Statement by Willy Kiekens, Executive Director for Republic of Slovenia and Ksenija Maver, Advisor to Executive Director

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.


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.

The authorities wish to thank the staff for constructive discussions and their balanced, well-structured report, and for their valuable insights that helped shape the Slovenia’s policy strategy during its crucial preparations for entering the ERM-2 and adopting the euro.

I. Recent Economic Developments

In the first quarter of 2004, the economy’s rebound continued, and inflation has declined faster than planned…

In April 2004, annual headline inflation was at 3.5 percent, down from 5.3 percent in April 2003 and 8.4 percent in April 2002. Core inflation was around 3.0 percent. This implies that the targets for the end of 2004 have already been met in April. The steep disinflation acquired momentum with the adoption of the program for ERM-2 entry and euro adoption launched last November by the Bank of Slovenia and the Slovenian Government. The program was paralleled by improved coordination of economic policies, a substantial disindexation of interests and wages, firm fiscal policies, a determined wage policy, better control of administered prices, and lowered excise duties in response to sharp oil price increases. These actions were complemented by a monetary policy that prevented capital inflows from generating inflationary pressures. Weak economic activity, at a level below potential, gave additional support. In addition, a large share of increasing domestic demand was satisfied by imports, which eased the pressure on domestic prices.

It is most important that inflation is declining in a sustainable way, with the external and internal accounts kept in balance. Slovenia’s economic policy actions were coordinated to avoid possible disruptions in the real economy.

Concerning the factors contributing to disinflation, the views of the authorities and the staff differ only in nuances. The staff concludes that the main force behind the disinflation was the widening of the output gap during the economic slowdown. The authorities believe that other factors, primarily policy coordination, wage de-indexation, fiscal prudence and wage restraint were also important and should be cited.

…. and the fiscal account remained close to balance.

The fiscal position during the first quarter of 2004 remained strong. Strong tax collection has kept revenues buoyant, exceeding the projections. Expenditures were strictly monitored and stayed below the budgeted limits. As a result the 2004 fiscal deficit target of 1.7 percent is within reach.

The monetary policy framework was kept unchanged.

Monetary policy remains focused on disinflation, keeping a close eye on parity with foreign interest rates to head off inflationary pressures caused by capital inflows. Backed by the strong deflationary trend and Slovenia’s declining country risk premium, the Bank of Slovenia has continued lowering policy interest rates and moderating the pace of the nominal depreciation of the tolar against the euro. Operational activities concentrated on aligning Slovenia’s monetary policy operations with the standards of the European Central Bank.

II. The Outlook for the Rest of 2004 and Beyond

Economic activity is picking up and the prospects over the next two years are positive.

Slovenian growth will be driven mostly by private consumption and investments. Private consumption will be encouraged by lower interest rates and the launching of a housing scheme, and will be restrained by the moderation of wage growth and uncertainties in the labor market stemming from competitive pressures within the EU. The prospects for both private and public investment are positive: conditions in the financial markets are favorable, and there are ambitious plans for infrastructure investments. The Bank of Slovenia foresees growth rebounding from the low of 2.3 percent recorded in 2003 to 3.1 percent in 2004, 3.6 percent in 2005, and 3.9 percent in 2006.

It is expected that the external current account position will weaken. Imports will be stimulated by domestic demand, but exports, while they will increase, will be restrained by the continuing uncertainty of the euro zone’s recovery. The current account, which was virtually in balance in 2003, is expected to register a deficit of about 1.0 percent of GDP in 2004. This deficit could rise to 2.0 percent in the years 2005 and 2006.

The inflation outlook is better than expected.

Given the strong momentum of disinflation, and the balanced macroeconomic situation, the Bank of Slovenia has revised its inflation forecasts for the end of 2004 from 3.5 percent to 3.2 percent, and for the end of 2005 from 2.9 percent to 2.8 percent. Inflation is expected to remain at 2.8 percent in 2006. These outcomes would ensure compliance with the Maastricht inflation target.

The authorities and the staff broadly agree on the growth and inflation projections. The authorities consider that the low demand scenario is the more likely. Accordingly their growth and inflation projections are also more modest than those of the staff.

The Government aspires to an early entry into ERM-2 and euro adoption at the beginning of 2007.

The milestones marking the path to ERM-2 and euro adoption, set last November by the Government and the Bank of Slovenia, are considered feasible, the more so because the general government deficit was 1.4 percent of GDP in 2003, the public debt is currently 27 percent of GDP, and the long-term interest rate was 4.99 percent in April 2004--all comfortably within the Maastricht limits. The exchange rate is stable, and the disinflation record is encouraging.

