PRESENTATION TO THE OPERATIONAL SUPPORT GROUP

SUPPORTING PUBLIC FINANCE MANAGEMENT REFORMS IN ECA COUNTRIES: THE EXAMPLE OF SLOVAKIA

Jean-Jacques Dethier(ECSPE)

Introduction

The World Bank has been involved since the beginning of the transition in developing operational approaches to improve the management of public finances. The reforms supported by the Bank have, broadly speaking, four main objectives: securing aggregate fiscal control and macroeconomic stability in the medium term; improving the allocative efficiency of public expenditures; promoting operational efficiency and cost-effective use of public funds; enhancing the transparency of government decisions and the accountability of officials and,

thereby, political sustainability of the programs.

There are Bank-financed public finance management projects in Hungary, Ukraine, Kazakhstan, Turkey, Russia (in preparation) and Slovakia (in preparation). Some treasury systems work has also been done as part of IBTA and IBL type loans in Azerbaijan, Armenia and Turkmenistan, and a project was identified in Uzbekistan. The EU (Phare/Tacis), the IMF and donors such as the US Treasury have financed technical assistance in this area in many countries.

Public finance management reforms have generally—but not always—been correlated with improvements in fiscal and macroeconomic performance, though there is a great cross-country diversity in the region in terms of fiscal performance. Broadly speaking, there are two categories of countries. In the first are the Central and Eastern European countries that are candidates to be EU Member Countries: they are well advanced in their PFM reforms and have, generally, improved their fiscal performance. Slovakia represents the exception. In the second category are the countries of the former Soviet Union and some Balkan countries (such as Croatia) where reforms are less advanced and fiscal performance often less impressive.1 1 In the countries of the former Soviet Union, fiscal management is, to a significant extent, a product of several years of using sequestration as the main tool of expenditure control, and as a corner-stone for achieving targets set in the financial programs supported by the IMF. In essence, sequestration means that, on a virtually daily basis, the government checks to see how much money it has collected in revenue, adds to that the agreed borrowing ceiling, and spends only that amount. In other words, expenditure is determined not by policy programs, but by the availability of cash. Sequestration was introduced in many countries as an emergency measure to deal with hyperinflation and has remained the norm since. While sequestration is an effective tool in the very short term, if retained for more than a few months it becomes extraordinarily destructive. There are two reasons for this. First, cash management is addictive. It divorces the underlying fiscal policy from the budget which is presented to Parliament, removes Parliamentary oversight and gives the government considerable discretion over spending priorities. The officials involved along the entire chain of command gain in stature and power from the exercise of the discretion. Second, it creates an extreme disincentive for the administrators of spending programs to adjust their policies. Cash management means that payments tend to be directed towards “hot spots”. One can generate

DEFINITION

To define “public finance management” we follow Ter-Minassian, Parente and Martínez-Mendez (1995) and include five basic functions of budgetary and financial management of government operations:

a. formulation of budgetary and tax policies, within the overall framework of macroeconomic policy;

b. budget preparations: formulation and evaluation of budget estimates for revenues and current capital outlays, and the elaboration and presentation of the budget to Parliament;

c. budget execution: execution and control of central government operations, as well as monitoring of the operations of extrabudgetary funds and local governments;

d. financial operations associated with the execution of the budget: cash management, maintenance of registers of government assets and liabilities, issue of government securities and guarantees, internal and external public debt management, and foreign aid management;

e. accounting and financial information systems: accounting for the operations of the central government, as well as the control and development of the government accounting and financial information systems;

f. auditing and evaluation: assessment of the compliance of the budget execution with the approved budget and other legal provisions, and more recently, analysis of the cost effectiveness of the use of public resources. This function is distinct from and complementary to, that of external auditors reporting to Parliament.

These functions are generally accomplished by the Ministry of Finance, with the central bank accomplishing some ancillary functions as an agent of the MOF. The MOF carries out several other functions of an administrative and regulatory nature (including the preparation of financial legislation, monitoring and control of non-bank financial intermediaries, financial monitoring and control of state-owned enterprises, and the regulation of wages and conditions of service of government employees) but these functions are outside of the basic budgetary and financial management functions of government.

FUNDAMENTAL QUESTIONS

a hot spot by accumulating large unpaid claims on the government so that the best strategy for a bureaucrat is to change as little as possible, and to keep accumulating the claims. An administrator who attempts to learn to live within the available budget does a disservice to his organisation, because it reduces the likelihood and the frequency of receiving funds. The persistent use of sequestration delays fiscal reform. While in terms of cash flows it may appear that the government is reducing its role, the actual range of activities and programs remains largely unchanged. Many of these activities remain unpaid for long periods of time, which only serves to reduce their efficiency even further. In other words, it is possible to say how many millions of roubles or hryvnia are spent on education, for example, but it is no longer possible to say what kind of education policy this buys. As a result, the government has no information to trade-off different priorities or to assess effectiveness and efficiency of spending. Fiscal policy is reduced to deciding what proportion of GDP to allocate to which spending ministry (Alex Sundakov, personal communication, 2/21/01).

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Ideally, in order to improve the design of our projects, we would need to have a satisfactory answer to the following question: What kind of reforms in public finance management are necessary for improvements in fiscal performance?2 In other words, what is it that really matters when it comes to budgeting? Is it having clear and transparent rules of behavior or incentive schemes? Or can financial discipline be enforced through better accounting, better reporting or better payment technology? How important are other factors for fiscal performance such as (a) having credible commitment mechanisms (budget rules) to limit the deficit and/or reduce the discretion of spending ministries; (b) controlling payments ex-ante against budget appropriations; (c) having frequent reporting and/or transparent budget information; (d) having efficient cash management (inter alia to reduce public borrowing needs); or (e) operating in a multi-year budgeting framework to lengthen the planning/policy horizon?

The answers to such questions are difficult because it is not clear whether we can disentangle the effects of individual institutional reforms on fiscal performance. Public finance management reforms involve a combination of changes in organizational incentives, institutions (rules) and information technology including Procedural rules for the preparation, discussion by the legislative branch and execution of the

budget, and institutional commitment mechanisms (such as balanced budget rules, Maastricht targets etc) to prevent overspending and to force relevant spending ministries and decision makers to balance what is affordable in aggregate against the policy priorities of the country.

Accuracy and transparency of fiscal data for the general government Making sure that the largest possible share of public expenditures is subject to the regular

budget process. This means in particular limiting the number of autonomous extra-budgetary funds.

Expenditures have to be predictable and be planned in a multi-year perspective (rather than having annual ad-hoc, “wish-list driven” spending decisions).

Treasury system to improve budget execution, make all government payments from a single account, control ex-ante any such payment against budget appropriations, and record them in a general ledger. The efficiency of cash management is improved by keeping cash centrally available at the single account and, thus, by reducing public borrowing needs.

To have more precise answers, we would need to carry out quantitative analyses of the impact of PFM reforms on fiscal performance. In this context, a major difficulty is the question of institutional endogeneity.3 As the institutions governing public finance management are themselves in flux in the countries considered, can we really test for the effects of these institutions? To solve this problem, it seems that we would need a two-equations approach: One equation for the impact of institutions on public finance performance and one equation for the “supply” of institutional quality.4 The latter would explain what kind of choices countries made in the development of their public finance institutions.2 Whether “performance” is measured in terms of reducing the fiscal deficit; not increasing the public debt; improving the allocative efficiency of public expenditures; or improving managerial efficiency and cost-effective use of public funds.3 Jürgen von Hagen, personal communication, 12/27/2000.4 Building such an equation could start with some simple facts. What has been the sequencing of reforms (i.e. which of the problems listed in the introduction were addressed first)? What is the role of international organizations such as the World Bank, IMF, OECD (Puma), EU (Phare/Tacis)?

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Previous research has largely focused on the effects of public finance institutions on deficits and debt and total spending.5 An important contribution from future research could be an answer to the question: Do good institutions help governments pursue fiscal priorities, for example: do they protect public investment or other long-term oriented elements of fiscal policy against changes arising from short-term fluctuations? Do good institutions lead to more consistent fiscal choices?6

Initial conditions are important, too. Where deficit and debt problems were important at the start of transition, adopting good quality institutions is more likely than in countries where these problems did not exist. There is probably also a connection to monetary policy: Hard-currency regimes such as currency boards are conducive to greater attention to fiscal conditions.

