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      FRIDAY, 28/10/2022 - Scope Ratings GmbH
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      Scope revises Slovakia’s Outlook to Negative from Stable, affirms rating at A+

      Rising energy supply risks, weakening macroeconomic prospects amid higher political uncertainty drive the Outlook change. EU fund inflows, strong fiscal discipline, and moderate public debt are key credit strengths.

      For the rating action annex, click here.

      Rating action

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

      Summary and Outlook

      The revision of the Outlook for Slovakia’s credit ratings to Negative, from Stable, reflects the following credit rating drivers:
       

      1. The country’s significant energy dependence on Russian oil and gas, which account for almost all energy imports. Despite mitigating factors that could partly cushion the impact of energy supply disruptions, among which bilateral agreements with a few alternative suppliers and temporary exemption under the European Union's sanction package, Slovakia’s energy security is highly vulnerable to a complete halt of Russia’s oil and gas exports. The country’s energy mix, skewed towards fossil fuels, also exposes the Slovak economy to a sustained period of commodity price volatility.
         
      2. The weakening of macroeconomic growth prospects because of the deteriorating economic outlook among European main trading partners and prolonged supply chain disruptions. Although the Slovak’s economy would avoid a recession in a baseline scenario, GDP growth forecast has been revised to 0.5% in 2023. Coupled with increasing borrowing costs and inflationary pressures, lower growth prospects would negatively affect Slovakia’s policy flexibility and fiscal consolidation plans. Moreover, institutional challenges and rising political uncertainty as the government lost majority in parliament may also have potential implications on the momentum for reforms and policy implementation.


      Slovakia’s ratings are supported by the country’s institutional strengths, underpinned by EU- and euro area memberships. The latter confers advantages via a strong reserve currency, access to ECB asset purchases and refinancing operations, as well as a fiscal framework strengthening Slovakia’s strong fiscal discipline. Furthermore, Slovakia’s ratings recognise access to substantive EU structural and recovery funds, moderate levels of public debt and a competitive export-oriented industrial base, anchored by foreign direct investment inflows.

      The Outlook revision reflects Scope’s updated assessments of Slovakia under the ‘domestic economic risk’ category of its sovereign methodology.

      The Negative Outlook represents Scope’s view that risks to the ratings are tilted to the downside over the next 12 to 18 months.

      The ratings/Outlooks could be downgraded if, individually or collectively: i) major energy rationing and/or weakening of external demand leads to an economic slowdown larger than currently projected, possibly with permanent output losses; ii) lower revenues and/or greater-than-anticipated fiscal loosening leads to a material deterioration of the fiscal trajectory and higher debt ratios; and/or iii) a rise in political uncertainty leads to a policy shift and/or delays in the reform agenda vis a vis milestones attached to EU funding.

      Conversely, the Outlooks could be revised to Stable if, individually or collectively: i) the swift diversification of energy supply and/or larger-than-anticipated EU solidarity mechanisms leads to a sustained, stronger-than-anticipated economic growth; and/or ii) sustained fiscal consolidation enables to reduce public debt to GDP beyond current expectations.

      Rating rationale

      The first driver of the revised Outlook is rising energy supply risks. A halt of Russia’s energy exports towards Slovakia could have material consequences on domestic production as households and businesses are among the largest users of Russian oil and gas. In 2020, Russia accounted for 85% (78%) of Slovakia’s total imports of natural gas (oil and petroleum products). Against this backdrop, Slovakia’s energy security is at risk should: i) the supply disruptions persist and/or escalate; ii) the government fails to reach timely agreement with alternative suppliers; iii) infrastructure and logistical bottlenecks hamper energy delivery to the local industry and customers; and/or iv) political tensions imperil European solidarity mechanisms.

