Output

1. Slovenia registered good and balanced economic growth during most of the 1990s, following the collapse of output associated with the dissolution of the Socialist Federal Republic of Yugoslavia (SFRY). The GDP growth rate peaked in 1997 at just over 4½ percent, and declined somewhat in 1998 to around 4 percent. The main contributors to growth during 1997-98 were domestic investment and external demand. In particular, the investment growth rate was both years in the double digits, fueled by low interest rates and strong corporate retained earnings and helped by wage growth that lagged that of productivity. Export growth was also strong during this period (close to 10 percent per annum), partly owing to favorable conditions in trading partner countries and partly to the real depreciation of the tolar (although this effect was reversed in 1998). Other domestic factors had only a limited impact on growth. Consumption increased at a slower pace than output, owing to the moderate wage growth and a small increase in the household saving rate (to 22 percent of GDP). As a result, the private consumption-to- GDP ratio declined by 1¼ percentage point in these two years. Also, the government consumption-to-GDP ratio was kept stable at around 20 percent.

2. There was a modest dampening of growth in 1999 due to weaker export demand. The slowdown in Western Europe, economic difficulties in Croatia, the Russian crisis and, to a very limited degree, the Kosovo crisis kept external demand low in the first half of 1999. Therefore, exports of goods and services declined during this period. At the same time, and in particular in the second quarter of 1999, imports surged in advance of the introduction of the VAT in July 1999. For the same reason, domestic demand picked up, largely compensating for the decline in external demand. Lower interest rates also helped spur consumption and investment, in particular in construction. In the second half of 1999, with the revival of demand in Europe, exports started to recover. This, coupled with only a partial reversal of the surge in domestic demand, led to an output growth of 3½ percent in the first three quarters of 1999 relative to the same period the previous year. For the year as a whole, the Institute of Macroeconomic Analysis and Development estimates 3¾ percent growth. ¹ The increase in investment and decline in domestic saving stemming from strong consumption growth in anticipation of the introduction of the VAT widened the domestic saving-investment gap. As a result, this gap was financed by foreign saving, leading for the first time to a current account deficit (see Section D).

Prices

3. Slovenia’s inflation performance continued to improve during 1997-98. From mid-1998, consumer price inflation started on a downward trend that lasted until mid-1999. One important reason for this was the decline in import prices associated with lower world prices. Other reasons include the continued conservative macroeconomic policy stance; a relatively stable tolar; and lower tax rates. By mid-1999, the 12-month inflation rate had come down to 4¼ percent. This favorable trend was interrupted in July, when the VAT was introduced. Prices jumped by 1¾ percent in that month, and continued to increase in the following months. By October, the impact of the VAT on inflation had tapered off, limiting the total direct effect of the VAT on the price level to three months and about 3 percentage points. The timing of the introduction of the VAT helped contain its impact on inflation, as price growth is seasonally low in the middle of the year. Also, some administrative price increases were partially postponed to avoid a larger surge in inflation. Industrial producer price inflation, on the other hand, continued its downward trend for most of the year, as it was immune to the introduction of the VAT. However, the increase in world energy prices in the second half of 1999 kept year- end industrial producer price inflation to 3½ percent.

4. Relative prices have been constantly adjusting during this period. In 1998, average inflation in the service sector was 9¼ percent, while average CPI inflation was 6½ percent (Figure 1). During the same period, prices in the non-tradable sector rose by 7 percentage points more than those in the tradable sector. While the major part of this relative price change can be attributed to productivity gains (see Chapter II), other factors also played a role: some taxes were increased (on services by 1½ percentage points, on transport services by 6½ percentage points on average, and the municipal tax on road use by 51 percent); custom tariffs were lowered in line with the EU association agreement; and administered prices were liberalized gradually (the share of administered prices in the price index was reduced from more than 22 percent in 1996 to less than 15 percent in 1999).

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Slovenia: Prices, Money and Interest Rates

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

Source: Bank of Slovenia1/Interest rates are indexed on an average of past inflation rates (TOM), so the real rates represented here are the component above the TOM.

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Corporate sector

5. The corporate sector as a whole, which includes about 38 thousand companies, improved its financial results during 1997-98. After registering a total loss of more than SIT 60 million in 1996 (1 percent of total revenue), commercial companies closed 1997 broadly in balance, and had net profits of SIT 37 million in 1998. The main reason for this improvement in 1998 was stronger net financial revenues rather than increased efficiency, as labor costs and costs of goods, materials, and services increased by more than operating revenues. ² Most of the profits were made in manufacturing, wholesale and retail trade, repair, transport, storage and communication sectors, while utilities registered the largest losses. Large companies (about 2 percent of the total) accounted for almost 70 percent of the assets, generated more than 60 percent of total revenues, and employed nearly 60 percent of all the workers. Medium-size firms were less than 5 percent of the total number of commercial companies, and small companies formed the remaining 94 percent.

Employment and unemployment

6. The good economic growth during the last three years did not translate into comparable growth in employment. After an increase of 3 percent in 1997, there was no significant growth in employment during 1998-99, as output growth was achieved primarily through gains in productivity. ³ The share of employment was the largest in services (48 percent of total employment) and industry (40 percent of total employment), while the share of agriculture was 12 percent. Broken down with respect to age and gender, the employment rate was highest among males between 25 and 49, the category that had also the largest participation rate (93 percent).

7. The unemployment rate increased to almost 8 percent in 1998. Figures from the second quarter of 1999 (the period of the annual labor force survey), indicate that unemployment came back down to 7.4 percent. ⁴ The unemployment rate was highest among those between the ages of 15 and 24 (around 18 percent) and those older than 40 (approaching 50 percent). Also, the majority of the unemployed were unskilled workers and long-term unemployed (48 percent and 65 percent, respectively). The share of unskilled workers among the unemployed is positively correlated with the duration of unemployment, from 39 percent of those unemployed for less than one year, to 72 percent of those unemployed for more than 8 years. More women than men were unemployed in 1998 (unemployment rates were 8.1 percent and 7.7 percent, respectively), and this pattern was unchanged in 1999. Unemployment is also uneven across regions, with little change in the regional distribution during the last two years, the regional registered unemployment rate varied between 10 percent (around Nova Gorica) and 22 percent (around Maribor).

8. In 1998, the government extended its active labor market policies to a broader range of the unemployed, but with an emphasis on young unemployed workers without basic or suitable vocational training; the unemployed above 40; and those that were declared permanently redundant (see Box 1). These policies appear to have had a significant impact on employment: of those who participated in the education and training programs, between 20 and 70 percent found employment within the first six months after graduation, depending on the type of the program.

Wages

9. During 1997-99, wages were controlled by a series of agreements among the social partners (trade and employers’ unions and the government). The 2-year Social Agreement reached in 1996, which regulated not only wage increases, but also included understandings on taxes, pensions, and other benefits, expired in 1997. A similar agreement was not reached afterward owing to disagreements among the social partners, but a more limited 2-year wage agreement, covering wage increases, was reached in 1997, and was incorporated into the Minimum Wage and Wage Adjustment Mechanism Act that was passed by Parliament and remained in force until mid-1999. In this agreement, the adjustment of the base wages for inflation was restricted for the first time to once a year and to 85 percent of actual past inflation. A safeguard clause was included, which allowed wage adjustments within the year if inflation turned out to be higher than projected, but it was not triggered. The social partners reached a new wage agreement in March 1999 for the period of 1999-2000. The agreement contained a similar safeguard clause, with projected inflation at 6.8 percent and 4 percent for 1999 and 2000, respectively. An exceptional indexation clause was included for 1999, to alleviate the impact of the introduction of the VAT on wages. This indexation allowed August wages to be increased by 85 percent of actual inflation in the first six months of 1999, but restricted the next wage increase by linking the magnitude of the increase to the three-months inflation prior to the introduction of the VAT, instead of the three months after that date. Also, additional clauses were included to allow employees with lower-than-average wages to receive temporary additional payments. Finally, the minimum wage was to be raised by more than the average wage, until the ratio of minimum to average wage reaches 58 percent from its current level of 53 percent.

10. As a result of these successive agreements, during 1997-99 wage growth remained moderate, underpinning a sustained improvement in profitability and cost competitiveness. In 1997, average gross wages per employee rose by 11¾ percent and real wage growth (at around 3 ¼ percent) was half a percentage point lower than productivity growth. In 1998, real wage growth was even more subdued (2¼ percent). Similarly, in 1999, real wage growth (real gross wages average increased by 2 percent year-on-year in the period through September 1999). According to the current wage agreement, real wages in the private sector are expected to rise by about 2 percent in 2000.