AN OPERATIONAL APPROACH: THE EXAMPLE OFTHE SLOVAK PUBLIC FINANCE MANAGEMENT PROJECT

There is no review of all public finance management-related projects undertaken by the Bank in the ECA region since the beginning of the transition (including both Treasury systems and support for reforms in budgeting and strategic planning of public expenditures). Such a review—drawing the main lessons from the experience of countries that have moved from planning-style public finance management to market-oriented public finance management systems—would be useful to improve our operational approaches.

In the absence of such a review, however, I will venture the hypothesis that, until recently, there has been too much emphasis in our projects on information technology and not enough emphasis on improving rules of behavior or incentive schemes in order to achieve financial discipline.

The Slovakia Public Finance Management Project, currently under preparation, proposes an approach which combines emphasis on incentives in the institutional/management structure with improvements in information technology.

Background

Slovakia is facing important fiscal challenges during its process of accession to the European Union. The general government deficit excluding privatization revenues, called guarantees and bank restructuring costs amounts to 4 percent of GDP in 2001. This represents a fiscal expansion with respect to 2000. However it does not raise concern in international financial markets

5 There is a large empirical literature measuring the effects of fiscal institutions on fiscal performance (see von Hagen 1992; Poterba and von Hagen 1999; Strauch and von Hagen 2000 and, for Central and Eastern Europe, von Hagen and Gleich 2000).6 Several theories about choosing management structures are tested in the recent political economy literature. For instance, von Hagen and Hallerberg suggests that countries with coalition governments are more likely to adopt medium-term frameworks and targets to guide fiscal choices than countries with one-party governments. The reason is that the internal structure of government is more adequate for such an approach when government consists of more than one party. Single-party governments tend to rely more on the leadership/management role of the treasury to secure fiscal discipline.

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because it is being underpinned by a strong package of structural reforms in the public sector agreed with the IMF and large privatization-related foreign direct investment inflows. The general government deficit is expect to decline to 2.2 percent of GDP by 2004. 7

The debt/GDP ratio does not pose, by itself, a serious problem. It was around 31 percent at the end of 2000—well below the Maastricht Treaty threshold. However, the significant increase in the public debt in the last five years (by 9 percentage points) and the high level of state guarantees (more than 15 percent of GDP) are matters of concern. Moreover, the share of foreign-currency debt in total debt is relatively high (52%) and the fact that about 1/3 the foreign debt is in non-euro currencies exposes the debt portfolio to a considerable exchange risk, thereby increasing the vulnerability of the economy to external shocks.

Reducing the fiscal deficit implies that the Government must urgently modernize its public finance management system and that the institutional capacity to manage public expenditure and the public debt needs to be developed. Improvements are needed in budgeting, financial planning; cash management, debt management, public accounts, payment system, public expenditure management and financial control. For external debt management, in a potentially volatile international financial environment, the benefits gained by Slovakia from prudent macroeconomic management and structural reforms could be compromised by losses caused by unexpected changes in foreign interest rates and exchange rates.

Government Strategy

The Government is introducing important reforms in the management of public finance including

(1) the creation of a Treasury and of a Debt and Liquidity Management Agency; (2) developing its capacity to carry out budgeting in a medium term fiscal framework; (3) the elimination of all extra-budgetary funds; (4) a major overhaul of its budgetary legislation and (5) improvements in budget classification.

Treasury. The reforms include the establishment of a modern system of public finance management and the development of the institutional capacity to support this system. The reform involves creating a State Treasury in the Ministry of Finance and, within the State Treasury, of a Debt and Liquidity Management Agency and putting in place management information systems. The country’s institutional capacity to strategically plan such a reform and manage the transition to a new public finance system is very limited and the Government urgently requires assistance in this area. Improvements in recruitment and personnel training will also be required to improve the quality and efficiency of public finances.

Fiscal Framework. The Government agrees that administering more efficiently public expenditures requires the development of a capacity to carry out budgeting in a medium term fiscal framework, with a multi-year rolling budget. The MOF has issued (in October 2000) medium term macroeconomic forecasts for 2000-03, an important first step in the development of a consistent fiscal framework. The fiscal framework being developed has two objectives.

7 See Annex on Macroeconomic and Fiscal Developments for details.

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(a) Aggregate fiscal discipline. Credibility of the macroeconomic framework requires not only realism in projections for aggregate revenue and expenditure, but also a check on the consistency between projected aggregate expenditure and the aggregate cost of existing policies at sectoral level. Social expenditures including health insurance, pensions and unemployment compensation are the priority areas that the government needs to focus on.

(b) Budgetary Strategy. A medium term framework would strengthen the process of strategic allocation in the budget. Review and revision of the framework would become a routine feature of the budget cycle, occurring early enough to set broad parameters for the budget. A strategic cabinet decision would be made during the first half of the cycle, prior to MOF circulation of detailed guidance on preparation of the annual budget. The process would ensure that major features of budget strategy are decided according to an open and contestable process.

Budgetary Institutions. The reform of public finance management involves the elimination of all extra-budgetary funds (except the Nuclear Fund) and the integration of their finances into the state budget. These funds, in particular the Road Fund, have accumulated a large debt (equivalent to 3.6% of GDP in 1999) and their expenditures systematically exceed their revenues. The state budget spends on average 1% of GDP per year to “subsidize” them. The extra-budgetary funds will be integrated into the state budget by January 1, 2002.

Fiscal Legislation. In conjunction with the above mentioned reforms, a major overhaul of the legislation on the budget to establish new rules for budgeting (State Treasury Act, State Debt and Guarantee Act, Budgetary Rules Act, etc) is planned. Moreover, a political decision has been taken to devolve more fiscal authority to regional and local levels of governments—which represents a complication for the reform of public finances. On February 23, 2001, the Národná Rada adopted a constitutional amendment which allows decentralization to be approved by a simple majority in Parliament. The existing legislation will also need to be amended to reflect the new tax and expenditure assignments to the regions and local governments.

Budget classification. The reform also includes the introduction of a functional budget classification in accordance with international standards starting with the 2002 budget. The Ministry of Finance is moving gradually toward the adoption of program budgeting.

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Sector issues to be addressed by the project

Initial assessment

We have some concerns (conveyed to the Government in our January 18, 2001 Aide Memoire) about the present state of the public finance management reforms. There appear to be some strategic gaps in the Government’s project design. In particular we

miss a vision of the main linkages between the institutions in charge of macroeconomic policy, budget, debt management and liquidity management/treasury. We would recommend that conceptualization and strategy formulation be done by a unit that is distinct from the Treasury Project Department, which must deal in detail with the demanding implementation of the IT component.

Managing the transition from the current to the future system will be crucial to the success of the project, and requires that project management have significant inter-ministerial inputs to the steering committee. There is also a need for more involvement of the National Bank of Slovakia and of key line ministries/agencies in the project process.

In terms of timetable, the Treasury Project Director envisages a 14-month development period and about 2-3 years for the overall project implementation, including the connection of 3000 spending units and budget institutions. Global experience suggests that this timetable is too optimistic, thereby increasing the associated risks. We will need to carefully define what can be achieved in 14 months and to identify “quick wins.”

We are aware of the fact that procurement for the Treasury Project (tender for the supply of information systems for the Treasury) is at a very advanced stage and that the Ministry of Finance has selected three hardware manufacturers that have met the tender criteria. We would advise to carry out some supplemental preparatory work before the basic IT system is procured. Presentations of packaged software features to the steering committee and to major users would also be desirable.

Debt management reforms could proceed in parallel on a fast track basis. It would be important, of course, that basic system designs and institutional arrangements take into account the various activities that are proceeding under the broader project. The MOF wishes to integrate debt management and cash management operations in a single agency. An early in depth analysis of the advantages and disadvantages of such an institutional setup is required. Reforming the domestic debt market (market organization, rules and participants) and the overall legal framework for debt management—in order to allow for more flexibility and room for maneuver—are priority tasks for the debt management agency to be created.

Project Components

The proposed World Bank project would support the Government’s reforms in public finance management:

(i) by assisting the Ministry of Finance in developing a program to strengthen the government’s institutional capacity for budgeting and for expenditure management;

(ii) by providing overall guidance for the implementation of the Government’s treasury project;

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(iii) by assisting the government in the creation of a debt agency, reforms of the domestic debt market and the legal framework for debt management and the debt market.8

The project would finance technical assistance to build up the capacity to manage the public debt, to maintain use of the framework as a routine feature of the budgetary system, and to provide guidance for the implementation of the treasury project. Technical assistance would include a range of services including consultant services in legal, institutional and IT areas and training of staff.

