Executive summary 1

1. Scene setter: economic situation and outlook 5

2. Imbalances, Risks, and Adjustment 14

2.1. Interplay of banking sector and corporate sector restructuring 15

2.2. Efficiency and costs of State Owned s and State Controlled Enterprises, and their impact on investment and business environment 29

2.3. Competitiveness, investment and the role of FDI 45

3. Other structural issues 58

3.1. Fiscal policy and taxation 59

3.2. Labour market, education and social policies 65

3.3. Business environment and Research & Development 71

3.4. Transportation, energy and environment 77

3.5. Public administration and civil justice 79

AA. Overview Table 82

AB. Standard Tables 91

LIST OF Tables

1.1. Key economic, financial and social indicators - Slovenia 9

1.2. MIP scoreboard indicators - Slovenia 10

2.1.1. Overview of executed recapitalisation measures and asset transfers to the BAMC 14

2.2.1. The network of state ownership and state control in Slovenia 26

2.2.2. Relative importance of State-owned enterprises/State-controlled enterprises (as % of total Non-financial companies) 27

2.2.3. Total fiscal implications of State-owned enterprises/ State-controlled enterprises to the state and the economy 34

AB.1. Macroeconomic indicators 82

AB.2. Financial market indicators 83

AB.3. Taxation indicators 84

AB.4. Labour market indicators 85

AB.5. Social indicators 86

AB.6. Product market performance and policy indicators 87

AB.7. Green Growth 88

LIST OF Graphs

1.1. Real GDP growth and contributions 3

1.2. Export market share 4

1.3. Export performance 4

1.4. Current account 4

1.5. Drivers of the trade balance surplus, 2007-2014 4

1.6. Net international investment position 5

1.7. Private non-financial sector debt-to-equity ratios in the EU (%) 6

1.8. Deleveraging contribution dynamics, debt-to-GDP change 6

1.9. Non-financial companies - change in investment 2008-13, % of value added 7

1.10. HICP and consumer confidence 7

2.1.1. Household deposit of sector - total deposits by type of bank 14

2.1.2. Deposit rates (< 1 year) 16

2.1.3. Deposit rates (> 1 year) 16

2.1.4. Total assets and loans of the Slovenian banking system 17

2.1.5. Composition of banks' liabilities 17

2.1.6. Net interest margin by bank 17

2.1.7. Growth rate of interest income and expenses of the banking sector 17

2.1.8. Change in stock of domestic credit and contributions 18

2.1.9. Credit growth - Total loans 18

2.1.10. Short term interest rates (< 1 year) 19

2.1.11. Long term interest rates (>1 year) 19

2.1.12. Indebtedness of the corporate sector 19

2.1.13. Cash flow capacity and profitability of the corporate sector 20

2.1.14. Credit growth - corporate loans (incl. SME) 20

2.1.15. Credit growth - foreign loans 20

2.1.16. New lending vs. prolongation 21

2.1.17. NPLs by type of bank 21

2.1.18. NPL ratios by type of bank 21

2.1.19. Structure of NPLs by bank (Q3 2014) 22

2.1.20. Coverage ratios type of bank 22

2.2.1. Share of State-owned enterprises/State-controlled enterprises in sectoral value added (as % of total sectoral valued added), 2013 26

2.2.2. Employment, 2013 – public, private and State-owned enterprises/State-controlled enterprises 27

2.2.3. Book value of equity of State-owned enterprises/State-controlled enterprises in Europe (as % of GDP) 27

2.2.4. OECD indicators for product market regulation (2013) 28

2.2.5. Employment at State-owned enterprises/State-controlled enterprises in Europe (as % of total employment) 29

2.2.6. Leverage ratio of State-owned enterprises/State-controlled enterprises and all Non-financial companies (excl. energy and public utilities sectors) 29

2.2.7. Profitability (ROCE) of State-owned enterprises/State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (2004-2013 average) 30

2.2.8. Profitability (ROE) of State-owned enterprises/State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (2004-2013 average) 30

2.2.9. Leverage ratio of State-owned enterprises/State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (2013) 31

2.2.10. Total factor productivity of State-owned enterprises/ State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (in %), 2004-2013 average 31

2.2.11. Profitability (ROE) of State-owned enterprises/ State-controlled enterprises by sector in Slovenia and other CEE countries (aggregate), 2013 32

2.2.12. Costs per employee of State-owned enterprises/ State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (2004-2013 average) 32

2.2.13. Debt leverage ratio of State-owned enterprises/State-controlled enterprises in Slovenia and other CEE countries (2013) 33

2.2.14. Labour productivity State-owned enterprises/ State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (in %), 2004-2013 average 33

2.2.15. Total government deficit and deficit increasing state interventions related to State-owned enterprises/State-controlled enterprises 34

2.2.16. Total government debt and debt increasing state interventions related to State-owned enterprises/State-controlled enterprises 35

2.2.17. Subsidies to all Non-financial companies relative to operating profit (EBITDA) and share of subsidies to State-owned enterprises/ State-controlled enterprises 35

2.2.18. Other fixed assets of State-owned enterprises/ State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (as % of total assets ), 2004-2013 average 36

2.2.19. Capital expenditure relative to operating profit (EBITDA) of State-owned enterprises/ State-controlled enterprises and all Non-financial companies 36

2.3.1. Reel effective exchange rate deflated by ULCE and ULCM 39

2.3.2. REER (ULCE) and new sectoral REER in Slovenia 40

2.3.3. Sectoral REER aggregate in SI and V4 40

2.3.4. Nominal Unit Labour Cost 40

2.3.5. SI NULC in tradable and non-tradable sectors 41

2.3.6. Productivity per hour worked 41

2.3.7. Nominal compensation per employee 42

2.3.8. Geographical and sectoral composition of nominal rate of change of goods exports 43

2.3.9. Density distributions of exports (goods) by quality 43

2.3.10. Non-cost competitiveness vis-à-vis EU28 43

2.3.11. Investment in the private sector 44

2.3.12. Private investment and private consumption 44

2.3.13. Potential output and components 45

2.3.14. Non-Financial Corporations savings and investment 45

2.3.15. GFCF by type 46

2.3.16. Investment by institutional sectors 46

2.3.17. Non-residential investment and NFC debt 47

2.3.18. Inward FDI 47

2.3.19. FDI inflows 48

2.3.20. FDI inflows in Slovenia, Visegrád 4, EU 48

2.3.21. FDI stock per sector in Slovenia, 2013 48

2.3.22. Sectoral composition of greenfield FDI in Slovenia, 2011-2013 48

2.3.23. FDI stock in tradable and non-tradable sectors 49

2.3.24. Origin of inward FDI, stocks in 2013 49

2.3.25. FDI stocks in Slovenia, Visegrád 4, and the EU 49

3.1.1. Gross debt % of GDP - DSA analysis 54

3.1.2. Gross debt % of GDP - institutional scenario 54

3.1.3. Decomposition of the population by age groups in Slovenia 55

3.1.4. Sustainability of the pension system in Slovenia 56

3.2.1. Employment in tradable and non-tradable sector 59

3.2.2. Long term unemployment as % of active population 59

3.2.3. Employment rate of vulnerable segments in Slovenia and the EU28 60

3.2.4. Cyclicality of temporary employment 61

3.2.5. % of low achievers on PISA tests in 2009 and 2012 in Slovenia 62

3.2.6. Public expenditure for formal education (in million EUR) 62

3.2.7. The likelihood of the old-age poverty rate 63

3.2.8. Social exclusion indicators 63

3.3.1. Components of administrative burden in Slovenia 65

3.3.2. Willingness of banks to provide the loans in the last six months 66

3.3.3. Level of intra-EU establishment 67

3.3.4. R&D investment 68

3.5.1. Institutional strengths and weaknesses in Slovenia 71

3.5.2. Government effectiveness 72

3.5.3. Diversion of public funds 73

LIST OF Boxes

1.1. Economic surveillance process 8

2.1.1. Measures taken by the Bank of Slovenia to improve corporate governance and risk management in banks 15

2.1.2. Structure of debtor companies liable for the NPLs 24

3.3.1. Overview and general assessment of absorption capacity for EU funds 68

LIST OF Maps

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In 2014 the Slovenian economy grew strongly. After a cumulative decline of more than 9% between 2008 and 2013, real GDP is estimated to have grown by 2.6% in 2014. Growth has been predominately export-driven but domestic demand has also started to show signs of recovery. The recovery in investment expenditure has been driven mainly by construction financed through EU funds, while private sector investment remains under pressure. Growth is estimated to slow down to 1.8% in 2015, before increasing to 2.3% in 2016. The unemployment rate remains below the EU average, falling to 9.8% in 2014 and expected to decline further. Public debt is forecast to stand at 83% of GDP in 2015 and gradually increase in the medium term.

In March 2014, the Commission concluded that Slovenia continues to experience excessive macroeconomic imbalances. This Country Report assesses Slovenia's economy against the background of the Commission's Annual Growth Survey which recommends three main pillars for the EU's economic and social policy in 2015: investment, structural reforms, and fiscal responsibility. In line with the EU Investment Plan, it also explores ways to maximise the impact of public resources and unlock private investment. Finally, it assesses Slovenia in the light of the findings of the 2015 Alert Mechanism Report, in which he Commission found it useful to examine further the persistence of imbalances or their unwinding. The main findings of the In-Depth Review contained in this Country Report are:

· The high level of non-performing loans and low credit demand from creditworthy firms may have implications on viability of the banking sector. Although confidence in the banking sector has returned, credit growth remains negative and profitability and viability of the banks can be further enhanced. Non-performing loans to non-financial corporations are still high relative to pre-crisis levels. Continued weakness in the cash flow capacity of the firms constrains lending opportunities and presents further risks to the asset quality and profitability of the banking sector.

· High debt, deleveraging pressures and the on-going restructuring in the corporate sector have negative implications on private investment and growth. The corporate sector has been deleveraging since the peak in 2010 but remains undercapitalised, which affects the sector's investment capacity. Low investment has implications on productivity and competiveness of the companies, their ability to innovate and also erodes Slovenia's potential growth.

