Republic of Slovenia: Staff Report for the 1999 Article IV Consultation

Slovenia is among the most successful transition economies of central and eastern Europe. The authorities have consistently maintained conservative macroeconomic policies, which together with the relatively favorable starting point, allowed them the luxury of a gradual pace of reform. This approach to economic policy has delivered macroeconomic stability while maintaining social consensus and political continuity; at the same time, however, it has delayed the restructuring in certain sectors. Developments in 1999 have shaped by changes in the external environment and temporary domestic factors.

Abstract

Slovenia is among the most successful transition economies of central and eastern Europe. The authorities have consistently maintained conservative macroeconomic policies, which together with the relatively favorable starting point, allowed them the luxury of a gradual pace of reform. This approach to economic policy has delivered macroeconomic stability while maintaining social consensus and political continuity; at the same time, however, it has delayed the restructuring in certain sectors. Developments in 1999 have shaped by changes in the external environment and temporary domestic factors.

I. Introduction

1. Slovenia is among the most successful transition economies of central and eastern Europe. It has a functioning market economy, a stable macroeconomic environment with sustainable growth, the highest standard of living and investment rating among transition countries, and has made significant progress towards convergence with the EU, with which it has started membership negotiations (Figure 1). To a certain extent, this is due to a relatively favorable starting position, particularly the exposure to competitive export markets gained when Slovenia was the most outward-looking of the republics of former Yugoslavia. But a key factor behind this success has been the approach to economic policy taken since independence.

Figure 1.
Figure 1.

Slovenia: International Comparisions 1/

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A001

Sources: World Economic Outlook, Bank of slovenia, and statistical office of the Republic of Slovenia.1/ Shaded areas are estimates.2/ EU includes 12 countries through 1994, 15 thereafter.3/ Period average.

2. The authorities have consistently maintained conservative macroeconomic policies which, together with the relatively favorable starting point, allowed them the luxury of a gradual pace of reform. The budget has historically been in broad balance (although small deficits have emerged since 1997) and general government debt is low (25 percent of GDP at end-1999, including debt of the former Yugoslavia assumed by Slovenia). From the outset of transition, monetary policy has been oriented towards reducing inflation in a framework of a managed float of the tolar and monetary targeting (initially base money and, since 1997, broad money M3). To counter the impact of large capital inflows, especially during 1995-97, the authorities used a combination of far-reaching capital controls (Box 1) and extensive sterilization. This allowed the Bank of Slovenia (BoS), within the context of its monetary targeting, to keep some control over the level and variability of the exchange rate. As regards structural reforms, the authorities have eschewed shock treatment. Price liberalization was gradual. State banks were rehabilitated during 1993-97, and the banking system was until recently protected from foreign competition with a ban on foreign branch banking and costly capital requirements on foreign subsidiaries. The privatization of viable socially-owned enterprises (completed in 1998) took place mostly through investment funds holding vouchers issued to the population, and internal buyouts at preferential terms (mostly by managers). Unprofitable enterprises were placed under the Slovene Development Corporation (SDC) for restructuring before privatization. A two-year freeze on share transfers following privatization and restrictions on foreign ownership gave the new enterprise owners time to adjust. Labor market regulation is extensive, wage-setting is centralized, and contracts are indexed. Finally, the pace of certain key reforms has been slow due to prolonged consultations with the social partners and lengthy parliamentary procedures.

Capital Controls in Slovenia, 1995-98

Objectives: (1) reduce the total volume of capital inflows; (2) encourage nondebt-creating financing; (3) lengthen the maturity of financing; and (4) allow some monetary autonomy.

Design: measures aimed at increasing the fixed cost of short-term inflows. Specifically: unremunerated custodian account requirement on new non trade-related foreign debt below certain maturity (5 years in 1995, raised to a peak of 7 years in 1997, then reduced to 4 years); closed foreign exchange position requirement on banks for new borrowing from abroad; and ban on foreign currency deposits for resident legal entities.

Impact: following the imposition of controls, bank borrowing abroad fell to negligible levels; foreign direct investment and portfolio inflows moved in opposite directions (FDI grew by 73 percent in 1997 while portfolio inflows declined by 63 percent); and the average maturity of new loans rose to 7 years in 1997 and has remained above that level since then. For greater detail, see background document.

3. This approach to economic policy has delivered macroeconomic stability while maintaining social consensus and political continuity; at the same time, however, it has delayed the restructuring in certain sectors. Inflation has decelerated, dropping below the 5 percent mark in early 1999. Growth has averaged around 4 percent in the 1990s, largely driven by exports. The economy is very open to trade and increasingly integrated with western Europe (exports amount to almost 50 percent of GDP, and more than two-thirds are absorbed by the EU). Competitiveness is strong; 1 the export sector is diversified and its market share has been increasing (Figure 2); and the current account has historically been in balance or surplus. But the banking system, though sophisticated and profitable, is oligopolistic and still dominated by two mostly state-owned banks. And the corporate sector is segmented: although aggregate performance has been improving, internally-privatized enterprises have restructured less aggressively and lag foreign-owned and externally-privatized firms in terms of productivity and profitability (Box 2).

Figure 2.
Figure 2.

Slovenia: Competitiveness Indicators

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A001

Sources: Bank of Slovenia; Statistical office; Institute for Macroeconomic Analysis and Development; and staff calculations.1/ Data for 1999 are the average of January through June.2/ An increase is an appreciation.

Segmentation in the Corporate Sector

uA01bx02fig01
uA01bx02fig01
Source: IMAD; data for 1997.Notes: Internal & SDC: Internally-privatized and not privatized firms held by SDC; External: externally-privatized; Foreign & new private: foreign-owned and new private firms.

