Slovenia: Economic Transformation and Eu Accession : Summary Report (World Bank Country Study)

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WORLD

BANK

COUNTRY

STUDY

19020 v.1 March 1999

Slovenia EconomicTransformationand E U Accession VolumeI. Summary Report

A WORLD BANK COUNTRY STUDY

Slovenia EconomicTransformationand E U Accession VolumeI: Summary Report

The WorldBank Washington,D.C.

Copyright © 1999 The Intemational Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing March 1999 World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. Some of the reports are published in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts-no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. The boundaries, colors, denominations, and other irnformation shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. The material in this publication is copyrighted. The World Bank encourages dissemination of its work and will normally grant permission promptly. Permission to photocopy items for intemal or personal use, for the intemal or personal use of specific clients, or for educational classroom use is granted by the World Bank provided that the appropriate fee is paid directly to Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, U.S.A., telephone 978 750 8400, fax 978 750 4470. Please contact Copyright Clearance Center prior to photocopying items. For permission to reprint individual articles or chapters, please fax your request with complete information to the Republication Department, Copyright Clearance Center, fax 978 750 4470. All other queries on rights and licenses should be addressed to the World Bank at the address above, or fax no. 202 522 2422.

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TABLE OF CONTENTS

Abstract .................................................... Currency and Equivalent Units ...................................................

v vii

Maintaining Macroeconomic Stability....................................................

1

Achieving EU Environmental Standards at Minimum Cost....................................................

5

Further Liberalizing Foreign Trade and Investment ....................................................

6

Enhancing Competition in the Financial Sector....................................................

8

Promoting Efficient Restructuring in the Enterprise Sector ...................................................

11

Facilitating Labor Market Adjustment ...................................................

12

Preparing the Agriculture Sector to Compete in the Single Market ...................................................

15

Improving Economic Infrastructure and the Delivery of Public Services .................................................. 16 Concluding Remarks .............

18

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Abstract

This country study is based on the findings of several missions that visited Sloveniaduring the second half of 1997and 1998. The report analyzeseconomicdevelopmentsof the past few years and policy options linkedto the challengesfaced by Sloveniain its pursuit of EuropeanUnionmembership. The report is composed of two volumes. Volume I is a summary report that condensesmain findings and conclusions. The report focuses mainly on the elimination of the remaining structural weaknessesas meansto maintainthe macroeconomicstabilitywhile increasingthe competitivenessof the Sloveneeconomyabroad,and redefiningthe sizeand roles of the public and private sectors. Volume II is the main report. It providesthe assessmentand technical analysisof selectedkey sectors of the Slovene economy. While each chapter is sector-specific in nature, the EU accession processdominatesthem. VolumeII is structuredas follows:ChapterI reviewsthe economicperformance during the transition, focusing on the stabilizationand recovery of the early years and the revival of outputgrowth impetusin 1997-98. ChapterII analyzesgrowthand income convergenceissuesin relation with the EU accessionprocess. Chapter III studiesthe environmentsector and the costs of implementing the EU directives. Chapter IV provides an assessment of the foreign trade sector, focusing on trade policy, exportperformancein the EU, and the contestabilityof domestic markets. ChapterV covers the challenges of the financial sector, reviewing mostly banking, but also capital and insurance markets. Chapter VI reviews enterprise sector issues: it concentrateson the privatization process,the remaining privatizationagenda and the performanceof the enterprisesectorpost-independence.ChapterVII studies the labormarket and socialpolicies. The chapter analyzesthe trends in the labormarket and assessesthe degree of adjustment and constraintsto effective performance. Chapter VIII analyzes the agricultural sectorin light of the fragile Sloveneecosystems. Finally,chapter IX studiesthe capacityof the municipal governmentsto deliver efficient and cost effective public services. The chapter focuses on the state of public utilities and the infrastructureinvestmentneeds at the communallevel. The reportwas preparedby a WorldBank team composedof Carlos Silva-Jauregui(ECSPE,team leader), Marcelo Bisogno (ECSPE, labor market), Julia Bucknall (ECSSD, environment),Rita Cestti (ECSSD, environment), Michel Debatisse (ECSSD, agriculture), Bozo Jasovic (consultant, capital markets and insurance),Bart Kaminski (DECRG,foreign trade and FDI), Philipe Lefevre (consultant, legal framework for banking), Tina Mlakar (ECSPE, enterprise sector), NathalieMoreno (ECSPE, competition policies),Mojmir Mrak (consultant,banking and municipal infrastructure),RobertPalacios (HDNSP, pensions), Rossana Polastri (ECSPE, macroeconomics,FDI and growth), Claudio Sapelli (consultant, labor market and social assistance), Helmut Schreiber (ECSSD, environment), Marko Simoneti(consultant,capital marketsand insurance),Carlos Rivas (consultant,financesector)and Milan Vodopivec(consultant,labormarket and social assistance). The report benefitedfrom valuable commentsand suggestionsreceived at differentstages from Hafez Ghanem, Michelle Riboud, Bernard Naudts, Frank Lysy, Carlos Cavalcanti, Ana Revenga, Robert Palacios,Michael Nightingale,Deborah Wetzel,Nathalie Darnaut,Borut Repansek,Kevin Ross, Roberto Rocha, Roger Grawe, Hennie van Greuning,Maureen Lewis, Frank Sader, Anthony Wheeler, Slovene governmentofficials, and participantsat the ECSPE seminars on Slovenia'sLabor Market and ForeignTrade and Investment. The authors also benefitedfrom the effectivecollaborationwith governmentofficialsand had the opportunityto discuss the main findings of the different missions at the Bank of Slovenia,Ministry of Agriculture,Forestryand Food; Ministryof EconomicRelationsand Development;Ministryof Economic Affairs, Ministry of Labor and Social Affairs, Ministry of Environmentand PhysicalPlanning,Ministry

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of Finance, Ministry of Foreign Affairs, Ministry of Science and Technology, Agency for Privatization, Institute for Pension and Disability Insurance, National Employment Office, Statistical Office of the Republic of Slovenia, Institute of Macroeconomic Analysis and Development (IMAD), Slovene Export Corporation, Slovene Development Corporation, Securities Market Agency, Environmental Development Fund and the Agricultural Institute of Slovenia. The missions had the opportunity to discuss key issues with academicians at IMAD, University of Ljubljana, Institute for Economic Research, Central and Eastern European Privatization Network, Center for International Competitiveness and GEA College. The report also benefited from discussions with representatives from four trade unions, Chamber of Economy, Deloitte & Touche, SKB Banka, Nova Ljubljanska Banka, Banking Association, Ljubljana Stock Exchange, Bank Societe Generale, National Financial Company, Banka Celje, Triglav Insurance Company, European Commission, International Monetary Fund (IMF), Organization for Economic Cooperation and Development, and European Bank for Reconstruction and Development. Special thanks to the IMF for its cooperation with the statistical data. The different mission members would like to express their gratitude to all our Slovene counterparts in the government, academia and business community, for the time they spent with us in open and friendly discussions. Their cooperation made this report possible. In particular, special thanks are due to Irena Sodin and Bojan Pogacar, International Department, Ministry of Finance for their effective support and organization of the multiple agendas. Rossana Polastri and Tina Mlakar provided research support. John Karaagac provided editorial assistance. Dolly Teju processed the report.

