## 1.      Slovenia      Inflation

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---

### Executive summary
- Slovenian HICP inflation rose from 3.8 percent in 2007 to 5.5 percent in 2008, well above the euro-area average.
- Commodity-related cost-push factors account for about 30 percent of the 2007–2008 surge in inflation.
- Demand-pull factors (business cycle) explain approximately 37 percent of the surge.
- The remaining roughly one-third of the surge is attributed to other factors, including possibly labor cost pressure.

### Supply-side: food and fuel price developments and pass-through
- International food and fuel prices:
  - 2007: food increased by 15.2 percent; fuel increased by 10.4 percent.
  - 2008: food increased by 23.4 percent; fuel increased by 40.1 percent.
  - Combined commodity price increases translated into about 2.0 percent contribution to Slovenia’s HICP inflation in 2007 and 3.1 percent in 2008.
- HICP composition:
  - Share of food and fuel in Slovenia’s HICP basket: 35.3 percent.
  - Share of food and fuel in euro-area HICP basket: 28.5 percent.
- Pass-through estimates:
  - A one percent increase in world fuel prices leads to a 0.29 percent increase in domestic fuel prices (Slovenia, 2001–2008).
  - Assuming full first-year pass-through, the first-round fuel pass-through accounted for 2.4 percentage points of inflation in the first nine months of 2008.
  - Domestic food price pass-through to core inflation: 0.66 percent increase in core per 1 percent increase in domestic food prices.
  - The second-round pass-through from domestic food and fuel prices to core inflation in Slovenia is elevated relative to advanced and emerging economy averages.

### Euro adoption and changeover effect
- Inflation differential after euro adoption increased for Slovenia (and comparable cases Greece, Ireland, Portugal); divergence is observable in the years immediately before and after adoption.
- Euro changeover effect on Slovenia:
  - Contributed 0.13 percent to inflation in December 2006 and 0.10 percent in January 2007.
  - Effect concentrated mostly in services prices.
  - Limited magnitude attributed in part to price control policies enacted during the first half of 2007.

### The catching-up (Balassa-Samuelson) effect
- Mechanism: faster productivity growth in tradables pushing up nontradable prices after ERMII is plausible for Slovenia.
- Estimated magnitudes:
  - A one percent difference in productivity growth between tradable and non-tradable sectors results in a 0.04–0.11 percent increase in the relative price of nontradables (estimated 2000–2008).
  - Estimated catching-up effect on Slovene HICP inflation in 2005–2007: about 0.3 percent, explaining roughly 10 percent of Slovenia’s inflation in that period.
- Conclusion: catching-up effect detectable but quantitatively small and stable; does not account for the 2007–2008 inflation surge.

### Demand-side: Phillips-curve results and cyclical effects
- Model and data:
  - Augmented Phillips-curve framework estimated (annual data, 1997–2007; Euro-12 countries and Slovenia).
  - Regressions include lagged inflation (persistence), the output gap, and international food and fuel prices.
- Key estimates:
  - Degree of inflation persistence (lagged inflation coefficient): about 0.8.
  - Output gap effect: a one percent increase in the output gap raises inflation by 0.28 percent.
  - Lagged inflation and the output gap together explain approximately 60 percent of Slovene inflation.
  - Country-specific interactions show lagged inflation and output-gap effects on Slovenia’s inflation are significantly larger than for the euro area average, consistent with more rigid labor markets.

### Observations and policy-relevant points
- Commodity-price shocks were a major direct contributor to the 2007–2008 inflation spike, amplified by a relatively large food and fuel share in the HICP basket and high pass-through.
- Demand-side pressures (positive output gap and inflation persistence) accounted for a larger share of the surge than commodity shocks.
- Euro changeover had only a small, short-lived effect; early 2007 price controls helped limit the impact.
- Balassa-Samuelson channel present but small; not a primary driver of the 2007–2008 surge.
- Policy implication: address structural bottlenecks and labor-market rigidities that amplify persistence and output-gap effects to help moderate future inflationary episodes alongside measures to mitigate commodity-price pass-through.

*Prepared by Piyaporn Sodsriwiboon; source content: _cr09160 - 1.      Slovenia      Inflation (IMF staff calculations and Eurostat data).*

### 12.       The overheating of the economy and the high persistence of inflation

### Causes and quantified contributions to the 2007–2008 inflation spike
- Slovenia’s output gap increased from about 1 percent in 2006 to 4.4 percent in 2008.
- Demand-pull factors explained approximately 37 percent of the increase in inflation in 2007–2008.
- Cost-push factors accounted for about 30 percent of the increase.
- Supply-side factors together with demand-pull factors explained approximately two-third of the surge in inflation.

