Gunter Deuber of DB Research -

In step with the booming Eurozone economy, Slovakia had in recent years been the growth high flyer, posting impressive GDP gains. Now, as a member of the Eurozone and a very open economy that is deeply integrated into the EU, the country faces the threat of a significant cyclical correction. Should Slovakia in future, however, readopt its past stability orientation, then the country will rapidly regain its status as one of Euroland's most dynamic economies.

The eu(ro)phoria in Bratislava in January was huge. Slovakia became the 16th member of the Eurozone club. The economic might of Euroland may have been scarcely enhanced by Slovakia's GDP of €65bn (equivalent to 1% of the Eurozone total), but the country's accession to the euro is remarkable nevertheless. Having charted a unique reform course, Slovakia became the first once fully integrated member of Comecon (the economic alliance behind the Iron Curtain) to enter the Eurozone. From its EU accession until 2008, Slovakia was - after Latvia - the EU newcomer in the 2004 round of enlargement that recorded the biggest increase in economic output. Above all, the expansion was sustainable compared to that in the Baltic countries. It was based on a high level of international competitiveness. In addition, the expansion of credit was moderate and was financed via local savings. This meant Slovakia relied little on foreign capital flows, and there was no financing of an excessive consumer credit bubble.

Attractive investment location for years

Since opening up to the West from the year 2000 onwards, Slovakia has distinguished itself as a magnet for investment. With the aid of intelligent incentives and stable economic policy the country managed to attract large sums of direct investment. In some years, Slovakia attracted more investment relative to GDP than five-times-bigger Poland, and the latest surveys show that the majority of investors are satisfied with the performance of their holdings.

A major share of the investment was funnelled into the industrial sector, thus enabling Slovakia to modernise its industrial base. Sound wage policy combined with significant productivity gains have helped to establish the country as a core European industrial nation. At the same time the investment dynamics transformed Slovakia into a small and very open economy that is deeply integrated into the single European market. Goods exports and imports amount to more than 150% of GDP, while intra-EU trade accounts for 90% of external trade.

The high integration of Slovakia's economy into the single European market also explains why the launch of the euro was a logical step and as a priority political objective did not fall victim to domestic policy squabbling at any stage. The Maastricht criteria were met spot on, although in Slovakia they were regarded as unfair to dynamic transition countries. Once in the Eurozone, Slovakia should maintain its enthusiasm for reform and its stability orientation. Nominal and real exchange rates have risen sharply in recent years. And since the nominal exchange rate to the euro is now fixed, Slovakia's international price competitiveness has become unfavourable compared with that of the Czech Republic or Poland, whose currencies have recently weakened against the euro. This disadvantage can only be offset by continuing to practise a stability-oriented wage policy. Such a stability orientation would also help to limit the macroeconomic risks that present themselves for EU cohesion countries in the Eurozone (think, for example, of the property bubble in Spain due to low real interest rates combined with higher inflation than in Euroland).

Strong focus on cyclical industries is a risk factor

Given the extensive economic integration into the EU and the focus on cyclical industries such as automaking, engineering and metalworking, it is clear that Slovakia as an exporting nation is being hit hard by the deep recession in Western Europe. In the first quarter of 2009, exports fell 28.9% and GDP contracted by 11.4% compared with the previous quarter (and by 5.6% year on year). To date, the country has, however, not come up with any substantial stimulus programmes, having set aside only €330m, or 0.5% of GDP; nevertheless, the public sector deficit will widen and Slovakia can expect to face an EU excessive deficit procedure. This is particularly the case because the government could become even more spend-happy during the period before the election campaign (parliamentary elections are scheduled in 2010) and against the backdrop of already high unemployment, which is currently the fifth-highest in the EU at 11.1%.

During a downturn, the structural weaknesses of Slovakia return to the fore. The unemployment rate did not fall below 9% during the boom. This was because of the shortage of skilled personnel in commercial and technical occupations, which is reflected in the highest share of long-term unemployed in the OECD. Furthermore, prosperity is concentrated in the west of the country - including the capital. In addition, the country is extremely dependent on energy supply from Russia - a hangover from the days when it was tied to Moscow in the early 1990s. Nearly 100% of the energy supply comes from Russian gas sources. When Ukraine and Russia had their now-regular gas dispute in January 2009, Slovakian industrial plants had to make do with a reduced energy supply. Moreover, Slovakia is being hit particularly hard by the current financial and banking crisis as bank loans are by far the most important form of company financing and significance is greater than in other central European economies.

Clear advantages over the "real Detroit"

All in all, Slovakia has reinforced its role as a successful reformer by adopting the euro. And despite the tendency towards a monostructure, the auto factories in "Detroit East" are among the most advanced and the most flexible in Europe. Investments are already being made to produce new small cars in tune with the trend towards more economical vehicles. For Slovakia, the current recession thus represents a cyclical downturn after years of exceptional outperformance and not a structural crisis - as is the case in the "real Detroit." The considerable cyclical weaknesses of major trading partners like Germany or the Czech Republic, expected slumps in demand as a consequence of purchases being brought forward due to Europe-wide scrappage incentives and the generally heavy reliance on the European business cycle do not, however, suggest that there will be a rapid return to double-digit growth.

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