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SLOVAKIA: THE CONSE- and , two other countries which have recently adopted the . The combination of a QUENCES OF JOINING THE sound financial sector, a stability-oriented macroeco- EURO AREA BEFORE THE nomic policy framework, flexibility-enhancing labour market regulations and competition-friendly product CRISIS FOR A SMALL market regulations are of key importance for the abil- ity of a small euro member country to absorb adverse CATCHING-UP ECONOMY external shocks (Brixiova et al. 2009; Berka et al. 2012). The specific challenge for is to replace its historically important, but now fading, external JARKO FIDRMUC* AND drivers of growth, which have been dependent on ANDREAS WÖRGÖTTER** large-scale Foreign Direct (FDI) , with domestic sources of growth which emphasise innovation and knowledge-intensive start-ups, while A catching up euro member in and out of the crisis utilising and fostering the opportunities of a transi- tion to green growth. At the same time, public With its entry into the euro area Slovakia experienced finances will need to be brought back onto a sustain- a significant change in the macroeconomic framework able path. for a small, catching up economy. In the run-up to Slovakia’s entry, borrowing costs fell, the exchange rate risk disappeared and the growth outlook for the Interactions between euro adoption and the crisis economy improved (Huefner and Koske 2008). worked both ways Together with earlier financial sector privatisation and liberalisation, the introduction of the euro Although the 2009 crisis was a common factor, eco- reduced barriers for borrowers (Huefner and Koske nomic developments in Slovakia have been different 2008). However, in the Slovak case, the international from other small member countries that recently financial crisis aborted the expected boom before it joined the euro area (Figure 1). Like elsewhere, could take hold. Slovakia’s GDP fell significantly; however, unlike in Slovenia and Estonia, its recovery was strong, bring- For peripheral euro area member economies, the ing GDP back to its pre-crisis level during 2011. The financial crisis worsened access to international labour market reaction was very strong in Estonia, financial markets because of perceived liquidity where the rate fell. However, it was rel- problems and contagion effects, which have only atively weak in Slovenia, where unemployment has recently been taken into account by enlarging the continued to rise. Developments in Slovakia have ECB’s toolkit and by establishing a European sover- been in-between, as unemployment has been stuck at eign debt intervention architecture. As a result, euro high levels. What is not immediately clear is what adoption did not improve the financial conditions of caused the occurrence of a jobless recovery with rela- these economies fully. By contrast, the fact that the tively high rates of GDP growth in Slovakia and the exchange rate is no longer available as a macroeco- nature of the institutional constraints that the coun- nomic stabilisation tool has raised fears that the country cannot adequately deal with adverse exter- * Zeppelin University, Friedrichshafen and , nal shocks, thereby making it a more likely victim of . ** OECD Economics Department and University of Technology, contagion. . The authors assume full responsibility for the content of this paper, which is not necessarily shared by the OECD Secretariat or its member countries. The authors are grateful to Caroline Klein, This study describes how Slovakia navigated the crisis Robert Price and Robert Ford for comments on an earlier draft, and how it returned to strong, albeit jobless, growth. Beatrice Guerard for statistical assistance and Josiane Gutierrez for secretarial assistance. This paper is a revised and shortened Further insights are provided by a comparison with version of Fidrmuc et al. (2013).

57 CESifo Forum 1/2013 (March) Special

Figure 1 tricht criteria meant that Slova - possibly missed the opportu- Real GDP growth and unemployment rate nity to run a stricter fiscal course A. Real GDP growth B. Unemployment rate during the boom years. As a re - 1997Q1 = 100 % of labour force 220 25 sult, it inherited a pro-cyclical

200 policy bias, which made fiscal 20 expansion during the crisis par- 180 ticularly costly and painful to 15 160 reverse.

