## _cr16122

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### Export and GDP Growth
- Exports were the main contributor to GDP growth in recent years; by 2015 exports of goods and services had increased by 20 percentage points of GDP compared to their post-crisis low in 2009.
- Slovenia is well integrated in European supply chains with more than 90 percent of goods sold to other European countries; Germany is the largest export market, followed by Italy and Austria.
- Slovenia’s exports to Germany stable at about 20 percent of total exports over the past ten years, though values grew rapidly.
- From 2008 to 2015:
  - Slovenia’s current account switched from a deficit of 5 percent of GDP in 2008 to a surplus of 7¼ percent of GDP in 2015.
  - Total German and Austrian imports rose by 23 and 13 percent, respectively; Italian imports dropped by 5 percent.
  - Slovenia’s exports of goods increased by 13 percent since 2008; nominal GDP rose only by 1½ percent; real demand for imports rose by only 2¼ percent.
- Savings–investment dynamics (phased):
  - 2007–09: savings fell; sharp fall in private investment more than offset fall in savings, improving the current account.
  - 2009–11: little change in current account.
  - 2011–13 (banking crisis): moderate fall in private investment caused significant current account improvement.
  - 2014–15: improvement driven by significant income growth (led by exports) and hence savings; investment growth turned positive but lagged income growth.
- Aggregate contributions:
  - From 2007 to 2013 the 7 percent of GDP improvement in the current account balance resulted primarily from a fall in private investment (from 30 to 17 percent of GDP).
  - In the last two years the 4 percent of GDP improvement in the current account balance resulted primarily from export-led growth.

### Exports, value added, and sectoral integration
- Gross exports decomposition components: (1) DVA in final goods; (2) DVA in intermediate goods not processed for further exports; (3) DVA in intermediate goods processed for export; (4) DVA in intermediate goods exported but later re-imported; (5) FVA in intermediate goods included in domestic exports.
- Foreign value added (FVA) increased over 20 years but by only five percentage points in Slovenia versus at least 12 percentage points in all CE4 countries.
- Germany supplies the largest share of FVA for most countries; Germany’s share in Slovenia has dropped slightly; Italy is the second largest source.
- Slovenia’s exports of intermediate goods to Germany increased by 2 percentage points of total exports; the share of intermediate goods exports to Germany is 5 percent of total exports for Slovenia (CE4 range 4–6 percent).
- Key sectors in German supply chain involvement: transportation, electrical equipment, machinery, chemicals.
- In Slovenia transport equipment, machinery, and pharmaceuticals make up almost half of total exports; motor vehicles account for almost 9 percent of total exports.
- The share of FVA in Slovenia’s transport equipment exports rose by about 6 percentage points over 20 years; already relatively high in 1995 (over half of gross value for transport equipment in Hungary, Slovakia, and Slovenia).
- Conclusion: Slovenia’s integration into German supply chains contributed materially to export performance, on a par with regional peers, but room remains for deeper integration in automobiles.

### Constraints on investment and corporate balance sheets
- Despite strong exports, private investment has not rebounded strongly due to an overhang of corporate debt and weaker collateral quality for unreformed domestic firms.
- Exporters faced fewer constraints (larger firms, retained earnings, access to external financing, better collateral).
- Empirical findings on deleveraging (2007–14):
  - Median debt-to-assets: Slovenia, Czech Republic, Slovakia "hovered around 60-70 percent"; Poland "closer to 50 percent"; Hungary "closer to 35 percent".
  - "45 percent of all sampled Slovenian firms faced excessive debt levels in 2014" (excessive defined as financial debt greater than 5 times EBITDA).
- Debt service capacity:
  - 10 to 30 percent of sampled firms (country dependent) have interest coverage ratios below one.
  - In Slovenia and Slovakia, "2/5 of micro enterprises do not have the cash flow to cover annual interest payments."
- Investment dynamics:
  - Investment by companies in Slovenia and the CE-4 fell significantly with the financial crisis and continued to contract through 2014.
  - Weak balance sheets increase susceptibility to financing constraints; with the exception of micro-enterprises, indicators of financial health broadly returned to pre-crisis levels but investment has not recovered.

### Empirical econometric findings (firm-level)
- Dependent variable: d ln(I)i,t where I = Gross investment.
- Key regressors include lagged CAS, ROA, DA, OVER, ASSETS, and post-2008 interactions; for Slovenia, a lagged ECB diffusion index for bank credit conditions (BLS) is included.
- Post-crisis: investment rates more sensitive to indebtedness and interest-paying capacity; higher indebtedness reduces investment for Slovenian and Polish firms post crisis.
- Selected regression coefficients (examples preserved exactly as reported):
  - Credit conditions (Slovenia, all firms): "-0.623***".
  - Cash-to-asset (Slovenia overall): "2.863*** (0.000)".
  - Return on assets (Slovenia overall): "1.292*** (0.000)".
  - Debt overhang (Slovenia overall): "-0.082*** (0.007)".
  - DA (post, Slovenia overall): "-0.455*** (0.003)".
- Threshold estimates for Slovenia:
  - Debt-to-assets optimal thresholds: Large firms: "76"; SME: "10".
  - Debt-to-EBITDA turning points (debt-overhang): Large firms: "8"; SMEs: "1".
- Interpretation: marginal debt accumulated after these thresholds diminishes investment growth.

### Aggregate debt reduction calibration and policy options
- "Back of the envelope" estimate: aggregate debt of small- and micro-sized firms should be reduced by up to 30 percent of GDP from 2014 levels.
- Calibration details:
  - Average debt-to-asset ratio for medium-, small- and micro-size firms in 2014: "56 percent."
  - To lower the ratio to the threshold level of about "10 percent" absent new equity, these firms would need to reduce debt by about €12 billion.
  - New equity would lower the needed amount of debt reduction.
  - SMEs accounted for 60 percent of non-financial corporate investment over 2006–14.
- Policy recommendations to accelerate investment:
  - Monitor implementation of NPL guidelines by the Bank Association and Bank of Slovenia and adjust as needed.
  - Consider a centralized privately funded entity (SPV) for SME NPL resolution to quickly reduce NPL burden and free collateral.
  - Further transfer assets to the Bank Asset Management Company (BAMC), especially claims on companies already in its portfolio.
  - Facilitate equity financing, including mezzanine financing, particularly for SMEs.
  - Sponsor or support regional efforts to develop a market in distressed debt.

### Banking sector crisis, recapitalization, and NPL resolution
- Crisis impact:
  - Foreign-to-total liabilities for Slovenian banks fell to 13 percent by September 2015 from a 40 percent peak in June 2008.
  - NPLs rose from 3.8 percent in 2008 to a peak of 14.4 percent in 2012.
  - 2013 asset quality review found capital shortfalls relative to reported September 2013 levels: foreign-owned banks 78 percent shortfall; domestically owned banks 244 percent shortfall.
- State interventions:
  - State bank recapitalization cost: 10 percent of GDP; six banks received injections in 2013–14.
  - BAMC (established late 2012) enabled transfer of 53 percent of the EUR 9.4 billion in NPLs from five recapitalized government banks by end-2014, primarily loans to large state-owned corporates.
  - Over 70 percent of remaining NPLs concentrated at SMEs.
- Asset quality and capital (as reported):
  - System wide NPLs: 10.3 percent (EUR 3.7 billion) in November 2015; corporates represent 60 percent.
  - Overall capital ratios by September 2015: CAR 20.5 percent; Core tier 1 19.8 percent.
  - Credit contraction (December 2015 yoy): credit to private sector contracting by 5.7 percent total; credit to nonfinancial corporates contracting by 10.2 percent.
  - ROE: 6.1 percent; Net interest margin: 2.2 percent.
  - Deposits with agreed maturity fell by over 25 percent since early 2013.
- Regulatory developments:
  - 2012 FSAP recommended privatization of state-controlled banks and strengthening BOS powers.
  - March 2015 Banking Law transposed CRD IV and included capital buffers and early intervention frameworks; remaining BRRD provisions planned for transposition by April 2016.
  - Single Supervisory Mechanism (SSM) expected to strengthen supervision and align with European standards.