      However, mitigating factors could cushion the impact of the shock. Slovakia’s gas storage facilities that are filled at 83% should help to avoid business closure and energy rationing through H1 2023 as it accounts for about half of annual consumption. Other mitigating factors include: i) initiatives with bilateral partners to use liquefied natural gas and secure alternative energy supply, among which the launch of a pipeline with Poland to access LNG terminals in the Baltic Sea and the Baltic Pipe gas pipeline to access Norwegian gas; ii) agreements with Qatar and Norway to reduce dependence on Russian energy by more than two-thirds by end-2022 according to the authorities; and iii) the launch of a third reactor (471-megawatt) at the Mochovce nuclear power plant. Slovakia also benefits from a temporary exemption under the sixth package of European sanctions to continue selling on the domestic market Russian oil received through the Druzhba pipeline until end-2023.

      The second driver of the revised Outlook reflects Scope’s view that the country’s medium-term growth outlook has weakened materially because of the deteriorating economic outlook among European main trading partners and prolonged supply chain disruptions, interrupting the economic recovery from the Covid-19 pandemic and weighing on the pace of fiscal consolidation. With energy supply increasingly at risk, the real GDP growth rate declined at 1.8% YoY in Q2 2022, down from 3.1% in Q1 2022, while inflation rose to 14.2% YoY in September 2022, up from 14.0% in August 2022, the energy representing about 27% of households’ consumption expenditure. Scope expects the real GDP growth rate at 1.8% in 2022 (3.0% in 2021) and 0.5% in 2023 as energy security concerns and inflation take a toll on private demand. The domestic economic activity would also suffer from the sharp economic slowdown of the European Union, accounting for 78% of Slovakia’s total exports, among which Germany (AAA/Stable) as one of Slovakia’s main trading partners. Prolonged disruptions in global value chains would also weaken the manufacturing sector, among which the Slovak automotive industry accounting for around 12% of GDP and 48% of industrial production. In this context, inflation would increase to about 12% in 2022 and peak at around 15% in 2023, one the highest in the euro area and the CEE. In the longer run, persistent energy supply disruptions affecting energy-intensive industries could lead to permanent output losses that would reduce Slovakia’s potential GDP growth, which is currently estimated at 3% per year.

      Coupled with increasing borrowing costs and inflationary pressures, lower GDP growth prospects would weigh on the fiscal consolidation plans in the context of ongoing institutional challenges and rising political uncertainty.

      Slovakia’s fiscal deficit is projected at 4.9% of GDP in 2022 and 6.4% in 2023 (-3.2pps of GDP compared to the previous estimate) as the inflation aid package is estimated at 1% of GDP in 2023. Projections are less favorable than the medium-term fiscal consolidation strategy detailed in the Stability Programme in April 2022, which foresees a rapid reduction of the fiscal deficit from 5.1% of GDP in 2022 to 2.1% of GDP in 20251. In addition, long-term implications of the energy crisis and/or delays in implementing the structural reform agenda would weigh on the fiscal deficit. Still, Slovakia’s strong fiscal framework should enable to reduce the deficit below 3% of GDP by 2027.

      Finally, ongoing institutional challenges have increased the risk of instability ahead of the next legislative elections in February 2024, including through a no-confidence vote and early elections, which could additionally weigh on the implementation of structural reforms and fiscal consolidation. Intra-coalition disputes led the Slovak government to lose parliamentary majority in September 2022 after the withdrawal of the Freedom and Solidarity party (‘SaS’) from the ruling coalition led by prime minister Heger. The current three-party coalition (‘Ordinary People and Independent Personalities’, ‘We Are Family’, ‘For the People’) represents about 16% of voting intentions, against 45% for the three main opposition parties led by Peter Pellegrini (‘HLAS-SD’), Robert Fico (‘Smer-SD’), and Richard Sulik (‘SaS’). A change in policy making is unlikely at this stage but the loss of parliamentary majority reduces policy flexibility to manage the energy crisis and pass reforms agreed under the EU Recovery and Resilience Plan. As Slovakia faces adverse demographic trends, alike most of rating peers, a reform of the pension system is set to be implemented by 31 March 2023. Linking the effective retirement age on life expectancy would reduce long-term age-sensitive expenditure by about 3pps of GDP according to the authorities.

      Slovakia’s A+ rating also reflect the following key credit strengths.

