Slovakia carried out deeper structural and public-finance reforms in 2002-2006 than any of its regional peers. But the economic model that Slovakia created is now undermining its financial health: The economy depends too heavily on its export-oriented, foreign-owned automotive industry, while home-grown businesses are poorly financed and unproductive. The country took a severe blow when the global crisis struck and foreign demand for cars plunged. This fragile, rigid economic structure feeds into the second risk factor: Unemployment, which has gone through the roof and shows no signs of coming down. A third factor that could pose a stumbling block to recovery is “social populism” – popular, irresponsible political promises that can push up the budget deficit and shake investor confidence, especially in an election year.

 

 

 

1. Fragile and rigid economic model (the automotive sector)

 

Being one of the largest automotive manufacturers in the CEE region, the Slovak economy is extremely dependent on the sector. Investments from Peugeot SA, Kia Motors Corp. and Volkswagen AG have significantly boosted export capacity over the past few years. However, this segment is highly exposed to international competition. The credit crunch may be responsible for the current turmoil, but even before the crisis, Slovakia’s “dual economy” – a competitive, foreign-owned industrial sector versus an undercapitalised, unproductive domestic SME sector – carried the risk of instability. This was difficult to explain to people in a country whose macroeconomic indicators were the best in the region. The quick onset of the recession took both the government and the public by surprise (see chart below).

 

More data on the Slovak economy’s reliance on the automotive sector (2007)

  • The automotive industry is the motor of the Slovak economy, accounting for around 35% of total industrial production in 2007.
  • Total vehicle production surged 93.3% between 2006 and 2007, reaching 571,071 units.
  • Slovakia’s location at the heart of Europe and its relatively cheap labour force are the country’s main attractions for international auto-industry investors.
  • Total automotive exports from the country reached SKK 564 billion ($27.07 billion) in 2007, compared to SKK 402 billion ($19.3 billion) in 2005.

Source: Eurostat (Q3 data: flash estimate)

 

When it became obvious that the crisis was causing a drastic slowdown in the auto industry, the government implemented a €300 million rescue package and initiated a used-car trade-in program. This helped to counteract the decline in car sales domestically – but Slovakia’s vehicle makers send only a fraction of their output to the home market. The administration was powerless to address the problem of dwindling exports. As a member of the Eurozone, the government has limited scope to intervene with budgetary measures or monetary-policy decisions. Slovakia therefore has little choice but to wait for a pickup in foreign demand for cars and other exports. Yet even this will be but a short-term fix. Long-term recovery will be impossible without strengthening domestic small- and medium-sized enterprises. The next administration will need to diversify the country’s economic base and place greater emphasis on knowledge-intensive businesses that can stimulate and sustain growth.


A country’s “car-dependence” can be illustrated by dividing the car production by the number of employed people: The Slovakian figure of 0.24 tops countries in central Europe and beyond. The crisis has brought the one-sidedness of Slovakia’s economy to the surface and has made it clear why it needs to change.

 

Source: Political Capital calculation based on data from Eurostat and the International Organization of Motor Vehicle Manufacturers (see original figures below)

 

 

 

2. Structural unemployment

 

The global recession pulverized Slovakia’s export-driven economy and took a severe toll on industrial production. The unemployment rate is now at 12% and is expected to increase further.

High unemployment was always the Achilles’ heel of the Slovak economy, though it had been decreasing in the years before the crisis.  In the 1990s, most communist countries in central and eastern Europe were able to ease joblessness by wooing foreign investors with promises of cheap labour. Slovakia was held back by then-Prime Minister Vladimir Meciar, whose authoritarian reputation hurt his country’s ability to attract job-creating investments.

 

FDI inflows began to improve in the mid-2000s thanks to former Prime Minister Mikulas Dzurinda’s reform measures. The nation soon became the regional “automotive superpower,” pushing joblessness down below 10 percent. But when the credit crunch hit, Slovakia’s economic model broke down, taking jobs with it (see previous item).

 

 

Source: Eurostat

 

All countries in the region experienced a spike in joblessness when the crisis struck, but Slovakia’s was the sharpest.

 

With no strategy to increase the role of knowledge-intensive industries, Slovakia is running a risk of enduringly high unemployment. Cheap labour, once a magnet for foreign investors, can no longer satisfy an industry whose demands are growing more and more sophisticated. The problem is compounded by the fact that Slovak workers lack educational skills that would allow them to transfer to other jobs. If Slovaks want to exit from the crisis, they need to be able to adapt to changing circumstances. The predominant role of unskilled labour will make this difficult. The jobless rate is likely to keep growing in the next few months and might hit the 14% in spring 2010. It will be up to the new government to tackle this problem.

