August 22 (SeeNews) - Berlin-based Scope Ratings has affirmed Slovenia's long-term local- and foreign-currency issuer and senior unsecured debt ratings at A, with a stable outlook, it said.
The short-term issuer ratings of Slovenia was affirmed at S-1 in local and foreign currency, Scope Ratings said in a statement on Friday.
Slovenia's ratings are driven by the country’s wealthy and resilient economy, supported by a robust external performance; favourable market access and debt profile; and prudent fiscal policy, supporting a gradual reduction of primary deficits, Scope said.
Scope also said in the statement:
"Rating challenges include i) the limited diversification of energy supply amid geopolitical uncertainties weighing on the economic outlook; ii) a moderately high public debt burden; iii) labour market rigidities curbing GDP growth; and iv) adverse demographic trends with a rapidly ageing population that will place long-term structural pressures on fiscal sustainability through rising pension and healthcare expenditures.
The Stable Outlooks reflect Scope’s opinion that risks to the credit ratings over the next 12 to 18 months are broadly balanced.
The ratings/Outlooks could be upgraded if, individually or collectively, Slovenia’s: i) medium-term growth prospects notably improved, supported by structural reforms addressing long-term challenges including labour market rigidities and the adverse effects of an ageing population; and/or ii) the fiscal outlook improved, with public debt on a firm downward trajectory.
Conversely, the ratings/Outlooks could be downgraded if, individually or collectively, Slovenia’s: i) medium-term growth prospects notably deteriorated due to, for example, substantial and sustained energy supply disruptions; ii) fiscal outlook weakened due to protracted fiscal deterioration and/or; iii) political fragmentation and policy uncertainty curtail the implementation of needed reforms and/or result in lower EU transfers and/or foreign direct investments.
Rating rationale
The first driver underpinning the affirmation of Slovenia’s A/Stable ratings is its wealthy (GDP per capita stood at EUR 24,678 in 2021) and resilient economy, supported by the country’s robust external performance. Slovenia’s economy has recovered strongly from the Covid-19 impact, growing by 8.1% in 2021 and is expected to grow 5.6% in 2022, driven by robust private consumption and investment. The country’s GDP level thus already exceeds its pre-Covid output since Q3 2021 as the 2020 growth decline of -4.2% was lower than most of its peers.
Still, looking ahead Scope expects a slowdown in H2-2022 and 2023 given the adverse impact of Russia’s war in Ukraine, increasing consumer and producer prices, tighter financial conditions, and lower external demand. While private consumption has so far been supported by high employment, increases in salaries, accumulated savings from the previous periods and social transfers, persistent inflation (7.6% in 2022) and lower real wages should curb consumption during the rest of the year and in 2023. Investment growth, which was still strong in the first quarter, is also forecast to decelerate in the second half of the year due to the increasing uncertainty, lower expected foreign demand, higher financing costs and prices of investment goods and construction materials. Nonetheless, public investment continues to be supported by the implementation of the national recovery plan amid 2022 legislative elections. Overall, Scope expects growth to slow down to around 2.5% in 2023, markedly above the estimates of the European Commission of 1%1.
This more benign forecast also reflects Scope’s expectation of a sustained external performance. The country had continuous current account surpluses in the years before the Covid-19 crisis, averaging 4.6% between 2012 and 2019. The surpluses were underpinned by strong external demand and growth in manufacturing, services and tourism. Slovenia’s export-driven economy is well integrated with European trading partners; its biggest export market shares are Germany (18%), Italy (11%), Croatia (8%), Austria (7%) and France (5%). Slovenia’s global export market share also increased significantly by 20.2% over 2016-20.
Foreign demand recovered strongly last year despite supply chain bottlenecks, helping to maintain the current account at 3.3% of GDP in 2021, although still below pre-Covid levels. Even so, renewed pressures on energy and import prices, prolonged supply chain disruptions and the economic slowdown among EU trading partners are likely to pose challenges for Slovenia’s small, open economy in H2-2022 and 2023. While these issues will likely reduce the current account surplus in the short term, the foreign direct investment inflows sustained over the past three years, at an average of 3.1% of GDP, should help preserve the country’s external resilience.