### Financial development, market structure, and nonbank financing
- Financial Development Index findings:
  - Slovenia below average for the EA but above CEE and EME for 2004–2013.
  - Stronger position in financial institutions comparable to EA; weaker position in financial markets closer to CEE/EME.
  - Market deficiencies driven by very low levels of nonbank market development: stock market capitalization and trading volumes, number of debt securities issuers, stock market turnover.
  - Institutional depth components (pension and mutual fund assets) lag EA.
- Nonbank market developments:
  - Commercial paper net value issued rose to EUR 230 million in 2014 from EUR 9 million in 2011.
  - Outstanding corporate bonds net value increased to EUR 140 million from EUR 65 million in the same period.
  - In 2015 commercial paper and bonds represented 0.9 percent and 14 percent, respectively, of Ljubljana Stock Exchange market turnover.
  - International net financial position of corporates doubled to 28 percent of GDP in 2008–14 and increased by 10 percentage points in 2011–14.
- Banking market structure and risks:
  - Of 16 commercial banks, the top five control close to 70 percent of assets; the 10 smallest banks represent 25 percent of total assets (post-merger of Abanka Vipa and Banka Celje).
  - Low efficiency and profitability suggest potential benefits from consolidation, but avoid creating institutions that are "too big to fail."
- Policy directions for market development:
  - Accelerate balance sheet repair and NPL resolution to restore credit provision.
  - Strengthen regulation and supervision to moderate risk-taking and over-leveraging.
  - Develop local nonbank financial institutions and capital market options to provide equity financing alternatives for corporates, particularly SMEs.
  - Support incentives toward equity financing through easier foreign investment and a more dynamic privatization process.
  - Strengthen and expand pension and mutual funds as corporate finance sources.

### Improving labor markets, boosting FDI, and human capital (structural reforms)
- Human capital and training:
  - Two proxy indicators for human capital—higher education and upgraded vocational training—explain close to 50 percent of export performance in the EU (Rahman et al., 2015).
  - Slovenia compares favorably with the CE4 on human capital measures: share of young people with secondary or higher education similar to Czech Republic, Poland, Slovakia; larger shares of employees in continuous vocational trainings than Hungary, Poland, and EU averages.
  - Policy need: improve quality of education and upgrade vocational training to support export competitiveness.
- Labor markets:
  - Slovenia’s unit labor costs remain higher than CE4 in both whole economy and industry, though recent data suggest improvement.
  - Inactivity trap indicator suggests weaker incentives to work relative to CE4 countries.
  - Slovenia’s minimum wage is low relative to CE4, but relatively high unit labor costs offset comparative advantage in labor-intensive exports.
  - Policy implication: reduce unit labor costs via higher productivity and reduce disincentives to work.
- Foreign investment environment:
  - FDI inflows pre-crisis: CE4 averaged 4½ percent of GDP per year; Slovenia less than one percent of GDP per year.
  - FDI stocks: CE4 around 40 to 50 percent of GDP; Slovenia less than 15 percent of GDP over the last decade.
  - EFW 2015 reports perceptions of more restrictions on foreign ownership and investment in Slovenia relative to CE4; perception may have contributed to lower foreign ownership.
  - Policy implication: make foreign ownership regime more conducive for investors to attract FDI, especially greenfield investment.

### ECB QE: fiscal windfall and recommended fiscal response for Slovenia
- QE context:
  - ECB planned purchases exceed €1 trillion; for Slovenia planned purchases amount to €4 billion, representing some 12 percent of end-2015 public debt and around 2/3 of medium- and long-term debt amortization in 2016–17.
- QE fiscal windfall:
  - Slovenia’s bond yields declined by almost 150 basis points after QE launch.
  - Estimated QE-related "fiscal windfall" for Slovenia: 0.5 percent of GDP per year on average over 2016-17.
- VAR empirical results (panel of 12 EA countries, 1998-2015):
  - A negative 100 basis point shock to effective interest rate R leads PB to drop almost 0.3 percentage points below baseline four years after the shock; DEBT falls and remains about 2 percentage points below baseline by five years.
  - Constrained VAR scenarios:
    - "Gradual unwinding": PB falls by 0.35 percentage points by year one, 0.5 by year two, 0.6 by year three, and remains about ½ percentage point below baseline through year five.
    - "Rapid unwinding": PB falls by 0.3 percentage points by year one, 0.5 by year two, returns to baseline by year four, and ends above baseline by the end of the horizon; DEBT ends less than 1 percentage point below baseline by the end of the horizon.
- Policy implications:
  - Empirical and theoretical considerations argue for some front-loading of public investment while maintaining a credible medium-term consolidation plan; temporary loosening of the primary balance should be less than the reduction in interest costs so overall budget deficit and public debt decline.
  - VAR results suggest roughly half of QE-related interest savings could be spent over a two year horizon; for Slovenia this implies room to raise primary spending by some ¼ percentage points of GDP each year during 2016-17.
  - Recommended use of temporary fiscal space: public investment (EU-funded or domestic component) rather than wage bill or transfers, given reversibility and potential to offset private investment underperformance.
- Constraints and safeguards:
  - Any near-term stimulus must be consistent with SGP requirements (not breaching the 3 percent deficit limit); assuming adherence to 2016-17 budget targets, the suggested temporary expansion keeps Slovenia comfortably below the threshold.
  - Implementation capacity (availability of high-return public investment projects and administrative capacity) could constrain execution; calibrating to historical peaks suggests the envisaged temporary increase should be attainable.
  - Avoid fiscal procyclicality if the economy moves significantly above potential; IMF staff estimates a still negative output gap, absence of inflationary pressures, and a large current account surplus provide assurance against overheating.
  - Credibility condition: front-loaded spending must be embedded within a credible medium-term consolidation strategy to avoid credibility costs.

*Prepared by IMF staff; content based on IMF staff analysis in the provided chapter text.*

### 1. Export and GDP Growth _______________________________________________________________ 4

### 1. Export and GDP Growth

### A. Introduction
- Slovenia’s exports have been the main contributor to GDP growth in recent years.
- By 2015 exports of goods and services had increased by 20 percentage points of GDP compared to their post-crisis low in 2009.
- The rapid increase in exports was due to an increase in the nominal value of exports as nominal GDP was relatively steady over this period.
- Slovenia is well integrated in European supply chains; trade links between Germany and the CE4 contributed to rapid export and GDP growth in the CE4 and Slovenia shows similar integration patterns.

### B. Trade patterns and market shares
- More than 90 percent of Slovenia’s goods are sold to other European countries.
- Germany is Slovenia’s largest export market, followed by Italy and Austria.
- Slovenia’s top five export markets bought about half of Slovenia’s export products; the other half goes mainly to emerging European countries and countries in emerging Asia and the Middle East.
- Slovenia’s exports to Germany have remained stable at about 20 percent of total exports over the past ten years, while exports to Germany grew rapidly in value terms.
- Slovenia has maintained its trade shares of both German and World imports, but unlike most of the CE4 countries its shares have not increased significantly.
- Among the CE4 countries, Poland and the Slovak Republic have shown the largest gains in market shares.