Coverage of fiscal statistics

11. The general government accounts comprise the state budget, the local government budgets, the pension fund, and the health fund. The government uses two definitions of the fiscal balance. The first (general balance) is equal to the difference between total revenues and total expenditures. The second (overall balance) includes net lending (which, in Slovenia, includes privatization receipts in accordance with the current GFS Manual). To facilitate the identification of the effects of privatization revenues on the fiscal balance, the Statistical Annex tables present both definitions, as well as a deficit line treating privatization receipts as financing.

12. The accounting of other public funds is not uniform. Non-profit public entities (Zavods) are not consolidated into the general government. They comprise providers of public services that are wholly or partly state-owned but, in general, independently managed, e.g., hospitals, education institutions, cultural organizations, and sports centers. Under the new budget classification (in place since 1999), the transfers to these institutions are broken down along their economic classification, giving a more precise picture of the composition of general government spending. The nineteen extrabudgetary funds, including the Highway Fund, the Export Corporation, and the Deposit Insurance Fund, are also not consolidated into the general government accounts, although they also generally fulfill at least in part public functions. It should be noted, however, that the aggregate balance of the extrabudgetary funds is generally close to zero. In line with EU requirements, the Slovene government is working on a change in accounting practices with a view to consolidating those public entities and funds that are providing predominantly public services into the general government sector.

Developments in 1998

13. A midyear adjustment in budget expenditures, which more than offset a limited shortfall in revenues, resulted in a deficit for the general government of 0.8 percent of GDP, compared to 1.2 percent of GDP in the budget. In late summer 1998, it had become apparent that the budgeted revenue targets would not be met. This was primarily the result of lower collections of personal income tax, social security contributions, and sales taxes, owing to lower-than-projected wage growth and the resulting sluggish consumption growth. (Corporate income tax and non-tax revenues, on the other hand, performed better than expected.) To prevent a deficit overrun, the government imposed a 3 percent across-the-board spending cut on the state budget in late September. In addition, as in 1997, the government extended the 1998 fiscal year into January 1999, by which time revenues were only 0.2 percent of GDP below the budget target for the year. Expenditures, however, turned out 0.6 percent of GDP lower than budgeted.

14. There were no significant changes in the overall structure of revenues and expenditures in 1998. Total revenues increased somewhat to 43.1 percent of GDP, the same level as in 1995, while expenditures rose to their highest level since the start of the transition period, at 43.9 percent of GDP. In line with the progressive adaptation of the tax structure to EU standards, the revenue side saw a further decline in receipts from trade taxes, which amounted to 1.5 percent of GDP—only half the 1996 level—while the share of domestic taxes on goods and services continued to increase, reaching 14.8 percent of GDP. Social security contributions and income taxes remained unchanged at 13.8 percent and 7.8 percent of GDP, respectively. Non-tax revenues rose sharply to 2.7 percent of GDP, owing in part to higher entrepreneurial income. As in earlier years, the structure of expenditures reflected the government’s traditionally important role in income redistribution, with current transfers amounting to close to 20 percent of GDP. Current transfers comprise mainly those to households (17.7 percent of GDP), in particular pensions (12 percent of GDP), but also include the steadily increasing social transfers, such as child benefits and war veterans’ benefits.

Developments in 1999

15. Higher-than-budgeted expenditures were offset by the revenue impact of the change in the composition of aggregate demand toward domestic consumption. Thus, the overall government deficit remained unchanged relative to 1998 at an estimated 0.7 percent of GDP, slightly below the budget target of 0.8 percent of GDP (Figure 2). The main source of the expenditure overrun (a total of 0.5 percent of GDP relative to the budget) was the pension system, where the unexpectedly high adjustment of pensions in December 1998—after the approval of the 1999 budget—increased the basis for pension expenditures for the whole of 1999. While capital expenditures also turned out higher than budgeted, savings occurred in capital transfers and expenditures on goods and services. Overall revenues came out 0.7 percent of GDP higher than in the budget, with overperformance in tax revenues from goods and services and social security contributions more than offsetting shortfalls in nontax revenues and income taxes. Consumption tax collection, in particular, benefited from strong growth in consumption owing to the anticipated price effects of the VAT introduction in July. Income tax collection, on the other hand, remained somewhat subdued, and non-tax revenues suffered from lower profit transfers from public enterprises and financial institutions. Privatization revenues, originally budgeted at zero, amounted to 0.3 percent of GDP in 1999.

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Slovenia: General Government Operations 1/

(In Percent of GDP)

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

Source: Ministry of Finance, Slovenia.^1/ Estimates as of July 1999 provided by the Ministry of Finance.2/ The component balances are unconsolidated and do not add up to the consolidated general government balance.3/ Transfers to households, transfers to non-profit organizations, and subsidies.

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16. The budget volume once again reached a record level in 1999, with total revenues and expenditures reaching 44.5 percent of GDP and 45.1 percent of GDP, respectively. The revenue structure reflected the continuation of the long-term trend towards indirect taxation: the share of total taxes on goods and services grew from 14.8 percent of GDP in 1998 to 16.8 percent of GDP in 1999, while taxes from trade continued to decline, falling from 1.5 percent of GDP to 1.3 percent of GDP. The sum of income taxes and social security contributions relative to GDP remained unchanged compared with 1998. The major change on the expenditure side was an increase in current transfers by 1 percent of GDP, reflecting the higher spending on pensions. At the same time, spending on goods and services decreased somewhat.

17. The outcomes of the individual components of the general government provide some further information. The pension fund reported a deficit of some SIT 7 billion (0.2 percent of GDP) instead of the programmed SIT 4.3 billion, owing to the higher pensions. In the health fund, with a surplus of SIT 0.7 billion, the outcome was somewhat better than the budgeted balance. Local governments had been expected to generate a surplus of around SIT 7.9 billion, but the outcome was worse, only SIT 3 billion surplus, largely as a result of the increase in the number of local authorities by around 30. Finally, the state budget showed a SIT 20 billion deficit, as opposed to the budgeted SIT 30 billion. This was the major cause behind the better-than-budgeted outcome for the general government as a whole.

18. There was a major change in tax policy in 1999. Effective July 1999, the government implemented a new VAT replacing the previous sales tax, to comply with EU tax standards. The VAT carries a standard rate of 19 percent and a reduced rate of 8 percent (for food, water supply, and printed material), while some services, for example, medical and financial services, are free of tax. Overall collection from the new VAT and excise taxes was in line with expectations, as small shortfalls in VAT collection were compensated for by higher-than-expected receipts from excises. The shortfalls in VAT collection can be attributed to a slowdown in consumption (especially for durables) in the second half of the year, after the boom in the second quarter. The excise taxes on mineral oil, alcohol, and tobacco products, on the other hand, benefited from sustained demand for those products. The implementation of the VAT went smoothly without administrative disruptions. New taxes were also introduced on gambling, the sale of insurance services, and the sale of new and used cars, but total revenues from those taxes amounted to less than 0.2 percent of GDP.

19. Slovenia’s central government debt-to-GDP ratio reached almost US$5 billion, or 25 percent of GDP in 1999 (June data) up from 23.6 percent of GDP in 1998. About half of the debt stock (53.8 percent) was denominated in domestic currency, with euro- denominated (26.4 percent) and the U.S. dollar-denominated debt (17.6 percent) making up almost all of the remainder. Debt service amounted to some 3.9 percent of GDP in 1999, and is expected to increase further to a peak of 4.2 percent of GDP by 2001, before gradually declining over the following years with a minor hike in 2005. Interest costs, in particular, amounted to 1.4 percent of GDP in 1999, and are projected to decline over the medium term. Outstanding debt guarantees made up 6.2 percent of GDP in 1999. No further liabilities from the SFRY are expected to be added to Slovenia’s debt burden.

The 2000 budget

20. The budget for 2000, approved in January 2000, foresees an overall deficit of 1 percent of GDP, with lower revenues and expenditures than in 1999. In particular, spending is projected to fall from 45.1 percent of GDP in 1999 to 44.7 percent in 2000, _v and revenues to decline from 44.5 percent of GDP in 1999 to 43.7 percent in 2000. The major source of the expenditure savings is the reform of the pension system (Box 2), providing some 0.4 percent of GDP in savings annually. Continued wage moderation and a moderate expansion of the number of public employees by about 200 staff are expected to keep the overall payroll constant in percent of GDP. With exports, rather than consumption, re-emerging as the engine of growth, consumption taxes are projected to return to their 1998 level relative to GDP, while revenues from trade taxes to continue on its downward path, falling to 1 percent of GDP. Some of this fall is expected to be offset by higher revenues from the full-year effect of the excise taxes on oil, tobacco, and alcohol, and the other new taxes introduced in July 1999. Overall, the revenue projection for 2000 is clearly on the conservative side.

