Republic of Slovenia: Selected Issues

This Selected Issues paper examines the progress of Slovenia by focusing on four interrelated topics that are critically important to the evolution of the transition process and provides insights into the work that lies ahead. The paper concludes that the voucher-based privatization process has failed to truly transform the ownership structure of socially owned enterprises. The paper also investigates the inflation process in Slovenia through an empirical examination of some commonly used determinants of inflation in transition economies.

Abstract

This Selected Issues paper examines the progress of Slovenia by focusing on four interrelated topics that are critically important to the evolution of the transition process and provides insights into the work that lies ahead. The paper concludes that the voucher-based privatization process has failed to truly transform the ownership structure of socially owned enterprises. The paper also investigates the inflation process in Slovenia through an empirical examination of some commonly used determinants of inflation in transition economies.

III. Measures and Assessment of External Competitiveness1

A. Introduction

102. An analysis of Slovenia’s external competitive position is of particular interest because of the very open nature of its small economy, with foreign trade accounting for 133 percent of GDP in 1996. More importantly, as Slovenia moves toward full EU membership, competitiveness is of critical importance to its successful integration. The conventional measure of competitiveness is the real effective exchange rate (REER), for which there are a number of different indicators based on different price measures of tradable goods. While REER indicators may provide a guide, competitiveness is in fact a multidimensional concept which for macroeconomic analysis cannot be fully captured in one measure, A number of other factors affect competitiveness, including technology and education levels.2

103. An appreciation of the REER may be perceived by policymakers as a loss of competitiveness. This can pose a policy dilemma between the desire to both maintain price stability and preserve competitiveness. In addition, the REER appreciation may be accompanied by a deterioration in the external accounts. Recent research by Halpern and Wyplosz (1996) suggests that the tendency of the REER to appreciate in transition economies is an equilibrium response to productivity and other efficiency gains made in the process of moving to a market economy and ‘catching’ up with the advanced economies. Furthermore, a deterioration in the external accounts may simply represent an equilibrium response to the increased capital requirements and domestic demand associated with the process of economic development.3 It is therefore important to examine the factors underlying the developments in the REER as well as other external indicators, in order to assess whether competitiveness is threatened.

104. This paper assesses Slovenia’s competitiveness from a number of different angles.4 The analysis concentrates on the events following stabilization (1993-97). Section B presents the Halpern and Wyplosz ‘stylized fact’ concerning developments in equilibrium exchange rates in transition economies, and then draws on this work to analyze developments in Slovenia’s REER, the underlying factors influencing its movement, and the implications for competitiveness. Section C tries to shed further light on competitiveness by examining external developments including market share analysis and empirical estimates of import and export equations (for details see Annex I), These empirical findings are then used to try to assess the impact on the current account of an appreciation of the REER. Section D presents the conclusions, including prospects for competitiveness and policy implications.

B. Real Exchange Rate Developments

A “stylized fact” for the equilibrium exchange rate in transition economies

105. Recent empirical work by Halpern and Wyplosz (1996), henceforth referred to as H-W, presents a ‘stylized fact’ for the REER for countries in transition: an early profound exchange rate depreciation followed by continuing real appreciation, where the process of real appreciation is a combination of a return to equilibrium, following the early overshooting, and a further gradual appreciation, reflecting relative productivity and other efficiency gains in the course of the transformation process. Apart from the correction of the initial overshooting, the steepness of the appreciation depends on the backwardness of the transforming economy and the speed with which it implements structural reforms and catches up with the advanced economies.

106. H-W cite a number of factors that are likely to induce an appreciation of the real equilibrium exchange rate, including: (1) rapid productivity gains on account of the economic restructuring, as overstaffing is reduced and unprofitable activities are abandoned and new industries emerge; (2) the Balassa-Samuelson effect, which hypothesizes that, given competitive pressures within each country for workers with similar skills to receive similar wages, relatively rapid growth in productivity in the tradable goods sector would tend to push up the relative cost of production in the nontradable goods sector and hence the relative price of nontradables; (3) increases in the prices of natural resources, as well as public utility prices, which were traditionally set below world prices; as they are raised, the real exchange rate appreciates; (4) changes in the demand for public spending, including expenditure on infrastructure, and the overhaul of the tax structure, which is likely to result in shifts in relative prices; (5) capital inflows, such as those in the form of FDI for the purpose of modernizing and expanding the capital stock, tend to put upward pressure on the REER, while the gains in productivity may not be evident for some years; and (6) improved quality of goods, which would be reflected in terms of trade gains.

Trends in Slovenia’s competitiveness indicators

107. A comparison of trends in the various measures reveals a broadly similar pattern (Figure 1),5 After a pronounced fluctuation during the stabilization period (1991-92),6 external competitiveness indicators have been relatively stable, appreciating about 10 percent since 1993, in sharp contrast to other transition economies (Figure 1). This may reflect several factors: (1) the comparative strength of the market economy at the start of the transition process, as reflected in the very steep appreciation of the REER in 1992;7 (2) the gradualist approach to reform, which means the economy was subject to less radical shocks; (3) an active policy to prevent an appreciation of the REER by containing and neutralizing the effects of large capital inflows—which are perceived to threaten competitiveness—via sterilization and capital inflow controls. This latter factor has complicated exchange rate and monetary policy,8 repressed financial development, and limited economic growth, which in turn thwarts competitiveness.

Figure III-1.
Figure III-1.

Slovenia: Various Indicators of Competitiveness

Citation: IMF Staff Country Reports 1998, 020; 10.5089/9781451835670.002.A003

Sources: Bank of Slovenia, Institute of Macroeconomic Analysis and Development, IMF Research Department, OECD Analytical Database, and IMF staff estimates.1/ Trade weights are not identical, ulc-based REER for the overall economy uses IMF’s Research Department trade weights for Germany, France, and Italy; ulc-based REER industry uses BOS weights for seven major OECD trading partners.