### Augmented Phillips Curve — Arellano-Bond estimation (annual data 1997–2007)
- Reported estimated coefficients (robust standard errors in parenthesis):

  - Lagged HICP inflation:
    - 0.77 (0.06)***  
    - 0.79 (0.06)***  
    - 0.77 (0.04)***  
    - 0.35 (0.19)*

  - Output gap (% deviation from potential output):
    - 0.28 (0.05)***  
    - 0.27 (0.05)***  
    - 0.29 (0.06)***  
    - 0.29 (0.06)***

  - Oil price inflation:
    - 0.01 (0.00)**  
    - 0.01 (0.00)**  
    - 0 (0.00)*

  - Food price inflation:
    - 0.02  
    - -0.01

  - Slovene dummy:
    - -3.41 (1.78)*

  - Interaction of Slovene dummy with:
    - Lagged HICP inflation: 0.74 (0.23)***  
    - Output gap: 0.68 (0.21)***  
    - Oil price inflation: 0 (0.01)*  
    - Food price inflation: 0.04 (0.05)*

  - Dummy for Euro adoption:
    - -0.28 (0.14)**  
    - -1.06 (0.56)*

  - Constant:
    - 0.53 (0.14)***  
    - 0.39 (0.15)***  
    - 0.66 (0.17)***  
    - 1.43 (0.54)***

- Note: regression form provided in source; significance markers ***, ** and * imply significance level at 1 percent, 5 percent and 10 percent respectively.

### Diagnostic elements and labor-market rigidity
- Decompositions described include contributions from Inflation, Lagged Inflation, Output Gap, Oil Price Inflation, Food Price Inflation, Slovene dummy, Residuals.
- Labor market rigidity indicator (first principal component of 9 competition variables from Fraser Institute and World Bank Doing Business) shows Slovenia above the euro area (higher indicator means more rigid labor market).

### Conclusions and policy implications
- The 2007–08 inflation spike resulted from both cost-push and demand-pull factors.
- The global recession is alleviating inflationary pressures, but inflation differentials with other Euro area countries persist.
- Structural bottlenecks—specifically a more-rigid labor market—could continue to put labor cost pressures on the economy and hinder future growth.
- Policy recommendations:
  - Greater wage flexibility.
  - Further liberalization of employment protection legislation.
- Objective: achieve faster price adjustments and successful competition in the Euro area.

*Source: IMF staff analysis in “12. The overheating of the economy and the high persistence of inflation” (annual data 1997–2007; staff calculations, Figure 6, Table 2).*

### 21.      The outbreak of the global financial crisis in summer 2007 has had profound

### Effects on Slovenian banks and operating environment
- Slovenian banks were not affected directly by the US subprime crisis given their retail-oriented nature and low exposure to subprime securities.
- The international interbank market became more risk averse and liquidity conditions tightened significantly.
- Loan growth in Slovenia slowed sharply; banks adjusted their balance sheets.
- By the end of 2008, the stock market index had lost ⅔ of its end-2007 value.
- Sovereign risk spreads vis-à-vis the German ten-year government bond topped 100 bps.
- Housing prices decelerated since the beginning of the crisis.

### Balance sheet adjustments, funding, and liquidity
- Loan growth decelerated since summer 2007 and slowed especially sharply in the last months of 2008; corporate lending stalled and household lending remained weak.
- Banks substituted foreign financing with other sources including ECB funds and government deposits and made net repayment to foreign creditors in the last months of 2008.
- The banking system’s liabilities to the Eurosystem reached €1.2 billion at the end of 2008, or 2.5 percent of its total assets.
- The government issued treasury bonds in the amount of €1 billion in January 2009 and temporarily deposited the proceeds with the domestic banking system.
- As of January 2009, estimated ECB borrowing capacity was €2.7 billion, of which only 34 percent were used.
- At the beginning of 2009, the banking sector’s funding need was estimated at about €5 billion for the year.
- The government placed a three-year treasury bond of €1 billion internationally in January and deposited the receipts as short term deposits; a second tranche was scheduled in May (2009).

