Slovenia -- 2005 Article IV Consultation Discussions, Preliminary Conclusions of the IMF Mission
March 21, 2005
1. 2004 was a notable year for Slovenia: strong economic performance, European Union accession, ERM2 entry, and a change in government. The new government has publicly expressed support for the original goal of adopting the euro in January 2007. Social partners also remain supportive of this objective. Slovenia is well poised to enter the euro area (it already meets the Maastricht criteria for long-term interest rate and the fiscal deficit and debt ratios, and the exchange rate of the tolar vis-à-vis the euro has remained close to the central parity since ERM2 entry), but risks and challenges remain. While inflation has continued to steadily move closer to euro zone-compatible levels, further progress could be impeded if domestic demand pressures and higher producer price inflation were to feed through to consumer prices. Current conditions call for a stricter fiscal policy stance and the expenditure side of the budget needs to be adjusted to enhance the flexibility of fiscal policy. The favorable developments in real wages relative to productivity growth in 2004 should be sustained, and greater flexibility in wage setting mechanisms ought to be introduced. These aspects are elaborated below.
Recent developments and outlook
2. Real GDP growth in 2004 surpassed expectations owing to a large swing in net exports. Domestic demand growth maintained momentum, but did not take off as feared during the last Article IV consultation discussions. Private consumption strengthened appreciably, but to a lesser extent than expected. There was a marked restructuring of household financial assets and the propensity to save appears to have increased. Households channeled increasing amounts to mutual funds, insurance companies, and voluntary supplementary pension insurance, which more than offset the sharp jump in borrowings from banks. In contrast, gross investment growth slowed somewhat owing to smaller contribution of inventories. Outflows of investible resources from Slovenia increased in 2004: outflows of direct investment and portfolio investment rose to nearly 4 percent of GDP from about 2½ percent of GDP in 2003.
3. Progress with disinflation in 2004 was more rapid than envisaged, notwithstanding higher oil prices, a pick up in producer price inflation, and a narrowing of the output gap. Supply side and structural factors were important driving forces behind this trend: an improved harvest, elimination of duties on imports from the European Union, and increased competition in the retail market resulted in falling food prices and more moderate increases in the price of non-food items. Wage developments also played a positive role, as the pace of real wage increases lagged behind productivity growth by a wider margin than in 2003. Disinflation was additionally reinforced by the elimination of the depreciation policy upon ERM2 entry and the subsequent maintenance of exchange rate stability. Although the execution of fiscal policy in 2004 was prudent, it did not contribute to disinflation—despite a smaller deficit than envisaged in the budget, a higher-than-expected real GDP growth meant that there was a structural stimulus of 0.4 percent of GDP.
4. Looking ahead, a slowdown in economic growth can be expected. The likely contributory factors are slower export growth in line with the projected trend in import demand in Slovenia's main trading partners in the EU, and a downward correction for fewer working days in the year relative to 2004. Accordingly, the mission projects real GDP growth of 4 percent in 2005 and 3.8 percent in 2006, implying that the economy will continue to expand above or about its potential rate. A pick up in domestic demand growth is not foreseen on the assumption that (i) factors propping up financial saving by households will continue to be present; (ii) bank credit growth will stabilize as convergence of nominal lending rates appears to be more or less complete; (iii) investment abroad by Slovene enterprises and mutual funds will persist; and (iv) the downward revision of road construction plans will be in effect. Still, the risk of an increase in spending propensity cannot be entirely discounted.
5. In the absence of major shocks and with supportive policies, inflation is likely to fall further, though risks remain. In the mission's assessment, the achievement of the Bank of Slovenia's (BoS) inflation goal of 2.5 percent at end-2005 as well as during the assessment period for euro adoption looks feasible. But, there are upside risks to the inflation outlook. Although the effects of the narrowing of the output gap and higher producer price inflation on consumer prices have been muted thus far, they could be felt eventually with a lag. Another uncertainty is that the reference rate for the Maastricht criterion is not a firmly established target and depends on the actual inflation outturn in the relevant comparators during the assessment period. The reference rate based on the current inflation outturn of the comparators (2.2 percent) is below the BoS's projection of Slovenia's inflation during the assessment period (2.5 percent). Thus, inflation developments will need to be monitored closely, especially the evolution of monthly rates of both headline inflation and increases in prices of services. At the first signs of inflation beginning to exceed the targeted path or an assessment that the achievement of the Maastricht criterion may be under threat, corrective policy measures should be taken. During the assessment period there is little room to wait and see if the deviations are firmly entrenched. The various policy options are discussed below.