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CURRENCYAND EQUIVALENTUNITS

Currency Unit = Slovene Tolar (SIT)

I SIT/US$ SIT/DM

1991 55.60 34.81

1992 81.28 52.03

I

1993 113.24 68.43

1994 128.81 79.37

I

1995 118.52 82.66

1996 135.36 89.98

1997 159.69 92.12

1998 166.14 94.41

WEIGHTS AND MEASURES

Metric System ACRONYMSANDABBREVIATIONS

APR ATM BAT BOS BRA CAP CAR CEE CEECs CEEPN CEFTA CEM CMEA

Agencyfor Privatizationand Restructuring AutomaticTellerMachine BestAvailableTechnology Bankof Slovenia BankRehabilitationAgency CommonAgriculturalPolicy CapitalAdequacyRatio Centraland EasternEuropean Centraland EasternEuropeanCountries Central& EasternEuropeanPrivatizationNetwork CentralEuropeanFree TradeAgreement CountryEconomicMemorandum Councilof MutualEconomicAssistance

KBNG Kg. LB LDC LFP LFS LSE MEPP MFN Mg. MOAFF MOERD MOF

KomercialnaBanka Nova Garica Kilogram LjubljanskaBanka LessDevelopedCountry LaborForceParticipation LaborForceSurvey LjubljanaStockExchange Ministryof Environmentand PhysicalPlanning Most FavourableNation Milligram Ministryof Agriculture,Forestryand Food Ministryof EconomicRelations& Development Ministryof Finance

Co,

Carbon Bioxide

N.A.

Not Applicable

NEAP NEO NKBM PAYG NLB NO2 NOx NPP NPV

NationalEnvironmentalProtectionProgram NationalEmploymentOffice Nova KreditnaBankaMaribor Pay-as-you-go Nova LjubljanskaBanka NitrogenBioxide NitrogenOxide NuclearPowerPlant Net PresentValue Ozone OperationandMaintenance Organizationfor EconomicCooperation& Development OzoneDepletingSubstance PolandHungaryAssistancefor Economic Reconstruction PrivatizationInvestmentFunds ProducerSubsidyEquivalent QuantitativeRestrictions Researchand Development RevealedComparativeAdvantage RegionalEnvironmentalCenterfor Central and EasternEurope SocialAssistance SloveniaBourseIndex SloveneDevelopmentCorporation SecuritiesExchangeCommission SocialistFederalRepublicof Yugoslavia SloveneTolar StandardInternationalTrade Classification Slovenia

CPI CSCC CSL DAE DISAE

ConsumerPrice Index CentralSecuritiesClearingCorporation CooperativeSavingsand Loans Departmentof EuropeanAffairs Developmentof the ImplementationStrategiesfor Approximationin Environment DM GermanMark EAs EuropeAgreements EAA EuropeAssociationAgreement EAGGF EuropeanAgriculturalGuidance& GuaranteeFund EBRD EuropeanBankfor Reconstructionand Development EC EuropeanCommission ECoFund EnvironmentalDevelopmentFund ECU EuropeanCurrencyUnit EEC EuropeanEconomicCommunity EFTA EuropeanFreeTrade Agreement EMAS Eco-Management& AuditingScheme Ent. Enterprise EPACT EnvironmentalProtectionAct EPA EnvironmentalProtectionAgency ER ExchangeRate ERM ExchangeRate Mechanism EMU Economicand MonetaxyUnion EU EuropeanUnion FDI ForeignDirectInvestment FGD First DesulphurizationUnit FIAS ForeignInvestmentAdvisoryService FSU FormerSoviet Union FTA FreeTrade Agreement GATT GeneralAgreementof Tariffs and Trade GDP Gross DomesticProduct

03

O&M OECD ODS PHARE PIFs PSE QRs R&D RCA REC SA SBI SDC SEC SFRY SIT SITC SLO

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GEF GNFS GOS GS Ha HH ILO ISA ISP IMAD IMF IPOs IPPC ISO KBM

Global Environment Facility Goods and non-factor services Government of Slovenia Goods and Services Hectare Household International Labor Organization Insurance Supervisory Authority Index of Speculative Pressure Institute of Macroeconomic Analysis & Development International Monetary Fund Initial Public Offerings Integrated Pollution Preyention and Control International Standard Office Kreditna Banka Maribor

SME SO2 TAIEX TOM TORs UCITS UHT ULC UN US VAT VOCs WTO Yr.

Small and Medium-Sized Enterprises Sulfur Oxide Technical Assistance Information Exchange Office Base Interest Rate Terms of Reference Undertakings for Collective Investment in Transferable Securities Ultra High Temperature Unit Labor Cost United Nations United States Value Added Tax Volatile Organic Compounds World Trade Organization Year

FIscAL YEAR

January 1 to December 31

Vice President: Country Director: Sector Director: Sector Leader: Team Leader:

Johannes Linn Roger Grawe Pradeep Mitra Hafez Ghanem Carlos Silva-Jauregui

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Summary Report

Slovenia needs to enhance its capacity to compete abroad in preparation for joining the European Union (EU). As a small open economy, with exports and imports of goods and non-factor services accounting for over 50 percent of GDP each, Slovenia's most important growth and development engine has been its capacity to export its products. Trade will continue to be the growth engine of the future, thus Slovenia's requirement to excel and maintain its competitiveness abroad. Slovenia, which was already the most prosperous of the former Yugoslav republics, enjoys the highest per capita income level of transition economies, around US$13,000 as measured in purchasing power parity in 1997, international recognition and favorable prospects for joining the enlarged EU. To enhance competitiveness Slovenia needs to accelerate the structural reform agenda and generate sustainable growth. Slovenia should implement a series of reforms that will focus on: *

Maintaining macroeconomic stability in the context of free movements of goods, services, capital and labor;

*

Achieving EU environmental standards at minimum fiscal costs;

*

Further liberalizing the foreign trade and investment regimes;

-

Enhancing competition in the financial sector;

-

Promoting efficient restructuring in the enterprise sector;

*

Facilitating labor market adjustment;

D

Preparing the agriculture sector to compete in the single market; and

*

Improving the economic infrastructure and the delivery of public services.

