Republic of Slovenia
2006 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Slovenia

Slovenia is set to become the first among the new European Union member states to adopt the euro. Executive Directors emphasized the need to implement policies that increase productivity, create an efficient business environment and a flexible labor market, and improve sustainability of public finances in the face of population aging. Labor participation is also relatively low among the older and younger working-age population. To deal with these challenges, the authorities should speed up efforts to raise labor utilization by lowering marginal tax rates, improving the target of social benefits and reducing incentives for early retirement.

Abstract

Slovenia is set to become the first among the new European Union member states to adopt the euro. Executive Directors emphasized the need to implement policies that increase productivity, create an efficient business environment and a flexible labor market, and improve sustainability of public finances in the face of population aging. Labor participation is also relatively low among the older and younger working-age population. To deal with these challenges, the authorities should speed up efforts to raise labor utilization by lowering marginal tax rates, improving the target of social benefits and reducing incentives for early retirement.

I. Introduction

1. Slovenia is set to become the first among the new EU member states to adopt the euro. Aided by broadly favorable initial conditions and generally sound macroeconomic and incomes policies, Slovenia has over the past decade sustained robust growth with small external imbalances, while gradually lowering inflation to euro–area levels. Long–term interest rates, the fiscal deficit, the public debt ratio, and inflation were all within the Maastricht Treaty limits at end–2005. This, combined with the tolar’s two successful years within the ERM2, has set the stage for euro adoption in January 2007.

A01ufig01

Growth has been strong over the past decade.

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Source: World Economic Outlook.

2. The achievements notwithstanding, Slovenia faces structural challenges that need to be addressed to ensure success in the euro zone. Although Slovenia’s gradualist approach to reform has contributed to macroeconomic stability, it has left the country with many structural rigidities—notably an inflexible budget, a welfare system that discourages labor participation, and a restrictive business environment. The loss of the exchange rate instrument puts a premium on softening these rigidities. Over the longer horizon, Slovenia’s population aging is expected to be among the most rapid in Europe, creating strong fiscal pressure through higher pension and health spending. Combined with a productivity growth lagging behind that of the other new Central European EU members (NM–8), this demographic trend could also weaken the growth potential. With the near–term outlook largely benign, the Article IV consultation focused on how to deal with these medium– and longer–term challenges.

A01ufig02

Slovenia has lowered inflation to euro area levels.

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Source: World Economic Outlook, IMF.1/ Average for Czech, Estonia, Hungary, Latvia, Lithuania, Poland, and Slovakia.
A01ufig03

But progress in implementing structural reforms has been less impressive.

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Source: EBRD Transition Report, 2005.1/ Simple average across all categories surveyed. The closer the average is to 4 the closer the economy is to “the standards of an industrialized market economy.”

II. Background

3. Strong growth continued in 2005, bringing output close to potential (Table 1, Figures 1 and 2). In 2004, GDP growth reached a five–year peak of 4¼ percent, fueled by EU–accession–related investment, including inventory accumulation. Although the subsequent unwinding of inventories slowed domestic demand, growth in 2005 at 3.9 percent remained above the estimated potential of 3¾ percent, driven by strong exports. Consumption continued to contribute to growth, buoyed by real wage increases (of around 2 percent) and booming consumer loans. The strong activity boosted job creation, especially in services, and unemployment remained low at 6½ percent even as participation rates improved slightly. These trends, and the increase of the capacity utilization rate to the highest level in a decade, suggest that the output gap has been closed almost fully.

Table 1.

Slovenia: Selected Economic Indicators, 2000–08

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

For 2006–08, Spring 2006 forecasts of the Slovene Insitute of Macroeconomic Analysis and developments.

Revenue and expenditure exclude social security contributions paid for government employees.

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.

For deposits with maturity between 31 days and 1 year.

Figure 1.
Figure 1.

Slovenia: Economic Indicators, 1999–2007

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Sources: Bank of Slovenia; Ministry of Finance; Statistical Office; and IMF staff projections.1/ Fiscal deficit and public debt as of end–2005; interest rate as of February 2006; inflation rate as of March 2006.
Figure 2.
Figure 2.

Slovenia: Labor Market Indicators, 2000–05

(y–o–y percent change, unless otherwise indicated)

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Sources: Employment Service of Slovenia; Monthly Bulletin, Bank of Slovenia; WEO; and IMF staff estimates.1/ 2005 LFS data refers to third quarter.2/ For 2005, data refer to the second quarter.

