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