Maintaining Macroeconomic Stability Slovenia had some of the most favorable initial conditions of all transition economies, including its geographical location, skilled human capital and significant trade links with the West. These trade links were established in the 1970s and 1980s. At that time, Slovenian enterprises developed and engaged in long-run contracts with firms in the West. As a result of these links, during the breakup of Yugoslavia, Slovenia was able to quickly redirect its vanishing inter-republic trade to the West, thus generating fast economic turnaround. Despite the initial success in stabilizing the economy, Slovenia still suffers from persistent structural weaknesses. The large share of the public sector in the economy, the limited role of the financial sector in resource intermediation, the rigidities in labor market, and the low share of the private sector in production, employment and infrastructure, have resulted in lower growth relative to other leading transition economies in Central and Eastern Europe (CEE), but also to Slovenia's own growth

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potential. These weaknesses have resulted in loss in external competitiveness, which is due in part to the slow pace in the reform agenda. Moreover, the country's public finances are coming under increasing pressure from both high and indeed rising social security expenditures, mainly pension and health expenditures, and relatively high public sector wage increases in the early years of the transition. Indeed, the accession process will impose further expenditure pressures to bring Slovenia's standards to those prevailing in the EU. Slovenia faces today tougher competition for EU markets from its neighbors. As transition advanced in the l990s and the CEE economies recovered from the initial real shock, a fierce competition for a larger trade share in the EU has developed. Slovenia, who had a prominent position in the past, has lost some momentum in its export penetration in the EU. Western firms have now many choices in the region and exercise those choices in the form of stronger trade links and foreign direct investment (FDI). Most of the foreign trade in the region is closely linked to firms with FDI. While Slovenia's trade regime is quite liberal in comparison with other leading transition economies, its unwillingness to embrace FDI had hurt its capacity to accelerate restructuring, enhance efficiency and maintain the initial export performance trend. Slovenia's capacity to remain competitive has been hindered by at least three factors. First is an appreciation of the real exchange rate, which is due, in part, to strong capital inflows during 1993-97. Second is the wage pressures coming from the public sector and from privatized socially-owned enterprises, that have increased public expenditures and negatively affected enterprise profitability and investment decisions. Wage concessions have also been a factor in the appreciation of the real exchange rate, especially during 1994-95 when real wage demands exceeded productivity increases. This trend, however, has subsided in recent years. The third factor affecting competitiveness is the slow pace of restructuring in the enterprise, financial and other key sectors of the economy that has negatively impacted Slovenia's growth capacity. Slovene policy makers have faced the challenge of dealing with these complicated policy issues while trying to ensure that the capacity of Slovenia to export to the EU, its principal trade partner, is preserved. Over the transition years, the real exchange rate has appreciateds This stylized fact is a common occurrence in many transition economies as prices slowly adjust and productivity gaps with the EU narrow, but at different rates.1 Measured by unit labor cost, the appreciation in the real effective exchange rate in Slovenia between 1993-98 has been in the order of 23 percent. While most of the appreciation happened during the period when wage demands surpassed productivity changes, and not during the periods of high capital inflows, the loss in competitiveness that conveys this factor should be a constant remainder of the need to advance the restructuring process to boost efficiency and maintain sound macroeconomic policies. Without them, Slovenia's ability to compete in the EU single market will be limited. To cope with capital inflows the Central Bank imposed capital account restrictions. Significant capital inflows began in 1993. Starting in 1994 with a ban on short-term bank borrowing abroad, restrictions on capital inflows were progressively tightened. This has involved imposing an unremunerated 40 percent deposit requirement against foreign non-trade-related loans with a maturity of up to 5 years in February 1995 (extended to up to 7 years in July 1996). It also entailed raising foreign exchange cover requirements against foreign currency deposits in April 1995 (to 100 percent in the case of sight deposits). During the first half of 1996 capital flows intensified (especially credits to banks and enterprises), putting more pressure on monetary and exchange rate policies. Consequently, the Central Bank implemented new measures to slow these flows. Banks were required to increase their foreign assets pari See Halpernand Wyplosz(1997),"EquilibriumExchangeRates in Transition",IMF Staff Papers.

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passu with increases in their foreign liabilities in July 1996 as well as subjecting financial loans with maturity in excess of 7 years to a 10 percent deposit requirement in December 1996. Finally, tightening also required nonresidents to conduct their inward portfolio investments through custody accounts with a fully licensed bank in February 1997. The last measure was relaxed in July 1997 by exempting portfolio investments committed for more than 7 years from the custody account requirement and relaxed again in 1999 to 4 years. The critical question for the Slovene authorities is how to deal with capital account liberalization. With the ratification of the European Association Agreement (EAA) in October 1998, Slovenia will have four years to remove the capital restrictions. Capital account and financial liberalization are inevitable for countries that wish to take advantage of the substantial benefits from participating in the open world economic system. As recent international events have demonstrated, financial liberalization also has its dangers. These dangers rise from imprudent risks of individuals, enterprises or financial institutions that can create systemic disturbances. The risks cannot be completely suppressed, but they can be limited with sound macroeconomic policies aimed at containing aggregate financial imbalances. Proper private sector incentives for risk management in the financial sector are critical. With these safeguards, orderly and properly sequenced capital account and financial liberalization can be clearly beneficial. The Bank of Slovenia is already moving to eliminate some of the capital account restriction. On February 1, 1999 the Central Bank made significant changes to the legislation regulating capital movements. The restriction on short-term borrowing by Banks has been eliminated. Banks are required -since November 1998- to limit their monthly foreign exchange exposure to 10 percent of their capital. The non-interest bearing deposit requirement on foreign financial loans -imposed since 1995- was lifted. However, BOS retains the discretion to impose a non-interest bearing deposit of up to 30 percent-held at the BOS- for a period of two years from the date of disbursement of the loan. Also eliminated is the freeze -beyond the position at July 31, 1996- of the net foreign indebtedness position of commercial banks. Regulations concerning portfolio investments by non-residents and the use of custody accounts have also been recently changed Except for the purchases of shares representing non-residents' participation in voting power or capital of domestic firms of more than 10 percent, as well as, purchases of shares issued in primary markets, custody accounts established with licensed domestic banks have to be used to conduct operations in securities and derivatives traded in the secondary market. The custody accounts can be held in domestic or foreign currency. Commercial banks, however, are obliged to pay a premium in relation to the balances held in custody accounts. The premium is to be set quarterly by the BOS and will not be charged if the foreign investors held their balances for four years or more. The secondfactor affecting competitiveness of the Slovene economy is wage pressures. In the early years of the transition, real wages grew above agreed social partners' targets (and productivity increases). This was particularly true for the government sector, which then spilled over the wage demands into the entire economy. The outcome of wage pressures affected competitiveness in the real sector; it also affected social expenditures linked to wage increases, in particular pension payments. The need to establish wage discipline in the government sector was reflected in new wage adjustment law (enacted in mid-1997) that helped moderate real wage growth, helped ease wage indexation and helped reverse the trends of real wage increases exceeding productivity gains. As a result of these policies, unit labor costs started to fall. Although real gross wage growth moderated from 5.1 percent in 1996 to 2.4 percent in 1997 and 1.3 percent in the first eight months of 1998, wage growth in the government sector continued to outpace that in the private sector. Further efforts are thus required to avoid wage escalation in the future that may damage the prospects for growth and integration.