II. Background to the Discussions: Recent Economic Developments and the Changing Policy Environment

4. Developments in 1999 were shaped by changes in the external environment and temporary domestic factors. The slowdown in western Europe, the economic difficulties in Croatia (Slovenia’s fifth largest trading partner), and—to a much lesser extent—the crisis in Russia were reflected in lower exports (down 4.4 percent in U.S. dollar terms in the first three quarters of 1999 relative to the same period in 1998). The effect on activity was mostly offset by a temporary surge in domestic demand ahead of the introduction of the VAT in July: thus, real GDP growth in 1999 was only marginally below 1998,2 and unemployment declined to 7.4 percent. The effects of lower exports and the surge in domestic demand on the balance of payments, however, went in the same direction, and the current account recorded for the first time a deficit estimated at 2.4 percent of GDP. The drying up of financial flows to emerging markets implied that this deficit was partly financed by a drop in official reserves, which, however, still stood at US$3.1 billion (3 months of imports, or triple the level of reserve money) at year-end. CPI inflation fell to 4.3 percent in the year to June 1999, largely due to continuing wage moderation. However, the introduction of the VAT had a major—albeit lower than expected—impact on the price level (some 3 percentage points), and the CPI ended the year 8 percent higher than at end-1998.

uA01fig01

Current account and Trade balance

(In USS million)

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A001

5. Policies were adjusted to accommodate the changing macroeconomic environment while maintaining domestic and external stability. After a sizeable tightening in 1998, the fiscal stance remained on a more or less even keel in 1999: higher expenditures, following the trend of recent years, were offset by the impact on revenue of the change in the composition of aggregate demand towards domestic consumption. Thus, the general government deficit remained unchanged at 0.7 percent of GDP. 3 Within the confines of an annual M3 growth target of 16-24 percent, monetary policy was adjusted flexibly to the changing conditions. In the early part of the year, the BoS allowed the exchange rate to depreciate somewhat faster than in 1998, refrained from sterilization, and accommodated liquidity pressures (that arose partly as a result of a surge in demand for cash ahead of the introduction of the VAT), leading to a decline in interest rates. In the second half, to nip inflationary expectations in the bud, the BoS tightened its policy stance, which reversed the decline in interest rates, stabilized the exchange rate, and brought average annual fourth quarter M3 growth—the definition of the target—to 16 percent, the bottom of its target range.

6.The economic policy environment in Slovenia is changing fundamentally as a result of a significant acceleration of structural and institutional reforms (Box 3) following a critical European Commission report in November 1998. The implementation of the EU Association Agreement in February 1999 and the new Foreign Exchange Law in September 1999 liberalized most capital controls and dismantled the barriers to entry of foreign bank branches. Furthermore, the successful—despite earlier concerns of the staff (see Appendix III)—introduction of the VAT, the adoption of the pension law (after a three-year debate), and progress in a number of budgetary and treasury reforms were major steps towards rationalizing the structure of public finances. These measures enhanced Slovenia’s credibility and were recognized by the European Commission in its October 1999 Regular Report.

Recent Structural Measures

Financial sector and capital account

1. Foreign Exchange Law, adopted in September 1999, removed the deposit requirement on non trade-related debt; liberalized foreign currency accounts of residents (restrictions on those of nonresidents remain); lowered to 1 year the maturity of portfolio inflows subject to a custodian account requirement, and reduced its cost.

2. Implementation of the EU Association Agreement in February 1999 eliminated barriers to entry of foreign bank branches in the domestic banking system, as well as remaining restrictions on FDI and foreign ownership.

3. Banking Law, adopted in 1999, harmonized legislation with EU directives, allowed foreign bank branches, and introduced a deposit insurance scheme.

4. Bank agreement on deposit interest rate ceiling was abandoned, and deposit rates are determined freely.

5. Government announced plans gradually to privatize state-owned banks.

6. Securities Law, adopted in 1999, regulates the securities market and established a supervisory authority.

7. Insurance Business Law and Law on Ownership Transformation of Insurance Companies were adopted in January 2000. The latter paves the way for the privatization of insurance companies.

Public finances

1. A two-year budget framework was introduced in 1998 for 1999-2000.

2. The indirect tax system was reformed with the introduction of a VAT in July 1999.

3. Pension Law, adopted in December 1999, strengthened the financial prospects of the current pay-as-you-go system by gradually raising the retirement age, changing the basis of calculation of benefits, and launching a supplementary social insurance scheme; and introduced a voluntary, private pension pillar.

4. Organic Budget Law, adopted in September 1999, and the functional classification of budgetary expenditure, completed in 1999, laid the basis for improved budget management.

Privatization, deregulation, and private sector development

1. Energy Law, adopted in 1999, allowed private participation in power generation and distribution.

2. Telecommunications Law, adopted in 1999, cleared the way for privatization of the telecom company.

3. Maritime Law, currently in parliament, would facilitate further privatization of Koper port and facilities.

Law on Price Controls, adopted in 1999, reduced the number of controlled prices.

Law on Legal Proceedings, adopted in 1999, tightened and accelerated the court process in bankruptcy cases.

III. Report on the Discussions: The Implications of the New Environment

7. Against the background of a stable macroeconomic situation and positive near-term prospects (Box 4), the authorities and the staff agreed to focus this year’s consultation discussions on medium-term issues. First, the recent structural measures, particularly as regards capital flows and the financial system, would result over time in deep changes in the economic environment. Slovenia, which until now had been open to the world mainly through trade, stood to benefit from greater openness to foreign capital and deeper financial integration. In this new environment, however, it would be even more exposed to fluctuations of market sentiment and volatile capital flows. Second, given its advanced stage in the transition process, Slovenia was now starting to grapple with structural issues akin to those faced by some western European countries, such as capital market development and supervision, labor market flexibility, and the impact of long-term demographic trends on public finances. And third, the exigencies of EU and EMU accession would pose significant policy challenges over the medium term. On one hand, the harmonization process and convergence requirements would continue to be major stimuli for institutional reform and macroeconomic stability. On the other, harmonization would entail fiscal costs, while uncertainty about the date of accession might aggravate external vulnerability. In this connection, the authorities observed that their commitment to complete preparations for accession by end-2002 had thus far not been matched by an equally firm commitment from the EU regarding the date of accession.

Near-term Prospects

Economic activity is expected to pick up gradually during 2000, as foreign demand strengthens. Real GDP growth is projectedto average at least 4 percent in 2000, and inflation to resume its declining trend: based on current WEO oil price projections, CPI inflation could decline to about 4 percent by end-2000.

The current account deficit is projected to narrow slightly to about 2¼ percent of GDP. Faster export growth would be offset by an investment-driven increase in imports, as well as the permanent loss of certain traditional service receipts (income from duty-free shops and shuttle trade). Nondebt-creating inflows are expected to rise considerably as the privatization of banks gets underway, and the reserve position to strengthen.

