Mitja Gaspari
mandate 1. 4. 2001−31. 3. 2007

Adoption of the euro in Slovenia: an unorthodox approach to stabilisation

1. Adopting a new currency is always a complex project, which is determined by broad macroeconomic and structural microeconomic limitations. To these should be added good technical and operational project management, and effective communications with the public, who have to trust and internalise the new currency project. Adopting the euro in Slovenia was just such a project, and was able to draw on the previous experience of introducing the tolar, the new currency for an independent Slovenia, and the macroeconomic and structural reforms carried out in the nineties.

2. The macroeconomic stabilisation between 1992 and 1996 and the structural adjustments made between 1996 and 2000 were vital to the successful adoption of the euro. The first period saw the easing of inflation expectations and the stabilisation of the public debt as consequence of the coordinated monetary policy and fiscal policy, and the successful completion of negotiations with foreign creditors with regard to the debt of the former federation, which Slovenia assumed as part of the succession agreement. The second period saw a number of structural and institutional reforms in the area of taxation that reduced the tax burden on the export-oriented economy by reducing labour taxation (cuts in employers’ contributions), and through the competitive taxation of value-added of export-oriented firms (VAT).

3. At the turn of the millennium the idea that Slovenia should carry out two major projects to fully integrate into European economic flows and institutions came of age. Given the development of the economy and the changes made to the system of institutions, it was clear that the next phase of evolution would be joining the EU and joining the single currency. This political decision was followed by analysis of the political and economic measures needed to ensure an economically effective and socially sustainable transition into the European economic space and the adoption of a new currency. The new strategy of the government and Banka Slovenije set out two phases in the process. The first phase between 2001 and 2004 was seen as the period in which Slovenia would align its fundamental macroeconomic variables (inflation, fiscal position, interest rates and public debt) with the Maastricht criteria.

4. The second phase, after Slovenia had joined the ERM II, in which exchange rate policy would become a matter of common interest to Member States, would have to ensure the sustainability of the fundamental macroeconomic variables, thus providing for stability in the nominal exchange rate. There were two important assumptions in the new strategy of economic policy. First, the joint decision by Banka Slovenije and the government was that we would have to avoid the concept of the second-best solution, which would quickly reduce inflation to the desired level, but in so doing would give rise to imbalances in other segments of the economic system that could endanger the sustainability of the lower inflation rate. Second, it was clear that the necessary results could only be achieved very quickly by intensively coordinating monetary policy and fiscal policy.

5. At the outset of the first phase in the adoption of the new currency, economic policy faced three structural limitations that had a major bearing on the new strategy. VAT had been introduced in mid-1999, and caused a sudden upward spike in relative prices of services, particularly in the non-tradable sector, which because of the wage indexation mechanism in the economy passed through into general growth in prices of goods and services. Given the fiscal deficit, and the insufficient tax revenues relative to the planned fiscal expenditure, the next two years saw a systematic rise in taxes on goods and services, and adjustments to regulated prices, which triggered a supply-side price shock. Finally, there was the relaxation of capital flows with the rest of the world, which put great pressure on the central bank’s money supply, and resulted in an overly expansive monetary policy. Economic policy was faced with the dilemma of how to stabilise inflation at the European level under the existing structures of microeconomic restrictions, which prevented the successful use of traditional (orthodox) approaches to combating inflation.

6. Instead of inflation in general prices, the chosen target was prices in the non-tradable sector, as the lack of competition in the sector meant that these prices represented the main domestic transmission mechanism for general inflation. Because the liberalisation of capital flows with the rest of the world prevented Banka Slovenije from using the amount of primary money in circulation as an indirect target, this target was replaced by a policy of targeting real interest rates. The policy of stabilising real interest rates should have had the most effective impact on developments in aggregate demand, and via this channel on developments in the output gap and inflation.

7. At the same time targeting real interest rates on loans in the domestic currency required the closure of interest rate parity, i.e. the relation between nominal interest rates on domestic loans and loans in foreign currency domestically and/or in the rest of the world, under the assumed dynamics in the nominal effective exchange rate. The closure of interest rate parity as an operational objective required control over the movement of the nominal effective exchange rate of the tolar, which became an instrumental rather than a target variable in inflation stabilisation. In these economic circumstances fixing the nominal exchange rate in the period before joining the ERM II would have entailed downward pressure on prices in the tradable sector, but not prices in the non-tradable sector of the economy.