· High involvement of the state and weak corporate governance distorts resource allocation, and hampers investment and growth. The state is the largest employer, asset manager and corporate debtor in Slovenia. The state involvement in the economy had significant fiscal and economic implications for Slovenian economy since the onset of the crisis. State-owned entities have underperformed compared to their private-owned peers in terms of productivity and profitability both at national and peer country level.

· External competitiveness and external sustainability have improved considerably and risks appear to have subsided. Wage restraint since 2011 together with increased productivity and gains in non-cost competitiveness have helped to improve significantly Slovenia's external performance and position in terms of flows and stocks.

· The large increase in public debt in recent years creates additional challenges. A prolonged recession coupled with significant bank recapitalisations has resulted in a sharp rise in public debt. Slovenia has undertaken fiscal consolidation in recent years but the measures, particularly on the expenditure side, have been of a temporary nature and reforms of the fiscal framework have lagged. Furthermore, the ageing population creates pressures for the sustainability of the pension and long-term care systems.

· The labour market reform addressed segmentation and introduced greater flexibility. The labour market situation is showing signs of improvement but structural challenges persist as regards to long-term unemployment and the low employment rates of low-skilled and older workers.

· An improved business environment will assist in attracting foreign direct investment. The business environment is hindered by high government involvement and regulation, which poses obstacles to the inflow of investment. The latter would be important as a source of fresh equity and alternative funding, technology transfer and increased international trade integration.

· There is a renewed commitment to fight corruption and increase the effectiveness of public administration and the judiciary. The new government adopted a new two-year programme in January 2015, while the strategy for public administration is expected to be adopted in February 2015. The focus is now on prioritisation and implementation of the programme.

Overall, Slovenia has made some progress in addressing the 2014 country-specific recommendations. Policy measures to stabilise the banking sector have been completed. The Bank Asset Management Company is now fully operational. The restructuring of four major state-owned banks and the wind-down of two smaller domestic banks are on track. A corporate restructuring master plan and a centralised task force were established. A new corporate governance code for state-owned enterprises was adopted. The Slovenian Sovereign Holding, responsible for the management and divestment of state assets, is now fully operational. A draft asset management strategy is yet to be approved by the Parliament, and will be followed by the release of the divestment schedule for a number of well-targeted state assets. The privatisation programme is progressing, albeit with delays. The sales of the two largest assets are to be signed in April 2015.

The Country Report reveals the policy challenges stemming from the analysis of macro-economic imbalances, namely:

· Reinforcing the long-term profitability and reducing non-performing loans in the corporate sector will further strengthen the health of the banking sector. There is scope for further consolidation of the banking sector, which could be facilitated through the continuation of the privatisation process.

· Further deleveraging of the corporate sector would help restore the conditions for a rebound of private investment. The swift restructuring of the corporate sector through the application of existing tools, including the Bank Asset Management Company and the new insolvency legislation, will boost the recovery of cash-flows in the corporate sector. Attracting fresh equity investment from abroad can help reduce the high debt leverage and restore credit worthiness, an important prerequisite for resolving non-performing loans and improving banks' profitability.

· Further disentangling the complex network of state-owned enterprises would help mitigate possible risks to public finances. Slovenia could take advantage from the current positive market momentum to divest selected state-owned enterprises. This would assist in attracting foreign direct investment and improving the economic outlook. Sound management and enhanced corporate governance policies for state-owned assets can assist in averting risks of future state support.

· The right fiscal framework coupled with comprehensive expenditure reviews can help to enhance the sustainability of public finances. In particular, they would help shift the focus of budgetary execution from temporary measures and linear across-the-board cuts to targeted cuts and expenditure rationalisation, while assisting in generating efficiency savings. The comprehensive review of expenditure in the health sector can provide a useful blueprint for future reviews in other key policy areas such as education. While one-off spending reviews can have a major impact, the ultimate benefits are reaped when they become a regular part of the budget process.

· Attracting foreign direct investment will be essential in ensuring a sustainable recovery. The new Government has set an ambitious target of reaching the EU average stock of foreign direct investment by 2017. The forthcoming strategy could include a coherent set of both facilitation and promotion measures, including substantially reducing the administrative burden on both local and foreign companies.

Growth performance

With a loss of more than 9% of GDP, between 2008 and 2013, Slovenia experienced one of the largest economic contractions among euro area countries. A foreign-financed credit boom facilitated by the euro adoption fuelled aggressive leveraging of the corporate sector and a construction bubble. After a sharp contraction in 2009, the economy rebounded in 2010 and 2011, but entered a second recession in 2012. While initially a large contraction in investment was the main driver of the downturn, consumption began to decline from 2012 onwards (Graph 1.1). Because of the missed pre‑crisis opportunity to improve the resilience of the economy to shocks and its slow and insufficient response, Slovenia was more affected by the crisis than other member states.

Graph 1.1: Real GDP growth and contributions

Source: Eurostat, European Commission.

In 2014, Slovenia began to re-emerge from the recession. The Commission 2015 winter forecast ("Commission Forecast" hereafter) projects real GDP to have grown by 2.6% in 2014 (Graph 1.1). Growth has been predominately export-driven but domestic demand has also started to show signs of recovery. Private consumption supported by improving sentiment and decreasing unemployment (9.8% in 2014) have contributed to this improvement. The recovery in investment expenditure has been driven mainly by construction co-financed through EU funds. While potential growth has begun to recover, it remains significantly below pre-crisis levels, with labour and capital accumulation providing no contribution in 2014(Graph 3.3.13).

Growth is expected to continue. In 2015, economic growth is forecast to decelerate to 1.8%, before picking up to 2.3% in 2016 (Graph 1.1). The deceleration in 2015 is expected to be driven by a slowdown in the growth of public investment. However, private investment in equipment and machinery is expected to pick up progressively and support growth going forward. The acceleration in 2016 is mainly attributable to an assumed resumption in growth of public consumption.

Trade performance, current account and NIIP

On the export side, Slovenia has regained export market shares since 2013. This trend strengthened in the first half of 2014 following the substantial market share losses suffered between 2008 and 2012 (Graph 1.2). Other indicators, such as the Commission's export performance indicator ([1]) offers a slightly more positive picture already as of 2010 (Graph 1.3). Despite a significant underperformance in 2009, export performance measured by this indicator evolved thereafter in line with the EA and outperformed it in 2011. Even though Slovenia lagged behind peers such as the catching up Visegrád member states Czech Republic, Hungary, Poland and Slovakia between 2009-2012, the gap was reduced significantly in 2013.

Graph 1.2: Export market share

Source: Eurostat, WTO.

Graph 1.3: Export performance

Visegrád 4 – export weighted average Source: European Commission.

The current account surplus widened to 4.8% of GDP in 2013, mainly due to the increase in the trade balance (Graph 1.4). While services make up most of the trade surplus, the goods balance also turned positive in 2012 and is expected to have increased further in 2014. The rebound in exports has not yet been matched by a comparable recovery of imports, due to weak domestic demand, especially investment. Therefore, the change in the trade balance is predominantly driven by an increase in exports, rather than by a fall in imports (Graph 1.5). The income balance remains in deficit at average levels for a converging economy with a relatively high share of foreign capital. The balance of current transfers continues to play a marginal role in the current account balance.

Graph 1.4: Current account

Source: European Commission.

Graph 1.5: Drivers of the trade balance surplus, 2007-2014

Change in trade flows, current prices, 2007-2014(e). Source: AMECO.

After years of deterioration, net international investment position has started to improve (Graph 1.6). From a moderate negative level of -17.1% of GDP in 2006, the net international investment position deteriorated rapidly during the crisis, reaching its lowest level of -45.8% of GDP in 2012. The adjustment of the current account on the back of a rise in net exports helped to revert the trend in 2013 and 2014. Driven by strong current account surpluses the NIIP is expected to continue to improve in 2015-2016. Two counteracting trends have led to a structural change of the net international investment position - the significant reduction of net foreign liabilities of monetary and financial institutions since the peak of the crisis (Section 3.1), and the increase of general government borrowing on the international markets to finance the high 2013 deficit ([2]). This is consequently reflected in the increasing share of government debt securities which now form the biggest component (-18.8% of GDP) of the net international investment position in relative terms. Foreign direct investment is on the other hand limited to only -15.9% of GDP. In view of the negative net international investment position, current account surpluses are required in order to improve Slovenia's external position. The current account is expected to stabilise at around 6% in 2015 before starting to decline slowly, due to an expected progressive reduction in the trade balance surplus in line with accelerating domestic demand. Nevertheless, an elevated current account surplus is expected to persist as long as deleveraging continues.

Graph 1.6: Net international investment position

Source: European Commission.

Public sector debt has increased significantly from 22% of GDP in 2008 to 82% in 2014. While exceptional items, particularly bank recapitalisations, have significantly contributed to this increase, sustained primary deficits over the period have also attributed to the large increase in public debt. On a no-policy change basis, public sector debt is expected to steadily increase to 87% of GDP in the medium term (i.e. until 2025). Fiscal discipline is required to reduce the debt to GDP ratio (see Section 4.1).

Private sector deleveraging

Private sector indebtedness is among the lowest in the euro area, reflecting one of the lowest levels of household debt, but relatively high corporate debt. Despite doubling in the 2000s, private debt remained at a comparatively low level of 103.6% of GDP in 2013. However, there are substantial differences between the corporate and household sector. At 29.6% of GDP in 2013, Slovenia's households had the 2nd lowest level of indebtedness in the euro area. Conversely, the indebtedness of Slovenia's corporates is considerably higher, at 74% of GDP in 2013. While this is still close to the euro area average, the ratio of the corporate debt to equity is relatively high (Graph 1.7). Further analysis of firm level data is required as corporate debt in Slovenia is unevenly distributed across firms and is high when compared to their earnings and cash flow capacity to repay (Section 3.1). Non-financial corporations began to deleverage actively ([3]) in 2010 and reduced their indebtedness relative to GDP by 13 pps. by 2013.