The risks to these projections are related mainly to the external environment, notably the outlook for the EU area and the path of oil prices. The possibility that wage increases might exceed productivity growth—especially if the forthcoming elections fuel wage demands—is also a risk for inflation.

8. The discussion of alternative quantitative medium-term projections highlighted the uncertainties and increased external vulnerability for the economy over the medium term. With an open economy, a diversified export base, a relatively high private savings rate, and fairly sound public finances, baseline projections suggested that the medium-term outlook was stable, with growth remaining at historical levels; the current account deficit widening further but financed by private inflows; and a sustainable—albeit weakening—fiscal position. However, the authorities and the staff agreed that these projections were subject to substantial uncertainty. Not only would the outlook for growth continue to depend—as it always had—on foreign demand, but Slovenia’s deepening integration in the international financial market would increase the potential volatility of the capital account. A new episode of capital inflows would put pressure on competitiveness and might ultimately undermine growth. Conversely, turbulence in financial markets or a shift in perceptions of Slovenia could lead to the drying up of nondebt-creating flows. In either case, risks would arise for the banking system.

9. Discussions thus turned to the medium-term strategy that would minimize external vulnerability. It was agreed that the key elements of this strategy would be (1) sound, flexible, and coordinated macroeconomic policies that would not only underpin continued domestic and external stability, but would also allow a rapid and effective response to changes in the external environment; and (2) efficient and flexible domestic markets that would raise the economy’s potential growth rate, as well as help its ability to absorb external shocks. This strategy would lead to a somewhat better outcome than the baseline projections. As highlighted by the staff’s normative medium-term scenario (Table 3), growth would accelerate to at least 5 percent per annum fueled by exports and investment; inflation would continue to decline despite further adjustments in some administered prices to achieve full cost recovery; and the current account deficit would stay at around 2½ percent of GDP. More importantly, however, this strategy would reduce the sensitivity of the economy to unexpected deviations from the baseline. The staff scenario served as the reference point in the discussions of specific policies.

Table 1.

Slovenia: Selected Indicators

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Sources: Slovene authorities; and Fund staff calculations and projections.

Fund staff projections or latest actual.

October 1999.

November 1999.

The fall in unemployment in 1999 results from the reclassification of persons taking part in public work schemes as employed, rather than unemployed as was the case until January 1999.

Statistical Office definition.

Official statistics: include privatization revenues in net lending.

Daily average of latest month relative to the same period of previous year.

Excludes gold, SDRs, and IMF position.

Reserves are the foreign exchange reserves of the Bank of Slovenia. Debt of original maturity of up to one year.

Table 2.

Slovenia: Balance of Payments, 1994-2000

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Sources: Bank of Slovenia and staff estimates.

Excludes Slovenia’s share of debt associated with the 1988 New Financing Agreement as settled in June 1996.

Table 3.

Slovenia: Staffs Normative Medium-Term Macroeconomic Framework, 1997-2004

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Sources: Slovene authorities; and Fund staff projections.

External current account deficit (opposite sign).

Gross national savings are equal to gross domestic investment minus foreign savings.

Official definition including privatization receipts in net lending.

A. Public Finances

10. The starting point for the discussions was the emergence of certain trends in the general government accounts during the last few years, in particular

  • the increase in the ratio of public spending to GDP by almost three percentage points between 1996 and 1999, to over 45 percent

  • the rising share of resources (estimated at over three-quarters) spent on entitlements or legally-mandated programs; the share of social expenditure (including pensions), in particular, was high even by EU standards

  • within social expenditure, the rapid growth of social transfers, of which there were over 60 different types, mostly not means-tested

  • the growing size of state aid (which, at 3½ percent of GDP, was twice as high as in the EU; state aid per capita was also higher).

uA01fig02

Social Transfers

(percent of GDP)

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A001

General Government Social Expenditure, 1998

(in percent of GDP)

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Source: Staff estimates.

11. On top of these trends, the authorities were concerned that additional public spending pressures would emerge in the future, while the room for maneuver on the revenue side was limited. First, the EU was recommending increases in staffing and administrative outlays in virtually every single area of the public administration, while areas for potential savings were still to be identified. Second, demographic trends were already putting pressure on the public pension and health systems. 4 At the same time, higher taxes were not a desirable option. The ratio of tax revenue to GDP was already over 40 percent, and the room for maneuver within this envelope was limited: indirect taxation had already been harmonized with the EU and, while there was some room for expanding the base of direct taxation, the tax burden on labor was high and had to be reduced.

12. There was a shared concern that if not addressed, these factors would curtail the flexibility offiscal policy at a time when Slovenia’s increasing openness to capitalflows made this tool crucial for macroeconomic management. To address this concern, the authorities were taking the following measures. First, the 2000 budget aimed at a reduction in the expenditure ratio and a general government deficit of 1 percent of GDP (1.1 percent excluding projected privatization receipts). While higher than the original deficit target for 2000 in the 1999-2000 two-year budget plan (0.5 percent of GDP), the government considered this target appropriate and realistic: tax revenue projections were conservative, while the forthcoming elections limited the room for deeper spending cuts. Second, the pension reform, albeit less ambitious than the government’s original proposal, would ensure the viability of the system for at least 5-8 years before additional corrective measures became necessary. As well, this reform would start generating annual savings of about ½ percentage point of GDP immediately, underpinning the reduction in the aggregate expenditure ratio in 2000. Third, a number of initiatives were underway to improve efficiency, transparency, and accountability of public spending, notably the completion of the functional classification of the budget; the two-year budget cycle; the introduction of a unified treasury account; the planned medium-term budgeting for recurrent programs; the planned review of extrabudgetary funds in order to determine whether or not they should be part of the government sector; and the preparation of framework laws on public employment and on public administration. Fourth, the government intended as far as possible to accommodate the budgetary costs of EU accession by reallocating resources and, in some areas, ask for derogations or longer transition periods in the context of accession negotiations. Finally, on taxation, with the reform of indirect taxes completed, the Ministry of Finance was preparing plans for the reform of direct taxes. While still preliminary at the time of the discussions, these would aim at simplifying the system by reducing the number of marginal rates; lowering tax exemptions; and reducing the scope for tax avoidance created by the large gap between personal and corporate tax rates.

