Slovenia: 2007 Article IV Consultation - Preliminary Conclusions of the IMF Mission
March 16, 2007
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.
1. Slovenia has done well. After fifteen years of transition, Slovenia became the first among the new EU members to adopt the euro in January 2007. Sound macroeconomic policies have allowed Slovenia to sustain robust growth with small external imbalances and public debt while gradually lowering inflation and interest rates to euro area levels. EU entry has fostered deeper trade integration and intensified growth spillover from the region. Per capita income reached about 80 percent of EU-average in 2006.
2. To sustain this good performance in the euro area, Slovenia will need to maintain its commitment to policy discipline and boost structural reform. A balanced expansion will require tight fiscal and prudent wage policies, and sustained financial stability. Deeper structural reforms are needed to tackle Slovenia's many rigidities in public spending, financial sector and labor markets. Rapid aging also puts a premium on productivity and labor participation to boost potential growth. Given the still strong macroeconomic fundamentals and electoral pressures that could pick up next year, the current period presents the best opportunity to implement reforms.
The outlook is good provided sound policies continue
3. Convergence-related growth intensified in 2006, bringing output above potential. Growth reached 5.2 percent, the highest level in this decade, as robust credit growth and tax policies supported a broad recovery in investment. The strong economy has boosted job creation, mainly in services, and unemployment has declined. These trends, along with rising vacancies and a continued climb in capacity utilization to record levels, suggest that the output gap is now positive. Average inflation remained stable at 2½ percent, aided by receding oil prices and declining unit labor costs. However, the pick-up in core inflation in late 2006 raises concerns of overheating risks.
4. The near-term outlook is favorable, with risks to growth and inflation on the upside. In 2007, growth is projected to remain robust at 4½ percent. Although investment is expected to decelerate, owing to the termination of tax breaks and higher interest rates, domestic demand should remain the primary engine for growth with private consumption rising in line with disposable incomes. Exports are projected to grow more slowly in line with euro area trends, although the concurrent decline in imports will limit the net impact on growth. The current account should remain broadly unchanged. Core inflation is expected to rise slightly on account of the services sector, while the headline rate should remain stable at around 2½ percent, assuming continued prudent wage policies, and modest hikes in administrative prices. However, a fiscal expansion or a relaxation of incomes policies could well lead to demand pressures and fuel inflation. Continued strong credit growth and climbing asset prices add to these risks.
5. Over the medium term, the main risk to growth and faster convergence stems from a failure to boost competitiveness. Beyond 2007, growth is expected to remain around 4 percent and inflation at 2½ percent, assuming continued prudent fiscal and wage policies and further structural reforms. As the experience of the current EMU members since they adopted the euro suggests, failure to contain fiscal balances and wage growth and to boost structural reform and flexibility can lead to low growth and a loss of competitiveness when the economy slowed down. External risks also arise from higher world oil prices and a potential disorderly unwinding of global imbalances that would lead to euro appreciation and lower growth.
A balanced expansion and long-term fiscal sustainability, in the absence of pension reform, require a more ambitious fiscal consolidation than envisaged
6. Following its tradition of fiscal prudence, Slovenia maintained a broadly neutral fiscal stance in 2006. Preliminary data suggest that the general government deficit declined slightly to around ¾ percent of GDP in 2006 in cash terms (from about 1 percent of GDP in 2005). The budgetary overperformance, of around ½ percent of GDP, primarily reflects stronger than planned tax revenues from cyclical gains as well as one-off factors. In particular, windfall gains related to the adoption of International Accounting Standards helped boost corporate income tax collections, more than compensating for the reductions in payroll taxes. Total expenditures as a share of GDP remained stable despite tighter than planned public wage policies.
7. In the coming years, fiscal pressures on the government are expected to mount. The budget targets an increase in the general government deficit to 0.9 percent of GDP in 2007 and 1.2 percent of GDP in 2008 (without the VAT increase which the government plans to forego). This stance would be procyclical in an environment with growth above potential. Over the medium-term, the deficit would decline to ½ percent of GDP by 2009 and to a structural balance in 2011. Reaching these medium-term targets will be a challenge without significant and durable expenditure measures. While the welcome comprehensive tax reform lowering the regionally high personal and corporate income tax rates will kick-in starting 2007, most of the larger reductions in expenditures are backloaded to 2009. Furthermore, the rigid spending structure limits scope for adjustment, especially in adverse times. Additional spending pressures would come from the planned investments in the railways (about 30 percent of current GDP over the next decade which would be partially financed with public private partnerships). Together with age-related outlays, these spending pressures can increase public debt to unsustainable levels over time.