Graph 1.7: Private non-financial sector debt-to-equity ratios in the EU (%)

Source: Eurostat, European Commission.

Debt in the corporate sector remains high relative to firm's capacity to repay and is concentrated in a small number of large firms. About 100 firms with the largest excess debt ([4]) held 42% of the total excess debt in 2013 ([5]). The ratio of excess debt to net financial debt varies from sector to sector. Excess debt accounts for 92% of net financial debt in financial and insurance activities, and 78% in real estate activities (it is primarily unprofitable firms that contribute to the high figures), while manufacturing has one of the lowest figures at 26.2%. In addition, 90% of these over-indebted companies are focused on the domestic market and their capacity to repay the debt is thus dependent on a recovery in domestic demand ([6]).

Slovenia deleveraged actively resulting in negative credit flows but faced headwinds from contracting GDP until 2013. The change in the debt-to-GDP ratio can be split into four main drivers: net credit flows (loan repayments and lack of new lending), real GDP growth, inflation through the GDP deflator and other changes such as valuation changes (Graph 1.8). Since the peak of indebtedness in 2010, Slovenia's corporations deleveraged actively resulting in negative credit flows but contracting GDP exerted upward pressure on the ratio. In 2014 this has changed (real GDP is estimated to have increased by 2.6%) and Slovenia is again benefitting from this deleveraging channel. In addition, valuation changes and restructurings have also contributed positively to the corporate debt reduction. However, with inflation at historically low levels (0.4% in 2014 and forecast at -0.3% in 2015), the borrowers can no longer depend on inflation to reduce the real value of their debt.

Graph 1.8: Deleveraging contribution dynamics, debt-to-GDP change

Source: Eurostat, European Commission.

Active deleveraging has had a negative impact on domestic demand. Investment has been particularly affected in Slovenia. While saving rate of non-financial corporations remained largely unchanged, investment took the biggest hit in Slovenia compared to the euro area (Graph 1.9). Unless reversed, this trend will have negative consequences on productivity and economic growth in the medium and long term (more information on investment in section 3.3).

Deleveraging is expected to continue, albeit at a slower pace. Weak credit market conditions and the remaining high indebtedness of the corporate sector relative to earnings create pressure for further active deleveraging. This process is likely to be characterised by continued loan repayments and limited new lending activity. The Commission estimates ([7]) that the corporate sector will keep facing deleveraging pressures in the short term. However, deleveraging needs of the households appear limited and the household sector's balance sheet is expected to stop contracting in 2015. Going forward, expected GDP growth would contribute to reducing Slovenia's debt burden. This in turn would reduce the drag on aggregate demand and stress for asset markets.

Graph 1.9: Non-financial companies - change in investment 2008-13, % of value added

Source: Eurostat.

Employment and social conditions

The labour market showed signs of improvement in 2014. After 5 years of rising unemployment, the trend started to reverse. However, structural challenges remain. Long-term unemployment increased in 2014 making up over half of the total unemployed. Youth unemployment rate stabilised marginally below the EU average. The number of people at risk of poverty or social exclusion has risen consistently since 2009.

Inflation

Three different inflationary patterns are identified over the years in Slovenia. During the years preceding the financial crisis Slovenia experienced increasing inflation, which remained consistently above the euro area average and peaked at 6.5% in the first quarter of 2008. Between 2009 and 2012, core inflation remained at low levels and HICP developments were mainly attributable to changes in energy and unprocessed food prices. In the following period core inflation stabilised, but since the third quarter of 2013 it has gradually declined reflecting weaker domestic demand and declining import prices. In 2014, the steep fall in the oil price and declining food prices had a significant impact in driving headline inflation lower. Taking into account the improving consumer confidence and its lag with the headline inflation, the decreasing trend of HICP is expected to bottom out in the second quarter of 2015. Deflation of 0.3% is projected in 2015 before returning to a moderate inflation rate of 0.9% in 2016 as the economic recovery strengthens (Graph 1.10).

Graph 1.10: HICP and consumer confidence

Source: EUROSTAT, European Commission.

Box 1.1: Economic surveillance process The Commission’s Annual Growth Survey, adopted in November 2014, started the 2015 European Semester, proposing that the EU pursue an integrated approach to economic policy built around three main pillars: boosting investment, accelerating structural reforms and pursuing responsible growth-friendly fiscal consolidation. The Annual Growth Survey also presented the process of streamlining the European Semester to increase the effectiveness of economic policy coordination at the EU level through greater accountability and by encouraging greater ownership by all actors. In line with streamlining efforts this Country Report includes an In-Depth Review — as per Article 5 of Regulation no. 1176/2011 — to determine whether macroeconomic imbalances still exist, as announced in the Commission’s Alert Mechanism Report published on November 2014. Based on the 2014 IDR for Slovenia published in March 2014, the Commission concluded that Slovenia was experiencing excessive macroeconomic imbalances requiring decisive policy action, in particular the risk stemming from an economic structure characterised by weak corporate governance, high level of state involvement in the economy, losses in cost competitiveness, the corporate debt overhang, and the increase in government debt. This Country Report includes an assessment of progress towards the implementation of the 2014 Country-Specific Recommendations adopted by the Council in July 2014. The Country-Specific Recommendations for Slovenia concerned fiscal policy and long-term fiscal stability (including pension reform and long-term care); effective tailor-made active labour-market policy measures, skills mismatches, wages and labour market segmentation; restructuring of the banking and corporate sectors, including Slovenian Sovereign Holding; privatisation; selected aspects of the business environment; and fighting corruption.

Table 1.1: Key economic, financial and social indicators - Slovenia

Source: Eurostat, ECB, AMECO.

Table 1.2: MIP scoreboard indicators - Slovenia

Source: European Commission, Eurostat and DG ECFIN (for the indicators on the REER).

Balance sheet contraction, rising non-performing loans, erosion of capital buffers and liquidity pressures affected the Slovenian banking system from the onset of the crisis. All Slovenian banks, large state-owned banks in particular, have suffered sizeable losses and have significantly shrunk their balance sheets since the beginning of the crisis in 2008. The first phase of deleveraging was triggered by the international financial crisis. Many Slovenian-specific elements such as the high debt leverage of the corporate sector, the significant involvement of the state in the economy and short-comings in risk management and corporate governance, were revealed and reinforced by the crisis, triggering a sharp increase in non-performing loans in banks. These credit quality trends, together with deteriorating collateral values, quickly eroded capital bases and market confidence.

State of play of banking and corporate restructuring

Following the extensive overhaul of the banking system in 2013 Slovenia has taken further policy action to stabilise the banking sector in 2014. On 12 December 2013 the Slovenian authorities announced their strategy for the restructuring of the financial sector based on the outcome of the Asset Quality Review and Stress Test. The Stress Test identified capital deficits of up to EUR 4.8 billion, EUR 3.2 billion of which was provided by the state in December 2013. These measures were reinforced by several further policy actions to stabilise the banking sector in 2014. The recapitalisation of Banka Celje with EUR 190 million together with a transfer of assets of EUR 412 million (gross value) in December have been the latest measures taken by the Slovenian authorities. Overall six banks have received capital amounting to EUR 3.6 billion (Table 2.1.1). Foreign banks that took part in the 2013 stress test exercise (UniCredit Bank, Raiffeisen Bank, Hypo Group Alpe Adria) have also substantially improved their capital positions mainly through reduction of risk-weighted assets and/or direct capital injections by their parent banks. Although the results of the ECB comprehensive assessment published in October 2014 identified a joint capital shortfall of EUR 65.3 million for both NKBM and NLB ([8]), the exercise found that the measures taken to improve structural profitability and the retained earnings of the banks in 2014 will cover the shortfalls identified for both banks. Bank of Slovenia has sought an appropriate follow-up of the shortcomings identified by the Asset Quality Review exercise of 2013 and has introduced two macro-prudential initiatives targeted at easing competition for deposits – (i) a cap on deposit interest rates introduced in 2012 and (ii) minimum requirements for the ratio of annual changes of the stocks of loans to non-bank deposits to slow the rapid decline in the loan-to-deposit ratio (Box 2.1.1).

The Bank Asset Management Company has set out its strategy and business plan and is now fully operational. The Bank Asset Management Company has so far received assets with a total gross value of approximately EUR 5.0 billion (net value of EUR 1.7 billion) from four state-owned banks (Nova Ljubljanska Banka - NLB, Nova Kreditna Banka Maribor - NKBM, Abanka and Banka Celje) and two smaller domestic banks in wind-down - Probanka and Factor Banka (Table 2.1.1). Approximately two thirds of the exposures are in default. The objective of the Bank Asset Management Company for these loans will be to acquire the collateral (mostly real estate but also some equity and company assets). The remaining approximately 100 cases in the portfolio of the Bank Asset Management Company are companies with potentially viable core activities, which could be maintained if they were subject to an appropriate financial and operational restructuring.

Table 2.1.1: Overview of executed recapitalisation measures and asset transfers to the BAMC

Source: Bank of Slovenia, Commission services.

The restructuring of the highly leveraged corporate sector remains a key challenge for the banking sector and the Slovenian economy as a whole. The Ministry of Finance supported by the Bank of Slovenia has set up a comprehensive restructuring master plan. A task force has been established to monitor and coordinate the overall restructuring process, to facilitate the negotiation process between all stakeholders involved and to provide the necessary guidance and advice. The coordinating body of the task force is composed of representatives of the Ministry of Finance, the Bank of Slovenia, the Ministry of Economics, the Ministry of Justice and the Bank Asset Management Company and meets twice a month.

Credit and financial developments since mid-2013

The restored confidence in the Slovenian banking system has eased liquidity pressures. Confidence in the major state-owned banks has returned and there has been an inflow of retail funds since the beginning of 2014 (Graph 2.1.1). The market exit of Probanka and Factor Banka, two smaller banks that were competing intensively for deposits until September 2013, could have relieved the competition on deposits. Since mid-2013 deposit rates decreased by approximately, 150-200 basis points (Graph 2.1.2 and Graph 2.1.3). The closure of the gap in interest rates for deposits between state-owned and foreign-owned banks results from various factors, particularly the improved funding conditions of state-owned banks, the cap on deposit interest rates and the restoration of consumer confidence in state-owned banks.