      Firstly, Slovakia benefits from large inflows of EU funds. Funding request in the form of grants made by the government under the period 2021-2026 are among the largest in euro area countries in terms of GDP, with Slovakia’s Recovery and Resilience Plan amounting to EUR 6.3bn (about 7% of GDP). In July 2022, the European Commission approved the disbursement of EUR 398.7m with respect to the Recovery and Resilience Facility as Slovakia met the 14 milestones of the first instalment2,3. This comes in addition to the pre-financing of EUR 822.7m approved in October 2021 for a total amount of EUR 1.22bn. Furthermore, the European Commission adopted in July 2022 the EUR 12.8bn (14% of GDP) partnership agreement for the period 2021-2027, including EUR 4.2bn (5% of GDP) from the European Regional and Development Fund and the Cohesion Fund for green transition and less energy dependence4. The drawdown of EU funds constitutes an important buffer to mitigate the energy crisis and diversify supply, while transitioning towards a greener energy mix. In addition, Slovakia could be among the largest beneficiaries of solidarity mechanisms among EU member states, which remain uncertain at this stage. Still, EU financial support is undermined by Slovakia’s weak track record of EU fund absorption (only around 50% absorption rate over the 2014-20 EU multi-annual period as of September 2021, one of the lowest among the CEE).

      Secondly, Slovakia has demonstrated strong fiscal discipline. Despite rising uncertainties, Scope views the government as committed to sustainable public finances via national and European fiscal rules, once reactivated. Slovakia’s strong fiscal discipline was reinforced by the amendments to the fiscal framework in March 2022 with the introduction of multi-annual expenditure ceilings over the full electoral cycle and the Assessment of the compliance of expenditure limits delegated to the independent Council for Budgetary Responsibility5,6. This reform improves budgetary planning and supports policy flexibility via counter-cyclical fiscal measures as expenditure ceilings incorporate an escape clause should Slovakia experiences a real GDP decline of up to 3.0%. The reform also demonstrates the effectiveness of the EU and euro area memberships in strengthening prudent management as amendments to the domestic framework were part of the milestones related to the first payment of the EU Recovery and Resilience Plan. Scope expects Slovakia to continue improving its fiscal framework via the reform of the Constitutional Act on Fiscal Responsibility, including the amendment of the national debt brake rule moving from a gross debt to a net debt indicator. This would help reduce pro-cyclicality of Slovakia’s fiscal policies and mitigate further liquidity risks through large liquid financial assets estimated at 12% of GDP according to the government.

      Thirdly, Slovakia has a moderate public debt level. The general government debt is forecasted to decline from 63.1% of GDP in 2021 to below 60% of GDP by 2027. This is about 3pps of GDP above the previous projections, but still a modest level compared to the euro area average (around 95% of GDP). Furthermore, Slovakia benefits from challenging but still fair financing conditions compared to non-euro area countries, with 10-year yields trading at 3.5% against 10.3% for Hungary and 7.9% for Poland. Slovakia also benefits from a supportive debt profile with the ECB holding nearly half of outstanding government securities. The average maturity of the public debt is relatively high (+8 years) and almost all debt carries a fixed coupon and is denominated in euro. Public gross financing needs are estimated at EUR 10bn in 2023 (around EUR 7bn in 2022), among which about EUR 4.5bn of bond amortisation.

      Finally, Slovakia has a large and competitive export-oriented industrial base. Economic performance has been supported by the inflow of foreign direct investment to the automotive industry. Renewed investment post Covid-19 pandemic is expected to continue, which would maintain Slovakia’s net international investment position in deficit (-63% of GDP as of Q2 2022). In July 2022, Swedish car manufacturer Volvo announced an investment of USD 1.2bn to build an electric vehicle plant by 2026. However, large exposure to supply-side bottlenecks in the car industry constitutes a source of vulnerability, with one of the highest exposure to international value chains among the European Union. As a small, open economy specialising in the automotive sector, Slovakia remains reliant upon external demand and vulnerable to external shocks.

