Economic activity and balance of payments

Economic growth is projected to stay close to 4 percent in 2005 and 2006, down from 4.6 percent in 2004. The year-on-year rate of growth slowed from 4.3 percent in the fourth quarter of last year to 2.6 percent in the first quarter of this year, largely reflecting a sharp decline in gross capital formation. Other domestic demand components are in line with the projections. In the first quarter of 2005 seasonally adjusted GDP increased by 0.9 percent.

As a result of a better performance of the trade balance, the current account recorded a slight surplus in the first five months of 2005. Exports in this period were 12 percent higher than one year ago. Imports increased less than exports. The contribution of the foreign component to the first quarter economic growth was positive (1.3 percentage points). Nevertheless, the Bank of Slovenia expects a widening of the current account deficit from 0.9 percent of GDP in 2004 to 1.6 percent of GDP by the end of this year. The expected weakening of foreign demand, the deterioration in the terms of trade as well as the decline in net capital income are the most important causes of this worsening.

Inflation

In 2005, inflation has continued its downward path. Annual inflation was brought down from 3.2 percent in December 2004 to 1.9 percent in June 2005. The favorable disinflation reflects, in no small measure, sound and coordinated macroeconomic policies. Lower food prices, helped by the changes in the trade regime following the EU entry, also made an important contribution. The Bank of Slovenia’s April 2005 Monetary Policy Report projects stabilization of inflation at 2.4 percent by the final quarter of this year, and at 2.6 percent by the final quarter of next year. The envisaged gradual increase in inflation should be seen against the backdrop of strong disinflation recorded in the second half of 2004 after the EU entry in May 2004. The risks to the inflation projection stem mainly from further increases in oil prices. The inflationary pressures from increased domestic demand are moderate. Still, support from fiscal policy and the social partners will be essential for continuing the downward trend in inflation.

Fiscal policy

In June 2005, the Parliament approved the revised budget for 2005 which envisages a deficit of 1.4 percent of GDP, compared with a deficit of 1.7 percent of GDP projected in the initial budget adopted in December 2003. There is a clear commitment to sustain the path of fiscal consolidation in line with the medium term fiscal objective, which will support the euro adoption process by contributing to a sustainable decline in inflation. Preparations for the two-year 2006/2007 budget have already started.

The Government is working on changes in two areas. In the health system, the changes are aimed at streamlining the basic benefit package and at increasing some benefits for the lower income population. In the pension system, the changes include an adjustment of the pension indexation formula in order to make the pension increases consistent with the wage growth.

The recent analysis prepared by the Institute of Macroeconomic Analysis and Development (IMAD) on the challenges ahead, especially those related to euro adoption, underlines the positive contribution of fiscal policy to macroeconomic stabilization, and calls for increased flexibility on the expenditure side, especially in the face of the high share of non-discretionary spending related to wages and social transfers. This would be important in order to release fiscal resources for investment and co-financing of EU funds.

Monetary policy and exchange rate

The Bank of Slovenia has kept its policy rates unchanged, except for the refinancing rate. On two occasions, in December 2004 and in April 2005, it raised its refinancing rate by a total of 0.5 percentage points. The refinancing rate, currently at 3.5 percent, exceeds the ECB’s rate by 1.5 percentage points.

In the first six months of this year, the market rate moved in an even closer corridor around the central parity, compared with the first six months following Slovenia’s ERM2 entry on June 28, 2004. The deviation of the market rate from the central parity did not exceed 0.06 percent. In this period, the Bank of Slovenia also did not intervene in the foreign exchange market. In the twelve months-period until May 2005, the real effective exchange rate of the tolar depreciated by only 0.1 percent.

Financial sector

The Financial Stability Report published by the Bank of Slovenia in June 2005 points out that Slovenia’s banking system, capital market and insurance sector are sound and resilient to macroeconomic shocks, and compare favorably to those of other EU members. In the absence of major disruptions in the present trend of economic activity in Europe and in Slovenia, there are no serious reasons for concern. Nevertheless, the Report concludes that effective oversight of the financial system will be essential in the period leading to euro adoption.

