I. Introduction and Overview
1. While Slovenia’s economy is presently doing well, it faces several challenges in the coming years. In the financial sector, growing EU financial integration raises questions about vulnerabilities from increasing cross-border activities and about the ability of the state-dominated banking sector to deal with greater competition. Also, the relatively low level of development of Slovene capital market compared to EU peers may constrain growth and opportunities for diversification of risk. As for fiscal policy, the rigid structure of public spending limits Slovenia’s ability to adjust to shocks and meet medium-term fiscal targets in the face of declining revenues as a result of the ongoing tax reform.
2. This paper looks into these challenges and how they can be met. Specifically, the following four issues will be covered: (i) how efficient is the Slovene banking sector in the EU context and how contestable is the market; (ii) to what extent has the rapid rise in cross-border financial flows increased vulnerabilities in Slovene banks; (iii) what is the state of development of Slovene capital markets and how can the contribution of these markets to growth and financial stability be enhanced; and (iv) how could the fiscal institutional framework be strengthened to advance expenditure reform and preserve fiscal discipline?
3. To face the challenges of increasing EU financial integration, Slovene banks need to improve efficiency and profitability. Using both qualitative and quantitative empirical analysis, Chapter II finds that Slovene banks are among the least efficient in Europe, which can reflect low contestability compared to EU peers. Efficiency and contestability may have been influenced by market concentration and ownership. As state banks are the least efficient, privatization and other measures to increase bank efficiency could have important benefits.
4. Slovene banks’ rapidly expanding cross-border borrowing and lending warrants close monitoring of underlying vulnerabilities. Chapter III examines recent trends in foreign funding of Slovene banks and their exposures in the region, and using stress tests, assesses their resiliency to shocks. While stress tests do not point to high vulnerabilities, information on foreign credit exposure could be improved.
5. Deepening of capital markets could improve efficiency of financial intermediation. Chapter IV shows that the Slovene equity and bond markets remain narrow and illiquid offering limited investment opportunities. To deepen the capital market, a hybrid strategy should be pursued that seeks integration with international capital markets while continuing to enhance domestic markets tailored to local needs.
6. A stronger fiscal framework could help Slovenia preserve the discipline and credibility in implementing its fiscal reform program. Chapter IV discusses the experiences in the EU with medium-term expenditure frameworks and how to strengthen Slovenia’s framework. Given the need for an expenditure-based consolidation to achieve the fiscal targets, an expenditure rule should be considered.