Mission Concluding Statement 

Slovenia: Staff Concluding Statement of the 2017 Article IV Mission

March 28, 2017

Slovenia is enjoying a fourth consecutive year of steady economic growth that has lifted wages and employment. Moreover, financial stability has improved and the external position has strengthened. Yet challenges remain. Public debt has declined from its peak but remains high, bank balance sheets have been strengthened, but the NPLs of SMEs are proving stubborn, and the economy’s potential growth rate is low. A set of mutually-reinforcing policies can address these challenges: a credible reform-based fiscal strategy would lower public debt, continued supervisory and regulatory vigilance would help maintain financial stability, and further labor market reforms and privatization would support higher growth.

1. Sustained efforts to restore financial stability and pursue prudent macroeconomic policies are paying off well for Slovenia. In 2014–16, real GDP grew by 8.1 percent cumulatively, employment by 2.9 percent, and real wages by over 4 percent. [1] Growth has become more balanced recently. In 2016, private consumption accelerated, supported by improvement in sentiment and sustained wage and employment gains. Although public investment was nearly halved, reflecting lower absorption of EU funds, strong private investment––mainly in the export-oriented manufacturing segment––offset some of the decline. Amid robust trading partner demand, closer integration in regional supply chains, and competitiveness gains, exports remained a major driver of growth. Unemployment declined further, while remaining elevated at 7.9 percent.

2. We expect further robust growth in 2017, but the medium-term outlook is less favorable. We project 3 percent GDP growth in 2017, closing the output gap. Private consumption will remain strong, aided by continuing employment and wage growth. Private investment should continue its 2015 rebound, with capacity utilization near historic highs, strong profitability, and comfortable financing. Public investment should grow strongly as well if the absorption of EU structural funds recovers as expected. Supported by rising demand in trading partners, exports should continue boosting growth, external risks notwithstanding. Robust economic activity and rising commodity prices will raise inflation toward 1¾–2 percent, dispelling deflation risks. Over the medium term, the growth picture is less favorable with annual rates converging to the estimated potential growth rate of 1¾-2 percent. This low potential growth rate is constrained by adverse demographic trends and sluggish TFP growth.

3. Financial stability and Slovenia’s external position have improved considerably. Banks’ capital position is strong, and liquidity ample. The decline in bank credit has bottomed out, with credit to households growing robustly. The steady decline in NPL ratios has strengthened bank balance sheets, and the corresponding release of provisions has raised bank profitability. On the external side, the current account surplus widened to 6.8 of GDP in 2016, contributing to an improvement in the net IIP position by 4 percent of GDP.

4. Despite these successes, important challenges remain. Slovenia’s GDP and employment remain below their pre-crisis levels. Bank recapitalizations and the two recessions since 2008 nearly quadrupled public debt by 2015. Fiscal consolidation since 2011 has relied on a mix of structural reforms and one-off measures, with the latter now being reversed. While the pace of bank balance sheet repair has been fast by international standards, SME NPLs remain elevated, preventing indebted, but sound SMEs from borrowing. Moreover, banks’ business models are under pressure. Improving the functioning of the labor market and accelerating privatization remain important priorities.

5. A set of mutually-reinforcing policies can help reduce remaining fiscal and financial vulnerabilities and raise the economy’s growth potential:

• Adopt a credible reform-based fiscal strategy to reduce high debt, create adequate room for countering adverse shocks, and address the looming demography-related rise in spending;

• Complete the repair of bank and corporate balance sheets by resolving SME NPLs and encourage viable bank business models to safeguard medium-term financial stability;

• Step up structural reforms: improve labor market functioning and accelerate privatization.

A reform-based fiscal strategy to rebuild buffers and maintain sustainability

6. The authorities’ medium-term consolidation target is appropriate. Their goal to eliminate the budget’s structural deficit by 2020 and maintain this level afterwards will reduce debt to 60 percent of GDP by 2026. Rebuilding fiscal buffers would increase the space for a countercyclical response to growth shocks, keep borrowing costs low in the long term, and reduce vulnerability to external shocks. This policy would also keep debt contained over the long term as the population ages, and—provided the reform package reduces age-sensitive spending relative to GDP in the next few years—would allow accommodating in part the demographic shock when it becomes severe. The newly approved Fiscal Council can play an important role in monitoring and assessing fiscal performance.