140 10

120 Slovakia entered the euro area 5 100 with an exchange rate that was probably overvalued 80 0 1997 2000 2003 2006 2009 2012 1997 2000 2003 2006 2009 2012 The decade prior to the crisis was Slovak Estonia Slovenia Euro area OECD characterised by rapid growth in Source: OECD Economic Outlook database. GDP in Slovakia of around 6 percent, or about three times try faces in terms of increasing the job-richness of the the euro area average. Rapid convergence came hand- on-going strong recovery. in-hand with the strongest nominal and real apprecia- tion among OECD member countries, outpacing the The adoption of the euro in Slovakia happened after safe havens of and , as well as a long boom period, but just before the outbreak of resource-rich globalisation winners like and the financial crisis. This timing was particularly . Inflation and unit labour cost growth above advantageous in the sense that the accession criteria the euro area average contributed to nominal conver- (in particular the fiscal criteria) were easier to meet gence and added to the real appreciation stemming than for Estonia, which joined just one year later. from nominal appreciation. revaluations Estonia had to implement a 10 percent fiscal consoli- accelerated this development shortly ahead of the cri- dation package to keep the deficit sis. As a result, the Slovak currency appreciated by in line with the euro-accession criterion. At the time nearly 30 percent in real terms between 2006 and 2009 of the accession monitoring period in 2008, the (Figure 2). The financial crisis was also accompanied benchmark Slovak 10-year bond rate was still unaf- by an external (price) competitiveness shock for fected by the re-assessment of sovereign risks, fiscal Slovakia as several neighbouring economies in balances were still benefiting from the final stages of Central reacted to weaker external demand by the boom and inflation was being restrained by two strong competitive depreciations: the real effective successive revaluations of the . Figure 2 The financial crisis radically Real effective exchange rate based on unit labour costs

changed the external environ- Indices 1997Q1 = 100 ment of the highly export-depen- 200 Slovak Republic dent Slovak economy. Under 180 Estonia these conditions, the interaction Slovenia

of the crisis and the strong real 160 appreciation in the run-up to joining the euro area, generated 140 challenges that are still important for recent economic develop- 120 ments. Firstly, the exchange rate 100 was probably locked in at an excessively high level. Secondly, 80 the focus of fiscal policy on nom- 1997 1999 2001 2003 2005 2007 2009 2011 inal targets to meet the Maas - Source: OECD Economic Outlook database.

CESifo Forum 1/2013 (March) 58 Special exchange rate appreciated by a further 9 percent in Euro adoption changed the composition of drivers of 2009, after the country had entered the euro area. growth dramatically. Disinflation, enforced by the large output gap and increased unemployment, con- While rapidly growing economies also experience real tributed to wage moderation and imposed a cap on exchange rate appreciations, it nevertheless remains job-rich domestic demand growth. Together with size- questionable whether the acceleration of appreciation able productivity increases, wage moderation allowed immediately prior to the crisis would not have been a modest real exchange rate depreciation of about reversed if the nominal exchange rate had not been 2 percent in 2010 and 2011. This helped to prevent fixed just at the outbreak of the crisis. Considering employment in from falling even more, that regional peers had strongly depreciated their cur- although it did not generate new employment. rencies by between 5 percent (), However, the pace of exchange rate depreciation was 10 percent () and 20 percent (), it is considerably slower than that of the appreciation not far-fetched to conclude that Slovakia entered the before the crisis, indicating less capacity for internal euro area with an exchange rate that turned out to be devaluation than present in Estonia (Figure 2). overvalued in the face of the crisis. This is not in con- tradiction with the IMF (2012) assessment that It is interesting to note that the development of the Slovakia is not suffering from an external imbalance, real exchange rate was similar before the crisis in because competitiveness has been restored via an Estonia and Slovakia, although in Estonia it was only endogenous adjustment, which has included wage driven by differences in unit labour costs and not by restraint and productivity-increasing investment. changes in the nominal exchange rate. Real exchange rate trends were completely different for Slovenia Since euro adoption, real exchange rate movements (Figure 2). This pattern also corresponds to the dif- have been determined by inflation and unit labour fering trends in unemployment, which fell strongly in cost differentials vis-à-vis Slovakia's trading Estonia, stayed high in Slovakia and increased in partners. Inflation has actually shown a relatively Slovenia. Domestic demand, in turn, showed healthy large degree of fluctuation in this period. Euro adop- growth in Estonia, stagnation in Slovakia and appears tion arrested the earlier appreciation of the nominal to have nose-dived in Slovenia. euro exchange rate and related declines in import prices. Thus, domestic inflationary pressures were fully translated into rising inflation in the second half Sudden stop in FDI inflows hampers competitiveness of 2008. However, the financial crisis exerted a strong improvements downward pressure on inflation. Thus, inflation declined to less than 1 percent in 2009 and 2010, The adoption of the euro has not improved the attrac- below the average Balassa-Samuelson contribution to tiveness of Slovakia to foreign investors in the way 1 inflation because of the nominal convergence of non- that it was expected to before the crisis. In fact, it was traded goods prices. It could therefore be concluded the active investment promotion policy, business that Slovakia came close to a state of ‘effective’ defla- friendly structural reforms, low corporate income tion, with negative consequences for domestic taxes and the prospect of euro accession which result- demand. Simultaneously, wage increases decelerated ed in a surge in inflows of FDI from the early 2000s. dramatically from around 8 percent before the crisis However, the financial crisis reduced the worldwide to less than 1 percent in 2011. Indeed, nominal price supply of investment funds, particularly for emerging level convergence ground to a halt from about mid- economies in the EU and euro area. Furthermore, 2008. Contrary to other countries, labour productivi- euro appreciation vis-a-vis the Central Eastern Euro- ty increased strongly after the crisis – outperformed pean Countries outside the euro area has reduced the only by Estonia, helping to keep unit labour costs relative attractiveness of Slovakia as an investment down and to reverse the excessive pre-crisis real appre- location for export production, while before the crisis ciation to some extent. it was assumed that the neighbouring free floaters (Hungary, Czech Republic and Poland) would contin- 1 Égert (2011) estimates that the Samuelson-Balassa effect (related ue to experience with nominal appreciation. to productivity differences between the traded and non-traded goods sectors) was, at 1.2 to 2.0 percentage points annually, larger in Slovakia than in other new member states of the EU. According to Oomes (2005), a maximum appreciation of up to 3 percentage FDI actually fell significantly in 2010 (the remaining points annually can be achieved by price changes related to faster inflows concerned mainly equity investment in the productivity improvements in export-oriented manufacturing rela- tive to domestically-oriented services. financial sector) and remained negligible afterwards.