The project would finance

(a) Technical Assistance to strengthen the institutional capacity for budgeting and expenditure management in a medium-term expenditure framework

(b) Support activities for the Treasury project implementation, including: (i) A resident advisor for the overall coordination of the project, (ii) Change Management, incl. “marketing” of the project to end-users and

development of a common interministerial vision (team of 3 to 4 consultants working with the MOF and the line ministries officials during five months)

(iii) International benchmarking (one senior consultant over a six months period, as well as study travels abroad, seminars and various presentations for large audiences made by international experts)

(iv) Blueprint and modernization plan (two consultants during three months) (v) Remaining operations organized and monitored by two or three specialized

senior consultants intervening on a regular basis throughout project implementation.

(c) Technical assistance to set up the Debt Management Agency and design a new legal framework for debt management, including:

(i) A resident advisor to assist in setting up the Agency [possibly financed through a Project Preparation Facility in order to accelerate recruitment]

(ii) Technical assistance for various institutional issues (division of labor between liquidity and debt management, organization of middle office and back-office functions, etc); recruitment/personnel policy and wage structure; market reform (rules, participants and organization of the domestic debt market) and design of the new legal framework for debt management.

8 Progress on each of these components will not proceed evenly. For budgeting, the immediate priorities will be to use the framework as a check on the consistency of macroeconomic projections, which will imply aiming to capture adequately sectoral policies with major fiscal implications, rather than comprehensive sectoral coverage. In terms of expenditure management, it is suggested that initial focus be on selected areas that have important fiscal and macroeconomic implications, such as health care finance , social benefits and assistance, and key sectors such as transport.

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Project Rationale

During the original CAS discussions with the Government, a Public Sector Adjustment Loan supporting policy reforms in the public sector was envisaged. It soon became clear that (a) the country currently enjoys large FDI inflows and does not have a balance of payments need for adjustment lending; (b) the country’s main constraint is capacity in the public sector. What the country mostly needs is to build up its capacity for planning, preparing and executing the budget.

Lessons from Other Operations Reflected in Proposed Project Design

Project activities build upon the policy dialogue between the Government and the Bank in recent years. The need to strengthen the management of the public sector, and public finances in particular, is underlined in the recent CAS and in the EFSAL (June 2001 Board). In 2000-01, the Bank has produced several ESW pieces of relevance for this project: a report on Extra-budgetary Funds (prepared by the former State Secretary of Finance of Hungary); a report on Public Debt Management Issues (prepared by the Head and the Director of research of the Portuguese Debt management Agency); an assessment by Bank staff of the Government's Strategy for Building the Treasury System; and a report on budgetary rules for decentralization.

The World Bank has been involved in the reform of budgetary institutions and in improving the management of public finances in several Europe and Central Asia (ECA) countries including Hungary, Kazhakstan, Ukraine and Russia. The reforms supported by the Bank have, broadly speaking, four main objectives: (a) securing aggregate fiscal control and macroeconomic stability in the medium term; (b) enhancing the transparency of government decisions (and therefore the accountability of officials and political sustainability of the programs); (c) improving the allocative efficiency of public expenditures; and (d) promoting operational efficiency and cost-effective use of public funds.

Specifically on public debt management, this project benefits from other World Bank activities (including an IDF for the Czech Republic: Building institutional capacities in fiscal risk management, a Debt Management Technical Assistance LIL project in Thailand, the Public Finance Management Project in Hungary, and a Debt Management Implementation Plan for the Ministry of Finance of Poland) and general Bank's expertise in the public finance management area. The project also benefits from the integrated approach towards public debt management and risk management which is emphasized in the Guidelines for Public Debt Management developed jointly by IMF and the World Bank to assist countries to reduce financial vulnerability.

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Indications of borrower commitment and ownership

The borrower is strongly committed to these reforms. Reforms in public finance management have been agreed upon with the IMF in the context of a staff monitored program (SMP) and form part of the EU accession negotiations package.

Value added of Bank Support in this project

The Bank has a vast project experience in the area of public finance management. The Bank is also uniquely placed to play a substantive role of coordinating and “orchestrating” assistance (EU/PHARE and other external partners) to achieve the objectives mentioned above.

Background on Individual Project Components

COMPONENT 1. Institutional Capacity for Budgeting

The institutional capacity to prepare and execute the budget and to manage public expenditures is very weak in Slovakia. This issue is not addressed by the Treasury project document adopted by the Cabinet. Administering more efficiently public expenditures (amounting to SK 330 billion or 40% of GDP in 2000) would require the development of a capacity to carry out budgeting in a medium term expenditure framework (MTEF) and significant improvements in expenditure management. A first important step in the development of a consistent resource framework has been achieved in October 2000 by the MOF by developing a medium term macroeconomic forecasts for 2000-03.

Budgeting in the context of a medium term fiscal framework is a complex task requiring a radical shift in the way in which business is done in the public sector. Success hinges on a variety of factors, including: political commitment and endorsement at the highest level (Cabinet) to make and abide

by the difficult decisions involved in the restructuring of expenditures. Some ministries may need to scale back their activities so that more resources can be directed to higher priority sectors;

willingness to subject policy decisions with financial implications, made outside the budget process, to the discipline of the MTEF;

understanding of, and commitment to, the difficult decisions at the sector ministry level; commitment at all levels to abide by the budget decision so that new expenditure

decisions are not introduced during budget implementation that would require reallocation of resources;

improvements in expenditure control so that decisions are not undermined by over-expenditures and reallocation of funds during budget implementation;

improved macroeconomic management and revenue collection so that revenue shortfalls do not necessitate adjustments to the budget estimates;

strong management of assistance from EU-PHARE and other donors to ensure that they operate within the framework of the MTEF;

improvements to expenditure reporting on results.

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During appraisal of the project, we would need to develop a plan to progressively install the capacity to put in place these elements over a period of 3-5 years. The first priority is to use the medium term framework to check the consistency of macroeconomic projections and to ensure the commitment of line ministries and agencies. Rather than looking for comprehensive sectoral coverage, the first step would be to capture adequately health care (and possibly pension) policies which have major fiscal implications.9

COMPONENT 2. Treasury Project Implementation

The Slovak Government approved in July 2000 a “Strategy for Building the Treasury System by 2002” which is an important strategy paper and defining the objectives to be achieved in nine areas

Financial planning and budget preparation, Cash management, Debt management, Assets management, Consolidated accounting, Centralization of revenues, Payment system and Treasury single account, Public expenditure management, Financial control.

The document describes the present state of the public finance system and its shortcomings, and also includes a project schedule, cost estimates, a brief comparative study of the experience in four European countries, a brief inventory of the project risks and a financial return assessment. The document provides a clear summary of the main functional features of the future system. The document went through a long preparation process, integrates the contributions of several foreign experts and reflects important teamwork within the Ministry of Finance.

The assessment of the Treasury project given below is based on two brief missions by Bank staff in October 2000 and March 2001 and on the written documentation (strategy document and request for assistance) provided to us by the Project Director. We have not been presented with detailed documentation on the current state of implementation of the project.

9 The Government recently took the decision to decentralize, which represents a complication for public finance management. The existing legislation needs to be amended to take into account the transfer of fiscal authority to regional and local governments. On February 23, 2001, the Národná Rada (parliament) adopted a constitutional amendment which allows decentralization of public administration (incl. the creation of regions) to be approved by a simple majority in Parliament. New legislation is being developed will to define rules for the budgeting process of regional and local governments; and rules for their financial management and borrowing limits. The new legislation needs to (a) clarify the relationships between the state budget and the regional and local budgets; (b) define a sustainable budgetary resource base for regional and local governments; (c) determine clear criteria of allocation of shared taxes; (d) define financial equalization mechanisms; and (e) define the limits of regional and local governments' indebtedness and rules for regional and local borrowing. During appraisal, we will discuss the institutional improvements and strengthening of capacity that are necessary to ensure the proper enforcement of the legislation.

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We have two basic observations about the project:

The Treasury project represents a major reform of the State. The main Treasury functions (budget preparation, cash management, public expenditure management, financial control, etc) are topics that affect the daily operations of line ministries. Therefore the latter need to be closely involved in the process.

The strategy paper provides an excellent starting point for the project but is insufficiently detailed to proceed with implementation.

Overall Strategy

The following comments can be made about the Treasury project as envisaged in the document:

Sequencing and Planning. The document envisages only four main steps in the process of Treasury system implementation (“preparation”, “pilot testing without the information system support”, “pilot testing with the information support” and “overall extension”) and spells out only the starting point for the three first steps with no indication of planning breakdown per ministry or agency. Since the Treasury project encompasses large functional domains and will involve a considerable number of ministries and financial institutions, there is a need, especially at the strategic level, to describe more explicitly the sequencing of operations (i.e., the rationale for implementing a component before the other) and to specify in details the planning of the project spelling out in details the tasks to be accomplished by key government agencies.

