EurozoneEY Eurozone Forecast September 2013

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Outlook for Slovakia

Weak export demand and fiscal austerity will weigh on growth

Spain

Portugal

France

Ireland

Finland

Estonia

Belgium

Slovakia

Austria

Slovenia

Italy

Greece

Malta Cyprus

Netherlands

Luxembourg

Germany

1EY Eurozone Forecast September 2013 | Slovakia

Highlights

• GDP in Slovakia rose 0.3% in Q2, leaving the economy on track to grow by just 0.9% this year, down from 2% in 2012. Weak domestic demand, depressed by fiscal austerity, and subdued demand in key trading partners will account for the sluggish growth performance.

• Growth should accelerate in 2014, as pressure on domestic demand from austerity measures eases and export demand picks up. But at only about 2%, growth will be slower than we expected previously. This revision was made in the light of further austerity measures required to meet the budget deficit target of 3% of GDP.

• Weak demand at home, coupled with a bleak outlook for exports, will reduce incentives for local and foreign businesses to invest. Growth in foreign direct investment (FDI) inflows is expected to decline due to stagnation in the Eurozone, more rigid labor laws and an increase in corporate tax at the start of this year. In addition, the prolonged unwinding of the pre-crisis construction boom will remain a drag on investment growth, as construction accounts for almost half of fixed investment.

• We expect the scope for a pickup in exports to be limited over the forecast period, as export demand will be constrained by the

“lost decade” of growth in the Eurozone. Capacity constraints and slower labor productivity growth, which will be brought about by lower FDI in export-oriented sectors, mean that over the medium term exports are unlikely to repeat recent gains in market share.

• Private consumption showed some signs of stabilization in H1 2013, due to subdued inflation and anticipation of an improvement in the general economic situation by households. But we expect private sector consumption growth to remain sluggish in 2013–14, as employment growth will remain slow until the economy picks up fully, which is unlikely to be until 2015.

• The risks to our forecast are skewed to the downside. A weaker-than-expected recovery in key trading partners, particularly Germany and the Czech Republic, would slow Slovak exports and hurt GDP growth.

GDP growth

2013

0.9% GDP growth

2014

2%

Unemployment

2013

14.2%

Exports of goods and services growth

2013

1.6%

2 EY Eurozone Forecast September 2013 | Slovakia

Weak export demand and fiscal austerity will weigh on growth

GDP will accelerate from 2014 onwards …

With Slovakia’s GDP rising 0.3% in Q2, we continue to expect growth of just 0.9% this year, down from 2% in 2012. Weak domestic demand, depressed by fiscal austerity, and subdued demand in key trading partners will account for this sluggish performance. Growth should gradually accelerate from 2014, as pressure on domestic demand from austerity measures eases and export demand picks up.

… but further fiscal austerity will dampen prospects …

However, our growth forecast for 2014 has been lowered to 2% from the 2.4% seen in our June report. This revision is the result of the further austerity measures required to meet the budget deficit target of 3% of GDP in 2013.

In a recent statement, the finance minister ruled out further tax hikes to compensate for lower-than-expected revenues in H1 2013. As a result, any tightening is likely to come from lower public spending. After significant cuts in spending in previous years, it will be difficult to reduce it further without fundamental public sector reforms. Given the time constraints, it is likely that

investment will be lowered again after significant cuts in 2012 and H1 2013. According to our estimates, the Government will have to squeeze spending by about 0.2% of GDP to meet its target.

Changes to government investment usually have the largest impact on GDP of any of the fiscal levers, as this is usually the least wasteful form of public spending and can influence production capacity in the economy. In the short term, the effect of austerity measures is especially strong, as developments in the Eurozone in 2011 and 2012 have shown. This is mainly due to the inability of monetary policy to offset the negative effects of a fiscal squeeze and already-depressed demand in the economy. These spending cuts will affect the economy

Slovakia (annual percentage changes unless specified)2012 2013 2014 2015 2016 2017

GDP 2.0 0.9 2.0 3.5 3.7 3.5

Private consumption –0.6 –0.3 1.9 2.8 2.8 2.7

Fixed investment –3.7 –9.9 1.2 4.2 4.8 4.5

Stockbuilding (% of GDP) –2.3 –0.6 –0.1 0.0 0.1 0.1

Government consumption –0.6 –0.7 0.3 2.9 2.9 2.7

Exports of goods and services 8.6 1.6 3.3 4.7 4.9 4.8

Imports of goods and services 2.8 –0.2 3.4 4.6 4.8 4.6

Consumer prices 3.6 1.7 2.0 2.1 2.1 2.1

Unemployment rate (level) 14.0 14.2 13.9 12.9 12.0 10.9

Current account balance (% of GDP) 2.3 3.8 3.7 3.8 4.0 4.4

Government budget (% of GDP) –4.3 –2.9 –2.8 –2.7 –2.4 –2.1

Government debt (% of GDP) 52.1 54.0 54.9 54.7 54.1 53.3

ECB main refinancing rate (%) 0.9 0.6 0.5 0.5 0.5 0.7

Euro effective exchange rate (1995 = 100) 115.5 119.4 117.7 114.1 112.8 112.1

Exchange rate ($ per €) 1.28 1.31 1.24 1.19 1.18 1.18

Source: Oxford Economics.