Graph 2.1.1: Household deposit of sector - total deposits by type of bank

Source: Bank of Slovenia, Fitch.

Box 2.1.1: Measures taken by the Bank of Slovenia to improve corporate governance and risk management in banks Following the conclusion of the asset quality review (AQR) and the stress test carried out in 2013, which revealed serious shortcomings in the banks’ business processes and risk management practices, Bank of Slovenia asked all banks involved in the exercise to respond to the AQR findings that affected them. Three banks that benefited from state aid were asked to submit an action plan by the end of March 2014 to address the deficiencies identified in the AQR and to implement their plan before the end of 2014. Implementation of these action plans is being assessed by Bank of Slovenia in cooperation with the single supervisory mechanism (SSM). The banks have improved practices in many areas, especially underwriting standards and NPL work-out. Since December 2014, NPL and forbearance definitions are in line with EBA definitions in all banks. New and tighter corporate governance rules were introduced during 2014, in line with international standards. Further measures could be taken to address some shortcomings identified by the AQR in 2013 (e.g. on IT, data and quantitative aspects), but overall, risk management practices appear to have significantly improved during 2014 Bank of Slovenia has also introduced some additional regulations regarding banks’ corporate governance, relating to the membership and functioning of banks’ boards, strengthening the provisions on the management of credit, market and operational risks, on the internal control functions (i.e. internal audit, compliance and information security) and diligence of members of the management body, risk management and remuneration. Bank of Slovenia has also taken steps to improve its own effectiveness on banking supervision and in the area of corporate governance. In 2012, Bank of Slovenia requested an IMF review of its supervisory practices. On the basis of IMF’s recommendations, a detailed action plan was drawn up. In spring 2014, Bank of Slovenia carried out an internal reorganisation and again requested IMF technical assistance. Among other issues, this identified a lack of supervisory staff. A new central credit registry (CCR) for corporates and private persons is also being set up. This is expected to be operational from 2016 and will be connected to the other CCRs within the euro area to be used for micro- and macro-supervision and research purposes. During 2013 and 2014, with the instability in the banking sector and the AQR and stress test that followed, Bank of Slovenia’s on-site supervision activity was stopped due to lack of resources. On-site supervision activities will be resumed in 2015. Following a bilateral agreement, the SSM will also support Bank of Slovenia in monitoring non-systemic banks, which will certainly contribute to carrying out supervisory activity with adequate resources, based on high international standards. It will be important to monitor closely how the banks implement the new regulatory guidance on corporate governance and risk management and how they have addressed the shortcomings identified in the two AQRs to make sure the events of the recent past are not repeated.

Policy measures taken in 2013 and 2014 have facilitated the deleveraging of banks' balance sheets. Since 2012, negative credit flows have led to a steady decline of the loan stock, in particular in the state-owned banks. The deleveraging process that is currently underway has contributed to this decline. However, there are several one–off factors that have also affected the stock on an aggregate level. The commencement of the orderly wind down of Factor Banka and Probanka and the additional significant amount of provisions required as a result of the 2013 asset quality review further contributed to the strong decline in 2013. The significant fall at the end of 2013 was driven by the transfers of non-performing loans from NLB and NKBM to the Bank Asset Management Company (Graph 2.1.4). The additional transfers to the Bank Asset Management Company from Abanka in October 2014 and Banka Celje in December 2014 further reduced the aggregate level across the system.

Graph 2.1.2: Deposit rates (< 1 year)

Source: Bank of Slovenia.

The improvement of the funding situation and the reduction of the loan books allowed banks to repay most of their ECB borrowing and a significant portion of their interbank debt (Graph 2.1.5). Slovenian banks participated in the September and December 2014 Targeted Longer Term Refinancing Operations for EUR 706 million (71% of potential volume).

Graph 2.1.3: Deposit rates (> 1 year)

Source: Bank of Slovenia.

The funds helped the banks to continue the early repayment of the three-year Longer Term Refinancing Operations settled in 2011 and 2012, of which 90% have been repaid. NLB regained access to funding in the international capital markets in July 2014 supported by favourable market conditions ([9]).In view of the improved funding situation in the banking system the deleveraging pressure on domestic banks is expected to ease going forward. Foreign banks have also deleveraged although the size of their balance sheets have been reducing at a slower pace ([10]). Many foreign-owned banks (Raiffeisen Bank ([11]), Hypo Group Alpe Adria) have actively reduced their exposure to the Slovenian market and repaid part of the intra group lending to their parent institutions (see the significant increase of foreign loans in foreign banks in Graph 2.1.15). Although loan to deposit ratios of foreign-owned banks have decreased faster than in domestically-owned banks they are still higher due to the outstanding stocks of intra group funding.

Graph 2.1.4: Total assets and loans of the Slovenian banking system

Source: Bank of Slovenia.

Graph 2.1.5: Composition of banks' liabilities

Source: Bank of Slovenia.

After the significant losses of the past three years, the banking sector has returned to profitability in 2014. Net interest margins and profitability have started to recover (Graph 2.1.6). The higher net interest margins are mainly driven by the sharp reduction of interest rates on non-banking deposits (Graph 2.1.7). The improved profitability can be attributed to the significantly lower level of impairments and provisions and the growth in net interest income. For NLB and NKBM some beneficial effects on interest income arise from the high yield (approximately 4%) on government and Bank Asset Management Company bonds the banks received in December 2013 in the context of recapitalisations and asset transfers. This source of revenue however is temporary as the bonds mature in 2015-2016. The government and Bank Asset Management Company bonds received by Abanka and Banka Celje in 2014 were issued at significantly lower yield in line with the market developments (approximately 1.5%).

Graph 2.1.6: Net interest margin by bank

Source: Fitch.

Graph 2.1.7: Growth rate of interest income and expenses of the banking sector

Source: Bank of Slovenia.

Remaining challenges

Lending to the real economy remains constrained. Credit growth in Slovenia continues to be negative (Graph 2.1.8), although a large part of that negative growth is due to the one-off transfer of non-performing loans to the BAMC. The negative credit growth is more pronounced for domestic-owned than for foreign-owned banks, partly due to the speed of deleveraging of domestic-owned banks but also due to differences in market behaviour and the banks' risk aversion (Graph 2.1.9). The negative trend in lending to non-financial corporates is closely linked to the low cash-flow capacity and high leverage of the Slovenian corporate sector, the remaining high level of corporate non-performing loans on banks' balance sheets and the on-going financial and operational restructuring in the corporate sector. The number of creditworthy corporates requesting loans in the domestic market is low and competition for these clients is intense. Most of the nationally recognized, well-established and financially sound companies have access to financing abroad at more competitive rates, as loan rates (especially short-term) in Slovenia generally remain above those of their regional peers (Graph 2.1.10 and 2.1.11), or are taking the opportunity to tap international and domestic capital markets ([12]). Consequently, competition between domestic banks has further increased and has started to exert pressure on corporate lending rates, which could adversely impact net interest margins and profitability of the banks going forward.

Graph 2.1.8: Change in stock of domestic credit and contributions

Source: Bank of Slovenia.

Graph 2.1.9: Credit growth - Total loans

Source: Bank of Slovenia.

Graph 2.1.10: Short term interest rates (< 1 year)

Source: ECB.

Graph 2.1.11: Long term interest rates (>1 year)

Source: ECB.

The high debt leverage of the corporate sector is adjusting, but profitability and creditworthiness of borrowers has not yet significantly improved. The leverage ratio ([13]) increased from a moderate multiple of 4.8 before the crisis (2007) to its peak of 6.7 in 2009 (Graph 2.1.12), ([14]) also mirrored by an increase in the debt to total assets ratio. Deleveraging started in 2010 and has been progressing since then, though in different stages, which has formed three different categories of debtors (Box 2.1.2). In 2010 - 2011, deleveraging was mainly driven by market exits (bankruptcies or firm takeovers). Since 2012 financial liabilities of ongoing businesses have been declining (by EUR 0.4 billion in 2012 and by further EUR 0.5 billion in 2013) ([15]). The reduction of financial liabilities in viable firms is expected to have accelerated further in 2014 based on most recent data. Nevertheless, profit margins have not improved since their collapse during the crisis. This can be seen both in terms of operational profitability (Earnings before interest, taxes, depreciation and amortization - EBITDA margin ([16])), indicating that the capacity of the corporate sectors to generate cash flows and repay debt has not yet fully recovered. It is also evident from net profit margins, which remains squeezed due to high debt service costs (Graph 2.1.13).

Graph 2.1.12: Indebtedness of the corporate sector

Source: AJPES, Commission services.

Graph 2.1.13: Cash flow capacity and profitability of the corporate sector

Source: AJPES, Commission services.

Graph 2.1.14: Credit growth - corporate loans (incl. SME)

Source: Bank of Slovenia.

Graph 2.1.15: Credit growth - foreign loans

SID Banka not included Source: Bank of Slovenia.

The 3 major state-owned banks are particularly affected by the increased competition and the lack of good-quality credit demand. While state-owned banks are bound by the commitments provided in the context of the state aid restructuring procedures (i.e. minimum return on equity on new loans, maximum cost income ratio), foreign-owned banks have more flexibility. As a consequence of the new risk management policy of state-owned banks, loans to clients rated below B can in practice only be provided if they are highly collateralised or secured with a guarantee (e.g. by another bank, a parent company, a subsidiary or the state). Various lending support schemes have been launched by SID Banka (the Slovenian development bank) to enhance lending to SMEs, but few companies appear to meet the criteria, so the funds remain largely undrawn (Section 4.3).

In state-owned banks, lending has focused on the roll-over of stocks related to restructurings with new lending lower than in foreign-owned banks (Graph 2.1.16). One reason may be that the focus of the domestically owned banks is the on-going work-out of corporate non-performing loans which is resource intensive. A proportion of the "new lending" from foreign-owned banks is not targeted at the local economy but is linked to the reduction of the intra group lending from their parent institutions (Graph 2.1.15).

