IMF Executive Board Concludes 2007 Article IV Consultation with the Republic of SloveniaPublic Information Notice (PIN) No. 07/57
May 23, 2007
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 May 18, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Slovenia.1
Economic performance strengthened in 2006, supported by a recovery in investment and continued growth spillovers from the European Union. Declining real interest rates in the run-up to euro adoption on January 1, 2007 helped sustain credit growth and domestic demand. The strong economy boosted job creation, while unemployment declined and capacity utilization reached record high levels. In this environment, prudent incomes policies helped contain wage pressures, which, along with receding oil prices, sustained price stability.
Growth is projected to slow down slightly in 2007-08, as the investment boom decelerates. Domestic demand should remain the primary driver of growth as private consumption is expected to rise in line with higher disposable incomes and employment. Inflation is expected to remain broadly stable, assuming continued prudent policies. Overheating is a key risk—with tightening capacity constraints, the boost to demand from continued strong credit growth, climbing asset prices, and wage increases can unleash price pressures. Other risks to the outlook arise from higher world oil prices and euro appreciation.
While Slovenia's fiscal deficit narrowed in 2006, the authorities' fiscal plans for 2007 imply an expansionary fiscal stance despite the overheating risks and major medium-term policy challenges. The general government deficit amounted to ¾ percent of GDP in 2006, reflecting strong cyclical and one-off gains in revenues as well as a tighter-than-planned wage bill. In 2007, the government has started to implement an ambitious tax reform, which will lower revenues over a few years, and to increase infrastructure spending, which will be only partially offset by a tight wage bill and reforms in expenditures. These fiscal plans imply increases in the general government deficit to 1.3 percent and 1.7 percent of GDP in 2007-08, with a procyclical fiscal impulse of about 1 percent of GDP over the period. Over the medium term, the authorities target a deficit of about 1 percent of GDP in 2009 and structural balance by 2011, for which measures remain to be fully identified. With one of the most rapidly aging populations in Europe, the pension burden is also a major longer-term challenge for fiscal sustainability.
Cross-border integration of the financial sector has been on the rise as banks continued their borrowings abroad to finance strong domestic credit demand and expand their foreign operations. Despite increased vulnerability to credit risks and pressures on profitability, the financial sector remains sound to deal with these risks. Nevertheless, the largely state-owned banking sector is relatively inefficient by regional and EU standards and capital market development lags behind European Monetary Union (EMU) peers.
The main challenge to Slovenia's medium-term performance is to maintain competitiveness. Strong export growth and indicators of real exchange rate misalignment presently do not indicate a lack of competitiveness. Yet, sluggish growth in export market shares in the EU underscores the need for stronger technological upgrading of exports and productivity growth. Structural rigidities in the budget and in the labor and financial markets suppress economic flexibility, which contains potential growth and Slovenia's ability to deal with adverse shocks.
Executive Board Assessment
Executive Directors commended Slovenia's successful euro zone entry in January 2007, which was underpinned by sound macroeconomic policies that have allowed the full observance of the Maastricht Treaty convergence criteria. Economic growth has been robust and is projected to remain above the EU average for the next few years, while unemployment has continued to decline and inflation remains low and stable.
Looking forward, Directors observed that important challenges remain. They stressed that, to ensure successful euro area membership and sustained convergence, a strong commitment to fiscal and wage prudence and accelerated structural reforms will need to be maintained. The current favorable environment should be used to reduce structural rigidities and financial vulnerabilities, boost productivity and competitiveness, diminish state intervention in the economy, and improve the sustainability of public finances. Directors also noted that overheating risks remain and should be monitored closely.
Directors questioned the procyclical fiscal stimulus in 2007-08 implied by the government's fiscal plans at this cyclical juncture and recommended a neutral fiscal stance. To this end, they suggested that the consolidation should focus on reforming the rigid and inefficient spending structure.
Directors emphasized that, over the medium term, fiscal policy needs to deal with the challenges of an aging population while ensuring that the government's target of a structural balance can be achieved. They noted that, while reforms to reduce the tax burden are welcome, expenditure measures to support these targets remain to be fully identified and that the envisaged adjustment is backloaded. Therefore, up-front reforms in nondiscretionary spending and the relatively generous pension system would not only ensure a balanced expansion, but enhance budgetary efficiency and flexibility and address long-term fiscal sustainability concerns. Directors encouraged the authorities to take steps to forge the necessary political consensus for early reforms.
Directors observed that, while the banking system remains sound, Slovene banks are less profitable and efficient than their EU counterparts. Directors noted the pressure on bank profitability from declining interest margins, high costs, and state dominance in the banking sector, and encouraged the authorities to take measures to increase bank competition and efficiency, including privatization of state-dominated banks. Given the rapid credit expansion and increasing foreign activities of banks, Directors welcomed the steps being taken to strengthen bank supervision, including increased cooperation and information-sharing with foreign bank supervisors, and urged supervisors to closely monitor credit risks and exposures to foreign markets.
Directors noted that Slovenia's capital market development lags behind EU levels, resulting in heavy dependence on bank intermediation and in corporate leverage ratios that are well above the euro-area average. They therefore commended the authorities' efforts to foster integration with EU financial markets, which will expand saving and financing options and help strengthen the financial sector's contribution to Slovenia's development.
Directors stressed that further reforms in labor markets and the business environment would enhance competitiveness and Slovenia's long-run growth potential. They welcomed recent initiatives to remove administrative barriers to doing business, and called for additional efforts to attract foreign direct investment. While they also welcomed the improved incentives to work, Directors emphasized that increasing labor market flexibility further will require easing of employment protection regulations. Some Directors also questioned the sustainability of improving competitiveness by keeping wage increases below productivity gains.