Slovenia: An Economic Portrait of the New Euro Area Member State

Niels Peter Hahnemann, Economics

INTRODUCTION

Until 1991, Slovenia was part of Yugoslavia. Since its independence the country has undergone a rapid and successful economic restructuring process. On 1 January 2007 Slovenia adopts the euro as the first of the former Communist states to become part of one of the world's largest currency areas.  

Slovenia has a population of a little over 2 million, of whom just over 300,000 live in the capital, Ljubljana. The demographic structure is relatively homogenous. The population census from 2002 shows that approximately 83 per cent of the population are Slovenes and 5 per cent are Serbs, Croats or Bosnians, with the remainder not stated.

In 2005 Slovenia's GDP in current prices amounted to 27.6 billion euro. This is equivalent to 0.3 per cent of GDP in the euro area, which is slightly below the ratio for the euro area's hitherto smallest economy: Luxembourg, whose population is only around 400,000, however. In terms of purchasing-power-adjusted prices Slovenia's GDP in 2005 was 37.8 billion euro, and thus a little above Luxembourg’s GDP. In 2005 its GDP per capita was equivalent to 81 per cent of the overall EU average. After Cyprus, Slovenia is the most prosperous of the new EU member states with an income level on a par with Greece and just above Portugal, the two least affluent economies of the euro area, cf. Chart 1 (left).

Slovenia appears to be ready to join the euro area. The economy has enjoyed a long period of stability with moderate inflation and relatively modest deficits on both its government budget balance and current account of the balance of payments. The high economic growth since 2004, cf. Chart 1 (right), when the Slovenian tolar was pegged closely to the euro, underpins the assessment that the economy is prepared for the single monetary policy and the single currency.

This article presents an economic portrait of the new euro area member state with emphasis on the convergence criteria and the challenges ahead for Slovenia within Europe's monetary union.

THE CONVERGENCE CRITERIA

To be able to adopt the euro, an EU member state must fulfil a number of convergence criteria. In view of its stable economy, with high growth and limited macroeconomic imbalances, Slovenia has been able to fulfil the convergence criteria relatively quickly. The assessment of Slovenia by the European Commission and the European Central Bank, ECB, was conducted in May^[1] and approved by the European Council in June, i.e. after only two years' EU membership for Slovenia. Below, Slovenia's results are compared with each of the criteria.

Development in prices
The inflation criterion states that the average year-on-year rate of increase in HICP (the Harmonised Index of Consumer Prices), observed over a period of 12 months before the examination, may not exceed by more than 1.5 percentage points that of, at most, the three best-performing member states in terms of price stability. In March, the month for which the latest data was available when the assessment of Slovenia was conducted, the criterion value was 2.6 per cent, Slovenia's 12-month average inflation was 2.3 per cent, and actual headline inflation was 2.0 per cent year-on-year. Slovenia’s inflation was thus at the euro area inflation level of 2.3 per cent.

The development in Slovenia's average rate of inflation clearly shows its convergence with the euro area. In January 2006 average inflation dropped below the criterion value and has since then at no time exceeded it, even though during 2006 the inflation tendency reversed to moderately rising prices, cf. Chart 2 (left), due especially to increasing energy prices. All of the new EU member states are more vulnerable to energy price hikes than the euro area. Energy accounts for more than 13 per cent of Slovenia's CPI (consumer-price index), compared to 9 per cent in the euro area.

Exchange-rate stability
A condition for adopting the euro is participation in ERM II for at least 2 years without " severe tensions" , including unilateral devaluation. The Slovenian tolar has been part of ERM II since 28 June 2004, i.e. for more than 2 years.

Prior to its ERM II entry, Slovenia's exchange-rate policy was to write down the exchange rate vis-à-vis the euro by a fixed rate. This policy was discontinued when Slovenia entered ERM II, after which the exchange rate vis-à-vis the euro has been very close to the central rate, cf. Chart 2 (right). The market rate has not deviated from the central rate by more than +/- 0.2 per cent, even though with the exception of August 2006 Slovenia's central bank, Banka Slovenije, has not followed the ECB's raising of interest rates. In addition, interest rates were lowered on three occasions: in February, March and June. The spread between the official interest rate, 60 day tolar bills, and the ECB's interest rate has therefore narrowed considerably, cf. Chart 3 (left). Tolar-denominated money-market instruments are thus less attractive to commercial banks than euro-denominated instruments.

In July the Ecofin Council resolved that Slovenia would adopt the euro on 1 January 2007 at the present central rate, i.e. 239.64 tolars per euro.

Development in long-term interest rates
A requirement for adoption of the euro is that, observed over a period of one year before the examination, a member state has had an average nominal long-term interest rate that does not exceed by more than 2 percentage points that of, at most, the three best performing member states in terms of price stability. In March the criterion value was an upper limit of 5.9 per cent, but the average yield on long-term Slovenian government bonds was only 3.8 per cent, i.e. considerably below the criterion value and also lower than the unweighted average for the three member states on which the assessment was based. However, the criterion value included two non-euro area member states, i.e. Poland and Sweden. Compared to the euro area Slovenia had a small, but positive average yield spread of 0.4 percentage point over the 12-month period up to March.

The long-term yield has fallen in recent years in step with the global decline in bond yields, the stable macroeconomic development and the resulting perception that Slovenia could soon join the euro area. At the same time the yield spread to the euro area has narrowed as a result of the dampening of inflation. The yield spread has narrowed further since the end of 2005, cf. Chart 3 (right).

Fiscal policy
According to the convergence criteria the government budget deficit may not exceed 3 per cent of GDP, and the government debt may not exceed 60 per cent of GDP. 2005 is the reference year for the decision on adoption of the euro in 2006. In 2005, Slovenia's budget deficit was equivalent to 1.8 per cent of GDP, and the debt was 29.1 per cent of GDP.