8. Given these challenges, a more ambitious than envisaged expenditure-based consolidation is needed to ensure a balanced expansion, increase flexibility and attain the medium term targets. Based on these considerations, the mission recommends the following policies as key priorities:
· A neutral fiscal stance in 2007-08 to contain overheating risks: Excluding the VAT increase, the budgets would imply a procyclical impulse, measured as a change in the structural primary balance, of about ½ percent of GDP over 2007-08. Planned investment in railways would add another ½ percent of GDP to the impulse over the same period. A neutral stance could be achieved by a strict implementation of the wage bill along with further rationalization of current transfers. Early implementation of these measures would also help mitigate the risks in 2008-09 stemming from uncertainties in corporate income tax collections, and higher than planned wage bill and capital spending. The planned introduction of regional governments add to these risks if they are not fiscally neutral.
· Achieving the fiscal targets by permanent measures that improve flexibility and efficiency of spending. Recent reforms in social benefits through reindexation, central registration and their linking to active employment policies are important steps towards reducing budget rigidities. However, more substantial measures are needed to accommodate spending pressures over time and preserve the lower tax burden from recent reforms. For example, cross-country indicators of expenditure efficiency show more room to rationalize in areas such as education, health care, and social transfers and improve targeting of social spending. This can be facilitated through performance budgeting and linking funding with outcomes to preserve the quality of public spending. Devoting more resources and stronger government commitment to this effort will be important.
· Substantive changes to the pension system to ensure longer-term fiscal sustainability. Slovenia has one of the most rapidly aging populations, lowest average retirement age, and a high pension to wages ratio in Europe. The planned strategy for active aging aimed at keeping older worker longer in the labor force is desirable, but longer-term fiscal sustainability requires more ambitious systemic reforms that raise the effective retirement age and reduce generous benefits (in particular, the wage-based indexation and the assessment period), and increased reliance on private pensions. In the absence such reforms, the medium-term fiscal consolidation will need to be more ambitious by achieving a structural balance, or even a small surplus, by 2009.
9. Expenditure reform and fiscal discipline could be facilitated by strengthening the national fiscal framework. Slovenia currently has a two-year rolling budget framework, and relies on external macroforecasts for budget preparation. Yet, restructuring of the rigid spending has lagged behind and medium-term targets are recurrently shifted out. Strengthening the role of an independent fiscal institution in policy monitoring and assessment, and introduction of an expenditure rule that sets a nominal ceiling on spending based on a structural deficit target could enable more focus on expenditure-based consolidation and help preserve cyclical gains. To preserve overall fiscal discipline, a deficit rule for regional governments will be needed.
The banking sector remains sound but vulnerabilities should be reduced in good times to contain risks
10. The financial sector is developing from a low base and risks to financial stability in Slovenia are currently low. Although bank credit has increased fast, financial deepening remains modest compared to peers. The level of household credit, at 15 percent of GDP in 2005, is particularly low in the EU context. The banking system is also getting more integrated into the world markets. With a declining deposit base, banks have relied on foreign loans to finance credit growth, while the larger banks have increased their holdings of higher-yielding foreign assets, especially in Southeastern Europe. Despite these trends, bank soundness indicators are stable, and stress tests show that the sector remains robust to credit and interest rate risks. With euro accession and banks' comfortable capital positions, investor sentiment remains positive as indicated by low spreads and solid credit ratings.
