Public Information Notice No. 98/3

Press Information Notice: IMF Concludes Article IV Consultation with Slovenia

January 26, 1998

The IMF Executive Board on January 9, 1998 concluded the 1997 Article IV consultation¹ with Slovenia .

Background

Aided by a favorable starting position, independent Slovenia took an early lead among Central and East European transition countries in stabilizing and transforming its economy: by 1996, inflation had been lowered to single digits, per capita income had returned to its pre-independence level, and the international reserves position had become very comfortable. After moderating from 5.3 percent in 1994 to 4.1 percent in 1995, real GDP growth slowed further to 3.1 percent in 1996. As in 1995, domestic demand was the driving force behind the expansion in 1996, but with a clear slowdown in the growth of private consumption and investment. During 1997 real GDP growth is estimated to have risen to 3.7 percent, mostly reflecting the recovery abroad. The rate of inflation has remained stuck in the 7-11 percent range since August 1995, reflecting the combined effect of nominal effective depreciation, price adjustments for petroleum products and electricity, and wage pressure.

Real wages continued to grow strongly in 1996 and early 1997 as nominal wage growth exceeded the guidelines of the social agreement between business, government, and labor. In the absence of a new social agreement for 1997, a freeze on wages of civil servants and a lower degree of indexation restrained wages for the rest of the year. In 1996 the (RPI based) real effective exchange rate depreciated for the first time since 1992 as a large reduction in social security contributions reduced unit labor costs and the tolar weakened in nominal effective terms. After reversing itself in the first half of 1997, real effective depreciation resumed in the second half as the U.S. dollar continued to strengthened. All real exchange rate indicators point to a relatively modest appreciation of some 5-10 percent since 1993.

A small current account surplus and large capital inflows led to a record balance of payments surplus in 1996. A strong deterioration of the current account in early 1997--in part reflecting imports that had been deferred to take advantage of customs tariff reductions--is expected to have been largely reversed by year-end as merchandise exports responded to recovery in the EU. Moreover, the exports of services, especially tourism and transport, continued to grow. With the current account in approximate balance, continued capital inflows, including official borrowing and stable inward direct investment of approximately 1 percent of GDP, are projected to have raised the reserve cover to more than 5 months of imports.

The persistent capital inflows have posed a serious dilemma for monetary policy. In an effort to reduce stubborn inflation while maintaining competitiveness, the Bank of Slovenia continued to control base money, while staving off mounting currency appreciation pressure through capital inflow restrictions and sterilized intervention. High domestic interest rates and greater selectivity on the part of banks restrained the growth of credit in 1997, thus creating some room for outright intervention. Domestic interest rates, although falling gradually, have remained high in real terms, reflecting their backward indexation, capital inflow restrictions, and lack of competition among banks.

A small surplus on general government operations was recorded in 1996, thanks to buoyant tax collections and tight expenditure control. A larger central government surplus provided the resources to finance large reductions in pension contribution rates during the year and offset the rapidly rising deficit of the pension fund. While expenditure was controlled tightly in 1997 until the budget was finally approved in December, the general government finances have come under increasing pressure, mainly reflecting 1996 wage concessions, the full-year effect of the lower pension contributions, growth in social transfers, and further customs tariff reductions in connection with the EU accession and CEFTA agreements. Notwithstanding that some spending in early 1998 will be included in the 1997 budget, tight budget execution during most of 1997 makes it likely that the overall deficit will be slightly lower than the 1.5 percent of GDP envisaged in the recently approved general government budget.

The transformation to an economy based on private ownership of the means of production continues to make progress: the private sector now accounts for more than one half of value added and employment. The privatization of socially owned enterprises is nearing completion, but privatization of state-owned enterprises has yet to begin. Following their financial rehabilitation, the privatization of the two large state banks (and that of other state assets) still awaits approval of enabling legislation. Other unapproved legislation includes banking, foreign exchange, privatization of state assets, institutional reform of public service providers, public sector accounting, civil service reform, major taxes, and the pension system.

Executive Board Assessment

Executive Directors noted that tight macroeconomic policies and basic structural reforms in the years following independence had allowed Slovenia to make rapid progress toward stabilization, resume economic growth, and to improve the prospects for early EU membership. However, recent delays in structural reforms and a weakening fiscal situation threatened to impede further progress on reducing inflation and maintaining growth. Directors therefore urged the authorities to seize the opportunity offered by the favorable external environment to reduce inflation further, to make the economy more efficient and flexible, and to enhance its growth potential. In this respect, they considered that vigorous implementation of structural reforms and the rebalancing of the policy mix toward tighter fiscal and incomes policies and away from overreliance on restrictive monetary policy were crucial. Several Directors also noted that confidence in macroeconomic policy making could be improved by better policy coordination, greater transparency of policies, and administrative and regulatory reform. A few Directors further emphasized the desirability of improving governance as it relates to economic management.

Directors viewed the emergence of a fiscal deficit in 1997 and the potential of its future widening with concern. They stressed therefore that, in line with their underlying objective of overall fiscal balance, the authorities should push for the early adoption of a balanced budget for 1998 and should adopt a credible plan to reduce the relative size of government in the economy. Directors suggested that fiscal adjustment be largely expenditure-based. Priority should be given to measures to rein in the growth of spending on wages, social transfers, and pensions. The authorities should also examine ways to deliver public services more efficiently, through contracting out and privatization, for instance. Directors broadly endorsed the authorities' tax and pension reform plans and urged the early introduction of a value-added tax at a uniform rate.

The recent adoption of an annual monetary program was welcomed as an important step toward greater transparency and accountability in monetary policy. The Bank of Slovenia should be unequivocal in its commitment to sustained disinflation as its principal objective and assume responsibility for setting the inflation objective. Directors noted that monetary policy had been complicated by heavy capital inflows induced by high domestic interest rates. They stressed the importance of early action to remove the financial market distortions that kept domestic interest at a large premium. The chief actions required were deindexation of financial contracts, increased competition between banks, disallowance of the interest rate agreement among banks, and opening up to foreign bank branching. Several Directors also were of the view that, as pressure from capital inflows subsides with the decline in interest rates, the authorities should proceed with a gradual dismantling of restrictions on inflows. A few Directors cautioned against any premature dismantling of capital restrictions, noting that this should be undertaken only after the financial sector had been strengthened.

Pointing to the tendency for the real exchange rate to appreciate in the transition process, Directors considered that some nominal appreciation seemed appropriate in the period ahead to promote disinflation. Directors cautioned the authorities about making premature commitments about price and nominal exchange rate stability, while the transition process remained incomplete and the conditions for a successful peg had not yet been established.

Directors welcomed the recent progress on tightening incomes policy and stressed the importance of keeping a tight rein on government wages and encouraging decentralized wage bargaining and result-oriented compensation in the nongovernment sector. Underscoring the importance of structural reform for sustainable growth and disinflation, Directors urged the authorities to move quickly to reinvigorate their stalled reform process. Progress was needed on many fronts to promote deindexation and price liberalization; strengthen corporate governance; privatize remaining socially-owned enterprises and state assets; make the labor market more flexible; and develop financial markets. In this context, the authorities were urged to do their utmost to help break the backlog of reform legislation. These measures would also improve the climate for foreign direct investment.

Directors welcomed progress in strengthening banking supervision and in the financial condition of banks, but noted that further improvement in the supervision of the financial sector was needed. Directors called for the speedy introduction of a comprehensive set of financial market legislation and encouraged the government to divest itself of its share in two rehabilitated banks and foster consolidation by mergers and acquisitions.