Public Information Notice No. 04/60

Public Information Notice: IMF Concludes 2004 Article IV Consultation with the Republic of Slovenia

May 24, 2004

On May 7, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Slovenia.¹

Background

Domestic demand rebounded strongly in 2003 after three anemic years. All components of domestic demand strengthened appreciably, fueled by declines in interest rates and the associated pickup in bank credit to the private sector. However, there was a large negative swing in the contribution of net foreign demand to growth. Real GDP growth slowed to 2.3 percent, and the output gap widened. The external current account position receded from a sizeable surplus in 2002 to approximate balance in 2003. Competitiveness and other external vulnerability indicators remained satisfactory.

Progress with disinflation was better than expected. Year-on-year inflation declined from 7.2 percent at end-2002 to 3.5 percent in March 2004. Staff analysis suggests that the widening of the output gap associated with the economic slowdown was the dominant driving force behind disinflation in 2003. Other contributory factors, albeit to a lesser degree, were a moderation of the pace of tolar depreciation, smaller increases in regulated prices and indirect taxes, and excise tax adjustments to offset increases in international oil prices. While wage drift in the public sector slowed and economy-wide real wage growth in 2003 was broadly similar-about 2 percent-to that in 2002, the gap between wage and productivity growth narrowed.

The fiscal outturn in 2003 implied some withdrawal of stimulus. The general government deficit-1.4 percent of GDP-was slightly smaller than that envisaged in the mid-year supplementary budget and broadly similar to the outturn in the past three years.

Monetary conditions at the policy level remained broadly unchanged in 2003. Prompted by the deceleration in inflation, European Central Bank interest rate cuts, and a perception of falling country-risk premium, the Bank of Slovenia lowered its key policy rate steadily by a total of 3½ percentage points since December 2002 to 4.75 percent in April 2004. Meanwhile, the tolar continued to depreciate vis-à-vis the euro, though the pace of depreciation slowed from an annualized rate of 3.3 percent in December 2002 to 2 percent in March 2004. The indexation of financial contracts was eliminated in 2003. Bank lending rates fell in real terms, and private credit demand and interest-sensitive capital inflows picked up. A large part of the expansion of credit to enterprises was foreign currency-denominated, and was financed by rising bank borrowing from abroad.

GDP growth is expected to rebound in 2004 and rise above the potential rate subsequently. Growth is likely to be driven by strong domestic demand boosted by favorable business and consumer expectations triggered by European Union (EU) accession and prospective euro adoption, and a convergence-related decline in interest rates. In this environment, there is some risk of domestic demand boom. The contribution of net foreign demand to growth would likely remain negative in the foreseeable future, and the current account is expected to swing into a modest deficit. The prospective narrowing of the output gap is likely to slow down the disinflation process, complicating achievement of the Maastricht inflation criterion. Slovenia already meets the Maastricht criteria for long-term interest rates and the fiscal deficit and public debt ratios.

Following Slovenia's accession to the European Union on May 1, 2004, the authorities plan to enter ERM2 in the course of the second half of 2004 with the aim of adopting the euro in January 2007.

Executive Board Assessment

Executive Directors congratulated the authorities for their successful entry to the European Union (EU) on May 1, 2004 and their impressive macroeconomic policy achievements, and noted that the main challenge now is to ensure a smooth ERM2 entry and euro adoption, as well as to continue preparing the economy for successful performance within the union. Directors observed that Slovenia is in many respects well poised to join the euro area, particularly in light of the substantial real and nominal convergence in meeting most of the Maastricht criteria. They also considered that Slovenia's competitiveness appears adequate. Inflation, however, while falling, remains above the EU average.

Directors stressed that the intended early ERM2 entry and eventual euro adoption would depend critically on bringing inflation sustainably down to a level that, in addition to meeting the Maastricht criterion, would not hamper competitiveness once the exchange rate is fixed. Other key tasks are to ensure that fiscal and wage policies are capable of absorbing shocks. Directors cautioned that a credit-financed demand boom could complicate achieving the Maastricht inflation criterion and create stresses on the banking sector.

Directors welcomed the recent sharp drop in inflation. They noted that while the increased slack in the economy in 2003 was probably the main driving force behind disinflation, policy measures-such as a slower pace of tolar depreciation-also contributed. Directors also welcomed the efforts to limit excessive increases in administrative and regulated prices by pressing for greater cost efficiency and savings in public companies. In this context, some Directors stressed the need to further liberalize those prices. Directors commended the decision to eliminate indexation of financial contracts.

Directors underscored that monetary policy needs to play a pro-active role in the run-up to ERM2 entry by restraining monetary conditions in order to contribute to disinflation and help contain possible intense demand pressures under ERM2. While acknowledging the Bank of Slovenia's (BoS) concern that monetary restraint could trigger capital inflows and potentially impact competitiveness, Directors stressed that monetary conditions should not be loosened prematurely.

Directors emphasized that fiscal policy should be oriented to alleviating budgetary pressures related to EU accession and coping with the risk of a possible private sector demand boom. They welcomed the significant expenditure saving measures incorporated in the budget for 2004-05, and noted that these measures should be carefully safeguarded in an election year. Nevertheless, they stressed that further expenditure rationalization-particularly in the areas of health care, education, and social transfers-is essential to ensure sustained flexibility in fiscal policy and to achieve the authorities' medium-term goal of structural balance. Directors urged that, in the event of a demand boom, any revenue overperformance should be saved and any further lowering of payroll taxes avoided.

Directors stressed that wage policy needs to play a central role in fostering disinflation and safeguarding competitiveness. They commended the authorities for weakening wage indexation and reducing wage drift in the public sector, and urged them to consolidate these gains by restricting the cost of the new wage structure. Directors noted that wage policy can usefully contribute to disinflation by reducing wage increases relative to productivity growth, particularly in the nontradable sector. They also considered that achieving the Maastricht inflation criterion might warrant a temporary wage pact at the national and enterprise levels under the guidance of the government. Directors encouraged the government and social partners to fully eliminate wage indexation and move to a wage-setting system that ensures wage differentiation based on productivity.

Directors noted that the banking system is generally sound. However, they emphasized that strengthening supervisory and prudential oversight-in line with the Financial System Stability Assessment update-is essential to guard against the risks of rapid credit growth and stresses on the financial system. They noted signs that banks were starting to shift to more risky borrowers as a result of increased competition, and cautioned that this tendency was likely to intensify as profit margins were squeezed further. Given the potential for a credit boom and related risks in the run-up to euro adoption, Directors cautioned against any easing of the existing prudential regulations. They deemed appropriate the BoS's intention to complement the supervisory framework by introducing dynamic provisioning appropriate, while noting that other prudential tools may have to be considered to control surges in credit growth. Directors welcomed Slovenia's active AML/CFT efforts.

Directors urged the authorities to maintain the momentum behind structural reforms in other areas and to improve the environment for private sector development. They welcomed achievements in liberalizing utilities and transport services, and called for further progress in the natural gas, telephony, and transport sectors, as well as a broader privatization program. Directors also noted that stronger competition was likely to lead to lower prices, and hence usefully complement the authorities' disinflation efforts. The move toward the adoption of the euro would be helped by greater labor market flexibility and higher participation rates-especially among older workers.