8. A change of this type to monetary policy strategy also required a change to the fiscal policy strategy, which had to focus on multiple objectives. The first important objective was reducing and restructuring public expenditure, which it was thought would help to balance the fiscal position and to reduce the pressure on regulated prices caused by insufficient tax revenues. The second objective was restructuring the public debt by reducing the share of foreign debt and increasing the share of domestic debt. The government thereby helped Banka Slovenije in sterilising the financial inflow from the rest of the world, in stabilising the exchange rate in the ERM II, and in overseeing the convergence of interest rates with the Maastricht criteria. The third objective was modifying the tax system by reducing unsuitable tax allowances in the corporate taxation system, and eliminating wage indexation in the public and private sectors, partly with the help of the supplementary pension scheme for public sector workers.

9. Given the new monetary policy strategy, it was vital to make changes to the toolkit and the relationship with the commercial banks, which were the main transmission mechanism of monetary policy. Monetary policy had a positive impact in reducing inflation through suitably high interest rates until Slovenia joined the ERM II (an average of 4.5 percentage points), which reduced the pressure on inflation from aggregate demand. This was only possible because Banka Slovenije succeeded at the same time in maintaining interest rate parity (adjusted for the risk premium) at the level of between 1% and 1.5%. Stability in the interest rate parity was ensured by an active policy of intervening on the foreign exchange markets, which entailed adjustment of the nominal exchange rate, and therefore variability in the real exchange rate in the period leading up to Slovenia joining the ERM II. An important condition for the success of this policy was the banks’ trust in Banka Slovenije’s commitment to a closed interest rate parity.

10. An agreement was therefore reached between Banka Slovenije and the commercial banks envisaging that Banka Slovenije would also make permanent use of foreign exchange swaps in addition to 60-day tolar treasury bills. The upper and lower bounds of the swap rate were set, where the buy price was determined by the interest rate on 60-day tolar treasury bills, and the sell price could be no lower than the overnight deposit rate. Banka Slovenije additionally committed to making occasional purchases of accumulated surpluses of foreign currency inflows. When determining the dynamics of the exchange rate, Banka Slovenije was able to do so twice a week, and the banks were required to purchase at least 90% of the foreign currency offered at the intervention exchange rate. Outside the exchange rate interventions, the banks purchased foreign currency at the exchange rates determined freely on the foreign exchange market. Thus the nominal exchange rate became the main instrument for balancing capital flows via controlled adjustment.

11. When Slovenia joined the ERM II regime, economic policy had succeeded in meeting two of the four Maastricht criteria: the budget balance, and long-term interest rates. The reduction in inflation had not yet reached the target level for price stability in the EU, while the necessary level of stability in the nominal exchange rate began to be tested by entry into the ERM II, and the setting of a central parity exchange rate and allowed deviations around the parity rate over the next two years. The fiscal stability achieved in the first phase leading up to 2004 and the accompanying structural adjustments (wage deindexation, cuts in public spending and liberalisation of regulated prices) enabled a reduction in the pressure on monetary policy from excess consumption during this phase. By maintaining an active interest rate policy and closing the interest rate parity, Banka Slovenije was therefore able to ensure that monetary policy remained restrictive, without any repetition of large imbalances in the national economy. The reduction in inflation was gradual and sustained, and allowed for the setting of the central parity rate at the outset of the ERM II regime.

12. Moving into the second phase required the strict observation of fiscal sustainability and good cooperation between Banka Slovenije and the commercial banks in maintaining a stable exchange rate. The exchange rate policy became a matter of common interest to EU Member States, and was therefore no longer determined independently by Banka Slovenije. Given the reduction in country risk and currency risk after Slovenia joined the ERM II, the pressure on monetary policy from the net financial inflow from the rest of the world became increasingly pronounced. The decisive role was played by the agreement between Banka Slovenije and the banks on the foreign exchange market, which ensured the predictable stability of the nominal exchange rate without posing any threat at the same time to the trend of falling inflation. The successful sterilisation of these inflows was dependent on the banks trusting Banka Slovenije to maintain the closed interest rate parity, without the banks incurring any unexpected costs of foreign exchange operations. The foreign exchange swap instrument allowed Banka Slovenije to manage the situation on the foreign exchange market without giving rise to any uncontrollable costs and losses on its own income statement.