108. The most pronounced appreciation of the REER in the post-stabilization period occurred in the first half of 1995—some 14 percent (ULC-based REER, industry). This development coincided with an appreciation of the nominal effective exchange rate (NEER), as the government pursued a “hard tolar” policy. However, policy was modified in the second half of the year in response to concerns about competitiveness and the nominal effective rate depreciated, inducing a depreciation of the REER. However, the decline in the REER (ULC-based, industry) did not fully match the decline in the NEER, as part of the nominal depreciation was offset by price and wage increases. This was reflected in the widening of relative price differentials and higher real wages, which were not offset by relative productivity gains (Figure 2).9 Subsequently, in 1996, the REER depreciated relative to 1995, on account of favorable intercurrency effects, reflected in the decline in the NEER and remained relatively stable through the first quarter of 1997.10

Figure III-2.
Figure III-2.

Slovenia: Comparison and Key Components of REERs

Citation: IMF Staff Country Reports 1998, 020; 10.5089/9781451835670.002.A003

Sources: Bank of Slovenia, Institute of Macroeconomic Analysis and Development, WEO Competitiveness Database, International Financial Statistics (IFS), IMF Information Notice System (INS), IMF Research Department, and IMF staff estimates.1/ Compared to Austria, France, Germany, Italy, U.K., and U.S. IMF Research Department trade weights. Relative labor productivity is based on manufacturing productivity in trading partners.

Indicators of External Competitiveness

There are a number of indicators of competitiveness including the CPI-based, ULC-based, PPI-based REERs, and dollar wages. The choice among indicators is usually based on data availability and comprehensiveness of coverage of the tradable sector, as well as its ability to explain trade performance. The main indicators and their advantages/disadvantages are summarized below (for further details see Annexes I and II).

CPI-based REER—a broad-based indicator, which includes both goods and services, and the CPI is typically correlated with wage movements which are an important component of production costs. The main drawbacks are that it is vulnerable to distortions from price controls, it includes prices of nontradable goods, and it does not include intermediate goods.

PPI-based REER—it reflects the price of intermediate goods which are an important component of trade. However, it may not be good measure of profitability as exporters can “price to market” by squeezing profits in the short run.

ULC-based REER—this indicator is based on unit labor costs and serves as a measure of profitability, since unit labor costs are an important component of production costs. The main drawbacks are that it may overstate gain in competitiveness, as labor productivity gains are typically associated with increases in capital costs. Also, labor services acquired in production are typically excluded, and there may be differences in coverage among countries being compared. Also the coverage of the indicator may include nontradable sectors such as in the case of a ULC-based REER for the whole economy or for industry, which includes utilities.

Relative price of nontradables to tradables—noted in a strain of the literature as an important relative price in terms of its relationship to a country’s external position. However, it does not take into account productivity differences across sectors (the Balassa-Samuelson effect), and it is difficult to delineate traded from nontraded goods.

Dollar wage—a widely used indicator among transition economies, it provides an indication of the wage gap for comparison across countries. It also avoids the problem of selecting an appropriate base year for comparison. It has, however, problems of comparability in definition of wages costs and, in the case of transition economies, it may suffer from underreporting of direct labors costs.

109. While the REER remains below its post-stabilization peak in mid-1995, which may signal improved competitiveness vis-à-vis this reference point, the appreciation of the REER since 1993 might be construed as a loss. However, since the equilibrium exchange rate is unknown and since it has probably changed over time, these indicators alone do not provide enough information to assess the level of competitiveness.11 Thus, it is important to examine the underlying factors affecting the movements in the REER.12 Several measures are selected for further analysis: (1) the ULC-based REER for industry, which is widely considered to be a good indicator of the competitiveness of exports from this important sector; (2) a ULC-based REER for the whole economy,13 to provide a broader view of competitiveness vis-à-vis trading partners; and (3) the dollar wage, which provides a level basis for comparison and a sense of the size of the wage gap.

ULC-based REER for industry14 and the whole economy

110. An examination of developments in the main components of the ULC-based, industry REER—i.e., real average net wages and other income for industry (deflated by RPI), productivity in industry, and taxes on wages (including employers’ contributions to social security) in industry—suggests that, over the four-year period 1993-96, gains in real wages in industry were in line with gains in productivity15 while taxes were reduced (Table III-1, Figure 2). During the period 1993-96 there were substantial gains in productivity relative to trading partners, most notably in 1993-94 and some additional gains in 1996 (some of which may be cyclical, as these are not normalized ULC), reflecting economic restructuring, mainly in the form of labor shedding. In addition, the terms of trade improved by about 6 percent by 1996 relative to its 1993 value, part of which may reflect improved product quality (Figure 2). Relative productivity gains and improvements in product quality would tend to point to an equilibrium appreciation of the REER in the way described by H-W. However, two caveats should be noted. One, the gains in productivity from labor shedding in manufacturing are not indicative of long-term trends in productivity. Two, wage data may be underestimated to the extent that some forms of compensation may not be properly accounted for.

Table III-1.

Slovenia: Analysis of Competitiveness, Industry

(Annual percentage change)

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Sources: Institute of Macroeconomic Analysis and Development (IMAD), Bank of Slovenia, Statistical Office, and Fund staff estimates.

Data in parentheses are latest observations (first five months of the year, except ULC REER which is for the first 3 months of the year, relative to a year ago).

Ratio of gross wages and employers’ contributions to net wages.

Relative to manufacturing data for Austria, Germany, France, Italy, UK, US; IMF’s Research Department trade weights.

Unit wage costs in US$ based on IMAD estimate for Slovenian manufacturing.

Weighted average.