4. In keeping with its record of fiscal prudence, Slovenia maintained a tight fiscal stance in 2005 (Table 2). In a performance setting it apart from its Central European peers, Slovenia has maintained low fiscal deficits, with public debt below 30 percent of GDP. In 2005, the general government deficit, at 1.1 percent of GDP, was below target, due to one-off municipal revenues and lags in spending EU transfers.1 Tax revenues were buoyant, reflecting the recovery of indirect taxes from a temporary drop following EU accession. Adjusting for cyclical effects, the deficit implied a neutral fiscal stance for the year.

A01ufig04

Slovenia has maintained a conservative fiscal policy with low deficits and debt.

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Source: World Economic Outlook.1/ Net debt for Hungary.
Table 2.

Slovenia: Summary of General Government Operations, 2003–08 1/

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

Based on GSF 1986, unless otherwise indicated.

5. With limited scope for independent central bank action, monetary conditions tightened only marginally in 2005(Table 3 and Figures 3). Having set its key policy interest rate at 4 percent upon entering ERM2 in 2004, the BoS maintained the rate at that level through 2005. However, a surge in short–term capital inflows prompted reductions in February and March 2006 by 25 basis points each. Together with the recent increases in European Central Bank (ECB) rates, this narrowed the tolar–euro interest rate differential from 2 to 1 percent. Yet, the tolar–euro exchange rate has remained stable, aided by BoS swap operations.2 With a broadly unchanged REER and lower inflation, the BoS stance implied a slight tightening of monetary conditions in 2005.

Table 3.

Slovenia: Monetary Survey, 2000–05

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Source: Bank of Slovenia, Monthly Bulletin.
Figure 3.
Figure 3.

Slovenia: Monetary Conditions, 2000–06

(In percent)

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

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

6. In the context of broadly neutral macroeconomic policies, wage discipline has supported disinflation (Figures 4 and 5). Despite the diminished slack in activity, core inflation more than halved—to less than 1 percent—during 2005, owing to lower tolar depreciation expectations, increased competition following EU accession, and prudent macroeconomic and incomes policies. In particular, guidelines setting wage growth below that of productivity helped minimize second–round effects of energy price shocks. The benign core inflation led headline inflation to a historical low of 2½ percent during the year.

Figure 4.
Figure 4.

Slovenia: CPI Inflation and Components, 2000–06

(Year–on–year change, in percent)

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Sources: Statistical Office of the Republic of Slovenia; Eurostat; and IMF staff calculations.
Figure 5.
Figure 5.

Slovenia: Wages and Productivity, 1998–2005

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.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.

7. The current account moved to near balance in 2005, with strong export performance more than offsetting the impact of a terms–of–trade deterioration (Table 4 and Figures 6). The growing importance of Slovenia as a gateway to, and investor in, Southeastern Europe (SEE) boosted exports of services, especially tourism, transport, and construction. Despite the higher oil prices, moderation in domestic demand slowed nominal merchandise import growth to 11½ percent from over 16 percent in the previous year, while merchandise exports, led by cars, continued to grow by 12 percent. On balance, the current account deficit narrowed to about 1 percent of GDP from 2.1 percent in 2004.

Table 4.

Slovenia: Balance of Payments, 2000–10

(In millions of euros, unless otherwise noted)

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Sources: Bank of Slovenia; and IMF staff prorections.

A negative number indicates net creditor position.

Stocks and flows may not reconcile due to valuation changes.

Figure 6.
Figure 6.

Slovenia: External Sector Developments, 2001–05

(In percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Sources: Monthly Bulletin, Bank of Slovenia; and IMF staff calculations.
A01ufig05

Inflation declined in 2005 despite an increase in administered prices.

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Strong net service exports were the main determinant of the narrowing of the current account.

8. Despite the favorable external performance, indicators of competitiveness show a mixed picture (Figures 79). Measures of price competitiveness appear satisfactory, as evidenced by a stable real effective exchange rate and flat unit labor costs. Also, estimates of the equilibrium real exchange rate do not indicate a misalignment (see, for example, IMF Working Paper 05/27). However, in recent years Slovenia has underperformed regional competitors in gaining markets in EU–15 and world markets, and total factor productivity growth has lagged the NM–8, as has the pace of upgrading the quality and skill content of exports (Box 1 and SIP). Indeed, in 2005 manufacturing wages in Slovenia, adjusted for productivity, remained the highest among the NM–8.

