Press release - Financial Stability Review and Economic and Financial Developments report
Ljubljana, 10 January 2017
The Governing Board of the Bank of Slovenia discussed and approved the January 2017 Economic and Financial Developments report and December 2016 Financial Stability Review.
1. Economic and Financial Developments, January 2017
The outlook for growth in Slovenia’s exports in 2017 is favourable. According to the latest forecasts by international institutions, global growth is expected to be higher than in 2016. The forecast for growth in foreign demand according to the Bank of Slovenia methodology is also favourable, and provides a sound basis for the anticipated stable growth in turnover in Slovenia’s export sector. Despite the positive outlook, there remain numerous downside risks in the international environment, from changes in the political environment in certain advanced economies, increased social inequality, and mutual sanctions between the EU and Russia, to geopolitical tensions in the Middle East.
Economic growth in Slovenia remains among the highest in the euro area, thanks mainly to the competitiveness of the export sector. Over the last decade this has proven itself capable of increasing market share even in markets where demand is weak, and accounted for more than 40% of the 2.7% growth in GDP in the third quarter of 2016. Its contribution to growth across the euro area overall was insignificant. Households are making a significant contribution to growth in domestic demand: their consumption is becoming increasingly balanced in the wake of growth in employment and wages and an increase in consumer loans, consumption of non-durables having begun to grow. Investment in particular remains weak compared with the euro area overall, although the outlook is improving, as corporate investment activity is still strengthening, and government investment is also forecast to increase in 2017 as the disbursement of EU funds improves. The level of optimism in the economy measured by survey at the end of 2016 was comparable to the level before the outbreak of the crisis at the end of 2008.
The situation on the labour market improved further in the autumn months of 2016, although structural imbalances are also becoming increasingly evident. Employment growth exceeded 2% in the third quarter, while unemployment was down 9.8% in year-on-year terms in November. Employment is also forecast to continue rising in the first half of 2017 according to a number surveys, although approximately a third of employers are already facing shortages in qualified staff.
The current account surplus approached 7% of GDP in October, despite growth in domestic demand. This was attributable to rapid growth in exports of services, weaker growth in residents’ expenditure on travel in the rest of the world, and a narrower deficit in capital income. The merchandise trade surplus began narrowing slowly after May, as nominal growth in imports began outpacing growth in exports, primarily as a result of the rapid growth in imports of consumer goods that has accompanied the increase in private consumption.
Although the fiscal position is improving, continued diligence is required in controlling growth in general government expenditure. The general government deficit over the first three quarters of 2016 was estimated at 1.4% of GDP, while the target for the whole year is 2.2% of GDP. Despite the slowdown in the disbursement of funding from EU funds, there was a moderate increase in revenues, as increases in household consumption, employment and corporate earnings brought a rise in tax revenues. Fiscal cash registers also had a beneficial impact. The decline in general government expenditure on account of a sharp reduction in investment was also related to the decline in the disbursement of EU funds. The main contrasting fiscal development was the relatively high growth in employee compensation as a result of the gradual relaxation of austerity measures, which will continue in 2017 and 2018. Recent months have accordingly seen a sharp increase in pressure from various interest groups to raise general government expenditure, which could make it harder to meet fiscal targets should the economic situation be worse than current expectations suggest.
Deflation eased in the second half of 2016, as a result of the recovery in services prices, and oil prices in particular. Prices as measured by the HICP fell by 0.2% overall, compared with 0.8% in the previous year. Price developments in the early part of the year were primarily subject to January’s oil price shock. A favourable holiday season then pushed growth in services prices in the middle of the year. Energy prices stabilised towards the end of the year as a result of growth in oil prices. Headline inflation thus stood at 0.6% in December.