7. However, further consolidation requires substantial additional reforms. In our view, additional structural adjustment of 1.8 percent of GDP by 2020 over what current policies would yield is needed to achieve the authorities’ target. The authorities are aware of the challenge and are moving on several fronts. On pension reforms, they have published a White Paper with a set of reform options, some of which would expand the pension contributions’ base, gradually tighten retirement eligibility criteria, and—after a long transition—index benefits to inflation only. In the health sector, draft legislation would expand the base for health insurance contributions, unify the basic contribution rates for all insured, and limit the duration and amount of sick leave payments. While these proposals are steps in the right direction, we recommend additional structural reforms to improve the budget permanently:

• design a sustainable public wage system that motivates employees, rewards good performance rather than providing automatic, seniority-based wage hikes, and reduces the wage bill relative to GDP. This will require a multi-annual remuneration framework, with separate limits for the number of employees and the wage bill increase by budget sectors;

• implement further pension reforms. If adopted, the White Paper proposals to raise the retirement age to 67 and automatically adjust it to demographic trends, as well as to restrict early retirement further would be important steps. Additional adjustments can include: (i) moving quickly to index pensions to inflation only; (ii) abolishing the pension bonus, a relic from the 1980s, and (iii) eliminating pension income’s preferential tax treatment. Low-income pensioners should be supported through the social assistance system. Reforms to raise labor market participation rates, thus broadening the pension contribution base, would also help.

• put in place further health and education reforms that maintain the high quality of service but reduce costs, such as (i) expanding centralized procurement in the health care sector to benefit from stronger competition and economies of scale and (ii) further optimizing the school network and means-testing financial support for tertiary students. Overall, slowing expenditure growth below GDP growth can reduce health and education expenditure relative to the economy’s capacity to bear them without nominal cuts;

• reform the real estate tax so that it yields revenue equal to the OECD average and adjust specific excise tax rates as needed to prevent revenue erosion. Review the capital gains tax to enhance collections from high net-worth individuals.

  Implementation of these reforms will facilitate further sustainable consolidation and create room for growth-friendly fiscal policies, such as a much-needed expansion of public investment, active labor market policies, and cuts in the labor tax burden.

8. In this context, the 2017 budget leaves room for improvement despite the targeted reduction in the headline deficit. Taking into account the improved macroeconomic picture, we project a 2017 cash deficit of 1.3 percent of GDP, implying a structural improvement of 0.2 percentage points of GDP. This modest adjustment is, however, entirely due to sizable interest savings, while the structural primary balance would worsen by 0.3 percentage points of GDP. This goes against the need for further consolidation and may harm the credibility of the authorities’ medium term adjustment objective. We therefore recommend maintaining the 2017 structural primary balance at its 2016 level and saving the interest windfall. This implies additional adjustment of 0.3 percentage points of GDP that can easily be achieved by, e.g., reducing budget subsidies to their 2015–16 level of 1 percent of GDP and accelerating improvements in tax collection with a focus on risk-based audits.

Completing NPL resolution and encouraging viable bank business models to safeguard medium-term financial stability and support growth

9. Strong implementation of the authorities’ strategy to restructure SME NPLs is a priority. With the NPL ratio rapidly declining since late 2013, Slovenia managed to address a significant legacy problem of the crisis that still plagues other European countries. However, as elsewhere, SME NPLs––13.4 percent of total SME loans as of end-2016––are proving stubborn. While adequately provisioned, unresolved NPLs continue to impair financial intermediation to indebted, but otherwise healthy enterprises. In this regard, we welcome the implementation of the guidelines for SME resolution prepared by the Bank of Slovenia, the World Bank, and the Bank Association. The process includes evaluating bank NPL resolution strategies, including annual NPL reduction targets for 2017–19, and assisting banks to develop a toolkit for the restructuring. The success of this strategy hinges on close monitoring by supervisors and safeguards to prevent “evergreening” of NPLs.

10. An independent BAMC is best placed to maximize the return on large legacy NPLs. The BAMC has distinct advantages in NPL restructuring, including capacity to overcome collective action problems, access to a wide range of debt restructuring instruments (including debt-equity swaps), and broad latitude over restructuring of the corporates it takes over. Accordingly, we reiterate our view that the BAMC should continue to vigorously restructure and sell the claims in its portfolio and see no reason for transfers of substantial claims to the SSH. The BAMC’s credibility depends crucially on its independence, and we welcome the last set of amendments to the BAMC law that provide safeguards against past perceived infringements. The BAMC should be shielded from all kinds of political interference and encouraged to take full advantage of the powers the amendments confer.