11. Over the longer run, the banking system is expected to come under more pressure which calls for close monitoring of risks. Rapid credit growth, especially to enterprises, is raising credit risks. Due to low FDI and undeveloped equity markets, Slovene enterprises have relied on debt financing, which has led to increasing leverage ratios. To safeguard against rising credit risks, the mission recommends greater use of bank-specific stress tests, closer vigilance of balance sheet mismatches in the enterprise sector, and inclusion of past credits in the credit registry envisaged for 2008. While a continued increase in consumer and mortgage credit from low levels is unlikely to threaten financial stability in the near term, house price developments and household credit will need to be followed closely to detect any asset bubbles. The increasing share of foreign assets and liabilities in banks also warrants close monitoring of risks. In this regard, the good collaboration of Bank of Slovenia with foreign supervisors is welcome.
12. Using these good times to reduce the underlying vulnerabilities would help ensure financial stability over time. Declining interest margins and loss of foreign exchange revenue will put pressure on profitability, which is already regionally low, and rapid expansion can start stretching capital adequacy ratios. The high share of cross-ownerships (large number of indirect ownership linkages) can amplify systemic impact of shocks, as indicated by the recent experience in Iceland. Competition and market development may also have been constrained by state dominance in the financial sector. The absence of large state-dominated banks from the stock exchange weakens transparency and oversight over management. To reduce vulnerabilities from the cross-ownerships and improve transparency and corporate governance, the mission recommends listing the large banks and insurance companies in the stock exchange, implement strengthened regulations on board membership in line with EU norms, and rapid progress with privatization. In addition, the government should establish a clear strategy for banks in which it continues to hold important stakes, and eventual capital needs if expansion continues.
13. Further development of capital markets, together with stronger supervision, could help reduce vulnerabilities and deal with some other challenges in the Slovene economy. Indicators of financial development point to Slovenia lagging behind its EMU peers, and integration with European capital markets is just beginning. A more diversified supply of financial products could mitigate vulnerability to credit risks by risk transfer and better access to equity finance. The listing of the telecommunications company is a start for improving the depth and liquidity of the local stock market, and the mission encourages further listing of other large companies. The plans to link the local stock exchange to EU counterparts and to fully adopt the MiFID regulations, and the recent implementation of several EU directives are also welcome. The development of private pension funds by amending highly restrictive regulations on returns, apart from a boost to market deepening, would help deal with the fiscal costs of aging. The planned introduction of new laws on venture capital funds and the amendment of the law on investment funds could help financial innovation and equity financing for SMEs. The mission welcomes the plans for strengthening non-bank supervision to ensure a balanced development in the sector.
Other structural reforms should be accelerated to sustain growth
14. Structural reforms in the financial sector could boost productivity and facilitate convergence. The shares of high-tech products in exports and value-added, and information technology investment in Slovenia are well below the EU25 average. This mirrors slow structural change and sluggish growth in the number of new enterprises. Structural weaknesses in the financial sector may have contributed to problems in allocating resources to higher productivity activities. The bank-based financial system may have focused on providing bank credit to existing clients, while studies show that arms-length systems are better at allocating resources to new firms, technologies and activities. The development of capital markets can make a contribution to boosting technological upgrading and productivity.
15. Sustaining long-term growth in the euro zone will also require greater labor market flexibility and participation. The mission welcomes the implementation of new regulations making unemployment benefits more conditional on acceptance of work. A lower tax wedge for low-wage earners, and an active aging policy should help increase incentives to work. Ongoing discussions on reforms to the Labor Relations Law that allows greater clarity on the use of temporary jobs will help enhance labor market flexibility. These measures should be complemented by further liberalization of employment protection regulations to reduce the costs of labor and stimulate labor demand.
16. Simplification of the regulatory burden and strengthened judicial enforcement are key priorities to foster growth by improving the business climate. Slovenia ranks relatively low among European economies in the ease of doing business, due to a rigid labor market, difficulties in starting a business and property registration, and the time required for contract enforcement due to lengthy judicial procedures. Recent initiatives to reduce court backlogs and impose a mandatory assessment of administrative burden for new regulatory proposals recognize these challenges. Speedy implementation of these measures, along with the all-in-one system for business registration for corporations now envisaged for November 2007 should alleviate the administrative burden on business enterprises. The implementation of the government's privatization plans, would also help attract foreign direct investment and enhance efficiency.
We thank the Slovene authorities for their open discussions, excellent cooperation and warm hospitality. We wish them the best for continued success in the euro zone.