start of each year, ARDAL also announces which bond lines could be reopened and to which amounts. When ARDAL issues a new benchmark bond via syndication, this line is added to the list. Auctions are held on a monthly basis (see auction calendar). At the start of 2012, ARDAL targeted 5 lines: SD216 (4.35% Oct2025); Max: €880 900 000 SD218 (6M Euribor Nov2016); Max: €1 450 000 000
A sixth line was added after the syndicated new benchmark issuance early 2012. On January 11, the Slovak Republic was the first EMU country in 2012 to issue a new line via syndication. The bond was priced to yield MS+305 bps, at the tighter end of the initial spread guidance (MS+305/310 bps). The final order book amounted €1.3B, so ARDAL could print the initially targeted €1B.
SD219 (4.625% Jan2017); Max: €2 000 000 000
So far, the amounts set for SD206, SD213 and SD217 are reached and therefore these lines won’t be tapped again this year. ARDAL already issued €7.25B this year compared to a €7.5-8B target (>90% of this year’s bond issuance completed). More specifically, ARDAL raised €3.4B via the syndication of a new €-benchmark and €-auctions, €2B via Eurobonds and around €1.85B via bill issuance. For the remainder of the year, we expect ARDAL will hold a summer break after the June auctions (June 11). After the break, we expect ARDAL to finalize this year’s issuance and start the prefunding for 2013 (€0.5B SD188 redemption in January 2013; €1.5B SD211 redemption in March 2013) by further tapping SD216, SD218 and SD219.
Slovakia has around €27B outstanding government bonds (total debt outstanding was €32.1B as of May 23 2012), of which the lion share (+-94%) is denominated in euro. As mentioned before, ARDAL searched for a geographic diversification of its bond holders by placing foreign denominated debt this year as well (eg CZK, CHF and USD bond issues). The average maturity of the Slovak debt portfolio is around 5.1 years and it’s ARDAL’s aim to keep this above 5 years. The redemption profile of the Slovak debt shows that Slovakia has a €3-4B bond refunding need each year between 2013 and 2017. Further out the curve, outstanding bonds exceed €2B only in 2020 and 2025. The liquidity of Slovak bonds is very low on the secondary market but decent at primary auctions (although the issue sizes are of course not that high). Furthermore, bonds issued by Slovakia under international law (ahead of the adoption of the euro), “SLOVAK’s” (euro denominated) are more liquid than the domestic “SLOVGB’s” on the secondary market. SLOVAK bonds had an advantage for foreign investors amongst other because the withholding tax was lower than for SLOVGB’s. However, end 2010 the government solved this discrimination by leveling the withholding tax for both sort of bonds.
Slovak bonds trade on average with a 50-60 bps premium over Belgian bonds. Recently, the premium is slightly higher, as we saw a small shift out of AAA-debt into Austrian/French/Belgian debt in a hunt for yield. Slovakia can be considered as the weaker of the credits of this group, but clearly distances itself from the credit “group” that comprises Italy and Spain.
When the EMU debt crisis erupted again in November 2011, the asset swap spread of Slovak bonds increased significantly towards around 300 bps for the 10-yr. On top, the Slovak government collapsed in October and the political uncertainty added pressure on the Slovak bonds. Spreads remained elevated until the start of the year, when they started narrowing, supported by the ECB’s LTRO’s and the prospect of a new government (eventually established March 2012). Recently, the 10-yr benchmark trades around 180 bps over mid swap. Unlike for example Slovene bonds, Slovak bonds didn’t come under renewed pressure as Spain and Italy came back in the center of attention.
Conclusion
From an investing point of view, Slovak bond can be interesting for buy and hold investors hunting for some yield, diversifying away from core EMU debt while still avoiding the huge PIIGS risk. The current 60 bps yield pickup over Belgium/Czech Republic reflects an illiquidity premium (hard to trade in case of heightened market stress), as well as a domestic political risk premium. Furthermore, Slovak bonds can be influenced by worsethan- expected EMU growth, but this arguments counts just as well for other CEE €-denominated or Belgian bonds. Strong characteristics in Slovakia include a sound financial sector, an open competitive economy (higher growth potential) and likely the ability to keep deficit and debt ratio’s under control (cf. debt brake law in constitution) in the next few years.