59 CESifo Forum 1/2013 (March) Special

Thus, FDI did not contribute to Figure 3 the recovery from the financial Private and public debt crisis, while it was an important A. Outstanding loans to the private sector B. Gross public debt - Maastricht criterion building stone of the previous % of GDP % of GDP growth model (Fidrmuc and 140 60 Martin 2011). The successful 120 50 Slovak business model has thus come under pressure and a new 100 40 source of stimulus is needed for 80 30 the rapid catch-up of the Slovak

economy to continue. 60 20

In addition, the nature of FDI 40 10 inflows has changed. While FDI 20 0 flows were dominated by large 2004 2006 2008 2010 2012 1995 1999 2003 2007 2011

greenfield in the Slovak Republic Estonia Slovenia years prior to the crisis, the crisis Source: European Data Warhouse; OECD Economic Outlook database. investment in existing plants has since become more important. These investments adoption and the financial crisis. This study considers have created fewer additional employment opportuni- the possibilities of increasing both public and private ties and have been undertaken to defend the viability spending. As a result of budget consolidation, low of existing operations in the face of the strong real income growth, stagnating employment, stagnating appreciation before euro adoption, new competitors mortgages and increases in the servicing costs of in the and the poorer outlook for Slovakia’s loans as a percentage of income, growth in domestic main export goods (cars and flat screens). demand fell by 6 percent in 2009 and has not yet returned to its pre-crisis level of 2008, when it grew on FDI inflows have exerted a strong influence on the average by around 6 percent. Slovak economy. Employment growth was positively correlated with FDI inflows. The real exchange rate Slovakia achieved a substantial reduction in its gross appreciated during the periods of large capital public debt during its preparations for euro adoption inflows, but the overall effects remained moderate, (Figure 3B). Starting with a favourable public debt although positive, up to 2011. Until 2009, FDI in- position of around 50 percent of GDP in 2000, Slo - flows and employment growth increased as the real vakia was able to reduce its debt level to a mere exchange rate appreciated, while from 2009 onwards, 28 percent of GDP during the conversion process in the real exchange rate depreciated slightly and 2008. However, pressure on fiscal discipline was sig- employment growth and FDI inflows decelerated. nificantly reduced by the euro adoption. Correspond- Productivity gains were achieved both by new invest- ingly, public expenditure revived as a response to the ments and by reduction in low-productivity employ- financial crisis and the debt to GDP ratio almost ment, both contributing to an acceleration of produc- dropped to its initial level of 43 percent. By contrast, tivity growth in manufacturing. Actually, while indus- fiscal developments in Slovenia were characterised by trial employment was roughly constant throughout a smaller decline in debt prior to the euro adoption, the 2000s, it continued to fall after the 2009 crisis. yet a much steeper increase in public debt as a conse- Moreover, productivity and export performance are quence of the crisis. Estonia, which did not enter the closely related: FDI inflows (e.g. to sectors such as euro area until 2010, after the financial crisis, has kept automotives) appear to be geared towards productiv- the public finances stable and below 3 percent of ity increases and maintaining export competitiveness. GDP during the whole period.