### Banking soundness indicators and profitability (selected figures across 2004–2008)
- Regulatory capital to risk-weighted assets: 11.8 (2004), 10.5 (2008).
- Regulatory Tier 1 capital to risk-weighted assets: 9.0 (2004), 8.5 (2008).
- Capital (net worth) to assets: 8.1 (2004), 8.4 (2008).
- Nonperforming assets to classified claims: 3.0 (2004), 1.6 (2008).
- Net interest margin to average interest bearing assets: 2.9 (2004), 2.2 (2008).
- Operating expenses to average assets: 2.7 (2004), 1.7 (2008).
- Return on average assets (before tax): 1.0 (2004), 0.7 (2008).
- Return on average equity (before tax): 12.5 (2004), 9.0 (2008).
- Average liquid assets to average total assets: 5.3 (2004), 3.0 (2008).
- Foreign currency-denominated loans to total loans: 38.6 (2004), 6.4 (2008).
- Foreign currency-denominated liabilities to total liabilities: 44.5 (2004), 6.1 (2008).
- Ownership of banking sector (percent of equity capital) — Nonresidents: 32.3 (2004), 38.1 (2008); Central government: 19.1 (2004), 17.7 (2008); Other domestic entities: 48.6 (2004), 44.2 (2008).

### Profitability impact and major bank results
- Banking system profit in 2008 was down over ⅓ on the previous year’s (unaudited figures).
- NLB experienced a near 85 percent drop in net profits compared to 2007.
- NKBM posted a more than 50 percent drop in net profits due to net losses from financial assets and liabilities and higher provisions.

### Rating actions and market perceptions
- In late 2008, Moody’s downgraded the outlook on the long-term deposits of both NLB and NKBM from stable to negative.
- Moody’s changed Bank Financial Strength Rating of NLB from stable to negative; NKBM remained stable.
- Fitch affirmed Slovenia Long-term foreign and local currency Issuer Default Ratings (IDRs) at “AA” with stable outlook.
- Standard & Poor’s revised up its Banking Industry Country Risk Assessment (BICRA) on the Slovenian banking system.

### Government and central bank policy response
- Bank of Slovenia established a crisis management group and implemented liquidity stress tests.
- October 2008: government and central bank announced unlimited deposit guarantee for all individuals and small and medium enterprises for one year.
- Previously deposit insurance covered 22,000 euros per account (around 95 percent of the number of deposits but only 75 percent of the amount of deposits).
- Ministry of Finance decided to provide €12 billion in guarantees on banks’ new issuance of debt, available on a per need basis, in place until the end of the crisis.
- December 2008: government adopted amendments to the Public Finance Act to empower lending, guarantees, recapitalization, and bank asset purchases.
- Bank of Slovenia recommended banks raise additional capital and use most of their 2008 profits to bolster balance sheets.
- February 2009: government announced €1.2 billion partial government guarantees for loans to nonfinancial companies.

### Main risks and vulnerabilities
- Three major increased vulnerabilities:
  - (i) International liquidity, a main funding source, will remain tight in the near future.
  - (ii) As the recession deepens, nonperforming loans will increase, credit growth will slow, and banks’ profits will decline further.
  - (iii) Vulnerability to cross-border spillovers due to foreign banks’ operations in Slovenia and loan exposure to neighboring countries.
- Foreign borrowing accounted for about ⅓ of total liabilities of the banks: 52.3 percent for foreign banks, 27 percent for domestic large banks, and 24 percent for small banks.
- At the end of 2008, banks in Slovenia had to repay €3.8 billion to foreign banks within six months — about a quarter of the banking sector’s total debt to foreign banks and 8 percent of the banking sector’s total assets.
- A year earlier (end-2007) liabilities with maturity of up to six months amounted to €2.1 billion, 14.5 percent of banking sector’s debt to foreign banks and 4.9 percent of banking sector’s total assets.
- Proportion of liabilities to foreign banks with maturity of up to six months was highest for large domestic banks, about ⅓ of their total foreign liabilities at end-2008.

### Liquidity regulation and collateral
- Regulation requires liquidity ratios in two categories; category one must be maintained above one.
- Banks have maintained liquidity ratio in category two at a level higher than one in practice.
- Marketable assets usable as collateral for ECB borrowing appeared strong.
- As of January 2009, estimated ECB borrowing capacity was €2.7 billion, of which only 34 percent were used.
- Banks prefer not to rely on ECB funds to finance lending due to maturity mismatch and uncertainty of unilateral withdrawal.