Graph 2.1.16: New lending vs. prolongation

M – Major state-owned banks, O - Other domestic banks, F – foreign-owned banks SID Banka is not included Source: Bank of Slovenia.

The level of non-performing loans remains elevated compared to pre-crisis level, despite the transfers made by banks to the Bank Asset Management Company. In November 2014 the volume and level of NPLs in the banking system decreased to EUR 5.1 billion due to the transfer of non-performing loans to the BAMC and stands at a level of 13.1% ([17]). Nevertheless, the major state-owned banks have systematically higher non-performing loan ratios than foreign-owned banks although the former have benefitted from a transfer to the BAMC (Graph 2.1.18). The still high volume of non-performing loans in domestic banks (Graph 2.1.17) is the result of the selective and only partial transfer of non-performing loans to the BAMC, a still deteriorating quality of the domestic loan portfolio, the introduction of a stricter non-performing loan definition (to align with EBA guidance) and the poor asset quality in the foreign direct lending portfolios (which were not transferred to the Bank Asset Management Company). The increased restructuring efforts will materialise in the NPL levels with a time lag as key credit risk indicators will only adjust once operational restructuring is implemented and this takes time. In addition, restructured loans have to remain classified as non-performing loans for at least one year after the restructuring is concluded. System wide non-performing loans ratios are also affected by the contraction of new lending and the subsequent reduction of the loan stocks, particularly for banks that are winding down.

Graph 2.1.17: NPLs by type of bank

Q4 14 contains data until November 2014. Source: Bank of Slovenia.

Graph 2.1.18: NPL ratios by type of bank

Q4 14 contains data until November 2014. Source: Bank of Slovenia.

The majority of the non-performing loans are concentrated in the domestic corporate loan book. Only in the state-owned banks and in the banks in wind down the proportion of foreign corporate non-performing loans remains at levels above 30% (Graph 2.1.19). Foreign non-performing loans were not transferred to the Bank Asset Management Company and constitute about 22% of the total remaining stock of non-performing loans in all banks. They mainly consist of lending to companies outside Slovenia (mostly ex-Yugoslav countries, Bulgaria, Romania) but also lending of subsidiaries of the domestic banks in ex-Yugoslav countries, Bulgaria and Romania. Foreign non-performing loans are diverse in terms of sector and size and are often based on bilateral agreements It is therefore resource intensive to find a systematic solution to restructuring these wide ranging exposures.

Coverage ratios close to 60% reinforce the capacity of banks to absorb some losses from their non-performing loans portfolios. The relatively high coverage ratios ([18]) show that the remaining stocks of non-performing loans are better provisioned than in the past three years and therefore should pose less of an imminent risk to the solvency of the banks (Graph 2.1.20). The large state-owned banks report the highest coverage ratios, mainly due to supervisory actions taken by the Bank of Slovenia.

Graph 2.1.19: Structure of NPLs by bank (Q3 2014)

Source: Bank of Slovenia.

Swift restructuring and work out of the non-performing loans is crucial for enhancing long-term profitability and viability of the Slovenian banking system, boosting investment, strengthening domestic demand and supporting the economic recovery going forward. Enhanced cooperation amongst the different stakeholders, availability of working capital financing and fresh equity for the companies in restructuring are important recipes to facilitate and accelerate the work-out process. The Bank Asset Management Company and the bigger domestic banks follow a long-term value-based approach to restructuring. Smaller domestically owned banks which are in the process of winding-down (Factor and Probanka), as well as some of the foreign-owned banks which have started to reduce their exposure to the Slovenian market, have a shorter time horizon and seek a quick exit. This may present challenges when negotiating restructuring plans for companies.

The Bank Asset Management Company has no lending capacity and domestic banks are reluctant or unable to provide working capital to companies in restructuring as they are constrained by stricter lending and risk management policies. Alternative sources of financing like asset backed securities or corporate bonds could be further developed (Section 4.3). Fresh equity needs to be available to support the deleveraging of the companies. Debt-to-equity swaps driven by the Bank Asset Management Company will further increase the level of state ownership in the economy. Privately-based structured solutions, such as the establishment of special purpose vehicles, could provide an alternative solution. The role of the recently established corporate restructuring task-force is to monitor and coordinate the overall restructuring process and to provide the necessary guidance and provide solutions to the outstanding issues.

Graph 2.1.20: Coverage ratios type of bank

Q4 14 contains data until November 2014. Source: Bank of Slovenia.

Reinforcing the long-term profitability and reducing non-performing loans in the corporate segment are key to further stabilise the banking sector. The ongoing restructuring and rationalisation of the major state-owned banks provides an opportunity to reduce the cost base in a sustainable manner. Furthermore, there could be scope to increase the non-interest income of banks. Macro-prudential measures introduced by the Bank of Slovenia (Box 2.1.1) are supposed to improve the quality of lending activity, though it is still too early to assess the impact of these measures. The swift restructuring of the corporate sector by making full use of all existing tools, such as the Bank Asset Management Company and the new insolvency legislation, could boost the recovery of the cash-flow capacity of the corporate sector, which is an important prerequisite for enhancing the profitability of banks.

Further consolidation and enhanced corporate governance of the banking sector could be facilitated through the continuation of the privatisation process. The share of state-owned and state controlled banks in Slovenia has been high and has increased even further after the crisis as a result of the banking sector restructuring. More than 60% of Slovenian banks' assets are in the hands of state-owned banks. As a result of weak corporate governance and interconnectedness with other state-owned and state-controlled enterprises, Slovenian state-owned banks suffered significant losses during the crisis and experienced systematically higher non-performing loan ratios compared to foreign-owned peers (Graph 2.1.18). The rehabilitation of the banking sector had important fiscal implications for Slovenia, amounting to more than EUR 5.7 billion from 2007 to date (Section 3.2). Majority of these state interventions were capital injections covering past losses with a direct negative impact on both public debt and deficit (approx. EUR 4 billion), while the remaining were linked to setting up the Bank Asset Management Company ([19]) (EUR 1.7 billion in equity and bonds). Although risk management in state-owned banks has been improving over the past year, the state does not have the same incentive structure, economies of scale and expertise (e.g. risk modelling, IT, data collection) that a large international group can offer to its subsidiaries. Slovenia has committed to reduce the share of state ownership in the banking sector. Continuous progress in this area would further help to halt the negative feedback loop between the sovereign and the banking system.

Box 3.1.2: Structure of debtor companies liable for the NPLs Three main categories of debtor companies liable for NPLs can be identified: The first category consists of construction and infrastructure companies, where bankruptcy rates have already peaked and most of the inefficient firms have exited the market. The majority of these exposures have been transferred to the BAMC and a large proportion of the losses have already been recognised by banks. The BAMC needs to enforce the collateral of these loans, realise any possible gains and complete the insolvency procedures. The recovery value obtained by the BAMC, and subsequently the state, will mainly depend on how efficiently the stakeholders and the courts manage the insolvency procedures. The second category consists of highly leveraged financial holdings, management buy-out companies and other highly leveraged medium-to-large size Slovenian companies. The latter include a small number (up to 100) that have a high value and are economically important (2014 in-depth review: approximately 90 % of debt carry-over is concentrated in just a handful of companies), which are mostly reliant on domestic demand, with some state-owned or state-controlled exporters as an exception (e.g. Cimos, Elan). In several cases, these companies have used a relatively large amount of (or exclusively) debt financing to acquire stakes in various businesses and have placed this debt on the balance sheet of the acquired companies. The subsidiary businesses are mostly domestically focused and many of them might have viable core activities. Many of the exposures in this category (both holdings and large companies) have been transferred to the BAMC, though some remain with the banks as a result of not having qualified for transfer. The BAMC and the corporate restructuring task-force should focus on swift financial and operational restructuring of viable companies, which will be crucial for the recovery of investment and of domestic demand in Slovenia. The third category includes NPLs of other large corporates and SMEs with sound core business activities but which, during the boom years, expanded their activities in non-core areas such as real estate or tourism. This category also includes suppliers to companies in the second category that have suffered from reduced orders. Some of the exposures in this category have been transferred to the BAMC, but most of them are still on the banks’ balance sheets, either because they did not qualify for a transfer (e.g. exposures were too small or still performing) or they are with banks that have not (yet) transferred assets to the BAMC. Due to their size, the work-out of many of these companies has yet to begin, and needs to be a priority of the ongoing restructuring efforts. There is more to be done here than in the case of the large companies and holdings, and this will most likely continue to take up significant management resources of the banks.

The state involvement in the economy remains elevated and it has incurred significant fiscal and economic implications for Slovenia since the onset of the crisis, amounting to over EUR 13 billion. The state is the largest employer, asset manager and corporate debtor in Slovenia. State-owned enterprises and state-controlled enterprises ([20]) employ one fifth of the employees working in non-financial companies, and hold approximately one third of the total corporate assets and the total outstanding corporate debt. In the period 2007 to 2013 state-owned enterprises/state-controlled enterprises have significantly underperformed compared to their privately owned peers in terms of productivity and profitability at both a national and peer country level. Negative spill-overs from the high state involvement in the economy and inefficient corporate governance in state-owned enterprises/state-controlled enterprises distort resource allocation, harm the business environment and hamper private investment and growth. As a result, the corporate sector remains undercapitalised and the resolution of non-performing loans is progressing slowly, which in turn delays the recovery in the banking sector. This section analyses the complex nexus of state-owned banks, insurance companies and non-financial companies and the impact on the Slovenian economy.