### C. Developments in Slovenia’s current account and savings-investment dynamics
- Slovenia’s current account switched from a deficit of 5 percent of GDP in 2008 to a surplus of 7¼ percent of GDP in 2015.
- From 2008 to 2015, total German and Austrian imports rose by 23 and 13 percent, respectively, while Italian imports dropped by 5 percent.
- Slovenia’s exports of goods have increased by 13 percent since 2008, close to the weighted average of import growth in Germany, Austria, and Italy.
- For 2008–15, Slovenia’s nominal GDP rose only by 1½ percent, with real demand for imports rising by only 2¼ percent.
- Slovenia experienced a banking crisis in 2012–13, resulting in a nominal decline in both GDP and imports during this period.
- From a savings-investment perspective, the improvement in the current account went through phases:
  - 2007–09: income growth remained positive, consumption growth stronger, savings fell; a sharp fall in private investment more than offset the fall in savings, improving the current account.
  - 2009–11: increases in income and consumption were small and offsetting; investment slightly negative; little change in current account.
  - 2011–13 (banking crisis): income and consumption fell commensurately; little change in savings; a moderate fall in private investment caused the current account to improve significantly.
  - 2014–15: improvement driven by significant income growth (led by exports) and hence savings; investment growth turned positive for the first time since the start of the global crisis but lagged income growth.
- Aggregate contribution numbers:
  - From 2007 to 2013 the 7 percent of GDP improvement in the current account balance resulted primarily from a fall in private investment (from 30 to 17 percent of GDP).
  - In the last two years the 4 percent of GDP improvement in the current account balance resulted primarily from export-led growth.

### D. Constraints on investment despite export strength
- Private investment has not rebounded strongly despite strong exports, GDP growth, and a large current account surplus.
- Many companies are still struggling with an overhang of corporate debt which hinders their ability to invest.
- Exporters have been less affected because they are more likely to be large companies with substantial retained earnings, access to external financing, and/or easier access to domestic bank financing.
- Exporters can post good collateral in the form of export earnings; unreformed domestic firms with relatively high debts and relatively low equity and profits have suffered a deterioration in the quality of their collateral.

### E. Decomposition of gross exports and value added analysis
- Gross exports decomposition follows Koopman et al. (2011), Rahman and Zhao (2013), and IMF (2013): gross exports = (1) domestic value added (DVA) in final goods + (2) DVA in intermediate goods not processed for further exports + (3) DVA in intermediate goods processed for export + (4) DVA in intermediate goods exported but later re-imported + (5) foreign value added (FVA) in intermediate goods included in domestic exports.
  - Components (1)–(4) represent domestic value added in gross exports.
  - Components (3)–(5) represent domestic and foreign inputs into global and regional supply chains.
- Foreign value added in Slovenia’s exports increased over the last 20 years, but the increase was smaller than for each of the CE4 countries:
  - All CE4 countries showed increases in the shares of foreign value added in exports by at least 12 percentage points.
  - The share of foreign value added in Slovenia’s exports increased only five percentage points.
- Germany has the largest share of foreign value added in each country’s gross exports (except the Slovak Republic where Russia’s value added is largest).
- Germany’s share of value added in Slovenia’s exports has dropped slightly, while Italy is the second largest source of intermediate goods value added in Slovenia’s exports.
- Shares of each country’s value added in German exports have increased significantly since 1995, indicating increased integration.
- Slovenia’s exports of intermediate goods to Germany have increased by 2 percentage points of total exports — more than the CE4 countries (by 1 percentage point).
- The share of intermediate goods exports to Germany is 5 percent of total exports for Slovenia, similar to the CE4 (4–6 percent of total exports).
- The contribution of Slovenia’s integration in the German supply chain to export performance is on a par with other countries in the region.

### F. Sectoral composition and integration in supply chains
- The transportation, electrical equipment, machinery, and chemicals sectors are the most important for the CE4 countries and Slovenia in the German supply chain.
- In Slovenia, transport equipment, machinery, and pharmaceutical sectors make up almost half of total exports and have been the main contributors to export growth.
- Sectoral findings for transport equipment:
  - Foreign value added of transport equipment has increased as a share of Slovenia’s total exports, but less than most of the CE4 countries.
  - Motor vehicles are the largest category of transport equipment exports in Slovenia, accounting for almost 9 percent of total exports.
  - The share of foreign value added in Slovenia’s transport equipment exports increased by about 6 percentage points over the last 20 years, similar to the Czech Republic and Hungary but lower than in Poland and the Slovak Republic.
  - The share of foreign value added in Hungary, Slovakia, and Slovenia were already relatively high in 1995, comprising more than half of the gross value of transport equipment exports.
  - Although Slovenia’s transport equipment exports increased more rapidly than Slovenia’s total exports, they still lagged behind the increase in transport equipment exports of the CE4 countries.
  - In the largest category (automobiles), there remains room for additional integration into the German supply chains.

*Prepared by Ruo Chen and Lawrence Dwight (SPR); based on IMF staff analysis and the sources cited in the original chapter.*

### 13.      Improving labor markets, boosting foreign investment, and enhancing vocational

### 13.      Improving labor markets, boosting foreign investment, and enhancing vocational training would improve Slovenia’s competitiveness

### Structural determinants of export performance
- Empirical research links strong export performance with successful integration into supply chains and structural reforms. Rahman and Zhao (2013) associate strong global and European export performance since the late 1990s with supply-chain integration.
- Rahman et al. (2015) find that export competitiveness in the European Union single market depends on successful structural reforms in:
  - higher education,
  - upgrading skills,
  - wage incentives, and
  - an environment that supports foreign investment.
- Two proxy indicators for human capital—higher education and upgrading of vocational training and skills—explain close to 50 percent of export performance in the European Union (Rahman et al., 2015).

### Human capital
- Slovenia compares favorably with the CE4 on measures of human capital:
  - The share of young people with secondary or higher education in Slovenia is similar to levels in the Czech Republic, Poland, and Slovakia, and higher than the level in Hungary and the EU average.
  - Slovenia has larger shares of employees participating in continuous vocational trainings than in Hungary, Poland, and the EU averages.
- To utilize its skilled labor force, Slovenia needs:
  - efficient labor market functioning, and
  - a supporting foreign investment environment.

### Labor markets
- Unit labor costs:
  - Slovenia’s unit labor costs remain higher than the CE4 countries in both the whole economy and in industry, although recent data suggest an improvement.
- Labor market incentives:
  - The inactivity trap indicator suggests Slovenia provides weaker incentives to work relative to CE4 countries.
  - Definition: Inactivity trap = 1 – (in-work net pay – out-of-work net pay) / (in-work gross pay – out-of-work gross pay).
- Minimum wages and comparative advantage:
  - Slovenia’s minimum wage is low relative to that of the CE4 countries.
  - However, relatively high unit labor costs offset a comparative advantage in labor-intensive exports.
- Policy implication:
  - To provide an attractive labor market for multinational companies, Slovenia needs to reduce its unit labor costs (via increased productivity) and reduce disincentives to work.

### Foreign investment environment
- Role of FDI:
  - Foreign direct investment (FDI), particularly greenfield investment, has been a key channel to expand production via supply-chain development.
  - FDI inflows were the main component in net capital inflows to the CE4 countries before the financial crisis, averaging 4½ percent of GDP per year.
  - In contrast, FDI inflows to Slovenia were less than one percent of GDP per year before the crisis.
- FDI stocks:
  - The stock of FDI in the CE4 countries has been around 40 to 50 percent of GDP.
  - The comparable figure for Slovenia has been less than 15 percent of GDP over the last decade.
- Perceptions and restrictions:
  - Economic Freedom of the World (EFW) 2015 report indicates a perception that Slovenia has more restrictions on foreign ownership and investment than the CE4 countries, and that these restrictions have increased since the global financial crisis.
  - The EFW index is based on (i) prevalence of foreign ownership and (ii) regulatory restrictions on international capital flows.
  - The perception of greater restrictions may have contributed to lower foreign ownership in Slovenia.
- Policy implication:
  - Rahman et al. (2015) conclude that Slovenia should make its foreign ownership regime more conducive for investors.