Monetary and exchange rate policies
6. The BoS should guard against the upward risks to inflation. Thus, the mission endorses the BoS's intention to keep policy interest rates unchanged as long as market conditions will permit. If inflation did not follow the expected path and achievement of the Maastricht criterion was at risk, the BoS should tighten monetary conditions by using the appropriate policy instruments at its disposal and utilizing the flexibility provided under the ERM2 framework. The mission recognizes that, given the transmission lags, the scope for using orthodox monetary policy measures for meeting the Maastricht inflation criterion becomes smaller as one gets closer to the end of the assessment period. Therefore, wage and fiscal policies must provide the fullest support to disinflation.
Price and wage policies
7. With the aim of counteracting monopoly pricing and ineffective functioning of regulatory bodies, the authorities' disinflation strategy will continue to entail limiting increases in administered and regulated prices to no more than the projected inflation rate. In 2004, prices of certain categories under the regulatory price regime (notably, municipal services) increased by more than planned. A repeat slippage should be avoided in 2005. Consideration should be given to reconstituting the task force at the Ministry of Finance charged with monitoring administered and regulated prices.
8. The developments in the real wage-productivity growth gap in 2004 are welcome. The margin by which real wage increases lagged productivity gains widened in both the tradable and non-tradable sectors in the aggregate. However, an examination of the developments at a more disaggregated level suggests that there is scope for greater productivity-based differentiation in wage setting. For example, in contrast to the overall trend, the wage-productivity growth gap narrowed in 2004 in the trade and hotel sectors. Furthermore, real wage increases in these two sectors (which together account for slightly over one tenth of the economy-wide wage bill) lagged sector-specific productivity growth by less than the one percent economy-wide guideline specified in the Social Agreement. Applying sector-specific productivity increase as the basis for wage increase in individual sectors would serve to reduce supply-side inflation pressures. The mission also supports the elimination of wage indexation. The mission would recommend that these considerations be explicitly codified in the Social Agreement for 2006 and beyond.
9. The widening of the real wage-productivity growth gap in the tradable sector is appropriate for maintaining competitiveness under ERM2 and following euro adoption, and should not be allowed to erode. With the stabilization of the exchange rate under ERM2, the cushion provided to enterprises by the earlier depreciation policy no longer exists, and needs to be compensated by a higher wage-productivity growth gap.
10. As suggested during last year's Article IV consultation discussions, if achievement of the Maastricht inflation criterion were to come under threat, national considerations for meeting this criterion might warrant a wage pact at the national and enterprise levels between social partners under the guidance of the government.
11. Fiscal policy should be oriented toward supporting the disinflation goal (including coping with the risk of inflation exceeding the targeted path), securing sustained flexibility of the public finances, and achieving the medium-term goal of structural balance or small surplus. The figures for the supplementary 2005 budget are still being firmed up, which makes it difficult for the mission to present a definitive assessment of the government's planned fiscal stance in 2005. (We would appreciate if the supplementary budget projections are sent to us at the same time that they are submitted to Parliament, so that they can be incorporated and discussed in the Article IV staff report). In the interim, the mission would like to make a number of general recommendations based on the 2004 fiscal outturn, the revised macroeconomic outlook for 2005, and the discussions on the preliminary rounds of budget revision.
12. Targeting the same nominal headline deficit for the general government as that specified in the originally adopted budget for 2005 (SIT 109.5 billion) would be expansionary and, therefore, not appropriate. This would be tantamount to rolling back the expenditure savings achieved in the last quarter of 2004 as well as incurring additional expenditures that offset the higher revenue collections that is expected (on account of both a stronger economic performance as well as smaller-than-expected indirect negative impact of EU accession on the revenue side of the budget). At the very least, the structural deficit should remain the same as in 2004: this would be equivalent to targeting a headline deficit of SIT 80 billion.1 To be supportive of disinflation, a withdrawal of stimulus would be in order, implying a lowering of the structural deficit (and, pari passu, the headline deficit to below SIT 80 billion).
13. Achieving the same or lower structural balance would involve implementing the expenditure savings measures already built into the originally adopted 2005 budget (saving measures of about SIT 45 billion or 0.7 percent of GDP were foreseen), safeguarding the savings secured in 2004, and resisting demands for additional spending. Should the government find it necessary to undertake trade-offs between expenditure categories within the overall expenditure envelope, care should be taken to ensure that the expenditure structure does not become more rigid and therefore reduce policy flexibility. In this context, it should be emphasized that the expenditure structure should not also shift away from investment to current expenditures. The mission welcomes that the government is giving consideration to reforming social transfers and the health and education sectors. An early start with these reforms is essential for meeting the near-term and medium-term fiscal goals.
14. In formulating the supplementary 2005 budget, the authorities need to look at the implications of policy decisions in a multi-year or medium-term framework. In this context, the proposal under consideration for changing the existing indexation mechanism (which has resulted in pension growth lagging wage growth) will have a serious negative effect on the financial soundness of the pension system and public finances in general. The proposal would result in additional pension obligations increasing progressively from 0.2 percent of GDP (SIT 15 billion) to about 1 percent of GDP within seven years. This would add to the significant budgetary challenges already posed by an ageing population. As noted in the authorities' 2003 Pre-accession Programme report (in Table 9), without further reforms pension payments would rise from 13 percent of GDP in 2005 to about 18 percent of GDP in 2020. The mission recommends that the proposal to change the pension indexation mechanism be reconsidered and handled within the framework of a comprehensive reform package that preserves the long-term sustainability of the pension system.