Importance of State-owned enterprises and State-controlled enterprises in the Slovenian economy

A complex network of directly and indirectly state-owned or state controlled banks, non-financial companies, insurance companies and investment funds continues to weigh on the economy. At the end of 2014, 642 State-owned enterprises/State-controlled enterprises were identified as linked to the state via a complex cross-ownership structure. State control is exercised in several ways. Most of these 642 companies (over 61% in terms of book value of assets), are directly controlled by the Republic of Slovenia, through a single entity – the Slovenian Sovereign Holding (SSH) ([21]), or quasi-directly through the municipalities or the various state management funds (KAD, PDP([22]), DSU ([23]), Modra Zavarovalnica). Another 32% are indirectly controlled through the Bank Asset Management Company, the banks, the insurance companies, and other financial companies (e.g. mutual), which are all fully and directly owned by the Republic of Slovenia. While the corporate restructuring is on-going,the state influence is likely to increase through debt-to-equity swaps in the banks and the Bank Asset Management Company. The remaining 6.5% of state-owned enterprises/state-controlled enterprises are controlled through other state-owned enterprises/state-controlled enterprises and their subsidiaries (2.2.1).

The state is the largest asset manager and corporate debt holder in Slovenia. Although state-owned enterprises/state-controlled enterprises represent only about 1% of the total number of companies in Slovenia, they are highly significant from an economic perspective ([24]) and are relatively bigger in size compared to their private owned peers (Table 2.2.2). State-owned enterprises/State-controlled enterprises account for one third of the assets, a quarter of the value added, over 40% of the equity value and one third of the financial debt obligations of non-financial companies. State-owned enterprises/State-controlled enterprises presence is particularly strong not only in transport, energy and public utilities, but also in other sectors where state involvement is less pronounced in peer countries ([25]) (Graph 2.2.1) such as consumer staples, chemical industry, manufacturing, tourism and leisure ([26]). The state is the largest corporate debt holder in Slovenia through its prevalent ownership of the banking system (direct owner of more than 60% of the banking assets ([27])). The state also manages 88% of the pension assets and 60% of all insurance liabilities. In various cases, the state is present as both an equity and debt holder. The conflict between the two mandates in particular in distressed companies requires coordination in order to minimise the risks and maximise the returns for the state.

Table 2.2.1: The network of state ownership and state control in Slovenia

Source: Chamber of Commerce of Slovenia, Commission Services.

Graph 2.2.1: Share of State-owned enterprises/State-controlled enterprises in sectoral value added (as % of total sectoral valued added), 2013

Source: Orbis database and Commission Services calculations.

One third of the workforce in Slovenia is employed by the state. state-owned enterprises/state-controlled enterprises employ one fifth (19%) of all the workers in non-financial companies (approximately 80 000), and roughly additional 15 000 employees in the financial sector. Together with the 160 000 employees in the public sector this amounts to 33% (approximately 255 000) of total employment in Slovenia (Graph 2.2.2).

Graph 2.2.2: Employment, 2013 – public, private and State-owned enterprises/State-controlled enterprises

Notes: The employment data for State-owned enterprises/State-controlled enterprises includes the total number of employees in these companies without applying the proportion corresponding to the share of state ownership. Source: National Statistical office of Slovenia, The Agency of the Republic of Slovenia for Public Legal Records and Related Services (AJPES), Commission Services calculations.

Table 2.2.2: Relative importance of state-owned enterprises/state-controlled enterprises (as % of total non-financial companies)

Note: The table covers only 561 out of the total 642 companies as it excludes the banks, financial services, insurance and asset management companies (27); as well as companies in insolvency (27); newly established companies in 2014 (26) and one other company for which financial account were not available. The importance of state ownership in the banking sector is described in Section 3.1. Source: The Agency of the Republic of Slovenia for Public Legal Records and Related Services (AJPES), Chamber of Commerce of Slovenia, Commission services .

Graph 2.2.3: Book value of equity of State-owned enterprises/State-controlled enterprises in Europe (as % of GDP)

Source: 2012 OECD data on size and sectoral distribution of State-owned enterprises, Commission services calculations.

The state involvement in Slovenia is amongst the highest in Europe. The book value of equity of state-owned enterprises/state-controlled enterprises relative to GDP (Graph 2.2.3) is the highest in Europe if majority state-owned companies (over 50%) are taken into account and the second highest if minority stakes are also included (between 10% and 50%), while their share in terms of employment is the third highest in both cases (Graph 2.2.5). According to a set of OECD soft indicators ([28]), the extent to which the state owns, controls, or is involved in business in Slovenia (state control) is above the average in EU or in its Central and East European peers (Graph 2.2.5), particularly when it comes to government involvement in the network industries (equity shares in electricity, gas, rail, transport, air transport, postal services and telecommunications). Slovenia scores second worst in terms of involvement of the state in business operation (the extent and type of price controls and regulation) and the use of command and control regulation by the government (the extent to which government uses coercive as opposed to incentives based regulation in general and in specific sector, such as road freight, retail trade, air transport, railways, professional service). Moreover, free market principles such as price liberalisation and competitive decision-making based on incentives appear to be distorted as well relative to peers.

Graph 2.2.4: OECD indicators for product market regulation (2013)

Source: 2013 Indicators of product market regulation comprised by OECD. The graphs display different indicators (meaning described in the title of the graphs) on a scale from 0 – least restrictive state involvement/ control, to 6 - most restrictive state involvement/ control.

Graph 2.2.5: Employment at State-owned enterprises/State-controlled enterprises in Europe (as % of total employment)

Source: 2012 OECD data on size and sectoral distribution of State-owned enterprises, Commission services calculations.

State-owned enterprises/State-controlled enterprises financial performance and productivity ([29])

State-owned enterprises/State-controlled enterprises in Slovenia continue to be highly leveraged and many of them remain at risk of default. The debt leverage of state-owned enterprises/state-controlled enterprises has been higher than the debt leverage of all corporates since the onset of the crisis (Graph 2.2.6). Based on aggregated data, the leverage ratio ([30]) of state-owned enterprises/state-controlled enterprises stood at 7.2 in 2013 ([31]), above the 6.1 average for all corporates. More significant differences in the debt leverage of state-owned enterprises/state-controlled enterprises emerge on sector level. In 14 sectors out of 22 state-owned enterprises/state-controlled enterprises are highly leveraged (Table 2.2.2). Particularly exposed are companies in the mining, apparel & wood production, real estate and financial services sectors ([32]), as their operating profit ([33]) has been negative for a prolonged period and hence they are at risk of default.

Graph 2.2.6: Leverage ratio of State-owned enterprises/State-controlled enterprises and all Non-financial companies (excl. energy and public utilities sectors)

Source: The Agency of the Republic of Slovenia for Public Legal Records and Related Services (AJPES), Chamber of Commerce of Slovenia calculations.

Based on aggregated industry data ([34]), in 2013 state-owned enterprises/state-controlled enterprises generated net losses in certain sectors. On average state-owned enterprises/state-controlled enterprises posted weaker financial results mainly due to the higher net financial losses resulting from impairments of their non-core assets (e.g. stakes in non-core subsidiaries). Gross losses were concentrated in the financial services and the metal processing industries and accounted for 64% of the total losses generated by state-owned enterprises/state-controlled enterprises. Gross profits were mainly generated by the energy, chemical industry, and transport & storage industries (70% of total profits of state-owned enterprises/State-controlled enterprises).

Graph 2.2.7: Profitability (ROCE) of State-owned enterprises/State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (2004-2013 average)

Source: Orbis database and Commission services calculations.

Compared to their privately owned peers in Slovenia and in other Central and Eastern European countries, State-owned enterprises/State-controlled enterprises are less efficient in deploying their resources (capital employed). In 2013, profitability of State-owned enterprises/State-controlled enterprises in terms of return on equity ([35]) and return on capital employed ([36]) was lower than that of their privately owned peers – both domestic and foreign-owned. When compared against profitability of domestic private owned companies in Slovenia as a benchmark, State-owned enterprises/State-controlled enterprises underperform, while foreign-owned enterprises outperform in some sectors (Graph 2.2.7 and 2.2.8). Relative to State-owned enterprises/State-controlled enterprises in most other CEE countries, Slovenian State-owned enterprises/State-controlled enterprises also underperform based on industry level comparison in all sectors except for energy (Graph 2.2.8).

Graph 2.2.8: Profitability (ROE) of State-owned enterprises/State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (2004-2013 average)

Source: Orbis database and Commission services calculations.

State-owned enterprises/State-controlled enterprises are amongst the companies with the highest debt leverage relative to peers in Slovenia and in other Central and Eastern European countries. State-owned enterprises/State-controlled enterprises are relatively more indebted than their privately owned peers in almost all sectors apart from the chemical and pharmaceutical sector. Foreign-owned enterprises on the contrary are relatively less indebted than domestic privately owned companies in Slovenia in all sectors reviewed (Graph 2.2.9). Slovenian State-owned enterprises/State-controlled enterprises appear to be more indebted relative to the State-owned enterprises/State-controlled enterprises in most other Central and Eastern European countries based on industry level data (Graph 2.2.9).

State-owned enterprises/State-controlled enterprises are less productive than their peers in Slovenia and in other Central and Eastern European countries. Based on total factor productivity (TFP) estimations ([37]) for State-owned enterprises/State-controlled enterprises and foreign-owned companies in Slovenia, relative to domestic privately owned companies, underperformance of State-owned enterprises/State-controlled enterprises is observed in the majority of the sectors (Graph 2.2.10).

Graph 2.2.9: Leverage ratio of State-owned enterprises/State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (2013)

Source: Orbis database and Commission services calculations.

Given the large share of state owned enterprises in sectoral value added in some of these sectors (e.g. the chemical industry and postal services & ICT as described in table 2.2.2), underperformance of state owned enterprises can bear substantial economic costs.

Graph 2.2.10: Total factor productivity of State-owned enterprises/ State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (in %), 2004-2013 average

Source: Orbis database and Commission services calculations.

Graph 2.2.11: Profitability (ROE) of State-owned enterprises/ State-controlled enterprises by sector in Slovenia and other CEE countries (aggregate), 2013

Source: Orbis database and Commission Services calculations.

Foreign-owned companies in Slovenia seem to be more efficient and competitive than State-owned enterprises/State-controlled enterprises. While labour productivity of State-owned enterprises/State-controlled enterprises seems to be lower than in foreign-owned peers in most of the sectors examined, apart from tourism and other services (Graph 2.2.14), the costs of labour per head is higher than of those paid by private peers and similar to those paid by foreign companies (Graph 2.2.12). This indicates lower efficiency and competitiveness of State-owned enterprises/State-controlled enterprises relative to their foreign-owned and private owned peers.