111. To provide a broader view of the trends in the competitive position, a ULC-based REER for the whole economy was constructed. The indicator follows closely that of the ULC-based, industry REER during the period 1993-95 (Figure 1). As in the case of industry, relative productivity gains for the whole economy were made vis-à-vis trading partners, especially during 1993-94. Also, real wages did not exceed gains in productivity (Figure 3) during this period. However, by the end of 1996, the broad-based REER is more appreciated than that for industry, mainly due to substantial increases in service and public sector wages which pushed up aggregate wages and were not offset by productivity gains.16 Competitiveness was nonetheless preserved in 1996, mainly due to the temporary effects of favorable intercurrency movements and reductions in social security taxes (mentioned above). This suggests that corrective measures will need to be taken soon to link wage growth more closely to performance to avoid a loss of competitiveness. Some progress in this area was indeed made in 1997.

Figure III-3.
Figure III-3.

Slovenia: Factors Influencing Developments in Dollar Wages

(1993=100)

Citation: IMF Staff Country Reports 1998, 020; 10.5089/9781451835670.002.A003

Sources: Bank of Slovenia, Institute of Macroeconomic Analysis and Development, OECD Analytical Database, IMF Research Department, and IMF staff estimates.1/ Compared to Austria, France, Germany, Italy, U.K., and U.S. IMF Research Department trade weights. Relative labor productivity is based on manufacturing productivity in trading partners.
Dollar wage

112. Over the period 1993-96, Slovenia’s dollar wage for the overall economy increased by 37 percent.17 Much of the rapid rise in the dollar wage is due to a rebound of real wages after a substantial decline in 1991-92;18 and productivity gains resulting from industrial restructuring and deepening of the capital stock (as noted above, Figures 2-3). Furthermore, while dollar wages have increased substantially, they are still well below those of the advanced EU countries, and the market exchange rate appears to be below PPP estimates, suggesting that there is further room for catching up (Slovenia’s PPP-based wage was US$1,066 as opposed to US$2,314 in Austria, and the ratio of the PPP-based to market exchange rate was 1.13 in 1995).19 Of concern, however, is that dollar wages are well above those in the CEFTA countries (Slovenia’s wages are 2 to 3 times higher on a PPP basis). Yet, it is important to consider that the counterpart to high wages is higher productivity, as well as other factors, such as better access to markets and product quality.20 Likewise, in evaluating competitiveness vis-à-vis the EU, lower wages reflect in large part lower productivity, so that the catch up process involves making substantial productivity gains, as well as improving product quality and marketing of exports.21 As long as the upward movement in dollar wages is matched by productivity and other efficiency gains, it does not imply a loss of competitiveness.

C. External Performance

113. While the above analysis provides some indication of the underlying factors influencing developments in competitiveness, additional indicators such as export market share developments and the trends in the balance of payments can shed further light on this issue. A substantial loss of export market share over a period of time and/or a large and unsustainable external balance could point to an overvalued exchange rate and the need for policy measures to strengthen competitiveness.

Market share analysis

114. In recent years, about two-thirds of Slovenia’s exports went to the EU. As shown in Table III-2, Slovenia’s export growth exceeded growth of foreign market demand up until 1995, when there was a loss of market share, coinciding with the slowdown in the EU and the appreciation of the REER.22 Since then, exports have recovered, growing in line with export market growth in 1996 and further recovery is expected in 1997 with continued expansion in the EU.23 However, for the four year period, there was a cumulative loss of export market share of about 1½ percentage points, due to the poor performance in 1995. Estimates of export/import functions using various indicators suggest that the elasticity with respect to the REER is relatively small, particularly in relation to that of foreign demand, which is high (greater than one). This suggests that while most of the explanation of export performance is due to the sensitivity of exports to fluctuations in foreign demand, structural factors, such as reductions in overstaffing and regional/bilateral trade agreements, have probably also played a role (see Annex I). However, delays in carrying the reform process forward may have contributed to the lackluster performance of exports in recent years.

Table III-2.

Slovenia: Analysis of Market Shares

(Average annual percentage change)

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Source: World Economic Outlook, September 1997, preliminary.

Weighted average of real import growth of goods and services and goods (excluding oil) of trading partners; the weights for the trading partners are from the IMF’s Research Department, World Economic Outlook, Winter 1997.

Preliminary estimates from IMAD for the first four months of 1997.

Table III-3.

Slovenia: Market Shares of Central and Eastern European Countries in Advanced Economies 1/

(In percent)

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Sources: Direction of Trade Statistics. Data for Slovenia for 1991-92 from Bank of Slovenia and Statistical Office.

Defined as the country’s share of total advanced country merchandise imports.

Table III-4.

Slovenia: Merchandise Trade by End Use in Percent of Total Merchandise Trade

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Source: Statistical Office of the RS. data for 1996 not yet available.
Table III-5.

Growth, Investment and Current Account in Slovenia and Other CEFTA Countries

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Sources: World Economic Outlook, Bank of Slovenia, Institute of Macroeconomic Analysis and Developments.

115. The table also reveals that export performance has benefited from a change in composition, as the rapid growth of service exports has offset a substantial decline in merchandise exports relative to the average growth of their respective markets. Bole (1997) notes that machinery and transport equipment have increased their market share,24 while chemicals and manufacturing goods have lost market share. This suggests considerable restructuring within the manufacturing export sector, which would be expected in the transition to a market-based economy.25 Relative to 1993, the rise in exports of services has been driven principally by increases in travel-related services (which grew by about 26 percent, mainly in 1994) and construction services (mainly in 1994).

