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Rating action

Scope Ratings has today affirmed Slovakia's A+ long-term issuer and senior unsecured local- and foreign-currency ratings. The short-term issuer ratings have been affirmed at S-1+ in both local and foreign currency. Outlooks have been revised to Negative from Stable.

Summary and Outlook

The Outlook change to Negative on Slovakia’s A+ ratings reflects:

i. Slovakia’s external vulnerabilities, stemming from the economy’s high exposure to international value chains and high degree of reliance on its car industry, the latter which is adversely impacted by the coronavirus shock alongside potential risks from structural changes to the sector; and

ii. deterioration in the country’s near-term fiscal dynamics and increase in general government debt ratios, exacerbated by a sharp widening in budget deficits.

The government has put in place concerted measures to reduce the coronavirus shock’s impact on the Slovak economy.

The affirmation of Slovakia’s long-term ratings at A+ reflects: i) the economy’s EU and euro area memberships, which support credible macroeconomic policies and confer advantages via a strong reserve currency in the euro and access to loan and asset purchase facilities of the European Central Bank (ECB), which effectively acts as a lender of last resort; and ii) still moderate levels of general government debt, projected at 57.4% of GDP in 2020, which would remain below the EU’s Maastricht reference value of 60%.

The Negative Outlook reflects Scope’s view that risks to the ratings are tilted to the downside over the next 12 to 18 months. The ratings could be downgraded if, individually or collectively: i) there is a sustained increase in the general government debt ratio due to a deeper-than-expected GDP contraction and/or larger-than-anticipated fiscal loosening; ii) external finances deteriorate substantially due to sustained weak external demand or due to a structural shock to the automotive industry, leading to a markedly wider net external debtor position; and/or iii) financial stability concerns increase due to a build-up of macroeconomic imbalances.

Conversely, the rating Outlook could be revised back to Stable if, individually or collectively: i) authorities’ future fiscal consolidation increases expectations for a firm downward trajectory for the general government debt ratio in the aftermath of this year’s coronavirus shock; ii) there is a stronger-than-anticipated economic recovery in the period ahead without a substantial increase in macroeconomic imbalances; and/or iii) the implementation of structural reforms improves long-run growth potential, economic diversification and structural adjustments that adapt to future changes in the car industry.

Rating rationale

The first driver for the Negative Outlook is Slovakia’s external vulnerabilities that have been exacerbated by the Covid-19 shock. Scope projects Slovakia’s real GDP to contract by 5.3% this year, after growth of 2.3% in 2019. This baseline expectation assumes an average capacity utilisation in the economy of around 70% at Q2 2020 crisis lows (compared with 2019 output levels) and a gradual economic recovery in the second half of the year. In addition, growth expectations reflect measures deployed by authorities to contain the coronavirus’ transmission and drag on Slovak growth from exposures to economic contractions in the rest of the euro area. However, Scope points out that significant downside risks to baseline economic forecasts prevail due to the potential extended duration of the coronavirus shock and uncertainties regarding its impacts on Slovakia’s domestic economy and trading partners.

As a small, open economy specialised in the automotive industry, around 64% of Slovakia’s total exports relate to foreign inputs and domestically produced inputs used in third countries’ exports. This referenced share is one of the highest in the EU and constitutes a risk in times of major disruption to global value chains. In addition, industrial turnover in the machinery and transport equipment sectors has been falling by around 5% year-on-year since the second half of 2019 due to lowered foreign demand and economic slowdown in the euro area. More recently, the temporary halt to car production over the last month due to the coronavirus crisis has had a severe adverse economic impact, as this industry accounts for around 13% of Slovak GDP and 50% of industrial production.

Structural changes taking place in the car industry, including potential reorganisations of supply chains due to rising demand for electric automobiles and stronger cost competitiveness of some other eastern European car manufacturers, pose uncertainty for medium-run dynamics in automotive production growth in Slovakia and could present spill-over risks to the general economy. In addition, Slovakia’s unemployment rate is vulnerable to possible rise in longer-term job automation, with around 34% of jobs at high risk of automation – the highest such ratio in the OECD. These risks are partially mitigated by the flexibility and comparative advantages exhibited by Slovak car producers.