Domestic demand stagnates as a result of imposed Financial constraints increased only moderately after institutional constraints and wage restraints euro adoption

The sources of domestic demand are limited by insti- Before the crisis, mortgage loans and other borrowing tutional constraints that were imposed during euro by private households were facilitated by a large differ-

CESifo Forum 1/2013 (March) 60 Special ential between income growth and Figure 4 borrowing costs. Despite soar ing Loans to private non-monetary financial institutions real estate prices (Fidrmuc and Year-on-year percentage change % Senaj 2012), which generated a 30 considerable need for a house Slovak Republic 25 price correction after the crisis, loans were easily financeable 20 through income increases, with- 15 out having to de crease current consumption rates. This has 10 changed dramatically since the 5 crisis; with wages stagnating in 2009 and 2010 and with cloudier 0 income prospects, borrowers (and - 5 lenders) have become more cau- 2004 2005 2006 2007 2008 2009 2010 2011 2012 tious, increasing the savings rate. Source: OECD, OECD Economic Outlook database. Currently servicing old loans means less money is available for privatisation process and established their own net- current consumption spending and real estate invest- works (IMF 2012). This implies that shocks such as ments. Consequently, household demand for loans has the sovereign bond crisis rapidly spill over to weakened recently. Slovakia. Banking conditions generally improved in 2011, reflecting the improving conditions of the Despite its adoption of the euro, Slovakia has avoid- Slovak economy. The direct exposure of the Slovak ed a boom and bust scenario (Figure 3A). The banks to foreign assets is fairly low, but they can be main reason for this was the outbreak of the crisis affected by the impact of sovereign risk crises on simultaneously with euro adoption and the relatively their parent banks, which is the case in some euro cautious lending policy of banks before that point. area countries. Slovenia (euro adoption in 2007) and Estonia (euro adoption in 2010 and currency board since the early Lending conditions increasingly depend on the situa- 1990s) experienced a rapid credit expansion before the tion of the banking sector in countries from which the crisis (Brixiova et al. 2010). For Estonia, and to a less- parent banks originate (mainly Austria, but also er extent Slovenia, strong deleveraging needs imposed , Germany, Italy, Netherlands). Figure 4 a burden on the early phases of the export-led recov- shows the importance of foreign owned banks in the ery. By contrast, Slovakia recorded a relatively mod- banking system and their impact on economic devel- erate increase in the ratio of credit to GDP, from opment. The high degree of co-movement between 30 percent in 2006 to 39 percent in 2008 and Austrian, Italian and Slovak credit growth confirms the credit share hiked further to 46 percent in the first that credit growth is driven by the situation of the par- quarter of 2009 immediately after euro adoption. It ent banks. In particular, credit growth rates reached then stagnated during the financial crisis, avoiding a 30 percent annually before the financial crisis, this strong deleveraging episode. Overall, credit develop- being about four times higher than in Austria. ment in Slovakia was not characterised by the accu- However, credit growth rates dropped to about 5 per- mulation of financial vulnerabilities to the same in both countries in 2010. The difference between extent as in other emerging economies in Central and Slovak and source-country credit developments . increased only slightly in the past year, which con- firms the role of source country factors.