3EY Eurozone Forecast September 2013 | Slovakia

only after a lag, due to implementation delays. As a result, the drag on growth will be felt mainly next year, contributing to our lower growth forecast for 2014. On a more positive note, given the strong commitment of the Government to meet the deficit target of 3% of GDP, we believe Slovakia will be able to exit the excessive deficit procedure of the European Commission (EC) this year.

… and hurt investment

Weak domestic demand, coupled with a subdued outlook for exports, will reduce incentives for local and foreign businesses to invest. FDI inflows are expected to remain lower than before the financial crisis due to stagnation in the Eurozone, one of the main sources of investment into Slovakia. More rigid labor laws and an increase in corporate taxation at the start of this year will also hold back new investment.

Furthermore, significant reductions in public investment are also likely to delay the development of infrastructure, making Slovakia less attractive for foreign investors, especially in the key manufacturing sector. According to our estimates, public investment as a share of GDP remained below the levels of its key competitors for FDI in Central Europe, such as the Czech Republic, Hungary and Poland, during the last decade. Moreover, in 2013,

the volume of government investment is likely to be 42% below the 2011 level, and is expected to rise by only about 3.5% a year in 2015–17. This will further widen the gap in infrastructure development between Slovakia — especially its poorer regions — and neighboring countries.

In addition, the prolonged unwinding of the pre-crisis construction boom will remain a drag on investment growth, as construction accounts for almost half of fixed investment. According to the EC, the volume of order books in the construction sector remains very low by historical standards. Sluggish growth in house prices, which are not expected to reach pre-crisis levels until 2017 due to subdued economic activity, will remain a drag on construction activity.

Export growth will be weaker than before the crisis

A pickup in export demand should support the recovery in H2 2013 and thereafter. Recovering demand in the Czech Republic, which posted 0.7% growth in Q2, after six consecutive quarters of decline, should support demand for Slovak exports. In addition, economic activity in Germany, Slovakia’s main trading partner, is expected to remain relatively strong over the forecast period.

Figure 1Real GDP growth

% year

–6

–4

–2

0

2

4

6

8

10

12

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

Slovakia

Eurozone

Forecast

Source: Oxford Economics.

Figure 2Government budget balance

% of GDPUS$b

US$b (left-hand side)

% of GDP (right-hand side)

–14

–12

–10

–8

–6

–4

–2

0

–8

–7

–6

–5

–4

–3

–2

–1

0

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Forecast

Source: Oxford Economics.

4 EY Eurozone Forecast September 2013 | Slovakia

Weak export demand and fiscal austerity will weigh on growth

Figure 3Private consumption and total fixed investment

% year

–30

–25

–20

–15

–10

–5

0

5

10

15

20

25

30

1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

Consumption,private

Total fixed investment

Forecast

Source: Oxford Economics.

Figure 4Unemployment

% (seasonally adjusted rate, Eurostat)

7

9

11

13

15

17

19

21

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Forecast

Source: Oxford Economics.

However, the growth in demand for Slovak exports will be weaker than before the financial crisis due to the “lost decade” of growth expected for the Eurozone overall. Despite the Eurozone coming out of recession in Q2, deleveraging in public and private sectors, as well as poor access to affordable finance, will hold back growth in 2013–17. In addition, capacity constraints and slower labor productivity growth, due to lower FDI in export-oriented sectors, mean that over the medium term Slovak exports are unlikely to repeat recent gains in market share.

Lower inflation will provide some support to consumption …

Private consumption showed some signs of stabilization in Q1 2013, after four consecutive quarters of decline due to subdued inflation and anticipation of improvement in the general economic situation. After being flat in Q1, consumer spending may have showed a modest rise in Q2, according to retail sales figures.

Lower world energy prices, as well as weak domestic demand, will push inflation down to 1.7% in 2013, from 3.6% in 2012. The recent slowdown in producer prices, which declined by 0.7% year-on-year in Q2, should also feed through to consumer prices in the short term. This will provide some support to households’ real income, and therefore private consumption.

… but high unemployment will remain a drag

Despite low inflation, consumption growth will pick up only gradually, held back by continued high unemployment. The jobless rate is expected to average 14.2% this year, up slightly from 2012. Low labor mobility, as well as the concentration of unemployed people in poorer regions of the country, are likely to deter the

investment needed to generate faster employment growth and will hold back improvements in the labor market. Despite stronger economic growth in 2015–17 and government reforms, we expect unemployment to fall only slowly in the coming years and to still be close to 11% in 2017.

Downside risks come from the Eurozone and a weak labor market

Risks to our forecast are mainly on the downside. Given Slovakia’s strong links to the Eurozone, weaker-than-expected recovery in the region would hit exports and hence growth. And if financial stress in the Eurozone were to re-emerge, Slovakia’s financial sector is also likely to be hit hard. Financial market problems in the Eurozone could result in liquidity withdrawal from the Slovak banking sector, as the majority of financial institutions are owned by parent banks in Eurozone countries. This will put an additional drag on the domestic demand through the credit channel.

Another downside risk comes from the decline in unemployment in the medium term being even slower than expected. High and persistent unemployment can lead to the erosion of employees’ technical and social skills, thereby reducing the trend level of GDP growth. We believe that education and labor market reforms undertaken by the current Government will be slow to reduce long-term and youth unemployment, which are especially high in Slovakia. The country had the third-highest ratio of long-term unemployment to active population in the Eurozone in Q1 2013. It was behind only Greece and Spain, two countries which are still undertaking severe austerity measures to restore competitiveness.

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