### Key macro-structural outcomes and dynamics
- Current account:
  - Slovenia’s current account balance rose from a deficit of 5 percent of GDP in 2008 to over 7 percent of GDP in 2015.
  - From a trade perspective, the increase was driven by a significant increase in exports (in line with the growth of imports of Slovenia’s trading partners) while imports remained relatively flat (in line with low GDP growth in Slovenia).
- Savings and investment:
  - The 2008–2013 dynamics were driven by a large decline in private investment’s share of GDP.
  - Improvement in the last two years (relative to the report) was driven by a sharp increase in private savings.
  - The recovery in private investment has lagged, in part due to the corporate debt overhang.
- Integration into supply chains:
  - Foreign imports have contributed very modestly to Slovenia’s exports.
  - Slovenian goods have seen a significant increase in incorporation into the European supply chain, particularly for Germany.

### Policy recommendations and priority reforms
- Further boosting human capital:
  - Improve the quality of education to address demands of the marketplace.
  - Upgrade vocational training and skills to support export competitiveness.
- Reforming labor markets:
  - Reduce labor costs through higher productivity.
  - Reduce disincentives to work (address inactivity trap and related labor tax/benefit distortions).
- Increasing foreign direct investment:
  - Reduce perceptions of a relatively restrictive investment environment.
  - Make the foreign ownership regime more conducive for investors.

*Source: _cr16122 - 13.      Improving labor markets, boosting foreign investment, and enhancing vocational training (Republic of Slovenia, International Monetary Fund).*

### 11.      Deleveraging has been gradual. The median level of debt-to-assets in Slovenia, the

### _cr16122 - 11.      Deleveraging has been gradual. The median level of debt-to-assets in Slovenia, the

### Deleveraging overview
- Median debt-to-assets levels during 2007–14:
  - Slovenia, the Czech Republic, and Slovakia: "hovered around 60-70 percent" throughout 2007–14.
  - Poland: "closer to 50 percent".
  - Hungary: "closer to 35 percent".
- Evolution dynamics:
  - Ratio for all firms decreased somewhat toward the end of the period in each country except Slovakia, where it "jumped in 2009 and stayed at the more elevated level through 2014."
  - In all countries except Slovakia, micro-sized firms have considerably higher debt burdens than larger firms throughout most of the post-crisis period.
  - Highly leveraged firms shed more debt, while those with less debt maintained or increased their leverage.

### Debt overhang (excessive debt)
- Definition used: "financial debt greater than 5 times earnings before interest, taxes, depreciation, and amortization (EBITDA)."
- Sensitivity: Developments in excessive debt are "sensitive to annual fluctuations in cash flow from operations."
- Cross-country status (aggregate):
  - Czech Republic, Poland, and Slovenia: "reduced their debt overhang to pre-crisis levels" in aggregate.
  - Hungary and the Slovak Republic: "generally have the most excessive debt."
- Micro-enterprise specifics:
  - Among micro-enterprises, Slovenia firms "suffer the least from excessive debt" while Polish micro-enterprises "join their Hungarian counterparts with the largest amounts of excessive debt since 2011."
- Exact statistic: "45 percent of all sampled Slovenian firms faced excessive debt levels in 2014."
- Note: "EBITDA is an approximate measure of operating cash flow." The measure is consistent with a threshold analysis where "the threshold level for debt-to-EBITDA at which the marginal return in terms of more investment begins to diminish is 4 for all firms in Slovenia."

### Debt service capacity
- Interest coverage (EBITDA over financial expense):
  - "A significant number of firms (10 to 30 percent of the sampled firms, depending on the country) have interest coverage ratios (EBITDA over financial expense) below one."
  - In Slovenia and Slovakia, "2/5 of micro enterprises do not have the cash flow to cover annual interest payments."
- Implication: These firms "have to rely on other sources of financing such as cash balances, asset sales, or credit lines to cover annual interest payments."
- Relative standing: "With the exception of micro-sized firms, Slovenian firms in general can more easily cover interest payments out of cash flow from operations than their peers in comparator countries."

### Firms’ financial condition, investment and the effect of the crisis
- Investment contraction:
  - "With the onset of the financial crisis, investment by companies in Slovenian and the CE-4 fell significantly and continued to contract through 2014."
  - Corporate investment is measured as "the change in total tangible assets between t and t-1 plus depreciation and amortization over total tangible assets at t-1."
- Financial health and investment:
  - Weak balance sheets (e.g., debt-to-EBITDA > 5, interest coverage ratio < 1.5, or financing heavily reliant on debt) increase susceptibility to financing constraints.
  - "With the exception of micro-enterprises, indicators of financial health have broadly returned to their pre-crisis levels, yet investment has not recovered."
  - For micro-enterprises, persistent weak financial positions compound the investment slump.

### Empirical analysis and main econometric findings
- Model specification highlights:
  - Dependent variable: d ln(I)i,t where I = Gross investment (sum of annual difference of tangible fixed assets and depreciation and amortization).
  - Key regressors (lagged): CAS (cash and cash-equivalents to total assets), ROA (EBITDA/total assets), DA (financial debt to assets), OVER (EBITDA/Financial debt), ASSETS, and interactions of DA and OVER with a post-2008 indicator (post = 1 if year ≥2009).
  - For Slovenia, a lagged ECB diffusion index for bank credit conditions (BLS) is included.
- Changed relationships post-crisis:
  - "Post crisis, firms’ investment rates are more sensitive to their indebtedness and capacity to pay interest relative to the pre-crisis period."
  - For Slovenia, thresholds exist for debt ratios: "a turning-point level in the ratios’ values above which debt begins to influence investment negatively."
- Regression point estimates (selected values from Table 1 and discussion):
  - Credit conditions (Slovenia, all firms): "-0.623***".
  - Credit conditions (Slovenia, small and micro): "-0.620***".
  - Summary interpretation:
    - "More debt on top of already high debt levels leads to less investment. A higher level of indebtedness reduces investment by Slovenian and Polish firms post crisis."
    - In the pre-crisis period the coefficient on debt-to-assets (DA) is negative though insignificant; post-crisis it "becomes more negative and significant" for Slovenia and Poland.
    - For some less-indebted countries the coefficient on debt-to-assets "turns positive post crisis" and in some cases is significant.
    - EBITDA-to-debt coefficients: "becomes less negative or turns positive across all countries" for all firms and for small and micro firms, indicating "a firm’s ability or willingness to invest becomes more sensitive to operational cash flow relative to debt financing."
- Threshold estimates for Slovenia (Table 2 and discussion):
  - Debt-to-assets (DA) optimal thresholds:
    - Large firms: "76" (percent of assets).
    - SME: "10" (percent of assets).
  - Debt-overhang (OVER^-1, x EBITDA) optimal thresholds:
    - Large firms (debt-to-EBITDA level at which investment begins to decline): "8".
    - SMEs: "1".
- Profitability and liquidity:
  - "As expected, more profitable and liquid firms invest more." Coefficients on cash-to-assets and return on assets are positive and statistically significant in regressions (e.g., Return on assets coefficients: "1.292***", "1.060***", "0.698***", "2.143***", "0.922***"; Cash-to-assets coefficients: "2.863***", "3.534***", "2.414***", "3.519***", "2.785***" across country columns).
- Bank lending standards:
  - "Tighter bank lending standards lower investment." In Slovenia-specific estimations the coefficient on credit standards was negative and "highly significant."
  - The magnitude of the impact "was somewhat less for smaller firms."

### Aggregate debt reduction estimate and investment implications
- "A 'back of the envelope' calculation suggests that the aggregate debt of small- and micro-sized firms should be reduced by up to 30 percent of GDP from 2014 levels."
- Calibration:
  - Average debt-to-asset ratio for medium-, small- and micro-size firms in 2014: "56 percent."
  - To lower the ratio to the threshold level of about "10 percent" absent new equity, these firms "would need to reduce debt by about €12 billion."
  - "New equity would lower the needed amount of debt reduction."
- Investment share:
  - "SMEs accounted for 60 percent of non-financial corporate investment over the period 2006–14."
- Note: With a few exceptions, "large firms’ debt-to-asset ratios are under the relevant threshold."

