Slovenia -- 2004 Article IV Consultation Discussions, Preliminary Conclusions
January 23, 2004
1. Slovenia is on the verge of EU membership—a significant milestone. Policy makers now have to focus on laying the ground for a smooth transition to ERM2 and the adoption of the euro. The authorities have formulated a program that envisages ERM2 entry by end-2004 and euro adoption in January 2007. There is broad consensus of all political parties and social partners on these goals. The authorities' timetable appears feasible, but it is not free of risks. Although the economy is well poised in many respects (in particular, Slovenia already meets the Maastricht criteria for long-term interest rate and the fiscal deficit and debt ratios), some major challenges remain for the period ahead: the inflation rate, though falling, is well above the euro-area average; wage setting mechanisms are not sufficiently flexible; and the expenditure side of the budget needs to be adjusted to enhance the flexibility of fiscal policy. These challenges have to be met in an environment of looming risks of a domestic demand boom, which could pose particular difficulties once in ERM2 and its related narrow exchange rate band.
Recent developments and outlook
2. In 2003, there were several notable macroeconomic developments. All components of domestic demand rebounded strongly after three anemic years, but real GDP growth continued to be undermined by a weak external environment. The widening of the output gap, smaller increases in regulated prices and indirect taxes, and a moderation of the pace of depreciation contributed to a significant slowdown in inflation. The fiscal stance also complemented the authorities' disinflation efforts—the fiscal outturn implied a structural withdrawal, which partly offset the pickup in private demand. However, wage policy contributed little to disinflation. While real wage increases in 2003 were similar to that in 2002, the gap between wage and productivity growth narrowed significantly to below 1 percent.
3. Looking ahead, a rapid credit-financed demand growth looms on the horizon. The likelihood of this scenario should not be discounted. Indeed, it is possible that the upturn in the strength of domestic demand in 2003 represents the early stage of such a boom. Further demand side impetus is likely to come from declining nominal and real interest rates, release of funds from the national housing savings scheme, the introduction of tax on interest earnings, and from the effects of euro accession on growth and investment. The experience of non-core euro area countries in the late 1990s before euro adoption also suggests that a credit-financed demand boom is a clear risk. Exports should pick up in the period ahead in line with the anticipated recovery in Europe. However, with imports being boosted by the pickup in domestic demand, the contribution of net foreign demand to growth is likely to remain negative in the foreseeable future. Accordingly, the mission projects real GDP growth rebounding to 3½ percent in 2004 and rising to 4½ percent in 2006.
4. Achieving the Maastricht inflation criterion could be problematic, unless additional policy measures are implemented. Analysis carried out by the mission suggests that real GDP growth above the potential growth rate and a consequent narrowing of the output gap will slow down the disinflation process. It is also significant that a leading Slovene expert sees a reversal of the disinflation process as a possibility in 2005.
Monetary, exchange rate, and banking sector policies
5. Monetary policy should take a more active role in lowering inflation in the coming months. The mission would recommend that the Bank of Slovenia (BoS) restrain monetary conditions in the run up to ERM2 entry by reducing nominal interest rates cautiously and slowing the pace of depreciation deliberately. The mission understands the BoS's desire to minimize the risk of opening up the interest rate parity with abroad. However, it would be important to ensure that real interest rates are not forced down prematurely. Early monetary restraint and supporting policies appear advisable also to avoid a possible worst-case scenario of intense demand pressures under ERM2, when monetary tightening within a narrow exchange rate band could create a one-way bet, with the authorities facing either large sterilization costs or the need to let the exchange rate appreciate. If more than one round of appreciation proved necessary, competitiveness could take an appreciable hit.
6. A strengthening of supervisory and prudential oversight of banks is an appropriate measure to guard against the risks of excessive credit growth and banking sector distress. Increased competition from foreign-owned banks has lowered profitability of the other banks in Slovenia, and there are indications that a few in the latter group have begun to shift their focus to non-blue chip business clients (such as SMEs) and retail banking, including extending foreign currency loans to households. These tendencies are likely to intensify as profit margins are squeezed further. A few aspects of Slovene banking regulations—notably, with respect to provisioning (which is based on potential loss rather than realized loss), risk classification of borrowers, and capital adequacy calculation—force banks to take account of the risk associated with their lending and help contain excessive credit growth. Given the potential for a credit boom and related risks in the run-up to euro adoption, the BoS should not consider any loosening of the existing prudential regulations at this juncture. Furthermore, the Article IV mission would encourage the BoS to expand supervisory resources and to speedily implement the measures suggested by the recent FSAP update mission to shift to a risk-based approach for bank supervision. The mission also endorses the BoS' plan to use dynamic provisioning as a means to counter banks' otherwise rather procyclical behavior; this should be used in parallel with the risk-based approach.
7. Unhedged borrowing in foreign exchange by enterprises and households is a cause of concern, because of exchange rate risk under ERM2. A recent survey, although small and unrepresentative, carried out by the BoS showed that several large non-exporting enterprises—particularly in the public sector—were not hedged against currency risk. The BoS should encourage banks to offer hedging instruments to their clients, and to carry out appropriate credit risk analysis for cases where customers are not hedged against currency risk. The supervisory boards of public enterprises should also discourage unhedged foreign borrowing. In the case of foreign exchange lending to households, the currency risk is being shifted to insurance companies. It would be important to enhance the supervision of insurance companies. Supervisors will also need to ensure that banks strengthen individual-level credit risk analysis of households.