21. The new pension reform law, approved by parliament in December 1999 with the objective of achieving financial sustainability of the pension system, is a key piece of legislation for the public finances, including the 2000 budget. The stability of the pension system had been eroded by previous reductions in the contribution rate and extensions of benefits, as well as adverse demographic trends. While the reforms are expected to achieve a stabilization of the pension fund deficit at around 4 percent of GDP over the medium term, the objective of full financial viability was missed and further reforms will likely become necessary after at least five to eight years.

Overview

22. The Bank of Slovenia (BoS) officially pursues a policy aimed at lowering inflation to European levels and maintaining the stability of the currency. Since 1997, the intermediate target of the BoS has been the growth of the broad monetary aggregate M3 (defined as the daily average of the last quarter of the year relative to the same period last year). During 1995-98, to limit the impact of large inflows of foreign capital on the domestic economy and achieve its monetary targets, the BoS resorted to heavy capital controls. This allowed the BoS to maintain a significant amount of control over the level and volatility of the exchange rate. The BoS had to conduct its monetary policy in a limited competition environment, which hindered the efficient transmission of policy to the rest of the economy. Indeed, the banking system is dominated by three large banks holding over 50 percent of assets and concentrating about a 50 percent share of the markets for loans and deposits. Such domination extends to the interbank market, where interest rates are conditioned by the liquidity needs of the largest players. Moreover, since 1995, the BoS had officially sanctioned a cartel agreement imposing ceilings on deposit interest rates to limit the risk-taking behavior of smaller banks in the market for funds. These measures, together with the lack of short-term government debt securities with which to conduct monetary policy operations, limited the development of the domestic money market and weakened further the monetary transmission mechanism. However, during the course of 1999, the cartel agreement and most controls on capital flows were abolished. In addition, with the decision taken by the government to step up its program of Treasury bill issues at short and medium-term maturities, the operation of monetary policy can be expected to change drastically over the coming years. For a full discussion of the structural constraints on monetary policy, see Chapter III.

Recent monetary developments and policies

23. Until the middle of 1998, inflation had plateaued in the high single-digits, partly due to the pervasive indexation of the economy—wages, pensions and financial contracts—on past inflation. However, a policy of limiting adjustments in controlled prices (controlled prices increased by 10 percent in 1998, against the 14 percent increase of 1997), as well as the successful implementation of the wage agreement limiting wage indexation ⁵, resulted in the progressive weakening of inflation expectations. This provided momentum for a further decline of inflation from the second half of the year onwards, and allowed the BoS substantially to ease its monetary policy. By end-1998, inflation had fallen to 6.5 percent, against 8.8 percent year-on-year in December 1997. In the 1998 monetary program, announced in March, the BoS had set a target for the growth of broad money to 22 percent, with a range of ± 4 percentage points. With inflation on a downward trend, the BoS allowed real interest rates to fall, spurring an increase in private credit during the year (Figures 1 and 3). Nonetheless, the much lower-than-expected volume of foreign capital inflows (inward FDI, portfolio investment and nonbank borrowing abroad fell by half in 1998 relative to 1997, see Figure 3), meant that, despite the monetary easing in the second half of the year, broad money growth ended the year close to the lower range of its target, at 20.2 percent (Figure 4).

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Slovenia: Credit, Exchange Rates, and Capital Inflows

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

Source: Bank of Slovenia and IMF staff estimates.1/ Figures for 1999 are for the first three quarters.

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Slovenia: Monetary Developments

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

Source: Bank of Slovenia.1/ Foreign exchange deposits as percent of broad money.

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24. Inflation continued to decline in the first months of 1999, reaching an all-time low of 4.3 percent in June. The target growth for broad money in 1999 was lowered by 2 percentage points relative to 1998, to 20 percent, again with a ± 4 percentage points range. As M3 growth almost hit the bottom of this range in May, falling to 16.1 percent, and foreign capital inflows completely dried up following the crisis in Kosovo, the stance of monetary policy was relaxed further. Following a surge in domestic demand due to expectations of price increases following the introduction of the VAT in July, the BoS allowed the exchange rate to depreciate and refrained from sterilization. Moreover, as firms held on to their cash in preparation for the first VAT payments and households reduced their deposits in banks, generating liquidity pressures in the banking sector, the BoS accommodated these pressures and became for the first time in over 2 years a net provider of liquidity to the banking system (see below).

25. The impact of the VAT on prices caused inflation to jump back to its level of about a year ago. To pre-empt an inflationary spiral, the BoS tightened its policy stance in the second half of the year, bringing M3 growth down to about 15 percent in the last quarter. Average fourth quarter M3 year-on-year growth—the definition of the target—reached 16 percent, just the bottom of its target range, and the exchange rate stabilized. For the year as a whole, the exchange rate was depreciated by 5 percent against the mark and 9 percent against the dollar in 1999, most of it during the first half (Figure 3). In February and September, capital controls were removed in accordance with Slovenia's EU association agreement, virtually completing the opening of the capital account. ⁶ However, due to the international financial market conditions, over the first 3 quarters FDI inflows amounted to a mere US$66 million, and there was hardly any portfolio investment (US$2 million).

26. On January 31, 2000, the BoS announced its new policy program for 2000 and reaffirmed the primacy of its monetary target. It lowered the mid-point target for the growth of broad money to 15 percent and narrowed its range of fluctuation to ± 3 percentage points.

Changes in monetary policy instruments

27. The BoS relies on a wide assortment of instruments to conduct its policies. First, to sterilize foreign capital inflows, the BoS issues foreign exchange bills. Banks have a strong motive to purchase foreign currency bills, since such instruments can serve as collateral for BoS loans, can be temporarily sold to the BoS, and those with maturity of up to 120 days also serve to comply with the BoS requirement for banks to keep a minimum stock of foreign exchange. The BoS also uses this instrument for short-term repurchase operations (repos) to reduce the amount of foreign exchange in the market without affecting reserve money, and fine-tune the management of base money. ⁷ Second, the BoS intervenes directly in the spot foreign exchange market through outright sales and purchases of foreign exchange. In 1998 and 1999, the BoS signed an agreement with 12 banks (with a total market share of 70 percent) guaranteeing their concerted participation to such interventions. ⁸ Third, the BoS is attempting to control the growth of money supply through the use of a wide array of instruments. Among them, tolar bills of different maturities are issued to withdraw domestic liquidity, and quantity instruments, such as the use of different types of reserve requirements on domestic and foreign currencies, are also adjusted to control the growth of broad money. For more detail on the BoS’s instruments and their use, see Chapter III.

28. During 1998-99, the BoS continued to adjust this existing set of instruments to achieve its policy goals. To achieve lower inflation, the BoS was guided primarily by its M3 target and money market indicators (interest rates, realization of tenders, excess of mandatory reserves). Conditional on achievement of its monetary target, the BoS also tried to minimize exchange rate volatility, preserve competitiveness, and thwart capital inflows. During 1998 and 1999, however, the absence of significant foreign capital inflows allowed the BoS to reduce the outstanding stock of such instruments (Table 1). The drop of the interest rate differential with Germany also reduced the need for the BoS to keep intervening directly in the spot foreign exchange market (Figure 5). Thus, in the first half of 1999, the BoS became a net provider of foreign exchange in the market. This situation continued in the second half of the year, as the BoS continued to accommodate firms’ demand for foreign exchange, despite a pick up in interest rates resulting from banks’ need to attract deposits and the tightening of monetary policy to pre-empt an inflationary spiral following the VAT introduction.

Table 1.

Monetary Policy Instruments ^1/

Source: Bank of Slovenia.

^1/Quarterly average daily balances.

Table 1.

Monetary Policy Instruments ^1/

			1998				1999
		Stock at	I.	II.	III.	IV.	I.	II.	III.	IV.
		end-1997
						(in millions of tolars)
Loans to banks		3,968	2,386	1,233	474	508	2,241	7,722	3,940	1,706
	Lombard loans	0	167	364	107	125	509	576	34	14
	Short-term loans	3,968	1,784	560	8	0	583	3,201	2,252	1,337
	Liquidity loans	0	435	305	337	3510	1,060	2,363	1,028	333
	Last resort	0	0	4	22	32	89	542	309	13
	Overnight	0	0	0	0	0	0	1,040	317	9
	Tolar bill based	n.a.	435	301	315	319	971	781	402	311
Repurchase of foreign		5,179	3,739	8,004	3,541	2,810	7,138	16,795	23,304	11,666
exchange bills
BoS bills		369,313	377,075	393,047	398,878	390,211	375,057	367,244	347,404	331,513
	Tolar bills	58,388	62,102	56,566	70,769	78,944	66,045	45,901	39,481	19,381
	Twin bills	51	1,292	108	2,442	2,307	6,127	4,279	1,028	711
	Bills with warrants	17,349	23,469	31,342	25,273	20,374	22,178	31,065	18,005	14,077
	Foreign exchange bills	293,525	290,212	305,031	300,394	288,586	280,707	285,999	288,890	297,344
Government deposits		9,000	5,303	1,570	54	0	1,065	3,134	2,394	1,390
Reserve requirements		54,589	56,292	59,913	64,119	67,932	72,274	74,677	78,722	52,452
Purchase of foreign exchange			6,066	27,550	27,445	5,195	8,282	8,958	14,794	1,114
Sale of foreign exchange			9,521	5,847	2,747	16,224	3,538	41,527	25,274	1,755

Source: Bank of Slovenia.