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While wage growth containment is critical, it is by far not the only concern. Slovenia's wages are relatively low in comparison with EU countries, but wages are high in comparison with other leading transition economies with which Slovenia competes for the EU market share. In 1997, gross wages and salaries per month, as measured in ECU, at current exchange rates, where about ECU 800; more than two and a half times of those observed in the Czech Republic, Hungary and Poland. While this level of wages could imply a higher degree of productivity in Slovenia, it also points to the strong competitive pressures other countries in transition place on Slovenia's economy, and to the need to specialize in areas where Slovenia could have comparative advantage. These areas should include production where technology and human capital are intensive, rather than those where natural resource and unskilled labor are intensive. A thirdfactor affecting competitiveness in the economy is the pace of structural reform and its impact on factor markets and restructuring. Structural reforms slowly began to redefine the role of the private and public sectors, and to reorient the economy towards a market-based export-led growth and international integration. Yet the reforms moved slowly and did not deliver the expected rapid growth in private sector participation that can be seen in other leading transition economies from CEE. Paradoxically, while Slovenia was a forerunner at the beginning of the transition, it pursued a more gradualist approach to systemic transformation relative to other transition economies. By 1996, private sector participation in GDP reached only about 40 percent, well below the levels observed in Poland, Hungary, Czech Republic or Slovakia, which were already over 60 percent of GDP in 1994. Even today, Slovenia's private sector generates only about 50-55 percent of GDP. The implied level of public sector involvement is well above other acceding countries or the EU. The assets still in the hand of the public sector are vast. In the enterprise sector the State retained about a quarter of the ex-socially-owned firmnsthat were in the original privatization lot. Public utilities are also in the hands of the public sector, with little private sector participation in both the production of services and infrastructure investments. In the financial sector about 50 percent of the assets are directly or indirectly controlled by the public sector. While this ownership control does not necessarily mean that political decision dominate economic considerations, the privatization of state owned enterprises and banks remains one of the most important unfinished agendas in Slovenia's transformation to a private sector led market economy. Slovenia needs to further strengthen its public finances, particularly through social security reform andfaster privatization. This is the main way to improve public saving, to create incentives for private saving, and to gradually bring inflation down to EU levels. The report emphasizes the further opening of the trade and foreign investment regime, the strengthening of mechanisms for private sector development, and the regulatory framework so as to encourage a much faster involvement of the private sector in infrastructure development. Enhancing the mobility of capital and labor markets are crucial to absorb the outflow of workers out of updated industries into higher-productivity-growth activities such as in the export and service sectors. Important expenditure pressures come from social expenditures, mainly through the pension system. As a result of a deteriorating pay-as-you-go (PAYG) pension system, Slovenia's pension fund deficit has been growing since 1994. It reached 3 percent of GDP in 1997. Without a comprehensive pension reform, it is expected to deteriorate even more during the coming years. Fiscal balance is unlikely in the medium and long-term. Nonetheless, the government's three-pillar proposal was defeated. Instead, steps aimed at raising the retirement age, lessening the degree of indexation, further penalizing early retirement, raising contributions by the self-employed, and raising the cost of buying pension rights for time spent in education and military service will all represent the core amendments to the existing pension legislation. Moreover, in view of fierce opposition to a mandatory defined-contribution pillar, the government is formulating a two-pillar reform proposal with a financially balanced pay-as-you-go

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(PAYG) system as its principal pillar, supplemented by a voluntary fully funded system. This will reduce the pension deficit and give some breathing room to the authorities to build consensus for further reforms.

Achieving EU Environmental Standards at Minimum Cost Important adjustments to the EU legislation are required also in the field of the environmental policy. The EU, however, does not assume that any of the acceding countries will have adopted the environmental acquis in its entirety before the accession. Hence Slovenia is currently in a transition period, addressing its own national problems and priorities related to the environmental policy. The legislation is governed by the Environmental Protection Act of 1993 and various regulations and decrees. The EU accession requirements have already been incorporated in the National Environmental Protection Program, in the preparation for the first reading in the Parliament. As part of the National Strategy for the Adoption of the Acquis, the government prepared a strategy for the harmonization of the Slovene environmental legislation. It has been projected that environmental acquis will be adopted by the end of 1999, followed by the administrative procedures a year after. At the same time, investment costs have been estimated for the adoption of major environmental directives. Total investment costs amount to ECU 2.7 billion, or ECU 1,300 per capita. If the government commits to full compliance by 2005, the annual cost would be as high as ECU 450 million, a fourfold increase over current investment level (0.8 percent in GDP, 1997). Institutional changes, such as expenditure for administration, monitoring and enforcement require around ECU 23 million. Total costs will be apportioned between the public and private sector in the ratio: 70/30. Most of the environmental standards required by the White Paper, relating to the internal market, have already been adopted, but meeting water quality standards will be costly. In the field of water quality, the EU approximation costs are estimated at ECU 1,183 million. Most of the cost will be incurred to improve municipal wastewater treatments, followed by the industrial wastewater treatments. Majority of drinking water (90 percent) meets the EU quality standards. Next field, waste management, also requires similar investment (ECU 1,118 million). The most sensitive areas include development of several large municipal and industrial incinerators, and two hazardous waste incinerators. These items have already been addressed in the Strategic Guidelines on Waste Management, waiting for the government's ratification. A substantial cost will be incurred in regards with the closing of landfills, which are projected to exceed their capacity in less than 5 years. The field of air quality, on the other hand, does not require extraordinary measures (ECU 241 million), and some concerns have only been expressed regarding urban air polluting resulting from increased road traffic. Major polluters, such as power plant Sostanj and district heating plants will be replaced by Combined Heat and Power Plants and/or converted to natural gas. Finally, industrial pollution cost estimates are around ECU 50 million, and focus mainly on EU compliance for large combustion plants. Industrial pollution has been reduced in recent years due to application of new technologies and

operatingprocedures. The investment requirements of such a magnitude will depend on EU grants/and concessional finance, however, some utilities and municipalities will have to borrow on commercial tenns, thus

passing costs onto consumers. The ability to finance the investments will therefore to a large extent determine the pace of adopting EU legislation. The environment sector chapter identifies several recommendations that will help Slovenia meet the EU requirements as well as achieve optimal cost-and-benefit solution on a national scale:

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6

Institutional capacity has to be strengthened to increase the ability of the authorities to

enforce laws or set incentives to improve compliance. This will be fundamental to developing policies that bring greatest environmentalbenefits for a given expenditureor level of effort, and that use public and external funds most wisely, both in terms of maximumenvironmentalbenefit and reducingdistortionselsewherein the economy. >

Sloveniahas to negotiate carefully, sincefull complianceby 2005 is not realisticdue to large costs. Many EU directivesexplicitlycontain clausesthat allow for nationalcircumstancesor exemptionswhere environmentalbenefits are low or where costs are excessive.It will be importantto negotiate either derogationswhere it is agreed that there is no environmental benefit, or long transition periods for compliance with the most costly aspects of the directivesfor the smalleror less environmentallysignificantsourcesof pollution.