Financial contagion through parent banks’ lending Correlation analysis confirms these findings. Before the financial crisis, Slovak credit growth reported a One reason for weak credit developments is the medium degree of correlation (0.6) with the source adverse shocks which affected the multinational countries (except for Italy with negative correlation). banks active in Slovakia. The financial sector is After the financial crisis, the correlation increased to dominated by foreign-owned banks (based especially 0.9 between Slovakia and Austria, while it remained in Austria and Italy), which acquired stakes in the largely unchanged for the other countries.

61 CESifo Forum 1/2013 (March) Special

Trade integration declined during the financial crisis dependent on foreign demand, especially from Ger- many and the euro area. Business cycles in the indus- Tight trade linkages with Germany and other euro tries concerned are often more pronounced than in area countries mean that growth shocks in those other industries, especially services. For example, dur- countries (often themselves being caused by external ing the 2008/9 downturn the drop in demand was shocks, as in the case of Germany) are also transmit- especially strong for automobiles, iron and steel, and ted to Slovakia through the slowing of the trade building materials. Furthermore, the export industries growth. Yet the trade channel is strengthened by that have expanded are mainly capital intensive, strong financial links, including FDI. Slovakia is espe- meaning that growth of production translated only cially sensitive to developments in Germany and in marginally into a reduction of unemployment. The the euro area (IMF 2012). Figure 5 shows that the focus on large companies increases the mismatch in weak economic performance of the euro area resulted the Slovak labour market, which is characterized by in declining shares of this region in the exports of large regional imbalances. A significant number of Slovakia and other new member states, which had to the unemployed can be found in more remote, rural be compensated by exports to more rapidly growing regions with a low population density. Lastly, the destinations outside the euro area. As a result, the rapid success of the export-led growth strategy was financial crisis lowered the degree of economic inte- also achieved by the concentration on mobile indus- gration of the new member states into the EU. tries which, though they could move in quickly, could also leave easily, meaning that a relatively minor wors- It is interesting to note that the share of the euro area ening of business conditions or cost competitiveness in Slovak trade started to decline before the country’s could result in significant capacity outflows. EU accession in 2005. It confirms that trade between CEECs and the existing EU member states was already at its potential level before EU accession Policy Implications: what are the domestic and foreign (Bussière et al. 2008). Moreover, the declining EU imbalances? trade shares of Eastern European euro entrants cast doubt on the importance of the trade effects of a cur- Imbalances are illustrated by a jobless recovery, rency union, as intensively discussed in the literature stalling convergence, and a persistently high unem- (Frankel and Rose 2002), but viewed rather sceptical- ployment rate. Unemployment reached 20 percent of ly before the Eastern enlargement of the euro area labour force in the early 2000s. However, strong (Baldwin 2006). growth and convergence reduced the unemployment rate to a low of 10 per cent in 2008. Following this, the The export-led growth strategy has also had its par- fall in exports in 2008/9 was associated with a new ticular vulnerabilities for the Eastern European euro increase in unemployment to nearly 15 percent. The members. The Slovak economy has become strongly jobless recovery of 2011 did not succeed in improving the situation in the labour market. Entrants were strongly affected, Figure 5 particularly by the economic Export shares to euro area and Germany downturn, leading to a youth un - A. Export shares to euro area B. Export shares to Germany employment rate of 33 percent. A % % 70 70 similar situation was observed for unqualified labourers, whose situ- 60 60 ation had actually worsened dur- 50 50 ing the period of economic con-

40 40 vergence. Women, on the other hand, have not been significantly 30 30 more affected by unemployment 20 20 than men.

10 10 The following imbalances – of

0 0 domestic and foreign origin – 2000 2002 2004 2006 2008 2010 2000 2002 2004 2006 2008 2010 need to be tackled in order to

Slovak Republic Czech Republic Estonia Slovenia push Slovakia’s economy further Source: OECD, by Commody Statistics (ITCS) database. towards job rich growth that is

CESifo Forum 1/2013 (March) 62 Special high and sustainable enough to underpin a continua- References tion of the successful catch-up process of the early to Baldwin, R. (2006), The Euro’s Trade Effects, ECB Working the late 2000s: Paper 594.