^1/Quarterly average daily balances.

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Table 1.

Monetary Policy Instruments ^1/

			1998				1999
		Stock at	I.	II.	III.	IV.	I.	II.	III.	IV.
		end-1997
						(in millions of tolars)
Loans to banks		3,968	2,386	1,233	474	508	2,241	7,722	3,940	1,706
	Lombard loans	0	167	364	107	125	509	576	34	14
	Short-term loans	3,968	1,784	560	8	0	583	3,201	2,252	1,337
	Liquidity loans	0	435	305	337	3510	1,060	2,363	1,028	333
	Last resort	0	0	4	22	32	89	542	309	13
	Overnight	0	0	0	0	0	0	1,040	317	9
	Tolar bill based	n.a.	435	301	315	319	971	781	402	311
Repurchase of foreign		5,179	3,739	8,004	3,541	2,810	7,138	16,795	23,304	11,666
exchange bills
BoS bills		369,313	377,075	393,047	398,878	390,211	375,057	367,244	347,404	331,513
	Tolar bills	58,388	62,102	56,566	70,769	78,944	66,045	45,901	39,481	19,381
	Twin bills	51	1,292	108	2,442	2,307	6,127	4,279	1,028	711
	Bills with warrants	17,349	23,469	31,342	25,273	20,374	22,178	31,065	18,005	14,077
	Foreign exchange bills	293,525	290,212	305,031	300,394	288,586	280,707	285,999	288,890	297,344
Government deposits		9,000	5,303	1,570	54	0	1,065	3,134	2,394	1,390
Reserve requirements		54,589	56,292	59,913	64,119	67,932	72,274	74,677	78,722	52,452
Purchase of foreign exchange			6,066	27,550	27,445	5,195	8,282	8,958	14,794	1,114
Sale of foreign exchange			9,521	5,847	2,747	16,224	3,538	41,527	25,274	1,755

Source: Bank of Slovenia.

^1/Quarterly average daily balances.

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Slovenia: Interest Rates

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

Source: Bank of Slovenia.1/ Average of lending rates on capital loans and consumer credits.2/ Average of deposit rates with maturities ranging from 30 days to over a year.3/ First issued in September 1996.4. Differential between short-term deposit rates in Slovenia and Germany; the uncovered differential is adjusted for the one-month ahead change in the SIT/DEM exchange rate.

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29. To control liquidity, the BoS also issues a variety of short-term tolar-denominated bills (tolar bills, twin bills, bills with warrants) with maturities ranging from 2 to 270 days, and has a range of lending facilities, such as Lombard, short term, and liquidity loans. By September 1999, the stock of BoS tolar bills had dropped by 40 percent relative to the beginning of the year. At the same time, during the liquidity pressures preceding the introduction of the VAT in June 1999, the BoS provided short-term loans to the banking system and accommodated banks’ demand for liquidity by providing recourse to the overnight lending facility.

30. The BoS continued its program of de-indexation of its short-term monetary instruments—begun in 1995 with the de-indexation of all instruments with less than one- month maturity—by issuing, in September 1999, a 270-day bill bearing a nominal interest rate. Three-month Treasury bills issued by the government are also de-indexed, and 6-month Treasury bills were issued for the first time in October, also bearing a non- indexed interest rate. However, bank deposit and lending rates remain indexed to past inflation (through the TOM, the base interest rate calculated as the average of the past 12- month inflation, over which a separate real component is added), but the announced abolition in January 2001 of the accounting rule requiring banks to report the revaluation clause in their balance sheets should accelerate the process of de-indexation of the economy.

Current account

31. Slovenia enjoyed a roughly balanced external current account position until 1999. In 1997, as external demand picked up and the competitiveness of the Slovenian economy improved, exports surged more than 11 percent in real terms, and the trade deficit shrunk by ½ percent of GDP, but the current account remained broadly in balance as the surplus in services declined (Figure 6). Slovenia’s good external performance continued in 1998. Real export growth was strong (7 percent), and market penetration in trading partner countries continued. In addition, the terms-of-trade improved, as import prices declined more than the prices of Slovenia’s exports. However, imports of investment goods surged by almost 20 percent due to the increase in domestic capital formation. As a result, the trade deficit and the current account balance remained at roughly the same level as in the previous year.

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Slovenia: Balance of Payments and capital Markets

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

Sources: Bank of Slovenia, Ljubljana Stock Exchange, and IMF staff calculations.

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32. The current account moved for the first time into deficit in 1999. Some of the factors that led to the deficit were temporary. Of these, the most important was the weak demand from Slovenia’s major trading partners in the EU: in the first seven months of 1999, exports to these countries did not grow at all in U.S. dollar terms, compared with the same period in 1998. The impact of other regional crises compounded the deficit: exports to Russia fell to almost half of their volume a year ago to 1½ percent of total exports; and trade with Croatia, which constituted close to 10 percent of total exports until 1998, deteriorated substantially (exports fell by close to 20 percent). On the import side, the anticipated introduction of the VAT in July triggered a sharp increase in imports of consumption and investment goods in the first half of the year. Other factors that led to the emergence of a current account deficit were permanent. In particular, changes in the trade policy mandated by EU agreements have lowered import tariffs, reduced the scope for cross-border trade (especially in fuel), and eliminated duty free shops. These factors boosted imports and reduced revenues from services. Moreover, tourism expenditure of Slovenes, especially in Croatia, has been increasing steadily (this was partially compensated by income from Slovenian enterprises that cater to the tourists in Croatia). As a result of these temporary and permanent factors, the current account deficit swelled to 5 percent of GDP in the first half of 1999. In the second half of 1999, however, most of the temporary factors were reversed: the EU entered an economic upturn; the Kosovo crisis ended; and imports dropped sharply. Also, the depreciation of the tolar throughout 1999 helped the trade balance. Thus, for the year as a whole, the current account deficit is estimated to have been about 2’ percent of GDP.

33. The impact of the Kosovo crisis on the balance of payments was very small. It was felt mostly through two channels: declining tourism revenues in the second quarter of 1999, and rising service receipts owing to increased activity in Port Koper, as companies transported goods through this port as an alternate to land routes through Yugoslavia. Otherwise, trade was not directly affected by the conflict, because Slovenia’s trade with the republics of former Yugoslavia is small (except for Croatia), and the transportation of Slovene goods to other destinations does not depend on transit routes through Yugoslavia. Moreover, there was no discernible impact on investor sentiment and on FDI.

Capital account

34. After a surge in 1997, foreign direct investment inflows declined in 1998. Net FDI flows were US$295 million in 1997 (1½ percent of GDP), double their level in the previous year. But in 1998, FDI inflows were halved relative to 1997, despite much higher privatization revenues. (This was in part because most privatization deals were management-employee buyouts, and thus did not stimulate the inflow in foreign capital.)

35. In response, the government set up an Inter-Ministerial Working Group for Encouraging Foreign Direct Investment, and in 1999 the Trade and Investment Promotion Office started to implement measures to promote FDI. The measures included better access to industrial sites; incentives to raise employment that foreign investors can also benefit from; free investment services provided to foreign investors; and a greater public relations effort. However, in the first eleven months of 1999, FDI still was only a fraction (US$38 million) of the level reached during the same period the previous year (US$139 million). Meanwhile, outward FDI more than tripled to US$39 million for the same period, directed mostly toward Croatia.