### Stress tests, scenarios, and capital adequacy (BoS 2008 macro stress test scenarios)
- Scenarios (relative to baseline):
  - (i) real growth down by 2.8 percentage points;
  - (ii) interest rates up by 2 percentage points;
  - (iii) stop of foreign financing to the banks;
  - (iv) stop of foreign financing to the banks and an increase of 1 percentage point in the risk premium.
- Selected stress test results (effects on banks’ balance sheet relative to baseline, EUR million and percentage points):

  - Scenario 1 Growth:
    - Profit (EUR million) -22.9 (2009), -69.2 (2010)
    - ROE -0.5 (2009), -1.4 (2010)
    - Capital adequacy 0.3 (2009), 0.8 (2010)
    - Loan growth -5.7 (2009), -8.6 (2010)

  - Scenario 2 Interest rate:
    - Profit -197.5 (2009), -69.0 (2010)
    - ROE -4.5 (2009), -1.4 (2010)
    - Capital adequacy 0.1 (2009), 0.2 (2010)
    - Loan growth -2.6 (2009), -3.7 (2010)

  - Scenario 3 Liquidity (stop of foreign financing):
    - Profit -46.3 (2009), -106.6 (2010)
    - ROE -1.0 (2009), -2.1 (2010)
    - Capital adequacy 0.8 (2009), 1.4 (2010)
    - Loan growth -8.2 (2009), -11.6 (2010)

  - Scenario 4 Liquidity + risk premium:
    - Profit -206.9 (2009), -252.1 (2010)
    - ROE -4.7 (2009), -5.0 (2010)
    - Capital adequacy 0.8 (2009), 1.4 (2010)
    - Loan growth -8.2 (2009), -11.6 (2010)

- Box 2 notes:
  - Scenario (i) is already outdated given the latest growth outlook.
  - Tests did not consider changes to NPLs (so capital adequacy actually rose due to lower loan growth).
  - Last two scenarios show profits falling and loans contracting if foreign financing stops completely and risk premium rises.
- Micro stress tests: under liquidity, profit, interest rate shocks, banks would maintain capital adequacy ratios; depending on credit risk shock severity, some banks would need to raise capital.

### Asset side credit risk and corporate vulnerabilities
- Corporate debt reached 87.5 percent of GDP in 2008.
- Signs of high loan concentration and corporate vulnerability; certain industries more vulnerable: automakers, manufacturing, pharmaceutical.
- Corporate vulnerability indicators (2007):
  - Debt-to-assets ratio: Slovenia 29.6 (comparison: Czech 14.0, Euro zone 24.4, Greece 27.7, Hungary 17.0, Portugal 41.2).
  - Interest coverage ratio: Slovenia 6.6.
  - Return on assets: Slovenia 8.0.
  - Price to earning ratio: Slovenia 23.2.

### Cross-border exposures and spillover risks
- Nine foreign banks operate in Slovenia and rely heavily on parent funding, which can be withdrawn during crisis in parents’ home country.
- Austria and Germany are by far the largest lenders to Slovenian banks.
- Loans abroad (mainly to Balkans: Croatia, Montenegro, Serbia) reached close to 9 percent of total loans to the nonbanking sector by end-2008; loan expansion in this region halted since the global financial crisis.

### Conclusions
- Slovenia’s traditional banking sector dominated by large state-controlled banks weathered the global financial crisis relatively well so far, but is increasingly affected by deterioration of the international interbank market.
- Credit growth decelerated sharply and banks’ profit fell; banks partly substituted foreign financing with ECB funds and government deposits.
- Main challenges:
  - Secure adequate funding sources in the face of international liquidity squeeze.
  - Maintain adequate banking capital as the recession deepens and nonperforming loans increase.
  - Control effects of cross-border spillovers.

*Source: Bank of Slovenia; IMF staff analysis contained in the provided chapter.*

### 1.      Slovenia      Inflation.........................................................................................

### Slovenia      Inflation

### Executive summary
- Slovenian HICP inflation rose from 3.8 percent in 2007 to 5.5 percent in 2008, well above the euro-area average.
- Commodity-related cost-push factors account for about 30 percent of the 2007–2008 surge in inflation.
- Demand-pull factors (business cycle) explain approximately 37 percent of the surge.
- The remaining roughly one-third of the surge is attributed to other factors, including possibly labor cost pressure.

