Public Information Notice No. 05/97

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Republic of Slovenia

July 28, 2005

On July 20, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Slovenia.¹

Background

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. Investment growth slowed, owing to a smaller contribution from inventory accumulation. Exports rose markedly in response to stronger import demand in the main trading partners. However, because of a deterioration in the terms of trade on account of higher oil and commodity prices, the external current account deficit widened to almost 1 percent of GDP. Competitiveness remained adequate. However, owing to increased external financing by banks to fund their lending activities, total external debt rose sharply.

Progress with disinflation continued, notwithstanding higher oil prices, a pickup in producer prices, and a narrowing of the output gap. Year-on-year inflation 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. An improved harvest, the elimination of remaining duties on imports from the European Union, and increased competition in the retail market resulted in lower food prices and moderate increases in the prices of non-food items. Disinflation was additionally reinforced by the widening of the gap between real wage increases and productivity growth and by the stabilization of the exchange rate after ERM2 entry on June 28, 2004.

The monetary framework changed following ERM2 entry and monetary conditions became tighter. However, with further convergence of tolar lending interest rates and increased competition in the banking sector, bank credit accelerated. The pickup in credit growth was particularly strong for individuals. Upon ERM2 entry, the Bank of Slovenia ended its depreciation policy and set the central parity to at SIT 239.64 per euro, close to the then-prevailing market rate. Since then, the market rate has not deviated from the central parity by more than ±0.20 percent, and the Bank of Slovenia has kept its key policy interest rate (on 60-day bills) unchanged at 4 percent.

The general government deficit in 2004, at 1.4 percent of GDP, was lower than envisaged in the budget, but the expenditure structure became more rigid. Faced with uncertainties about 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.

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. In addition, factors that led to higher household saving in 2004 are likely to persist. The stimulus to growth from net foreign demand would be small in the foreseeable future. Export growth would ease in line with projected import demand in Slovenia's main trading partners, and the rising trend in import content of domestic demand is likely to continue. With higher oil prices contributing to a further deterioration in the terms of trade, the external current account is projected to widen to 1½ percent of GDP in 2005. The authorities expect average inflation of about 2½ percent in 2005. The revised 2005 budget envisages a broadly neutral fiscal stance.

Following EU accession and ERM2 entry in 2004, the authorities are concentrating on securing a smooth transition to euro adoption in early 2007.

Executive Board Assessment

Executive Directors congratulated the authorities for Slovenia's entry into the European Union and ERM2 in 2004 and subsequent strong economic performance. Directors considered that, taking into account the degree of real convergence with other EU economies, its competitiveness, and the fact that it already meets the Maastricht criteria for long-term interest rates, the fiscal deficit, and public debt ratios, Slovenia is well positioned to adopt the euro in early 2007. However, risks remain: although disinflation has continued, meeting the Maastricht inflation criterion during the assessment period (June 2005-June 2006) will be challenging, as will sustaining low inflation after euro adoption. The authorities will also need to address the budgetary implications of an aging population in order to meet the medium-term balanced budget objective.

Directors agreed that, given the intended policy stance, inflation in 2005-06 is likely to be modest, but they cautioned that higher oil prices, continued faster-than-potential economic growth, and larger-than-expected producer price increases could create upside inflation risks. They welcomed the authorities' readiness to take corrective measures—including monetary tightening—if signs emerged that inflation would exceed the target or that the Maastricht inflation criterion would be jeopardized. They emphasized, however, that the scope for monetary tightening to have its intended effect on inflation within the assessment period would become smaller as the end of the period approached. Directors supported the Bank of Slovenia's intention to keep policy interest rates unchanged, unless forced otherwise by market conditions.

Directors commended the authorities for their track record of prudent fiscal policy. They stressed the importance of maintaining a fiscal stance consistent with the aim of lowering inflation, as envisaged in the revised 2005 budget, which will also contribute to putting the public finances on the path to meet the official medium-term goal of structural balance. At the same time, the need to safeguard investment expenditure to support future economic growth was recognized. Directors noted that further fiscal consolidation would create room for higher spending within the Stability and Growth Pact (SGP) deficit threshold in case of adverse cyclical conditions.

Directors called on the authorities to strengthen their efforts to increase budgetary flexibility, noting the relatively large proportion of nondiscretionary spending in the overall budget. These expenditures should be contained, including through the reform of social entitlements and health care; restrictions on non-selective promotions; and a slower increase in public sector employment. Changes in pension indexation that result in higher pension payments should be avoided. In that light, Directors encouraged the authorities to consider linking pensions to inflation—rather than to wage growth, as is currently being considered—and addressing the issue of pension indexation in the framework of a comprehensive reform to ensure the long-term soundness of the pension system. They cautioned against further lowering payroll taxes, unless mechanisms are in place to ensure that the resources thus released are not used for wage increases.

Directors welcomed the indications that productivity growth was continuing to outpace the growth of real wages, and noted that wage restraint and greater wage flexibility will be crucial for adjusting to asymmetric shocks in the euro area. Directors urged the authorities and social partners to eliminate wage indexation in the Social Agreement for 2006, and to adopt a wage setting system that allows greater productivity-based differentiation of wages. Directors recommended that a wage pact at the national and enterprise levels be considered if achievement of the Maastricht inflation criterion was threatened.

Directors noted that Slovenia's banking system remains sound, with the banks adequately capitalized and profitable and their asset quality high. At the same time, due to stiff competition and interest rate convergence, banks are vulnerable to further margin compression in the transition to euro adoption. In addition, the high share of assets held by banks with fixed interest rates and longer maturities may raise their interest rate risks, and increased corporate borrowing in euro may raise their credit risks. Directors therefore welcomed the Bank of Slovenia's intention to maintain tight oversight of financial institutions and to monitor closely banks' exposure to credit and interest rate risks. They encouraged the authorities to enhance the supervision of insurance companies and to ensure that these companies have the capacity to set pricing, provisioning and capital at appropriate levels.

Directors observed that the growth of the economy over the past decade could be attributed in large part to the authorities' sustained structural reform efforts, but that much remained to be done in this area. Labor market flexibility needs to be improved, including by reducing employment protections, and the problem of the long-term unemployed addressed. Directors welcomed the consideration being given to further privatization, and the increased competition in the electricity and gas markets, and urged that this be extended to other sectors, such as telecommunications. Directors encouraged the authorities to simplify administrative procedures and regulation and further strengthen the business environment, which would help to attract higher levels of foreign direct investment and make the economy even more dynamic in coming years.