>

The governmentshould use public and EU subsidiesto direct investments towards strategic goals, during that long transition period. This is particularly important for wastewater collectionand treatment, and for municipalsolid waste.

>

Efficiency of public utilities has to be improvedby making eligibilitycriteria for grants, or

by forcingthe municipalitiesto use their own resources. Some economiesof scale can also be achievedby municipalcooperation.Technicalassistance from the EU and other sources couldalso be used to help the less efficientutilities improvetheir performance. >

It has to be determined which investments have the largest environmental impact, as to direct investmentsstrategicallyin the interimperiodtowards full compliance.

Further Liberalizing Foreign Trade and Investment The slow down of the process of microeconomic liberalization and restructuring has negatively impacted economic developments in Slovenia, implying a loss of the initial dynamism of the trade sector. Although nothing presages an impending crisis -as the economy is growing and as

macroeconomic stability does not seem to be in imminent danger- symptoms of declining vigor nonetheless abound. Export penetrationto the EU has run out of steam. After a three-year spell of double-digitgrowth rates over 1993-95,the value of total exports remainedflat for the 1996-97period. In the secondhalf of 1995and through 1996,exportperformancewas maintained,in largepart, due to the depreciationof the domesticcurrency. Moreover,the slow down in export expansionand the stagnation in net revenuesfrom servicescould negativelyimpactthe country's capacity to importcapital equipment, thus undermining its potential for restructuring and stronger economic growth. Although the current account has been in surplus during the transition (with the exception of 1995 when it recorded a negligible deficit), considering Slovenia's modernizationrequirementsthis cautionary policy outcome may not be optimal. From the perspective offoreign trade andforeign investment, the prerequisites of a good preaccession strategy generating growth, employment and improved microeconomic efficiency include easy entry of goods, services and capital to domestic markets. This should contribute to economic

growth through at least two channels:the reductionof barriersto efficient allocationof resources;and the creation of competitivepressureson domestic producersto reduce costs and launch new initiativesand products. The challengeis to get firms to revampproductlines,to streamlinemarketingefforts,and to cut costs. A business-friendlyenvironmentand a reliable supply of services-attracting foreign investment and creating opportunitiesfor participationin global division of labor, driven today mostly by vertical product differentiationand fragmentedtechnology-shouldhelp attainthese goals.

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One of the most important differencesbetweenSlovenia and other leading accessioncountries has been Slovenia's reluctanceto embraceforeign investment. Foreign investmentin Sloveniahas not reached its potential. The lower than expectedlevels of FDI do not result from unattractivenessof the Slovenianeconomy. On the contrary,Sloveniashould haveattracted a sizable amountof FDI. Low FDI inflows have been most likely the result of domestic impedimentsand governmentpolicies that have discouragedFDI inflows during the transition. Governmentpolicy favored national ownership in the enterprise sector. As a result, FDI has not played the primal role in enterprise restructuringas in other transition economies, most notably Hungary. Except for Renault's investment and the more recent Goodyear Tire & Rubber joint venture with Slovenia's Sava Group, a producer of car tires, firms investingin Sloveniahave been small to medium in size-a pattern reminiscentof FDI in Poland during the initial stagesof the transition,that is, beforethe FDI "take-off"of 1994-95. The experience of FDI in other transition economies extends over a period long enough to draw some generalizations as to their impact on restructuring and integration into international markets. FDI has helped integratedomesticproductioncapacitiesinto globalnetworks of productionand distribution, by acting as a powerful vehicle for transfers of technology and the best practices in management. FDI contributes to intraindustry linkages,allowing economies of scale through greater product specialization in differentiated products -particularly important for small economies. While conventionalcomparativeadvantagebrings aboutinterindustryspecialization-asit operateson groupsof products rather than within them- the force drivingtwo-waytrade in similar differentiatedproducts are economiesof scale associatedwith supplyinga largermarket. Sloveniawill benefit from attractingmore FDI. Slovenia needs to increase contestability of its domestic markets and generate a business friendly environment. Such an environmentis important,not only to attract needed FDI, but also to enhance domestic firms efficiency. The competitivenessof Slovenefirms, both domestic and foreignowned, also depends on competition at home from imports and domestic sources alike. This, in turn, hinges critically on a liberal trade and investmentregime. Institutionaland policy measures that would improve the business climate and improve the performance of Slovenia's economy share a common denominatorand that is the liberalizationof foreigntradeand the investmentregime. Thesemeasurescan be summarizedas follows: >

To improve the competition policy framework, rules and the enforcement capacities of competition authorities. One may consider granting anti-trust authority to a single independent institution empowered to assess competition and the welfare impact of important policy decisions as well as actions taken by firms affecting contestability of domesticmarkets and empoweredto monitortheir impactexpost;

>

To align MFN tariff rates on industrialproductswith those levied by the EU. This would not necessarilyinvolve a formal loweringof statutorytariffs but might simply involvea change in appliedrates;

>

To overhaul the current framework of state aids. This would involve establishing transparentmonitoringmechanisms,streamliningand reducingthe scope of subsidies.State aids should be also subjectto scrutinyby the competitionauthority once it is reformed;

>

To open servicesto foreign competition.This would involveinter alia removingprovisions limitingforeign equityand openingtelecommunicationsand insuranceto foreigncapital;

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>

To filly apply the principle of nationaltreatment in the sphere of foreign investment.This would involve removing legal provisions requiringthat purchases by foreigners of equity exceeding25 percent be subjectto governmentclearance;and

>

To change the rules governingthe agriculturalregime. This would involve supporting the agricultural sectorthrough direct paymentsratherthrough high agriculturalprices and trade policy (external border protection and export subsidies). In addition, since the present structure offers preference to low value added products(which obtain the largest levels of protection),this would entail changingthe current structureof incentivesto removethe bias againstprocessedagriculturalproducts.

Enhancing Competition in the Financial Sector The financial sector in Slovenia has undergone signfifcant restructuring over the recent years,

especiallyregardingthe banking system. In spite of these advances,the sector is still far from being internationallycompetitive in terms of product variety, soundnessand costs; it remains small in both absolute and relative terms. Consequently,the key overall objective in this area is to increase the internationalcompetitivenessof the financial sectorto a level that will allow its successful integration into the EU singlemarket and global financial market. The generalpolicy measuresrequired to achieve this are furtherprivatization,in particularof remainingstate banksand insurancecompanies;restructuring and consolidations;enhanced supervision;and legal approximationto EU legislation. Slovenia's EU preaccessionstrategy in the area of financial serviceswill comprisereforms in the banking,capital market and insurancesectors. The reforms aim at facilitatingthe developmentof the three sectors and preparing them for competitionin the single market. The EU accessionrequirementsin the sector are an important pushtowardsreforms.The reformsare essentialwhetherthe countryjoins the EU or not. In the banking sector, increasing the incentive structure, the capacity of banks to compete within and outside Slovenia and to face the pressures of banks abroad are key. Increasing competition

is of the highest importance for the Slovenian banking sector, which is characterized by high concentrationand a low degreeof in-countrycompetition. In order to addressthese problems,a whole set of policy measureswill haveto be introducedand implemented.The most importantones are: >

Open the banking sector more widely to foreign competition.