### Supply-side: Food and fuel price developments and pass-through
- International food and fuel prices:
  - 2007: food increased by 15.2 percent; fuel increased by 10.4 percent.
  - 2008: food increased by 23.4 percent; fuel increased by 40.1 percent.
  - Combined commodity price increases translated into about 2.0 percent contribution to Slovenia’s HICP inflation in 2007 and 3.1 percent in 2008.
- HICP composition:
  - Share of food and fuel in Slovenia’s HICP basket: 35.3 percent.
  - Share of food and fuel in euro-area HICP basket: 28.5 percent.
- Pass-through estimates:
  - A one percent increase in world fuel prices leads to a 0.29 percent increase in domestic fuel prices (Slovenia, 2001–2008).
  - Assuming full first-year pass-through, the first-round fuel pass-through accounted for 2.4 percentage points of inflation in the first nine months of 2008.
  - Domestic food price pass-through to core inflation: 0.66 percent increase in core per 1 percent increase in domestic food prices.
  - The second-round pass-through from domestic food and fuel prices to core inflation in Slovenia is elevated relative to advanced and emerging economy averages.

### Euro adoption and the changeover effect
- Inflation differential after euro adoption increased for Slovenia (and comparable cases Greece, Ireland, Portugal); divergence is observable in the years immediately before and after adoption.
- Euro changeover (currency conversion) effect on Slovenia:
  - Contributed 0.13 percent to inflation in December 2006 and 0.10 percent in January 2007.
  - Effect was concentrated mostly in services prices.
  - The limited magnitude of the changeover effect is attributed in part to price control policies enacted during the first half of 2007.

### The catching-up (Balassa-Samuelson) effect
- The Balassa-Samuelson mechanism is plausible for Slovenia due to faster productivity growth in tradables pushing up nontradable prices after ERMII.
- Estimated magnitude:
  - A one percent difference in productivity growth between tradable and non-tradable sectors results in a 0.04–0.11 percent increase in the relative price of nontradables (estimated 2000–2008).
  - Estimated catching-up effect on Slovene HICP inflation in 2005–2007: about 0.3 percent, explaining roughly 10 percent of Slovenia’s inflation in that period.
- Conclusion: the catching-up effect is detectable but quantitatively small and stable in recent years; it does not account for the 2007–2008 inflation surge.

### Demand-side: Phillips curve results and cyclical effects
- Model and data:
  - An augmented Phillips-curve framework is estimated (annual data, 1997–2007; Euro-12 countries and Slovenia).
  - Regressions include lagged inflation (persistence), the output gap, and international food and fuel prices.
- Key estimates and implications:
  - Degree of inflation persistence (lagged inflation coefficient): about 0.8.
  - Output gap effect: a one percent increase in the output gap raises inflation by 0.28 percent.
  - Lagged inflation and the output gap together explain approximately 60 percent of Slovene inflation.
  - Country-specific interaction terms show that lagged inflation and output-gap effects on Slovenia’s inflation are significantly larger than for the euro area average, consistent with more rigid labor markets.

### Empirical estimates of the catching-up effect (selected results from Table 1)
- Entire sample (2000:Q1–2008:Q2), example coefficients:
  - Lagged dependent variable (relative price dynamics): 0.93 (panel 1), 0.98 (panel 2), 0.92 (panel 3), 1.01 (panel 4).
  - Log labor productivity ratio (tradable/non-tradable): estimates in the range -0.05 to 0.11 depending on specification and subperiod.
- Subperiods:
  - Before ERMII (2000:Q1–2004:Q2): larger and more variable lag coefficients and productivity coefficients (e.g., -0.13 in one specification).
  - After ERMII (2004:Q3–2008:Q2): lagged dependent variable coefficients around 0.36–1.02; productivity coefficients positive and statistically significant in several specifications (e.g., 0.11, 0.05, 0.04, 0.06).

### Observations and policy-relevant points drawn from the analysis
- Commodity-price shocks were a major direct contributor to the 2007–2008 inflation spike in Slovenia, amplified by a relatively large food and fuel share in the HICP basket and high pass-through rates.
- Demand-side pressures (positive output gap and inflation persistence) accounted for a larger share of the surge than commodity shocks.
- The euro changeover had only a small, short-lived effect on inflation; price controls in early 2007 helped limit that impact.
- The Balassa-Samuelson (catching-up) channel is present but quantitatively small and not a primary driver of the 2007–2008 inflation surge.
- Implication: addressing structural bottlenecks and labor-market rigidities that amplify persistence and output-gap effects could help moderate future inflationary episodes alongside measures to mitigate commodity-price pass-through.

*Prepared by Piyaporn Sodsriwiboon; source content: _cr09160 - 1.      Slovenia      Inflation (IMF staff calculations and Eurostat data).*

### 12.       The overheating of the economy and the high persistence of inflation

### 12.       The overheating of the economy and the high persistence of inflation

### Causes and quantified contributions to the 2007–2008 inflation spike
- Slovenia’s output gap increased from about 1 percent in 2006 to 4.4 percent in 2008, while the increase was much smaller in the rest of the euro-area.
- Demand-pull factors explained approximately 37 percent of the increase in inflation in 2007–2008.
- Cost-push factors accounted for about 30 percent of the increase.
- The supply-side factors (including the spike in commodity prices) together with demand-pull factors related to the business cycle explained approximately two-third of the surge in inflation.

