Mission Concluding Statement 

Republic of Slovenia: Staff Concluding Statement of the 2022 Article IV Mission

November 21, 2022

Washington, DC – November 21, 2022:

An International Monetary Fund mission, led by Donal McGettigan, visited Slovenia during November 10–21, 2022, to conduct discussions on the 2022 Article IV consultation.

Recent Developments and Context

After an impressive post-pandemic recovery, Slovenia has continued to achieve strong economic growth, and unemployment stands at an historic low. Real GDP increased by more than 8 percent in 2021, thus surpassing its pre-pandemic level. Exports and private consumption were the main growth drivers, with the latter reflecting supportive pandemic policies and lower household savings rates. Economic activity remained strong in the first half of this year, with GDP growing by close to 9 percent year-on year, driven by strong domestic demand. Unemployment is at an historic low and labor shortages are pronounced in some sectors. Meanwhile, preliminary growth numbers from the statistical office indicate that growth fell in the third quarter.

At the same time, and in line with most peers, inflation has increased sharply in Slovenia. High international energy and food prices have led to a large increase in inflation, which stood at 10 percent in October. Although inflation has fallen modestly in recent months, it remains broad-based and core inflation has continued to increase.

Spillovers from Russia’s war in Ukraine have presented considerable challenges. Although Slovenia’s direct trade exposure to Russia and Ukraine is low, indirect effects through weaker external demand and high commodity prices are weighing on the economy, as are lower business and consumer confidence, and ongoing supply chain disruptions, for example in the auto industry, where output and exports have declined this year.

Outlook and Risks

Slovenia’s economic outlook has become more challenging. Growth is expected to fall from a projected 5.4 percent in 2022 to 1.8 percent in 2023 under staff’s baseline, which assumes no escalation of the war in Ukraine, a continued normalization of monetary policy, and fiscal stimulus in 2023 in line with the authorities’ budget. The slowdown is driven primarily by weaker external demand, and also by high inflation and greater uncertainty, which are expected to weigh on private consumption and investment growth. Over the medium term, growth is expected to rebound to its potential of around 3 percent a year, underpinned by ongoing structural reforms and strong investment, including under the EU-backed National Recovery and Resilience Plan (NRRP).

Uncertainty is also unusually high and risks are predominantly on the downside. The key risks stem from the war in Ukraine and include further commodity price increases, lower external demand, and supply chain disruptions. Inflation could also remain high for longer, possibly triggering higher wages and higher inflation expectations, which would in turn require a tighter policy stance. Other risks include a possible correction in real estate prices, which are seen as overvalued. Upside risks include a possible continued reduction in energy prices, and a stronger-than-expected tourism rebound.

Fiscal Policy

A tighter fiscal stance is warranted in 2023 to support disinflation and to contain relatively high public debt. From an estimated 3 percent of GDP in 2022, the fiscal deficit could increase to 5 percent of GDP next year should the large contingency fund (equivalent to about 2 percent of GDP and designed for energy price mitigation measures) be used fully. With a positive output gap, high capacity utilization, a tight labor market, and rising core inflation, such an expansionary fiscal policy would fuel domestic demand and would work against monetary policy tightening efforts. It would be prudent, therefore, to save at least part of the contingency fund and to reduce the deficit in cyclically adjusted terms relative to 2022. Should downside risks materialize, automatic stabilizers should be allowed to operate fully, and temporary and targeted support should be deployed to protect the most vulnerable. The specific policy response should depend on the type and severity of the shock. Meanwhile, the authorities should continue with their proactive debt management policies, which have helped accumulate a significant cash buffer.

While a range of measures have been taken to alleviate the impact of high energy prices, these need to be better targeted. Support so far has varied from vouchers for vulnerable households and compensation for affected firms to across-the-board tax cuts and price ceilings. Although similar to measures taken by many peers, the untargeted measures are inefficient, costly and delay needed adjustment to higher prices. The current price caps on electricity and gas should, therefore, be replaced with temporary and targeted lump sum benefits to low- and possibly some middle-income households or block tariffs that cover basic energy consumption needs only, while allowing market prices to apply to the rest of the energy consumed. Support to firms should be temporary, limited to companies that have been affected significantly by the high energy prices and that were in good financial standing before the crisis, and should include incentives to increase energy efficiency. Support to firms should continue to be compliant with the EU state aid framework.

A growth-friendly consolidation would help rebuild fiscal buffers. Given rising age-related spending pressures and still-high public debt, a sustained fiscal consolidation and fiscal structural reforms are needed to ensure the long-term sustainability of public finances. Improving the tax policy mix to reduce the reliance on labor taxes, which are high, while increasing property taxes, which are low, and broadening the tax base could generate additional revenue and induce a positive labor supply response. Efforts should be made to continue to improve revenue administration, drawing on recent IMF technical assistance (TA). Reforming the pension system is a priority, given the large increase in pension spending expected over the medium- and longer-term. In staff’s view, reform options include gradual adjustments to the retirement age and to indexation rules. Further strengthening public investment management is also critical given the envisaged scaling up of public investment. The framework for monitoring and managing fiscal risks should also continue to be strengthened through the use of analytical tools, supported by IMF TA.