13. The staff saw the short-term fiscal policy setting as broadly appropriate. While the short-term outlook did not warrant an increase—however marginal—in the deficit from the 1999 level, the conservative tax revenue projections provided scope for a better-than- budgeted outcome, and the targeted reduction in the expenditure ratio was welcome. The staff urged the government to ensure strict adherence to the expenditure limits in the budget and, if economic conditions changed significantly during the year, to stand ready to adjust its target. Specifically, in case of faster-than-projected growth, the underlying fiscal stance should be maintained by using the additional cyclical revenue to reduce the deficit; and in case of sizeable capital inflows, the fiscal stance should be tightened.

14. However, from a medium-term point of view (the main focus of discussions), the staff questioned whether the government’s measures were sufficient to ensure a sound and flexible fiscal policy framework, in line with the normative scenario in Table 3. In this connection, the staff was concerned that the forthcoming elections might distract the government from these medium-term priorities.

  • The pension reform was a commendable step, but only addressed part of the wider problem of social spending. Difficult issues in health care, such as improving management and controlling costs in hospitals, remained open and, despite the efforts of the Health Insurance Institute to contain costs, the system was projected to move to a deficit of up to 1 percent of GDP in the coming years. Furthermore, social transfers were projected to continue growing in the 2000 budget.

  • The measures taken to improve the efficiency of public spending were welcome, particularly the intention to review the activities of the multitude of extrabudgetary funds. Although their combined financial position was balanced, many of them had considerable leeway in managing own resources and issuing public debt. However, in order to bear results soon, effort was needed over a broader front, including setting standards for public services; reforming state aid; extending program budgeting to all ministries; and starting the reform of public employment. The staff also argued that, although the 2001 budget would be approved after the coming elections, the present government should announce targets for 2001 in the context of the two-year budget cycle.

  • There was a high risk that the tax reform plans would be postponed to the next parliament which, in practice, would cause considerable delay and uncertainty about the outcome. As regards the content, the staff supported the broad objectives of the Ministry of Finance in this area but, in addition, saw the tax reform as an opportunity to reduce the tax burden on labor; bring all sources of income, including social transfers, under the income tax net; and level the tax treatment of different sources of capital income.

B. Monetary and Exchange Rate Policy

15. The authorities intended to continue with the current policy framework—until the requirements of EMU made a change necessary—but recognized that increasing openness to capital flows would defy the traditional modus operandi of the BoS. In the authorities’ view, exchange rate flexibility continued to be preferable for Slovenia as long as inflation and interest rates were above western European levels, especially given the structural rigidities in the public finances and the labor market. The requirements for the EU and EMU did not dictate a change in the exchange rate regime, at least until EU accession and participation in ERM-II, although the remaining capital controls would have to be abolished by 2002. In the context of a flexible exchange rate regime, an announced broad money target provided greater discipline, transparency, and credibility than a highly discretionary inflation targeting framework. In the view of the authorities, this benefit offset the concerns about the stability of money demand in a changing financial environment. However, the authorities felt that the way this policy framework was implemented in practice had to change. The recent liberalization (and eventual planned abolition) of capital controls would make it harder for the BoS to continue “business as usual”, fine-tuning its interventions and maintaining a delicate balance between its objective of lowering inflation and its desire to preserve competitiveness. Thus, the monetary policy program for 2000 (announced in January) re-affirmed the primacy of the M3 target and lowered the target range vis-à-vis 1999 to 12-18 percent. While acknowledging the need to accept greater exchange rate flexibility than in the past, the authorities were also mindful of the importance of the nominal exchange rate for expectations and concerned about the costs of excessive volatility. They thus saw continuing scope for intervention to dampen such volatility. In case of large short-term inflows, they also noted that the recent Foreign Exchange Law allowed the BoS to strengthen capital controls temporarily.

16. The staff argued that the new environment would necessitate greater focus on the broad money target and the ultimate objective of disinflation and less on the exchange rate, as well as better coordination between monetary and fiscal policies. The staff commended the authorities for the successful disinflation, and endorsed the monetary policy target for 2000: by narrowing the target range (a key staff recommendation during the consultation discussions) and setting a midpoint below the outcome for 1999, the BoS clearly signaled its intention to ensure that, following the temporary flare due to the VAT, inflation would resume its downward path to no more than 4 percent by end-2000. In the event of renewed capital inflows, intervention-cum-sterilization could no longer be seen as the only line of defense,5 but greater nominal exchange rate flexibility should be used as a deterrent. If the inflows reflected foreign direct investment or movements of relatively stable, long-term portfolio capital, a real appreciation might be inevitable, and indeed desirable. In either case, fiscal policy should also be tightened if the inflows persisted. Finally, the staff acknowledged that, given the empirical evidence of their efficiency (Box 3) and the fact that the authorities did not envisage a completely free float of the tolar, a strengthening of controls on portfolio inflows might be warranted in the event of sudden large inflows that were out of line with economic fundamentals, provided this was clearly understood to be a temporary measure. However, the staff urged the authorities not to lose sight of the ultimate objective of complete capital account liberalization, and warned of the potential credibility pitfalls if the recent steps toward liberalization were seen to be reversed.

17. The absence of an efficient interest rate transmission mechanism would be an increasingly serious handicap for monetary policy in the new environment. The BoS attributed the weakness of the transmission mechanism to the lack of a competitive domestic financial market structure, as a few large banks dominated both the interbank and the lending markets. The staff agreed, but also saw the lack of competition in the interbank market partly as the result of the BoS’s past policy: by providing banks with high-yield sterilization instruments, consenting to an agreement on a deposit rate ceiling (abandoned in 1999), and imposing capital controls, the BoS had limited competition and reduced the interbank market to an overnight lending facility. This difference of view aside, both sides agreed on the need to deepen the money market and improve the interest rate transmission mechanism.

  • The BoS and the Treasury had already started expanding the menu of instruments throughout the yield curve, and all maturities up to 9 months had been de-indexed. Slovenia’s Accounting and Audit Institute had decided to abolish the revaluation clause from the accounting standards by 2001, which would remove the main obstacle to de- indexation of private financial contracts.

  • These measures would spur the development of the interbank market and allow the BoS to rely less on direct interventions in the foreign exchange market for managing liquidity.

