Slovenia 2011 Article IV Consultation--Concluding Statement of the Mission
March 21, 2011
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.
An export-oriented recovery is underway. But domestic demand and potential output growth are unlikely to return to their pre-crisis trends, dampening medium-term growth prospects. The main challenges are to manage the deleveraging process, promote sustainable growth, and bring down unemployment. Fiscal policy is appropriately tightening but the quality of the adjustment needs to be improved to ensure its durability. Implementation of the pension reform is a “sine-qua-non” condition to preserve fiscal stability and prevent increases in sovereign financing costs. Banks suffer from weak capitalization and asset quality. Their governance should be strengthened, including by broadening the investor base.
Economic outlook: from overheating to deleveraging
1. The global crisis exacerbated previous imbalances in the fiscal, financial, and real sectors. Easy external financing conditions and expansionary fiscal policy before the crisis led to a credit boom, rising debt in the corporate sector, and increasing wages. The global financial crisis and the sharp fall in external demand brought the domestic boom to an abrupt end. The legacy of the boom-bust cycle is an over-indebted corporate sector and weaker banks. It also contributed to current large fiscal deficits, higher unemployment, and deteriorated competitiveness. More importantly, high pre-crisis growth led to expectations that Slovenia could grow out of its structural problems, leading to postponement of long-overdue reforms.
2. Slovenia is experiencing a sluggish recovery. In the near term, exports will drive real GDP. Investment will likely remain subdued due to deleveraging, the winding down of large construction projects, and tighter international financial conditions. Consumption growth is also expected to be modest in view of weak labor market conditions and fiscal retrenchment.
3. Risks to the outlook are tilted to the downside. While near-term export prospects have improved, weak balance sheets of banks are an ongoing risk to growth. Moreover, the inability to contain the general government wage bill, pension spending, and other entitlement outlays could threaten fiscal sustainability. Finally, additional increases in labor costs could further erode competitiveness and undermine the recovery.
4. Without structural reforms, potential output growth is expected to be lower than before the crisis. The construction boom, a main force behind gross capital formation in the run-up to the crisis, is unlikely to be repeated. Other factors include slower productivity growth, higher structural unemployment, and more difficult financing conditions. Policy makers and social partners should recognize that potential output growth is unlikely to return to its pre-crisis trend without structural reforms.
Financial sector: recapitalization, governance, and public sector involvement
5. The crisis hit banks hard. Due to losses on exposures to the indebted non-financial corporate sector, particularly construction and financial holding companies, banks’ aggregate profits turned negative in 2010. Total assets declined and corporate credit growth remained anemic. In contrast, household borrowing was strong, mainly thanks to mortgage loans, which allowed shifting some credit risk from overextended construction companies to less-indebted households. In spite of the previously announced phasing-out of liquidity assistance by the ECB and the government, and tighter foreign funding conditions, banks did not suffer immediate liquidity pressures.
6. Banks’ capitalization needs to be strengthened. Slovenian banks are among the most thinly capitalized in the EU, particularly the systemic domestic banks. Ongoing uncertainty about asset quality exacerbates this problem. The introduction of Basel III will also require more capital, although the effects will be smaller than in other countries thanks to more limited use of hybrid capital and tighter supervisory requirements. Publicly-announced recapitalizations for the systemic banks are a good start, but probably insufficient. The authorities should further tighten capital requirements and stand ready to inject public funds if private investors are not forthcoming. Higher capitalization will keep the banks’ franchise value and contain the cost of borrowing.
7. Using distortive instruments to boost lending to non-financial corporations should be avoided. Lending to non-financial corporations is weak mostly because the sector is over-indebted. While the mission appreciates the need to ensure adequate credit supply for credit-worthy companies, a tax penalizing banks for scaling back exposures to risky borrowers distorts banks’ risk management. The mission sees some merits in having a systemic approach to the management and selling of stakes in non-financial companies that banks seized as collateral following bankruptcies. This solution should aim at making banks’ portfolio more transparent and accelerating the restructuring of companies if necessary. However, the approach chosen should have no fiscal implications.
