Republic of Slovenia: Staff Report for the 2004 Article IV Consultation

This 2004 Article IV Consultation highlights that domestic demand in Slovenia rebounded strongly in 2003 after three anemic years. All components of domestic demand strengthened appreciably, fueled by declines in interest rates and the associated pickup in bank credit to the private sector. Progress with disinflation was better than expected. Year-over-year inflation declined from 7.2 percent at end-2002 to 3.5 percent in March 2004. IMF staff analysis suggests that the widening of the output gap associated with the economic slowdown was the dominant driving force behind disinflation in 2003.

Abstract

This 2004 Article IV Consultation highlights that domestic demand in Slovenia rebounded strongly in 2003 after three anemic years. All components of domestic demand strengthened appreciably, fueled by declines in interest rates and the associated pickup in bank credit to the private sector. Progress with disinflation was better than expected. Year-over-year inflation declined from 7.2 percent at end-2002 to 3.5 percent in March 2004. IMF staff analysis suggests that the widening of the output gap associated with the economic slowdown was the dominant driving force behind disinflation in 2003.

I. Background

1. With Slovenia scheduled to accede to the European Union (EU) on May 1, 2004, the authorities plan to enter ERM2 in the course of the second half of 2004 with the aim of adopting the euro in January 2007. The authorities’ program and policy strategy for euro adoption has been discussed domestically in various fora. 1 There is broad consensus of all political parties and social partners on these goals.

Selected Indicators of Optimal Currency Area Properties

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Sources: Eurostat; and Adopting the Euro in Central Europe—Challenges of the Next Step in European Integration (forthcoming IMF Occasional Paper).

Sum of absolute values of the differences between the shares of gross manufacturing output by industry and euro-area shares. The higher the indicator, the greater is the deviation from the average manufacturing structure of the euro area. Data are for 2000, except for Greece (1999).

Maastricht Criteria and Slovenia’s Current Position

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Sources: Slovene authorities; Eurostat; and IMF staff projections.

WEO projection of the three lowest inflation rates in the EU during 2005–06 plus 1½ percentage points margin.

Average for the 12-month period ending February 2004 for the three lowest inflation rate countries in the EU plus 2 percentage points margin.

Average annual inflation for the 12-month period ending March 2004.

Coupon rate on 10-year government bond issued in October 2003.

ESA-95 basis. On GFS-basis, the deficit is estimated at 1.4 percent of GDP.

2. Slovenia is well poised to enter the euro area in many respects. Real convergence in per capita income and productivity is comparable to that of some noncore euro countries. Slovenia stacks up well on optimal currency area properties, particularly with regard to business cycle correlation, similarities in production structure and share of intra-industry trade, and strong trade links. In addition, Slovenia already meets the Maastricht criteria for long-term interest rates and the fiscal deficit and debt ratios.

3. However, significant policy challenges lie ahead for successful participation in the monetary union. The inflation rate, though falling, is still above the EU average and thus distant from the Maastricht criterion; wage-setting mechanisms are not sufficiently flexible; the expenditure side of the budget needs to be adjusted to enhance the flexibility of fiscal policy; and the current exchange rate arrangement entailing steady depreciation needs to be relinquished for a stable exchange rate around central parity. These challenges have to be met in an environment of looming risks of a domestic demand boom, which could pose particular difficulties once in ERM2.

4. Domestic demand rebounded strongly in 2003 after three anemic years, though the weak external environment continued to be a drag on overall growth. All components of domestic demand strengthened appreciably, fueled by declines in interest rates and associated pickup in bank credit to the private sector. However, there was a large negative swing in the contribution of net foreign demand to real GDP growth, which slowed to 2¼ percent, and the output gap widened. Exports to the EU remained subdued, and exports to the main non-EU destinations slowed markedly, reflecting the weaker macroeconomic situation in these countries. With imports being boosted by the pickup in domestic demand, the external current account position receded from a sizeable surplus in 2002 to approximate balance in 2003 (Figure 1 and Table 1).

Figure 1.
Figure 1.

Slovenia: Economic Indicators, 1998–2005

Citation: IMF Staff Country Reports 2004, 150; 10.5089/9781451835748.002.A001

Sources: Data provided by the Slovene authorities; and IMF staff projections1/ Figures for 2002 have been adjusted for the shift in the budget accounting to a pure cash basis.The general government balance for 2004–05 refers to the budget approved by the parliament.
Table 1.

Slovenia: Selected Economic Indicators, 1999-2005

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Sources: Data provided by the Slovene authorities; and IMF staff calculations and projections.

Budget projections by the Ministry of Finance for 2004-05.