The new Banking Law

proposesthat branchesof foreign banks would be permitted;opening the sector to foreign branch offices is also required by the EAA. Opening the sector to branch offices and liberalizingthe provisionof crossborder financialservicesis expectedto improvethe range and sophisticationof services that are available, while the additional competition arising from this move is likely to createmorepressurefor rationalizationamongsmall banks. >

Privatization of the two big banks, NLB and NKBM, and other banking shares in the hands

of thepublic sector. The main objectivesof the bank privatizationstrategyhave not yet been clearlydevelopedby the government,which needs to focus on this agenda. Privatizationof these importantbanks should involvea transparentprocess. It shouldinclude one or several strategicinvestorswho would strengthencorporategovernancein the banks. Moreover,the banks should be sold primarily for cash in order to reduce public debt or to finance key structural reforms. Participationof strategic partnersin the privatizationof the two banks would, in addition to bringingfresh capital, lead to a more rapid growthin domestic banking servicesand expertise. It would also help to acceleratethe integrationof western standards intothe Slovenianbankingindustry.

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>

Abolition of the inter-bank agreement on the maximum deposit interest rates. This is scheduled for 1999 and is expected to contribute to increased competition among banks. The agreement is not compatible with the needs to strengthen competition in the market. Competition in the deposit market, as in the credit market, is instrumental in forcing banks to identify their areas of comparative advantage and to increase efficiency.

>

Introduction of a new deposit guarantee scheme. Eligible deposits have been defined in the new Banking Law, as well as the ceiling for guaranteed deposits. The banks will seed the deposit guarantee fund; State intervention is not envisaged. The proposed deposit guarantee scheme solution incorporated in the new Banking Law will improve the degree of competitive neutrality in the banking system. Specifically, this will occur by offsetting the impact of explicit or implicit state guarantee that may be seen to lie behind large banks, either because they are state-owned or/and because they are simply viewed as too big to fail.

>

Internal restructuring in the banking system. The banking system operates at high costs and with few services. Internal restructuring is needed to increase profitability and, thus, reduce operating cost on the one hand and expand the range of activities from classical services to more sophisticated products and services on the other. The process involves a whole set of productivity supportive policy measures, including further reduction in the number of bank employees and a consolidation of the banking sector through mergers, particularly of small banks. There is also a need for continuous education and training activities of the bank staff in order to improve its expertise in various areas, particularly in areas such as credit and risk assessment and investment banking.

>

Supportive policy measures to protect lenders and depositors. For banking sector reform to be effective, policy measures within the sector will have to be accompanied by supportive policy measures in many other segments, including in the consumer protection area where a general law has recently been adopted by the Parliament. An enabling legal environment, for example, is instrumental in protecting the rights of lenders. Although legislation regulating bankruptcy procedures, collateral provisions, procedures of execution against a company, execution proceedings and land register regulation have all been put in place, judicial and administrative support must be strengthened in order to speed up its implementation.

>

Harmonization of the Slovenian banking legislation to that in the EU. Significant advances were made with the recently approved new Banking Act. The new Act provides a framework for the incorporation of Slovenian banks into the international financial environment and will open the sector more widely to foreign competition. The new Banking Law is, however, not be fully compatible with all stage two banking sector directives. The new Banking law is in line with Large Exposure Directive, the Directive on Supervision of Credit Institutions on a Consolidated Basis, the Directive on Annual Accounts and the Consolidated Accounts of Credit Institutions and Other Financial Institutions. It includes provision related to the single banking license and home country control, but these provisions will only apply at the time of accession to the EU. The basic principles of the Capital Adequacy Directive are covered in the new law, although more detailed provisions for implementation shall be determined by BOS decrees in the subsequent years before accession.

In contrast to banking and insurance -which have both been to a certain extent burdened with the legacy from the pre-transition period- capital market development is an entirely new segment of the financial sector. Although the market has experienced sustained growth, especially since 1994, it

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remains small and depends mainly on privatization related activities. The key policy recommendations of the report on capital market issues are the following: >

Creating an enabling environment for capital market development. Further development of the market will require consistent enhancement of all components of the market, including a further increase in market capitalization and improvement of its liquidity, diversification of both individual and institutional investors, increased opportunities for brokers and other professional participants in the market, and increased protection to minority shareholders. The success of this policy depends, to a great extent, on the incentive structure set in place to cope with the supply of shares that privatization funds may bring once listed. As a result, it is important to establish the correct policy conditions for increasing domestic and foreign demand for shares of listed companies. This includes the elimination of the securities tax bias. With the introduction of the VAT law in 1999 the securities tax bias will be eliminated.

>

Enhancing regulatory capacities. The new draft Securities Market Act puts the emphasis on the development of prudential rules and on the strengthening of supervision mechanisms. Besides increasing the initial capital requirement, the draft law regulates own funds, capital adequacy, large exposure, and liquidity ratios. In the case of an investment firm belonging to a financial group, all prudential rules must be applied on a consolidated basis. All these regulatory changes are expected to lead to increased competition and to greater market stability. The new Securities Market Act will also put the legislation in accordance with the EAA. Specifically, the Act will provide for national treatment of investment firms (there has been a 3-year transition period agreed with regard to brokers' financial services), and will therefore also abolish the 24 percent ceiling on non-resident stakes in investment firms. Adjustments are also needed in the legislation regulating investment funds. Legislation governing the use of custody accounts in portfolio investments by non-residents has been relaxed in 1999, to just four years. Custody accounts, however, will not be abolished, thus maintaining the market segmentation. This differentiation will have to be eliminated as will the tax treatment differentiation, if the authorities want the securities market to be a savings and investment mechanism.

>

Strengthening of supervisory institutions. The changes in the regulatory framework will have to be accompanied by continuous strengthening of the supervisory institution. It is of utmost importance that the attributes and institutional capabilities of the Securities Exchange Commission (SEC) are enhanced on time, both in terms of the number of staff and in terms of the institution's expertise. To effectively supervise the fast growing securities market industries, there must be enhanced co-operation among supervisory institutions in all three segments of the financial sector.