### Policy options and conclusions (focus on Slovenia)
- Key conclusion: "Corporate leverage, particularly for SMEs, needs to be reduced further to accelerate investment." Financial frictions are likely to remain elevated.
- Examples of potential policy interventions:
  - "Closely monitor bank implementation of the NPL guidelines provided by the Bank Association and the Bank of Slovenia, and adjust these guidelines if needed, based on the implementation experience."
  - "Consider again the benefits of a centralized privately funded entity (SPV) for SME NPL resolution." Rationale: "This would quickly reduce the lingering burden NPLs place on bank lending and stimulate greater economic activity by freeing up productive resources (e.g., blocked collateral)."
  - "Further transfer assets to the Bank Asset Management Company (BAMC), especially claims on companies that are already part of its portfolio." Rationale: "This would facilitate speedier resolution of bad debts by mitigating creditor coordination issues."
  - "Explore ways to facilitate equity financing, including mezzanine financing, particularly for SMEs." Rationale: "Additional equity would provide resources for investment, and improve corporate leverage ratios enhancing the creditworthiness of corporate borrowers." Note on mezzanine: it "may give the lender the right to convert to an ownership or equity interest in the company if the loan is not paid back."
  - "Consider sponsoring or supporting regional efforts to develop a market in distressed debt (IMF, 2015d)."

*Source: IMF staff analysis as presented in the provided chapter text.*

### References

### _cr16122 - References

### References Cited
- Banka Slovenije, 2015, “Policy Strategy Paper for Slovenia, 2015,” Ljubljana, Slovenia.
- Barkbu, Bergljot, S. Pelin Berkmen, Pavel Lukyantsau, Sergejs Saksonovs, and Hanni Schoelermann, 2015, “Investment in the Euro Area: Why Has it Been Weak,” IMF Working Paper No. 15/32 (Washington: International Monetary Fund).
- Bending, Tim, Markus Berndt, Frank Betz, Philippe Brutscher, Oskar Nelvin, Debora Revoltella, Tomas Slacik and Marcin Wolski, 2014, “Unlocking Lending in Europe,” Working paper, Economics Department (Luxembourg: European Investment Bank).
- Budina, Nina, Sergi Lanau and Petia Topalova, 2015, “The Italian and Spanish Corporate Sectors in the Aftermath of the Crisis,” IMF Selected Issues Paper, IMF Country Report No. 15/167, pp. 22-48.
- Caprirolo, Gonzalo, and Miha Trošt, 2015, “Deleveraging of Non-financial corporations: Taking stock,” (Forthcoming in Bancni Vestnik).
- Christiansen, Lone, and Annette Kyobe, 2014, “Corporate Sector Vulnerabilities,” Selected Issues Paper, IMF Country Report No. 14/174 (Washington, D.C.: International Monetary Fund).
- Damijan, Jože, 2014, “Corporate financial soundness and its impact on firm performance: Implications for corporate debt restructuring in Slovenia,” EBRD, Working Paper No. 168.
- Fazzari, Steven, Glenn Hubbard and Bruce Peterson, 1988, “Financing Constraints and Corporate Investment,” Brookings Papers on Economic Activity, Vol. 1. pp. 141-95.
- EBRD, 2014, Strategy for Slovenia (London: European Bank for Reconstruction and Development).
- EBRD, Transition Report 2015-16, 2015, “Rebalancing Finance,” (London: European Bank for Reconstruction and Development) (Draft).
- European Central Bank, 2014, “Deleveraging Patterns in the Euro Area Corporate Sector,” ECB Monthly Bulletin (February).
- Gabrijelčič, Mateja, Uroš Herman, and Andreja Lenarčič, 2015, “Debt Financing and Firm Performance before and during the Crisis: Micro-Financial Evidence from Slovenia,” Ljubljana, Slovenia.

### Annex I — Definitions of Financial Ratios, Variables, and Firm sizes
- CAS: Liquidity (Cash and cash-equivalents/Total assets)
- DA: Debt-to-assets (Financial debt1/Total assets)
- DE: Debt-to-equity (Total liabilities/Shareholders’ equity)
- EBITDA: Earnings before interest, taxes, depreciation, and amortization, i.e., total revenue less total expenses (excluding interest, taxes, depreciation, and amortization).
- ICR: Interest coverage ratio (EBITDA/Financial expense)
- PRMG: Profit margin (Earnings before taxes (EBT)/Operating revenue)
- OVER: Debt overhang (Financial debt/EBITDA)
- ROA: Return on assets (EBITDA/Total assets)

Firm Size Classification (in millions of euros, unless otherwise specified)
- Operating revenue: Large > 100; Medium 10-101; Small 1-10; Micro < 1 (implied by table structure)
- Total assets: Large > 200; Medium 20-202; Small 2-20; Micro < 2 (implied by table structure)
- Employees (number): Large > 1000; Medium 250-1000; Small 50-250; Micro < 50 (implied by table structure)
- Other criteria: listed; and not large; and not large or medium; All others
- Note 1: Financial debt equals long-term debt plus current liabilities. Alternatively, it equals total liabilities less other non-current liabilities.
- Source: Orbis by Bureau van Dijk
- 1/ Must match at least one of the conditions to be included in the size designation.

### Annex II — Regression Results by Country and by Firm Size (Dependent variable: Log-difference of tangible fixed assets)
- Regression table includes country panels (Slovenia, Czech Republic, Hungary, Poland, Slovakia) with columns for all firms and by firm size (1=large firms; 2=medium firms; 3=small and micro firms).
- Selected coefficient estimates and p-values (p-values in parentheses; * p<0.10; ** p<0.05; *** p<0.01):
  - Cash-to-asset: e.g., Slovenia overall 2.863*** (0.000); Czech Republic overall 0.350*** (0.000); Hungary overall 2.911*** (0.000); Poland overall 3.519*** (0.000); Slovakia overall 3.463*** (0.000).
  - Debt-to-assets: e.g., Slovenia overall -0.123 (0.490); Czech Republic overall -1.741 (0.435); Hungary overall 0.797 (0.340); Poland overall -0.039 (0.757); Slovakia overall -0.156 (0.243).
  - Return on assets: e.g., Slovenia overall 1.292*** (0.000); Czech Republic overall 18.675*** (0.002); Hungary overall 6.791*** (0.000); Poland overall 2.143*** (0.000); Slovakia overall 1.843*** (0.000).
  - Debt overhang: e.g., Slovenia overall -0.082*** (0.007); Czech Republic overall -4.183** (0.042); Hungary overall -1.307*** (0.000); Poland overall -0.041* (0.072); Slovakia overall -0.054** (0.019).
  - DA (post): e.g., Slovenia overall -0.455*** (0.003); Czech Republic overall 2.527 (0.400); Hungary overall 0.636 (0.373); Poland overall -0.519*** (0.000); Slovakia overall -0.393*** (0.001).
  - Overhang (post): e.g., Slovenia overall 0.062* (0.075); Czech Republic overall 2.796* (0.078); Hungary overall 1.143*** (0.001); Poland overall 0.015 (0.516); Slovakia overall 0.052** (0.025).
- Additional statistics:
  - r2 and F reported per column (examples): Slovenia r2 0.230, F 718.5; Czech Republic r2 0.167, F 4.238; Hungary r2 0.190, F 8.568.
  - Sample sizes N given per column (examples): Slovenia N 51,775; Czech Republic N 3,453; Hungary N 3,525; Poland N 110,090; Slovakia N 95,647.
- Note: All regressions include firm and year fixed effects. Standard errors are clustered at the firm level.
- 1/ First country column is for sample with all firms in that country. Other country-columns: 1=large firms; 2=medium firms; 3=small and micro firms.