  • Eventually, moving to a relatively limited and rationalized menu of intervention instruments would allow the BoS to signal its policy intentions more clearly, and further streamline the channels of transmission of monetary policy by allowing firms and households to anticipate the direction of future interventions and adjust their portfolios.

C. Banking System and the Financial Sector

18. The authorities’ long-term strategy for the banking system had resulted in a sophisticated, profitable, and well-supervised sector which, however, had not developed its full potential. The rehabilitation of the state banks, enforcement of strict supervisory standards (Slovenia was compliant or largely compliant with 22 of the 25 Basle Core Principles), and the very gradual opening up of the sector to foreign competition had contributed to the development of a profitable—by EU standards—domestic banking system. However, despite recent steps towards consolidation, the system was overcrowded (24 banks and 76 savings & loan institutions) and dominated by state-owned banks; operating costs had increased and were high even by EU standards; and, as staff research had shown, the market structure was oligopolistic (see background document).

Bank Performance indicators, 1998

(In percent)

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Source: Bank of Slovenia; The Banker.

Germany, Italy, France, and Spain; data for 1997.

19. The key measure now on the agenda was the privatization of the two state-owned banks: it would improve governance in these banks; enhance competition and stimulate further consolidation in the system, allowing it to withstand the increasing exposure to capital flows; and help accelerate the restructuring of the corporate sector. The government had originally announced its intention to start by privatizing one-third of Nova Ljubljanska Banka (NLB—the largest bank) by end-1999 and complete the privatization of both banks by the time of the elections. This could be facilitated by the dilution of the state’s share through consolidation with other domestic banks (a process that started in early 2000 in the second- largest state-owned bank). However, the privatization of one-third of NLB had been delayed, and the speed, extent, and modalities of privatization (strategic partners vs. dispersed shareholding, foreign vs. domestic owners) had been politicized and were still unresolved.

20. In the staff’s view, the government needed to ensure the widest possible consensus on the following strategy:

21. As the nonbank financial sector was gradually gaining importance, its institutional and regulatory framework urgently needed strengthening. The domestic capital market had an expanding role in mobilizing financing, as well as accelerating ownership restructuring and improving governance in the corporate sector. The following initiatives—which were already underway—were identified as key: creating a proper regulatory and supervisory framework (including the consolidated supervision of bank groups); clarifying the ownership structure and selling the state share in insurance companies (a process that was started with the long-delayed passage of the Insurance Law in January 2000); and restructuring the privatization investment funds, which are major participants in the capital market. In this connection, the staff stressed the need to ensure transparency and avoid conflicts of interest among related groups.

D. Labor Market

22. Although the institutional structure of the Slovene labor market had contributed to wage moderation in recent years, the staff questioned whether it was sufficiently flexible given the openness of the economy. The relatively centralized wage bargaining process, the government’s important role in the negotiations, and—not least—the restraint shown by the social partners had kept wage growth since 1997 at or below productivity growth, including in the 1999 wage agreement (though the staff noted that recent high increases in the public sector had instigated calls—which had thus far gone unheeded—to re-open negotiations in the private sector). However, wage contracts were still partially indexed to past inflation, and there were important structural rigidities that discouraged employment creation and impeded the efficient allocation of labor: (1) the tax wedge was high (taxes and contributions were over 50 percent of gross wages), (2) employment protection legislation (EPL) was restrictive, in some areas (e.g., rules on layoffs and sick leave) even more than in the EU; and (3) the indexation system was designed to award proportionately higher increases to minimum wage earners. As to the last point, the staff argued that wage compression could be particularly damaging in a market characterized by high incidence of unemployment among low-skilled, low-income workers.

23. The authorities’ assessment of the overall performance of the labor market was positive. They saw wage moderation as a significant achievement (the more so as it was achieved by consensus) and, based on their experience, partial indexation had not prevented disinflation. The mandatory higher indexation payments for minimum wage earners was an important gesture for social cohesion, and had not created significant distortions (indeed the data did not reveal relative wage compression, either within or across sectors, and the wage distribution in Slovenia was still wider than in most EU countries). As regards EPL, however, they agreed that certain features were too restrictive. A draft Employment Law addressing some of these issues had been submitted to parliament in 1997, but its passage had been delayed by lack of agreement with the social partners.

24. In the face of high structural unemployment, Slovenia had developed an extensive menu of active labor market policies. Unemployment was primarily concentrated among older, less qualified workers and the long-term unemployed, reflecting the impact of industrial restructuring during the transition. The authorities had put in place a set of active policies including on- and off-the-job training and retraining programs, job subsidies, and public works (the latter for those with low probability of a job re-entry). The increasing budgetary resources devoted to these programs were mostly financed by the reform of the unemployment benefit system in 1999 which, by tightening eligibility for, and reducing the duration of, unemployment benefits, lowered the cost of passive programs. The authorities considered these active programs a success, noting that the cost of a job placement was lower than in similar active programs elsewhere in Europe.

E. Other Issues

25. The method of privatization followed in Slovenia had delayed the consolidation of corporate ownership, creating pockets of inefficiency; however, consolidation had now begun, and initial results were encouraging. With the basic regulatory framework in place, there was little the government could do directly to speed up the process. Besides bank privatization, two important steps underway were the streamlining of bankruptcy legislation and the elimination of administrative barriers to foreign direct investment. On the latter, a recent study by the Foreign Investment Advisory Service would provide guidance for further improvements. The staff expressed concern about the expansion of activities of the Slovene Development Corporation in providing subsidized loans to enterprises. Not only was the rationale for this dubious but, more importantly, it took place without proper oversight.

26. There had been progress in succession issues. Paris Club debt continued to be serviced under the terms of the 1993 agreed minute. The bilateral agreement with Japan had been ratified and the outstanding amount repaid, while negotiations on the two remaining bilaterals (Norway and Italy) were advanced. However, no progress had taken place on the dispute with Croatia regarding the assets of the former Ljubljanska Banka Zagreb branch.

27. The discussions included an assessment of the effectiveness of past technical assistance from the Fund and of possible future needs (Appendix III). The authorities generally regarded the assistance provided by the Fund—one of several agencies providing technical assistance—as efficient and beneficial, despite occasional disagreements with specific recommendations. They identified as priorities the restructuring of the budget process, the assessment of transparency and practices in monetary and financial policies, and further improvements in the national accounts (where significant assistance was provided by Eurostat).