Projections by the Institute for Macroeconomic Analysis and Development (IMAD).

Revenues and deficit figures have been adjusted for the shift of budget accounting to a pure cash basis. Without the adjustment, the general government deficit would have reached SIT 156 bn, or 3.0 percent of GDP, as the unadjusted figures contained only 11 months of VAT and excise tax.

Budget figures for 2004-05.

For deposits with maturity between 31 days and 1 year.

Data have been revised according to the External Debt Guide 2003.

GDP and its Components

(Real growth rates in percent, unless otherwise noted)

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Sources: Statistical Office; and IMF staff estimates.

5. Progress with disinflation was more than envisaged by either staff or the Bank of Slovenia (BoS). Year-on-year headline inflation declined from 7.2 percent in December 2002 to 4.6 percent in December 2003, and fell further to 3.5 percent in March 2004. Core inflation fell to below historical lows at end-2003. Staff analysis suggests that the widening of the output gap associated with the economic slowdown was the dominant driving force behind disinflation in 2003. Other contributory factors, albeit to a small degree, were a moderation of the pace of depreciation of the tolar, lower increases in regulated prices and indirect taxes, and excise tax adjustments to offset increases in international oil prices. Wage developments contributed little to disinflation. While the economy-wide real wage increase in 2003 was broadly similar to that in 2002, the gap between wage and productivity growth narrowed, to below the threshold norm of 1 percent specified in the Social Agreement (Figure 2).

Figure 2.
Figure 2.

Slovenia: Wages and Productivity, 1998-2003

Citation: IMF Staff Country Reports 2004, 150; 10.5089/9781451835748.002.A001

Source: Statistical Office of the Republic of Slovenia.1/ Wages in respective sector divided by wages in the manufacturing sector.2/ Includes public administration; education; health; and other social services.3/ Includes distributive trade; hotels and restaurants; transport, storage, and communications; financial intermediation; and real estate.
uA01fig01

Headline and Core inflation

(y-o-y percent change)

Citation: IMF Staff Country Reports 2004, 150; 10.5089/9781451835748.002.A001

Source: Statistical Office of the Republic of Slovenia; and Bank of Slovenia..

Productivity and Real Wages

(Percent change)

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Source: Statistical Office of the Republic of Slovenia.

6. The fiscal outturn in 2003 implied a withdrawal of stimulus (0.6 percentage point of GDP), complementing the authorities’ disinflation effort. The general government deficit––1.4 percent of GDP—was slightly smaller than that envisaged in the mid-year supplementary budget and broadly similar to the outturn in the past three years. Collections in most tax categories surpassed expectations despite slower-than-expected growth. However, expenditure on goods and services and use of contingency reserves (a one-off payment to compensate farmers for drought) exceeded the budgeted levels, and were partly offset by a cutback in investment spending plans (Table 2).

Table 2.

Slovenia: Summary of General Government Operations, 2000-05

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Sources: Ministry of Finance; and IMF staff calculations and estimates.

Revenues and deficit figures have been adjusted for the shift of budget accounting to a pure cash basis. Without the adjustment, the general government deficit would have reached SIT 156 bn, or 3.0 percent of GDP, as the unadjusted figures contained only 11 months of VAT and excise tax.

Pre-accession aid of the EU was until 2003 classified as grants.

7. Monetary conditions at the policy level remained broadly stable. The BoS continued with its monetary and exchange rate policy framework in which interest rates are adjusted in response to inflation dynamics and inflation expectations, while the exchange rate is also managed to avoid widening the uncovered interest parity with the aim of discouraging interest-sensitive capital inflows. Prompted by the deceleration in inflation, European Central Bank (ECB) rate cuts, and a perception of falling country-risk premium, the BoS lowered its key policy rate (on 60–day bills) steadily by a total of 3½ percentage points since December 2002 to 4¾ percent in April 2004. Meanwhile, the pace of depreciation of the tolar vis-à-vis the euro slowed from an annualized rate of 3.3 percent in December 2002 to 2 percent in March 2004, equivalent to a virtually unchanged bilateral real exchange rate (Figures 3 and 4).

Figure 3.
Figure 3.

Slovenia: Monetary Conditions Index, 1999-2003

(1999m1=0)

Citation: IMF Staff Country Reports 2004, 150; 10.5089/9781451835748.002.A001

Source: IMF staff estimates.1/ Interest rate measured with the BoS 60-day bill rate. End-of-quarter data.2/ Interest rate measured with the long-term lending rate to enterprises. The monetary conditions index assigns 67 percent weight to changes in the real interest rate, and 33 percent weight to changes in the real exchange rate. The calculation does not assume any Samuelson-Balassa effect. End-of-quarter data.
Figure 4.
Figure 4.