2. Financial Stability Review, December 2016*
The stabilisation of the macroeconomic environment and the forecasts of continuing GDP growth in the coming years are having a beneficial impact on the financial position of business entities and households. The recovery of the real estate market is strengthening the portion of demand that banks are ready to support to a greater extent with loans, and could contribute to economic growth in various sectors. In such an environment the greatest risks to the banking sector come from the low interest rate environment, which sets banks the challenges of income generation and exposure to interest rate risk. The corporate sector is stronger than a few years ago, and is also less dependent on bank financing. For banks there remains the risk related to the amount of new financially stable debtors, and the problem of attracting new business. This has been reflected in the slow decline in the proportion of non-performing loans in the banks’ portfolio, despite the increasingly active resolution of this segment of the portfolio.
The further developments in income risk and interest rate risk and the ability to generate new capital and to maintain a stable capital position also depend on the banks’ ability to generate income in the low interest rate environment.
Table 1: Illustration of risks in the Slovenian banking System
The banks’ performance improved in 2016, primarily as a result of a reduction in credit risk and lower impairment costs, and the one-off impact of increased non-interest income. The main constraints on income generation remain the contraction in turnover and the fall in interest rates. Net interest income, which accounts for approximately two-thirds of the banks’ gross income, is continuing to decline, and the banks are unlikely to maintain the current level of profitability in the future.
In recent years net interest income was under the prevailing influence of price factors, and less under the influence of volume factors, despite the contraction in bank turnover. As a result of the faster fall in asset interest rates over the last two years, the price factors on the asset side of the balance sheet have prevailed over the effects on the liability side, which are already losing their impact owing to the low levels of deposit rates reached. Further shortening of the average maturity of deposits would not have a major beneficial impact in the banks’ income. Under these conditions it is only possible to maintain or increase net interest income by increasing volume factors, i.e. turnover or the amount of lending. According to Bank of Slovenia forecasts, an increase in loans to the non-banking sector will not be achieved until 2018. The maturing of relatively high-yielding securities over the next two years will see the loss of another major source of interest income.
The increase in the quality of bank investments is having a beneficial impact on the banks’ income via a decline in impairment costs. In light of the high coverage of non-performing claims by impairments achieved, the further reduction in credit risk and the continuing favourable macroeconomic developments, impairment costs can be expected to have a positive impact on income generated. However, impairment costs are pro-cyclical in nature, and do not necessarily have a long-term positive impact on the banks’ income generation.
Bank lending to corporates cannot be expected to return to its average of the pre-crisis years any time soon. The structure of the Slovenian economy has changed since the outbreak of the financial crisis. Construction, which made a significant contribution to economic growth in the pre-crisis period, and was financed primarily by domestic banks, has declined sharply as a proportion of value-added. The banks are significantly less exposed to construction and to financial holding companies than in the past, as a result of numerous and large-scale corporate bankruptcies and the contraction in these sectors. Firms that finance themselves outside the Slovenian banking system are also becoming more important in the manufacturing and services sectors.
The healthy part of the economy, the part that is contributing most toward economic growth, changed the structure of its financing in previous years, with greater reliance on internal resources and on financing in the rest of the world. The proportion of total corporate financial liabilities accounted for by non-residents reached 27%, compared with 17% in 2008. Firms under majority foreign ownership, which are largely financed directly or indirectly via their (new) owners, are increasing their financing in the rest of the world. The domestic banking system is thus losing a specific part of its financially stronger and more creditworthy demand. If the changing structure of the economy is an external factor over which the banks have no major influence, adjusting to the needs of creditworthy clients has become a necessity that derives from the challenges of the low interest rate environment and requires the careful weighting of risks and returns in individual investment segments. If the banks wish to increase income over the long term, they will have to significantly improve the effectiveness of their risk management, and to be able to take up risks in new business and new sectors.