8. The mission supports the BoS's plan to adopt a narrow exchange rate band around the central parity under ERM2 and the continuation of a contractual agreement with banks on foreign exchange market intervention. Given the considerable uncertainty about how the exchange rate stability criterion will be interpreted for ERM2 participants, ensuring compliance with the criterion in the minimum time possible calls for primacy being given to limiting exchange rate variability. The mission was informed during the discussions that the BoS has received informal feedback from ECB staff that the continuation of the current foreign exchange intervention arrangement would be agreeable to the ECB. In view of the inherent risks of volatility under ERM2, the BoS's preference to stick with a familiar and tested system of sterilized intervention that will in any case no longer be needed once Slovenia adopts the euro is understandable.
9. Several factors may protect Slovenia against exchange rate volatility under ERM2—though risks remain. Besides the managed foreign exchange intervention arrangement, the risk mitigating factors include subordinating domestic interest rate decisions to those in the euro area, the small projected fiscal deficit, a thin government securities market, and enhanced policy coordination between the government and the BoS.
Price and wage policies
10. The authorities' disinflation strategy will continue to entail limiting increases in administered and regulated prices to no more than the projected inflation rate. The mission is pleased to note that, as recommended during the last Article IV mission discussions, the plans for adjustments of administered prices have been formulated in a two-year framework for 2004-05. There are already indications that capping of administered prices is leading some service providers to undertake cost-saving measures.
11. Wage policy, together with fiscal policy, has to bear the burden of absorbing shocks once monetary policy independence is surrendered upon ERM2 entry. It is worth noting that in preparation for euro adoption, Finland, Greece, Ireland, Italy, and Spain changed their wage setting procedures and achieved moderation of wage increases. For some of them, this involved elimination of indexation. In the public sector in Slovenia, progress has been made in weakening indexation and slowing wage drift, but a critical area still remains to be addressed. The mission would encourage both the government and social partners to ensure that the cost of the new public sector wage structure remains within the budgeted wage bill envelope.
12. The mission is concerned that negotiations for private sector wage policy for 2004-05 are still at a preliminary stage. The position of trade union representatives that the current collective bargaining system is biased toward discussion of wage indexation and that the system needs to be overhauled has merit. The mission supports a complete elimination of wage indexation, and a careful crafting of a collective bargaining system that enhances wage flexibility and is cognizant of competitiveness considerations. However, the tentative proposal of some trade unions for wage increases of the same nominal amount for all workers does not pass muster, as it would likely impair the viability of enterprises that have a large proportion of employees in the low wage brackets.
13. In the short term, a special approach to wage policy may be required, especially if achievement of the Maastricht inflation criterion was under threat. Analysis carried out by the mission suggests that wage policy would contribute to disinflation through a widening of the gap between real wage and productivity growth. If this gap is not influenced by the national level collective bargaining process but is determined by developments at the enterprise level—as claimed by trade union representatives in their meeting with the mission—national considerations for meeting the Maastricht criteria might warrant, for a temporary period, a wage pact at the national and local levels between the social partners under the guidance of the government.
14. The rolling two-year budget for 2004-05 embodies the government's commitment to maintaining tight fiscal discipline, despite having to cope with the fiscal pressures connected with EU accession. The budget, which entails a virtually unchanged fiscal stance in 2004-05, incorporates significant expenditure saving measures and reallocation of expenditures, and has built-in safeguards against downside risks to revenue. However, as a demand boom is not anticipated in the budget assumptions, the mission would in that event emphasize the importance of the government saving any revenue overperformance and ensuring an improved fiscal performance. The mission does not consider it advisable to apply revenue overperformance toward reducing payroll taxes. Given the current wage setting mechanisms, there is a high likelihood of enterprises using these resources for granting wage increases.
15. In order to enhance the flexibility of fiscal policy and achieve the goal of structural balance over the medium term, the authorities will need to make a decisive start with the expenditure saving measures recommended by the November 2003 FAD mission on public expenditure rationalization. There is scope for rationalizing spending in health and education and bringing down the duration of certain social benefits to prevailing international standards. In addition, consideration should be given to reducing the rigidities from indexation of social transfers that do not target the most vulnerable groups. The Article IV mission would also encourage the authorities to reconsider the proposal of the "White Book" to merge private health care insurance premiums with the public sector in 2005. Such a move would weaken the role of the private sector and put upward pressure on labor costs with potential spillover risks for inflation. In general, modalities of health care reform should take into account macroeconomic stability and fiscal sustainability considerations. Health care reform, a priority for Slovenia, should first address the existing inefficiencies in the system.
16. In sum, adopting the euro will entail major economic changes, and the requirements for successful participation in the monetary union are demanding. There are considerable vulnerabilities in the process of euro adoption. The risks should not be downplayed. Complacency could destabilize the euro adoption process. The authorities should aim to implement policies to meet the Maastricht criterion decisively and in a timely manner. We wish Slovenia success in its endeavor.
We would like to thank the Slovene authorities for the close cooperation with the mission, their hospitality, and for the stimulating discussions.