### Augmented Phillips Curve — Key estimation results (Arellano-Bond Dynamic Panel Estimation)
- Dependent variable: HICP inflation. Annual data range from 1997–2007.
- Reported estimated coefficients and associated robust standard errors (as presented):

  - Lagged HICP inflation:
    - 0.77 (0.06)***  
    - 0.79 (0.06)***  
    - 0.77 (0.04)***  
    - 0.35 (0.19)*

  - Output gap (% deviation from potential output):
    - 0.28 (0.05)***  
    - 0.27 (0.05)***  
    - 0.29 (0.06)***  
    - 0.29 (0.06)***

  - Oil price inflation:
    - 0.01 (0.00)**  
    - 0.01 (0.00)**  
    - 0 (0.00)*

  - Food price inflation:
    - 0.02  
    - -0.01

  - Slovene dummy:
    - -3.41 (1.78)*

  - Interaction of Slovene dummy with:
    - Lagged HICP inflation: 0.74 (0.23)***  
    - Output gap: 0.68 (0.21)***  
    - Oil price inflation: 0 (0.01)*  
    - Food price inflation: 0.04 (0.05)*

  - Dummy for Euro adoption:
    - -0.28 (0.14)**  
    - -1.06 (0.56)*

  - Constant:
    - 0.53 (0.14)***  
    - 0.39 (0.15)***  
    - 0.66 (0.17)***  
    - 1.43 (0.54)***

- Note (as in source): The regression takes the form tititititi Xyy ,,, * 1,. .).(.εφγπβαπ++−++= − where π is HICP inflation, (y-y*) is output gap as percentage deviation from potential output, and X is the set of control variables (e.g., change in oil price and a dummy for Euro adoption). The regression is estimated by Arellano-Bond dynamic panel technique. Robust standard errors shown in parenthesis. ***, ** and * imply significance level at 1 percent, 5 percent and 10 percent respectively.

### Figure 6 diagnostic elements (as described)
- Left figure: deviation of Slovenia's contribution from the euro area average in 2007 and 2008 combined, decomposed into:
  - Inflation, Lagged Inflation, Output Gap, Oil Price Inflation, Food Price Inflation, Slovene dummy, Residuals.
- Middle figure: difference of Slovenia's contribution from 2006 to 2008, decomposed into the same categories.
- Right figure: Labor market rigidity indicator (first principal component of 9 competition variables from Fraser Institute and World Bank Doing Business). Higher indicator means more rigid labor market; plotted values show Slovenia above the euro area.

### Conclusions and policy implications
- The spike in Slovenian inflation in 2007–08 was a consequence of both cost-push and demand-pull factors.
- The global recession is alleviating the inflationary pressures; however, inflation differentials with other countries in the Euro area persist.
- Structural bottlenecks—specifically a more-rigid labor market—would continue to put labor cost pressures on the economy, potentially hindering Slovenian growth in the future.
- Policy recommendations (identified as key requirements):
  - Greater wage flexibility.
  - Further liberalization of employment protection legislation.
- These measures are recommended to achieve faster price adjustments and successful competition in the Euro area.

*Source: IMF staff analysis in “12. The overheating of the economy and the high persistence of inflation” (annual data 1997–2007; staff calculations, Figure 6, Table 2).*

### 21.      The outbreak of the global financial crisis in summer 2007 has had profound

### 21.      The outbreak of the global financial crisis in summer 2007 has had profound

### Effects on Slovenian banks and operating environment
- Slovenian banks were not affected directly by the US subprime crisis given their retail-oriented nature and low exposure to subprime securities.
- The international interbank market became more risk averse and liquidity conditions tightened significantly.
- As a consequence, loan growth in Slovenia slowed sharply and banks adjusted their balance sheets.
- By the end of 2008, the stock market index had lost ⅔ of its end-2007 value.
- Sovereign risk spreads vis-à-vis the German ten-year government bond topped 100 bps.
- Housing prices decelerated since the beginning of the crisis.