13. The issues in the final phase of joining the euro in the period of 2005 and 2006 were a combination of various factors that were acting to fuel aggregate demand, to increase the inflows of foreign financial assets and to increase bank lending activity in Slovenia. There was a tax reform, which slowed growth in tax revenues, and an expansion of infrastructure projects, which raised growth in government expenditure. This led to an expansive fiscal policy, which was accompanied by a positive credit cycle as a consequence of the large net inflow of capital from the rest of the world, which could not be neutralised in full by Banka Slovenije measures. This credit cycle was additionally encouraged by the ECB through interest rates that were too low, despite economic activity in the euro area heating up. In addition, the government opted to restructure the public debt by issuing euro bonds, which put additional pressure on the excessive liquidity of the domestic banks. Further pressure came from the release of bank provisions caused by the new international financial reporting standards. Despite the adverse macroeconomic trends, which came to full expression in 2007 and 2008, the actual adoption of the euro at the beginning of 2007 was carried out successfully. Alongside the European Commission, confirmation had also come from the ECB in its convergence report, which assessed Slovenia’s readiness to join the euro.

14. For the fundamental lessons that can be drawn from the project of joining the euro, we should rely on five basic findings:

• an essential prerequisite for a successful outcome to the project was a joint public commitment by the government and Banka Slovenije to the successful realisation of the project, and the consequent close substantive coordination of the entire process between fiscal and monetary policy,
• prior to the adoption of the euro, the basic objective of monetary policy was maintaining sustained and simultaneous internal and external balances to prevent any adverse effects on the stabilisation of relative prices, and to allow monetary policy to act with appropriate restrictiveness with regard to the pressure on prices in the non-tradable sector coming from demand,
• fiscal policy needed to be systematically prudent and more restrained than it would otherwise have been had there been no such project; there was a need for an advance budget reserve in light of the absence of an independent monetary policy after joining the euro; greater flexibility in the fiscal policy response to external shocks was essential,
• the adoption of the euro needed to be undertaken quickly, because otherwise the opportunity costs of delaying the economic political and structural changes to adopt the new currency over a longer term would be high,
• the higher the level of euroisation in the national economy, the shorter the time of parallel circulation of the old and new currencies could be.

15. We should end with the assessment of the managing director of the IMF, Dominique Strauss Kahn, quoted in From Tolar to Euro: “Slovenia has managed the transition process well. Judicious policy choices contributed to economic restructuring and stabilisation, which facilitated the eventual adoption of the euro and the successful integration of Slovenia in the European economy.”

Appendix

Figure 1: Convergence of the nominal exchange rate and inflation: annualised quarterly growth in the exchange rate and quarterly figures for year-on-year CPI

Figure 2: Variability in uncovered interest rate parity (UIP) and the real exchange rate: annualised quarterly growth in the real effective exchange rate and annual uncovered interest rate parity

Figure 3: Real interest rates (on tolar loans) and UIP

Figure 4: Determination of swap rates

Figure 5: Signalling of changes in exchange rate (intensity of signalling is represented by the percentage of days in the quarter with active signalling)

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¹Programme for ERM II Entry and Adoption of the Euro, Banka Slovenije and Government of the Republic of Slovenia, Ljubljana, November 2003
²V. Bole, Strategy for entering the euro area, in From Tolar to Euro, edited by V. Bole and L. MacKellar, CEF, Ljubljana 2010
³B. Banerjee and H. Shi, Determinants of inflation in Slovenia on the road to euro adoption, in From Tolar to Euro, edited by V. Bole and L. MacKellar, CEF, Ljubljana, 2010
⁴The model estimates in Bole and in Banerjee and Shi confirmed the impact of the output gap and real interest rates on inflation to be significantly stronger than the impact of the exchange rate.
⁵2006 Convergence Report on Slovenia, European Economy, EU Commission, 2006
⁶Convergence Report on Slovenia, ECB, May 2006