Slovenia has fulfilled all Maastricht convergence criteria for the adoption of the euro. Following the recommendations by the EU Commission and the European Central Bank, on June 15 and 16, 2006 the European Council gave the political go–ahead for Slovenia’s adoption of the euro on January 1, 2007. When the EU finance ministers will meet on July 11, 2006, they are expected to formally adopt the decision and to fix the parity between the Slovenian tolar and the euro. On June 2006, the European Commission proposed that with effect from January 1, 2007, the exchange rate be fixed at 239.640 Slovenian tolars for one euro, which is the central rate at which the Slovenian tolar entered ERMII two years ago. Slovenia will become the 13^th EU member state to adopt the euro as of January 1, 2007. These milestones crown the substantial efforts invested by the Slovenian people into what has become a national project. However, as discussed during the staff discussions for the Article IV consultation held in March 2006, the agenda is not yet finished, either on the macroeconomic or on the structural front.

The staff discussions showed a broad agreement between the authorities and the staff team on the major policy issues.

Recent economic developments: economic activity, fiscal and monetary policies and inflation

Economic trends in Slovenia remain broadly favorable. In the first quarter of 2006, economic growth was 5.1 percent year on year. For 2006 as a whole, the authorities’ growth estimate is the same as the staff’s (4.2 percent) and– like the staff’s forecast– slightly lower in the next two years.

The Government’s Framework of Economic and Social Reforms adopted last November is designed to significantly improve the competitiveness of the economy and to impart a new momentum to growth for the period beyond 2008. The authorities are now considering several important reform measures.

On the fiscal front, tax reform aimed at lowering the burden on labor is high on the agenda. The plan is to specify all its elements by autumn– after taking into consideration the advice of the IMF’s Fiscal Affairs Department mission which will visit Ljubljana in July– and to have the reform ready for implementation in 2007. On the expenditure side, the Employment and Insurance Against Unemployment Act, which is being currently discussed in the Parliament, aims at better linking unemployment benefits to active job search and at making the benefits system more transparent. A Social Protection Act, which would require greater work effort by the recipients of social benefits is also being discussed in the Parliament.

Finally, the Ministry of Finance, with the help of the IMF’s Regional Public Financial Management Advisor, is planning to address more systematically the issue of expenditure efficiency and flexibility, as discussed with the staff, by improving budget procedures. It is intended that work in this area will start with pilot projects in the fields of primary education and family allowances.

As for wages, agreements were reached in June for adjustments in both private sector and public sector wages. An increase of 2 percent was agreed for private sector wages in 2006 and 2007. For public sector wages, an increase of 2.35 percent will apply for 2006. However, only about half of this increase will, in effect, be disbursed in 2006 and the rest being retained until 2007 and then used for the elimination of wage disparities in line with the new collective agreement. Thus, the general increase in wages is in line with expected inflation.

Earlier this year, the Bank of Slovenia started to align its interest rates with those of the ECB. On June 8, 2006, the Bank cut the interest rate on 60–day tolar bills by 0.25 percentage points to 3.25 percent. The objective of this move– which was made in parallel with the ECB’s interest rate increase– was to make Slovenian tolar instruments less attractive for banks, and to encourage them to replace tolar bills with European money market instruments.

There has been no significant excess supply of or demand for foreign exchange in the markets since Slovenia joined ERM II, which indicates that the central rate is sustainable in the long run. Since Slovenia has joined ERM II and up until June 2006, the average differential between the exchange rate in the spot market and the central rate was 0.06 percent

In May 2006, the EMU convergence price index in Slovenia was 2.4 percent, up from 2.3 percent in the previous month but by 0.3 percentage point below the convergence criterion. Inflation was one of the toughest challenges faced by Slovenia in meeting the Maastricht criteria. Helped by the Bank of Slovenia’s moderately restrictive monetary policy, and coordination between the monetary, fiscal and other macroeconomic policies, the inflation criterion has been met since last November. The Bank of Slovenia forecasts the average inflation rate to be 2.2 percent for 2006 and 2007, and 2.6 percent for 2008. Challenges going

Challenges going forward

Keeping the macroeconomic environment supportive of sustained growth will require vigilance on several fronts:

* Maintaining long–term sustainability of the general government budget and its compliance with the Stability and Growth Pact (SGP), as well as providing an adequate safety reserve in the public finances. With regard to demographic changes and the ageing population, further reform measures will be necessary, especially in the pension and the health systems, as well as other policies. The Framework for Economic and Social Reforms provides for some preventive measures. These include in the public pension system, raising the participation of the elderly in the work force so as to increase the retirement age. In the private pension system, it is intended to provide incentives to enhance the coverage of voluntary funded pension schemes and to increase the contribution of individuals to these schemes. It will also be essential to increase public awareness of the implications of the demographic shift.

* Containing the wage growth. The social agreement for the period 2006– 2009 is still being negotiated. Its overall objective is to prevent an increase in wages not justified by a corresponding rise in productivity in either the private or the public sector. The plan is to keep – for the time being – the average wage growth lagging behind productivity growth.

* Keeping inflation in check. Some inflationary pressures may continue in the short run, but in the long run there are no major risks to price stability, assuming the continuation of a moderate growth in labor costs and relatively balanced growth in aggregate supply and demand. The low level of core inflation and the expected absence of higher energy prices feeding through into other prices are the two most important arguments supporting this position.

The pressure, brought by rounding following the euro adoption, is expected to be limited and temporary as it would be forestalled by the mandatory informative dual pricing effective from March 1, 2006 until six months after the euro adoption. However, there is the risk associated with the possible Value Added Tax (VAT) increase, the rise in excise duties and the relaxation in administered price policy, in particular in the energy sector. There is also the risk associated with higher oil prices. At the same time, the key tools already tested in the disinflation process, such as the government–backed plan on regulated prices for the period 2006– 2007, will continue to be in place also after the euro adoption.

* Managing financial sector risks. The process of financial integration with the European Union (EU) has increased both the dependence on financial conditions abroad and the competition among banks. In 2005, interest rate risk increased, and credit risk diminished. Euro adoption will significantly reduce the exchange rate risk. Managing risks, the interest risks in particular, will become very important in the increasingly uncertain international environment. The Bank of Slovenia is considering stepping up its banking supervision activities and engaging in a constructive dialogue with the banks in order to improve risk management further.

* Supporting structural reform. The government–backed reform package proposes measures aimed at increasing the flexibility of the economy. These will comprise deregulation of product markets and promotion of competition. Also, steps to secure greater labor market flexibility are on the agenda. These include greater regional, professional and educational mobility, greater flexibility of employment protection, and more flexible forms of employment. All these measures could contribute to greater macroeconomic stability and higher economic growth.

Conclusion

The fulfillment of the Maastricht convergence criteria, the favorable forecasts and the positive expectations of European institutions indicate that Slovenia is ready to adopt the euro. This step will mark the de jure conclusion of the task of integration that started with the European Agreement in June 1996. The Slovenian authorities are aware that in de facto terms, this task is not yet over and depends on the successful implementation of the reform agenda.