Republic of Slovenia: Staff Report for the 2005 Article IV Consultation

This 2005 Article IV Consultation highlights that Slovenia’s real GDP growth accelerated to 4½ percent in 2004 driven by a large positive swing in the contribution of net foreign demand, while domestic demand growth maintained momentum. Private consumption strengthened, though to a lesser extent than expected owing to an apparent increase in the propensity to save. Economic growth is expected to moderate to 4 percent in 2005, but would still be above estimates of potential. Domestic demand is expected to ease, owing to a further slowdown of inventory accumulation.

Abstract

This 2005 Article IV Consultation highlights that Slovenia’s real GDP growth accelerated to 4½ percent in 2004 driven by a large positive swing in the contribution of net foreign demand, while domestic demand growth maintained momentum. Private consumption strengthened, though to a lesser extent than expected owing to an apparent increase in the propensity to save. Economic growth is expected to moderate to 4 percent in 2005, but would still be above estimates of potential. Domestic demand is expected to ease, owing to a further slowdown of inventory accumulation.

I. Background

1. Slovenia reached two significant milestones in 2004: European Union (EU) accession on May 1 and ERM2 entry on June 28. The authorities’ goal is to adopt the euro in early 2007. There is broad consensus of all political parties and social partners on this objective.

2. Slovenia is well poised to adopt the euro, but risks and challenges remain. Real convergence in terms of per capita income and productivity is comparable to that of some non-core euro countries. Slovenia already meets the Maastricht criteria for long-term interest rates and the fiscal deficit and debt ratios. The exchange rate of the tolar vis-à-vis the euro has remained close to the central parity since ERM2 entry. However, while inflation has steadily moved closer to eurozone compatible levels, achievement of the Maastricht criterion could be at risk if faster-than-potential economic growth and higher producer price inflation were to feed through to consumer prices. Though recent developments in real wages relative to productivity growth have been favorable, wage-setting mechanisms are not sufficiently flexible. Also, current conditions call for a tighter fiscal policy stance and a lowering of expenditure rigidities.

Slovenia: The Maastricht Criteria

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1½ percentage points above the three lowest inflation rates in the EU. For 2005, criterion based on WEO projections.

2 percentage points above the rates in the three lowest inflation rate countries in the EU. For 2005, rate on 11-year government bond issued in January.

ESA-95 basis

3. Economic performance in 2004 was strong, and policy implementation was generally in line with the Fund’s advice(Box 1). Real GDP growth accelerated sharply to 4½ percent, driven by a positive swing in the contribution of net foreign demand. Exports to the main EU and non-EU destinations rose in response to stronger import demand in these countries. However, with the terms of trade deteriorating owing to higher oil and commodity prices, the external current account deficit widened to almost 1 percent of GDP (Figure 1 and Table 1).

Figure 1.
Figure 1.

Slovenia: Economic Indicators, 1999–2006

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.A001

Sources: Bank of Slovenia; Ministry of Finance; Statistical Office; and IMF staff projections.1/ Figures for 2002 have been adjusted for the shift in the budget accounting to a pure cash basis.
Table 1.

Slovenia: Selected Economic Indicators, 2000-06

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

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

Revised budget for 2005. Figures include higher transfers from EU and EU-related expenditures.

Figures reflect a shift in the budget accounting to a pure cash basis entailing only 11 months of VAT and excise tax revenues. Adjusted for the methodological change, the general government deficit would be 1.5 percent of GDP.

Including loans and other claims.

For deposits with maturity between 31 days and 1 year.

uA01fig01

Slovenia’s Exports and Non-oil Imports of Partner Countries 1/

(Percent change in real terms)

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.A001

Source: World Economic Outlook.1/ Partners are: Austria, Bosnia Herzegovina, Croatia, Czech Republic, France, Germany, Hungary, Italy, Poland, Russia.

Policy Recommendations and Implementation

In concluding the last Article IV consultation, Executive Directors focused on policies to ensure a smooth transition to ERM2 entry and euro adoption as well as strong performance in the monetary union (http://www.imf.org/external/pubs/cat/longres.cfm?sk=17421.0).

Over the years, the authorities have generally heeded the Fund’s policy advice, except with regard to monetary policy. The BoS pursued a more gradual approach to tackling inflation than advocated by the staff. Nevertheless, recent progress in disinflation was better than expected.

In 2004, the implementation of monetary policy was cautious. In line with the Fund’s advice, the BoS did not lead the market in lowering nominal interest rates prior to ERM2 entry. Under ERM2, it has given primacy to exchange rate stability.

On the fiscal front, despite the elections, the authorities implemented expenditure saving measures to contain the deficit within the budgeted level. However, there was little progress in laying the ground for expenditure rationalization that would ensure achievement of structural balance in the medium term.

The authorities took steps to strengthen banking supervision and implement the recommendations of the 2004 Financial System Stability Assessment (FSSA) update.

