Slovenia -- 2003 Article IV Consultation Discussions, Preliminary Conclusions of the IMF Mission
December 18, 2002
Preliminary Conclusions of the Mission
1. The Slovene economy continued to show considerable resilience to a further weakening of the economic environment in the European Union (EU) in 2002. Real GDP is estimated to have increased by 3 percent, similar to the performance in 2001. This owed much to a recovery in private investment spending and a further expansion of exports to the markets of southeastern Europe. This diversification of trade bears the hallmarks of a permanent shift rather than a temporary phenomenon, and testifies to the strength and dynamism of Slovene firms. With terms of trade also improving, the external current account recorded a sizeable surplus. There were large inflows of foreign direct investment, but the Bank of Slovenia (BoS) skillfully sterilized them, with cooperation from the government. However, employment growth slowed down. Real wage increases also slowed, monetary conditions became tighter, and the fiscal outturn implied a small discretionary withdrawal. Nevertheless, inflation remained sticky at around 7 percent.
2. There are major challenges to be overcome in the period ahead. Inflation needs to be brought down to 3-4 percent while ensuring ERM2 entry at a viable exchange rate. Also, the general government expenditure to GDP ratio should be put on a sustainable downward path based on a clear medium-term expenditure framework. Meeting these challenges will require addressing the institutional factors contributing to inflation, a more aggressive use of monetary and exchange rate policy, and fiscal structural reforms. These tasks have to be undertaken in an environment where real GDP growth is set to rise gradually and the macroeconomic outlook is subject to downside risks.
The growth outlook
3. The mission's assessment of the growth outlook is somewhat less optimistic than the scenario envisaged in the rolling two-year budget for 2003-04. Private consumption is likely to pick up slowly, given the neutral outlook of the business community on employment and a projected temporary slowdown in the increase of pension expenditure in 2003. Expectations indicators also point to a modest recovery of private investment. In addition, the increasing tendency of Slovene firms to invest abroad implies lower availability of funds for domestic investment. Assuming a recovery in EU economies, export growth should remain strong. On this basis, the mission's central projection is for real GDP to grow by 3.3 percent in 2003 and 3.7 percent in 2004, with downside risks from uncertainties about the strength of the EU's expected recovery and the outlook for international oil prices. The external current account surplus is projected to narrow slightly. Imports should pick up as domestic demand recovers, but its growth is likely to be below export growth.
4. The rolling two year budget for 2003-04 has been formulated consistent with Slovenia's medium-term goal of attaining close to structural balance before adopting the euro. The budget targets a modest reduction of the general government underlying deficit to 1.2 percent of GDP in 2003 and 0.9 percent of GDP in 2004. This would imply a small negative structural impulse in both years. The mission supports the proposed stance for 2003. As for the budget for 2004, it may have to be recast to address the possible negative fiscal effects of EU accession and other risks (see¶6 below).
5. There is downside risk on the tax revenue front. The budget projections do not take into account the revenue shortfalls in 2002 and, as noted before, the assumptions for growth of GDP and domestic demand for 2003-04 may be optimistic. With the medium-term expenditure consolidation objective in mind (see ¶6 below), the mission would recommend that the government focus on revising downward revenue estimates and identifying spending cuts accordingly at an early stage, and that it utilize as little as possible the room for an additional SIT 15 billion (¼ percent of GDP) borrowing authorized in the 2003 budget.
6. Against the background of the carry-over effects of revenue shortfall in the previous year as well as the EU-related implications, the question is whether achievement of the current deficit target for 2004 would be feasible without upsetting the inflation objective. The potential revenue shortfall is difficult to assess with certainty at this stage. As for the fiscal effects of EU accession, the latest assessment of the Ministry of Finance shows that the budget could face additional pressures equivalent to about 0.5 percent of GDP annually during 2004-06. The priority should be to meet the additional pressures through resource reallocation. However, if there are insurmountable difficulties to fully readjust expenditures in the short run, consideration could be given to a temporary increase in the fiscal deficit (i.e., a partial accommodation). In the mission's view, the SIT 15 billion (¼ percent of GDP) room for additional borrowing built into the 2004 budget could be utilized toward this end. Given the openness of the economy, the impact of a higher fiscal deficit on inflation would be smaller than if expenditure pressures were covered through higher indirect taxes. While a higher deficit could raise questions about the government's commitment to the fiscal objectives elaborated in the Pre-Accession Economic Programme (PEP), the concerns would likely be allayed if the government set out a clear medium-term expenditure consolidation plan.