The banking system strengthened but the demanding external environment does not allow for complacency. The Banks’ capital ratio is solid at 11.8 percent. Also, profitability has increased owing mainly to strong non-interest income. The share of non-performing loans in bank portfolios amounts to a mere 3 percent, and the overall quality of the banks’ portfolio is improving. The foreign exchange risks are manageable in light of the smooth process of transition to the euro that has already started in banks. Nevertheless, rapid growth of lending combined with easing loan standards in the face of intensifying competition, increased income variability and declining interest rate margins expose the banks to new risks. To sustain the current favorable position, the Bank of Slovenia is urging the banks to stay prudent and vigilant, and to enhance risk management, especially with regard to the interest rate risks. In parallel, the Bank of Slovenia will be further strengthening the banking supervision capacity and monitoring.

The insurance sector is performing relatively well. The coverage of technical provisions by assets recorded a level of 111 percent at the end of 2003. In 2004, insurance companies also improved their capital adequacy as measured by the surplus of the available capital above the required minimum capital.

The claims ratio for credit insurance, which accounts for only 2 percent of insurance companies’ total collected premium, improved significantly from the previous years to 0.66 in 2004. In view of the low proportion of credit insurance and the trend of decreasing proportion of new banking loans insured by insurance companies (the proportion of new loans insured by insurance companies fell by 0.6 percentage points to 2.2 percent from the end of 2003 to the end of February 2005), there are no serious reasons for concern about the transfer of credit risk from the banking to the insurance sector.

Euro adoption

Slovenia comfortably complies with four of the five Maastricht criteria, and has stepped up efforts to meet the fifth, i.e. the inflation criterion. At the end of 2004, public debt amounted to 29.4 percent of GDP and the budget deficit was at 1.9 percent of GDP, well below the respective 60 percent and 3 percent targets. Moreover, at 4.3 percent, long term interest rates are well within the actual limit of slightly above six percent. Also, the exchange rate has been stable. In June 2005, the 12-month average price inflation as measured by the EMU convergence price index dropped to 3.0 percent and lowered the difference to the EMU convergence criterion from 1.8 percentage points in July 2004 to 0.7 percentage points.

Half way down the two-year ERM2 path, Slovenia has demonstrated the sustainability of its macroeconomic policy required for the euro adoption. It intends to introduce the euro as its legal tender on January 1, 2007, subject to positive convergence reports by the European Commission and the European Central Bank and the approval of the European Council, and following the irrevocable fixing of the tolar/euro exchange rate expected to be decided in June 2006. A one- year testing period that will inform the convergence reports has started in June 2005.

The January 2005 master plan for the euro changeover was endorsed by the Bank of Slovenia and the Slovenian Government and builds on the November 2003 joint program for euro adoption. The joint program defines the responsibilities for meeting the euro adoption targets. The master plan sets the stage for resolving technical aspects of this process. The technical preparations are coordinated by a special committee co-chaired by the Bank of Slovenia and the Ministry of Finance. The committee includes a number of institutions each entrusted to prepare their action plans and reports on implementation. Slovenia plans to adopt the euro under the Big Bang scenario which provides for one week of dual circulation of tolars and euros. To increase public awareness of the functioning of the economic and monetary union and to provide practical advice, communication with the households and the business community, especially the financial sector, has already been enhanced. The introduction of the dual display of prices is envisaged by March 1, 2006.

Structural issues

In June 2005, the Government endorsed Slovenia’s new strategy for sustainable development that sets five priority areas and defines targets, actions and milestones for the period until 2013. On the economic front, improving competitiveness, deregulating the economy, adjusting the social model, enhancing innovation and investments into research and development, addressing the problem of ageing population, are its most important pillars.

Conclusion

Coordination of all economic policies will be key to meeting the conditions for adopting the euro. Monetary policy needs to preserve exchange rate stability. Fiscal policy has to continue the gradual fiscal consolidation process, enhance the quality of public finance and contribute to offsetting inflationary pressures. The social partners must make sure that the wage growth in all sectors lags behind the productivity growth by at least one percentage point. The government should allow only a moderate growth of administered prices. The financial supervision must ensure the stability of the financial sector. A favorable external environment would help, and a bit of luck would also be welcome.