Slovenia -- 2006 Article IV Consultation, Preliminary Conclusions of the IMF Mission
March 28, 2006
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
Slovenia's high living standards attest to its economic strength. The biggest risk ahead is that euro adoption could engender complacency in confronting the challenges for continued success in the euro area. Given the significant role of the external sector, looking forward, Slovenia is particularly vulnerable to a persistent increase in unit labor costs that would lead to a gradual erosion of competitiveness and delayed convergence. The loss of the exchange rate instrument puts a premium on a prudent fiscal policy, and flexible wages and prices to react to the ups and downs of economic cycles. We wish the authorities success in pursuing the policies required for thriving in the euro area, and thank them for their generous hospitality, excellent cooperation, and high quality of the discussions.
1. Within two years of entering the European Union and the ERM-2 mechanism, Slovenia stands on the verge of euro adoption. This milestone marks the culmination of an economic transformation that began with the country's independence in 1991, through which Slovenia successfully achieved robust growth with small public and external imbalances, while gradually lowering inflation to euro-area levels. At end-2005, long-term interest rates, the fiscal deficit, the public debt ratio, and inflation were within the limits required under the Maastricht Treaty. With macroeconomic indicators expected to remain favorable in the near term, the policy debate is appropriately focused on the period after euro adoption (January 1, 2007).
2. Going forward, the key challenges will be to maintain a balanced expansion, improve the economy's flexibility, and increase competitiveness and productivity to support convergence. Slovenia's gradualist approach to reform has ensured stability but challenges remain in addressing structural rigidities that constrain the growth potential, such as inefficient public spending, welfare and tax systems that discourage labor participation, and restrictive labor regulations. These challenges and the imminent adoption of the euro, underscore the importance of pursuing fiscal and wage policies consistent with a balanced expansion, while increasing the focus on policies to improve economic flexibility and long-term growth.
Macroeconomic developments and outlook
3. The economy sustained its strong momentum in 2005 without igniting inflation. Despite some moderation of domestic demand owing to an investment slowdown, GDP increased by 3.9 percent, as the trade deficit narrowed based on robust exports. With potential growth estimated at 3¾ percent, the current pace of economic expansion implies diminishing slack and an economy close to potential. Yet, average inflation in 2005 fell to 2½ percent—the lowest rate ever—as wage guidelines set to lag productivity growth, the smoothing of oil price increases through excise tax rates, and a stable exchange rate helped sustain steady disinflation by minimizing second-round effects of energy-price shocks.
4. The outlook remains bright in 2006 and in the medium term, assuming prudent fiscal and restrained wage policies. In 2006, domestic demand is expected to drive growth of slightly over 4 percent supported by an investment recovery. Modest oil price increases, nominal wage growth of no more than 5 percent—implying real wage growth still lagging productivity growth—and a neutral fiscal stance would result in inflation remaining near the current level. While external developments remain a concern given uncertainties over the sustainability of the euro area recovery, the main near-term risks are domestic. Credit growth remains very strong, and larger wage settlements than those of the 2005 guidelines would have knock-on effects for pensions, household demand, inflation, and competitiveness. An expansionary fiscal stance in 2006—an election year for local governments—would test capacity utilization limits and fuel inflationary pressure. Further increases in oil prices would pose an additional risk, as the room for offsetting tax measures has been exhausted. Beyond 2006, real growth is expected to remain at 4 percent with inflation staying at around 2½ percent. However, a careful calibration of fiscal policy together with wage restraint and strong productivity growth are essential to sustain non-inflationary growth. In this regard, current pent-up wage pressures pose a risk over the medium term, especially following euro adoption.
5. In keeping with its long-standing record of fiscal prudence, Slovenia maintained a tight fiscal stance in 2005. Preliminary data suggests that the general government deficit narrowed to about 1 percent of GDP. Both revenues and expenditures of the central government were in line with the budget, but municipalities' operations were in surplus due to one-off revenues, while EU-related transfers and expenditures lagged official expectations owing to delays in implementation. Adjusting for cyclical effects, fiscal policy is estimated to have exhibited a virtually neutral stance for the year.