36. Other financial flows were less important until the capital restrictions were relaxed in 1999. The capital controls imposed during 1996-99 (see Box 3) had had significant effects on the structure of external liabilities. Bank borrowing abroad, in particular, which had been rising during the previous two years, was abruptly cut to negligible levels in 1997 owing to the prohibitive costs implied by the capital controls. After the controls were relaxed in 1999, such borrowing was revived (in the first eleven months of 1999, loans to banks increased by US$232 million, against US$35 million the year before). Loans taken by enterprises followed a similar pattern. Moreover, portfolio investment during 1997-98 was lower than what could be expected based on developments in FDI: in 1997, FDI increased by 73 percent but portfolio investment declined by 63 percent. There were signs that this pattern was also in the process of being reversed after the removal of the restrictions in 1999. Overall, however, the relaxation of capital controls in 1999 did not appear to have had a major immediate impact on the capital account.

External debt and trade issues

37. Slovenia’s external indebtedness has remained moderate. Total external debt increased by around US$0.8 billion in 1998 (to 45 percent of GDP), and another US$0.5 billion in the first eleven months of 1999. Roughly half of this additional debt was private. The total external debt-to-exports ratio, which has been increasing since 1993, continued on the same trend. At the same time, the ratio of international reserves to total debt dropped below 60 percent in the third quarter of 1999, as a result of the drop in reserves.

38. Paris Club debt negotiations have been completed with most countries, and debt payments have begun. Total outstanding debt as of September 1999 to five members of the Paris Club amounted to US$54 million. The bulk of this, US$43 million, was to Germany. Agreements with Italy and Norway have not yet been ratified, but basic principles have been agreed. On the other hand, the negotiations on determining Slovenia’s share in some US$80 million of exit bonds issued by the former SFRY as part of the 1988 New Financing Agreement have remained stalled.

39. Regarding trade policy, the schedule of trade liberalization consistent with the EU directives is on track. Slovenia is already to a large extent in conformity with the Acquis on External Relations and Development Aid. Full liberalization of trade with the EU will take place by end-2001, and trade with third countries will converge to the EU rules by end-2002. However, the convergence of Slovene agricultural policy to that of the EU is still an outstanding issue (Slovenia satisfies the WTO rules on agriculture).

40. On multilateral agreements, since Slovenia became a member of the WTO in 1994, it has complied with all associated tariff and other obligations. Quantitative restrictions remain in the agricultural sector and the textile industry, but, as dictated by the WTO, these are to be abolished by 2005. The CEFTA agreement is on track without any changes. Slovenia has not signed the Trade in Information Technology Agreement yet, but it is expected to do so well ahead of EU accession. Slovenia ratified the Fifth Protocol of the General Agreement on Trade in Services in June 1999. Besides these agreements, Slovenia has 32 bilateral trade agreements, with an additional one waiting to be ratified by the Turkish parliament.

Box 3.

Capital Controls 1996-98

The capital account restrictions imposed during 1996-98 had a major impact on the structure of capital inflows and foreign liabilities. Faced with strong and increasing capital inflows (see figure), the BoS imposed broad restrictions aimed at bank borrowing abroad and portfolio investment in Slovenia. First, the BoS imposed a balancing requirement on foreign exchange accounts, which froze banks’ net foreign positions as of end-July 1996. At the same time, the 40 percent interest-free deposit requirement imposed in 1995 on short-term loans taken abroad by residents was extended to include loans with maturities up to 7 years. Later, in February 1997, all nonresident portfolio transactions were required to be channeled through custodian accounts that were bound by the balancing requirement. In June 1997, this restriction was relaxed marginally by exempting from the balancing requirement portfolio investment with a commitment of more than seven years. The definition of portfolio investment was also kept very broad, including any transaction that would result in less than 50 percent of total ownership of an enterprise. After the introduction of the restrictions, the BoS frequently had to adjust the regulations to ensure the restrictions were not circumvented.

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Slovenia: Capital Account, 1995-99

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

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In 1999, in accordance with the Association Agreement between Slovenia and the EU, the BoS relaxed most of these restrictions, as well as others that had been introduced earlier. In particular, incentives to borrow abroad were partially restored, with remaining disincentives targeted more to shorter maturities. In February, the BoS removed the balancing requirement on foreign exchange liabilities of banks, abolished the non-interest bearing deposit on foreign loans, and allowed banks to take short-term loans abroad and individuals to contract loans with nonresidents. In addition, the definition of portfolio investment was narrowed to those transactions that would affect less than 10 percent of total ownership of an enterprise, and to those with less than 4 years commitment Banks were obliged to purchase options at a premium in an amount equal to the balance on the custodian accounts, to be exercised only in case of foreign exchange outflow from the custodian accounts. In September, the BoS reduced further the capital controls on portfolio investment to those with less than 1 year maturity. Certain other restrictions remain: resident natural persons are prohibited from maintaining accounts and purchasing securities abroad. In addition, the BoS preserves its right to impose capital account controls for a period of up to six months if the objectives of monetary and exchange rate policies are threatened.

The model

45. The basic model is one of a small open economy producing traded and nontraded goods with the following sectoral production functions (see Froot and Rogoff, 1995):

where Y denotes output, and A, L, and K stand for productivity, labor, and capital, respectively with the subscripts T and N indicating the traded and nontraded sector. Capital is mobile internationally, as well as between sectors. With perfect competition in both sectors, profit maximization equalizes the international real interest rate R with the marginal product of capital in the two sectors:

with the price of tradables set equal to one, and P denoting the price of nontradables relative to tradables (P_N / P_T). As the interest rate determines the capital-labor ratio in the traded goods sector, the real wage in that sector is uniquely determined by the marginal product of labor:

Labor mobility ensures that wages are equalized across sectors,

so that the system can be solved for the relative price of nontradables. In particular, the price ratio is determined by relative productivities and sectoral production elasticities:

where lower-case letters indicate logarithms.

46. Equation (7) reflects the central Balassa-Samuelson hypothesis, namely that differences in sectoral productivities determine the relative price of nontraded goods. The effect comes about through capital mobility and the equalization of sectoral wages due to the mobility of labor. The wage in the traded goods sector is determined by the marginal product of labor. As the wage is the same for labor in the nontraded goods sector, if labor productivity is lower there, the wage exceeds the marginal product of labor in that sector and drives up the relative price. The higher the sectoral productivity differential, the higher the relative price of nontradables. The impact of the productivity differential on the relative price is directly proportional if the labor elasticities in the production functions are equal (i.e., δ = γ); with a higher labor elasticity in the nontraded sector, however, the effect is enhanced, and even equal sectoral productivities induce a positive price differential.

47. Looking at first differences yields inferences about the inflationary impact of differential productivity growth rates. The change in the overall price level in the economy can be presented as the sum of the changes in the price levels of traded and nontraded goods, weighted by the respective output shares where π represents inflation and σ the share of nontraded goods in total output, and a dot indicates the change over time. According to equation (8), domestic inflation is given by the price change in traded goods, which in a small open economy is exogenously determined on the world market; and the change in the relative price of the nontraded goods, which is driven by the differential growth rates in sectoral productivities.

48. Given the underlying assumptions of capital mobility and purchasing power parity for traded goods, it is possible to trace international inflation differences to the differences between the respective sectoral productivity growth rates in the individual countries. Assuming, for simplicity, that the output share of nontraded goods is equal across countries, the inflation differential between two countries is driven by the difference in the growth rates of the relative domestic price of the nontraded good

where an asterisk indicates the foreign country variables. According to equation (9), the country with the larger sectoral productivity growth differential will experience faster inflation.

49. This international aspect of the Balassa-Samuelson effect can be used to analyze the difference in inflation experiences among countries. Assuming that productivity growth in the traded goods sector exceeds that in the nontraded goods sector, and that the productivity growth differential is higher in less developed countries than in developed ones, the Balassa- Samuelson effect predicts that inflation in a less developed country would exceed that in its more developed counterparts. This difference would also explain the appreciation of the real exchange rate in CPI terms.

50. The productivity effects described above are of particular relevance for transition economies, and this makes the assessment of their precise impact on inflation and exchange rates imperative. However, it should be noted that, given its focus on the supply side, the Balassa-Samuelson model can only be used to assess long-term equilibrium movements. This poses a problem for the analysis of transition countries, in which market forces have been determining prices for a relatively short time, and a long-run equilibrium may yet have to be reached. In the short term, the assumptions on labor and capital mobility may not hold, making the actual outcome also dependent on demand-side factors. This means that the results of the empirical analysis should be interpreted with caution.

The data

51. The availability of data for Slovenia imposes a number of constraints on the empirical analysis, the most important being the lack of reliable estimates of total factor productivity. Although this is the variable of interest according to the theoretical framework, its computation depends on sectoral data for the capital stock, which are not available for the time period under consideration. As a consequence, labor productivity is used to approximate total productivity in this paper. ² This introduces a bias in the estimation to the extent that capital-labor ratios change at different speeds in the tradable and the nontradable sectors. In particular, a faster increase in the capital-labor ratio in the tradables sector than in the nontradables sector reinforces the effect of faster total factor productivity growth on the real exchange rate, while a slower increase would dampen it.