Slovenia: Inflation, Interest Rates, and Depreciation, 1999-2004

(In percent)

Citation: IMF Staff Country Reports 2004, 150; 10.5089/9781451835748.002.A001

Sources: Bank of Slovenia; Eurostat; and Statistical Office of the Republic of Slovenia1/ Difference between long-term lending rates in Slovenia (tolar credit) and Germany.2/ Vis-à-vis the euro area.3/ Depreciation vis-à-vis the euro.

8. Lending rates of banks fell in real terms in 2003, and private credit demand and interest-sensitive capital inflows picked up. With the elimination of indexation of financial instruments, lending rates of banks became more sensitive to competition and movements in the interest rate on foreign-currency denominated loans. It would appear that for a large segment of blue-chip corporate customers, aggressive pricing by foreign-owned banks has already resulted in convergence with nominal interest rates abroad. These banks are typically charging EURIBOR plus a margin of 60–80 basis points on foreign-currency denominated loans; tolar loans are priced equivalently after adjusting for expected depreciation. About two-thirds of the expansion of credit to enterprises in 2003 was foreign currency denominated (primarily in euros), and financed by rising bank borrowing from abroad. Overall, foreign currency-denominated lending to households was minimal, though such transactions jumped in the fourth quarter following the liberalization of regulations (Figure 5 and Table 3).2

Figure 5.
Figure 5.

Slovenia: Selected Monetary Developments, 1999-2004

Citation: IMF Staff Country Reports 2004, 150; 10.5089/9781451835748.002.A001

Source: Bank of Slovenia.
Table 3.

Slovenia: Monetary Survey, 1999-2003

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Source: Bank of Slovenia, Monthly Bulletin.

9. Competitiveness and other external vulnerability indicators remain satisfactory. The unit labor cost-based real effective exchange rate and relative profitability index have remained broadly unchanged since early 1998 (Figures 6 and 7). Slovenia’s market exchange rate as a ratio of the PPP exchange rate (relative to the euro area) also was stable during 1998–2002. Over the past two years, Slovene exporters have regained the loss in EU market shares experienced during 1999–2000 and have progressively increased their presence in non-EU countries, though the latter appears to have plateaued. With the increased resort to external financing by banks and enterprises, total external debt increased to about 53½ percent of GDP at end-2003. Short-term external debt (on residual maturity basis) in 2003 was about two-thirds the level of gross official reserves, and external debt service payments were about 15½ percent of exports of goods and nonfactor services (Table 4).

Table 4.

Slovenia: Vulnerability Indicators, 1999-2003

(In percent of GDP, unless otherwise indicated)

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Sources: Data provided by the Slovene authorities; Bloomberg; and IMF staff calculations.

NFS denotes nonfactor services.

Remaining maturity basis.

uA01fig02

Export Market Shares, 1998-2003

(1998Q1=100; 4-quarter moving average)

Citation: IMF Staff Country Reports 2004, 150; 10.5089/9781451835748.002.A001

Source: Direction of Trade Statistics.
Figure 6.
Figure 6.

Slovenia: Exchange Rate Indicators,1998-2003

(1998q1=100) 1/

Citation: IMF Staff Country Reports 2004, 150; 10.5089/9781451835748.002.A001

Sources: Bank of Slovenia Bulletin; Eurostat; IFS; and IMF staff calculations.1/ Trade weights based on 1998-2000 data for exports of goods. Partner countries comprise: Austria, Croatia, France, Germany, Italy, Poland, United Kingdom, and United States.2/ Unit labor costs in Slovenia relative to those in trading partner countries, adjusted for manufacturing producer price inflation—a rough indicator of developments in profitability.
Figure 7.
Figure 7.

Slovenia: Wages, Productivity, and Product ULC in Manufacturing, 1998-2003

(1998q1=100) 1/

Citation: IMF Staff Country Reports 2004, 150; 10.5089/9781451835748.002.A001

Sources: Statistical Office of the Republic of Slovenia; and IMF staff calculations.1/ Seasonally adjusted.2/ Defined as the ratio of nominal wages to producer price index.3/ Defined as the ratio of real product wages to productivity.