6. The government's budget plans envisage a small expansion in 2006 and a gradual deficit reduction over 2007-08. The aim is to achieve a deficit of 1 percent of GDP by 2008 (from 1½ percent of GDP in 2006) and overall balance by 2010. In response to regional tax competition and to increase supply-side incentives, the authorities are considering an accelerated phasing-out of the payroll tax, and reducing the progressivity of personal and corporate income taxation, offset by an increase in indirect taxes. On balance, the plan combines a reduction of the tax burden as a share of GDP over the next three years (by about 1 percent of GDP) with expenditure reductions amounting to about 1½ percent of GDP, focused on the public sector wage bill, discretionary spending, and social expenditures. However, most of these measures are yet to be approved and the ongoing public sector wage negotiations could result in larger spending than currently envisaged.
7. While a reduction in taxation could enhance growth, expenditure reform is needed to improve economic efficiency, contain demand pressures, and address the fiscal effects of ageing. We agree that a sharp fiscal adjustment is not required as the medium-term debt outlook remains favorable. Planned tax cuts are appropriate given the relatively high level of Slovenia's marginal effective tax rates. But these need to be supplemented by benefit reform to (i) provide incentives for increased labor participation, particularly of young, lower-skilled, and older workers (see below); (ii) accommodate lower tax revenues; and (iii) make room for higher spending for an ageing population. In this context, we recommend:
• 2006 fiscal stance. Based on the 2005 outturn, the budgeted fiscal stance in 2006 would be expansionary by ½-¾ percentage point of GDP. Given a sharp stimulus from public enterprise infrastructure spending and in view of near-term inflation risks, the mission recommends using appropriate discretion to target a neutral fiscal stance, which implies a deficit of about 1 percent of GDP (compared to 1½ percent in the budget).
• Medium-term adjustment plan. The structural deficit is expected to decline by a negligible amount over the next three years, and adjustment to achieve the targets is somewhat back-loaded. With cyclical conditions that are expected to improve steadily, and in light of sustainability issues from ageing, the authorities need to aim for early achievement of structural balance or a small surplus. Accordingly, a prudent position would be to target a smoother structural adjustment of ⅓-½ percentage points of GDP in both 2007 and 2008, reaching near balance by 2009. In this context, the mission welcomes the intention to strengthen spending discipline, as this will also enhance the countercyclical nature of fiscal policy. Government guarantees to public enterprises have been increasing, and we suggest curbing the accumulation of state contingent liabilities to prevent an erosion of fiscal control over time.
• Improving the flexibility and efficiency of public spending. The stability of key spending areas relative to the EU-15 reflects budget rigidities, owing to the substantial share of entitlement programs in total spending, long duration and wide coverage of social benefits, the centralized wage-setting mechanism, benefit indexation methods, and institutional impediments to rationalizing excess school and health care capacity. For example, a decline in the school-age population has not been offset by a corresponding decline in the number of teachers and primary schools, leading to high costs per pupil. We suggest better linking spending policies to outcomes, and increasing the room for fiscal maneuver through a review of social sector funding arrangements and strengthening the targeting of benefits to low-income households. This will allow medium-term fiscal adjustment to focus on inefficient expenditure.
• Addressing the fiscal effects of ageing. The authorities estimate that even after the planned phasing-in of higher statutory retirement ages and gradual reduction of benefits, pension spending will rise by over 7 percentage points until 2050, from an already high level of 11 percent of GDP in 2004. Under current policies, the mission calculates a long-run fiscal sustainability gap—the permanent adjustment needed to restore intertemporal balance—of 10 percent of GDP in net present value terms. Every year of delay increases this gap by ⅛ percentage point of GDP. The mission recommends a comprehensive approach to pension reform that considers (i) a shift to a notional account system that strengthens the link between benefits and contributions; or (ii) a parametric reform based on increasing the retirement age further and revising the generous pension indexation parameters for calculating the pension base. In addition, measures are needed to encourage long-term retirement savings, especially for middle- and high-wage earners. Accordingly, the mission welcomes the proposed introduction of employer-based retirement savings accounts and encourages the removal of a minimum guaranteed return on the voluntary pensions to stimulate higher long-term savings. Early action is warranted given the long lags with which these policies yield savings.
8. Despite Slovenia's steady economic performance, productivity growth has not shown the dynamism seen among regional competitors, and labor participation has been falling in relative terms. Labor utilization rates have been declining relative to the EU-15 average over the past decade and high marginal effective tax rates may be creating welfare walls that discourage work, especially among low-income workers. Trailing productivity performance compared with other Central European countries may reflect weak investment, labor market rigidities, and regulatory constraints. These factors are slowing convergence to euro area income levels. In this context, a key challenge will be creating a dynamic environment capable of re-allocating labor and capital between regions and industries in the face of changing external demand and production patterns. In our view, priorities include:
• Improving incentives to work. The authorities´ proposal to tie continued payment of unemployment benefits with activation policies is welcome. A more comprehensive tax and benefit reform to reduce marginal effective tax rates, together with pension reform, should increase the incentives for labor participation among younger and older workers.