52. A further constraint relates to the definition of tradable goods. Ideally, the assessment of tradability should be based on the analysis of individual goods; earlier studies employed, for example, the export share of individual sectors as an indicator for tradability. ³ This study will instead rely on a broader distinction of the two sectors. Given that around 90 percent of Slovenia's exports are manufactured products, tradable output is defined as that produced in the manufacturing sector, while nontradable output is the remaining. Again in line with earlier contributions—and to facilitate comparisons with those results—agriculture is excluded from the study, as agricultural markets in Slovenia and trading partner countries are to a large extent distorted by state intervention.

53. The period of analysis is 1993 to 1998. Quarterly output data for Slovenia are only available in constant prices. Using annual data, quarterly series in current prices were derived in the following way: for tradables, constant price output was inflated using the quarterly producer price index for the manufacturing sector. For nontradables, it was assumed that the price was driven to a large extent by labor costs. Consequently, quarterly figures for labor productivity at constant prices in the nontradable sector were derived by assuming smooth transition between the annual observations. These were then employed to imply a quarterly pattern for the behavior of nontradable output in current prices. All series were found to be stationary over the observation period.

The facts and international comparisons

54. To give a feel of the magnitude of the effects under investigation, this section presents the results of a model simulation for Slovenia, as well as for three other transition economies, the Czech Republic, Estonia, and the Slovak Republic. ⁴ The results suggest that, despite their similar position as relatively successful transition economies, the four countries differ significantly with regard to the magnitude of the Balassa-Samuelson effect.

55. Figure 7 presents the simulated and observed behavior of the relative price of nontradables. To derive the former, the calculated (labor) productivities and the sectoral labor shares, reflecting factor elasticities in the production function, were inserted into equation (7), yielding the sectoral price differential predicted purely based on productivity differentials. If the Balassa-Samuelson model holds, the two series should move in unison in the long run. In fact, the observed relative price of nontraded goods, represented by the solid line in the chart, rises by 20 percent between 1993 and 1998, and during the same period the predicted value increases by 23 percent. This provides prima facie evidence that, in the long run, the relative price of nontradables is indeed linked to changes in productivity. Indeed, it appears that the underlying productivity effects were stronger than suggested by the observed change in the relative price of nontradables. Looking at individual years, the observed and the predicted series move closely together between 1993 and 1996. For 1997, the predicted price increases more sharply than the actual, while this pattern is reversed in 1998.

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Relative Price of Nontradables ^1/

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

^1/ p_bs: relative price of nontradables according to Balassa-Samuelson model; p_obs: observed price of nontradables.

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56. The contribution of the Balassa-Samuelson effect to domestic inflation, simulated on the basis of equation (8), appears to have increased over time (Figure 8). CPI inflation decreased monotonically, but with diminishing speed, between 1994 and 1998. At the same time, the average absolute inflation impact of sectoral productivity differentials amounted to 2.6 percent per annum, with a marked spike in 1997. This suggests that the share of productivity-induced inflation has increased over time, and that it may become increasingly difficult to reduce inflation to EU levels if the productivity differentials persist.

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Balassa-Samuelson Effect and Inflation ^1/

(in percent)

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

^1/ BS_eff.: Baiassa-Samuelson effect on inflation

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57. The Balassa-Samuelson effect causes an appreciation of the CPI-based real exchange rate to the extent that the sectoral productivity growth differential in the domestic country exceeds that abroad. Figure 9 shows how Slovenia’s real exchange rate relative to its four largest trading partners (Germany, Italy, Austria, and France) has moved compared to the domestic relative price of nontradables. Theoretically, the difference between the two variables represents the impact of the Balassa-Samuelson effect on inflation in the partner countries, i.e., with differential productivity growth of their own, those countries also experience supply-side inflation that has a dampening effect on their own CPI-based real exchange rate. Over the observation period, the difference in the appreciation of the two indicators amounted to roughly 4 percentage points, indicating that the Balassa-Samuelson effect in Slovenia’s main partner countries amounted to a weighted average of less than 1 percent. This finding is in line with the results of Alberola-Ila and Tyrvainen (1999). It should be noted, however, that this finding is tentative and should be interpreted cautiously, as the difference is likely to be influenced by several additional factors over such a short period of time.

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Relative Price of Nontradables and Real Exchange Rate ^1/

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

^1/ reer: real effective exchange rate; p_obs: relative price of nontradables.

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58. On the basis of the preceding discussion, Figure 10 leads to the tentative conclusion that Slovenia’s competitiveness has remained stable during the observation period, despite the appreciation in the CPI-based real exchange rate. As the Balassa-Samuelson effect reflects long-run productivity changes between sectors, the resulting inflation and real appreciation should not be viewed as a loss of competitiveness. Rather, the analysis of competitiveness in the traded goods sector should focus on production costs in that sector. The real exchange rate based on unit labor costs (ULC) represents one common tool for this analysis, as it captures a large part of those costs. In the case of Slovenia, the divergent behavior of the CPI- based real exchange rate and the ULC-based real exchange rate supports the view that the former is indeed driven by differential productivity growth and that underlying competitiveness has not deteriorated. ⁵

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Real Effective Exchange Rate ^1/

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

^1/ Reer_cpi, reer_ulc: CPI and ULC band real effective exchange rate.

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59. While the simulation points to a relatively strong impact of the Balassa-Samuelson effect in Slovenia, evidence from other transition economies suggests a considerable variance in its size. As can be seen from Figure 11, the impact of the Balassa-Samuelson effect in the Czech Republic appears to be broadly similar to that in Slovenia. The observed relative price of nontradables increased by some 14 percent since 1994, while the theoretical model predicts a slightly higher increase of around 16 percent. The decrease in both variables in 1998 suggests business cycle effects: a drop in manufacturing output resulted in a decrease in labor productivity, which was in turn reflected in a lower expected price of nontradables. The contribution of the productivity differentials to domestic inflation is higher in the Czech Republic than in Slovenia, which may in part be explained by the former’s more pronounced disinflation earlier in the transition process.

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Relative Price of Nontradables and Inflation in Other Transition Economies

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

Note: Symbols as in preceding text figures.

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60. The data for Estonia and Slovakia show striking differences between the theoretically predicted and observed relative price of nontradables. In Estonia, the impact of the Balassa- Samuelson effect appears to be very limited, suggesting that other factors have been driving the relative price ratio. This is also reflected in the low contribution of the productivity differentials to domestic inflation. A potential explanation lies in the relatively low valuation of the kroon when Estonia entered into its currency board agreement, which resulted in a subsequent real appreciation through price increases of nontraded goods. Slovakia exhibits the opposite characteristics: the theoretical model overestimates the change in the price of nontradables significantly, and points to a high, but variable, contribution of productivity differentials to inflation.

Estimation

61. The simulation of the model suggests that productivity differentials do indeed explain the increase in the relative price of nontradables. A first step in the empirical verification is to estimate the pure Balassa-Samuelson model with quarterly data. Estimating equation (7) yields the following:

where a equals the right hand side of equation (7), i.e., α = (δ/γ) α_T - α_N. ⁶ The use of quarterly data results in autoregessive residuals, which is addressed through the inclusion of a lagged endogenous variable; specification tests indicate no violations of regression assumptions; seasonal dummies are not reported. The numbers below the regressors are the coefficients, and t-values are presented in parentheses. The long-run elasticity of the relative price of nontradables with regard to productivity differentials is given by β₂/(l-β₁) and is equal to 1.1, i.e. slightly higher than expected from the theory, and in line with the results of the simulation.

62. While the results of both the simulation and the regression show a strong influence of the productivity differential on the relative price of nontradables, additional factors may also play a role. One indication of this is that the long-run estimated parameter of the productivity differential exceeds one. Furthermore, the behavior of the structure of output provides some preliminary evidence that supply-side effects are not the only driving factors behind the price ratio: in the absence of other influences, the Balassa-Samuelson effect alone would drive up the share of tradable goods in total output. However, as Figure 12 shows, the share of tradables in Slovenia's output has remained stable during the observation period, as has, indeed, the entire output structure.

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Structure of Output ^1/

(in percent)

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

^1/ Excluding agriculture.

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63. If sectoral labor and international capital mobility do not hold in the short run, demand factors and differences in the speed of price adjustment between the two sectors can also have an impact on the relative price of nontradables. This suggests extending the set of explanatory variables in equation (10). The first variable to be included is an indicator of monetary policy, which may, through its effect on the nominal exchange rate, affect the relative price of nontradable goods. With tighter monetary policy, the nominal exchange rate has a tendency to appreciate. While the immediate effect of the tightening on the nontraded goods sector may be small, the traded goods sector has to adjust its prices to keep them at the internationally given level, inducing an upward tendency in the ratio between the two prices.