116. Although, for the most part, Slovenia’s exports appear to be keeping pace with the comparatively slow growth in its traditional export markets, relative to world export growth, export performance is weak. This suggests that further gains could be reaped by regional diversification. Direction of trade data suggest that while the share of merchandise exports to industrial countries in total exports rose by several percent in 1993-95, data for 1996 show rapidly expanding markets in CEFTA, the countries of the former SFRY, and BRO countries. Another important question is how Slovenia has fared in relation to other central and eastern European economies. The table below reveals that while Slovenia has been able to maintain its market share in industrial countries since 1992, the other CEFTA countries have been able to make gains. As Slovenia’s share remains comparatively high, part of this may reflect its strong competitive position at the start of the transition process which enabled it to quickly reorient its export markets to advanced European markets. This is reflected in the increase in Slovenia’s market share in industrial countries between 1991 and 1992.26 In addition, the market share developments in industrial countries in the above table only include merchandise trade, so that any gains in market share by service exporters would not be accounted for.

Balance of payments developments

117. During the period following stabilization (1993 onward), balance of payments developments were characterized by several factors: (1) the disappearance of the large current account surplus by 1995; (2) a widening trade deficit, caused mainly by rising imports of capital goods; (3) a rising surplus on services, mainly driven by higher travel receipts; and (4) a steady accumulation of reserves, reflecting capital and current account surpluses (Figure 4). The underlying factors are examined below to see if they signal an erosion in competitive position.

Figure III-4.
Figure III-4.

Slovenia: External Developments

Citation: IMF Staff Country Reports 1998, 020; 10.5089/9781451835670.002.A003

Sources: Bank of Slovenia, Statistical Office, and IMF staff estimates.

118. The elimination of the current account surplus reflects mainly the recovery of domestic demand, particularly investment, after stabilization and hence does not point to a decline in competitiveness. The savings-investment balance helps to explain the decline in the current account balance. In 1992, the investment/GDP ratio was low owing to uncertainty concerning economic policies, particularly those relating to the privatization process. Subsequently, there was a substantial rise in the investment/GDP ratio, by about 6½ percentage points over the period 1992-96, a significant part of which reflects investment in infrastructure. Meanwhile the domestic savings ratio declined by about 2½ percentage points in the same period, reflecting mainly a lower private saving ratio relative to 1992, which was in part due to a resurgence in expenditures on consumer durables, especially in 1993.27 By 1996, the current account was close to balance; subsequently the current account deteriorated in the first five months part of 1997.28

119. The widening of the trade deficit reflects mainly a rapid increase in imports, principally capital goods (see Table below). This reflects higher investment in state enterprises, new private businesses, and infrastructure, which would be expected to raise the productive capacity of the economy. In addition, export performance remained relatively stable in relation to GDP. Although it deteriorated somewhat during the latter part of 1995, continued expansion in the EU should bring about an improvement this year (as noted above).

120. The service balance has improved steadily since 1993, mainly on account of increased receipts from tourism. A recent paper by Bole (1997) suggests that the rise in tourism reflects mainly shuttle trade (daily tourism along the border) driven principally by lower prices in Slovenia, particularly lower oil prices. Since these prices will eventually have to be raised to world prices, Bole concludes that this trade is not sustainable. However, it seems that a recovery of services to pre-independence levels would be expected following stabilization,29 as well as further expansion given the potential for growth in this sector. Also, the share of service exports in total exports is substantially lower (about 20 percent) than in other tourism-intensive countries such as Greece (40 percent) and Austria (30 percent). It could be argued then that an improvement in the service balance stemming from the expansion of more standard inward tourism could be sustainable.

121. The current and capital account surpluses during the period allowed a steady buildup of reserves. Increased capital inflows reflected: (1) FDI inflows, which had remained relatively stable in relation to GDP since 1992, at about 1 percent of GDP—which is low compared with other transition economies; (2) substantial inflows of foreign currency holdings of households, most of which occurred in 1993-94 in response to the return to political and monetary stability after independence; and (3) commercial credits and loans by enterprises, which took place mainly in 1993-94 until capital inflow restrictions in July 1995 stopped this flow; (4) increased foreign portfolio investment in the form of bonds after normalization of relations with international creditors and the awarding of an investment grade A rating in mid-1996.30 A gain in creditworthiness would likely improve the prospects for sustainability of current account deficits and, in turn, imply a higher real equilibrium exchange rate.31 Meantime, foreign portfolio equity investment is negligible, reflecting in part the slow progress in privatization, as well as recent measures to restrict these inflows.

Is there scope for nominal and real appreciation?

122. The table below compares developments in GDP growth and the current account of Slovenia with those of other CEFTA countries. The table reveals that while Slovenia’s current account remained near balance over the last two years and those of most of the other CEFTA countries deteriorated, Slovenia’s growth performance has been significantly weaker (see Table below). In addition, investment relative to GDP was several percentage points lower than in most of the other CEFTA countries in 1996. Part of this can be explained by the authorities’ active policy of sterilizing and restricting capital inflows, which as noted above, has contributed to the substantially smaller REER appreciation in Slovenia compared to other transition economies.

123. If policymakers were to relax capital inflow restrictions, these inflows would provide additional financing for investment. At the same time, higher inflows would induce a nominal and real appreciation, which would tend to cause a deterioration in the external accounts. Based on the estimated elasticities for exports and imports with respect to the REER and income,32 it is possible to make a rough approximation of the impact on the trade balance of an appreciation of the exchange rate. For example, a sustained 10 percent REER appreciation of the tolar could result in a deterioration of the external balance by some two percent of GDP.33 Even so, a deficit of two percent of GDP would still be well below that of the other CEFTA countries. It should be noted, however, that this analysis is only a partial assessment, as no account is taken of the possible consequences of higher capital inflows and the REER appreciation on growth and inflation. It would be expected that higher growth would widen the trade deficit on account of increased imports (mainly investment goods), but this effect would likely diminish over time as export growth would benefit from increased capacity and higher total factor productivity. Furthermore, in the context of the intertemporal saving-investment model, it may be optimal to run current account imbalances for some time, in the sense of the current account as a venue for resource allocation between countries. This would be particularly relevant for Slovenia, which is in the process of narrowing the relative income gap with the advanced countries.34