Graph 2.2.12: Costs per employee of State-owned enterprises/ State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (2004-2013 average)

Source: Orbis database and Commission services calculations.

Graph 2.2.13: Debt leverage ratio of State-owned enterprises/State-controlled enterprises in Slovenia and other CEE countries (2013)

Notes: Due to negative value of the denominator (EBITDA) the estimates for Romania and Bulgaria are not relevant. Source: Orbis database and Commission services calculations.

Graph 2.2.14: Labour productivity State-owned enterprises/ State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (in %), 2004-2013 average

Source: Orbis database and Commission services calculations.

Fiscal and economic implications of state ownership in Slovenia

The total fiscal and economic implications of state involvement in the economy for the period 2007-2014 are estimated at over EUR 13 billion or just over one third of 2013 GDP. The total fiscal and economic implications of State-owned enterprises/State-controlled enterprises is considered as the sum of a number of transactions estimated in the following categories: (i) state interventions related to the rehabilitation of the banking sector ([38]), (ii) foregone profits of State-owned enterprises/State-controlled enterprises when compared to overall profitability achieved for all Non-financial companies by sector ([39]), (iii) subsidies paid by the state to companies which either became insolvent, or need external support to maintain operational profitability, (iv) equity increases of State-owned enterprises/State-controlled enterprises paid directly by the state, (v) drawn guarantees, and (vi) debt assumptions by the state. The potential future fiscal implications stemming from the drawing of outstanding guarantees and other contingent liabilities are not included in the number. While by far the largest portion of the costs is due to financial sector stabilisation measures (43%), considerable amount was also associated with wider economic implications in terms foregone profits of State-owned enterprises/State-controlled enterprises compared to their private peers (38%). The former has no direct impact on public finances and is estimated just to demonstrate the amount of potential lost value added for the state and the economy. EUR 8.2 billion (62% of the total and 22% of GDP) have direct budgetary impact – either through increase of government deficit, debt or both in most of the cases (Table 2.2.3).

Table 2.2.3: Total fiscal implications of State-owned enterprises/ State-controlled enterprises to the state and the economy

Source: The Agency of the Republic of Slovenia for Public Legal Records and Related Services (AJPES), Ministry of Finance database, Chamber of Commerce of Slovenia calculations, Commission Services.

A quarter of the increase of public debt from 2007 to 2014 can be attributed to state interventions related to financial and non-financial State-owned enterprises/State-controlled enterprises. Slovenia's gross consolidated government debt almost quadrupled from 2007 to 2014 (from EUR 7.9 billion to EUR 30.3 billion at the end of 2014). In terms of GDP it increased from 22.7% to 82.2%. A quarter of this increase (EUR 5.7 billion or 15 percentage points) was due to costs related to State-owned enterprises/State-controlled enterprises, such as capital injections, debt forgiveness, drawn guarantees as well as EUR 1.5 billion of Bank Asset Management Company bonds issued to enable the transfer of Non-performing loans to the Bank Asset Management Company (Graph 2.2.16). In addition, government deficit was also negatively impacted, particularly by the recapitalisations of the state-owned and state-controlled banks during the crisis (Graph 2.2.15).

Graph 2.2.15: Total government deficit and deficit increasing state interventions related to State-owned enterprises/State-controlled enterprises

Source: The Agency of the Republic of Slovenia for Public Legal Records and Related Services (AJPES), Ministry of Finance database, Chamber of Commerce of Slovenia calculations, Commission Services.

State-owned enterprises/State-controlled enterprises continue to pose considerable fiscal risks. About EUR 6.4 billion of contingent liabilities to the state budget are currently outstanding in the form of guarantees (18% of 2013 GDP). The significant state involvement in the economy in terms of State-owned enterprises/State-controlled enterprises high share in total assets, equity and liabilities of the corporate sector, particularly in the banking and the insurance sector increase the risks to public finances going forward.

Graph 2.2.16: Total government debt and debt increasing state interventions related to State-owned enterprises/State-controlled enterprises

Source: The Agency of the Republic of Slovenia for Public Legal Records and Related Services (AJPES), Ministry of Finance database, Chamber of Commerce of Slovenia calculations, Commission Services.

An important part of the profitability of State-owned enterprises/State-controlled enterprises and the corporate sector as a whole is supported by soft budget constraints ([40]) in the form of subsidies. The Slovenian economy is increasingly supported by various forms of subsidies, which is a source of moral hazard at management level and may adversely distort decision-making in companies, particularly decisions related to investment. In 2007-2013 the inflow of subsidies to the corporate sector amounted to approximately EUR 400 million per annum. In several sectors, the share of subsidies is greater than 20 % of operating profits (EBITDA). These are agriculture (50%), mining (78%), public utilities (26%), media (60%) and public administration, education and health (21%). State-owned enterprises/State-controlled enterprises received one third of all subsidies in 2013. One of the main beneficiaries of the subsidies was the Slovenian Railway holding (accounting for approximately 50% of all subsidies).

Graph 2.2.17: Subsidies to all Non-financial companies relative to operating profit (EBITDA) and share of subsidies to State-owned enterprises/ State-controlled enterprises

Source: The Agency of the Republic of Slovenia for Public Legal Records and Related Services (AJPES), Ministry of Finance database, Chamber of Commerce of Slovenia calculations.

Soft budget constraints combined with a limited strategic and financial management capacity distorted resource allocation and negatively affected the profitability of State-owned enterprises/ State-controlled enterprises. In line with the higher debt leverage, capital expenditure at State-owned enterprises/State-controlled enterprises was higher than at all corporates (Graph 2.2.19) both relative to operating profit and sales. This should have translated into higher profitability of State-owned enterprises/State-controlled enterprises compared to all corporates. Instead, available financing has been channelled to unproductive investments – i.e. less profitable (or loss-making) non-core activities as evident by the relatively higher share of non-core assets on the balance sheet of State-owned enterprises/State-controlled enterprises compared to private peers (Graph 2.2.18). ([41]) As these investments are less profitable than the core activities of the parent company, the overall profitability (return on equity) is negatively affected through impairments of these non-core assets. The highest level of non-core investment of State-owned enterprises/State-controlled enterprises is in the financial and insurance activities, which includes financial holding companies, in professional, scientific and technical activities, and in consumer staples and retail.

Graph 2.2.18: Other fixed assets of State-owned enterprises/ State-controlled enterprises and foreign-owned companies relative to domestic private owned companies (as % of total assets ), 2004-2013 average

Source: Orbis database and Commission services calculations.

State-owned enterprises/State-controlled enterprises Corporate governance framework and privatisation in Slovenia

Sound management and enhanced corporate governance policies for State-owned enterprises/State-controlled enterprises can assist in mitigating the risks of future state support on public finances. The level of state support provided to State-owned enterprises/State-controlled enterprises in Slovenia has been considerably above the EU average in recent years. State-owned enterprises have commenced the deleveraging of non-core assets accumulated during the boom, which will weigh on their profitability in the coming years. In parallel to addressing these legacy issues, the focus should shift to enhancing the core business of State-owned enterprises and identifying sectors where state involvement is not necessary. Slovenia could further benefit from the strong momentum and return of confidence after the restructuring of the banking sector in 2013 and 2014 in order to accelerate the privatisation process.

A new corporate governance code for State-owned enterprises was adopted in December. The new framework is reportedly in line with the basic recommendations of international practice it (i) ensures that State-owned enterprises and private companies operate on an equal footing (ii) enhances the separation of the functions of the state from its capacity as an owner (iii) applies across the spectrum of State-owned enterprises (with limited exceptions) under the "comply or explain" principle (iv) reinstates the roles of the company corpora, in particular the supervisory board, and the company's position towards the different stakeholders (v) realises the principles of transparency and touches upon a number of long-awaited issues such as the remuneration and bonuses of the company boards. Contrary to its predecessor, the new code does not exclude the parallel application of other corporate governance frameworks (e.g. that one of listed companies), thus eliminating the cases of privileged or otherwise differentiated treatment of State-owned enterprises in comparison with privately held companies. Finally, corporate governance of State-owned enterprises is explicitly connected to the goals of the forthcoming strategy on state assets, which will ensure a consistent treatment of State-owned enterprises.

Graph 2.2.19: Capital expenditure relative to operating profit (EBITDA) of State-owned enterprises/ State-controlled enterprises and all Non-financial companies

Source: The Agency of the Republic of Slovenia for Public Legal Records and Related Services (AJPES), Ministry of Finance database, Chamber of Commerce of Slovenia calculations.

The Slovenian Sovereign Holding, in charge of the management and divestment of state assets is fully operational but its asset management strategy is still to be approved. In June 2014, the ex-Slovenska odškodninska družba, d.d. ("SOD") fund was transformed into SSH following the amendment of its articles of association, in accordance with the new law adopted in late March 2014. ([42]) In order to perform its mandate, Slovenian Sovereign Holding requires a strategy reflecting the country's objectives and specifying the classification of state assets in strategic, important and portfolio investments. The deadline laid down in the law for the government to table its proposal in the parliament for that strategy and for a new supervisory board for Slovenian Sovereign Holding (July 2014) has passed. A plan for a new privatisation cycle, expected by November 2014 is also missing in the absence of the strategy. A draft asset management strategy entered intergovernmental consultations in January 2015 and is expected to be approved by the Parliament in March 2015. Within one month after the adoption of the strategy SSH will set up the annual asset management plan, which will include the new divestment schedule for additional state assets. A new supervisory board is expected to be appointed by the Parliament in the coming months after the Ministry of Finance completes the evaluation of the candidates in February 2015. A number of measures have been taken to make SSH operational, such as the adoption of an asset management policy in December 2014 ([43]). The operational aspects regarding the establishment of the SSH, e.g. required corporate transactions and legal transformations provided for in the law, are also on track ([44]).