15. The authorities should firmly implement the restrictive policy on promotions and additional public sector employment as set out in the Pre-accession Programme and the Convergence Report. The wage bill in 2004 exceeded the budgeted level, in part owing to higher-than-envisaged increase in employment, which will have carryover effects into 2005. The risk of additional staffing needs on account of adaptation to EU rules and requirements was acknowledged by the authorities during the last Article IV consultation discussions. However, a large part of the cost overrun also reflected salary creep due to promotions—an area where a restrictive policy was supposed to have been in place and saving generated. It appears that this trend is continuing in 2005 as well.
16. The government envisages further reduction of payroll taxes to enhance competitiveness and intends to link this measure to the new Social Agreement for 2006 and beyond. The mission would not recommend further lowering of payroll taxes unless the wage setting mechanism was designed to prevent the extra resources from being used to grant higher wage increases. Recent and past experience in Slovenia shows that reductions in payroll taxes have indeed been used toward wages.
17. Looking beyond 2005, the government needs to firm up a medium-term fiscal consolidation plan that aims at achieving a structural balance or a small surplus. This requires action now, while general economic conditions are favorable. Waiting until 2006 or beyond will only make implementing the necessary adjustment measures all the more difficult.
Financial and other structural issues
18. Financial soundness indicators show that the Slovene banking system is currently healthy. However, it would be desirable to keep an eye on several trends:
· Competition has resulted in shrinking interest margin and lower net interest income, and made banks particularly vulnerable to a fall in interest margin. Banks have responded by improving cost efficiency and increasing non-interest revenues. Thus far, there is no evidence of banks taking credit risk to a greater degree, but the situation needs to be monitored closely.
· Banks are funding their lending to households and enterprises not only from their own deposit base, but also by borrowing from abroad. The associated build-up of external debt—which at almost 60 percent of GDP is already quite high—represents a potential vulnerability.
· There is the potential of the banking system being exposed to interest rate risk and exchange rate risk indirectly via the corporate sector. The commercial banks visited by the mission noted that they are appropriately hedged against interest rate risk and direct exchange rate risk, and that they encourage clients who are not naturally hedged to take appropriate cover. The BoS should ascertain to what extent this practice is being followed by the banking system at large, and make recommendations, as necessary.
· Banks are transferring credit risk on household loans to insurance companies. With insurers recording a very high ratio of claims paid out to collected premiums (averaging about 90 percent during 2001-03) on credit insurance, it would be desirable to take a closer look at systemic risks from insurance companies to banks.
· The mission supports the BoS's intentions to preserve its current prudential regulations and provisioning system to the extent this is possible within the framework of the International Financial Reporting Standard that is to go into effect from January 2006.
19. The mission welcomes the authorities' intention to further reduce the involvement of the government in the production sphere and to promote foreign direct investment. Market conditions have improved the prospects for early privatization of the telephone company and the steel mills. Although Slovenia has introduced several laws aimed at improving the business environment, it appears from our discussions with representatives of the business community that potential investors still find the business environment challenging, especially with regard to administration and regulation and labor costs. The mission suggests that more attention be given to the implementation of the laws. Also, measures to increase labor market flexibility would provide a strong signal to foreign and domestic investors. These measures ought to be accompanied by adequate compensating measures that look after the welfare of workers within the budget envelope. Slovenia is certainly at a disadvantage vis-à-vis other new EU member states with respect to relative unit labor costs. Thus, it would be difficult to attract investors interested in mass production. We agree that the focus should be on exploiting Slovenia's comparative advantage (for example, a highly educated and skilled labor force) and seeking investors who can create a niche in specialized markets.
20. In sum, Slovenia has made encouraging progress towards euro adoption, but the prospect is not free of risks. Policies should be oriented toward minimizing these risks, achieving the official euro adoption goals, and performing strongly in the monetary union. We wish Slovenia success in its endeavor.
We would like to thank the Slovene authorities for the close cooperation with the mission, their hospitality, the extensive and high-quality written responses to the questionnaires, and for the stimulating discussions.
1 Potential GDP growth underlying this calculation has been estimated by the IMF staff using the H-P filter method. If potential growth estimates of the Ministry of Finance are used, an unchanged structural deficit would imply a headline deficit of SIT 95 billion. However, it should be pointed out that the Ministry's latest potential growth estimates are different from those shown in Table 3.5 of the recent (January 2005) Convergence Program Update. Because of time constraints, it has not been possible for the mission to discuss the reasons for the Ministry's revisions to the potential growth estimates.