D. Conclusions

124. Slovenia began the transition process in a relatively strong competitive position vis-à-vis other transition economies, evidenced by its ability to quickly reorient its exports—mainly in the more technologically demanding areas—to the markets of the advanced European economies. Gains in competitiveness were made in the early years, revealed by increases in export market shares and relative productivity. However, the outcome of delays in implementing necessary structural reforms are beginning to show up in lagging growth and productivity increases that are being surpassed by real wage gains, and lackluster export performance. Meanwhile, policymakers have actively tried to safeguard competitiveness by fending off capital inflows—which they see as a threat to competitiveness—via sterilization and capital inflow restrictions. As a consequence, Slovenia has avoided the steady upward appreciation of the REER predicted by the H-W stylized fact and the substantial current account deficits experienced in other transition economies. However, there appears to have been a cost in denying the economy needed investment funds for development through restrictions on capital inflows.

125. These developments suggest that, while competitiveness appears to be adequate, corrective measures of the types recently taken will need to be maintained and reinforced to keep wages in line with productivity and increase efficiency. A policy of depreciating the nominal exchange rate—a blunt instrument that affects all sectors of the economy equally—only leads to higher inflation with a short lag.35 Therefore, from a policy perspective, competitiveness is most effectively addressed via structural measures—including, implementation of the ownership consolidation phase of the privatization process and increased participation by foreign investors;36 decentralized wage bargaining; early elimination of wage and financial instrument indexation; and implementation of tax and pension reform measures to reduce the burden of wage taxes—to ensure that competitiveness is maintained over the medium term.

126. If further structural reform efforts are made and impediments to capital inflows are removed, there may be scope for further appreciation of the REER. Slovenia’s wages still remain low in comparison to the EU average. The wage gap can be narrowed through gains in productivity relative to abroad and by other improvements in efficiency, such as product quality and innovation, that would produce terms of trade gains, suggesting that there is latitude for an appreciation of the REER without threatening competitiveness. While an appreciation of the REER, due to nominal exchange rate appreciation, may worsen the external current account, it may be optimal for Slovenia to run a measured deficit as a venue for resource absorption in the process of ‘catching up’ with the EU countries.

ANNEX I: Empirical analysis of competitiveness indicators in explaining trade flows

127. This annex presents the model and estimation results of an empirical analysis of the relationship of various measures of the REER37 to trade performance.38 One measure of the usefulness of an indicator for assessing competitiveness is its ability to explain movements in trade flows. The estimation model is based on Marsh and Tokarick (1994), who employ the following basic error-correction model:

ΔT=α+β1ΔY+β2ΔREER+β3T1+β4Y1+β5REER1(1)

where T is the log of trade flows as noted below, Y is an income term, which is the log of real GDP for Slovenia when looking at imports and the log of foreign demand in the case of exports,39 REER is the log of the measure of the real effective exchange rate. By including the lagged variables, the regression allows for both short-run and long-run dynamics. The short-and long-run elasticities can be easily computed; the coefficients β1 and β2 are the short-run elasticities with respect to income and the REER, respectively. The long-run elasticities are then derived from the above-estimated coefficients: the long-run elasticity with respect to income is equal to -β43, and the long-run elasticity with respect to REER is -β5/β.40 The absolute value of the coefficient of the lagged value of exports, β3, is the speed of adjustment to the long-run equilibrium. The expected signs of coefficients of the income term are positive; in the case of the coefficients of the REERs, the expected sign of the coefficient is negative for exports and positive for imports.

128. The estimation results using the four different measures of the REER are given in Tables III-A1-III-A4 and are broadly similar (based on the expected sign and significance of the t-statistic of the coefficients)41 suggests that the indicators perform fairly similarly in relation to imports and exports.42 This is not surprising given the similar behavior of these indicators during the estimation period.

Table III-A1.

Slovenia: Estimation Results for Real Export Equation1/ Merchandise Exports

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Sources: Bank of Slovenia, World Economic Outlook Competitiveness data base; and Fund staff estimates, OECD.

NLS estimation on quarterly data for the period January 1993 through December 1996. * indicates significance at the 10 percent confidence level, ** at 5 percent, *** at 1 percent.

T-ratios are in parentheses below the parameter estimates.

Defined as average gross wages/gdp in dollars relative to ULC for whole economy of 3 major trading partners (Germany, France, Italy); trade weights from IMF’s Research Department.

It was found that the lagged value of the REER performed better in the short-run.

Table III-A2.

Slovenia: Estimation Results for Real Export Equation1/ Exports of Goods and Services

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Sources: Bank of Slovenia, Statistical Office of the Republic of Slovenia, World Economic Outlook Competitiveness Database, and OECD Analytical Database.

NLS estimation on quarterly data for the period January 1993 through December 1996.* indicates significance at the 10 percent confidence level, ** at 5 percent, *** at 1 percent.

T-ratios are in parentheses below the parameter estimates.

Defined as average gross wages/gdp in dollars relative to ULC for whole economy of 3 major trading partners (Germany, France, Italy); trade weights from IMF’s Research Department.

It was found the the lagged value of the REER performed better in the short run.

Table III-A3.

Slovenia: Estimation Results for Real Import Equation1/ Imports of Merchandise Goods

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Sources: Bank of Slovenia, Statistical Office of the Republic of Slovenia, and World Economic Outlook Competitiveness Database, OECD Analytical Database.

NLS estimation on quarterly data for the period January 1993 through December 1996, * indicates significance at the 10 percent confidence level, ** at 5 percent, *** at 1 percent.

T-ratios are in parentheses below the parameter estimates.

