SMER SURPRISES WITH MODERATE ECONOMIC POLICY

UNCLAS BRATISLAVA 000839 SIPDIS SIPDIS E.O. 12958: N/A TAGS: ECON EFIN PGOV LO SUBJECT: SMER SURPRISES WITH MODERATE ECONOMIC POLICY REF: A. BRATISLAVA 490 ¶B. BRATISLAVA 457 Sensitive but Unclassified ¶1. (SBU) Summary - Prime Minister Robert Fico celebrated his first 100 days in office by getting cabinet approval for a budget that is in line with the Euro Maastrict criteria and does not alter the flat tax regime that was put in place by the last government. Fear of a significant drop in the Slovak Crown and strong approval ratings are two of the key elements behind what is seen by many as a significant change in economic policy direction from the pre-election rhetoric. Despite this initial success, doubts remain about Fico's commitment to fiscal prudence if it conflicts with accomplishing his pre-election promises, the competence of his close economic advisors, and his overall commitment to maintaining a positive business environment for investors, especially with regard to labor policy. End Summary -- COMPETENT ADVISORS AND A SCARE BY THE CENTRAL BANK -- ¶2. (SBU) Fico's appointment of Jan Pociatek, a 35-year old IT businessman with no previous macroeconomic or government experience, as Finance Minister was welcomed by the business community. Although Pociatek is close to top Fico advisor Robert Kalinak (they are co-owners of several Bratislava restaurants),he is not viewed as a Fico crony. More importantly, Pociatek came out as a strong supporter of the previous government's economic reforms and made it clear from the time he was appointed that he planned to maintain the January, 2009 target for Euro adoption. Pociatek's deputies, long-time Finance Ministry official Frantisek Palko and businessman Peter Kazimir, are also viewed as capable technocrats who support maintaining the status quo in economic policy. ¶3. (SBU) PM Fico did not commit to a position on Euro adoption in the pre-election campaign and attempted to keep all options open in his first weeks in office. Due to concerns about the policy direction of the new Smer-led coalition, the central bank intervened by spending Euro two billion in the first three weeks after the election to support the ailing Slovak Crown. With Fico and Pociatek sending contradictory signals about the governments intentions, Central Bank governor Ivan Sramko requested an urgent meeting on July 13 with the two top officials to advise the new government on "standard communication tools." According to officials that participated in this briefing, Sramko made careful use of charts and statistics to make a strong case that Slovakia faced a severe financial crisis if the new government did not come out with a clear and unequivocal economic policy. At the press conference after the meeting Fico outlined his strong support for Euro adoption, noting that "we want to do all that is necessary, and we've informed the central bank governor about our plans for ensuring that the Euro adoption timetable is maintained." -- SOUND TAX AND BUDGET POLICIES -- ¶4. (U) Smer marked its first 100 days in office with the cabinet approving a budget with a deficit ceiling of 2.9 percent, which is below the 3 percent Euro target. This was no easy feat considering that the 2007 deficit target includes the costs of pension reform (calculated at 1.1 percent of GDP),which has been excluded in previous years. Although the budget still has to be approved by Parliament, Fico stated that the coalition would not accept any proposals that increased the fiscal deficit. Projected deficit targets for 2008 and 2009 are 2.9 percent and 1.9 percent, respectively. ¶5. (U) In order to achieve this result, Fico had to step back from his pre-election promises of increased social spending and an overhaul of the previous government's flat tax reform. On the spending side, the state budget expenditure increased by SKK 17 billion (USD 580 million) to SKK 347 billion (USD 11.8 billion) with only a few ministries achieving an increase in their budgets. The biggest increases are for pensioners, healthcare, education and agriculture, while the ministries of defense and transportation have seen the sharpest declines. The defense ministry received a nominal increase of 2.2 percent, which is actually a drop as a percentage of GDP from 1.7 percent to 1.6 percent. ¶6. (U) The budget projects revenues of SKK 308 billion (USD 10.5 billion) for 2007, an increase of SKK 35 billion (USD 1.2 billion) over 2006. This increase is based on strong economic growth, which is forecast at 7.1 percent for next year, a 10 percent across-the-board cut in adjusted state expeditures, a new excise tax on tobacco, and dividends from state-owned companies. Prior to the election Fico had spoken about several possible changes to the tax code including the introduction of a dividends tax, launching of a special tax on natural monopolies and highly profitable companies, and reintroduction of a progressive income tax. These would have helped offset decreased revenues from a reduction in the value-added tax (VAT) for medicines, medical supplies, food and books (See Reftel A.) -- MISMATCH BETWEEN PROMISES AND REALITY -- ¶7. In the end there is little is common between what was promised and the government's final tax proposal. The government has maintained the flat tax model and none of the proposed "new taxes" have been included at this time. Instead of introducing new taxes, the government worked around the margins or the current system and reigned in their ambitions on the VAT. In fact, with the elimination of deductions for those earning more than SKK 88,500 (USD 3000) a month, the income tax is now more flat than it was before. Other changes include a reduction in the amount of the tax bill that corporations can assign to NGOs from two percent to 0.5 percent, and a reduction in the amount that self-employed craftsman can deduct for business expenditures. For the time being the VAT will be reduced to 10 percent (from 19 percent) for drugs and medical supplies. To make up for the lack of new sources of revenue, the government has requested all ministries to cut administrative costs (minus costs for wages, energy and insurance) by 10 percent, although the savings from this reform will not be realized until 2008. -- BUDGET RAISES FICO'S CREDIBILITY -- ¶8. (SBU) Long before the election it was clear that the fall budget debate would be the first true indicator of any new government's ability to manage the economy. To say that Fico has passed this first test is an understatement. The concensus among financial analysts, who generally take a skeptical view of Fico on economic issues, has been quite positive. As an example, ING's chief economist Jan Toth changed his forecast of Slovakia's likelihood of adopting the Euro by 2009 from 35 percent to 65 percent based on the cabinet's approval of the budget. Although he continued to encourage the government to further cut spending to help cut inflation, Central Bank Governor Ivan Sramko gave a positive assessment of the budget both in public and privately with the Ambassador in a meeting earlier in the week. Likewise, the business community has been pleasantly surprised with the budget developments. ¶9. (U) Even the opposition recognizes that there is very little to criticize. Finance State Secretary Palko was scheduled to participate in two separate televised debates of the budget in the evening on October 11th, but both were canceled because the opposition parties did not want to participate. Former Prime Minister Dzurinda found little to criticize in the budget, and instead focused his attack on Fico's inability to fulfill his election promises. -- BUT WILL INVESTORS KEEP COMING? -- ¶10. (SBU) Staying on track for Euro adoption and maintaining the flat tax regime are important elements for foreign investors. An informal survey of companies, however, indicates that the key issue that companies are watching is what changes will be made to the labor code. An increase in minimum wage by 10.1 percent to SKK 7,600 (USD 260) a month was generally non-controversial, but other possible changes that would reduce the flexibility of the labor code, especially the ability to hire part-time workers and to use employment agencies, are of greater concern. The Labor Minister, Viera Tomanova, has had detailed discussions with trade unions and is broadly promoting a strengthening in the position of labor unions and contract workers, but detailed proposals are not expected until the spring. The American Chamber of Commerce has had its requests to meet with the labor minister turned down. Even the finance State Secretary, Peter Kazimir, has told us that he is concerned SIPDIS about what proposals may come from the labor ministry because of the lack of transparency at the ministry. ¶11. (U) The economy ministry's negotiations with energy distributors and producers has also caused some concern about the risks that companies operating in Slovakia could face. Although it is generally agreed that final prices paid by consumers are relatively high compared with production costs in the nuclear-dominated energy sector, Economy Minister Jahnatek's heavy-handed approach in setting new prices is not seen as the ideal solution. After failing to encourage energy distribution companies to accept across-the-board cuts of six percent, which would have been inconsistent with current regulatory statutes, Jahnatek submitted a legislative amendment to the cabinet in early October that would increase MOE's supervisory authority (and thereby decrease the regulator's independence) and expand the powers of the regulatory authority to include natural gas for companies and production prices for electricity. Together with the continued rhetoric by Fico against natural monopolies and the cancellation of the privatization of Bratislava airport, these moves illustrate a trend of greater state control in the economy. -- COMMENT -- ¶12. (SBU) Fico has shown that he can put forward a responsible budget proposal, but questions remain about whether he is a true believer in fiscal responsibility and Euro adoption in 2009. So far he has been dealt a very good hand with strong macroeconomic fundamentals and growing approval ratings. Fico's sensitivity to criticisms that his program does not fulfill his socialist campaign promises creates the greatest risk that he will not stay the course over the coming months and years. What remains clear is that Prime Minister has the final say on key policy decisions, whether economic or otherwise, and that his cabinet continues to speak with one voice, even in budget decisions where there were clear winners and losers among the ministries. End Comment. VALLEE