Due to imperfect regulation and insufficient supervision, the insurance sector is characterized by a relatively large number of small and poorly capitalized insurance companies. In contrast to banks, insurance companies have yet to start their restructuring. The process of insurance sector restructuring should include a range of policy measures aimed at increasing the efficiency of insurance companies and at reducing their operational costs. The most important ones are these: >

Enhancing competitiveness in the insurance sector. Within this context, each company should clearly identify its comparative advantages, concentrate efforts in those areas and look at potential partners for future co-operation. As in the banking sector, insurance companies will have to boost productivity by increasing efficiency of the staff and/or by expanding the volume of operation. In this respect, training the staff for specific areas of

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insurance business, as well as the provision of new services offered to potential clients are crucial. All these measures, carried out within individual insurance companies, will be effective only if accompanied by a government policy to open the market to more external competition. In this respect, the EAA provides clear guidelines for the gradual elimination of discriminatory clauses in existing legislation. In addition to the gradual opening of the insurance market to foreign companies, there is a need to prepare a strategy for the privatization of state holdings in the insurance sector. )

Legal harmonization with the EU. A priority for the insurance regulator is to adjust the legislation to the current requirements of the insurance sector. In addition to eliminating discrimination against foreigners, the new draft Insurance Companies Act is expected to address several key areas, including: (i) provisions on clear separation of life from non-life insurance activities; (ii) provisions regarding pre-bankruptcy procedures; (iii) provisions regulating the responsibilities of management and governing boards; (iv) provisions on the role of the supervisory authority; and (v) prudential regulation provisions.

0

Improving regulatory and supervisory capacities. The insurance sector regulatory and supervisory capacity is the weakest of the three branches of the financial system -banking, capital market and insurance. Improved regulation and enhanced supervision of the insurance industry is necessary. This implies that the supervisory institution must be strengthened in terms of the number of staff and their expertise. The staff must be continuously upgraded in order to keep pace with the increasing complexity of the insurance industry and its growing interrelation with other segments of the financial sector.

Promoting Efficient Restructuring in the Enterprise Sector In a transition economy like Slovenia, the process of reform in the enterprise sector includes both the redefinition of proper ownership rights and structures, mostly through privatization, as well as the actual restructuring of the enterprises. This restructuring can be thought of as the transition from a highly distorted economy with many loss-making enterprises, to a market economy in which most enterprises are profitable. Improvements in enterprise efficiency and profitability set the foundations for sustained economic growth but also increase living standards. Restructuring is also a precondition for accession to the EU, and it is doubly necessary to insure that Slovene enterprises compete in that single market without recourse to government subsidies. Progress in restructuring proceeds faster when corporate governance is improved by privatization, and when the enterprises are subject to hard budget constraints imposed by both the government and creditors. Restructuring is easier if, in the macroeconomic area, enterprises face an environment where fiscal discipline, open trade, a competitive exchange rate, and moderate wage pressures prevail. This facilitates financial discipline and enables the real sector to recover its production and export-bases; the combination of these factors allows enterprises to generate profits and to improve financial perforrnance. In the process of transferring ownership of socially-owned enterprises, about 1,500firms were privatized The benefits from privatization come, in large part, from the changed structure of incentives that the firms face. This brings improvements in corporate governance, productivity and efficiency to the real sector. Nonetheless many questions remain as to the benefits and consequences of the privatization process undertaken by Slovenia thus far. While there is no doubt that a large proportion of the sociallyowned assets were transferred to the private sector, the impact of this privatization process on the behavior of firms appears less than expected. Is there, after all, a real difference between the self management of socially-owned firms and the dispersed ownership of a joint stock company with state or insider control? Have the firrns been truly privatized or just de-socialized? Has the privatization process

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inducedthose changesneeded to cope with a new competitiveenvironment?Has it helped or hindered restructuring?These issues are importantsince the privatizationof socially-ownedenterpriseshas ended and many firms continue to suffer heavy losses. Moreover,the State has come out of the privatization processas a large shareholder. Tke dominance of insider's control after privatization has implied less overall restructuring and efficient enterprise governance than one might have expected. Companies with insider ownership

and control show the following characteristics:they (a) are inclinedto under-invest; (b) prefer higher wages instead of long term growth; (c) make the firm unattractiveto foreign investmentpartnerships; (d) have inefficientmanagementcontrols;(e) possesslow mobilityof labor; and (f) are overly dependent on credit and, thus, likely to resultin a high incidenceof failureand futurebankruptcy. The overall picture of the enterprise sector in Slovenia shows that the aggregate enterprise sector continues to operate with sizable losses. The losses reported during 1994-96 were, however, to a

largedegreea consequenceof expensivefinancing(and/orthe effect of accountingstandards),aggravated by the poor performanceof certainownershipclasses, most notably non-privatizedenterprises. The net operatingprofit has slowly improved in all private sector categories,which represent a good part of the bulk of the Slovenian enterprise sector. Slow but steady improvementover the last three years is an importantsign of the gradual restructuringtaking place in Slovenia. In non-privatizedand state sectors, however, this has not been the case. The non-privatizedenterprises,accountingfor about 25 percent of the privatization pool are still generating net operating losses, which causes concerns regarding the efficiency and adequacy of the restructuring efforts as well as the increasing role of the Slovenian DevelopmentCorporation. Private sector development and the reduction of the public sector share in the economy, both

though privatization and the rationalization of public expenditures, should be among the principal objectivesof the governmentand a key componentof Slovenia'sEU accession strategy. To rejuvenate the processof enterprisereformthe governmentshouldaddressthe followingkey issues: >

Encourage better corporate governance in the privatized enterprise sector. This can be

done through a series of measuressuch as strengtheningminority shareholdersprotection, improving the quality and disclosure of informationof the firms, enhancing bankruptcy proceduresand increasingthe enforcementcapacityof the capitalmarket regulatoryagency; >

Advance the unfinished privatization agenda. The unfinished privatization agenda includes:

(a) the privatizationof state-assets(publicutilities, state banks, etc.); (b) the privatizationof residual stakes in already privatizedenterprises;and (c) the resolution of the privatization gap problem. >

Accelerate the transposition of the Acquis. This will improve the business climate to attract

needed FDI and to stimulate enterprise and banking sector reforms. This, in turn, will reduce financing cost, improve performance and enhance the prospects for the enterprise sectorto compete,in equalterms, on the Union's singlemarket. Facilitating Labor Market Adjustment The Slovenian labor market shared the same basic characteristics, and some of the same distortions, of other socialist economies. These included heavy social sector employment, full or quasi-

full employment,together with some hidden unemployment;sizable female participation in the labor force, a well educated labor force, heavy employment in industry, little geographic mobility, an

