Slovak bonds perform well and confirm role in semi-core


Growth slowed, but still strongest in EU apart from Baltics


Deficit below 3% threshold in 2013; debt ratio below 60%, but rising


Poor liquidity in Slovak bonds, but yield pick-up versus semi-core is more than enough for buy-and-hold investors




Slovakia confirms role in semi-core


In mid?2011, the second phase of the EMU sovereign debt crisis pushed Spanish, Italian, but also other countries‘, including Slovak, yields sharply higher. In the case of Slovakia there was additional political uncertainty after the collapse of the government. In November 2011, yields/asset swap spreads of Slovak bonds hit record levels. Spreads remained elevated until the start of 2012 when they started narrowing, supported by the ECB’s LTRO’s and the prospect of a new government (eventually established in March 2012). Throughout that year, Slovak government bonds drew more and more attention from investors. In a hunt for yield, Slovakia offers the best opportunity for a yield pickup in the semi?core (preceding Czech republic, Belgium, France and Austria). However, not only the higher yield tempted investors, but also the underlying fundamentals of the Slovak economy played a role.


The strongest proof of the relatively good position of Slovakia came mid?March/early April of 2012, when a new episode of the sovereign debt crisis started. Spanish/Italian/Slovene yields/swap spreads exploded again, but Slovak ones decoupled and further converted towards the EMU semi?core. The stronger Slovakian rating vis?à?vis the periphery certainly helped.


Demand for Slovak bonds remained underpinned until the start of this year. Further supported by ECB action (OMT) and Draghi’s promise to do whatever it takes, asset swap spreads declined towards lowest levels on record.


Since mid?February 2013, Slovak bonds came under modest pressure on the secondary market. They remain slightly more vulnerable to mood swings on peripheral bond markets. Italian elections, the Cypriot bank recapitalisation and doubts over the situation in Slovenia are examples. Another factor is supply related. Less liquid bond markets, like the Slovak one, are more profoundly impacted by new (large) supply. Investors prepare by switching out of old bonds. At the end of February, Slovakia successfully launched a new 10?yr benchmark (€1.75B 3% Feb2023 MS+122 bps) via syndication. The combination of these factors led to an underperformance versus swap and versus Czech Republic and Belgium until end March. As the situation on EMU bond markets eased and supply was digested, Slovak bonds started outperforming and spreads might narrow further.


We are convinced that for buy and hold investors, Slovak bonds offer a nice premium over Belgian OLO’s or Czech bonds. The spread/yield pick up is largest at the wings of the curve: 50?60 bps in ASW spread terms compared to 40? 45 bps at the belly of the curve. For the longer end, it’s logic that the Slovak yield curve is steeper than e.g. the Belgian one. This yield pick?up reflects the liquidity premium of the rather illiquid Slovak bond market and the lower Slovak rating. Slovakia is rated A2 at Moody’s, A at S&P and A+ at Fitch. The outlook of the ratings is stable, apart from the negative outlook at Moody’s. The Belgian and Czech government bond ratings respectively are Aa3/AA/AA and A1/AA?/A+. The higher pick?up at the short end of the curve can be partly explained by repo market rates.
Credible AAA/AA sovereign bonds can be repoed to secure funding well below Euribor rates. Slovak government bonds are more considered as corporate bonds in the repo market and can’t be used to secure such ultra?cheap funding. This element plays in the advantage of strong (Western)? Europeans sovereigns. At the graph above, you see that Czech bonds have the same disadvantage at the front end of the curve.



Funding well advanced


This year’s official funding need was estimated at €8.45B, though the real number will be lower as Ardal (Slovak debt agency) already pre?financed a large chunk in 2012 (total issuance €8.43B compared with €7.6B need). Year?to?date, Ardal raised €5.38B via a combination of regular auctions, a private placement, the launch of a new 10?yr syndicated benchmark and CHF?denominated retail bonds. For the rest of the year, we expect at least one more benchmark issue.
This should nearly complete the 2013 funding (+? 80%), after which Slovakia can start prefunding for next year.