### Annex III — Threshold Effects (Debt-to-assets and Debt-to-EBITDA turning-point tests)
- Objective: test for existence of a “turning point” threshold effect between investment growth and debt–to–assets and debt-to-EBITDA ratios in Slovenia.
- Model basis: same as equation (1) in main text, replacing pre-/post- debt-designations with a variable measuring deviation relative to a potential threshold (methodology follows Hansen (1999) and Khan and Senhadji (2000)).
- Specification for debt-to-assets threshold test:
  - dln(Ii,t) = γ1 dai,t-1 + γ2 dumi,t-1 DA* (dai,t-1 − DA*) + Xi,t-1 β + αi + αt + εi,t
  - dumi,t-1 DA* = {1 if dai,t-1 ≥ DA*; 0 if dai,t-1 < DA*}
  - da = Debt to assets
  - X = Vector of control variables (CAS, ROA, OVER)
  - DA* = Threshold level for debt to assets
  - αi = Firm fixed effects; αt = Year fixed effects; εi,t = Error term
- Threshold selection:
  - DA* is chosen to minimize the residual sum of squares S(da) across da in the range da = 1 percent to da = 100 percent.
  - For debt-to-EBITDA threshold, replace da with over-1 (i.e., debt-to-EBITDA) and threshold variable DA* with OVER-1*, threshold range 1 to 10 with increment of one.
- Interpretation of coefficients:
  - γ1 estimates effect of debt burden on investment change for firms below the threshold.
  - γ2 is coefficient on difference between observed debt and threshold when observed debt is above threshold.
  - γ1 + γ2 is impact on investment change when debt exceeds the threshold.
- Empirical procedure:
  - Regressions run separately for sub-sample of large firms and for SMEs (all firms not classified as large).
  - For debt-to-assets threshold, this amounted to one hundred regressions per sub-sample; thresholds reported correspond to the DA* that minimizes RSS across these regressions.
- Practical implication: the turning-point threshold implies that marginal debt accumulated after debt hits the threshold diminishes investment growth.

### ECB Quantitative Easing: Implications for Fiscal Policy (Sections A–C)
A. Introduction — context and scope
- Key points:
  - ECB implemented significant QE since mid-2015 to address inflation well below target and the zero lower bound constraint.
  - QE focuses on long-term EA sovereign paper in secondary markets to lower long-term interest rates and boost credit and aggregate demand; other channels include exchange rate, wealth, and portfolio rebalancing.
  - Total planned purchases of government paper exceed €1 trillion.
  - For Slovenia, planned purchases amount to €4 billion, representing some 12 percent of end-2015 public debt and around ⅔ of the medium- and long-term debt amortization in 2016–17.
- Paper’s focus: explore appropriate fiscal response in Slovenia to QE, noting QE’s temporary nature but potentially significant impact on public debt service costs.
- Previewed policy conclusion: empirical and analytical considerations argue for a nontrivial fiscal response in Slovenia, notably some front-loading of public investment while maintaining a credible medium-term consolidation plan; temporary loosening of the primary balance should be less than the reduction in interest costs so that overall budget deficit and public debt decline.

B. Fiscal “Windfall” of QE
- Empirical observations:
  - Slovenia’s bond yields declined by almost 150 basis points after QE launch, in line with other EA periphery countries; prior to QE Slovenia’s spreads had narrowed by almost 400 basis points since end-2013.
  - Slovenia’s QE-related “fiscal windfall” estimated at 0.5 percent of GDP per year on average over 2016-17.
  - Slovenia’s windfall is somewhat lower than Italy and Ireland but significantly larger than most other EA countries, mainly due to comparatively large near-term rollover needs and previous market access difficulties.
- Policy relevance: the sizable QE-related reduction in debt service costs raises the question of how much to loosen the primary balance versus saving the windfall.

C. Fiscal Reaction Functions — Empirical Analysis
- Methodology:
  - Estimated a 5-variable VAR on a panel of 12 EA countries over 1998-2015 (EMU period), with endogenous variables: effective interest rate R (interest payments over last period’s debt stock), primary balance PB (ratio to GDP), real GDP growth g, inflation INF, and public debt ratio DEBT as predetermined.
  - System estimated with one lag (Akaike criterion), Cholesky identification; unconstrained VAR shocked R by 1 percentage point.
- Unconstrained VAR results:
  - Following a negative 100 basis point R shock, PB drops almost 0.3 percentage points below baseline four years after the shock.
  - Lower PB only partially offsets the R shock, and DEBT falls, remaining some 2 percentage points below baseline by the end of the five-year horizon.
  - Positive impact on INF after a brief price puzzle; no significant impact on output growth detected.
- Constrained VARs to better capture QE persistence:
  - Constrained VAR I (“gradual unwinding”): R restricted to remain at its initial post-shock level over a two-year period then allowed to evolve endogenously.
  - Constrained VAR II (“rapid unwinding”): R returns quickly to baseline by year three and remains there—captures scenario of strong inflation leading ECB to reverse purchases.
- Constrained VAR I results:
  - PB falls by 0.35 percentage points below baseline by year one, by 0.5 percentage points by year two, and by 0.6 percentage points by year three; PB remains about ½ percentage point below baseline through year five before gradual tightening.
  - Despite easier primary balance, lower average borrowing costs and somewhat higher inflation keep DEBT lower relative to the unconstrained VAR throughout the five-year horizon.

*Italic: Source: _cr16122 - References (IMF).*

### 15.      The profile of the estimated fiscal response under the “rapid unwinding” specification

### 15.      The profile of the estimated fiscal response under the “rapid unwinding” specification

### Estimated fiscal response under the “rapid unwinding” specification
- Constrained VAR II (Figure 5) implies a distinctly sharper fiscal tightening as QE is unwound compared with the gradual unwinding scenario.
- Primary balance (PB) path under rapid unwinding:
  - PB falls by 0.3 percentage points below baseline by year one.
  - PB falls by 0.5 percentage points below baseline by year two.
  - PB returns to baseline by year four.
  - PB ends up above baseline by the end of the forecast horizon.
- Intuition: Faced with rapid unwinding of QE, fiscal authorities front-load spending to take advantage of low financing costs, then tighten sharply as borrowing costs bounce back rapidly.
- Debt (DEBT) path under rapid unwinding:
  - The decline in DEBT is more moderate than in the “gradual unwinding” case.
  - DEBT ends up less than 1 percentage point below baseline by the end of the forecast horizon, as higher interest cost and lower inflation dominate the tighter PB.

### Robustness and common findings across QE specifications
- Despite specification differences, empirical results are qualitatively consistent.
- Robust results regarding fiscal response to lower borrowing costs:
  - The primary balance tends to loosen upfront while borrowing costs remain low.
  - This primary easing does not fully offset the lower interest bill.
  - As a result, the overall balance improves and the debt ratio falls.

### Fiscal reaction functions — analytical considerations
- A class of micro-founded theoretical models emphasizing consumption smoothing can yield results consistent with empirical patterns.
- Main building blocks of the illustrative model (slightly modified version of de Groot et al. (2015)):
  - Household intertemporal utility maximization, with utility from private consumption and public good provision (public good treated as exogenous and subject to a stochastic shock).
  - Household intertemporal budget constraint; household income consists of labor income taxed at an exogenous tax rate, subject to a stochastic shock.
  - Interest rate faced by households is an increasing function of total household debt.
  - Government intertemporal budget constraint, with changes in expenditure and tax fiscal instruments subject to (convex) adjustment costs.
  - Interest rate faced by the government is an increasing function of government debt.
- Commitment capacity:
  - Imposing that fiscal authorities can commit to a certain deficit path ex ante allows a benevolent government to follow a time-invariant optimal policy that maximizes household utility subject to constraints.
  - Higher government expenditure in response to temporarily low interest rates is a direct implication of optimal household consumption smoothing including utility from public spending.
  - A temporarily low interest rate today (implying higher future rates) leaves intertemporal budget constraints unaffected, implying (noninterest) spending must be lower in the future to revert to steady-state debt paths.
- Time inconsistency and extensions:
  - Perfect commitment is a strong assumption and rules out time inconsistency; present bias for public spending is a recognized problem.
  - Extensions that incorporate endogenous commitment mechanisms (e.g., along lines of Halac and Yared (2014, 2015) building on Amador et al. (2006)) can support an optimal tradeoff between commitment and flexibility.
  - Such extensions add history dependence to the optimal rule but retain key features: temporary increase in primary expenditure in response to a temporary decline in interest rates, which does not fully offset savings in debt service costs, with debt eventually returning to its original steady state level.