8. Housing sector developments should be monitored carefully. While households’ balance sheets are strong relative to EU averages, indicating scope for additional borrowing, the authorities should ensure that recently buoyant mortgage lending does not lead to the creation of new imbalances. The mission welcomes the Bank of Slovenia’s willingness to tighten the cap on loan-to-value ratios if necessary. The public sector should not use scarce fiscal resources to purchase housing to sustain the construction sector; this would impede necessary price adjustments and create moral hazard.
9. Banks’ governance should be strengthened, including by broadening the investor base. Expanding ownership to include private and foreign investors will help address long-standing governance and risk management weaknesses by reducing possible state interference in credit allocation. The authorities should set out clear divestment strategies and commit to their implementation.
Fiscal sector: improving the quality of the adjustment
10. The fiscal deficit is set to continue narrowing in 2011. Containment of the wage bill, reduced indexation of pensions and other entitlements combined with capital expenditure and capital transfer cuts are expected to lower the deficit. These steps more than offset revenue declines arising from the existence of one-off non-tax revenues in 2010.
11. The mission supports the fiscal consolidation targets but is concerned with the composition of the adjustment. In light of the uncertainty in financial markets and contingent liabilities, the mission considers the planned consolidation necessary. The authorities are committed to the consolidation path. However, additional measures over and above those announced so far are needed to sustainably bring the general government deficit below 3 percent by 2013. Measures are mostly temporary and largely rely on extending policies introduced in 2011.
12. Durable consolidation measures should be specified and implemented. A census of public employees, functional reviews of institutions, and a pay study comparing compensation in the public and private sectors should be carried out. Moreover, the policy of removing disparities in public sector wages should not increase the general government wage bill; social programs should be better targeted and their eligibility criteria tightened. The government should also reduce public sector employment by 1 percent per year in 2011 and 2012 as planned. The rise in the minimum wage that was already implemented last year may put pressure on the public wage bill when the freeze is lifted; lasting consolidation measures should be introduced to offset this effect if it materializes.
13. The pension reform is a critical step in the right direction and should be promptly implemented. Slovenia is projected to have one of the largest pension expenditures in the EU by 2050. Moreover, projections suggest that transfers from the state budget to the pension fund would remain very large even after the pension reform. Additional measures will need to be implemented going forward to ensure sustainability, including: (1) a more rapid increase in the effective retirement age to 65 years of age for both men and women; (2) moving indexation gradually towards full price indexation; (3) automatically indexing the retirement age to life expectancy at retirement once an effective retirement age of 65 has been attained.
Structural reforms: preserving competitiveness
14. Wage growth needs to be contained. The increase in the minimum wage in 2010 prevented wages to fully respond to the downturn. It hurt employment in labor-intensive sectors and put upward pressure on the general wage level, exacerbating already high unit labor cost compared to regional peers. The mission suggests eliminating the mandatory wage supplement for years of service in order to foster employment, particularly of older workers. The mission also advises cancelling any further indexation of minimum wage in view of its high level and potential spillover effects on other wages. Going forward, ensuring alignment of wage and productivity growth will be crucial given the large share of labor-intensive goods in exports.
15. Greater labor market flexibility is critical to boost potential growth. The crisis will have a durable impact on employment given the structural nature of some of the job losses and limited labor market flexibility. The Mini-Jobs Act and the pension reform will increase employment. But the enacted reforms have so far not addressed the need to reduce employment protection of regular workers, which remain among the highest in OECD countries. The mission recommends enacting rapidly the envisaged reduction in notice periods and severance payments. This would facilitate the reallocation of workers across sectors, avoid increasing labor market dualism, and foster FDI inflows.
16. Enhancing FDI attractiveness would contribute to boosting productivity growth. Slovenia ranks relatively low among European economies in indices of competitiveness and ease of doing business. FDIs have therefore been low in the past. The authorities have adopted several measures to improve the business climate, including the introduction of the “one-stop shop” for company registration. Further reforms should focus on reducing administrative burden, simplifying bankruptcy procedures, enhancing competition in product and financial markets, and accelerating the divestment process, notably in key infrastructure sectors.
We thank the Slovenian authorities for open discussions, excellent cooperation, and warm hospitality.