Looking at Slovakia’s redemption profile and taking into account earlier communication from Ardal, the new benchmark will have a 2018 maturity. In 2018, Slovakia only has a small Eurobond outstanding. Before 2018, they face a yearly redemption of €4B to €4.5B. Regarding regular auctions, bonds on tap will be SD 218 (Euribor flat; Nov2016), SD 219 (4.625%; Jan2017), SD 223 (3.375%; Nov2024) and SD 225 (3%; Feb2023). Other bond lines can be opened pursuing requirements of debt management and demand of investors.


The liquidity of Slovak bonds is very low on the secondary market but decent at primary auctions. This year’s syndicated 10?yr deal printed €1.75B at syndication with a 1.29 bid cover. The launch of SD 23 (Nov2024) at the end of 2012 resulted in a €1.25B issuance with a 1.68 bid cover.



Growth is losing momentum


The Slovak economy lost momentum last year. GDP growth slowed from 3.2% in 2011 to 2.0% in 2012.
Nevertheless, the Slovak economy continues to easily outpace growth in other EU countries with the exception of the non?EMU Baltics. Economic growth slowed throughout the year and was only a meagre 0.7% y/y in Q4 of 2012. We expect little change in the growth pace during the early part of this year, which was confirmed in a 0.6% Y/Y increase of GDP in Q1 of 2013..


Q4 GDP figures disappointed market expectations (1.6% y/y) because of worse than expected foreign demand. Whereas exports remained the only positive contributor to growth, they decelerated from 11.6% y/y in Q3 to 7.1% y/y in Q4 2012. All other items declined. Domestic demand, and mainly household consumption, is dampened by the government’s fiscal austerity package and falling consumer confidence. Final household consumption decreased by 1.2% y/y in Q4 2012 after falling 0.6% y/y in Q3 2012. Consumer confidence worsened again at the end of last year, influenced by rising unemployment and an uncertain economic outlook (mainly in the Euro zone). Government consumption dipped by 0.3% y/y due to spending cuts that aim at a reduction of the public deficit. Furthermore, private companies are hesitating to invest due to the unclear economic outlook and declining demand. As a result, the gross fixed capital formation decreased by 5.0% y/y in the last quarter of 2012 and closed the year with an overall decline of ?3.7%.


The outlook for investment is clouded as higher taxation and weaker growth in Slovakia’s main export markets take their toll. German GDP dropped in Q4 of 2012 and grew only marginally in Q1 2013. The Czech economy, Slovak’s second trading partner, is mired in its longest recession in history. As a result, Slovakia’s Ministry of Finance reduced its previous 2013 economic growth forecast of 2.1% to 1.2%.The European Commission lowered its forecast to 1.0% y/y. Our in?house 2013 GDP estimate stands at 0.9%.


Household consumption might revive only later this year, supported by higher disposable income caused by lower inflation and a stabilization of unemployment (though at high levels). Firms should also start rebuilding inventories because of an expected economic recovery next year. The European Commission expects the pace of growth to pick up resulting in 2.8% growth in 2014, a view we endorse.



Little additional support from car sector


Looking to the supply side of the economy, the car sector is operating near full capacity (95%), suggesting that no significantly increase of production is likely this year. The sector produced about 900 000 cars, a 40% y/y increase.
Production of overall transport equipment was up 26% y/y in 2012. Given its importance for the Slovak economy, the declining car sales on Western European markets is really worrying. Some car plants decided to reduce the number of working days in early 2013 (e.g. PSA). However, the stronger performance of emerging markets (namely BRIC) could help balance a possible underperformance of Western European car sales (at least to some extent). The industrial sector overall registered a significant slowdown in its production early 2013. The auto sector was the only driving force behind manufacturing growth last year and also in Q1 2013.
Slovakia is benefiting from its strong competitive position in multinational plants chain (eg VW) and should benefit from the favourable production mix of on the one hand cheap and small cars and on the other hand large and luxury cars.
This makes the car sector more resilient to an unfavourable development in one segment of the car market. So despite the high comparison base, the car production should remain the driving force of the industrial sector in 2013. Other sectors could gain momentum only later this year on condition of a growth revival in the euro zone .