Schedule. The Treasury project schedule is not realistic. It is unfortunately not reasonable to achieve all the steps involved in such a complex project (preparation, procurement, development and implementation) within a period of two years. Based on the international experience, the average duration of a project of such a scope is about 43 months. It is possible to organize the project in such a way that “quick-wins” can be implemented (see below) but the implementation of all project components require a period of 4 years.

Financial Costs. The financial schedule is not realistic and needs to be thoroughly revised. Overall, we estimate that the cost of the project may exceed the budget described in the ‘Strategy’ document by 30 to 35%. Project costs appear to be under-estimated in three areas: Preparation costs. The future organizational and functional model needs to be spelled out

in more details. Important practical issues such as line ministry involvement, future relations with the National Bank for State accounting services, detailed classifications that are needed (budgetary, economic/functional, analytical or by program...), medium term planning of public expenditures and the expenditure commitment system must absolutely be addressed now, and these issues need to be added to the bidding documents.

Transition costs. Designing and implementing successfully such a radical change in administrative habits at the state-wide level induces additional costs. It is necessary to integrate into the project the costs of inter-ministerial management, communication plan, and “marketing” of the different project components to the main users.

Operation and Maintenance costs. The normal yearly maintenance of a packaged software usually represents 15 to 17% of its initial purchase and parameterization costs.

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Moreover, every two years a major upgrade is released and it is not recommended to skip more than one release to maintain the system up-to date. The cost of the implementation of those major upgrades may reach 25-27% of initial project costs. The government needs to integrate these costs in the budget of coming years.

In summary, our view is that the strategy paper is a good cornerstone for the project but is insufficiently detailed to proceed with implementation.

Present State of Project Preparation

The Treasury project has many very positive elements, including:

1. Political Commitment and Ownership. The Cabinet has endorsed the project, which has the full backing of the Minister. The minister herself actively presides the Steering Committee and closely monitors all key issues regarding the project (management, staffing and financing). This gives a lot of strength and credibility to the project.

2. The core team of IT specialists in charge of the Datacentrum is highly skilled and very committed. They have a sound technical background and are as cautious in developing the project technical architecture.

3. The project management structure that was selected, the prominent role given to the steering committee and the assignment of the management of the project to a treasury department are indicative of the quality of choices made on project management and staffing.

4. The issuance of the “red book” to inform Slovak officials on project implementation is an interesting first attempt to develop a real communication plan.

5. The various studies and preparatory works already achieved especially for what regards the future IT system functional and technical architecture represents important assets.

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Project Management Structure

There is a paradox in the project management structure. The Treasury project represents a reform at state-wide level and not only at the level of the Ministry of Finance. Its management structure must therefore reflect this fact. In spite of the fact that budget preparation, cash management, public expenditure management, financial control, etc are topics that affect the daily operation of line ministries, the project in its present management structure does not include line ministry participation. This situation is likely to lead, in time, to serious problems. On a number of functional and IT technical issues, detailed studies requirring the collaboration of line ministries must be performed especially during the project preparation phase.

The Budget Section and Accounting Section of the Ministry of Finance do not appear to be sufficiently involved in the functional preparation and control of the project. At stake, in the medium term, is the organization of the Ministry of Finance and the future of these sections and departments. Their directors and close deputies should actively participate in discussions on the design of the new functions and the control on their implementation. In all the countries where such projects have recently been implemented (Canada, Singapore, France) the leading role in modernization and functional preparation has been given to a prominent person from the Budget and/or Treasury administration.

The leadership for conceptualization and functional design and the responsibility for the implementation of the project should not be given to the same team. The appropriate control of a State-wide project requires a dual structure with a “functional team” controlling the progress of the “IT implementation team”. Moreover, experience shows that the day-to-day concerns of both teams are so considerable that responsibilities should not be given to a single person.

Within state administration, the number of officials involved in the project is insufficient to leverage the reform. There is a lack of a common vision of the project shared between ministries. The priority seems to have been given to the preparation of IT system implementation. However, the experience of similar projects in other countries shows that change must be managed. In order to be successful, each project component needs to be tailored to each category of “clients” (ministers, directors, managers, functional and IT specialists, and end-users) and each one of these categories urgently needs to be identified, organized and coached about on the nature of the reform, in such a way that they become natural “agents of change.” Numerous technical means exist to share efficiently and rapidly project knowledge. Far from being artificial and unnecessary “marketing,” this “change management” component of the project is a key factor for the success of the reform.

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Planning, Functional And Technical Preparation

The detailed planning schedule was never presented to the World Bank but the declared objective is still to complete the project in 2002. Such planning should be based on a more realistic schedule (4 years), and spelled out in writing in details, with the close help of the main state financial institutions and line ministries. It seems that the fiction that the project can be completed by 2002 prevents the management team from performing an in depth investigation of potential “quick-wins” for the project.

A four year horizon implies the necessity to quickly obtain results that can then be used to gain support in the Cabinet and political support. “Quick-wins” are simple organizational and IT realizations requiring an extensive IT network but only limited definition and development efforts. The classic example, which was implemented in several countries, is to install early in the project the overall scheduled IT equipment and inter-ministerial network and to use a workflow software together with common productivity software (such as electronic mail, word processing, spreadsheets, web-site designing software) to provide useful—though incomplete—solutions or processes improvements to end-users. The workflow for the annual budget preparation or the workflow for creating and approving budgetary appropriations, modifications and transfers is perfectly suitable for such an implementation. In the case of Slovakia, it is still time to design those “quick-wins” and to integrate them into the overall planning.

Supplemental functional and technical work is absolutely required before project implementation in three areas:

1. From a functional point of view, it highly advisable to agree on classifications since they represent the core parameters of the packaged software. We found no evidence during our missions that such work was being done. In virtually all countries, budget classifications inherited from manual processes

are a kind of “all purpose classification” collecting information with different dimensions (organizational, nature of expenditure and geographical dimensions). In a package software, on the contrary, financial records are sorted thanks to specialized classifications. Cross reports can be made using several classifications. Therefore it is of capital importance, before moving to the implementation step, to elaborate or review all the classifications and to specify each one of them to meet a precise objective: Budget, economic, geographic, analytic and investment programs classifications must be created (or “cleaned up”) to enforce their particularities and avoid inter-classifications redundancies.

A similar comment can be made regarding the organization of ministries and agencies to be connected to the future system and their related administrative chart for each given financial process. The workflow software included in all packaged software will require precise parameters and flowcharts to convoy its work to each end-user according to its professional profile and role. Before the implementation of the system, modernization and functional studies must reconsider all information flows, profiles and roles. Otherwise a considerable increase in project implementation costs will inevitably occur.

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2. All the works performed by the administration and the preparation work which is still to be performed should be spelled out and organized in a single blueprint summarizing project decisions

3. Finally a Modernization plan needs to be carefully spelled out with its classical parts:

Proposed Interministerial Management Structure

A revitalization of the project will require the close involvement and cooperation of line ministries and agencies. Moreover, the project structure can be reshaped to authorize both their real participation and still guarantee a close control of the project by the Ministry of Finance.

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Slovak Public Finance Reform Recommended Type of Inter-Ministerial Management Structure.

Public Finance Reform Steering Committee

(Chairman =Minister of Finance)

Inter-Ministerial Public Finance Reform

Commissioner(Permanent Secretary

of the Steering Committee)

Director of Treasury Project Implementation

Heads of Line Ministries and Financial + Audit Institutions

(I.e.: Central Bank)

“Change network” and Modernization working groups

World Bank TA Resident Advisor+ WB Consultants Staff

EU Counselor Delegate

Line Ministries End-Users Panels

Line Ministries Experts Panels

Line Ministries Co-Developers

Direction of Treasury Project Implementation

Development Unit

Implementation Unit

Operations & Maintenance(Part of Datacentrum)

Software Package Implementation Consulting Team

Development Unit

Implementation Unit

Operations & Maintenance

Stee

ring

, Mod

erni

zatio

n &

Com

mun

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ion

Stru

ctur

eIm

plem

enta

tion

Stru

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Line Ministries Public Finance Reform Correspondents

Components

Under the World Bank project, it is proposed to finance

A Resident Advisor to assist in the overall coordination of the project

Technical assistance in 5 different fields: 1. Strategic planning, Functional Definition, Blueprint and Modernization plan;2. Development of a joint governmental vision and a “change network”, Management of the

transition to the new system (also called “change management”) and Communication plan;

3. Legal regulatory and procurement advice;4. Project management support (including the intra/extranet project documentation

repository web-site development);5. Technical IT and telecom expertise.