The banks are seeing a gradual reduction in credit risk. Given their high coverage of non-performing claims by impairments, and their high capital adequacy, the banks are relatively well-protected in the event of a major deterioration in portfolio quality. The banking system’s capital is five times the stock of claims more than 90 days in arrears not covered by impairments, an incomparably higher figure than a few years ago. Capital adequacy improved again in 2016, primarily as a result of a further decline in capital requirements, and to a lesser extent as a result of a further increase in capital. Despite the favourable capital adequacy at system level, individual banks could face a capital shortfall in adverse circumstances. The retention of earnings in capital is therefore important, if there is no guarantee of meeting the prudential requirements over the upcoming medium term of two to three years, having regard for the upcoming regulatory requirements (IFRS 9, MREL).
The banks’ focus on domestic funding is reducing their dependence on the wholesale financial markets, but at the same time the low interest rate environment is introducing instability into this structure. Sight deposits now account for 41% of total liabilities, and the figure is expected to increase further. There is a need for deliberation of the potential encouragement of long-term saving and investment. The risk of instability in deposits is mainly present in highly volatile deposits by corporates, which have recently faced additional costs in maintaining sight deposits in accounts at certain banks, and which began to stagnate in 2016 after several years of increase. In a favourable investment environment corporate deposits, on which the opportunity cost of maintaining the deposits has been low to date, could be withdrawn from the banking system to a certain extent towards new commercial investments, or towards various financial assets or real estate.
The banks’ high liquidity and opportunities to obtain additional liquidity from the Eurosystem constitute an important safety valve in bridging any increased liquidity requirements on the part of the banks owing to a widening maturity gap between investments and funding. The banks’ liquidity requirements have reached 10% of total liabilities, a figure several times higher than a few years ago. The banks’ liquidity risk thus remains at a low level, with favourable primary and secondary liquidity. However, the importance of secondary liquidity could increase rapidly in the event of increased instability in sight deposits triggered by external shocks. A large portion of secondary liquidity at Slovenian banks is concentrated in government securities.
The banks are seeing a further increase in interest rate risk, in the wake of the funding of investments of ever-lengthening maturities with short-term and sight deposits. The gap between the average repricing periods for asset and liability interest rates is widening. On the asset side in particular the lengthening of the average repricing period is also attributable to an increase in the proportion of loans with a fixed interest rate. In the event of a rise in interest rates this will be reflected in a decline in the banks’ net interest income.
The supply of loans with a fixed interest rate is encouraging household borrowing. Household loans have already exceeded corporate loans on bank balance sheets, in terms of net value. After declining for several years, consumer loans also recorded positive growth in 2016, the rate having already matched growth in housing loans.
The real estate market is continuing to undergo a stable recovery, which began in 2015, without any signs of overheating. Residential real estate prices are rising moderately, and the volume of transactions is increasing. Indicators of the sustainability of housing lending at banks are stable, and do not suggest any increased risk to the banking system. The situation in the real estate market is stable, and currently does not represent any direct risk to financial stability, although exposure to systemic risk could increase at the beginning of a new financial cycle. Over longer horizons, there is a possibility of increased risks in the real estate market, in the event of faster growth in prices or in the volume of transactions in real estate. The favourable financing conditions and relatively low real estate prices could encourage greater demand not just from those seeking housing, but also from investors, which could put upward pressure on real estate prices with potential risk to the banking system. For this reason the Bank of Slovenia introduced two macroprudential instruments in the form of recommendations in September 2016: a maximum limit on LTV and DSTI as macroprudential recommendations for housing loans. The two instruments would become binding in the event of increased risks as a result of a failure to observe the recommendations, while an increase in risks despite the observation of the recommendations would be followed by a tightening of the instruments’ parameters.
Because of the poorly developed domestic capital market, shadow banking in Slovenia is also developing more slowly than elsewhere in Europe. The main source of shadow banking in Slovenia consists of money-market and bond investment funds and other financial entities (other than insurance corporations and pension funds), such as leasing companies. The size of the shadow banking sector in Slovenia is estimated at EUR 5.5 billion, or 8% of the financial system’s total financial assets. Shadow banking in Slovenia declined in the past, primarily as a result of the contraction in leasing business and the winding-up of numerous financial holding companies in the first five years after the outbreak of the economic crisis.