64. Fiscal policy can affect the relative price ratio through two channels: its impact on the structure of total demand, and its impact on the exchange rate. Regarding the first, assuming that the share of nontraded goods in total demand is higher in the public than in the private sector, an increase in public expenditures should induce an upward bias in the price of nontraded goods. The exchange rate effect of fiscal policy, on the other hand, is similar to that of monetary policy: looser fiscal policy would lead to a weakening of the exchange rate and a lower relative price of the nontraded good.

65. Finally, the level of income may also affect the relative price of nontradeables. It has been observed that in richer countries, total demand is more geared toward nontraded goods, implying that preferences shift with rising income levels. Consequently, rising income levels may increase the relative demand for nontradables and push up their relative price. ⁷

66. In order to capture the impact of these factors, the following variables have been added to the original regression equation. Monetary policy is captured by the change in the monetary base; the fiscal policy variables are the expenditure-to-GDP ratio (measuring government demand) and the deficit-to-GDP ratio (to capture the exchange rate effect). Income is measured by per capita GDP. Including these variables, the econometric results are as follows:

where db stands for the percentage change in the monetary base and exp represents the expenditure to GDP ratio. Tests for specification errors remain insignificant. The long-run elasticities are 1.0 for the productivity differential, -0.3 for changes in the monetary base, and 1.2 for the expenditure-to-GDP ratio. The parameters for fiscal deficit and per capita income come out insignificant and, thus, appear not to affect the relative price of nontradables. This suggests that the exchange rate impact of the fiscal deficit was small and/or outweighed by monetary policy. Including current and lagged values of per capita income resulted in significant parameters in some specifications, but with the coefficients summing up to zero, implying that changes in income have only a transitory effect on the relative price of nontradables.

67. The results show that, in addition to productivity differentials, monetary and fiscal policies appear to have had a significant impact on the relative price of nontradables in the period under observation. The long-run elasticity of the price ratio relative to productivity changes is now equal to one, fully in line with the prediction of the Balassa-Samuelson model. As expected, monetary tightening is associated with an increase in the relative price of nontradables, as is an increase in public expenditures. Regarding the latter, a one percentage point increase in public expenditures induces a 1.2 percent increase in the price of nontradable goods, a result broadly in line with findings for OECD countries (see de Gregorio, Giovannini, and Wolf, 1994). Nevertheless, the long-run net effect of the monetary and fiscal variables is negligible, since, as shown in equation (10), productivity differentials explain the full increase in the price of nontradables during the observation period. This is a consequence of the practically unchanged level of the two variables during the observation period.

Policy targets and instruments

85. To estimate the extent of feedback between objectives and instruments and assess the efficiency of monetary policy in achieving these objectives, it is necessary to model the operation of monetary policy by identifying objective variables, which guide intervention decisions, and instrument variables, used to achieve a specific objective. Monetary policy efficiency is taken to depend on the extent of the trade-off accepted in the achievement of one objective while pursuing a conflicting objective. Such trade-off emerges, for instance, when the BoS accepts the inflationary effect of pursuing its exchange rate objective, or when it accepts increased exchange rate volatility when pursuing its disinflation objective.

86. In line with the stated mission of the central bank, two variables are assumed to be the objectives of monetary policy interventions: inflation and the nominal exchange rate. The choice of instrument variables is more difficult, because in practice, the BoS relies on a wide assortment of different instruments (see Chapter I for details). To “lean against” appreciating pressures on the exchange rate arising from capital inflows, as well as to limit its volatility, the BoS has been intervening directly in the foreign exchange market and issuing large amounts of foreign exchange bills (in DM or US$) of varying maturities. Therefore, in a general sense, the BoS interventions in the foreign exchange market is the instrument associated with the exchange rate objective.

87. However, it is not possible to summarize these interventions in a single instrument variable. Data on the outstanding stock of foreign exchange bills issued by the BoS ⁸ capture only interventions geared towards sterilizing the inflows that have already been realized, before they are monetized. ⁹ The BoS, however, has often intervened directly in the spot foreign exchange market to pre-empt incipient capital inflows and prevent the attendant exchange rate appreciation. The stock of foreign exchange bills does not capture these interventions, and thus gives only a partial picture of the BoS's actions in pursuit of its exchange rate objective.

88. Unfortunately, data on the BoS’s interventions in the spot foreign exchange market are not available. However, these interventions were for the most part guided by the size of the differential between domestic and foreign (specifically German) interest rates: a differential rising above 1’-2 percentage points (to allow for a risk premium) would usually trigger a direct purchase intervention of the BoS in the market to thwart potential capital inflows. Therefore, changes in the interest differential can be used as a proxy for the BoS's foreign exchange market interventions. Together with the stock of foreign currency bills, this would provide a near-complete picture of the BoS's actions in pursuit of its exchange rate objective.

89. To achieve disinflation, the BoS has been using as an intermediate target the growth of money supply (base money until 1996, and broad money M3 since 1997) which, in turn, it has been controlling through a variety of interventions, among which tolar bills of different maturities are the most predominant. ¹⁰ During the late 1990s, these bills were issued mainly to sterilize the liquidity effect of the BoS’s interventions in the foreign exchange market. Again, the interest rate carried by these bills was not the relevant intervention instrument, but rather the outstanding stock of bills issued. However, the above-mentioned sequence of events suggests that, at least during the time period under observation, the stock of tolar bills was very strongly correlated with the stock of foreign exchange bills. Therefore, including tolar bills in the VAR would not add much significance to the model. Since operations in tolar bills affect directly base money, base money is instead chosen as the instrument variable used to pursue the BoS’s inflation objective. The table below summarizes the variables used in the VAR model.

Instruments	Objectives
Spot foreign exchange market interventions	Exchange rate
(proxied by the interest rate differential)
Stock of foreign exchange bills
Base money	Inflation

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Instruments	Objectives
Spot foreign exchange market interventions	Exchange rate
(proxied by the interest rate differential)
Stock of foreign exchange bills
Base money	Inflation

90. Instrument variables in the VAR are base money; the outstanding stock of foreign exchange bills as reported in the balance sheet of the BoS; and the differential between the domestic interest rate on 3 to 9 month tolar deposits and the German 3-month interbank rate (fibor, later re-denominated euribor). The objective variables are the tolar-DM exchange rate (an increase of the exchange rate is a depreciation), calculated as the monthly average of daily market rates; and monthly inflation. Because part of the CPI consists of controlled prices outside the reach of monetary policy, the market-determined component of the CPI is used in the VAR as the objective variable. All variables are expressed in nominal terms, so that the dynamics of prices can be estimated separately. To control for DM inflation, the German CPI is included as an exogenous regressor in the VAR system of equations. Variables are deseasonalized when a strong seasonal pattern appears to be present. ¹¹

Estimation

91. Monthly data from January 1995 to October 1999 are used for the estimation. The availability of relatively high-frequency data allows us to focus on a relatively limited time period (thus providing results of greater relevance to the present time) without having to worry about sample size problems. ¹² Engle and Granger tests reject the hypothesis of cointegration between the variables in levels and interest and exchange rates. Given the non- stationarity of variables in levels, growth rates are used for the stock of foreign exchange bills and base money (three-month centered moving averages are used for the latter to smooth out some of its volatility). These growth rates are monthly, in order to preserve as much information as possible on the monthly pattern of interactions between endogenous variables. The same transformation is made for the nominal exchange rate given its upward trend. Augmented Dickey-Fuller tests reject the presence of a unit root in the transformed variables, as well as in the interest rate differential and free price inflation, at least at the 5 percent significance level. This transformation, therefore, is sufficient to provide stationary time series. Likelihood ratio tests suggest the inclusion of 6 lags for each variable. The results, however, are found to be robust to the lag structure. ¹³

92. The model is estimated as a structural VAR (S-VAR) of the type pioneered by Bernanke (1986) and Sims (1986). In this approach, each variable is a function of its own lagged values, as well as those of the other variables, thereby capturing the endogeneity over time of both instruments and objectives of monetary policy. Given V the vector of five endogenous variables considered in the model, Xthe vector of exogenous variables, A and B matrices of coefficients to be estimated, and e the vector of innovations, the system of equations can be represented as

93. This system can be used to estimate impulse response functions, which trace the response over time of all endogenous variables to a one-standard-deviation shock to one of them. The model presented above, however, is unidentified: the errors are serially uncorrelated, but share common components across equations, so that a shock cannot be identified as originating from a particular variable. Identification is achieved by imposing and testing restrictions on the contemporaneous correlations of the variables at each time. The identifying restrictions imply a specific decomposition of these errors into orthogonal components, thereby recovering the original innovations driving the dynamics of the system. Instead of using a typical recursive decomposition of errors relying on a particular ordering of the endogenous variables (also known as the Choleski decomposition), an S-VAR model tests directly which restrictions on the contemporaneous interactions best fit the data. If more restrictions are imposed than those strictly necessary to identify the system, these “overidentifying” restrictions are also tested for their significance.