COMPONENT 3. Public Debt Management

Objectives

Eliminating or substantial reducing foreign exchange risks will be hard to do in Slovakia because it will be near impossible to find swap matches for the size of the required hedging transactions. It may be worth considering, however, to replace foreign debt by domestic debt: i.e. to issue domestic debt – favoring a deeper domestic debt market – and pre-pay (purchase) foreign debt. Furthermore, swapping part of the non-euro related debt into euro-denominated debt could also contribute to the reduction of the overall exchange risk.

For the domestic public debt portfolio, debt management policy should enhance the liquidity of the government securities market by increasing the transparency and predictability of debt issuance, and creating liquid benchmark issues spread along the yield curve. Greater transparency could be attained by planning and reporting in advance the financing requirements of the government, the maturity structure of future borrowing, and the auctions dates of domestic debt issuance for the financial year. Greater predictability could be achieved by relying on regular and non-discretionary issuance, primarily through auctions. By increasing liquidity and attracting a larger investor’s base, the borrowing costs of the government can be lowered.

Debt management operations in the primary market are not transparent nor predictable. In fact, market participants consistently report that there is a low degree of commitment of the authorities to the schedule of auctions that is announced for each quarter; the dates of the auctions are frequently changed or postponed without previous notice and pre-announced tender amounts are often different from the amounts awarded. Hence, it is not possible to provide the market with a stable and foreseeable reference to schedule the investment of cash flows. Such practices, which are intended to avoid adverse market conditions in order to achieve short-run

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debt service cost objectives, if systematically adopted, affect the credibility and integrity of the issuing process, causing risk premia to rise and long-run debt service costs to increase.

Debt issuance practices do not increase liquidity and do not attract a larger investor base. Coupon interest rates of new issues appear to be systematically set below the secondary market levels. The bonds issued in this way are mainly placed in state-owned banks, at par, which do not receive the corresponding discount that would be expected in such circumstances. This practice, intended to attain lower budget costs, creates a barrier to entry in the market to entities with international standardized accounting procedures, mainly non-resident financial institutions. It not only diminishes liquidity, but also hampers the establishment of a wide and solid network to distribute debt.

When a bond issued in such a condition starts to be traded on the secondary market, it necessarily records a market price below the issuing price, originating systematic capital losses to the entity that bought it on the primary market at par. As foreign financial institutions operating in the Slovak Republic usually evaluate their portfolios on a marked-to-market basis, in accordance with international accounting standards, they would have to recognize those losses in their books. However, state-owned banks are not yet obliged to apply those standards. But although they do not recognize their potential losses, it reduces their capacity to actively trade on the secondary market. In a context where most state-owned banks are currently being privatized, these practices that disrupt the smooth functioning of debt market could affect the supply of funds to the domestic market in the near future.

Current Institutional Setup for Public Debt Management

In the current institutional setup for public debt management, the National Bank of Slovakia and the Debt Management Department of the Ministry of Finance share the relevant functions. The NBS cooperates with the MOF in the issuance of public debt instruments, including preparation of the issuance calendar and publishing the issuance conditions. The primary sale of public debt instruments is organized by the NBS (including conditions and rules of sale; contracting with market participants; registration of market participants; monitoring and market research preceding the sale; and carrying out the auctions themselves). The NBS administers the central registry of short-term Treasury bills and issues regulations for this registry; contracts with market participants; administers asset accounts of traders; keeps the record of trade transactions on Treasury notes on primary and secondary markets and of redemption of outstanding T-bills. The NBS is also in charge of foreign currency debt, including servicing the existing foreign debt service (payment of interest and redemption of credit principals to creditors in foreign currencies); participating in contracting new debts from multi- and bilateral agencies (such as loans from the World Bank, JEXIM, EIB, etc) and issuing eurobonds. The NBS participates in the preparation of documents related to new lending activities in foreign financial markets, and in its technical realization and verifies the trustworthiness of potential MOF partners that offer their services for sovereign borrowing.

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Government Reform Program

The MOF has taken the decision to integrate debt management and cash management operations in one agency within the State Treasury. The creation of this agency would be a crucial step to modernize its public debt management and, by making it more efficient, to minimize its cost and impact on budget expenditures over time. However, specific implementation plans have not yet been developed and some of the key institutions involved – the National Bank of Slovakia and the Debt Management Department of the Ministry of Finance – are only marginally involved in the reform process, possibly reflecting concern about the effects that implementation of the initiative could have on them. This is similar to the experiences in other countries and underlines the need to ensure the participation of all involved agencies for the transition to the new system to be successful.

Integrating debt management and cash management operations

The advantages and disadvantages of integrating debt management and cash management operations in a unique agency need to be analyzed in depth. For instance, recently, that was done in the United Kingdom, where the Bank of England transferred initially the debt management operations to the new Debt Office, and more recently (summer 2000) also transferred the cash management operations.

Because of its different dimensions, the term, 'government cash management' is often used loosely among policy makers, and governments have taken a variety of approaches in deciding where these responsibilities should rest.10 In general, however, government cash management objectives tend to be twofold. First, sound cash management practices are needed to ensure that government agencies (such as government departments) manage their cash balances efficiently, so that the government does not have 'surplus' cash on hand and consequently has not borrowed excessively in the capital markets and incurred unnecessary debt servicing costs and market risk. A second main objective is to neutralise the impact of the government's cash flows on the domestic banking sector, which arise from the government's fiscal policy and balance sheet management more generally. This is important in order to ensure that the government's transactions do not create large and unpredictable changes in liquidity in the banking system and undermine monetary policy.

At the heart of government cash management is the need to have an efficient government accounting system and sound procedures for monitoring and controlling government spending and forecasting revenues. Developing and maintaining these systems is a core responsibility of the ministry of finance.

Building a sound foundation for government financial management, budgetary analysis and responsible cash management requires government agencies to forecast their revenue and spending flows on a regular basis. While this information may be needed on a monthly basis (or more regularly) for budgetary analysis, government cash managers in developed government debt markets require this information on a daily basis in order to assess the size of the offsetting market transactions needed to neutralize the net cash injection or withdrawal into the domestic 10 Taken from Graeme Wheeler and Fred Jensen (forthcoming)

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banking system. Government debt management agencies in Finland, New Zealand, Sweden, the United Kingdom, the United States and several other countries require access to forecasts of expenditure and revenue flows by government agencies on a daily basis. Government departments and ministries may be required to forecast their monthly, weekly and daily spending and revenue patterns for the year as a whole, and comparison between those forecasts and actual departmental revenue and spending patterns provides valuable insight into the way in which the major government spending agencies are managing their cash flows.

It is not necessary for the government debt managers to be involved in collecting the forecasts of departmental revenue and expenditure. This data could be collected elsewhere in the ministry of finance (e.g. in a budget department or financial management department). It is, however, essential that the government debt managers have access to these forecasts and to comparisons with actual cash balances in order to gauge the size of the required liquidity management transactions, assess the quality of cash management in the different government agencies, and review and, if necessary, amend the government's overall borrowing program. If the central bank undertakes the liquidity management transactions as an agent for the government debt managers, they will also need this information -- although the central bank could also forecast liquidity flows based on historic patterns and by obtaining forecasts from the larger government agencies. The central bank could, for example, review previous years cash flow patterns to determine whether there is any marked seasonality.

At the same time measures should be considered to encourage heads of government agencies to take cash management seriously by improving the efficiency of their working capital cycles and reducing their daily cash balances. Sound practices might include collecting revenues and other receivables quickly and developing policies for procurement and the payment of creditors to secure the best pricing and payment terms. It may also include measures to ensure that the use of departmental bank accounts is rationalised and revenues are deposited quickly. For example, approval of the government debt managers may be needed to open every new government bank account. Sanctions and incentives to promote efficient departmental cash management can play an important role, because heads of government agencies are funded centrally and often do not otherwise bear the cost of their funding or the consequences of poor cash management. These sanctions could include reduced levels of funding or the payment of interest to the ministry of finance on excess cash balances. Government debt managers should be consulted in designing any system of sanctions and incentives and also be involved in considering issues such as: whether government departments should have check writing responsibilities (as opposed to this function being centralised within the ministry of finance) and whether departments should be free to manage their own banking relationships or whether there is merit in tendering out government departments' day to day banking business to a commercial bank in exchange for lower fees and an extended range of banking services.