Defined as average gross wages/gdp in dollars relative to ULC for whole economy of 3 major trading partners (Germany, France, Italy); trade weights from IMF’s Research Department.

Table III-A4.

Slovenia: Estimation Results for Real Import Equation1/ Imports of Goods and Services

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Sources: Bank of Slovenia, Statistical Office of the Republic of Slovenia, World Economic Outlook Competitiveness Database, OECD Analytical Data Base.

Nonlinear least squares estimation on quarterly data for the period January 1993 through December 1996, * indicates significance at the 10 percent confidence level, ** at 5 percent, *** at 1 percent.

T-ratios are in parentheses below the parameter estimates.

Defined as average gross wages/gdp in dollars relative to ULC for whole economy of 3 major trading partners (Germany, France, Italy); trade weights from IMF’s Research Department.

129. For exports of goods and services, the short-run estimates suggest that both foreign demand and the REER (lagged one period) play a role with the expected signs.43 The estimated long-run elasticities of exports (both goods and goods and services) with respect to foreign demand, proxied by real GDP of Slovenia’s major advanced trading partners,44 45 are estimated to be between 1.9 and 3.7 and are significant in most cases. The long-run elasticities of exports with respect to REER are estimated at between -0.3 and -1.1, although they are statistically insignificant in most cases.46 The speed of adjustment is fairly fast, ranging from 0.3 to 0.6, or between two to three quarters. Furthermore, the finding that there is a high elasticity of exports with respect to foreign demand supports the notion that the sluggishness of exports in 1995-96 was mainly due to the slowdown in the EU.

130. Short-run dynamics of income do not appear to be play a role in determining imports.47 However, the short run effect of the REER on imports is strong, between 0.7 and 1.1 (for goods and goods and services). The long-run elasticity of real imports with respect to income was estimated between 1.3 and 1.6 for imports (goods and goods and services),48 while long-run estimates for imports with respect to the REER are between 0.2 and 0.4; and the speed of adjustment is very rapid.

131. These results should be viewed with caution, however, owing to the short span of the data (that is, the number of years, not the number of observations). A longer time period for estimation is needed to assess the long-run relationship of the REER with respect to trade. The lack of significance of the REER as a long-run determinant for exports also suggests that structural factors may have been more important than the REER during the period. Also, these measures of the REER do not capture other important nonquantifiable factors affecting competitiveness. Therefore, it is important to look at other indicators of competitiveness such as export market shares.49

ANNEX II: External Indicators of Competitiveness

132. Slovenia publishes a number of commonly used indicators of external trade competitiveness, including the REER based on retail prices (RPI-based),50 unit labor costs for industry (ULC-based, industry), and producer prices (PPI-based).51 In addition, some other broad-based measures can also be constructed from available data: the price of tradables to nontradables (the internal terms of trade), the dollar wage, and the ULC-based REER for the whole economy.52 The RPI or CPI-based REER is one of the broader measures, as it includes manufactured goods and services and is usually fairly comparable across countries. It also has the advantage that retail/consumer prices are typically correlated with wages, which are an important factor in production costs. However, there are a number of drawbacks: (1) it is vulnerable to distortions stemming from price controls, which account for about one fourth of items included in Slovenia’s RPI; (2) it includes nontradable goods and services;53 and (3) it does not include prices of intermediate goods, which account for a large amount of trade. Alternatively, the PPI-based index is derived from the prices of tradable goods and hence is likely to reflect the degree of substitutability of these goods with those of Slovenia’s trading partners. However, it also suffers from distortions. For instance, if the tradable goods are close substitutes for foreign goods, exporters can “price to market” when the exchange rate appreciates by squeezing profits in the short term.54 As a result, it may not present a very good measure of relative profitability and incentives to shift production from domestic to tradable sectors. Also, the PPI-based indicator is often not very comparable across countries because of differences in commodity composition. The ULC-based REER for industry has the advantage that it provides an indication of the profitability, which is particularly important for Slovenia where manufactured goods accounted for about three-fourths of total exports of goods and services in 1995.55 However, it also includes utilities which are typically not tradable. While it avoids a number of the problems associated with the CPI- and PPI-based indices, there are drawbacks: (1) labor productivity gains due to substitution of capital for labor are frequently associated with an increase in unit capital costs, so that a decrease in this indicator may overstate underlying gains in competitiveness. Likewise, additional nonlabor costs in production, such as intermediate goods costs, may distort the return to capital;56 (2) labor services acquired from other sectors in the process of production are typically excluded and there may be cross-country or intertemporal differences in the use of labor services from other sectors; (3) problems with international comparability may result in differences in the definition of the sector.

133. In addition, to these widely available measures, alternative broad-based measures of competitiveness include the price of tradables to nontradables (the internal terms of trade, Pn/Pt) and the dollar wage. Pn/Pt is faulted because it fails to account for the differences in productivity across sectors. There also is the difficulty of defining tradable/nontradable goods (the Institute of Macroeconomic Policy and Development defines tradable sectors as those which export or import an above average proportion of their output). Also, the impact of an increase in Pn/Pt on the trade balance may be mitigated if similar trends occur in competitor countries, as seems to be the case.57 The dollar wage is widely used among transition economies as it is a level, as opposed to index, measure. As such, it has the advantage that it avoids the problem of selecting an appropriate base year and, more importantly, it gives a sense of the size of the gap in wages when comparing across countries. Since it is wages for the overall economy, it also reflects gains in productivity of the economy relative to abroad, as opposed to other indices such as the RPI-based REER (which moves on account of productivity differences across sectors) and the ULC-based industry REER (which only reflects relative productivity gains in the industrial sector). It, however, has the problem of comparability across countries in definition of labor costs and, in the case of transforming economies, of undereporting of wages as direct labor costs used to be only a portion of total costs given the “social function” of firms.

References

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1

Prepared by Sheila Bassett.