In recent years the budget deficit has been relatively stable in the range of 2 to 2.5 per cent of GDP, except for 2000-01, when the deficit rose, cf. Chart 4, among other reasons because commitments to a public war injury fund had to be carried as expenditure.

The convergence reports from both the ECB and the European Commission pointed out that government expenditure related to the population's ageing is expected to increase particularly strongly in Slovenia in the coming decades, and in fact more strongly than in both the new EU member states overall and the old EU. The reason is that in 20 years' time Slovenia will have a larger retired population segment than other member states.

SLOVENIA IN THE EURO AREA

Slovenia's rapid and successful achievement of the demanding nominal convergence process is a vital indication that the economy is ready to enter the euro area. This is confirmed by high economic growth, continuously declining unemployment, and strongly rising employment in the last couple of years during which the tolar has been pegged closely to the euro. However, the strong economic progress has entailed a modest current-account deficit.

In the long term, participation in a monetary union requires an adaptable economic structure. In recent years Slovenia has undergone a comprehensive restructuring process and – as in the other new EU member states – the economy has been integrated into the European production structure. Especially the manufacturing sector has undergone structural adjustment.

The structure of the new member states' manufacturing sector has thus been adjusted to that of the highly-developed EU member states through rationalisation, down-sizing and modernisation, and the private service sector has been developed. This entails among other things that intra-industrial trade in intermediaries and semi-manufactures will account for an increasing share of the new member states' total industrial trade. This development has also been observed in Slovenia. The growth in industrial production is therefore relatively closely correlated with industrial production in the euro area's " locomotive" , Germany, although not as closely as in the core member state Austria, but closer than in member states towards the periphery of the euro area such as Greece and Portugal, cf. Chart 5.

Slovenia's economic structure nonetheless still differs substantially from the rest of the euro area, including Greece and Portugal. As in the other new EU member states, the manufacturing sector accounts for a considerably larger share of the overall economy than in the euro area. However, the special aspect in Slovenia's case is that its manufacturing sector is also larger than those of many of the other new EU member states, with the exception of the Czech Republic. The private service sector is equivalently less developed.  

For many years Slovenia has received less foreign direct investment, FDI, than any of the other new EU member states. In the period 2000-04 FDI corresponded to only 2.3 per cent of GDP, compared to an average of 5 per cent in the new member states. The speed of the privatisation process, including within the financial sector, has been characterised as slower than in the other new EU member states.^[2]

There are no signs of any problems with Slovenia's competitiveness. Exports are rising steadily, the real exchange rate is stable,^[3] and wage and price increases are moderate. However, the average rate of increase in exports since the mid-1990s has been lower than in e.g. the Czech Republic and Hungary, and imports have also shown slower growth. This indicates that the " catch-up" effect has not been as strong a driver of Slovenia's economy as in the other new member states, due to Slovenia's relatively favourable starting point. At the outset of the transition process in the early 1990s Slovenia was already considerably more affluent than the other transition economies that have since joined the EU. Slovenia's export performance within the EU is in line with that of Greece and Portugal, but unlike these two member states and most of the other new EU member states, Slovenia's current-account deficit is relatively modest. All in all, Slovenia thus already appears to be relatively well-integrated into intra-EU trade.  

Slovenia's overall labour participation rate is slightly above the euro area level, whereas for most of the other new EU member states it is lower as a consequence of the reform process in recent years, which for a period has reduced the demand for labour. Moreover, the labour participation rate of the older age groups is significantly lower than in the euro area, and also lower than in most of the other new member states, cf. Chart 6. Slovenia's low participation rate for its older age groups reflects that it has the lowest average retirement age in the EU. In 2003 the effective retirement age was slightly above 56, compared to around 61 in the euro area, and 58-61 in Poland, Hungary and the Czech Republic. The existing pension system, for instance, is an incentive to retire early. The tax and social security system also affects the supply of labour. Interview surveys thus show far lower unemployment than is actually registered, probably because a large proportion of the registered unemployed are not actually looking for work. The latter is necessary for them to be counted as unemployed in the interview surveys. This may be related to the interaction between a progressive tax system with high tax rates (the highest income tax rate is 50 per cent) and social benefits at the OECD level or higher.^[4]

The structure of Slovenia's labour market is characterised by some of the rigidity seen in many of the euro area member states. For example, labour market legislation is relatively stringent,^[5] wage formation is centralised at sector or national level, and a large proportion of the overall employment is covered by collective agreements.^[6] Unlike the other euro area member states Slovenia conducts an incomes policy. Under the latest agreement between the government and the social partners, wage increases must be at least 1 percentage point below productivity increases. Another special characteristic is that Slovenia still conducts a type of cost-of-living adjustment since wage development is closely linked to inflation via indexation to expected inflation.  

The low supply of labour has consequences for the flexibility of Slovenia's fiscal policy. In 2005 government expenditure accounted for 48 per cent of GDP, which is higher than the averages of 42 per cent for the new EU member states and 44 per cent for the old member states. Especially social security expenditure is high. For most budget areas the cyclicality of government expenditure is a good deal lower in Slovenia than in both the new and the old EU member states.^[7]

CONCLUSION

Slovenia has a well-functioning economy and is already well-integrated into the European economy. In some aspects, however, the economy is less flexible. For instance, there is a relatively high degree of budgetary rigidity in government finances. Together with the lack of expenditure flexibility, the ageing of the population will exert pressure on government finances. A need for considerable fiscal-policy adjustments in the years to come can already be foreseen in order to keep both the deficit and the debt in line with the Maastricht Treaty's requirements.

THE NATIONAL SIDES OF THE SLOVENIAN EURO COINS