Coniemporaneous interactions

94. The table below summarizes the identifying restrictions and provides the estimated coefficient for the contemporaneous effect of a shock to one variable on each of the others. Empty cells mean that innovations in a variable affect others only with a lag of a month. This specification of the contemporaneous interactions is found to significantly fit the data 86 percent of the time.

Contemporaneous Interactions of Variables

Note: (^**), (^*) denote significance at the 5 and 10 percent level, respectively.

Contemporaneous Interactions of Variables

Shock to	Inflation	Interest gap	Exchange rate	Base money	Forex bills
Effect on
Inflation	1	-	-0.23*	-	-
Interest gap	-	1	-	-	-
Exchange rate	-	-0,01	1	-	-
Base money	-0.02	-	1.86**	1	0.69**
Forex bills	-0.72**	-	-0.16	-	1

Note: (^**), (^*) denote significance at the 5 and 10 percent level, respectively.

View Table

Contemporaneous Interactions of Variables

Shock to	Inflation	Interest gap	Exchange rate	Base money	Forex bills
Effect on
Inflation	1	-	-0.23*	-	-
Interest gap	-	1	-	-	-
Exchange rate	-	-0,01	1	-	-
Base money	-0.02	-	1.86**	1	0.69**
Forex bills	-0.72**	-	-0.16	-	1

Note: (^**), (^*) denote significance at the 5 and 10 percent level, respectively.

95. Estimation of the restrictions shows that monetary policy instruments respond within the month to exchange rate and inflation developments, but not inversely. The hypothesis of a contemporaneous effect of a change in the instruments on inflation or the exchange rate is strongly rejected by the data, reflecting some lag in the transmission of policy. Innovations in the exchange rate affect the stock of foreign exchange bills immediately, but it takes a month for the stock of foreign exchange bills to affect the exchange rate. A shock to the exchange rate is also found to affect base money within the month, suggesting that there is some monetization or, on the contrary, “oversterilization” of the BoS’s exchange rate interventions. The significant positive estimated parameter of an increase in the stock of foreign exchange bills on base money suggests the first alternative, but it may also reflect an accommodating stance of the BoS immediately after it withdraws foreign currency from the system. A shock to inflation also affects immediately both policy instruments. As expected, a positive shock to inflation leads to a tightening of base money. However, the sign of the impact on the stock of foreign exchange bills is, at first sight, counterintuitive: following a positive shock to inflation, the BoS seems to inject more foreign currency in the system. This may reflect an increase in repo operations by banks, which need to borrow from the central bank by temporarily selling their foreign exchange bills as the initial shock to inflation reduces real liquidity.

96. As expected, some contemporaneous interaction is found between the objective variables. Changes in the exchange rate affect inflation within the month, but the reverse is not true. The sign of the effect is contrary to standard theory, although the coefficient is only weakly significant: an appreciation tends to increase inflation in the same month. Also, a rise in the interest differential triggers appreciation pressures on the exchange rate within the month. This, however, probably means that the BoS’s direct intervention on the foreign exchange market to close the interest differential takes at least a month to take effect. Finally, the interest differential is found not to be affected by base money within the month, reflecting the slow transmission of monetary policy to market interest rates.

Impulse response functions

97. The impulse response functions illustrate the dynamic impact of the effects reported in the table over time, allowing for the changes in the lagged variables to feed back on the shocked variable. This tool allows the measurement of the effectiveness of monetary policy, in the sense discussed in the introduction.

98. Figure 14 presents the effects of a positive 1 percentage point shock to inflation over a 24-month horizon. This shock generates a policy response on impact, as base money is immediately tightened by 0.6 percent. This is gradually transmitted to the interest rate differential, and triggers an appreciation of the domestic currency. The combination of the monetary tightening and the exchange rate appreciation brings inflation back down below its pre-shock level after 3 months. However, in response to the appreciation, the BoS reacts by issuing foreign exchange bills to withdraw foreign exchange. The appreciation reaches 1.3 percent on the fifth month after the shock to inflation, just after the rise in the interest differential peaks at 200 basis points. The sale of foreign exchange bills intensifies until, on the sixth month, the appreciation of the tolar slows down and the exchange rate reverts gradually towards its pre-shock level. But as the stance of monetary policy is now relaxed, inflationary pressures begin to emerge. The exchange rate begins to overshoot its pre-shock level on the tenth month, triggering inflation. In response, the BoS undertakes a second- round monetary tightening about 12 months after the first one. This leads to a new increase in the interest rate differential which, after a peak depreciation on the 18^th month, triggers a new appreciation of the exchange rate. At the end, abstracting from other shocks, a 1 percentage point increase in inflation ends up generating a 1 percentage point appreciation of the tolar after 2 years, while inflation is brought back to its initial level. During this time, the BoS's intervention has introduced a lot of volatility in prices and the exchange rate: inflation has lost and regained 2 percentage points before converging back to its initial level, and the exchange rate has gone through appreciation and depreciation cycles. Over the 24 months following the initial shock to inflation, exchange rate volatility is on average 3.5, which represents 65 percent of the one observed in the data over the sample period. This cyclical pattern underscores the constant state of alert the BoS needs to maintain in the conduct of its operations, as it “chases its tail” trying to counteract the feedback between its inflation and exchange rate objectives.

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Slovenia: Effect of a One Percentage Point shock to Inflation over a 24-months Horizon

(In percent)

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

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99. The closely correlated time paths of inflation and the exchange rate suggest a strong passthrough effect (as would be expected in a small and very open economy). But, interestingly, the simulation shows this passthrough is not symmetric: while inflation appears to fall faster than it rises after an initial shock to its level, it takes a lot less for the exchange rate to appreciate than to depreciate. This means that an appreciation helps lower inflation quickly, while a depreciation in transmitted into higher inflation more slowly. This finding could be explained by the existence of some downward rigidity in the interest rate.

100. In a similar vein, Figure 15 illustrates the effect of a positive 1 percentage point shock to the rate of depreciation of the exchange rate over time. The BoS immediately reacts by injecting foreign currency through the purchase of foreign exchange bills to limit the rate of depreciation of the tolar. It also tightens base money supply to limit inflationary pressures resulting from the faster depreciation. Inflation increases only very slightly as a consequence of this immediate policy response, by about half a percentage point after 2 months. Both monetary tightening and the progressive rise in the interest rate differential, which reaches 400 basis points on the fifth month, amplify the effect of the policy. The depreciation is gradually reversed, and the exchange rate appreciates by half a percentage point 6 months after the shock. This gives an additional impetus to disinflation (once again, an appreciation seems to translate rapidly into reduced inflation). However, the appreciation immediately leads the BoS to reverse the stance of its exchange rate policy and start issuing foreign exchange bills to withdraw foreign currency. This, combined with a reduced interest rate differential, causes the exchange rate to start depreciating on the ninth month after the initial shock. In turn, this causes a second-round monetary tightening. The same pattern of cyclical interactions between objective and instrument variables is evident as after an innovation in inflation. Volatility of the exchange rate estimated over the 24 months following the initial shock reaches about 40 percent of its level observed in the data. The results also imply that an unexpected increase in the rate of depreciation of the exchange rate translates, after many policy rounds, into a 0.2 percentage point increase in inflation.

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Slovenia: Effect of a One Percentage Point Shock to the Exchange Rate Over a 24-month Horizon

(In percent)

Citation: IMF Staff Country Reports 2000, 041; 10.5089/9781451835625.002.A002

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101. The discussion of the impulse response functions in these two examples illustrates how the BoS did not accept the inevitable trade-off between inflation and exchange rate appreciation but, in trying to achieve both objectives, engaged in interventions that aimed at canceling out the effects of each other. Aside from being inefficient, this strategy was also, to some extent, self-defeating. Although one of the explicit objectives of monetary policy in Slovenia is to limit the volatility of the exchange rate, the results of the model suggest that 40 to 60 percent of the actual volatility of the exchange rate during the period under observation was related to the interaction of various monetary policy interventions. In addition, variance decomposition of the exchange rate confirms that about half of the volatility of the exchange rate in the first twelve months after the initial shock is due to the interaction of monetary policy instruments.