Construction in protracted recession


Construction output is still struggling and having its own problems. The sector declined for the 5th consecutive year.
The hopes are now mainly on infrastructure projects linked to the EU funds. We entered the final 2 years of the drawing period (till 2015) and there is still a big amount of money set aside for railways, roads and highways. However, the construction of residential properties should remain weak.



Labour market conditions may stabilize


The labour market feels the effect of sharply slowing economic growth. The unemployment rate rose to a 9 year high (the highest level since EU entry in 2004) and stood at 14.3% in 2012 (from 13.5% in 2011). The unemployment rate could stabilise around 15% in mid?2013 and start declining later this year if our expectations of an economic revival materialize. Real wages declined for the last two years, but this may not last. Indeed, the decline of inflation below 2% should push real wages higher, but only a slight 0.5% increase is likely. Nevertheless, it would slightly support household consumption, an improvement after two years of outright decline.



Inflation on declining path


The weak domestic demand and higher unemployment weigh on inflation. Headline inflation (HICP) declined from 3.2% y/y in December 2012 to 1.7% y/y in April 2013. The main factor was the more favourable development of regulated prices compared to 2012. Moreover, food prices surprised with a slower price rise and fuel prices decreased.
Nevertheless, demand led inflation pressures are under control. Net inflation (adjusted for the effect of regulated prices, indirect taxes and volatile food prices) declined from 2.3% y/y at the end of 2012 to 1.4% y/y in March 2013. It is expected to remain at these low levels during the remainder of the year. Looking forward, we expect a deceleration of headline inflation (HICP) towards 1.6% at the end of the autumn, followed by a small rise towards 1.8% by the end of 2013. For 2014, we expect inflation to stabilize slightly above 2.0% in 2014, as the improvement on the labour market will be gradual keeping wage growth low.



Budget deficit to drop below 3% in 2013


After the elections, the Smer?government committed to resuming the consolidation process, which stalled in election year 2012, and bring the 2013 budget deficit below 3% of GDP. Slovakia is in the EU Excessive Deficit Procedure and faces the risk of a financial fine if it fails to reach the EDP?target. Not complying is thus no option for the government as the political consequences would be high. The Slovakian stability programme foresees that the deficit will be reduced to 2.9% in 2013, 2.6% in 2014, 2% in 2015 and 1.3% in 2016. The primary balance (excluding interest charges) should be balanced in 2015.


The 2012 budget deficit on a cash basis (central government) amounted to EUR ?3.8bn at the end of 2012, exceeding the plan by EUR 135 million, resulting in a 5.3% deficit?to?GDP instead of ?5.1% originally planned. However, the general government deficit in ESA 95 terms (which is the important one that covers also social security and local governments) was 4.35% of GDP instead of the 4.6% of GDP targeted. Regarding the January – March 2013 period, the central government deficit amounted to less than EUR 1bn that is approximately EUR 200 mil. lower compared to Q1 2012. The tax collection was also slightly better by roughly 2% in year?on?year terms, suggesting the deficit reduction is on track.


The downward revision of the 2013 GDP forecast (from 2.1% to 1.2%) has a negative impact on the (expected) tax revenues by an estimated EUR 360 million (0.5% of GDP).
This will be partly covered by the use of reserves created after the pension fund reform. The rest of the revenue shortfall will be covered by higher dividends from state owned companies. In this way, the government wants to keep its promise to cut the 2013 fiscal deficit below the 3% of GDP threshold. We think that these measures will indeed lower the deficit to GDP towards the 3% to GDP threshold.
However, the measures are not structural which means that renewed measures are needed in 2014 only to avoid a renewed deterioration.


Therefore, if growth still falls short of the reduced forecasts, extra austerity measures are needed. The larger part of consolidation efforts so far came from the revenue side.
Therefore, if needed, more measures may this time target the expenditure side of the budget.



Debt-to-GDP is mounting fast


Less positive news is the increase of the government debt to GDP ratio from 43.3% in 2011 to 52.1% in 2012.
 However, the underlying increase is less outspoken than the headline figure suggests, as it was partially due to the contribution to ESM and the pre?funding of the 2013 financing needs. Both counted for up to 4%?points of GDP.
Nevertheless, the debt rise is still fast and needs to be stopped. Therefore, the government approved consolidation with deficit reduction to 2.9% in 2013 and 2.4% in 2014 and 1.9% in 2015. This year will be important as the country need to fulfil the conditions of the European Fiscal Compact (deficit below 3%).