### Balance sheet adjustments, funding, and liquidity
- Loan growth decelerated since summer 2007 and slowed especially sharply in the last months of 2008; corporate lending stalled and household lending remained weak.
- Banks substituted foreign financing with other sources including ECB funds and government deposits and made net repayment to foreign creditors in the last months of 2008.
- The banking system’s liabilities to the Eurosystem reached €1.2 billion at the end of 2008, or 2.5 percent of its total assets.
- The government issued treasury bonds in the amount of €1 billion in January 2009 and temporarily deposited the proceeds with the domestic banking system.
- As of January 2009, estimated ECB borrowing capacity was €2.7 billion, of which only 34 percent were used.
- At the beginning of 2009, the banking sector’s funding need was estimated at about €5 billion for the year.
- The government placed a three-year treasury bond of €1 billion internationally in January and deposited the receipts as short term deposits; a second tranche was scheduled in May (2009).

### Banking soundness indicators and profitability (Table 4 highlights)
- Regulatory capital to risk-weighted assets: 11.8 (2004), 10.5 (2008) [figures listed across 2004–2008].
- Regulatory Tier 1 capital to risk-weighted assets: 9.0 (2004), 8.5 (2008).
- Capital (net worth) to assets: 8.1 (2004), 8.4 (2008).
- Nonperforming assets to classified claims: 3.0 (2004), 1.6 (2008).
- Net interest margin to average interest bearing assets: 2.9 (2004), 2.2 (2008).
- Operating expenses to average assets: 2.7 (2004), 1.7 (2008).
- Return on average assets (before tax): 1.0 (2004), 0.7 (2008).
- Return on average equity (before tax): 12.5 (2004), 9.0 (2008).
- Average liquid assets to average total assets: 5.3 (2004), 3.0 (2008).
- Foreign currency-denominated loans to total loans: 38.6 (2004), 6.4 (2008).
- Foreign currency-denominated liabilities to total liabilities: 44.5 (2004), 6.1 (2008).
- Ownership of banking sector (percent of equity capital) — Nonresidents: 32.3 (2004), 38.1 (2008); Central government: 19.1 (2004), 17.7 (2008); Other domestic entities: 48.6 (2004), 44.2 (2008).

### Profitability impact and major bank results
- According to unaudited figures, the banking system’s profit in 2008 was down over ⅓ on the previous year’s.
- NLB experienced a near 85 percent drop in net profits compared to 2007.
- NKBM posted a more than 50 percent drop in net profits due to net losses from financial assets and liabilities and higher provisions.

### Rating actions and market perceptions
- In late 2008, Moody’s downgraded the outlook on the long-term deposits of both NLB and NKBM from stable to negative.
- Moody’s changed Bank Financial Strength Rating of NLB from stable to negative; NKBM remained stable.
- Fitch affirmed Slovenia Long-term foreign and local currency Issuer Default Ratings (IDRs) at “AA” with stable outlook.
- Standard & Poor’s revised up its Banking Industry Country Risk Assessment (BICRA) on the Slovenian banking system.

### Government and central bank policy response (Box 1)
- The Bank of Slovenia established a crisis management group and implemented liquidity stress tests.
- In October 2008 the government and the central bank announced unlimited deposit guarantee for all individuals and small and medium enterprises for one year.
- Previously deposit insurance covered 22,000 euros per account (around 95 percent of the number of deposits but only 75 percent of the amount of deposits).
- The Ministry of Finance decided to provide €12 billion in guarantees on banks’ new issuance of debt, available on a per need basis, in place until the end of the crisis.
- In December 2008, the government adopted amendments to the Public Finance Act to empower the government to lend and provide guarantees to financial institutions, recapitalize banks, and purchase bank assets.
- The Bank of Slovenia recommended banks raise additional capital and use most of their 2008 profits to bolster balance sheets.
- The government issued treasury bonds of €1 billion in January 2009 deposited with the domestic banking system.
- In February 2009, the government announced €1.2 billion partial government guarantees for loans to nonfinancial companies.

### Main risks and vulnerabilities
- Three major increased vulnerabilities:
  - (i) International liquidity, a main funding source, will remain tight in the near future.
  - (ii) As the recession deepens, nonperforming loans will increase, credit growth will slow, and banks’ profits will decline further.
  - (iii) Vulnerability to cross-border spillovers due to foreign banks’ operations in Slovenia and loan exposure to neighboring countries.
- Foreign borrowing accounted for about ⅓ of total liabilities of the banks: 52.3 percent for foreign banks, 27 percent for domestic large banks, and 24 percent for small banks.
- At the end of 2008, banks in Slovenia had to repay €3.8 billion to foreign banks within six months — about a quarter of the banking sector’s total debt to foreign banks and 8 percent of the banking sector’s total assets.
- A year earlier (end-2007) liabilities with maturity of up to six months amounted to €2.1 billion, 14.5 percent of banking sector’s debt to foreign banks and 4.9 percent of banking sector’s total assets.
- The proportion of liabilities to foreign banks with maturity of up to six months was highest for large domestic banks, about ⅓ of their total foreign liabilities at end-2008.