 


3. Social Populism: Polices that irritate investors and boost the budget deficit

 

Social populism is one of the hallmarks of the government of Prime Minister Robert Fico. Since his left-wing Smer party was formed in 1999, Fico has built up his popularity with a mix of “pragmatic” populist promises and nationalist rhetoric.

 

Source: Focus Institute

 

Social populism, nationalism and authoritarianism – the myth of the strong, single-minded leadership – is a legacy of former PM Vladimir Meciar (still a member of the coalition with his HZDS party) and resonates well with the Slovakian public. Generally, Fico is quite cautious and makes behind-the-scenes compromises in order to keep investors happy. But sometimes (especially during election campaigns), his populist pandering can spawn malevolent and harmful decisions against foreign investors. In the future we can expect steps that are extremely popular with the people, but which can deteriorate the business climate directly (governmental or bureaucratic decisions against investors) or indirectly (by significantly raising the budget deficit).


Populism notwithstanding, Fico has kept the most important economic reforms enacted by his predecessor. He kept the currency stable (a crucial factor in maintaining the inflow of FDI) and ushered his country into the Eurozone in January 2009. He also kept Dzurinda’s 19% flat income tax. On the other hand, Fico’s government has rolled back some important parts of Dzurinda’s program: It reopened the second pension pillar in order to lure people back to the state-owned retirement system and abolished health care co-payments that were designed to eliminate unnecessary consumption of medical services. In addition, privatization has ground to a halt on Fico’s watch.

 

The unfavourable effects of the economic crisis have had little impact on Smer’s popularity in 2009 (see chart above). Most Slovaks are satisfied with the government’s performance, raising chances for a second Fico term in 2010. The PM manipulates popular prejudices, positioning his party and his government as the sole protector of the Slovakian people using anti-capitalist, anti-Hungarian and anti-Roma rhetoric. Though the government still espouses essentially market-friendly politics, it remains uncertain exactly how big a role social populism will play in shaping policy. It left a significant mark on the new law on strategic companies (see below).


The following are manifestations of social populism that may damage the business environment:

 

1. Law on strategic companies

Since its inception nearly four years ago, the Smer government has been in constant conflict with multinational energy enterprises and other natural monopolies. The controversy started when the government began pressuring these companies to accept price caps in 2006. The latest skirmish was over the law on strategic companies, which raised widespread concern when it passed in November 2009.


The law, valid until the end of 2010, authorizes the state to buy any bankrupt firms that it deems “strategic:” Major energy companies, refiners, heating companies and water supply enterprises might all be classified as strategic. If such an enterprise goes bankrupt, the state will have a pre-emptive right to take over the firm and find a new owner later.

 

Market players agree that the bill potentially curbs company owners’ property rights by limiting their strategic decision-making powers: Opposition parties voted against the law, saying it reflects paternalistic attitudes and seriously damages Slovakia’s credibility and competitiveness.

 

Though the government has always ardently supported nationalising the energy sector – sometimes resulting in loud arguments – it is not out of question that the administration’s aim is to re-privatise these companies to influential business players close to the PM. The energy lobby is on quite good terms will Smer, whose ascent would not have been possible without support from the energy-sector entrepreneurs who built up their companies, influence and fortunes during the Meciar government. This is especially true for nuclear energy – when Fico was in opposition, he was labelled the “spokesman for atomic energy.” The strategic company law follows a familiar pattern: It’s popular, widens the government’s room for economic manoeuvre and serves the interests of the businesses that back the government.

 

2. Social Promises – Raising the deficit

Fico’s promise to introduce a 13th month pension in 2011 can be regarded as a campaign gambit, but it’s one that a second Fico government would find extremely difficult to fulfil. Its implementation may raise the already-growing budget deficit to new heights (both the Finance Ministry and European Commission predict the government will overspend by 6.3% of GDP; Eurozone members are required to keep their deficits below 3% of GDP). Neighbouring Hungary used to have a similar extra month’s pension, but budgetary concerns forced the government to cancel it. Fico’s fanciful promises can push opposition parties into a position where they feel the need to make irresponsible pledges as well. This spiral of promises significantly raises the risk of looser fiscal discipline after the elections.