IMF Executive Board Concludes 2006 Article IV Consultation with the Republic of SloveniaPublic Information Notice (PIN) No. 06/73
July 7, 2006
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On June 30, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Slovenia.1
Slovenia is set to become the first among the new European Union member states to adopt the euro. Aided by broadly favorable initial conditions and generally sound macroeconomic and incomes policies, Slovenia has over the past decade sustained robust growth with small external imbalances, while gradually lowering inflation to euro-area levels. Long-term interest rates, the fiscal deficit, the public debt ratio, and inflation were all within the Maastricht Treaty limits at end-2005. This, combined with the tolar's two successful years within the ERM2, has set the stage for euro adoption in January 2007.
The Slovene economy continued to grow strongly in 2005 amid a stable macroeconomic environment. Real GDP growth reached 4 percent supported by strong exports, while the unwinding of inventories accumulated in 2004 ahead of EU accession slowed domestic demand and imports. In spite of the oil price-driven deterioration of the terms of trade, the external current account deficit in percent of GDP declined by half to about 1. As growth remained above potential and idle capacity tightened, the output gap likely closed. Competitiveness remained adequate, supported in part by the continued positive gap of 1 percent between productivity and real wage growth. External debt jumped by 13 percentage points to 71½ percent of GDP reflecting strong foreign borrowing by banks.
Average inflation in 2005 declined to 2½ from 3 ½ percent in 2004. Despite the reduced available slack, core inflation more than halved to less than 1 percent during the year, owing to lower tolar depreciation expectations, increased competition following EU accession, and conservative wage policy. In particular the implementation of the guideline requiring real wage to trail productivity helped minimize second-round effects of energy price shocks.
The fiscal deficit in 2005 remained low and public debt was kept at below 30 percent of GDP. At 1.1 percent of GDP, the general government deficit was better than projected, reflecting one-off municipal revenues and lags in spending EU transfers. Adjusting for cyclical effects, this deficit implied a neutral fiscal stance. Tax revenue was buoyant, as indirect taxes recovered from a temporary drop following EU accession in May 2004.
Monetary policy through 2005 was marginally tight, but credit growth remained strong. Upon entering the ERM2 in 2004 the central bank set its key policy rate at 4 percent and kept it unchanged until end-2005, 200 basis points (bps) above the European Central Bank (ECB) refinance rate. However, a surge in short-term capital inflows in early 2006 and Bank of Slovenia's desire to prompt banks to gradually switch away from its bonds ahead of euro adoption led to cumulative reductions in the policy rate of 75 bps, which together with increases in the ECB refinancing rate, narrowed the interest rate differential with the ECB to 50 bps. Buoyed by strong foreign borrowing by banks, credit growth accelerated by 3 percentage points to 23 percent. Bank profitability and asset quality remained adequate and non-performing loans declined—in part reflecting a rapid expansion of new credit. However, the relaxation of credit standards owing to intense competition for market share and the increased recourse to variable-rate contracts have increased interest and credit risks.
In 2006, growth is projected to remain around 4 percent, but would be more balanced. The contribution of domestic demand would rebound, reflecting a recovery in investment and steady growth of consumption. Investment would be supported by highway construction, and lower inventory de-cumulation. Exports would continue to grow in line with favorable conditions in the EU, while import growth would accelerate, reflecting stronger domestic demand. This, combined with a further deterioration of the terms of trade would lead to the widening of the external current account to 2 percent of GDP. Despite an expected up-tick in core inflation, the Maastricht inflation ceiling is not expected to be breached, aided by price competition in the euro zone and continued wage restraint. Fiscal policy would need to be at least neutral to support this benign outlook.
Structural reform is still lagging, leaving the economy with many rigidities that pose challenges to growth and fiscal sustainability in the long run. Slovenia is beset with a relatively unfriendly business environment with an inflexible labor market, stringent business regulations, and a high share of government ownership of enterprises. This has led to lackluster performance in attracting Foreign Direct Investment (FDI) relative to other Central European countries. Generous welfare and retirement benefits have reduced labor participation, while one of the fastest aging populations in Europe, highlights the challenge to long-run fiscal sustainability.