During the run up to ERM-2 entry, monetary policy will remain focused on disinflation and exchange rate stability. After ERM-2 entry, exchange rate stability will be the only remaining objective, with interest rate policy subordinated to the stability of the exchange rate. The central parity at the time of ERM-2 entry will be jointly established by the Slovenian Government, the Bank of Slovenia, the European Central Bank, the Euro group, and the European Commission. It is expected to be near the market rate prevailing at the time of Slovenia’s ERM-2 entry. It is also expected that Slovenia will accept the ERM-2’s standard fluctuation band. During the ERM-2 period, Slovenia’s monetary policy instruments will remain unchanged, since they are well tailored to the local environment and can serve as a powerful tool for efficient market interventions that may be required under the ERM-2 arrangement.

The ERM-2 period will entail risks endangering the inflation target and exchange rate stability. Excessive private consumption and wage growth could undermine the inflation and exchange rate objectives. The macroeconomic environment should remain stable to avoid that the financial markets would be tempted to test the sustainability of the central parity. Preserving fiscal stability is the key to preserving the credibility of the central parity and avoiding a prolonged stay in the ERM-2. Wage discipline and fiscal prudence will be important tools for avoiding developments that could seriously damage the economy, and especially employment. A strong publicity campaign has made these tradeoffs well known to the public.

Fiscal policy will be key to maintaining macroeconomic stability.

Fiscal policy will have to ensure continued macroeconomic stability and keep inflation in check. Measures for safeguarding the strength of the public finances will include, first, imposing rational limits on public consumption to ensure the maintenance of sufficient reserves to allow automatic stabilizers to be used to their full extent; and second, restraining public sector wage growth.

It is beyond doubt that this will not be easy, especially during the approach of the elections scheduled for next October. The fiscal targets have been secured by two important safeguards. First, the budget for 2005 was already locked in last December with the framework of Slovenia’s 2004-2005 budget, and will not be adjusted until the spring of 2005, after the macroeconomic outlook is assessed. Second, the rule for the strict monitoring of the budget execution has been put in place, and will be followed notwithstanding the overperformance of the first quarter revenues.

Slovenia’s improved fiscal outlook makes some room for fiscal action. The authorities intend to increase the competitiveness of the corporate sector by advancing the planned reduction of the payroll tax by six months, from next January to July 2004. This measure, which will reduce the 2004 budget by some five billion Slovenian tolar, equivalent to 0.08 percent of GDP, is aimed at reducing the cost of labor and helping companies that pay lower wages. To keep the tax holiday from spilling over into higher wages, the reduction of the payroll tax will not become effective until safeguards are put in place to ensure that private sector wages are kept within the pre set limits.

Wage policy is considered essential for securing a smooth ERM-2 entry.

Real wages are expected to rise by 2.0 percent annually, lagging behind productivity growth. The largest contribution to wage moderation will come from the public sector, where an agreement concluded last July among the social partners has locked in the growth of public sector wages. Real increases of no more than 0.5 percent for 2004 and 1.0 percent for 2005 are expected.

The wage setting arrangement for the public sector has defined the path for private sector wage adjustments. On April 28, 2004, the social partners reached a national agreement limiting private sector wage growth in 2004 and 2005 to one percentage point below productivity growth, which provides for making adjustments in 2005 if the 2004 targets are not met. At the individual level, the agreement secures a lump sum wage increase for all workers aimed at reducing wage disparities. Negotiations have now started at the level of individual industries, to make the agreed wage settlement operational and effective. This will clear the way for the payroll tax reduction.

The financial system remains robust but is coming under increasing competitive pressure from the EU.

The recent mission for updating Slovenia’s FSAP has confirmed that Slovenia’s financial system is sound. It has provided valuable advice on how to address problems arising from the increased competitive pressures resulting from EU entry. The mission’s recommendations will provide the framework for an Action Plan to be coordinated by the Bank of Slovenia, which will monitor the practical implementation of the mission’s advice just as it did after initial FSAP exercise in 2000.

The Bank of Slovenia is considering a reinforcement of banking supervision, especially in light of stronger pressures to lend to weaker clients. The Bank might also introduce at the beginning of 2005 dynamic provisioning to counteract cyclic upturns, if international accounting standards would not yet apply.

III. Conclusion

A few days ago, Slovenia became a member of the European Union community. The promise of EU accession was a major factor in securing public support for the structural and institutional reforms aimed at bringing sustained growth and macroeconomic stability. The Slovenian economy today has remarkable resilience. It has come very close to achieving price stability; the current account deficit and the fiscal deficit are expected to remain modest; the financial system is robust; and safeguards against the risks have been put in place.

From the beginning of its independence to the present day, Slovenia has never needed financial assistance from the Fund. But its regular Article IV consultations and technical assistance missions have enabled it to constantly check its policy approach with the Fund’s staff. The Fund’s expertise, the frank exchange of views, and especially the readiness of Fund missions to examine everything from conceptual policy issues to the effectiveness of those policies, were highly valued features of these consultations. At this important moment of EU accession, the authorities wish to express their sincere gratitude for the Fund’s good advice, and for the support for their stabilization policies embodied in the valuable reports resulting from these discussions.