Whenever possible, governments seek to separate cash or liquidity management transactions from the implementation of monetary policy. When the central bank is undertaking liquidity management transactions on behalf of the government debt managers, the debt managers will wish to see the size of the daily open market operations (or whatever instrument is used to manage government liquidity) match the forecast liquidity injection or withdrawal. For example, treasury bills might be used by the central bank to undertake open market operations

20

for liquidity management purposes on behalf of the government debt managers. If, for example, there is a very substantial net cash injection form the government to the banking sector on a particular day (e.g., associated with pension payments) the central bank could offset this by auctioning treasury bills to the commercial banks for the amount of the net injection. If, on the other hand, there is a very substantial drain from the banking system to the government (e.g., due to tax payments) the central bank could inject liquidity into the banking system by buying treasury bills equivalent to the amount of the net withdrawal of liquidity.

While the debt managers may be prepared to reject bids if they are uncompetitive, they would not wish to see the central bank alter the size of its daily open market operations with a view to signaling a change in monetary policy. If the central bank announced much larger open market operations than needed for the government's liquidity management purposes, and this involved selling Treasury bills or a similar instrument, financial markets would view this as a desire by the central bank for tighter monetary conditions and a firmer monetary policy. Similarly, where the government debt managers undertake their own cash management transactions, the central bank will be anxious to see that the daily liquidity transactions undertaken do not exceed the liquidity target as this could interfere with the central bank's implementation of monetary policy. Such a move could cause the financial markets to question the credibility of monetary policy or to assume that the government debt managers 'excess trades' represent a government interest rate view. Formal institutional arrangements such as agency agreements can be valuable in clarifying the responsibilities between the government debt managers and the central bank.

To summarise: Government debt managers in the UK, Sweden and Ireland (the French debt office has recently announced its intention to do so) undertake their own cash management transactions. It is unlikely that they can undertake these liquidity trades any cheaper than the central bank. The main benefit is that it gives the debt office greater market contacts and makes the separation from monetary policy more complete. The central bank, in turn, would be concerned to see that these transactions do not undermine monetary policy (i.e., that the volume of trades is consistent with the daily cash injection or withdrawal required). Where these transactions are undertaken by the central bank, they are often undertaken under an agency agreement which clarifies decision making responsibilities, and prevents the central bank from using these transactions to signal a change in monetary policy.

All this becomes much more difficult when the debt managers and central bank are entirely dependent on the primary market (and same set of borrowers, e.g., capture institutions) for funding the government's borrowing needs and conducting monetary policy. In this situation, regardless of who conducts the government's cash management, the main requirement is that the ministry of finance and the central bank work closely together, share information on liquidity flows and discuss ways of dealing with them.

Reforming the Domestic Debt Market Reform

Expectations of a “quick fix” of the debt structure and of immediate gains resulting from the establishment of a debt management agency need to be tempered. There are a number of factors that stand in the way of quick fixes and early gains, and that need to be addressed regardless of

21

the institutional arrangements for debt management. First, the domestic market is very narrow and limited in its possibilities and is not able to accommodate sizeable transactions, in particular if they involve sophisticated instruments. Second, the foreign currency component of the outstanding debt offers more possibilities for changing the debt structure (without reducing the total currency exposure). However, if the intention is to reduce the existing currency risk, this will imply higher interest costs (or similar costs), and, similarly, reducing interest costs will imply engaging in higher risks of another nature.

The planned debt management reform is an integral part of the wider and ambitious public finance management reform discussed above. Not all of the concerns expressed about the treasury project (see Component 2) would apply to the initiative to establish a debt management agency. Indeed, debt management reforms could proceed on a parallel basis, and in other countries establishment of a debt management agency has at times preceded the establishment of an integrated treasury system and the reverse has been the case in some countries as well. It would be important that basic system designs and institutional arrangements do take into account the various activities that are proceeding.

Reforming the domestic debt market (rules, participants, organization, etc) and the overall legal framework for debt management (in order to allow for more flexibility and room for maneuver) are tasks that are as urgent as creating a debt management agency. These reforms are the cornerstone for better debt management, regardless of the institutional arrangements that are envisaged. If the decision to create a debt agency is implemented in the short run, the reform of the domestic debt market and of the overall legal framework must be a priority task for the new agency. Market participants should be closely involved in the restructuring of the domestic debt market and of the legal framework, since they will be the key players in such market and the main vehicle for the implementation of the reforms.

There is an excessive proliferation of public sector entities that engage in general government borrowing, making it difficult to get a grip on the overall budget deficit and financing, and to obtain efficient borrowing terms. Centralization of the borrowing activity in a single entity is crucial to a more efficient management of the public finances. Without a single borrowing entity it would be very difficult to control the public deficit, in terms of either level or volatility, since it is extremely difficult to evaluate properly the risk exposure of the sovereign debt. Centralization of borrowing prevents public entities other than Central Government (as represented by the Ministry of Finance) from drawing on futures taxes (needed to repay debts) to circumvent existing budget expenditure restrictions. With centralization of borrowing, only Government itself, with authorization of the Parliament, will be the legitimate entity to incur future tax obligations. The Government’s decision to abolish all extra-budgetary funds and incorporate their functions into the overall budget, represents an important step towards more effective controls and management of debt.

In terms of governance arrangements, asset/liability management in Slovakia is currently not consistent with the best governance practices developed by the European Union member countries. Asset/Liability Management institutions must become more accountable, transparent, and streamlined. Coordination between government agencies so far has been inadequate at both

22

strategic (goal-setting) level and operational (transaction) level. This yields a sub-optimal debt management strategy, as demonstrated, for example, by excessive costs of government debt servicing. Transaction flows in the current Asset/Liability Management system should also be streamlined, and Treasury cash management needs to be improved.

Project Sub-Components

In accordance with the request from the Slovak authorities, the component will (1) support the establishment of a Debt and Liquidity Management Agency within the

State Treasury in the Slovak Ministry of Finance; (2) assist the government in reforming the domestic sovereign debt market (organization

of the market; selection of participants, organization) and the overall legal framework for debt management;

(3) provide assistance and training to develop the risk management systems of the Agency with three dimensions: risk measurement, risk assessment and integration with Front and Back Office systems.

The Subcomponents are:

1. Strategic and Preparatory Work to Reform Debt and Liquidity Management. Local and international consultants, including a resident adviser to the Minister of Finance, would carry out the following preparatory tasks:

Analyze alternative institutional setups for the agency, in particular consider the advantages and disadvantages of integrating debt management and cash management operations in a unique agency.

Develop an approach for asset/liability management consistent with the best governance practices developed by the European Union Member Countries to ensure financial accountability and transparency, as well as coordination between public agencies at both strategic (goal-setting) level and operational (transaction) level.

Define the tasks of the agency, including its role in promoting liquidity of the government securities market

Define the relationships of the agency to the Ministry of Finance, State Treasury, National Bank of Slovakia (coordination of the liquidity and debt management with central bank monetary policy) and financial community.

2. Assistance in Setting Up a Debt and Liquidity Management Agency within the State Treasury in the Slovak Ministry of Finance. A team of local and international consultants, including a resident adviser to the Minister of Finance, would assist in the following tasks:

Prepare the legal act establishing the agency Prepare the statutes of the agency Prepare the legislative package for liquidity and debt management outsourcing Set up the organisational structure of the agency and division of responsibilities between

departments

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Define the principles of financing the operational costs of the agency Define a recruitment strategy for the staff of the agency Amend or Prepare legislation on public debt and public guarantees Amend or Prepare legislation on the government securities market Define the accounting principles of the agency Define responsibilities for approving guidelines and internal procedures Set up principles of performance evaluation Set up control mechanism for liquidity and debt management operations Define liquidity and debt management reporting requirements.

3. Develop Risk Management Systems. Initially there will be a need to upgrade the Middle Office (risk analysis) functions in the Government Debt Department of the MOF and, at one point, to transfer them to the agency. The Agency will need to develop its risk management systems along three dimensions: risk measurement, risk assessment and integration with Front and Back Office systems, on both debt and reserve management side. As a starting point, the MOF will need to improve the recording of their asset/liability positions. The information system(s) should consolidate information on all debt management instruments and should allow the authorities to actively manage portfolio risks against preset performance benchmarks. Other necessary improvements are better compliance checking, performance measurement of active dealing, and attribution analysis of performance. Public debt data should be concentrated in one system in the agency, and should be used to improve the accountability of fiscal agent functions that the NBS will perform for the MOF. Staff skills in risk management should be improved via specialized training programs.