2

As noted in Feldman (1994), indicators of international competitiveness should not be construed as measures of economic well-being. Furthermore, Krugman (1994) discusses the misuse of the term competitiveness as a reason for economic difficulties that are primarily domestic in origin.

3

See, for instance, Williamson (1994).

4

The paper does not estimate an equilibrium REER. Such estimations for transition economies are problematic for a number of reasons, including the short time span for estimation and lack of data. However, estimates by Halpern and Wyplosz for Slovenia serve as additional evidence for the analysis of competitiveness.

5

Simple correlation tests among various indicators show that they are strongly related, with the correlation coefficients all exceeding 91 percent for the period 1993-96. Given significant differences in definition and coverage (see Box 1), the similarity in the movement after stabilization is somewhat surprising. It may be due to factors such as, the close relationship between wages and the RPI due to indexation and the very gradual freeing of controlled prices (mainly nontradables).

6

Monetary independence became effective in October 1991 with the introduction of the tolar. Prior to this time, Slovenia operated within the dinar-based monetary system.

7

Slovenia’s exports—which accounted for close to 50 percent of GDP in 1990—were already largely oriented toward industrial countries before independence. It can therefore be said that they had already passed the test of market competition. As a consequence, Slovenia was able to re-orient its exports to EU markets from the former SFRY relatively quickly. In addition, most of the expansion of exports took place in technologically more demanding sectors such as electrical appliances, automobiles, and chemicals.

8

There have been frequent reversals in monetary policy during the period. While the exchange rate was allowed to float initially, a real exchange rate rule was imposed from mid-1992 to mid-1994 and the Bank of Slovenia (BOS) resisted pressures for a nominal and real exchange rate appreciation through active sterilization of inflows. Subsequently, there was unannounced nominal stability until mid-1995, when on account of concerns about competitiveness, the BOS abandoned its ‘hard tolar’ policy and imposed restrictions on foreign borrowing in July 1995 to try to stave off short-term capital inflows. Since January 1996, there has been a return to unannounced nominal stability with heavy sterilization and further intensification of capital inflow restrictions.

9

Empirical research into the causal links between the exchange rate and inflation indicates that there is a strong and significant positive relationship between inflation and nominal depreciation with a very short lag. See the preceding chapter of this selected issues paper.

10

The RPI-based REER increased in April-May, mainly on account of increases in fuel prices. This process of decontrolling fuel prices, while adversely affecting profitability of firms in the short-run, represents an elimination of a price distortion which would be expected to improve economic efficiency. Therefore, a rise in the REER on account of removing price distortions should not be construed as a decline in competitiveness.

11

Empirical estimates of H-W suggest that Slovenia was in the neighborhood of its equilibrium REER by 1996. However, given the large errors often associated with these estimates, one cannot rely solely on these findings.

12

Of course, this analysis still does not tell us whether the level of the exchange rate is appropriate. That is why other indicators, including the level of dollar wages in relation to other countries and indicators of external performance such as the trade balance and current account, also need to be looked at (see Section C).

13

The index is constructed from data on economy-wide gross wages in dollars divided by real GDP. The trading partner data is based on ULC data for the whole economy from the OECD Analytical Database for three major advanced EU trading partners (Germany, Italy, and France). The trade weights are obtained from the IMF’s Research Department.

14

Industry includes mining and quarrying (4 percent of industry), manufacturing (88 percent of industry), and electricity, gas and water supply (8 percent of industry).

15

The results are, however, disappointing with respect to the aims of the national/tripartite wage agreement, which sought to contain wage growth below that of productivity. This reflects in part a centralized wage bargaining process which does not encourage wage differentiation across sectors, although performance varies considerably (see OECD (1997)).

16

To some extent this overstates the impact on tradables to the extent that nontradables are included (e.g., public sector wages are not in the tradable sector). However, developments in these wages have a significant demonstration effect for the other sectors. This is especially true given the centralized bargaining process.

17

It subsequently fell in the first part of 1997, mainly on account of the strength of the U.S. dollar.

18

Real average monthly net wages fell nearly 20 percent in the two-year period.

19

PPP-based wage data are from the Statistical Office of the Republic of Slovenia and OECD. For estimates of PPP exchange rates in selected transition economies see Havlik (1996).

20

In a recent survey of business managers by Slovenia’s Chamber of Commerce, executives were the most negative with regard to competitiveness vis-à-vis EU, citing productivity, industrial policy, access to and the cost of capital, and access to selling markets as the main disadvantages. Factors viewed as advantages in relation to EU were gross wages and availably of work force. Relative to Central European competitors, the managers rated labor productivity, worker qualifications, and quality of infrastructure as positive factors, while disadvantages included taxation, gross wages, and the exchange rate.

22

The elasticity of exports with respect to changes in foreign demand may be greater than one (for instance, recently, the BOS estimated an elasticity greater than 1 for Slovenian exports in relation to a measure of foreign demand based on a weighted average of trading partners imports). Also, the measure of foreign demand used in Table III-1 is based on merchandise import volume, excluding oil. Therefore it includes imports other than manufactured goods and may overstate market growth for Slovenia’s exports which are concentrated in manufacturing. For example, Germany’s real imports of goods rose 6.3 percent in 1995, while the volume of imports of manufactures rose only 3.9 percent (based on data from the OECD Analytical Database).

23

So far, indicators are favorable, merchandise export volumes were up 5.8 percent in the first four months of the year relative to last year. Also, tourism indicators at the beginning of this year have been very buoyant; in the first four months of this year, the number of foreign tourists rose 14 percent and the number of overnight stays was up 18 percent over a year ago.

24

This is the sector where the foreign investment enterprises are the most “overrepresented.” (IMAD, “Foreign Direct Investment in Slovenia,” 1997).