Financial Sector Policy

Slovenian banks are well-capitalized and profitable but heightened global economic and financial risks warrant continued close monitoring. Asset quality remains strong, with non-performing exposures of around 1 percent, although in certain segments, notably in pandemic-affected sectors and loans previously under moratoria, such exposures are significantly higher. With continued monetary policy normalization, interest margins are expected to improve, which will, over time, support profits. Among other factors, increasing intermediation carefully and keeping costs under control would build on this and help ensure profit sustainability in the medium term. The war in Ukraine has increased risks, however, even though Slovenian banks’ direct exposures are limited. Continued close monitoring of asset quality and appropriate loan-loss provisioning remain important. In addition, the tightening in financial conditions may expose vulnerabilities to variable interest rates, in particular, for loans to non-financial corporations.

Slovenia’s macroprudential stance is broadly appropriate and real estate market developments have prompted a welcome regulatory response. Given the risks from strong credit growth, and elevated economic uncertainty, consideration should be given to a modest increase of the countercyclical buffer, currently set at zero; it could be adjusted down if conditions deteriorate more than expected. Macroprudential policies should remain flexible to ensure the right balance between financial stability and credit supply to the economy. Rapid house price growth has increased concerns about real estate overvaluation and the Bank of Slovenia has appropriately responded by changes in macroprudential policies, including the introduction of a sectoral systemic risk buffer and lower loan-to-value limits on second homes.

Efforts should continue to improve insolvency frameworks and ensure efficient restructuring mechanisms. While the number of bankruptcies proceedings fell in the last two years, it could increase should downside risks to the outlook materialize. Staff welcomes the authorities’ reform of the insolvency framework which aims to promote early access to restructuring measures and to increase the efficiency of preventive procedures.

On a related issue, legacy loans in Swiss francs need to be handled carefully and steps taken to prevent a recurrence. Here the authorities should encourage voluntary loan renegotiations based on the individual ability to repay, while avoiding changes to past contracts. Looking ahead, possible future lending in foreign currency to unhedged borrowers, including to households, should be discouraged.

The authorities should continue bolstering the anti-money laundering and combatting the financing of terrorism (AML/CFT) framework. In line with the recommendations made in the 2017 Mutual Evaluation Report by MONEYVAL and the MONEYVAL 2022 follow up report, the focus should be on enhancing supervision of financial institutions and other covered entities, ensuring that accurate and up-to-date beneficial ownership information of legal persons is available to competent authorities, and reinforcing ML investigations and convictions.

Structural Policies

Energy security should remain a key policy priority. Despite Slovenia’s dependance on natural gas imports from Russia, supply disruption risks are clearly mitigated by the strongly diversified domestic energy mix—gas plays a minor role in electricity generation—and the availability of alternative gas supplies, including of LNG. The authorities should, nevertheless, make contingency plans and secure sufficient alternative supplies to avoid disruptions in a worst case scenario. Guided by EU initiatives, it is important that measures be taken to increase energy savings. Over the longer term, it is important to continue to diversify energy supplies and further develop renewables to reduce dependence on fossil fuels, in line with the REPowerEU initiative.

Strengthening the resilience of the energy sector should be compatible with Slovenia’s green transition. While temporary reliance on more polluting energy sources to secure energy supplies may be needed in the short term, it is important to continue to keep a focus on long-term climate goals. Reforms and investments under the authorities’ NRRP should continue to promote renewable energy sources and enhance the climate resilience of infrastructure and other assets, diversifying the energy mix and supporting climate adaptation. Slovenia already has relatively high effective carbon tax rates, mostly in the form of taxes on energy, which is welcome, but some polluting sectors such as transport continue to benefit from exemptions or from low carbon tax rates. Carbon prices high enough to provide the right incentive for these sectors should be put in place over time as the energy crisis abates.

Securing future sustained and inclusive growth in Slovenia calls for further labor market reforms and digitalization to boost productivity. With an ageing population, less active groups (youth, the elderly) need to be encouraged to participate in the labor market. Policies to address disincentives should include reducing the high labor tax wedge (in a revenue neutral manner), reforming unemployment and pension policies to contain early exit from the labor market, and tackling other barriers, for example, skill mismatches and inflexible work arrangements. Active labor market policies need to be well aligned with market needs, and the education and training agenda should be adapted to meet new demands from the ongoing green and digital transitions. Good progress has been made on digitalization and continued efforts to close remaining gaps in digital skills, the use of internet, and the integration of digital technologies in businesses and public services would positively contribute to future productivity and growth.

The team would like to thank the authorities for their exceptional assistance with the mission’s work and the authorities and other stakeholders for their warm hospitality and for the comprehensive and constructive discussions.