IV. Staff Appraisal

28. Slovenia has embarked on institutional and financial system reforms that will change profoundly the economic landscape in the coming years. In a commendable acceleration of structural reforms last year, capital controls were significantly liberalized, the banking system was completely opened to foreign competition, and obstacles to foreign ownership were lifted. These reforms, albeit beneficial, will expose the economy to greater competitive pressures and short-term volatility. The elimination of the extra prop of capital controls, in particular, will increase the burden on fiscal policy for macroeconomic management; make the conduct of monetary policy harder; expose the financial sector to greater risks; and require greater flexibility in the exchange rate and the labor market.

29. The current short-term macroeconomic policy setting is appropriate but, given the uncertainties relating to the speed of recovery and capital market conditions, the authorities should stand ready to adjust financial policies flexibly during the year, if needed. A broadly unchanged fiscal position and a modestly tightened monetary policy was an appropriate policy stance in the context of the projected gradual recovery, declining inflation, and a stable balance of payments outlook. If, however, economic conditions change—especially if capital inflows strengthen and growth is faster than projected—the additional cyclical revenues should be used to reduce the deficit below the current target, rather than finance additional spending, while monetary policy should continue to be primarily focused on price stability. As well, the social partners should resist calls to re-open the current wage agreement.

30. From a medium-term point of view, recent trends in the size and structure of public expenditure, if unchecked, will circumscribe the ability of the government to use fiscal policy for macroeconomic management, just as the changes in the economic environment will require increasing reliance on this tool. The government, aware of this risk, has launched several well-targeted initiatives in this area. The recent overhaul of the pension system—although it does not provide a complete long-term solution to the finances of social security—is welcome, particularly as it will allow a reduction in the expenditure-to-GDP ratio already in 2000. But a more comprehensive expenditure policy is needed, with clear medium-term targets for a reduction of the level and improvement of the structure of spending. A crucial element would be measures to arrest the growth and improve the targeting of social transfers, as well as initiate the reform of the health system. The government’s initiatives in the area of budget management are commendable and should be continued. The review of extrabudgetary funds should result in the consolidation of funds with public policy functions into the general government, while the remaining funds should eventually be privatized. The government should also keep the focus on the reform of public administration and employment. Finally, the two-year budget cycle should be maintained.

31. The Ministry of Finance’s plans for direct tax reform go in the right direction, but bolder steps are needed to reduce distortions and improve incentives. This reform should be given priority, and every effort should be made to include it in the legislative agenda of the present parliament. In addition to reducing the burden and simplifying the income tax system, the reform should aim at limiting the distortions and increasing the fairness of the tax system, and—in conjunction with measures to reduce social spending over the medium term—reducing the tax burden on labor.

32. The overall monetary and exchange rate policy framework remains appropriate, but exposure to greater external volatility will require a more flexible and effective monetary policy, as well as better coordination with fiscal policy. The BoS should remain focused on the objective of disinflation. The primacy of the BoS’s broad money target implies that, in the event of renewed capital inflows, the BoS will likely have to accept greater exchange rate flexibility. If inflows are sustained, fiscal policy must also be used to support monetary policy. In the case of Slovenia, there might be conditions in which the temporary strengthening of capital controls would be appropriate. But in principle, every step towards the complete capital liberalization planned for 2002 should be viewed as irreversible. The BoS should also take steps to deepen the money market and reduce over time its interventions in the foreign exchange market. The development of an efficient money market will allow the BoS to pursue more effectively its inflation objective.

33. Bank privatization and the development of a strong, well-supervised, and transparent financial sector are key for limiting the risks of greater capital mobility, deepening financial intermediation, and accelerating corporate restructuring. The government should announce a clear, credible plan and timetable for privatization of the two state-owned banks. This plan should preserve the independence of the banks, aim at complete or near-complete divestment of the government’s holdings, and ensure the presence in each bank of a core shareholder or group of shareholders with sound banking expertise, regardless of nationality. Bank supervision is strong, and should continue to be strengthened with the full implementation of the Basle Core Principles. The nonbank financial sector, however, is relatively less developed, and its supervision is fragmented and needs improvement. Among the most urgent tasks are the sale of the remaining state holdings in insurance companies and the restructuring of the privatization investment funds, which should improve market transparency.

34. As the rest of the economy, the labor market will increasingly be influenced by external volatility. At present, the legal and institutional setup of the labor market is very restrictive in certain areas, notably employment protection legislation and the wage setting system. Although the latter has delivered wage moderation in recent years, it needs to become more flexible to deal with future shocks. Partial backward-looking indexation, albeit consistent with continued disinflation, will always make the achievement of price stability more costly; forward-looking indexation based on the official inflation target would reduce these costs by anchoring expectations. The long-delayed Employment Law should be passed, and employment protection legislation be liberalized. Active labor market policies have been a notable success so far, but future extensions should take place with due regard to their cost and effectiveness.

35. The process of corporate restructuring must be stimulated by measures to facilitate the entry and exit of firms, encourage foreign investment, and reduce the role of the state. Encouraging domestic and foreign investment, eliminating barriers to private economic activity, and streamlining bankruptcy procedures are key measures in this area. The mission of the Slovene Development Corporation is increasingly questionable, and it should be prevented from expanding its activities without proper oversight.

36. The next Article IV consultation with Slovenia should remain on the standard 12- month cycle.

APPENDIX I

Slovenia: Fund Relations

(As of November 30, 1999)

I. Membership Status: Succeeded to membership on December 14, 1992; 1 Article VIII status as from September 1, 1995.

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None.

V. Financial Arrangements: None.

VI. Projected Obligations to Fund (SDR Million; based on existing use of resources and present holdings of SDRs): None

VII. Exchange Rate Arrangement

The currency of Slovenia is the tolar (SIT). Slovenia maintains a managed floating exchange rate. The exchange rate of the tolar is determined in the interbank market, in which the Bank of Slovenia (BoS) is a major participant. Like any other market participant, the BoS buys and sells foreign exchange at the market-determined exchange rate. On January 12, 2000, the middle rate for spot transactions in the interbank market was SIT 191.89=US$1.