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

      Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides a first indicative rating of ‘bbb+’ for Slovakia. Slovakia receives a one-notch positive adjustment to this indicative rating based on the reserve currency adjustment under Scope’s methodology. As such, the ‘a-’ indicative rating can be adjusted under the Qualitative Scorecard (QS) by up to three notches depending on the size of qualitative credit strengths or weaknesses relative to a peer group of countries.

      Scope has identified the following QS relative credit strength for Slovakia: i) fiscal policy framework; ii) debt profile and market access; iii) current account resilience; iv) external debt structure; v) banking sector performance; and vi) banking sector oversight. By contrast, the following credit weakness has been identified relative to peers: i) macro-economic stability and sustainability.

      The QS generates a two-notch positive adjustment and indicates A+ long-term ratings for Slovakia.

      A rating committee has discussed and confirmed these results.

      Factoring of Environment, Social and Governance (ESG)

      Scope explicitly factors in ESG issues in its rating process via the Sovereign Rating Methodology’s standalone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) and in the methodology’s qualitative overlay (QS).

      Environment-related risks in Slovakia remain material. The country performs poorly in terms of CVS score for Co2 emissions per GDP compared to most of its peers, while it has a relatively better performance in terms of GHG emissions per capita. Energy intensity is higher than the EU average, with GHG intensity of Slovakia’s energy consumption having decreased only by 17% in 2020 compared to 20007. The country’s energy mix reflects the exposure to higher energy prices given the 25% share of energy supply represented by natural gas as of 2020 – of which 85% is imported from Russia – followed by nuclear energy (25%), oil (22%), and coal (14%). Renewables currently represent 17.3% of final energy consumption, although a new target of 19.2% of renewables by 2030 has been set in the National Energy and Climate Plan (NECP). The long-term EU budget represents a unique opportunity for Slovakia to accelerate the rate of GHG emissions reduction to attain carbon neutrality by 2050.

      Slovakia’s performance across key social dimensions is mixed. Socially related credit factors are reflected in steadily increasing old-age dependency ratios, high regional inequality (among the highest in the OECD), moderate unemployment rates (6.1% in Q2 2022), gender employment gap (15% in 2020) near EU averages, and below-EU-average poverty ratios and risk of social exclusion.

      Under governance-related factors, Slovakia’s performance is weaker than that of other euro area member states in the CEE, as assessed via the World Bank’s Worldwide Governance Indicators, with a negative performance more specifically in the control of corruption and government effectiveness. Timely implementation of reforms outlined in the Recovery and Resilience Plan will be crucial for Slovakia’s to strengthen further its governance framework.

      Rating committee
      The main points discussed by the rating committee were: i) Slovakia’s growth outlook; ii) debt and fiscal trajectories; iii) external sector developments; iv) financial sector developments; and v) peers.

      Rating driver references
      1. Stability Programme of the Slovak Republic for 2022 to 2025, Ministry of Finance
      2. Preliminary assessment of the first payment request submitted by Slovakia on 29 April 2022, European Commission
      3. NextGenerationEU, June 2022, Slovakia's request for EUR 398.7 million disbursement
      4. EU Cohesion Policy: Commission adopts €12.8 billion Partnership Agreement with Slovakia for 2021-2027
      5. Investor Presentation, October 2022, Debt and Liquidity Management Agency
      6. Evaluation of compliance with the rules of budgetary responsibility, Council for Budget Responsibility
      7. European Semester Country Report, May 2022, EU Commission

      Methodology
      The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 27 September 2022), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
      Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies..
      The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months. 

      Solicitation, key sources and quality of information
      The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit 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 substantially material sources of information were used to prepare the Credit Ratings: public domain.
      Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
      Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

      Regulatory disclosures
      These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
      Lead analyst: Thomas Gillet, Associate Director
      Person responsible for approval of the Credit Ratings: Giacomo Barisone, Managing Director
      The Credit Ratings/Outlooks were first released by Scope Ratings on January 2003. The Credit Ratings/Outlooks were last updated on 3 December 2021.

      Potential conflicts
      See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings. 

      Conditions of use / exclusion of liability
      © 2022 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Fund Analysis GmbH, Scope Innovation Lab GmbH and Scope ESG Analysis 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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