The second driver supporting Slovenia’s A/Stable ratings reflects its strong market access and favourable debt profile. Borrowing conditions remained favourable in 2021 thanks to the ECB’s accommodative monetary policy. Since the launch of the Pandemic Emergency Purchase Programme in March 2020, the ECB has purchased around EUR 6.5bn of Slovenian public debt on the secondary market by end-July 2022, accounting for almost all of the country’s nominal debt increase since the end of 2019, in addition to net cumulative purchases of EUR 2.9bn under the Asset Purchase Programme over the same period. This helped keep the 10-year Slovenian government bond yields at a low 0.1% on average last year, almost unchanged from 2020. The benchmark government bond yield has remained anchored but has increased since the Russia-Ukraine war to around 1.5% to 2.0% - still, a very favourable cost of debt compared to historic levels and non-euro area peers.
Sound debt management has helped to lengthen the average debt maturity to 10 years, reduce the share of debt held by non-resident investors from 80% in 2014 to 57% in 2021 and build high cash reserves, currently at around EUR 8bn (15% of GDP). These measures provide substantial buffers against both market volatility and higher interest rates, reinforced by the Bank of Slovenia’s significant holdings of government debt securities (around 32% of the total) and the introduction of the ECB’s Transmission Protection Instrument.
The third driver supporting Slovenia’s A/Stable ratings is its effective and prudent fiscal policies. In the two years before the pandemic crisis, sustained fiscal discipline led to budget surpluses and declining debt levels. This provided the government with fiscal space to implement large-scale support when the pandemic hit, at more than 10% of GDP over 2020-22. These measures were effective at preserving the economy, but also reversed the improving debt trajectory, with fiscal deficits reaching 7.8% of GDP in 2020 and 5.2% in 2021.
Yet, the decrease in last year’s general government deficit was better than projected in the 2022 Draft Budgetary Plan, by EUR 1bn. This reflected stronger-than-expected economic growth as well as buoyant tax revenues, which grew 14.2% from the 2020 level and exceeded the 2019 pre-crisis level by 5.5% in 2021. The commitment to prudent fiscal policies was also shown during the pandemic, when the Fiscal Council warned to contain fiscal trends not directly related to the mitigation of Covid-19 impacts to preserve the sustainability of the fiscal balance in the medium term. As a result, the 2021 deficit excluding Covid-related measures amounted to only 0.7% of GDP, despite higher expenditure for investments and social benefits2.
Scope expects the fiscal deficit to gradually decline from 5.2% of GDP in 2021 to 5.0% in 2022 and 4.5% in 2023 and to converge towards 3.3% by 2027 – slightly above the Maastricht criteria. This conservative fiscal trajectory reflects Scope’s assessment of the adoption of fiscal measures for higher energy prices, the planned reform of personal income tax and the current uncertainty around the coalition’s additional fiscal and business-friendly measures over the coming legislative period. This, together with growth converging towards 2.5% over the medium-term and slightly higher inflation in 2022-23, will result in public debt to decrease from 74.7% of GDP in 2021 to 68.9% in 2023, and further down to 68.1% by 2027, once Covid related measures are fully withdrawn and the energy crisis is addressed. Even so, Slovenia’s debt dynamic is expected to underperform peers such as Estonia – with the lowest debt to GDP ratio in the CEE-11 – or Slovakia – where public debt should hover around 50-55% of GDP by 2027. Still, Scope notes positively the expected gradual decline in the primary deficit and the associated reduction of public debt.
