The Slovak Republic enjoyed several years of very strong growth and has made significant progress in catching-up to the income levels of the more advanced economies. In 2006 and 2007, GDP growth was the highest among OECD countries and the unemployment rate fell substantially. Nevertheless, notwithstanding the stellar economic performance at the national level, the benefits of higher growth remain fairly concentrated in those geographical areas where FDI inflows have been strongest, leaving large regional economic dispersions. Mirroring the progress in catch up, the exchange rate has appreciated by around 20% since 2006. Growth has been underpinned by significant structural reforms. The introduction of a flat tax raised the attractiveness of the Slovak Republic as a business location for domestic and foreign investors and, together with welfare reforms, has raised work incentives. On the fiscal side, the pension reform reduced the future fiscal costs of ageing, while raising the short-term deficit of the defined benefit system. However, recent measures will contribute to increasing future fiscal costs.

The Slovak economy has enjoyed a stellar performance in recent years, growing significantly faster than other OECD economies. However, the economy is now facing a major slowdown reflecting the headwinds from the global economy. While past growth has contributed to further catching-up to the income levels of the more advanced economies, the gap relative to the European Union (EU) countries prior to the 2004 accession remains large, reflecting both lower productivity levels and lower labour utilisation. Going forward, adapting the economy to life within the euro area is the key challenge. Being a catch-up country with a significantly lower price level relative to the euro area is adding to the challenge, as the Slovak economy will have to deal with financial deepening, low real interest rates and changes in its economic structure. Flexible labour and product markets as well as a suitable fiscal policy framework are essential ingredients to cope with these challenges as they will facilitate the adjustment to shocks in the absence of the previous possibilities of changes in the exchange rate or monetary policy settings. In addition, these ingredients are also the best contribution of policy to sustaining high economic growth.

As in other catch-up countries inflation is likely to stay high going forward due to nominal convergence. To better cope with the risk of a too rapid pick up of wages during the convergence process on the one hand and to raise the adjustment potential of the economy to macroeconomic shocks on the other, labour and product market flexibility is essential. Three main areas for improvement are discussed in this chapter. First, wage flexibility should be safeguarded by avoiding significant increases in minimum wages and by abolishing legal extension of collective wage settlements. Second, competition needs to be strengthened, especially in the liberal professions where entry and conduct regulation should be eased. In addition, the points of single contact that already exist for small enterprises should be extended to entrepreneurs of the liberal professions. Third, a wider use of information and communication technology (ICT) could lead to important productivity gains. Removing obstacles to the spread of e-business and a swift implementation of e-government are imperative.

Euro area entry calls for more fiscal flexibility to absorb cyclical shocks that cannot be dealt with by the common monetary policy. At the same time fiscal consolidation must not be put at risk, especially given rising ageing-related costs. The current fiscal framework could be improved by introducing multi-year expenditure ceilings and by removing pro-cyclical elements in fiscal rules. An adjustment account that serves to register breaches of fiscal rules and eliminates them over time could help in coping with projection errors. To ensure long-term sustainability of public finances it is essential not to dilute the substantial improvements in the long-term balance of the defined-benefit pillar associated with past pension reforms. The government should consider making participation in the defined-contribution pillar mandatory for new labour market entrants or, at the very least, make it the default option. For current workers the pillars should remain closed. Moreover, further parametric changes such as increasing the retirement age in line with life expectancy gains and reducing unsustainable elements in the pension formula would improve the balance of the defined-benefit pillar.

House prices have risen strongly in past years, helped by rising incomes and declining interest rates. At the same time, construction of new dwellings has remained fairly muted and has only recently shown signs of picking up. A characteristic feature of the Slovak housing market, and a consequence of the privatization programme initiated in the early 1990s, is the virtual absence of a private rental market. As euro membership will most likely go along with easier financial conditions and also entails limited availability of national policy tools, current housing policies will have to be adjusted. The challenges are to avoid overheating of the housing market in the medium term, in part by making supply more reactive to demand, and to phase out the hurdles that are currently impeding the private rental market, which would facilitate labour mobility.