Berka, M., M.B. Devereux and C. Engel (2012), “Real Exchange Rate • Foreign investors are increasingly concerned about Adjustment in and out of the ”, American Economic Review: Papers & Proceedings 102, 179–185 the inability to combine sound public and private Brixiova, Z., M. Morgan and A. Wörgötter (2009), Estonia and Euro balance sheets with sustainable economic growth. Adoption: Small Country Challenges of Joining EMU, OECD For Slovakia there is a tension between the fading Economics Department Working Papers 728. external drivers of growth and the large and grow- Brixiova, Z., L. Vartia and A. Wörgötter (2010), “Capital Flows and the Boom-bust Cycle: The Case of Estonia”, Economic Systems 34, ing consolidation needs. 55–72.

• Export capacity is dependent on the competitive- Bussière, M., J. Fidrmuc and B. Schnatz (2008), “EU Enlargement and Trade Integration: Lessons from a Gravity Model”, Review of ness of existing FDI plants with little or no inte- Development Economics 12, 562–576. gration into local supply networks and a weak out- Calvo, G., F. Coricelli and P. Ottonello (2012), The Labour Market look for job creation. Competitiveness is driven by Consequences of Financial Crises with or without Inflation: Jobless and Wageless Recoveries, NBER Working Paper 18480. wage restraints and productivity increases and less Égert, B. (2011), “Catching-up and Inflation in Europe: Balassa- by the development and exploitation of compara- Samuelson, Engel’s and Other Culprits”, Economic Systems 35, tive advantages in knowledge intensive operations 208–229. with a high local value added content and a high Fidrmuc, J. and M. Senaj (2012), , Consumption and Housing Wealth in Transition, NBS Working Paper 2, National Bank job creation capacity. of Slovakia, Bratislava.

• Domestic demand depends on the income growth Fidrmuc, J., C. Klein, R. Price and A. Wörgötter (2013), Slovakia: A generated by the foreign-owned export sector. Catching Up Euro Area Member in and out of the Crisis, OECD Economics Department Working Papers 1019. Adverse external shocks are therefore not mitigat- Frankel, J. and A. Rose (2002), “An Estimate of the Effect of ed, but rather propagated by the positive correla- Common on Trade and Income”, Quarterly Journal of tion of private consumption and residential invest- Economics 117, 437–466. ment with income growth in the export sector. Huefner, F. and I. Koske (2008), The Euro Changeover in the Slovak Republic: Implications for Inflation and Interest Rates, OECD Economics Department Working Papers 632.

Domestic sources of growth are not well-developed. IMF (2011), Slovak Republic: 2011. Article IV Consultation – Report; Informational Annex; and Public Information Notice on the Spending on innovation is low and the interaction Board Discussion, IMF Country Report 11/122, Washing - between domestic knowledge producers and the econ- ton DC: IMF. omy is weak. Regional mobility is low and regional IMF (2012), Slovak Republic: 2012 Article IV Consultation, IMF Country Report 12/178, Washington DC: IMF. differences in labour market performance are large. Oomes, N. (2005), Maintaining Competitiveness under Equilibrium Social housing is not geared towards regions with a Real Appreciation: The Case of Slovakia, IMF Working Papers 05/65. growing employment potential. The capital market financing of business start-ups is underdeveloped. The lending of the financial sector is restricted to the local deposit base, which become a constraint once a new growth cycle sets in. Consumption and mortgage financing are overrepresented.

The jobless recovery in Slovakia fits well with consid- erations about the recovery pattern after a financial crisis (Calvo et al. 2012). The growing risk aversion of lenders increases the ratio of the collateral value to the loan, which favours capital intensive investment projects in existing enterprises. Maintaining the employment level during a financial crisis would therefore require a larger wage adjustment than that which would follow from the cyclical response of wages to increasing unemployment. The consequence of reduced lending by the financial sector is a combi- nation of wage and job restraint. This underlines the importance of a sound financial sector for the recov- ery from a financial crisis.

63 CESifo Forum 1/2013 (March)