4. Domestic demand growth did not take off as feared by the staff, but maintained momentum. Consumption and investment contributed about equally to GDP growth. However, their growth rates exhibited contrasting trends. Private consumption strengthened appreciably, though to a lesser extent than expected owing to a marked restructuring of household financial assets and an apparent increase in the propensity to save. Households channeled increasing amounts to mutual funds, insurance companies, and voluntary supplementary pension insurance, which more than offset a sharp jump in bank borrowing. In contrast, investment growth slowed, owing to a smaller contribution from inventory accumulation. Moreover, outflows of investible resources from Slovenia increased in 2004: direct and portfolio investment outflows rose to nearly 4 percent of GDP from about 2½ percent of GDP in 2003.

Demand and Credit Growth, Financial Saving of Households, and Capital Flows

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Sources: Bank of Slovenia and Institute for Macroeconomic Analysis and Development (IMAD).

5. Progress with disinflation continued, notwithstanding higher oil prices, a pickup in producer prices, and a narrowing of the output gap. Year-on-year headline inflation Demand and Credit Growth, Financial Saving of Households, and Capital Flows (In percent of GDP)declined from 4.6 percent in December 2003 to 3.2 percent in December 2004 and fell further to 2.1 percent in May 2005. Supply side and structural factors were important driving forces behind this trend: an improved harvest, the elimination of remaining duties on imports from the EU, and increased competition in the retail market resulted in falling food prices and moderate increases in the prices of non-food items (Figures 2 and 3). Wage developments also played a positive role, as the pace of real wage increases in both the tradable and non-tradable sectors lagged behind productivity growth by a wider margin than in 2003 (Figure 4). Disinflation was additionally reinforced by the stabilization of the exchange rate after ERM2 entry.

Figure 2.
Figure 2.

Slovenia: CPI Inflation and Components, 2000-2005

(Year-on-year change, in percent)

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.A001

Sources: Statistical Office of the Republic of Slovenia; Eurostat; and IMF staff calculations.
Figure 3.
Figure 3.

Slovenia: PPI and CPI Inflation, 2000-2005

(Year-on-year change, in percent)

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.A001

Sources: Statistical Office of the Republic of Slovenia; and IMF staff calculations.
Figure 4.
Figure 4.

Slovenia: Wages and Productivity, 1998-2004

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.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.

Productivity and Real Wages

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Sources: Statistical Office of the Republic of Slovenia; and IMF staff calculations.

Measured on value added basis.

6. The monetary framework changed following ERM2 entry, and monetary conditions became tighter. Until June 2004, the BoS continued with its policy of lowering interest rates gradually in response to the deceleration in inflation, while depreciating the exchange rate at a steadily slowing pace to avoid widening the uncovered interest parity. Upon ERM2 entry, the BoS ended its depreciation policy, and set the central parity at SIT 239.64 per euro, close to the then-prevailing market rate. Since then, the market rate has not deviated from central parity by more than ±0.20 percent, and the BoS has kept its key policy interest rate (on 60-day bills) unchanged at 4 percent (Figure 5).

Figure 5.
Figure 5.

Slovenia: Monetary Conditions, 2000-2005

(In percent)

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.A001

Sources: Bank of Slovenia; Eurostat; and Statistical Office of the Republic of Slovenia.1/ Vis-à-vis the euro.

7. However, with further convergence of tolar lending rates and increased competition in the banking sector, bank credit accelerated in 2004. The pick-up in credit growth was particularly strong for individuals, but the bulk of the credit continued to be absorbed by enterprises. While most of the new loans to individuals were tolar denominated, about four-fifths of new lending to enterprises was euro denominated (Figure 6). With slow growth in deposits on account of lower interest rates and increased alternative saving opportunities, banks increasingly resorted to foreign financing from parent banks and through syndicated loans to fund their lending activities (Table 2). For both enterprises and individuals, interest rates on new tolar-denominated loans declined in nominal and real terms, while nominal rates on new euro-denominated loans were broadly stable. Aggressive pricing by foreign-owned banks to increase market share has resulted in lower interest rates on euro-denominated loans than abroad, while rates on tolar-denominated consumer loans are comparable to those in the euro area (Figure 7).

Figure 6.
Figure 6.

Slovenia: Credit Developments and Capital Inflows, 2000-2004

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.A001

Source: Bank of Slovenia.
Table 2.

Slovenia: Monetary Survey, 2000-2004

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Source: Bank of Slovenia, Monthly Bulletin.
Figure 7.
Figure 7.

Slovenia: Bank Lending Rates on New Loans, 2003-2005

(In percent)

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.A001

Sources: Bank of Slovenia; Eurostat.

Bank Financing (Annual Net Flows)

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Source: Bank of Slovenia

8. The general government deficit was slightly lower than envisaged in the budget, but the expenditure structure became more rigid. The temporary decrease in VAT receipts due to the elimination of border customs control upon EU accession was higher than anticipated. However, the shortfall was offset by higher collections of profits tax and non-tax revenues. Faced with uncertainties on VAT receipts, the authorities cut spending on goods and services in the fourth quarter. Capital expenditure from domestic resources was also lower than budgeted. However, the wage bill exceeded the budgeted level, owing to a higher-than-envisaged increase in employment and promotion-related wage creep toward the end of the year, which will have carryover effects into 2005. Receipts from the EU budget were only one half of the level envisaged, and expenditure associated with the undrawn funds was not executed (Table 3).