25

Merchandise exports are mainly concentrated in the highly competitive manufacturing sector. Over 80 percent of merchandise trade is concentrated in three of the nine one-digit SITCs (transport and machinery, manufactured goods classified by material and miscellaneous manufactured articles). There is, however, diversity within these classifications.

26

Total merchandise imports of advanced countries amounted to US$2.7 trillion in 1992. A 0.05 percentage point increase in market share of advanced countries would amount to about US$1.3 billion.

27

A decrease in the private saving ratio may also reflect a drop in enterprise profitability in the initial years of transition, following the steep decline in output and price liberalization, as has been the case in most transition economies; subsequently, this is expected to strengthen with progress in transition (EBRD, Transition Report 1996).

28

This is in part due to imports which had been deferred from the previous year in anticipation of a customs duty reduction on January 1, 1997.

29

In 1990, there was a service surplus of 6.6 percent of GDP.

30

Subsequently, Slovenia floated its first Eurobond of US$325 million in July 1996.

32

Based on average values of parameter estimates for the various REER indicators for the elasticity of exports/imports of goods and services with respect to income and the REER presented in the annex.

33

This assumes that there is full pass through of the tolar appreciation into export prices which takes place over a two year period. Export volumes, while still growing contract by several percentage points as a consequence of the real appreciation, while import volume growth is significantly higher. The impact on the current account of the contraction in the real foreign balance is partly mitigated by higher export prices.

34

See Krueger (1996) for an assessment of the experience of Hungary.

37

The measures are those based on the RPI; PPI; ULC, industry; and ULC, whole economy.

38

While in theory such an analysis would be conducted on the trade balance, for purposes of this paper trade flows are disaggregated into imports and exports of goods and services, and goods, all measured in volume terms. This is done because estimating an equation for the difference of two large numbers can lead to imprecise estimates. Also, it may be desirable to see whether the composition of trade between services and goods has a bearing on which indicator is preferable, for example, the ULC-based indicator, may perform better in relation to merchandise trade rather than goods and services.

39

As noted in Marsh and Tokarick, while arguably a domestic and foreign income term should be included in both the import and export equation (especially if exports are seen as an excess supply phenomenon), including two income terms would cause problems of collinearity, which would make the interpretation of income elasticities difficult, so only one income term is used in the equations.

40

Formal tests (unit root tests) would not be expected to produce conclusive results because of the short time span, only four years, even though there are 16 observations using quarterly data (see Campbell and Perron (1991)). A simple plot of the series suggests the series have a persistent tendency to move upward over time, suggesting that they are nonstationary.

41

This is a simplistic approach and probably insufficient to distinguish between alternative indicators. Marsh and Tokarick carry out non-nested hypothesis tests using pair-wise comparisons. They were unable to find a clear indication of dominance of one indicator over another.

42

Given the few observations, such statistical tests may not be robust. In addition, the analysis of the long and short run must also take into account that only a few years are being used to assess these dynamics.

43

It was found that in the case of exports, REER lagged one period performed better than the contemporaneous value.

44

Austria, Germany, France, Italy, UK, and the U.S.; trade weights are based on those of the IMF Research Department.

45

This finding is similar to findings in other empirical work. For instance, estimates of elasticities of export volumes with respect to the REER for countries in the APEC region (Ito, et. al. (1996)) tend to be relatively small (panel estimates resulted in a short-run elasticity of -0.18 and long-run elasticity of -0.80) and statistically insignificant for individual countries in a number of cases; some explanation for this may stem from factors such as changes in trade policy or shifts in the type of tradable goods.

46

Recent BOS estimates also indicate a strong elasticity of exports with respect to foreign demand, greater than 1, (although the BOS’s elasticity is lower than the one presented here, as the foreign demand variable in the BOS estimates is based on foreign imports, as opposed to GDP). The BOS estimates for the elasticity with respect to the REER are substantially smaller than the ones presented here.

47

Income is lagged to avoid simultaneity with imports, as imports are a determinant of income.

48

These estimates compare with long-run elasticities of imports with respect to the REER of 0.28 and with respect to income of 1.46 for panel estimates of APEC countries (Ito, et. al, (1996)). The panel estimate was insignificant in the long run and about half the value of the average for the countries. And as noted above, for exports, changes in trade policy or shifts in the type of goods being traded were possible factors in the imprecise estimates of the REER. Other authors, such as Kumar, et. al., (1993), estimate an elasticity of import volumes with respect to relative prices of 0.37 for net-debtor countries.

49

Marsh and Tokarick (1994) conclude that none of the indicators which they tested fully captures all of the theoretical aspects of competitiveness and none of the indicators works uniformly well across the G-7 countries.

50

The RPI is used as the measure for inflation in Slovenia as opposed to the CPI which is used in most countries. The measures differ mainly due to the weights. In 1998, the Statistical Office plans to stop producing the RPI.

51

A limitation of other REERs is that comparing unit values of exports in a specific import market implicitly adopts a view of competitiveness based on competition among exporters in a given import market, and is not a view based on the relative incentives to produce tradable and nontradable goods (McGuirk, 1986).

52

See Marsh and Tokarick (1994) for an assessment of competitiveness indicators.

53

Consequently, it is likely to appreciate on account of the Ballassa-Samuelson effect, which predicts increases in nontradable prices relative to tradable prices on account of productivity differences across these two sectors.

54

As noted in Feldman (1994), such a policy is not sustainable in the long run and therefore these indicators of competitiveness are better viewed in a medium-term perspective.

55

Data for 1996 are not yet available.

56

A correction to this is possible by using the value-added deflator in manufacturing (Lipschitz and McDonald (1991)); this, however, poses data availability problems in most countries.

57

De Gregorio et. al., (1994) provide evidence of an increase in the relative price of nontradables for 14 OECD countries.

Republic of Slovenia: Selected Issues
Author: International Monetary Fund