Figure 7.
Figure 7.

Slovenia: Exchange Rate Indicators, 1998–2005

(1998q1═100) 1/

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.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 trading partner countries relative to those in Slovenia, adjusted for manufacturing producer price inflation–a rough indicator of developments in profitability.
Figure 8.
Figure 8.

Slovenia: Wages, Productivity, and Product ULC in Manufacturing, 1998–2005

(1998q1═100) 1/

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Sources: Statistical Office of the Republic of Slovenia; and IMF staff calculations.1/ Seasonally adjusted. 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/ Defined as the ratio of nominal wages to producer price index.3/ Defined as the ratio of real product wages to productivity.
Figure 9.
Figure 9.

Slovenia: Competitiveness Indicators and Export Market Shares of Slovenia and New Member States

(1998q1═100), 1998–2005

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.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 appreciation.3/ Calculated as the share of nominal exports of each individual country in the combined nominal imports of the following countries:Austria, France, Germany, Italy, United Kingdom, and United States. The share declines for all countries in 2004 because of higher oil and commodity imports.

Slovenia: Sources of Current Account Improvement, 2005

(Change in millions of euros over the same period of previous year)

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Sources: Bank of Slovenia; and staff estimates.Sources: Bank of Slovenia; and staff estimates.
A01ufig06

Wage growth has been moderating, ensuring lower unit labor cost pressures over the past few years.

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Sources: Statistical Office of the Republic of Slovenia; and staff calculations.
A01ufig07

Total factor productivity trails regional peers.

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Source: World Economic Outlook, IMF.1/ CEE-4 consists of Czech Republic, Hungary, Poland, and Slovak Republic.
A01ufig08

Slovenia’s manufacturing wages, adjusted for productivity, are relatively high.

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Sources:Country authorities; and staff calcualtions.
A01ufig09

Slovene exports have been unable to increase market penetration in the EU–15.

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Source: Direction of Trade Statistics, IMF.Note: Calculated as the share of nominal exports of each individual country in the combined nominal imports of EU 15 and the US.

Trends in the Skill and Technology Content of Exports

Slovenia’s competitive position in the high-tech industries of the EU–15 is eroding as regional competitors gain markets at a faster pace. Revealed comparative advantage indicators—Slovenia’s high–tech export share relative to that of the world—show that, although Slovenia had a strong initial competitive position, other NM–8s are catching up fast.

A01ufig10

Revealed Comparative Advantage of High–Tech Sector, 1994–2004

(Ratio)

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

The pace of quality improvement has also been slower than in the other NM–8s. The change in unit value ratios (UVRs) of Slovene exports—a proxy for quality—has been lagging behind that of NM–8 exports. This is linked to Slovenia’s small gains in market share in EU–15. A possible explanation is Slovenia’s relatively favorable initial position, which reduces the scope for catch–up. But, given the low FDI, Slovenia may have missed opportunities to gain from technological spillovers and market linkages.

A01ufig11

Change in Market Share versus Change in UVR, 1994–2004 (Ratio)

Citation: IMF Staff Country Reports 2006, 249; 10.5089/9781451835779.002.A001

Source: COMTRADE; and staff calculations.

9. Cross–border flows increased in 2005, signaling closer integration with global financial markets in the run–up to euro adoption (Table 5). With domestic interest rates declining toward EU levels and the local stock market underperforming, investors sought to diversify their portfolios to higher yielding markets abroad. In particular, households’ appetite for foreign–oriented mutual funds and firms’ direct investment abroad increased. Also, as deposits were declining as a source of funding, banks resorted to longer–term foreign borrowing—mostly at variable rates and with higher liquidity risk—to meet the strong demand for credit. Although gross external debt increased rapidly as a result, net debt remains at 20 percent of GDP, which together with the imminent euro adoption and a one–to–one reserve cover of short–term liabilities suggests resilience to sudden changes in market conditions.

Table 5.

Slovenia: Vulnerability Indicators, 2000–06

(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 2010 and 5.38 percent (coupon) German government bond maturing 2010.

NFS denotes nonfactor services.

Remaining maturity basis.