11. Banks’ business models will need adjustments going forward, calling for active engagement of the supervisors. Banks remain adequately capitalized and liquid, and have increased profitability in recent years. However, banks’ net interest income is under pressure as (i) high-interest assets mature and are replaced by low-interest ones, and (ii) demand for domestic bank loans grows only modestly, while (iii) deposit interest rates are already near zero. Raising non-interest income, while successful so far, has limits as the volume of new loans generating commissions and fees is moderate, and deposit fees risk pushing household money into alternative forms of savings. Banks are also facing increasing competition from the non-bank financial sector. Finally, the decline in risk provisioning has a large one-off component that will fade as NPL resolution is completed. All this calls for a reassessment of banks’ business models––probably requiring further bank consolidation, deep cuts in operating costs, and search for new income sources. We recommend an active dialogue between the authorities and the banks on these issues and enhanced supervisory vigilance for signs of unsustainable operations.

12. Bank privatization plans are encouraging, but some concerns remain. The privatization of the two remaining large state banks is of key importance to ensure that they operate on commercial principles and transfer technology and management systems that could help them expand into new activities and reduce costs. We thus very much welcome the decision to complete the privatization of NLB this year and to start the privatization process for Abanka in 2017 as well. Regarding NLB, we however remain concerned about the plan to privatize the bank with the restriction that no private investor can have higher ownership than the state’s 25 percent. Dropping the restriction would allow strategic investors to take a controlling stake and further improve the bank’s performance. Moreover, we recommend completing the sale of Abanka well before the deadline of mid-2019 agreed with the EC. An early sale would allow dropping the constraints on the bank’s activity imposed by the use of state aid and help its competitiveness and profitability.

Deeper labor market reform and accelerated privatization to raise potential growth

13. Our analysis of the effects of the 2013 labor market reform reveals mixed results. The 2013 reform was an important step in liberalizing the labor market. To reduce pervasive labor market duality, the reform relaxed protection of individual dismissals and offered a mix of fiscal incentives and penalties to increase the relative attractiveness of open-ended contracts vs. temporary ones. However, while duality was reduced immediately after the reform, this effect appears to have faded over time. At the same time, aggregate employment and unemployment outcomes do not appear to have materially improved after controlling for the rise in economic activity in 2014-16. Meanwhile, emerging skills mismatches are slowing the decline in unemployment.

14. These findings suggest the need for substantial recalibration of labor market policies. First, the growing economy offers a good opportunity to further increase the flexibility of open-ended employment contracts and help create more such jobs. Second, more retraining courses for the unemployed designed with input from employers would alleviate skills mismatches. In the longer run, an apprenticeship system developed in cooperation between the education system and employers (similar to those in Germany and Austria) would help systematically develop the necessary skills. Efforts should also be made to retain older experienced workers in the labor force by targeted training in new technologies and flexible working hours. Third, taxation of low wages, including social security contributions, should ensure that the entry-level net wage is markedly higher than social assistance benefits.

15. A sustained privatization effort is called for to improve governance and raise the economy’s productivity. This effort should include significant revisions in the strategy for SOE management passed in 2015. The current strategy classifies SOEs managed by the SSH into “strategic” (majority state ownership), “important” (the state retains a 25 percent stake that allows for control in important decisions), and “portfolio” (full control is ceded to the private owners), with the latter only a small fraction of the total SSH portfolio by value. We recommend significantly reducing the number of companies classified as “strategic” and “important”, especially in sectors like manufacturing and tourism, which are best left to the private sector. We also recommend stepping up the sale of companies currently slated for privatization, including the 25 SOEs prepared for sale in 2016 and the remnants of the 2013 list, including Telecom Slovenije. Timely sales without onerous conditions would strengthen the viability of the firms and maximize receipts for the taxpayer. To be able to do its job most effectively, the SSH should be free of outside interference in its activities.

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We thank the authorities for their unsurpassable hospitality, candid and informative discussions, and exceptional assistance to the mission’s work.