### Liquidity regulation and collateral
- Regulation requires liquidity ratios in two categories; category one must be maintained above one.
- Banks have maintained liquidity ratio in category two at a level higher than one in practice.
- Marketable assets usable as collateral for ECB borrowing appeared strong.
- As of January 2009, estimated ECB borrowing capacity was €2.7 billion, of which only 34 percent were used.
- Banks prefer not to rely on ECB funds to finance lending due to maturity mismatch and uncertainty of unilateral withdrawal.

### Stress tests, scenarios, and capital adequacy
- BoS 2008 macro stress test scenarios (relative to baseline):
  - (i) real growth down by 2.8 percentage points;
  - (ii) interest rates up by 2 percentage points;
  - (iii) stop of foreign financing to the banks;
  - (iv) stop of foreign financing to the banks and an increase of 1 percentage point in the risk premium.
- Stress test results (summary table, effects on banks’ balance sheet relative to baseline, EUR million and percentage points):
  - Scenario 1 Growth: Profit (EUR million) -22.9 (2009), -69.2 (2010); ROE -0.5 (2009), -1.4 (2010); Capital adequacy 0.3 (2009), 0.8 (2010); Loan growth -5.7 (2009), -8.6 (2010).
  - Scenario 2 Interest rate: Profit -197.5 (2009), -69.0 (2010); ROE -4.5 (2009), -1.4 (2010); Capital adequacy 0.1 (2009), 0.2 (2010); Loan growth -2.6 (2009), -3.7 (2010).
  - Scenario 3 Liquidity (stop of foreign financing): Profit -46.3 (2009), -106.6 (2010); ROE -1.0 (2009), -2.1 (2010); Capital adequacy 0.8 (2009), 1.4 (2010); Loan growth -8.2 (2009), -11.6 (2010).
  - Scenario 4 Liquidity + risk premium: Profit -206.9 (2009), -252.1 (2010); ROE -4.7 (2009), -5.0 (2010); Capital adequacy 0.8 (2009), 1.4 (2010); Loan growth -8.2 (2009), -11.6 (2010).
- Box 2 note: Scenario (i) is already outdated given the latest growth outlook; tests did not consider changes to NPLs (so capital adequacy actually rose due to lower loan growth); last two scenarios show profits falling and loans contracting if foreign financing stops completely and risk premium rises.
- Micro stress tests: under liquidity, profit, interest rate shocks, banks would maintain capital adequacy ratios; depending on credit risk shock severity, some banks would need to raise capital.

### Asset side credit risk and corporate vulnerabilities
- Corporate debt reached 87.5 percent of GDP in 2008.
- Signs of high loan concentration and corporate vulnerability; certain industries more vulnerable: automakers, manufacturing, pharmaceutical.
- Table 5 corporate vulnerability indicators (2007):
  - Debt-to-assets ratio: Slovenia 29.6 (comparison: Czech 14.0, Euro zone 24.4, Greece 27.7, Hungary 17.0, Portugal 41.2).
  - Interest coverage ratio: Slovenia 6.6.
  - Return on assets: Slovenia 8.0.
  - Price to earning ratio: Slovenia 23.2.

### Cross-border exposures and spillover risks
- Nine foreign banks operate in Slovenia and rely heavily on parent funding, which can be withdrawn during crisis in parents’ home country.
- Austria and Germany are by far the largest lenders to Slovenian banks (Figure 9 distribution shown).
- Loans abroad (mainly to Balkans: Croatia, Montenegro, Serbia) reached close to 9 percent of total loans to the nonbanking sector by end-2008; loan expansion in this region halted since the global financial crisis.

### Conclusions
- Slovenia’s traditional banking sector dominated by large state-controlled banks weathered the global financial crisis relatively well so far, but is increasingly affected by deterioration of the international interbank market.
- Credit growth decelerated sharply and banks’ profit fell; banks partly substituted foreign financing with ECB funds and government deposits.
- Main challenges: secure adequate funding sources in the face of international liquidity squeeze; maintain adequate banking capital as the recession deepens and nonperforming loans increase; control effects of cross-border spillovers.

*Source: Bank of Slovenia; IMF staff analysis contained in the provided chapter.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09160.pdf_