Slovenia: A Small, Very Open Economy

Following independence in 1991, Slovenia quickly achieved macroeconomic stability and launched systemic structural reforms. From 1993 to 2000, annual growth averaged 4.3 percent but slowed to about 3 percent in 2001, due both to weaker foreign demand and declining investments. However, recent indicators show that Slovene companies responded to the slowing of economic activity by increasing productivity. This, together with the nascent world recovery, provides a basis for optimism about Slovenia’s prospects in 2002 and later years.

The current account and the fiscal deficit are now at moderate levels; the public debt-to-GDP ratio is 25 percent; and the total external debt-to-exports ratio is 57 percent. Slovenia’s economic position can be considered strong. Inflation declined from 201 percent in 1992 to 6 percent in 1999, and after a short spike in 2000, was 7 percent at the end of 2001. In the first two months of this year, this favorable trend was interrupted when inflation rose to 8 percent, due to a recent rise in the taxation of tobacco and alcohol, and an increase in the VAT and some administered prices. However, the interruption is seen as temporary.

Slovenia’s transition has involved two especially demanding challenges: first, the agenda of EU accession; and second, the problems peculiar to small, open economies.

The first challenge, the run up to EU and EMU membership, placed significant demands on macroeconomic management, especially in the field of public finance and monetary policy. Until today, Slovenia reviewed and closed 26 of the total 29 chapters of the EU legal norms, i.e. the Acquis communautaire, and hopes to conclude EU accession negotiations by the end of 2002. Under the optimistic scenario Slovenia would enter the EU in 2004, soon after that join the ERM 2, and adopt the euro in 2006.

The second challenge, mastering the problems of a small open economy in transition, required finding innovative solutions that sometimes differed from textbook examples. Slovenia’s gradual and prudent approach to stabilization and structural reforms has clearly proved its worth. For example, the cautious attitude toward capital account liberalization enabled the economy to cope remarkably well with financial crises.

These same two challenges had also to be taken into account by monetary and fiscal policy, and by the bank privatization process.

Monetary and Exchange Rate Policy

Since its establishment in 1991, the Bank of Slovenia’s primary goal of achieving and maintaining price stability has remained unchanged, and its strategy combining monetary targeting and a managed float exchange rate regime has been successful.

In November 2001, the Bank of Slovenia set the monetary framework for the period leading up to EU accession, and for the later period before accession to ERM 2. The framework establishes medium-term targets for the further reduction of inflation, to 5.2–5.7 percent by the end of 2002 and 3.5–4.2 percent by the end of 2003.

And all the way up to Slovenia’s accession to ERM 2, the central bank will monitor, similarly to the ECB’s monetary policy, two pillars. The first is money in circulation, i.e. all indicators that as far as possible directly reflect the behavior of M3 and its individual components.¹ The second consists of indicators that explain the economic situation (in particular the exchange rate, interest rates and interest rate spreads, balance-of-payments indicators, wages, and administered prices).

Given the greater uncertainty that characterizes small open economies, and the short time since capital account and financial liberalization, this strategy has many advantages over an explicit targeting of inflation. In principle, up until accession to the EU, the central banks of accession countries have an entirely free hand in choosing an exchange rate regime and the strategy of monetary policy targeting and implementation. The Bank of Slovenia will make every effort to ensure a smooth transition to the new and demanding EU environment.

This does not imply that the managed float exchange regime gives the central bank complete discretion in its operations. The BoS is using an operating rule that is consistent with a managed floating exchange rate regime, as described in recent academic work.² Under this operating rule, equilibrium is obtained by targeting the uncovered interest rate differential vis-à-vis the euro through the simultaneous and consistent determination of the exchange rate and the nominal short-term interest rate. This procedure supports the inflation objective by preventing speculative inflows.

Fiscal Policy

In 2001, Slovenia approved three important documents that provide a medium-term strategic approach to fiscal policy. These are the Medium Term Development Strategy, which is the basis of the Pre-accession Economic Program (PEP) for the period until 2005, and the Budget Memorandum for 2002/2003.