Table 3.

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 percent of GDP, as the unadjusted figures contained only 11 months of VAT and excise tax.

On the basis of the macro framework presented by the authorities when the budget was adopted.

In 2005, foreign debt falling due was replaced by domestic debt.

General Government Operations in 2004

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Source: Ministry of Finance

9. Competitiveness remains satisfactory. The unit labor cost (ULC)-based real effective exchange rate (REER) and the relative profitability index have remained broadly unchanged since early 1998. The CPI-based REER has been relatively flat since mid-2003, consistent with the conclusion of recent IMF staff studies that the tolar appeared to be in line with its fundamentals1 (Figures 8 and 9). In recent periods, Slovene exporters have increased their presence in both EU and non-EU countries, and many have promoted market penetration through establishing affiliates abroad. However, the increase in EU market share has been smaller for Slovenia than for the neighboring new EU-member states (NMS), although Slovenia’s bilateral real exchange rate vis-à-vis these countries has depreciated (Figure 10).2 The better export performance of the neighboring NMS is likely a reflection of higher inflows of foreign direct investment and the associated preferential market linkages.

Figure 8.
Figure 8.

Slovenia: Exchange Rate Indicators, 1998-2004

(1998q1=100)1/

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.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 9.
Figure 9.

Slovenia: Wages, Productivity, and Product ULC in Manufacturing, 1998-2004

(1998q1=100)1/

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.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.
Figure 10.
Figure 10.

Slovenia: Competitiveness Indicators and Export Market Shares of Slovenia and Selected New EU Member States (1998q1=100), 1998-2005

Citation: IMF Staff Country Reports 2005, 253; 10.5089/9781451835755.002.A001

Sources: IMF Direction of Trade Statistics; and IMF staff calculations based on data from national authorities.1/ ULC in manufacturing in euros.2/ Ratio of Euro ULC between Slovenia and EU accession candidates. An increase indicates appreciatio3/ Calculated as the share of nominal exports of each individual country in the combined nominal import of the following countries: Austria, France, Germany, Italy, United Kingdom, and United States. The market share declines for all countries in 2004 because of higher prices of oil and commodity imports.

10. The build-up of external debt represents a potential vulnerability. With the increased external financing by banks, total external debt rose rapidly in the past two years to about 60 percent of GDP at end-2004. However, the net debt position was small, at below 10 percent of GDP. Short-term debt (on residual maturity basis) remained less than gross official reserves, though the debt ratio increased. The external debt service ratio was broadly unchanged (Table 4).

Table 4.

Slovenia: Vulnerability Indicators, 2000-04

(In percent of GDP, unless otherwise indicated)

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

Credit including loans and other claims.

Yield differential between 5.38 percent (coupon) Slovene eurobond maturing in 2010 and 5.38 percent (coupon) German government bond maturing in 2010.

NFS denotes nonfactor services.

Remaining maturity basis.

II. Report on the Discussions

11. The discussions centered on policy priorities for achieving smoothly the authorities’ goal of early euro adoption and for strong performance in the monetary union. The authorities were narrowly focused on the immediate main challenges: to implement policies that will lower average inflation to a rate that meets the Maastricht inflation criterion and to maintain exchange rate stability within the “normal fluctuation margins” of ERM2. They believed that continuation of current monetary conditions, restraint in administered price adjustments, wage moderation, and a neutral fiscal stance would enable achievement of the euro adoption goal. The staff thought that fiscal policy should adopt a more restrictive stance to reduce the risks to the disinflation objective. The authorities were less concerned than the staff about the risks, but would consider corrective policy measures as necessary. The staff noted that maintaining low inflation and competitiveness after euro adoption and addressing the budgetary implications of an ageing population would be continuing challenges, and advised faster progress in achieving the official medium-term goal of structural fiscal balance and in enhancing wage and fiscal policy flexibility.

A. Macroeconomic Outlook

12. There was consensus that economic growth would likely moderate to around 4 percent in 2005-06—an expansion still above estimates of potential and implying a further narrowing of the output gap. Domestic demand growth is expected to ease, owing to a further slowdown of inventory accumulation and the dampening effect of lower tax relief on investment that will come into force in 2006 (Table 5). While not ruling it out completely, the authorities perceived the risk of a pick-up in private consumption growth to be small. They pointed to various explanations why a domestic demand boom had not materialized in Slovenia and may be absent in the period ahead (Box 2). The staff agreed that the factors stimulating household saving in non-bank financial institutions and outflows of investible resources were likely to persist and that, with convergence of nominal lending rates virtually complete, bank credit growth should stabilize. However, in the event of a further acceleration in credit growth, the authorities would need to give consideration to appropriate offsetting policy response, particularly on the fiscal front.

Table 5.

Slovenia: Macroeconomic Framework, 2000-2009

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

Government capital transfers are not included in government investment. From 2006, it is assumed that measures to achieve the government’s goal of structural balance in the medium term are implemented.