KEY ISSUES Context: Slovenia is facing a deep recession resulting from a vicious circle of strained corporate and bank balance sheets, weak domestic demand, and necessary fiscal consolidation. The headline deficit remains around 4¼ percent of GDP in 2013 excluding bank restructuring costs, and public debt—55 percent of GDP at the end of 2012—is increasing rapidly. Concerns about growth, banks, and the fiscal gap and large fiscal contingent liabilities have kept sovereign borrowing rates high. Based on the asset quality review (AQR) and stress tests (ST), the government is recapitalizing state-owned banks. Challenges: (i) building on the planned recapitalization, promptly restructure banks to ensure financial stability; (ii) restructure the corporate sector to avoid a recurrence of financial problems; (iii) pursue gradual fiscal consolidation over the medium term, including via further pension reform, to safeguard debt sustainability. Staff views: The independent AQR and ST and recapitalization are key milestones. However, only restructuring the corporate and bank sectors, including a thorough clean-up of bank balance sheets, and reducing the role of the state in the economy can sustain durable growth. Without this, the bank recapitalization will be only a stop-gap—albeit expensive— measure. Corporate restructuring, involving debt-equity swaps to deleverage viable companies and liquidation of unviable ones, is needed. The bank asset management company (BAMC) and the new insolvency law can facilitate this but more nonperforming loans (NPLs) than currently proposed should be transferred to the BAMC. The authorities’ plan appropriately envisions a reduction in the general government deficit (excluding bank restructuring and recapitalization costs) to 3½ percent of GDP in 2014 and below 3 percent of GDP in 2015, but additional, upfront measures of some 1 percent of GDP may be needed to achieve the 2014 target. In the medium term, additional consolidation is necessary to address the fiscal costs stemming from bank restructuring. In addition, pension reforms are needed in response to unfavorable demographic trends. Authorities’ views: After bank recapitalization, corporate restructuring facilitated by transferring part of the bad assets to the BAMC and by the new insolvency law is a priority, but expanding corporates’ access to credit is also important. Privatization of 15 companies, including Telekom, NKBM, Abanka, and (partly) NLB, will further improve governance. While acknowledging fiscal risks for 2014, the authorities are optimistic about the fiscal measures, and will consider corrective actions later in the year if needed. A second round of pension reform will be considered after 2015 when the pension freeze will expire. Decisive implementation of reforms will decrease further the cost of borrowing.