In 2021, Scope expects a partial recovery in real GDP levels with annual growth of 4.7%, reflecting a 2021 rebound in foreign demand, higher investment and employment recovery. However, the speed of recovery remains subject to significant risk, depending on the duration of the shock and intensity of measures activated to contain the virus’ transmission.

The second driver for the Outlook change is the worsening in fiscal dynamics, weakened by higher spending needs in the near-term due to the coronavirus shock alongside cyclical fiscal deterioration owing to deep recession in 2020. The budgetary supportive measures amount to 1.3% of 2019 GDP per month in direct costs, including a partial contribution of employee salaries for companies and the self-employed affected by containment measures, as well as credit guarantees for business loans, equating to 0.5% of GDP per month. As a result, Scope expects the general government deficit to widen from 1.3% of GDP in 2019 to 6.8% in 2020, before falling to 3.2% in 2021.

Scope expects the general government debt ratio to increase to 57.4% of GDP in 2020, from 48% as of 2019 and thereafter remain largely unchanged in 2021. Furthermore, according to the Slovak Council for Budget Responsibility, long-term fiscal sustainability has deteriorated over the last two years, compounded by the government’s decision in 2019 to cap the retirement age at 64. Corrective fiscal measures amounting to 1.32% of GDP are needed in the form of permanent increases in general government revenues and/or decreases in expenditures, up from 1.2% in 2017, to keep general government debt below a 50% of GDP threshold over the long-term. This is in addition to another 1% of GDP required to offset the negative impact from the retirement age cap. These projections were estimated before the markedly higher deficits now expected for 2020-21.

Slovakia’s ratings also reflect the following key rating drivers:

Slovakia’s A+ rating is anchored by historically strong macroeconomic fundamentals and a competitive industrial base, with real growth having averaged 3.3% during 2015-19, benefitting from large investments made in its automotive industry. This led to a steady improvement in labour market outcomes over the referenced period, with the unemployment rate having fallen to an all-time low of 5.4% by January 2020, before edging higher to 5.6% as of March.

Slovakia’s ratings account moreover for the country’s moderate public debt burden of 48% of GDP entering this year’s crisis, well below the EU’s 60% debt-to-GDP ceiling (compared to a current average of 54% among country peers (EU sovereigns with a ‘a’ rating level) as of Q4 2019). Moderate public debt levels have been supported by credible constitutional budgetary rules and debt constraints that foresee corrective measures should a certain debt threshold be exceeded (the lowest debt brake sanction threshold of 50% of GDP has been reduced by 1pp each year since 2018). Slovakia’s solid market access (for example, a 10.5-year bond of EUR 1.5bn with a 1% coupon was issued on 7 April), continued access to the ECB’s liquidity facilities, as well as increased EU budgetary support and greater flexibility in the deployment of EU structural funds in 2020 support financing of Slovakia’s spending needs at accommodative borrowing rates. The yield spread on the 10-year Slovak government bond over similar-duration German bonds increased moderately to about 115bps at time of writing, compared to 40bps in January 2020.

Following the February 2020 parliamentary elections, Slovakia formed a government with a constitutional majority of 95 seats in the 150-seat parliament, comprising of former opposition parties led by the centre-right OĽaNO. Scope expects the current government to support a pro-Western and pro-EU orientation. Scope views positively government plans to undertake judicial and anti-corruption reform, as well as improve healthcare and education systems, areas in which Slovakia has made limited progress to this stage. These reforms will be crucial given Slovakia’s unfavourable demographic dynamics, which weigh upon long-term growth potential. The old-age dependency ratio (those aged 65 years and over as a percentage of persons aged 15-64) is projected by the European Commission (EC) to increase from 24.5% in 2019 to 32.9% by 2030, driven by ageing. Slovakia’s old-age dependency ratio would, however, remain the fourth lowest in the EU in 2030. Before 2020, the EC estimated Slovakia’s medium-run potential growth at around a 3% per annum, compared to a 3.6% average in the Visegrád group as a whole.

Slovakia’s banking sector is well capitalised and profitable, with a system-wide tier 1 capital ratio of 16.7% of risk-weighted assets and a return on equity of 9.5% as of Q4 2019, close to euro area averages of 17.8% and 8.3% respectively. Non-performing loans were below 3% of total loans as of the same quarter. Scope, however, expects this year’s economic contraction to markedly weaken asset quality as well as profitability in the banking sector.