The PEP reflects part of Slovenia’s dialogue with the EU. Such programs were prepared by all EU accession countries in 2001. Slovenia’s PEP sets forth the medium-term fiscal goal of replacing the present low budget deficit with a balanced budget by 2005. This will be done by imposing strict limits on expenditures. The ratio of general government expenditures to GDP is projected to decrease from 45.2 percent of GDP in 2002 to 42.4 percent in 2005. The ratio of general government revenues to GDP is projected to remain unchanged at 42 or 43 percent of GDP until 2005. This will gradually reduce the gap of 1.3 percent of GDP at the end of 2001 to zero by 2005.

Crucial for success in reining in the ratio of expenditures to GDP will be the reduction of the wage bill and the interest bill. It is important to note that the growth of public wages will slow this year as a result of the replacement of backward-looking wage indexation by forward-looking indexation. In addition, the GDP ratio of interest payments will decrease (from 1.61 percent of GDP in 2002 to 1.15 percent of GDP in 2005) as a large portion of the public debt will be retired using privatization proceeds expected to amount to a cumulative 7 percent of annual GDP during the period from 2002 to 2005. Additional measures—such as more efficient use of public funds (subsidies, health) and the transfer of some public services to the private sector—will help reduce government expenditures.

Another important innovation was the introduction of a two-year budget in November 2001. The PEP paved the way for preparation of the Budget Memorandum and of budgets for the period 2002/2003. Using a two-year fiscal framework in budget preparation has the advantage of affording more flexibility in streamlining priorities. In particular, budget users will find it easier to sequence their programs and allocate their resources over a broader time horizon.

The year 2002, with a projected budget deficit of 2.5 percent of GDP, will be difficult, but already in 2003 this deficit is expected to fall to 0.7 percent. So although spending constraints will be especially tight in 2002, the budget in 2003 and later years will improve and make room for investment and development programs.

Despite the downward trend of the economy, the government will not allow the full play of automatic stabilizers in 2002 because they could compromise the medium-term fiscal strategy. The political commitment to all three documents-the Strategy, the PEP, and the Budget Memorandum-is strong. The measures needed to achieve the projected results are clearly defined. And it is widely recognized that for a small open economy like Slovenia’s a fiscal deficit is undesirable. The prospects for achieving the goals defined by these three documents are therefore good.

Bank Privatization

The banking sector reforms launched by Slovenia in 1993 started with the rehabilitation of commercial banks that were near bankruptcy. The state issued bonds worth some 10 percent of that year’s GDP, purged the banks’ portfolios of bad assets, and worked to resolve inherited problems (e.g., foreign debts) that burdened their balance sheets. During the process, two of the three banks being rehabilitated merged. And since 1997 the two newly rehabilitated banks have been highly profitable.

Before their rehabilitation was complete, privatizing these banks was not feasible. And because Slovenia’s external position was strong, there was no need to unload them quickly on foreign buyers. The state preferred instead to ready them for the tough market conditions ahead.

The privatization of the two banks began in 2001 with the government’s program calling for the partial privatization of the Nova Ljubljanska Banka (48 percent) and the Nova Kreditna Banka Maribor (65 percent).

Negotiations with potential buyers (mostly from neighboring countries) are presently under way, so the final outcome is not yet known. The selection process is cognizant of the two goals set by the government’s privatization program adopted last year: first, the privatization should strengthen competitiveness and efficiency of the banking system, and second, the government intends to hold out for a good financial result, so that the proceeds of the banks’ privatization can be applied to reimburse the government’s costs connected with their rehabilitation.

The staff has provided valuable insights into the theoretical arguments and empirical evidence concerning the pros and cons of allowing foreign banks to participate in bank privatization. Bank privatization should also be viewed in the light of its monetary and fiscal effects on the economy. Changing the ownership structure of banks in which the state still holds a majority stake presents a special challenge for the entire Slovene economy.