### Policy implications and additional constraints
- Overall recommendation:
  - Given the temporary nature of QE, there is little ground to deviate from a medium-term objective for the primary balance that safeguards public debt sustainability.
  - There appears scope for some near-term flexibility allowing a transitory increase in public good provision.
- Quantification of temporary room:
  - VAR results under QE-relevant specifications suggest roughly half of the QE-related interest savings could be spent over a two year horizon.
  - In conjunction with the estimated “fiscal windfall” for Slovenia (Figure 2), this implies room to raise primary spending by some ¼ percentage points of GDP each year during 2016-17.
- Recommended spending composition:
  - Public investment (either EU-funded or domestic component) is the best candidate to use the extra primary spending space.
  - Rationale:
    - Up-front increases must be reversed later years; wage bill, transfers, and possibly goods and services are difficult to scale back.
    - Public investment is typically part of multi-year plans and easier to reallocate across periods.
    - Public investment could help offset underperformance in private investment relative to baseline.
- Additional constraints to consider:
  - Consistency with the SGP:
    - Any near-term stimulus must be consistent with SGP requirements, notably not breaching the 3 percent deficit limit.
    - Assuming Slovenia adheres to its 2016-17 budget targets, the suggested temporary expansion would leave it comfortably below this threshold.
    - The precautionary arm of the EDP prescribes a minimum annual structural fiscal adjustment; adequate safeguards and structural fiscal reforms of current spending that strengthen credibility should allow some flexibility.
  - Implementation capacity:
    - Availability of public investment projects with high rates of return and administrative capacity to manage them could constrain implementation.
    - Calibrating this constraint at the average of the three highest levels of public investment (in terms of GDP) reached over the previous 10-year period suggests the envisaged temporary public investment increase should be attainable.
  - Avoiding fiscal procyclicality:
    - Models do not capture cyclical considerations; it would be undesirable to provide extra stimulus if it moves the economy significantly above potential.
    - IMF staff estimates of a still negative output gap, absence of inflationary pressures, and a large current account surplus provide assurance against overheating.
- Credibility condition:
  - The strategy of front-loaded primary spending hinges on a credible medium-term fiscal consolidation strategy.
  - It is essential that higher near-term primary spending not be perceived as signaling compromise of medium-term fiscal targets, as credibility costs could offset benefits.
  - Any near-term stimulus should be pursued within a credible consolidation strategy underpinned by an adequate institutional framework to assure fiscal sustainability.

*Source: _cr16122 - 15.      The profile of the estimated fiscal response under the “rapid unwinding” specification*

### 6.      The global financial crisis brought a sudden stop of capital inflows and associated

### 6.      The global financial crisis brought a sudden stop of capital inflows and associated

### Crisis impact, deleveraging, and NPL buildup
- Foreign to total liabilities ratio of Slovenian banks fell to 13 percent by September 2015 down from a 40 percent peak in June 2008.
- NPLs (mainly from corporates) increased sharply, peaking at 14.4 percent in 2012 from 3.8 percent in 2008.
- Systemic dynamics:
  - Squeeze in funding sources forced pronounced deleveraging and a dramatic cut in lending that reinforced the recession.
  - Corporate difficulties led to rapid deterioration in banks’ portfolios, imposing operating losses that reduced banks’ capital and increased solvency risks.
- 2013 asset quality review of eight banks found capital shortfalls relative to reported September 2013 levels of:
  - Foreign-owned banks: 78 percent shortfall.
  - Domestically owned banks: 244 percent shortfall.

### State bank recapitalization and BAMC interventions
- State banks were recapitalized at a total cost of 10 percent of GDP.
- Six banks received capital injections in 2013–14.
- Bank Asset Management Company (BAMC) established in late 2012 enabled transfer of 53 percent of the EUR 9.4 billion in NPLs from five recapitalized government banks by end-2014, primarily involving loans to large state-owned corporates.
- Over 70 percent of remaining NPLs are concentrated at small and medium-sized enterprises (SMEs).
- Transfer details and sales:
  - Over 70 percent of claims against large corporates were transferred to BAMC; some claims less than 90 days in arrears were also transferred.
  - The sale of NKBM to a U.S. equity fund was announced in June 2015; NKBM is the second largest bank with a 12 percent share in total bank assets and deposits and a 9 percent share in total loans. NLB has shares of 32, 34 and 30 percent, respectively.

### Measures to support NPL resolution and sector stabilization
- Corporate Insolvency Framework reform (2013) opened options including voluntary multilateral restructuring agreements (MRAs); BAMC also implements MRAs.
- Supervisory Actions by the Bank of Slovenia (BOS) included reporting requirements: 3-year management plans and restructuring strategies, asset reclassification, and release of impairment provisions.
- Most MRAs have involved debt re-profiling but not debt reduction, new financing, nor recapitalization.

### Current balance sheet repair status and credit conditions (as reported)
- System wide NPLs were at 10.3 percent (EUR 3.7 billion, of which corporates represent 60 percent) in November 2015.
- Overall capital ratios by September 2015:
  - CAR: 20.5 percent.
  - Core tier 1: 19.8 percent.
- Credit contraction (as of December 2015, year-on-year):
  - Credit to the private sector: contracting by 5.7 percent total.
  - Credit to nonfinancial corporates: contracting by 10.2 percent.
- Bank profitability and margins (September 2015):
  - ROE: 6.1 percent.
  - Net interest margin: 2.2 percent.
- Deposit dynamics: fall on deposits with agreed maturity since early 2013 (by over 25 percent).

### Regulatory and supervisory framework developments
- 2012 FSAP assessment (IMF and World Bank) recommended privatization of state-controlled banks to address governance weaknesses.
- Basel Core Principles assessment identified BOS weaknesses, recommending strengthened powers in areas including:
  - Licensing or removal of bank supervisory board members.
  - Requirement for banks to obtain authorization for acquiring non-bank financial companies.
  - Power to direct banks to increase capital (without shareholders’ discretion impeding BOS requirement).
  - Greater granularity in reporting of problem assets.
  - Addressing relatively low provisioning of NPLs.
- 2012 amendments to the Banking Law provided BOS with:
  - Increased powers in relation to banks’ supervisory board members.
  - Broader powers for financial stability measures (including appointment of extraordinary administration, compulsory disposal of shares, capital increase, and transfer of assets and liabilities).
  - Power to authorize qualifying investments of banks in other financial undertakings.
  - Increased powers over execution of supervisory measures, especially recapitalization requirements.
  - Legal protection of supervisors.
- March 2015 Banking Law transposed CRD IV and included frameworks for capital buffers and early intervention, and recovery of credit institutions and investment firms (part of BRRD). Remaining BRRD provisions were planned to be transposed by April 2016 in the context of the Law on Banking Resolution.
- Single Supervisory Mechanism (SSM) framework expected to strengthen supervision and align standards with European best practices, applying common rules and procedures across “important” and “less important” banks.
- Other European initiatives (macroprudential framework, credit register) were expected to reinforce national regulatory and supervisory frameworks once fully operational.