Slovak debt is still modest compared to most euro zone countries, but given the relatively low income, the country needs to stop the debt ratio from rising further. The new government took a good start with its 2013 budget, but should sustain efforts in the next years. The Constitutional debt brakes (see box) might prevent the government to loosen the budgetary reins. However, slightly disconcerting, there are from time to time voices in government and opposition circles pleading for changes to the law on the debt brakes. Not to skip it altogether, but to adapt it. The recent contributions to ESM and EFSF, to help other EMU countries, affected the debt ratio quite substantially for reasons that in fact are largely outside the realm of the government. The debt brakes might also restrain room of manoeuvre at some unfortunate moment, e.g. when Slovakia would be hit by an external shock. So, there are arguments to debate on the debt break law. According to forecasts, the debt ratio might rise a bit further to slightly below 57% in 2014. Next elections are scheduled in 2016, which makes the government even more nervous about the debt break law, as it might be obliged to take draconic and political unpleasant measures at the most unfortunate political moment. Changing the law for these reasons would of course be a very negative development, but risks on such developments are small.


Prime Minister Fico sides with some European politicians in calling for less strict fiscal tightening. On the European level, more flexibility will most likely be allowed to some countries. However, in the case of Slovakia, it is far for certain that any substantial loosening will be accepted. The Slovak structural deficit is slightly higher than the headline deficit, suggesting that negative cyclical developments had no big impact on the headline deficit, contrary to the case of many peripheral countries where the structural deficit is much lower than the headline one because of a deep recession. As a small country, Slovakia wouldn’t gain much via a loose budgetary policy, as it might see some of the stimulus flowing towards other countries. So, it is unlikely Slovakia will turn its back to its budgetary consolidation path, and even in case Europe would allow some leniency, it will be more symbolic.




Comfortable external surplus


In the past, Slovakia accumulated current account deficits (as did most other Central European countries). The profound restructuring of the economy around the turn of the century, the prospect of and later on the entry in EU (and EMU) lured a lot of capital flows. In the case of Slovakia, the money largely found its way to sound investment opportunities that strengthened the fabric of the economy.


The period of high current account deficits (over 8% of GDP in 2005?2006) is over for now. 2012 was the first year since 1995 that Slovakia registered a current account surplus (2.0% of GDP), due to a historically high trade surplus. The Slovak National Bank counts on a 2.9% surplus in 2013 and even 3.8% in 2014. We are more cautious and expect the surplus to stabilize in 2013, before expanding in 2014 when the new VW welding plant is operational. So, the economy is not dependent on foreign financing and is less vulnerable during periods of higher risk aversion.




Sound banking sector


The Slovak banking sector is sound and well capitalized. It did not need government support in the post?Lehman crisis era. Local banks are well capitalized. The capital adequacy ratio was increased significantly during 2012 and reached 15.7% at the end of 2012. It was due to a rise of equity through retained earnings and a revaluation of bonds available for sale. On the other hand, the profitability of the sector fell by approximately 30% mainly due to the implementation and further increase of the bank levy. The FTT (financial transaction tax), which is currently under discussion at European level, could negatively impact the profitability, as are declining net interest margins. However, this is the general trend in Europe as the banks are operating in a low interest rate environment already for some time. Finally, the weak economic environment and high unemployment might lead to a rise of the Non Performing Loans, albeit from rather low levels. NPLs declined to 5.6% at the end of March 2013 from 5.7% registered a one year ago. But are slightly higher compared to 5.3% result booked in September 2012 and unchanged from the level seen at the end of 2012 (5.6%). Nevertheless, the strong solvability should enable the banking sector to cope with these adverse developments. The stress tests confirmed this assessment. On top of the strong solvability, other strong points of the banking sector include a low loan?to?deposit ratio (about 80%), the absence of FX loans in the loan portfolio and the ability of the sector to generate net interest income as the main source of the profit (approximately 70%). So, from a sovereign debt perspective, the situation of the banking sector causes little reason for concern so far.