In addition, household indebtedness has been rising, which has made Slovak households and banks more vulnerable to this year’s sharp economic contraction and anticipated rise in unemployment. Household debt amounted to 45.9% of GDP in Q4 2019 (or 77.8% of household disposable income), up on 43.2% in Q4 2017, with household debt ratios the highest among central and eastern European countries. This has been driven by previous strong growth in house prices, averaging 7.5% YoY in 2019, and associated robust mortgage lending. Household borrowers’ capacities to respond to significant shocks, either from a sudden increase in interest rates or a sudden drop in house prices, is moderate. Household net financial assets are the second lowest in the EU, after that in Romania, at 49.3% of GDP in 2018. However, risks are in part mitigated by the central bank’s macroprudential actions, including limits on debt service-to-income and loan-to-value ratios.

While Slovakia’s net international liability position remains significant at 65.5% of GDP in 2019, around 42% of Slovakia’s gross external liabilities relate to inward foreign direct investment, which curbs risks that external balance sheets deteriorate markedly in times of global stress and enhances the long-term sustainability of the external position. The current account deficit widened to an average of 2.8% of GDP over 2018-19, from 1.9% in 2017. This, however, mostly reflects growth in imports related to the increased production capacity of car manufacturing plants.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative ‘A’ (‘a’) rating range for Slovakia. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.

For Slovakia, the following relative credit strengths are identified: i) growth potential of the economy; and ii) market access and funding sources. The following relative credit weakness is identified: i) current account resilience.
The combined relative credit strengths and weaknesses generate a one-notch upward adjustment and indicate a sovereign rating of A+ for Slovakia.

A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope considers sustainability issues during the rating process as reflected in its sovereign methodology. Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, under which Slovakia has below-average performance among euro-area Central and Eastern European member states as assessed by the World Bank’s Worldwide Governance Indicators. This reflects the limited progress made by former Slovak governments regarding institutional reform, although the EU’s as well as the euro area’s robust economic and macroprudential governance frameworks provide support in this area.

Slovakia’s performance across key social dimensions is mixed. This is reflected in earlier improvements in employment rates, to 73.4% (of those aged 20-64) in 2019, in line with the EU average, a below EU-average poverty level but high regional economic disparities – the latter among the highest in OECD countries.

Productivity growth in Slovakia remains moderate, averaging 1.6% YoY in 2019. Two key reasons for this are the lack of a long-term research and innovation strategy and limited expenditures in research and development, with the latter accounting for just 0.84% of GDP in 2018 across all sectors, significantly below a euro area average of 2.22%. The EC’s Digital Economy and Society Index 2019, which assesses digital competitiveness in EU member states, ranks Slovakia in 21st place, below the EU average.

The share of renewable energy in Slovakia’s total energy consumption stood at 11.9% in 2018, both below a EU average of 18% and the EU target of 20% by 2020.

Rating committee
The main points discussed by the rating committee were: i) Slovakia’s growth outlook, exposure to the Covid-19 shock; ii) debt and fiscal trajectories, fiscal stimulus; iii) external sector developments and car industry; iv) labour market and demographics; v) financial sector developments, household debt; vi) the government’s fiscal and reform programme; vii) peers.

Rating driver references

1 Debt and Liquidity Management Agency (ARDAL)

2 National Bank of Slovakia, Financial Stability Report 2019

3 The Council for Budget Responsibility, Report on the Long-Term Sustainability of Public Finances

4 The Council for Budget Responsibility, Debt Brake

5 National Bank of Slovakia, Monthly Bulletin March 2020

6 European Commission Country Report Slovakia 2020

7 IMF – 2020 Fiscal Monitor

8 OECD Economic Surveys: Slovak Republic 2019

9 IMF World Economic Outlook, April 2020

10 SARIO, Slovak Investment and Trade Development Agency

Methodology
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’ (21 April 2020), is available on www.scoperatings.com. Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list. The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The rated entity and/or its agents did not participate in the ratings process. The rating was not requested by the rated entity or its agents. The rating process was conducted:
With Rated Entity or Related Third Party Participation [NO]
With Access to Internal Documents                              [NO]
With Access to Management                                        [NO]
The following material sources of information were used to prepare the credit rating: public domain.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the rating, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Lead analyst: Levon Kameryan, Analyst
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 15.11.2019.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2020 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin.
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