Slovakia Economic Insights: sluggish economy, dynamic politics

The country has managed to achieve economic growth despite high inflation, but it has come at the expense of a large public deficit. On the other hand, the political situation is quite unstable. Currently, the country is being governed by a temporary technocratic government, and there are plans for early elections in September.

“Stable economic development in the high inflation environment was reached at the cost of a high public deficit.”, says Boris Fojtík, Economic Analyst, Tatra banka Slovakia.

The consumption boom in Slovak households that lasted for almost two years after the pandemic has finally come to an end in the first quarter of 2023. It took five consecutive quarters of declining real wages to impact real consumption, which decreased by 2.1% compared to the previous year in terms of actual purchasing power. However, when considering the nominal figures, consumption actually increased by 13% YOY.

Spending on restaurants and hotels grew by 30%, while food and housing accounted for 60% of the overall budget increase. Despite higher food spending, Slovak households consumed 3.9% less in real terms.

Household consumption has been strong, but it has resulted in a decrease in savings. In Q3 2022, savings reached a record low of 3.4% of disposable income. In Q1 2023, it slightly increased to 3.6%. These extremely low savings levels are not sustainable in the long term. However, we anticipate that they will stabilize as inflation decreases and wages increase in nominal terms.

Despite lower household spending, the Slovak economy still grew by 0.3% compared to the previous quarter and by 1% year over year. The main reason for this growth was the positive impact of net exports, which benefited from lower imports resulting from reduced consumption and industry pre-stocking in the previous period. Additionally, supply chain issues in the industrial sector have improved. However, the energy-intensive part of industrial production remained slow.

At first sight, the Slovak economy has survived the most critical winter period relatively unharmed, especially in terms of energy supplies and prices. However, the future outlook has worsened, leading us to maintain our unchanged forecast of 1% YOY growth for 2023. The effects of a restrictive monetary policy are impacting the economy through various channels. Household consumption, which has been weakened as mentioned earlier, is expected to recover gradually as real wages increase.

Sentiment in the industry sector is shrinking due to anticipated lower demand, while the construction sector is experiencing mixed effects. Public investments are supporting construction, but there is a decline in real estate development due to reduced house affordability and lower demand. The expected decrease in residential construction may be offset by public infrastructural projects funded by the EU. However, data until April 2023 shows modest growth of only 0.7% in construction output.

EU funds will likely drive investments in the public sector, while monetary policy may dampen investments in the private sector, at least in the short term. Nonetheless, investments are expected to be the only part of domestic demand that will grow in 2023.

Our forecast indicates that the growth of the Slovak economy is unlikely to experience a significant acceleration, despite potential improvements in the external environment in the medium term (2024-2025). The new government will need to implement necessary fiscal consolidation measures, which will limit GDP growth to 1.6% in 2024 and 2.1% YOY in 2025. However, there may be some positive factors such as increased household consumption and improved sentiment, which could later stimulate private investments. Notably, the investment by Volvo in new production facilities in 2025-2026 is expected to have a particularly positive impact.

The labor market is currently stable, with the unemployment rate slightly above 6%, which is just 0.6% higher than the lowest rate in history. We anticipate that the unemployment rate will remain around 6% throughout the forecasted period. However, due to modest economic growth, job creation will be limited. Additionally, the labor market will face challenges related to a shortage of workers due to an aging population.

The number of foreign employees is rapidly increasing, setting new records each month. With currently under 4% of the workforce, foreign employees are filling all new jobs, preventing a 10,000-employee shortage. This trend of substituting domestic workers with foreigners will continue, posing challenges for the government, companies, and society.

Due to a persistent labor shortage and a period of high inflation, nominal wages are expected to increase in the coming years. The significant inflation has caused a gap between the gross operating surplus and employee compensation, creating potential for substantial wage growth. Therefore, we anticipate wage growth of 10% and 8.5% yoy in 2023 and 2024 respectively. However, it is important to note that real wage growth, accounting for inflation, is not expected until 2024 at the earliest.

Inflation has started to decrease after reaching its highest point in the first quarter of this year. The rise in food prices was more persistent than anticipated, causing overall inflation to peak at 15.4% a month prior to food prices reaching their maximum of 28.2% YOY in March.

The reintroduction of free meals in school cantinas, as a unique domestic factor, further contributed to the change in the inflation trend in May. Additionally, the statistical office observed a slowdown in monthly growth across various consumption categories. We expect this downward trend to continue, eventually bringing headline inflation down to single-digit figures by the end of 2023.

Nevertheless, developments in Q1 2023 have raised our inflation expectations to 11.6% yoy. For 2024, we forecast inflation of 5.2% yoy. The impact of rising energy prices on inflation calculations is uncertain, but we anticipate a larger contribution in 2024. This is due to two factors: compensating regulated prices from the state budget is unsustainable, and fuel prices are expected to decrease only slightly in 2024. In 2023, fuel prices should contribute more significantly to disinflation.

On May 15th, President Čaputová appointed a technocratic caretaker government to lead the country until the upcoming parliamentary election in September. This government, led by Ľudovít Ódor, Deputy Governor of the National Bank of Slovakia, is composed of professionals and former government officials who are not affiliated with any political party.

The appointment of a technocratic government was necessary after the resignation of Caretaker PM Eduard Heger, as leaving the country without a functional government for over four months until the elections was not an option. The role of a technocratic government is often humorously summarized as 'keeping the lights on', but Ódor's government has a slightly broader scope. Their responsibilities are primarily focused on managing day-to-day issues, preparing budget proposals, and ensuring the efficient utilization of EU funds, including the Next Generation EU funds.

“We find it most likely that the government that comes out of the September elections will consist of a broader coalition of parties (from center-right to center-left) that want to maintain the country’s current foreign policy direction (pro-EU/Ukraine/NATO).”, says Andrej Martiška, Economic Analyst, Tatra banka Slovakia.

Early parliamentary elections are scheduled for September 30th and their results are currently very hard to predict. Firstly, there is typically significant volatility in voters' preferences in Slovakia during elections. Secondly, there is currently a high number of parties in polls hovering near the 5% threshold needed to enter parliament. Despite these uncertainties, it is likely that the resulting government will be a broader coalition of parties ranging from center-right to center-left, with a shared commitment to maintaining the country's current foreign policy direction favoring the EU, Ukraine, and NATO. A more detailed analysis and forecast of the election will be provided separately.

However, forming a government after the elections is expected to be a time-consuming process, as potential coalition parties will need to negotiate and reconcile their differences. This could lead to political uncertainty prevailing for weeks or even months following the elections.