7. Intentions of expenditure consolidation are apparent in the rolling two-year budget and are very much welcome, but more needs to be done to cope with the additional pressures on account of EU accession and other risks. The main initiatives are to cut expenditure on goods and services in 2003 and maintain it constant in real terms thereafter (except for the Ministry of Defense and Ministry of Interior), moderate real wage increases and change the public sector wage-setting system, and avoid additional entitlements for social transfers beginning in 2004. In all these areas, it would be important to ensure that the enforcement mechanisms are in place to achieve the desired results and that political will does not falter. In particular, a breaching of the budgeted wage bill for 2004 should be avoided during the forthcoming collective bargaining agreements. For subsequent years, if necessary, consideration should be given to specifying a wage bill ceiling consistent with making room for new spending priorities, instead of having a prior target for public sector wage growth in relation to economy-wide wage growth. Further reform of the pension system is a medium-term priority, given the demographic challenges facing Slovenia. The savings in pension expenditure in 2003 are temporary, the result of a one-time gain from the change in the indexation formula. To begin with, savings could be achieved by switching indexation of pensions to inflation instead of wages. Also, efforts should be directed toward improving the efficiency and targeting of other social transfers, and addressing the rapid increase in expenditure and the rising deficit of the health fund.
8. The mission welcomes the steps being taken in the area of public debt management. The shifts toward borrowing in the domestic market and a longer maturity structure should help in the development of the domestic primary and secondary markets for government securities. We look forward to receiving from the authorities a fully-fleshed out fiscal and public debt sustainability analysis by mid-January 2003, with the aim of incorporating it in the staff report to be considered by the IMF Executive Board.
9. Securing lower wage increases in the public sector is a priority, not only for budgetary reasons but also because of its demonstration effect on the private sector. Data provided by the Statistical Office indicate that, during 1999-2002, average wages in the public sector increased at a faster pace than average wages for the economy as a whole and outstripped productivity gains. The mission, therefore, welcomes the government's decision to restrict extraordinary promotions in the public sector, and to introduce a new wage setting system in 2004 under which collective agreements for the public sector would be centralized and bonus payments would be performance-based and subject to an upper limit.
10. In the context of ERM2 entry and the eventual adoption of the euro, real wage flexibility would be essential. Currently, the indexation of basic wages to inflation gives rise to real wage resistance. The government should set an example through eliminating indexation in public sector wage setting. Although from 2004 individual-level indexation would not apply across the board during the four-year transition to a new wage structure, the indexation principle has been applied for establishing the overall wage bill for the 2004 budget. Nevertheless, it would be important to ensure that provision for indexation is not formalized in the forthcoming collective agreements for the public sector. The mission would recommend that the government make every effort toward the social partners achieving a full understanding of the need for this measure, so that negotiations based on nominal increases of wages are introduced not only in the public sector but also in the private sector. Understandably, for securing cooperation from the social partners, it will be essential to demonstrate the authorities' commitment to sustainable and rapid disinflation.
Monetary, exchange rate, and price policies
11. A greater effort is required to bring inflation down. The original objective of 4 percent inflation by end-2003 will not be met. However, the expectation of the BoS is that continuation of the present stance of monetary policy and addressing the problem of changes in administered prices and indirect taxes will bring inflation down to this level before entry into ERM2, now planned for end-2004. The mission agrees that disinflation can be achieved without changes to the existing monetary framework, but believes that consideration should be given to a more aggressive use of monetary and exchange rate policy, even supposing that public sector wage and price policies were better behaved.