Executive Board Assessment
Executive Directors commended the Slovenian authorities for the successful economic transformation that has paved the way for the country's entry into the euro zone in January 2007. They pointed to solid economic growth, low inflation, moderate public and external debt levels, and a sound banking system as evidence that years of prudent macroeconomic and incomes policies have paid off.
At the same time, Directors stressed that while the near-term outlook remains benign, important challenges remain for the medium term. Sustaining income convergence in the euro zone requires more attention to improving economic flexibility and long-term growth prospects. Directors therefore emphasized the need to implement policies that increase productivity, create an efficient business environment and a flexible labor market, and improve sustainability of public finances in the face of population aging.
Directors noted that the imminent loss of the exchange rate instrument puts a premium on fiscal and incomes policies to sustain a balanced expansion in the near term. With the output gap virtually closed and interest rates converging toward euro area levels, Directors stressed the need for a neutral fiscal stance in 2006 to contain inflation risks. This would require achieving expenditure savings to keep this year's fiscal deficit below budgeted levels. Directors also emphasized the importance of continuing with prudent wage settlements to contain price pressures and achieve a balanced growth.
Directors emphasized that over the medium term fiscal policy needs to deal with the challenges of an aging population, while improving the flexibility and efficiency of public spending. They welcomed the authorities' commitment to achieve a structural fiscal balance over the medium term, but recommended a frontloaded adjustment. This would help achieve balanced growth and provide an early start to addressing long-term fiscal sustainability concerns related to population aging. Directors welcomed the authorities' plans to reduce the progressive income taxes to enhance incentives to work and boost growth, but emphasized the need to accompany tax reform with expenditure rationalization. They urged the authorities to focus expenditure reforms on reducing fiscal rigidities and age-related spending pressures. Priorities in this regard would be parametric reforms of the pension system, revisions of the level and indexation mechanisms of social benefits, and linking social benefits to work-reinsertion policies.
Directors acknowledged that the authorities' consensus-based approach to reforms had helped preserve social cohesion, but noted that the authorities need to speed up the implementation of policies that boost productivity growth and increase labor flexibility and participation to maintain competitiveness and ensure faster convergence. They noted that while price competitiveness appears adequate and export growth strong, Slovenia trails other new EU member states in gaining market shares. They also observed that Slovenia's productivity growth lags behind that of its regional competitors, reflecting Slovenia's high income level as well as weak FDI and technological spillovers. Labor participation is also relatively low among the older and younger working-age population. To deal with these challenges, Directors urged the authorities to speed up efforts to raise labor utilization by lowering marginal tax rates, improving the targeting of social benefits, and reducing incentives for early retirement. Simplifying business regulations and reducing constraints that create labor market rigidities would increase efficiency and attract FDI. In this respect, they welcomed the creation of centralized registration for independent entrepreneurs and encouraged extending it to larger corporate entities. Directors also supported the authorities' plan to accelerate the divestment of public companies.
Directors observed that while the banking system is sound, bank supervision should be enhanced to guard against market and credit risks. The rapid increase in credit amid competition for market share has exposed banks to higher credit risks, especially as interest rates in the euro zone are set to rise. Directors noted that although banks are expected to be resilient to these shocks in the near term, euro adoption will pressure profitability through competition, yield convergence, and loss of foreign exchange related revenue. Directors welcomed the steps taken to ensure adequate liquidity standards upon euro adoption, but called on the authorities to strengthen supervision of banks' credit assessment standards to ensure continued strong balance sheets. They encouraged enhanced coordination with foreign supervisors to limit contagion risks arising from the regional concentration of funding. Directors also urged further progress in increasing the role of the private sector in the banking system to boost efficiency in an increasingly competitive international environment.