4. Capacity Building in Decision-support, Reporting and Analysis. Efficient procedures for public finance management rely on strong reporting and analysis capacity to support strategic and operational ALM decisions. This capacity must be employed to evaluate the performance of the Government’s asset/liability portfolio and its individual components, conduct its stress-testing according to the different risk dimensions, and enable the decision-makers to select and apply optimal risk management strategies. Specialized analytical software should be implemented to develop portfolio models, cash-flow and stress testing scenarios, to identify the vulnerability of the government’s A/L portfolio to specific shocks and risks. Analytical reports should be designed and made available to relevant decision makers, other appropriate government agencies, the legislature and to investors, to improve the country’s creditworthiness profile; and to the broader public to strengthen the transparency of the Government’s asset and liability management policy. Staff of the agency should be trained to conduct such portfolio risk analysis.

Expected Outcomes

Choice of institutional framework. The project will assist the authorities in analyzing the options available; selecting the appropriate institutional framework for the new public debt and liquidity management agency, given Slovak circumstances, and in drafting the legislation and status of the agency.

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Debt management and financial analysis system is upgraded and expanded: The fully integrated debt management system will support debt and asset management operations. This will significantly improve the Ministry’s analytical and reporting capabilities. It will also allow the Ministry to provide timely and efficient information to its management, to the public, and to investors.

Monitoring of public assets and liabilities improved: This will allow for better preparation with respect to borrowing decisions as well as with respect to the government's capability to monitor its on-lending operations and the granting of guarantees.

Risks of public debt and assets identified and controlled: Introduction of modern risk management techniques and appropriate decision-making regulations will enable debt management to be carried out under controlled risk parameters. This will greatly add to the sustainability of public finances.

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Annex.11 SLOVAKIA: MACROECONOMIC AND FISCAL DEVELOPMENTS

A. Macroeconomic Performance After Independence

1. Slovakia registered one of the best macroeconomic performances in Central Europe after its independence from the Czechoslovak Federation in 1993. As shown in Table 1, inflation declined to single digits in 1995, one of the lowest inflation rates in the region. At the same time, the economy initiated a strong, export-led recovery, despite a contraction of fiscal and investment expenditures. The initial output recovery seemed sustainable, as it was based on exports, and took place in a context of small fiscal deficits and current account surpluses. The prospects of high growth were reinforced by the highest investment ratio in the region, and the expectations of improved investment efficiency driven by fast privatization. By early 1996, Slovakia seemed destined to become one of the leading performers in Central Europe.

2. In the 1996-1998 period, however, the current account shifted to persistent deficits of about 10 percent of GDP, driven primarily by a dramatic increase in fixed investment (Table 1). The sharp investment expansion did not raise much concern initially, as there were hopes that such large investment outlays would increase export capacity and eventually repay themselves. However, it became apparent that much of this increase in investment included sub-optimal projects driven by perverse incentives, generous public guarantees on foreign borrowings, extensive political interference in bank lending, and weak corporate governance. The inefficiency of many investment projects was progressively revealed by the widespread reports of corruption and the lack of enterprise restructuring (reflected in growing enterprise losses).

3. The increase in the current account deficit was exacerbated by an expansionary fiscal policy, as indicated by the shift from a fiscal surplus of 0.4 percent of GDP to deficits of around 5 percent of GDP. These numbers understate the full extent of the expansionary policy, since large contingent liabilities were also built up in the form of extensive guarantees on foreign borrowings of enterprises and extra-budgetary funds.

4. In an effort to offset increasingly lax fiscal policies, and prevent the current account from deteriorating even further, the National Bank of Slovakia (NBS) progressively tightened the monetary policy from 1996 to 1998. This policy contained the current account at 10 percent of GDP, but at the cost of very high real interest rates (real lending rates in excess of 20 percent p.a.) and repeated periods of turbulence in the foreign exchange market. The tight monetary policy was ultimately not able to sustain the exchange rate in the face of speculative attacks related to the Russia crisis, forcing the NBS to float the currency in October 1998.

11 From Enterprise and Financial Sector Adjustment Loan (EFSAL) President’s Report

Table 1: Key Economic Indicators, 1993-2000(in % of GDP unless otherwise indicated)

Post-Independence Growth with External Balance

Emergence of Internal and External Imbalances

Period of Stabilization and Reform

1993 1994 1995 1996 1997 1998 1999 2000 Real SectorReal GDP growth (% p.a.) -3.7 4.9 6.7 6.2 6.2 4.1 1.9 2.2CPI Inflation (% p.a.) 23.2 13.4 9.9 5.8 6.1 6.7 10.6 12.0Unemployment rate (%) 12.9 14.6 13.7 12.6 12.8 13.8 17.5 18.2Exports/GDP 58.4 61.6 59.8 55.2 58.0 61.2 61.5 73.5Fixed Investment/GDP 31.6 28.3 26.4 34.2 35.9 38.0 30.8 30.0General Government1/

Overall Balance/GDP -6.6 -1.2 0.4 -1.3 -5.0 -4.8 -3.6 -3.3Primary Balance/GDP -3.6 2.4 2.6 0.8 -3.2 -2.5 -0.8 -0.7Expenditures/GDP 48.5 45.1 45.7 46.6 47.7 44.9 44.8 41.4Debt/GDP .. 25.0 22.8 27.4 29.7 30.4 31.4 31.8External AccountsCurrent Account Balance/GDP

-4.7 4.6 2.1 -10.6 -9.6 -10.0 -5.7 -3.5

Foreign Direct Investment/GDP

1.1 1.6 1.1 1.0 0.4 1.5 3.5 10.0

Gross External Debt/GDP 26.9 32.0 30.9 38.8 48.4 55.9 53.4 56.6Net External Debt/GDP .. .. 2.9 10.0 16.6 27.4 31.1 27.61/: For 1998-2000, excludes privatization revenues and called guarantees.

THE GOVERNMENT’S REFORM PROGRAM

27. Stabilization Efforts Since 1999. Following a renewed bout of currency turbulence in May 1999, the new Government introduced a package of stabilization measures which resulted in a nearly 2 percent of GDP improvement in the primary deficit (Table 1). The new Government also significantly increased administered prices (gas, electricity, heating, post, and railways), curtailed the granting of guarantees, and began structural reforms in the enterprise and financial sectors. These reforms resulted in a sharp decline of fixed investment from 38 to 31 percent of GDP which, together with the tightened fiscal stance, contributed to a significant reduction in the current account deficit to 5.7 percent of GDP in 1999. The tightened fiscal stance allowed the NBS to ease monetary policy somewhat. The improved policy mix and the structural reforms contributed to a sharp reduction in real interest rates, a nominal appreciation of the koruna, an increase in foreign reserves, and a rapid decline in the spreads on Slovak eurobonds (Figure 1).

28. The deficit of the General Government was unchanged in 2000, but the current account deficit declined further to 3.5 percent of GDP. This improvement was underpinned by strong export performance, following the acceleration of growth in the EU and strong productivity growth in exporting industries. At the same time, import growth was contained by a further

2

decline in fixed investment (to 30 percent of GDP) and by a sharp 3.4 percent reduction in real private consumption resulting from a second round of increases in administered prices and the decline of real wages. Most importantly, FDI flows reached 10 percent of GDP, exceeding the current account deficit by a wide margin and leading to a reduction in net external debt for the first time since 1993 (Table 1). The large FDI flows were in part the result of the successful privatization of the Slovak telecom company. However, non-privatization related FDI reached nearly 4 percent of GDP in 2000, reflecting the Government’s policy of encouraging the entry of foreign capital.