Despite these credit strengths, Slovenia’s ratings are challenged by several credit weaknesses:
First, the limited diversification of energy supply is posing serious risks amid the heightened geopolitical uncertainty due to the prolonged Russia-Ukraine war. Natural gas, while representing only 11.3% of the energy mix, is mostly imported from Russia – 81% of total gas imports as of 2020. Slovenia also has no gas storage capacity. A major disruption in Russian gas supply during the winter could threaten Slovenia’s economic outlook as it could slow supply chains and production in major sectors dependent on natural gas, such as automotive, which contributes 10% of GDP. Reducing the dependency on Russian gas will also be challenging in the next years, given that the transition towards a coal phase out by 2033 could lead to higher reliance on fossil fuels in the short-term. Against this backdrop, Scope expects greater efforts to increase energy supply diversification, prioritising investment in renewable energy, alongside initiatives to improve the network and storage infrastructure (42% of the Recovery and Resilience Plan is earmarked for climate transition). In that respect, projects aimed at improving the energy infrastructure and strengthening cooperation with neighbouring countries will be crucial. The bilateral agreement with Italy signed in July to increase gas imports from Africa as well as additional agreements for shared gas supply with Croatia and Austria, which are under negotiation, will help to cushion the impact of supply disruptions and gas rationing.
Second, the resumption of fiscal consolidation after the pandemic crisis may be challenged by the growing structural pressures on the budget over the medium-term. The budget deficit is likely to stay high due to additional costs for long-term care, projected at up to 0.8% of GDP, in combination with lower revenues due to the approved cuts on personal income tax that will reduce tax revenues by up to 1.3% of GDP. The Slovenian Fiscal Council estimates that the new tax reform will cause public debt to rise by 4-14pp of GDP in the medium term – although the overall impact could be lowered by the reform of the personal income tax planned by the new government. Moreover, an ageing population and declining number of births will result in a shrinking working age population over the next decades and a projected median age of the population of about 50 years by 2050. These factors will lead to Slovenia having the second biggest increase in public pension expenditure among the 27 EU member states, projected to reach 16% of GDP by 2070.
However, reforms addressing ageing-related spending pressures, on which disbursements from the EU Recovery and Resilience Facility (totalling EUR 2.2bn or about 4% of GDP) are contingent on, could mitigate some of these structural spending pressures. Scope also notes positively that this year’s electoral victory of the three-party coalition led by Prime Minister Robert Golob reinforces the prospect of structural reforms, as the coalition aims to align policy and fiscal rules with the country’s development agenda. This includes a reform to strengthen the first pension pillar and increase pension savings, whose effective implementation will be fundamental for long-term budget sustainability in view of the expected increase in pension and healthcare spending3.
Third, persisting structural rigidities in the labour market are hindering sustained GDP growth. Employment and activity rates are low among the older segment of the population, at 53% of those aged 55-64 against the euro area’s 61%. In addition, the share of temporary contracts among young people aged 15-29 is 39%, above a euro-area average of 36%. These issues have been exacerbated by short-term dynamics that have led to low mobility, increased minimum wage and high labour taxes. Further, labour shortages could weigh on production, particularly in the construction, information and communication sectors. Lastly, the planned green and digital transformations will require massive public investment to address skill mismatches and improve the country’s appeal to high-skilled foreign workers. That said, labour market conditions have been improving with the recovering economy and the implementation of reforms targeting labour market flexibility and lower labour costs. Unemployment fell to 4% in June 2022, in line with pre-pandemic levels and well below the euro area average of 6.6%. However, keeping the reform momentum on the labour market, with the implementation of all the measures outlined in the National Recovery Plan is key to preserve the recent improvements and address structural challenges.
Finally, the rapid rise in real estate prices poses risks for domestic financial stability. Since 2015, the rise in house prices, at 50%, has outpaced the improvement in economic fundamentals, with real GDP up by just under 30%. The Covid-19 crisis did not dampen this trend, with house prices higher by 12.9% in Q3 2021 YoY against the euro area’s 9.2%. Labour shortages and rising costs are also limiting new construction, contributing to overvaluation in the housing market. The Bank of Slovenia therefore reported the highest composite indicator of relative overvaluation in over a decade, at 13%. However, as stated by the European Systemic Risk Board, the adopted macroprudential policies – such as limits on debt-service-to-income and loan-to-value ratios for households – have been sufficient to improve lending standards on new housing loans and mitigate risks. Large maturity gaps in banks’ balance sheets between assets and liability also constitute another source of vulnerability."