II. Report on the Discussions

10. The discussions focused on the vulnerabilities during the run-up to euro adoption, and on the policy requirements for achieving a successful transition and strong performance in monetary union. The main challenges are to implement policies that will lower average inflation to a rate that meets the Maastricht criterion (estimated at 2¾ percent during the assessment period 3) and that thereafter avoids loss of competitiveness once the central parity is fixed; and to maintain exchange rate stability within “the normal fluctuation margins” of ERM2 for at least two years. The authorities’ policy strategy centers around keeping the current monetary and exchange rate framework until ERM2 entry, continue addressing the cost-push factors that have contributed to inflation inertia over the past years, enhancing wage flexibility, and maintaining fiscal discipline and modifying the indexation mechanisms for social transfers. The authorities’ strategy paper considers the risks inherent in the euro adoption process to be manageable and the macroeconomic scenario underlying the budget for 2004–05 does not anticipate a domestic demand boom. The staff viewed this scenario as overly benign, and placed a higher likelihood on a credit-financed demand boom, with implications for the achievement of the Maastricht inflation criterion. Thus, while generally supportive of the authorities’ overall policy framework, the staff advised a more deliberate role for monetary policy in the period up to ERM2 entry, faster progress in enhancing wage and fiscal policy flexibility, and further strengthening of bank supervision.

11. Over a number of years, the authorities have generally heeded the Fund’s policy advice, though with differences persisting on how monetary policy could best contribute to disinflation. During the past year, the authorities made progress in implementing structural and fiscal policies emphasized by Executive Directors at the conclusion of the last consultation on April 16, 2003 (Box 1).

Policy Recommendations and Implementation

In concluding the last Article IV consultation discussions with Slovenia, Executive Directors focused on policies to address two main challenges: lowering inflation sharply before entering ERM2, and returning in 2004 to the previously planned path of fiscal adjustment (http://www.imf.org/external/pubs/ft/scr/2003/cr03108.pdf).

During the past year, in line with Fund advice, the authorities enhanced policy coordination on administered prices, eliminated indexation of financial contracts, and initiated steps to weaken wage indexation. However, the BoS did not adopt a more aggressive disinflation effort through accepting a stronger tolar, as advised by the Fund, out of concerns that this would trigger capital inflows, and kept monetary conditions broadly unchanged. Nevertheless, for reasons explained in ¶5, progress in disinflation was better than expected.

On the fiscal front, the time horizon for achieving the medium-term goal of structural balance has lengthened, because of fiscal pressures connected with EU accession. Still, as per Fund advice, the authorities have focused on restraining increases in the wage bill and social transfers. Furthermore, they sought and obtained technical assistance from the Fund in November 2003 to identify further means of expenditure rationalization.

On financial structural issues, the authorities have implemented most of the recommendations of the 2001 FSAP. A FSSA update was undertaken in November 2003 (Box 4).

A. Macroeconomic Outlook

12. The staff pointed to various factors that suggested a high likelihood of a credit-financed demand boom in the offing, similar to that experienced by noncore euro-area countries in the late 1990s prior to euro adoption. The strong upturn in domestic demand in Slovenia in 2003 likely represents the early stages of a demand boom. In the period ahead, further demand-side impetus to external borrowing and bank credit is likely to come from favorable business and consumer expectations triggered by EU accession and prospective euro adoption, and from a convergence-related decline in interest rates. Domestic demand is also likely to be fueled by the release of funds from the housing savings scheme beginning in mid-2004. Dynamic simulations for Slovenia carried out by Fund staff, applying the parameters of a model of credit growth in the euro area, also suggest a potentially rapid acceleration in credit in the next few years. 4 Senior policy makers conceded that a demand boom was a potential risk, but did not consider it as their baseline scenario.

13. There was consensus that the contribution of net foreign demand to growth would likely remain negative in the foreseeable future. Exports should pick up in line with the anticipated recovery in the EU, though imports, driven by strong domestic demand, are expected to increase at a faster pace. Accordingly, the staff projects real GDP growth rebounding to 3½ percent in 2004 and rising above the potential rate subsequently to 4½ percent in 2006. The external current account is expected to swing into a deficit in 2004 that would widen progressively to a peak of about 2 percent of GDP in 2007 (Tables 5 and 6). Under this scenario, which assumes that credit-financed domestic demand pressures will be self-correcting and that foreign direct investment inflows will recover upon euro adoption, the external debt-to-GDP ratio is projected to increase by about 10 percentage points over the medium term and stabilize at about 63 percent in 2008–09. Sustainability is not an imminent concern, but developments merit monitoring (Appendix III).

Table 5.

Slovenia: Macroeconomic Framework, 2000-08

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Sources: Data provided by the authorities; and IMF staff projections.
Table 6.

Slovenia: Balance of Payments, 2000-05

(In millions of euros, unless noted otherwise)

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Sources: Bank of Slovenia; and IMF staff projections.

Revised data as per the External Debt Guide 2003.

Stocks and flows may not reconcile due to valuation changes.