VIII. Last Article IV consultation

The last Article IV consultation was concluded on January 7, 1999 (SM/98/272). It was agreed that Slovenia would remain on the standard 12-month cycle. The Acting Chairman’s summing-up of the discussion was circulated as SUR/99/3.

XI. Technical Assistance

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APPENDIX II Slovenia: Relations with the World Bank Group

I. IBRD Operations

Slovenia succeeded to membership in the World Bank on February 25, 1993. Of the three loans that it inherited as a successor to the former Socialist Federal Republic of Yugoslavia, only one loan for the Slovene Coast Water Supply and Sanitation Project remained under implementation. The loan closed in December 1998.

Since Slovenia became a member of the Bank in its own right, an Enterprise/Financial Sector Adjustment Loan (EFSAL), in the amount of US$80 million equivalent, was approved by the Bank’s Board in July 1993. The EFSAL was fully disbursed and closed in December 1995. An Investment Recovery Project (DM75 million) was approved by the Board on July 25, 1996. This project aimed at complementing the EFSAL by providing long-term finance through three commercial banks for the new cycle of private investments resulting from Slovenia’s program of enterprise and financial sector reforms. The project, however, was negatively affected by the capital restrictions imposed by the Bank of Slovenia in 1996, delaying its ratification by the Government. Given the changes in the financial sector conditions, the three commercial banks involved have decided not to participate in the project. As a result, the Government asked the Bank to cancel the project.

An Environment Project (DM35 million) was approved by the Board on May 30, 1996. The project would reduce ambient concentrations of particulates and sulfur dioxide in polluted cities of Slovenia along with the health damage associated with exposure to air pollution. It includes an air pollution abatement component and an institutional strengthening component. The Bank is also involved in other environment-related activities, such as the phaseout of ozone depleting substances financed by the Global Environment Fund (GEF).

A Real Estate Modernization Project (US$15 million) was approved by the Bank’s Board on June 1999. The project development objective is to improve the efficiency of real estate administration systems in Slovenia. This will include improvement of the real estate registration system, upgrading the legal framework for real estate transactions, establishment of an agricultural land use monitoring system to meet European Union accession requirements, and designing and testing of a market-based real property tax and valuation system.

A Health Sector Reform Project (US$12 million) has been recently appraised. The project would modernize the management information system of the health sector aiming at improving the efficiency and effectiveness of health care services delivery, through more coherent policy-setting; purchasing; surveillance; facilities and case management, on the basis of a unified national health information system. The project is expected to go to the Board during the second half of the current fiscal year.

In addition to these projects, the Bank has provided technical assistance and policy advice to the authorities in specific areas such as BOTs and concessions, banking supervision, regional development, private sector networks, treasury, privatization and state asset management, pension and health sector reforms and housing finance. A housing finance project is under consideration during the current fiscal year.

The Bank prepared in close collaboration with the Slovene authorities a Country Assistance Strategy (CAS) for the period FY98-2000. The first assistance strategy paper on Slovenia was approved by the Board on June 1997. The CAS defined the areas, level and composition of assistance to be provided during the next three years. It comprises a balance of lending and non-lending services. CAS priorities have been constantly revised with the authorities, focusing the yearly program of assistance on the key priorities defined with the government. Given Slovenia’s relatively high per capita income and access to international credit markets, Bank operations were designed to address government selected high priority objectives. Non-lending services included a series of studies and sector reviews on topics such as EU accession, labor market, housing finance, private sector involvement in infrastructure and pension reform. Selective technical assistance in areas chosen by the government, including state asset management and privatization, and treasury and public debt management. An update of the CAS will be conducted this fiscal year.

The first Country Study on Slovenia, entitled Slovenia Economic Transformation and EU Accession was finalized in March 1999. The report was presented in Ljubljana on March and in Brussels on May 1999. The country study makes an assessment of the current state of development of the Slovene economy from the perspective of the EU accession process. It focuses on the structural transformation of the economy.

II. IFC Operations

IFC’s active portfolio in Slovenia is composed of one operation in the area of financial services for a total of US$5 million. IFC has provided assistance to Nova Ljubljanska Banka in its restructuring efforts. It has also provided assistance in the preparation of securities legislation and revamping of the stock exchange.

APPENDIX III Slovenia: Review of Fund-provided Technical Assistance and Statistical Issues

This appendix presents an assessment of the outcome of technical assistance (TA) provided to Slovenia, as well as of future needs, reflecting the views of both the authorities and the TA-providing departments. In the area of statistics, in particular, this appendix also provides an assessment of Slovenia’s statistics.

I Statistics

Balance of Payments Statistics

Slovenia has not received technical assistance from the Fund in balance of payments statistics since March 1995. At present, balance of payments data for Slovenia are comprehensive and of high quality, and have been published in the Balance of Payments Statistics Yearbook since 1993 (with estimates of the international investment position published since 1996). No major technical assistance needs are foreseen in this area.

Government Finance Statistics

A government finance statistics mission visited Ljubljana in November 1997 to assist the authorities in establishing statistical reporting in accordance with GFS methodology and provide data for publication in the GFS Yearbook. The authorities found the advice of the mission very valuable in preparing the new economic classification for the budget. A follow-up mission in November 1999 found that significant progress had been made. With assistance from FAD experts, the Ministry of Finance has implemented a chart of accounts based on GFS classification concepts, and it is expected that the complete set of data will be available for the GFS Yearbook for 2000. However, consolidated general government data still do not show all extrabudgetary operations. The government intends to review the activity of extrabudgetary funds with a view to clarifying whether they should be included in the general government.

Money and Banking Statistics

Slovenia received technical assistance from the Fund in the area of money and banking statistics in 1994, 1995, and 1997. The last mission (September 1997) reviewed the Bank of Slovenia’s procedures for collecting and compiling monetary statistics and found that they were generally consistent with the Fund’s methodology. The mission recommended some further disaggregation of accounts by sector, which was introduced in late 1997. The mission also discussed the methodology and primary data needs for compiling monetary statistics according to the forthcoming Manual on Monetary and Financial Statistics, and concluded that some further modifications of the chart of accounts might be needed to conform with the Manual’s sector and instrument classifications. Monetary statistics are timely and of good quality. Recently, the authorities requested advice on the treatment of subordinated debt in the monetary aggregates, and immediately took steps to implement STA’s recommendations.