• Enhancing labor market flexibility. While the motivation for job search should improve once the tax and benefits systems are reformed, the source of some youth unemployment may also lie with the education system, which has weak links to private sector skill demands. The new dynamism of the housing market should reduce impediments to regional labor mobility. Concurrently, relaxing labor market regulations including through lower costs of hiring and firing and a wage-setting mechanism that allows an opt-out for distressed companies, will be needed to increase labor demand. Implementing such measures during good times will mitigate their potential impact on unemployment.
• Improving the regulatory environment and reducing the cost of doing business. Slovenia has the smallest private sector share among the EU-8. This suggests the need for accelerating divestment of state holdings in strategic companies, including the banking, telecom and electricity sectors, to strengthen entrepreneurship and corporate governance, and enable a more efficient market-based resource allocation. Privatization would also help create a reserve for unfunded pension liabilities. Slovenia's business climate also ranks the lowest among EU-8 countries owing to labor market rigidities, lengthy and cumbersome procedures for business registration, and difficulties in establishing property rights and enforcing contracts. We welcome the introduction of the all-in-one system for registration of individual entrepreneurs, urge its extension to corporations, and suggest a further reduction of regulatory barriers, particularly by strengthening judicial efficiency.
• Fostering a faster climb up the technology ladder. The relatively slow growth in productivity indicates that Slovenia is not climbing up the technology ladder fast enough. While there is evidence of increasing specialization into high-tech sectors, the pace of export quality upgrading appears to be lagging behind regional competitors. Maintaining its relatively favorable position and improving productivity growth will thus require more internal competition, higher investment in research and development, innovation—including through a more fluid interaction between research centers and firms—and foreign direct investment to fully benefit from technological spillovers.
9. In the run-up to euro adoption, financial markets have increasingly integrated with the euro area, and the Bank of Slovenia (BoS) has little scope for an independent monetary policy. Following a reduction in policy rates by the BoS, and an increase in rates by the ECB, there is now a one-percentage-point differential between BoS and ECB rates. In an environment of strong cross-border flows, the BoS may not be able to maintain this differential for much longer with Slovenia's risk premium falling fast and growing external borrowing by banks. Nevertheless, we support the BoS´s approach to maintain the differential for as long as markets permit in order to avoid fueling the upward momentum of an economy with a rapidly closing output gap.
Financial sector issues and vulnerabilities
10. The banking system remains sound and stable, but bank profitability is increasingly under pressure in a highly competitive environment. Yield convergence is compressing bank margins, euro adoption will eliminate most of banks' exchange-rate based income, and persistent competition for market share is leading to a relaxation of credit standards and borrower quality. Yet, applying the new International Financial Reporting Standards would effectively result in a decrease of required provisioning. The authorities´ transitory measure of classifying the released provisions as reserves will alleviate this impact, but in the longer run, the combination of these factors could lead to a weakening of balance sheets. The mission recommends close supervisory scrutiny of banks against weakening credit assessment standards, to ensure that the structural balance sheet transformation they face does not entail distress for some institutions.
11. Euro adoption will virtually eliminate exchange rate risks, but the banking system is increasingly susceptible to market risks. Gross external debt is increasing rapidly due to bank borrowing for on-lending. Although part of the foreign liabilities is recycled into liquid foreign assets—which may reduce vulnerabilities—a substantial share of the new loans comprises variable-rate loans. So far, borrowers have only seen rates go down, and as euro-area interest rates rise, the borrowers´ ability to pay, and the quality of loans could be affected. Banks need to increase public awareness of interest rate risks, and supervisors need to develop more comprehensive data on household indebtedness, including indicators of debt concentration and debt-servicing capacity of indebted households. The growing volume of mortgage lending suggests that the housing market is a related risk, and a database of residential real estate transactions should be established to monitor developments in prices and turnover. The extent of the risk transfer to insurance companies through credit insurance also needs to be closely monitored. Given that banks rely extensively on foreign funding, problems with foreign banks or neighboring countries who share a common lender, could trigger financial contagion. Bank supervision needs to strengthen coordination with foreign supervisors of banks—parent banks, lenders, and subsidiaries—with large exposure to Slovenia to contain such contagion risks.