Figure 1: Selected Economic Indicators

3

Real Interest Rates, 12 month moving average

-505

101520

1/1/95 1/1/96 1/1/97 1/1/98 1/1/99 1/1/00

Real ST Deposit Real ST Lending

Credit to Enterprises in Percent of Total Credit

70%

80%

90%

1/1/93 1/1/95 1/1/97 1/1/99

Reserves, excluding gold

2450

2950

3450

3950

4450

Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00

Stabilization package introduced

Yearly Growth of Money and Credit

05

10152025

1/31/96 1/31/97 1/31/98 1/31/99 1/31/00

Broad Money Total Credit

Slovak Eurobonds: Spread over German Bunds

100150200250300350400450500

12/28/98 6/28/99 12/28/99 6/28/00

8.0 % DM1,000 mn 2003 7.500 Euro500 mn 2004

Exchange Rate v.s. Euro

37394143454749

1/2/98 7/2/98 1/2/99 7/2/99 1/2/00 7/2/00 1/2/01

29. The successful stabilization of the economy has come with large short-term costs, however. The contraction of domestic demand slowed GDP growth to about 2 percent in 1999 and 2000. The unemployment rate has risen from 13 percent to 19 percent, as a result of lower GDP growth and stronger financial discipline. Inflation has temporarily accelerated to an average of about 11 percent in 1999 and 2000 following the overdue liberalization of administered prices and the increase of VAT rates. Fortunately, these short-term costs do not seem to have decreased the population’s support to the Government and the political will to consolidate the stabilization and complete the reform program. This is evidenced by the opposition’s defeat in a referendum held in November 2000 which was intended to force new elections and, in February 2001, by the Government’s success in passing several amendments to the constitution requiring a two thirds majority vote in Parliament.

30. The Medium-term Macroeconomic Framework. The Government’s medium-term macroeconomic framework is expected to consolidate the positive results of the 1999-2000 stabilization program, and has been designed with two major objectives in mind: first, to ensure a stable environment for the successful completion of the structural reforms and a resumption of growth on a sustained basis; and second, to demonstrate the country’s capacity to join the EU by the middle of the decade. The Government’s macroeconomic program for 2001 and 2002 has been elaborated in collaboration with the IMF, as reflected in the Statement of Economic Policies approved by the Slovak Cabinet on March 28, 2001. The Fund will monitor this program in the context of a Staff Monitored Program (SMP). Macroeconomic policies in the period 2003-2005 will be primarily driven by the Government’s objective to join the EU at the earliest possible date. Meeting this objective will require a demonstrated capacity to maintain a stable economic environment and, shortly after accession, to comply with the terms of the EU’s Stability and Growth Pact which, inter alia, calls for structurally balanced budgets.

The 2001 budget was elaborated under difficult initial conditions, including a substantial loss in projected revenues and increases in expenditures due to external commitments. The revenue loss—projected at 1.5 percent of GDP—is due primarily to the reduction in the corporate income tax rate from 40 percent to 29 percent (a measure expected to promote foreign and domestic investments) and the elimination of a temporary import surcharge introduced in 1999. At the same time, expenditures related to structural fiscal reforms will increase, including civil service reform (though such a reform should result in savings in the medium-term), as will expenditures related to EU and NATO commitments.

The 2001 budget contains a number of measures designed to offset these revenue losses and expenditure increases, but the offsetting is not full, because Parliament was reluctant to adopt a very stringent budget after two consecutive years of contracting real domestic demand and slow growth. As shown in Table 5, the 2001 budget agreed with the IMF in the context of the SMP implies a small increase in the general government deficit (excluding privatization revenues, called guarantees, and bank restructuring costs), from 3.3 percent of GDP in 2000 to 3.9 percent of GDP in 2001. The modest fiscal expansion in 2001 does not raise concern, however, because it is taking place in a period of large privatization-related FDI, and because it is being underpinned by a strong package of structural public sector reforms agreed with the IMF in the SMP. Such reforms are expected to put Slovakia’s public finances on a much sounder footing in the medium-term.

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During the first quarter of 2001 the Government issued SK105 billion in special bonds to restructure the banks, the equivalent of nearly 11 percent of 2001 GDP, as shown in Table 5. These explicit Government bonds will replace temporary loans from the banks to the workout agencies that were issued at the start of the bank restructuring program, and that have been guaranteed by the Government (see the banking restructuring section). The increase in explicit Government debt will amount to only 5 percent of GDP, however, as the Government intends to use part of the large proceeds of privatization in 2001 (estimated at around 10 percent of GDP)12

to retire its explicit debt, as well as the privatization bonds issued by the NPF. 13 The Government also intends to use the large privatization revenues for the repayment of other outstanding liabilities of the public sector, including the arrears of some social funds, and some borrowing guarantees.

TABLE 5: KEY ECONOMIC INDICATORS, BASE SCENARIO, 2001-2005  2000 2001 2002 2003 2004 2005GDP Growth and Inflation:Real GDP growth (% p.a.) 2.2 3.0 4.0 5.0 5.3 5.5Inflation: Average CPI (% p.a.) 12.0 6.9 6.0 5.0 4.0 3.8

Main Components of GDP: (in % of GDP)Private Consumption 52.7 54.7 55.0 55.0 55.0 55.3Fixed Investment 30.0 30.8 31.0 31.2 31.5 31.8Fiscal Accounts:General Government Deficit 1/ 3.3 3.9 3.2 2.7 2.2 1.8Government Debt 31.8 36.3 34.6 33.4 32.0 30.3External Accounts:Current Account Deficit 3.5 4.7 4.6 4.5 4.4 4.2Foreign Direct Investment 10.0 12.1 8.0 3.0 3.0 3.0Gross External Debt 56.6 52.6 48.7 45.2 41.9 38.1Net External Debt 27.6 15.8 10.2 10.0 9.7 9.3Foreign Reserves/Months of Imports 3.3 4.4 4.8 5.3 5.6 5.8Memorandum items (% of GDP):Stock of Bank Restructuring Bonds -- 10.8 9.8 8.9 8.1 7.4Interests on Restructuring Bonds 2/ 0.4 0.6 0.8 0.7 0.6 0.51/: Excludes privatization revenues, called guarantees and bank restructuring costs.2/: Interest payments on restructuring bonds begin in 2002. For 2000 and 2001 data reflect interest payments on the guaranteed bridge loans to SKA and KOB (see banking restructuring section).

GDP growth is likely to increase slightly to 3 percent in 2001, driven by the modest fiscal expansion, a resumption of private investment, and an increase in consumption resulting from

12 The privatization of the gas sector will account for a large share of the total revenues expected for 2001.13 The remaining 2.7 percent of GDP in NPF bonds will be redeemed in 2001. Only about 1.5 percent of GDP

in NPF bonds are held by households.

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the redemption of NPF bonds and a return to positive real wage growth after 2 years of decline. As a result of the expected increase in domestic demand and the slowdown in exports due to slower EU growth, the current account deficit is projected to increase to about 4.7 percent of GDP in 2001, up from 3.5 percent of GDP in 2000. However, the larger current account deficit projected for 2001 does not present much concern, as it is expected to be more than covered by the substantial FDI flows projected for the year—FDI is conservatively estimated at 12 percent of GDP due to large privatizations and a sustained increase in greenfield investment. As a result, external vulnerability should decline further as net external debt continues to decline in 2001 and international reserves are expected to exceed 4 months of imports.

GDP growth is expected to accelerate further to 4-6 percent p.a. in 2002-2005, driven by an increase in private investment and consumption. The envisaged growth rates can be comfortably achieved, given Slovakia’s high ratio of investment to GDP and the expected increase in efficiency that will result form the structural reforms. A prudent fiscal stance would call for a steady reduction in the fiscal deficit to ensure that the current account deficit remains in a sustainable range of 4 to 4.5 percent of GDP, despite the growth of private investment and consumption. Such a level of current account deficit would be consistent with a declining path of the ratio of net external debt to GDP if, as seems likely, greenfield investment would continue to flow at about 3 percent of GDP in the years following 2002, when privatization revenues are expected to taper off.

The Government recognizes the need to tighten the fiscal stance in 2002, and has agreed under the SMP to reduce the 2002 budget deficit to a range of 3.0 to 3.5 percent of GDP (excluding privatization revenue, called guarantees and bank restructuring costs). Such a fiscal tightening would allow the authorities to rebalance the policy mix and relieve pressure on monetary policy in 2002, which will have to continue to cope with large expected capital inflows (due primarily to the privatization of electricity utilities). Such a fiscal tightening would leave more room for a resumption of growth in real credit to the private sector, following several years of decline, thus facilitating a moderate increase in private investment.

In subsequent years the budget deficit is expected to be trimmed further by about 0.5 percent of GDP per year, to fall below 2 percent of GDP by 2005. The fiscal path envisaged for the 2003-2005 period reflects the structural measures introduced in 2001, and involves an accumulated fiscal adjustment of roughly 1.5 percent of GDP. This adjustment would open room for a moderate expansion of private investment and consumption relative to GDP, concurrent with a slight reduction in the current account deficit relative to GDP. The fiscal path would ensure a steady reduction in public debt and total external debt relative to GDP, and would also place Slovakia closer to the balanced structural budget required by the Stability and Growth Pact (in the years following EU accession).

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