Future work in this area will be considered in light of arrangements with the European Central Bank (ECB). The Fund has begun collaboration with the ECB to work with candidate countries on compilation of a single set of monetary statistics compatible with the requirements of the Fund and the ECB. A representative from Slovenia attended a seminar at the ECB in December 1999 on compilation of monetary and financial statistics required of EMU member countries. Candidates were advised by the Fund of their continuing obligation to provide useful and timely monetary and financial statistics to the Fund, regardless of their status vis-à-vis the EMU. Nonetheless, they were informed that the Fund would collaborate closely with the ECB to assist the countries in compiling a set of statistics consistent with the needs of both the Fund and the ECB. The candidate countries are under no compulsion to work toward preparation of statistics for EMU membership, but most appeared ready to undertake work in the short term.

Real Sector Statistics

Two STA missions (December 1995 and May 1997) provided technical assistance on national accounts statistics to the Statistical Office of Slovenia (SO). The SO follows primarily the European System of Accounts 1995. Annual GDP estimates by industry and expenditure categories are compiled at both current and constant 1992 prices. Quarterly GDP estimates at constant prices by industry are regularly published within 80 days after the reference quarter. The 1997 mission noted several outstanding issues, notably (i) implementing improved procedures for estimating changes in inventories to appropriately exclude holding gains; (ii) including installation costs in the valuation of gross fixed capital formation; (iii) replacing, as possible, the use of physical quantity indicators with volume indices obtained by deflation of output in the derivation of constant price estimates; (iv) reconciling the external transactions in the national accounts with the balance of payments data; and (v) compiling current price quarterly GDP estimates.

The SO, in concert with OECD and EURO STAT, has not agreed that improvements are needed in its inventory data (point (i) above), but has taken steps to address all other recommendations. The SO’s priority at this stage is harmonization with EUROSTAT practices, and any future Fund technical assistance in this area will have to be accordingly coordinated.

As regards consumer and producer prices, the indices are compiled in accordance with international standards. The SO also compiles a retail price index (RPI) which differs from the consumer price index in weights only. As suggested by the national accounts mission, the SO has plans to discontinue the compilation of the RPI.

Special Data Dissemination Standards

Slovenia has subscribed to the SDDS, and its metadata, including the description of its dissemination practices and advance release calendar, are presented on the Data Dissemination Bulletin Board.

II. Fiscal Affairs

Public Expenditure Management (PEM)

FAD technical assistance in the PEM area began in January 1995, and is continuing with the assignment of a Fiscal Panel Expert as resident general budget advisor to the Ministry of Finance (MoF) since January 1999. As a result, substantial improvements have taken place in the areas of budget classification; budget presentation; computerization of budget preparation and selected segments of treasury operations; improving budget execution process and fiscal reporting; and preparing the groundwork for introducing a ledger accounting system and the treasury single account. The expert’s assignment has now been extended until late 2000. FAD assesses this TA project as a successful technical co-operation between FAD and the MoF. The authorities also evaluate the quality of technical assistance in this area as exceptional.

Looking forward, weaknesses remain regarding the coverage of government expenditures at various spending levels and the cash and debt management functions. In particular, the accounting department (and computer database) of the MoF does not track transactions at the Ministry and local government levels, and the present system is characterized by multiple bank accounts with large idle balances.

Tax Administration

After technical assistance on tax policy in 1993 and 1997, FAD’s assistance in tax administration began in April 1999 with a mission on the implementation of the VAT. The mission came to the conclusion that although the law was in relatively good shape, preparations for its implementation were considerably behind schedule, and the Slovenian tax administration was not prepared effectively to administer a new VAT in July 1999, and made specific recommendations for actions to be taken to advance preparations. This was followed by a letter from FAD to the Minister of Finance urging that these actions be completed before implementation or, alternatively, that implementation be postponed.

The MoF disagreed with FAD’s assessment of its readiness to introduce the VAT. Indeed, on July 1 the VAT was introduced, and indications since then are that its implementation has been successful. FAD experts still believe that substantive problems with organization, computerized information systems, and audit and control procedures (including VAT refund procedures) continue to exist, additional work to improve VAT regulations is likely to be required, and a follow-up mission would probably need to visit Ljubljana around one year after the implementation of the VAT to review the experience.

III. Monetary and Exchange Affairs

The last mission to Slovenia was in June 1996. Since then, the Bank of Slovenia has been receiving significant technical assistance from the G10 and the Bank for International Settlements. At the 1999 Annual Meetings, the Bank of Slovenia requested a broad diagnostic mission covering Basle Core Principles Assessment and Code of Good Practices on Transparency in Monetary and Financial Policies, followed by a letter by the Governor on November 16, 1999.

APPENDIX IV Slovenia: Survey of Reporting of Main Statistical Indicators

(as of mid-January 2000)

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Note: BOS, SORS and MoF stand for Bank of Slovenia, Statistical Office of the Republic of Slovenia, and Minislry of Finance respectively.
1

As staff research shows (see background document) the real appreciation since 1993 has largely been driven by sectoral productivity differentials (Balassa-Samuelson effect).

2

The Institute of Macroeconomic Analysis and Development and the staff estimate 3% percent for 1999, while the Statistical Office estimates 4 percent, compared to 3.9 percent in 1998.

3

Partly reflecting a drop in privatization receipts, which are included in net lending. Excluding these receipts, the deficit narrowed from 1.1 percent in 1998 to 0.9 percent in 1999.

4

Slovenia’s demographic situation was already difficult: the dependency ratio (pensioners to contributors) was 0.58 and growing. Without corrective measures, the deficit of the pension system would triple from its current level of 4 percent of GDP by about 2010.

5

Indeed, staff research has shown that this approach in the past had lowered the effectiveness of monetary policy in achieving its inflation objective (see background document for details).

1

On January 15, 1993, the Fund found that Slovenia was able to meet its obligations under the Articles and that it was a member of the Fund, effective December 14, 1992, the date of the Fund’s finding that the former Socialist Federal Republic of Yugoslavia (SFRY) had been dissolved.

Republic of Slovenia: Staff Report for the 1999 Article IV Consultation
Author: International Monetary Fund