Jan Cienski in Bratislava -

Slovakia made a mistake pinning its economic development so closely to the car sector, admits Jan Pociatek, the finance minister, as the country looks set for a 6.2% economic contraction this year.

"Cars are one of the pillars of our economy," Pociatek says in a recent interview with bne. "We have to learn the lesson from this - being as dependent on the auto sector as we are is not good."

The auto sector has become by far the biggest driver of the Slovak economy. Volkswagen, which has a plant just north of Bratislava the capital, alone accounts for about 15% of Slovakia's exports. As well, France's PSA Peugeot Citroen has a €700m plant in the city of Trnava, and Korea's Kia has its €1bn factory in the northern city of Zilina.

Tying the country's fortunes to cars seemed like a good idea just a few years ago, and helped propel Slovakia to posting the fastest growth rate in the EU in 2007 - 10.4%. In that year, Slovakia was making 570,000 cars a year, which turned it into the highest per-capita car producer in Europe, churning out 106 cars per 1000 Slovaks.

The good times ended in 2008. Estimates had called for production to reach 800,000 cars last year and to top 1m in 2009; instead, production last year stayed at 2007 levels, and some analysts expect production to fall by a fifth this year. That is dragging down the Slovak economy, which is suffering more than its neighbours in the Czech Republic and especially Poland, which have more diversified economies.

Euro celebrations

Just half a year ago, Slovakia was revelling in its success after becoming the first former Soviet bloc country to adopt the euro as its currency. After spending the 1990s under the authoritarian governments of Vladimir Meciar, which had left Slovakia lagging far behind its regional peers, the last few years of economic reforms, burgeoning foreign investments and fast growth seemed to have shaken off that miasma.

Now some economists worry that by adopting the euro, Slovakia has made itself less competitive. Jan Toth, chief economist of UniCredit Slovakia, says that Slovakia used to have the cheapest labour in the region, but now is tied with the Czech Republic and above Poland and Hungary, all of whom have seen their currencies depreciate against the dollar and the euro thanks to the effects of the crisis.

Although Pociatek admits the next year's growth rate will probably be an anaemic 0.5%, he has no doubts that joining the common currency was a good move. "If we did not have the euro, we would have depreciated like Hungary with the forint," he says, adding that being in the Eurozone is likely to be a compelling advantage for foreign investors when they again begin looking to set up factories and offices in Central Europe.

The slowing economy is posing unexpected challenges for Pociatek's boss, Robert Fico, the prime minister. Fico won power in 2006 on a promise to backtrack on the often-painful economic reforms of his predecessors. While talking a good populist game, Fico actually undertook very few changes to the economy. He is trying the same approach with the current crisis, taking symbolic measures such as halting car purchases for various ministries. But as the downturn's effects become more pronounced, he is being put under pressure to act. "We did not decrease spending significantly," admits Pociatek.

Acknowledging that the unemployment rate is likely to top out next year at about 13.5%, Pociatek is looking at Slovakia's vaunted 19% flat tax, which the finance minister says gives Slovakia one of the lowest tax/GDP ratios in the EU. "This fact will have to be evaluated in the future," says Pociatek.

However, economists like Zdenko Stefanides of Slovakia's VUB Bank warn that toying with the flat tax could undercut the country's attraction for foreign investors. "We would lose the image of having a tax-friendly business environment," says Stefanides, who notes that if the country's high social security taxes are included in the mix, then Slovakia does not have a particularly low overall tax rate.

However, such steps are likely to be popular with the voters backing Fico's Smer-Social Democracy party, and with parliamentary elections due next year, the temptations to put in a "millionaire tax" aimed at the wealthiest will be strong.

In the end, PM Fico's salvation is likely to come from abroad. Just as the crisis didn't originate in Slovakia, its resolution will also come from outside. And when the German economy revives - on August 13, Germany stunningly announced that it had already emerged from recession in the second quarter - and German consumers reopen their wallets, the Slovak economy will likely revive. "We believe that once the situation improves with our trading partners, we will recover faster than others," says Pociatek. "Our wages are still well below the levels of West European countries like Germany. We have a skilled workforce and we still have a big potential."

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