12. The mission recognizes that a more aggressive disinflation effort entails risks of speculative capital inflows and of a consumption boom that could lead to external imbalances as well as undermine the disinflation efforts. However, so far speculative inflows have not posed a threat, and the mission's assessment is that there is scope for "testing the waters" without unduly exposing the economy to risks. Should signs of speculative flows emerge, the BoS should allow variability in the exchange rate to introduce uncertainty and possibly inflict losses and deter other speculative inflows.
13. The BoS should give greater credibility and accountability to its inflation objectives. Given the importance of exogenous price shocks, the mission would suggest that the BoS also forecast and monitor a measure of inflation that excludes administrative prices and indirect taxes, to help it better assess underlying price pressures and shape public expectations. It would be important to ensure that the first round effects of price shocks do not spill over into second-round price increases, to the detriment of core inflation expectations. Also, in the period ahead, with growth projected to pick up, the BoS should remain vigilant and act to forestall incipient price pressures.
14. The mission welcomes the enhanced cooperation between the government ministries and the BoS on the plans for adjustments of administered prices in 2003. The orientation of policies to the eventual adoption of the euro as well as the need to eliminate uncertainties require that administered price adjustments be approached from a medium-term perspective and that a multi-year path be prepared and agreed between the relevant parties. The authorities need to be cautious that capping administered price increases at the projected inflation rate does not disguise latent inflationary pressures or contribute to losses for the service providers. Of course, it would be important to fend off monopolistic pricing through a stronger regulatory framework, and to keep pressure on enterprises to generate greater internal savings through efficiency gains and restructuring.
15. According to the representatives of the banking community, the initial fears surrounding the de-indexation of short-term financial contracts undertaken in July 2002 proved to be unfounded. Buoyed by this experience, from November, the leading commercial bank began to offer long-term deposits and loans at nominal interest rates linked to the 60-day Bank of Slovenia tolar bills, and other banks have followed suit. With the banking sector taking this initiative, it would only seem appropriate to formally terminate indexation of all financial contracts, even though conditions for a first-best reference rate are not yet in place. The mission would encourage the authorities to repeal the relevant law at an early date.
16. With the entry of foreign investors in the banking sector, competition in the retail banking market has increased, prompting banks to lower costs and introduce new products. The mission, therefore, welcomes the completion of partial privatization of the NLB. It is unfortunate that no offer for the privatization of the NKB met the guidelines. Although the current performance of NKB may be adequate, injection of private capital would seem desirable for the bank to remain competitive in the new environment. The mission believes that consideration is being given to merge the NKB with the postal bank, with the aim of making the enlarged bank more attractive to private investors.
17. The rapid increase in foreign-currency denominated loans could pose a risk for banks if borrowers are not hedged against currency risk. The mission understands that banks are required to take into account the foreign exchange exposure of their clients in risk classification, and that the bulk of these loans are to exporters who are trying to hedge their balance sheets. Nevertheless, currency risk could be a problem in the case of foreign currency borrowing by large public companies which operate primarily in the domestic market. It is important that the supervisory boards of these companies and the Treasury are aware of the possible risks of foreign-currency denominated loans, and ensure that their exposure is appropriately hedged.
18. Steps have also been taken in other areas on the structural front. The mission welcomes the initiatives underway to reduce the role of the state in the steel companies and the energy distribution system. The mission is also pleased to learn that the implementation of the authorities' Financial Sector Action Plan is expected to be completed by Spring 2003.
19. Slovenia is today among the most successful transition economies. Real convergence and economic integration with the EU are well advanced; well-executed policies have helped the country avoid the macroeconomic imbalances experienced elsewhere; and the strong competitive position and global orientation of Slovene firms have enabled them to gain a solid foothold in foreign markets. The remaining structural reform agenda must now be tackled and attention given to engineering a smooth landing of the economy on the way to the eventual adoption of the euro. The challenge ahead will be to move courageously, recognizing that policy choices may imply some short-term costs, and build a broad-based consensus. We wish Slovenia success in its endeavors.
We would like to express our thanks to the Slovene authorities for the close cooperation with the mission, their generous hospitality, and for the stimulating discussions.