Slovenia could further benefit from the strong momentum and return of confidence after the restructuring of the banking sector in order to accelerate the privatisation process. The privatization programme is making progress, albeit with delays. A list of fifteen companies was compiled in 2013 for a first cycle of expedited privatization, ([45]) out of which three companies have been divested through privatisation and one company has been acquired by its creditors through a debt-to-equity swap executed as part of the restructuring process. Amongst the companies that were privatised, the sale of the airport, Aerodrom Ljubljana, was the largest transaction and was completed in October 2014. The sale process for the biggest assets on the list, Telekom Slovenije (the largest telecom and the sole owner of the telecommunication network in Slovenia) and NKBM (the second largest bank, owning 11% of total banking assets) is on-going, albeit with some delays, and is expected to be signed in April and March 2015 respectively.

The asset management plan could enhance the transparency and credibility of the privatisation process. As Slovenia prepares a new cycle of privatisations it is important that the list of companies is consistent with the SSH's priorities and strategy. The privatisation of selected State-owned enterprises/State-controlled enterprises in a transparent manner can assist in attracting FDI, and improve the economic outlook for the Slovenian economy. Furthermore, any proceeds from the process can assist in reducing public sector debt and enhancing the sustainability of debt going forward.

Price and cost competitiveness

Since 2013, Slovenia has been performing relatively well on external markets, reflecting recent competitiveness gains. While certain losses in external price and cost competitiveness have occurred due to wage increases between 2008 and 2010, the most recent data and a new sectoral Real Effective Exchange Rate database show relatively positive competitiveness developments, mainly owing to Real Effective Exchange Rate depreciation in the tradable sectors.

The moderation in prices and costs after 2012 has contributed to the improvement of Slovenia's export performance. The traditional indicator of price and cost competitiveness at the macroeconomic level, Real Effective Exchange Rate deflated by Unit Labour Costs in total economy, shows a steady retreat from the significant appreciation between 2007 and 2010 (Graph 3.3.1 – lhs). The appreciation suggested a substantial loss in cost competitiveness, which may have been partly reflected in the loss of market shares in 2009-2012. The subsequent Real Effective Exchange Rate depreciation could partially explain the improvement in Slovenia's export performance since 2013, as competitiveness shifts tend to affect trade performance with a lag.

Rapid aggregate wage growth coupled with stagnating productivity and labour hoarding had previously contributed to generating imbalances. While part of the Real Effective Exchange Rate appreciation was due to rapid wage growth, the surge in the trend in 2009 was largely caused by an unexpected decrease of production and a resulting decline in productivity per employee. Collapsing economic activity combined with labour hoarding as workers were kept on the job through work support schemes weighed severely on firms' profitability, mainly in the non‑tradable sectors. The tradable sectors adjusted quickly so as to safeguard their competitiveness. For example, Real Effective Exchange Rate based on the unit labour costs in the manufacturing sector remained broadly stable over the last 15 years (Graph– 3.3.1 rhs).

A measure of competitiveness based on sectoral unit labour costs provides a more granular representation of competitiveness developments. It shows that Slovenia made considerable gains in price and cost competitiveness in the pre-crisis period but confirms deterioration in competitiveness in the run-up to the crisis that is now reversing (Graph 2.3.2). This new Real Effective Exchange Rate indicator aggregates competitiveness at sectoral level to obtain an economy-wide measure of competitiveness, which captures heterogeneous dynamics among sectors. It controls for the main limitation of the traditional Real Effective Exchange Rate, which confounds changes in the sectorial structure with changes in the unit labour costs per sector and does not account for the influence of global technological developments on different sectors.

Graph 2.3.1: Reel effective exchange rate deflated by ULCE and ULCM

Index 2000 = 100 Source: European Commission.

Graph 2.3.2: Real Effective Exchange Rate (Unit Labour Costs in total economy) and new sectoral Real Effective Exchange Rate in Slovenia

Index 2000 = 100 Source: European Commission.

Slovenia's cost competitiveness evolution has been more favourable than that of most of its peers (Graph 3.3.3). While this new indicator ([46]) is available only until 2011, it is expected to have improved further beyond this horizon due to favourable productivity developments and a very limited wage growth since 2011. In addition, Bank of Slovenia ([47]) estimated an equilibrium competitiveness indicator based on unit labour costs for Slovenia vis-à-vis EA-12 and compared it with those of its main trading partners. According to this indicator based on unit labour costs, price and cost competitiveness has substantially improved since 2010. A recent extension of this analysis confirms that the competitive position of Slovenia returned to equilibrium in 2014.

The Nominal Unit Labour Cost index is once again approaching the euro area average (Graph 2.3.4). This follows a period of decoupling due to the acceleration in wage growth at the time of no additional productivity gains. The three years (2008-2010) with flat hourly productivity and still growing wages adversely impacted Slovenia's price and cost competitiveness vis-à-vis the Euro Area. Nevertheless, Slovenia's Nominal Unit Labour Costs still grew slower than those of most of its peers.

Graph 2.3.3: Sectoral Real Effective Exchange Rate aggregate in SI and V4

Index 2000=100 Source: European Commission.

Graph 2.3.4: Nominal Unit Labour Cost

Index 2002 = 100 Source: Eurostat.

While Nominal Unit Labour Costs in the tradable sectors adjusted quickly and safeguarded their competitiveness, the adjustment in the non-tradable sectors started later and is taking more time. Non-tradable sectors (real estate activities, construction, public administration, defence, education and health, and scientific, administrative and support services) were the main contributors to the increase in the Nominal Unit Labour Cost but they have very little impact on the external competitiveness of the Slovenian economy. The tradable sectors saw a more favourable evolution, also compared to the peers and the Euro Area. Increases in productivity and wages in the tradable sector (until 2007) inevitably translated into increases in wages in the non-tradable and less productive sectors; this fuelled inflation and led to an accelerating Nominal Unit Labour Cost. Such an evolution in Nominal Unit Labour Costs is part of the convergence process and is in line with the Balassa-Samuelson effect (Graph 2.3.5). The protracted correction of unit labour costs in the non-tradable and protected sectors could pose certain risks that their higher costs pass through into the tradable ones and affect their external competitiveness. These risks are present in particular during boom periods.

Graph 2.3.5: Slovenian Nominal Unit Labour Cost in tradable and non-tradable sectors

Tradable sectors ISIC A, C, G-I, J. Index 2000=100 Source: Eurostat, European Commission.

Slovenia's labour productivity continues to grow faster than the EU average (Graph 2.3.6). Productivity gains were achieved mainly in the tradable sectors. By composition, they are positively reflected in the recent ULC trends. Productivity measured in terms of GDP per hour worked improved continuously over the last decade with the exception of stagnation around the crisis years. Although productivity per person employed dropped in 2009 as production contracted during the crisis, growth of productivity per hour worked remained broadly in line with its Visegrád 4 peers both before and after the crisis and consistently considerably better than the EU or EA averages. Labour productivity per hour worked provides a better picture of productivity developments in the economy, as it eliminates differences in the full time/part time composition of the workforce across countries and years (it eliminates the impact of the large use of short-time work support schemes during the crisis in Slovenia, whereby headcounts were maintained but hours worked decreased).

Graph 2.3.6: Productivity per hour worked

Index 2000=100 Source: Eurostat.

Recent wage growth has been moderate and supportive of competitiveness (Graph 2.3.7). Even though wage growth significantly outpaced the EU and Euro Area average between 2000 and 2008, it remained broadly in line with productivity developments and the need for convergence. The main notable exceptions are the high increases in 2008, partially attributable to the payment of wage disparities in the public sector and the indexation of wages to relatively high inflation in the previous year; and in 2010, resulting from a large increase in the minimum wage.

The level of the minimum wage remains comparatively high. The level of the minimum wage in relation to average gross monthly earnings remains the highest in the EU. This is partly due to the design of the minimum wage-setting system, which includes various allowances (e.g. for night work, overtime) and a global indexation encompassing all of these components and not just basic pay. In addition, since 2008 the minimum wage increased by 33% while the gross wages per employee by 9%. The short distance of the minimum wage from the average wage is also related to the low level of wage dispersion in the country ([48]).In 2014 the minimum gross wage was EUR 789.15, having grown by 0.7% from the previous year, while the ratio of the minimum wage to average gross monthly earnings was 51.4%, the highest in the EU. This is also reflected in high relative labour costs for minimum wage workers that may relate to the low employment level of the least skilled workers (see section 4.2) ([49]). In January 2015, the minimum wage was increased by 0.2%. Going forward, in the current low inflation environment, the ratio between the minimum and the average wage is expected to decrease.

Graph 2.3.7: Nominal compensation per employee

Source: AMECO.

There have been some changes in the wage-setting system, yet excluding the minimum wage. The new government signed the Social Agreement in January 2015 with the social partners; which will be valid for the period 2015-2016. The agreement establishes collective agreements as the basis for private sector wage setting, while inflation and a share of sectoral productivity will be taken into account in bipartite wage negotiations. The Social Agreement also indicates that public sector wage growth has to lag behind private sector wage growth. It does however not contain any change to the setting of the minimum wage. A contribution to the continuity of wage moderation comes from further reductions in the public wage bill, which was adopted in December 2014 following an agreement between the government and trade unions. The agreement extends to 2015 the savings measures adopted in 2012 and 2013, and also introduces additional measures. In 2013, the total paybill in the public sector decreased by 4.1% as compared to 2012 and the number of people employed in the public sector by 1.5%. According to the first estimates of the government, an additional EUR 36 million EUR of savings, including reduced performance bonuses, could be achieved in 2015 with respect to 2014.

Non-cost competitiveness

Price and cost competitiveness can only partially explain export performance. There is evidence that non-price factors are very important, particularly in countries that have been through a real convergence process. These factors include product and geographical specialisation, developments in quality of products, notably through research and innovation process, consumer preferences in the importing countries, as well as the ease of doing business (efficiency of public administration, taxation policies, regulation, capital and labour market conditions, access to finance and investment etc.)

Trade developments in Slovenia have been largely driven by its geographical and product specialisation (Graph 2.3.7). Slovenia's exporters benefited