### Indicators of financial development and Slovenia’s position
- Traditional size metric: private sector credit-to-GDP; credit in Slovenia doubled in 2004–10.
- Financial Development Index (FD index) covers institutions and markets and includes depth, access, and efficiency.
- Cross-country findings:
  - Non-monotonic (bell-shaped) effect of financial development on growth and stability; as economies evolve, benefits from institutions decline and benefits from markets increase.
  - Strong regulatory and supervisory frameworks promote both financial stability and financial development.
  - Faster financial development raises risks to economic and financial instability if regulation and supervision lag.
- Slovenia’s FD index evolution (2004–2013):
  - Slovenia below the average for the EA, but above CEE and EME.
  - Narrowing gap with EA reversed from 2009; index moved towards average for CEE and EME.
  - Sub-indices: stronger position for financial institutions (comparable to average EA), weaker position for financial markets (closer to average CEE and EME).
  - Components show relatively strong access levels for both institutions and markets, and weaker depth and efficiency—much lower for markets than for institutions.
  - Market deficiencies driven by very low relative levels of nonbank market development: stock market capitalization and trading volumes (shares to GDP), number of debt securities issuers, and stock market turnover ratio.
  - Institutional depth components such as assets of pension and mutual funds lag behind the EA; mutual fund assets are well below the EA and similar to EME/CEE.
  - Evolution 1995–2013 skewed towards increased relevance of financial institutions and a decrease in the role of markets, contrasting with more balanced development in the EA and EME.
- Position relative to turning point:
  - Based on estimations in Sahay and others (2015), Slovenia would lie close to the turning point where positive effects of financial development on growth and on growth volatility begin to decline.
  - The estimated turning point for positive effects to begin to decline is on average in the 0.4 and 0.7 range with a 95 percent confidence level; results should be taken with caution.

### Future prospects and policy recommendations
- Main diagnostic: financial deepening in Slovenia produced low-quality financing, risk build-up, vulnerabilities, and declining investment efficiency; current bank assets are not productive enough with significant misallocation and high NPLs.
- Priority policy directions:
  - Accelerate balance sheet repair and NPL resolution to restore credit provision and bank income generation capacity.
  - Better regulation and supervision to moderate incentives for risk-taking and over-leveraging; effective implementation of key regulatory principles could shift the turning point where benefits of financial development decline.
  - Further financial market development to rebalance toward markets over institutions, focusing on increased access and efficiency.
  - Develop local nonbank financial institutions and capital market options to provide equity financing alternatives for corporates, particularly SMEs.
  - Support incentives toward equity financing through easier foreign investment and ownership and a more dynamic privatization process.
  - Strengthen and expand pension and mutual funds as sources of corporate finance, recognizing challenges: small domestic stock market size and low turnover, limited interest in domestic-focused mutual funds, consolidation toward global/regional strategies, and pension funds’ strategy to invest abroad.

### Implications for the banking sector
- Banks face limits to traditional credit provision while balance sheet repair continues.
- Key trends and constraints:
  - High NPLs reduce profitability and keep lending standards tight.
  - Credit to the private sector continues to contract; loan-to-deposit ratio falling.
  - Funding constrained with a fall in deposits with agreed maturity since early 2013 (by over 25 percent).
  - Share of foreign in total liabilities reduced to below 13 percent from the 40 percent peak in mid-2008, without an offsetting increase in other funding sources.

*Republished content unit from IMF country chapter on the Republic of Slovenia.*

### 26.      Given these factors and the relatively undeveloped capital market, a migration of the

### _cr16122 - 26.      Given these factors and the relatively undeveloped capital market, a migration of the

### Nonbank financing and market development
- Commercial paper net value issued in the domestic market increased to EUR 230 million in 2014 from EUR 9 million in 2011.
- Outstanding corporate bonds net value increased to EUR 140 million from EUR 65 million in the same period, recovering from a sharp decline in 2012–13.
- In 2015 commercial paper and bonds represented 0.9 percent and 14 percent, respectively, of the Ljubljana Stock Exchange market turnover.
- These shares suggest potential for expansion of commercial paper and bond instruments in the local market.
- Cross-border financing to corporates increased in 2014 with issuance of equity and debt securities, mostly to the EU.
- The international net financial position of corporates doubled to 28 percent of GDP in the period 2008–14 and increased by 10 percentage points in 2011–14.
- Domestic loans to corporates continued to shrink in 2015 (yoy), albeit at a lower rate; the yoy growth rate has been negative since early 2011.

### Bank efficiency, consolidation, and profitability
- Banks exhibit low efficiency and profitability, indicating potential benefits from consolidation.
- Of the 16 commercial banks operating in Slovenia, the top five control close to 70 percent of the assets while the assets of the 10 smallest banks represent 25 percent of the total. (These numbers reflect the merger of Abanka Vipa and Banka Celje.)
- Without higher efficiency and competitive lending rates, banks will tend to lose share in credit provision, particularly to corporates.
- Small banks, with less opportunity for economies of scale and diversification, are more likely to be vulnerable to various shocks.
- Privatization of public banks could generate efficiency gains if followed by active supervision and regulation.
- Authorities should be careful not to create too big to fail institutions.

### Market segmentation and borrower access to external funding
- A process of market segmentation could result with the best corporate credits potentially moving to borrow from abroad or from nonbanks, while banks retain lower-tier credit risks.
- Evidence of disintermediation: nonbank financing to corporates, including SMEs, is on the rise in Europe, although from a relatively low level.
- Initiatives to improve funding to SMEs include publicly tradable debt (mini bonds), equity, private-debt funds, private placements, and direct borrowing from nonbanks.
- Banks need to offer flexible conditions to borrowers with access to external funding to remain competitive.

### Constraints on banks’ ability to expand credit
- State-aid rules in the context of the bank recapitalization process impose limitations on sectoral lending and on minimum required rates of return (return on equity) for project lending.
- The bank restructuring plans of the major state-owned banks approved by the European Commission determined a minimum return on equity of 7-10 percent.
- Higher European regulatory capital requirements with additional capital buffers represent an increase to banks’ cost of funding, as more and better quality equity is required.
- To resume lending, banks need to accelerate balance sheet repair and NPL resolution.

### Financial Development Index (FD index): construction and implications
- The FD index captures indicators of financial institutions (FI) and financial markets (FM) across three dimensions: access, depth, and efficiency.
- Six sub-indices: FIA, FID, FIE; FMA, FMD, FME.
- Dataset comprises annual data for the period 1980-2013 for 176 countries (25 advanced, 85 emerging, and 66 low-income developing countries).
- Indicators are winsorized at the 5th and 95th percentiles; each indicator is normalized between zero and one using a global mini-max procedure; higher values mean greater financial development.
- Sub-indices and higher indices are constructed using principal component analysis with weights from the PCA.
- Minimum and maximum values of all indices are zero and one, respectively.
- The FD index and sub-components are used in growth and stability analysis via the specification:
  - ẏ_it = α + β_0 FD_it + β_1 FD_it^2 + β_2 (FD_it · Interact_i) + β_3 X_it
  - where y is per capita real GDP growth, FD is the financial development index (or sub-component), Interact accounts for additional interactions, and X includes controls: initial income per capita, education (secondary school enrollment), trade-to-GDP, consumer price index inflation, government consumption-to-GDP ratio, and foreign direct investment-to-GDP ratio.
- Estimation method: dynamic system generalized method of moments (GMM) over non-overlapping five-year periods in the 1980-2010 range, based on a 128-country sample.
- Findings summarized in the IMF paper:
  - Financial development increases growth and stability, but the effects weaken at higher levels of financial development, and eventually become negative.
  - Financial deepening drives the weakening effect; fast deepening of financial institutions can lead to economic and financial instability if not countered by adequate regulation and supervision.
- For economic volatility and financial stability analyses:
  - Economic volatility measured by rolling five-year standard deviation of growth.
  - Financial stability approximated by distance to distress, defined as [capital to assets + return on assets / standard deviation of return on assets].

*Source: _cr16122 - 26. Given these factors and the relatively undeveloped capital market, a migration of the; Republic of Slovenia, INTERNATIONAL MONETARY FUND (content unit provided).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16122.pdf_