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egalitarian wage structure, overly generous fringe benefits, and government and worker involvement in the determination of wages. During the transition Slovenia's labor market experienced the same stylized trends as did many other Central and Eastern European (CEE) transforming economies; these trends included a decline in both labor force participation and employment rates, an increase in unemployment rates and the appearance of structural unermployment. During the transition, the labor market also experienced, at first, a steep decline in real wages, then followed by a reversal that generated an increase in real wages well above productivity. Slovenia's labor market seems to be slow in adjusting to the new economic conditions. The limited flexibility in the labor market is reducing its capacity to allocate resources efficiently. The barriers to labor market flexibility seem to be many. The first barrier is labor skill mismatch, a natural outcome of the transition. Labor skill mismatch generates supply constraints and keeps structural unemployment from coming down. The second barrier is an institutional wage negotiation and wage settling mechanism based on both social agreements and collective bargaining agreements that determine wages at almost all levels, including the minimum wage, sectoral wages and beyond. This semi-centralized mechanism is pushing lower wages up while keeping higher wages capped, with little or no link to productivity increases. As a result, the relation between wage growth and productivity growth is weak. Moreover, relatively little freedom is left to the market to generate needed adjustment in relative wages among sectors and individuals, thus further hindering labor market adjustment. High labor costs in the form of income (personal versus corporate) and wage taxation, social security contributions, hiring and firing costs and by-law fringe benefits constitute the third barrier. As a result, these high costs are generating the wrong set of incentives for firms to promote new employment opportunities for the labor force to reallocate. This compels some employers to offer temporary jobs, beyond their use as a screening mechanism, and in some cases pushes employers and employees to informality. Finally, overprotective employment legislation constitutes a fourth barrier, increasing both entry and exit costs, reducing labor flexibility, and hindering job creation incentives. The challenge for the government is to design and implement effective labor market policies in order to adequately protect individuals who have been disproportionately affected by the transition, without imposing undue fiscal and labor costs, and without creating adverse incentives to take on jobs. To that end, social protection policies -in the forn of unemployment insurance, social assistance and other income support programs- must be well designed, monitored and implemented. If insufficient or poorly targeted, social protection mechanisms will not be sufficient to cope with structural issues and to avoid poverty. If excessive, they will generate perverse incentives in the labor market and possible undue fiscal costs affecting the welfare and long-termngrowth prospect of the country. Key issues to be address by the authorities concerning labor market performance in Slovenia are the following: >

Structural unemployment, created in part by the mismatch between supply and demand for labor skills, remains a critical problem in Slovenia. Loss making finns employed about 25 percent of the working population and are concentrated in labor intensive sectors where employees have low skills. Once unemployed, these workers are trapped outside the formal economy because new market conditions demand higher degrees of education and skill. Active labor market policies should be designed and target to address this difficult issue. Passive policies should contemplate the need to support higher levels of this structural unemployment as transition advances.

>

Increase labor marketflexibility. In the area of labor legislation, the government needs to focus on policies that encourage a more flexible labor market. There is a wide range of choice in these standards, which vary greatly across countries. Strict employment protection

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standards are two-fold: countries with high standards of protection appear to have higher rates of long-term unemployment as well as higher rates of unemployment among young persons (age 14-24) relative to adults. Slovenia should avoid introducing measures that are not really required for accession but that could prove detrimental to a successful adjustment in the labor market. As small and medium-sized firns represent the engine of employment growth, it would be highly undesirable to hinder their expansion. The need for a decentralized wage policy to encourage enterprise-level bargaining should be increased. Most EU countries are currently expanding the scope of their decentralized wage bargaining, and linking wage setting to firm performance; Slovenia should do the same. New legislation affecting labor relationships attempts to make labor markets more flexible, and reduce rigidities and implicit costs, approximating the norms to those of the EU. These laws pave the way towards satisfying the requirements for accession to the EU. Provisions concerning health and safety in the workplace, as well as equal employment opportunity and working time are contained in the new draft legislation, which the authorities hope Parliament will approve in 1999. Legal harmonization with the EU. As the process of accession to the EU advances, Slovene authorities are making a considerable effort to adjust the regulatory framework of the labor market to meet EU requirements. Slovenia's compliance with the acquis communautaire implies recognizing both a set of minimum rights for workers as well as standardized labor conditions resembling those prevailing in the EU The White Paper prepared by the EU identified four areas of social legislation (linked with labor markets) where legal harmonization and convergence is needed, namely: (a) equal opportunity for men and women; (b) health and safety at work; (c) labor law and working conditions; and (d) coordination of social security schemes. Efficient targeting of social policies. Social policies must play a crucial role during the remainder of the transition, as well as during the pre-accession period. To make them fiscally sustainable and to reduce the perverse incentives they may generate in labor markets, efficient targeting and design will be critical. Removing restrictions on foreign employment. Accession to the EU will encourage Slovenia to remove existing inconsistencies in the regulation of foreign employment. The free movement of workers, envisioned under the EU single market legislation, would require changes in the national laws prior to full EU membership for Slovenia. Access of foreign workers to employment will have to be free from discrimination on the ground of nationality for workers from EU countries. Residency requirement for enterprise managers will have to be eliminated. Access to the EU will also open further opportunities for Slovenian workers abroad. The employment of foreign workers will remain dependent on labor market conditions but will encourage cooperation between Slovene and foreign firms. Improving monitoring and compliance. Compliance with some EU regulations could increase labor costs and adversely affect labor demand and enterprise competitiveness. Implementing such regulations also means setting up ways to monitor compliance by firms (labor inspection. for instance) and allowing workers to exercise their rights (through administrative and judiciary bodies). Budgetary resources will need to be devoted to these activities Once the broader impact of reforms is factored in, however, the net impact on economic efficiency and welfare is likely to be positive. Health costs may come down and (after accession) the coordination of social security systems could enhance labor mobility, thus reducing unemployment pressures.

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Reduce the tax bias on labor. As the fiscal situation permits, there should be efforts to reduce taxes on labor, in particular the wage tax and contributions for pensions, sickness and employment insurance. High taxes on labor are not only harmful to job creation but may also encourage tax evasion. While it is likely that tax evasion is currently less a problem in Slovenia than in other transition economies, small firms typically cannot afford the same compensation costs as larger enterprises; they are more difficult to target for audit and enforcement. Thus, if taxes are too high, fewer small firms will be established, wages will tend to be under-reported, and the size of the informal sector will tend to increase. The experience of other transitional economies suggests that, in an economy undergoing rapid structural change, a vicious circle of increasingly high tax rates and a shrinking tax base could be set in motion.

As the authorities work to meet the White Paper requirements, they should not lose sight of the implications of the EU accession process for the labor market, and consequently should prepare the ground for admission beyond mere legal adjustments. Indeed, the economy is likely to experience increasing competitive pressures as the process of economic approximation to EU markets advances. This points to the need for further restructuring -for a flexible environment that promotes both labor mobility and allows a greater diversification of wages across sectors and individuals. In the run-up to accession, Slovenia has the opportunity to make its labor markets more efficient. In a time of rapid economic change, labor market flexibility would ease the reallocation of factors of production from non-competitive to competitive firms, thus feeding economic growth while reducing unemployment. Moving quickly towards mutual recognition of educational and training systems and professional qualifications with the EU will also help Slovenia strengthen its human capital. Investments in education are likely to have the highest returns. The rapid professionalization of its civil service needs to be part of this process. Preparing for, negotiating, legislating, and implementing EU norns requires that the training of civil servants, including intermediate and technical staff, be intensified.

Preparing the Agriculture Sector to Compete in the Single Market The Slovenian agriculture sector is economically small, but environmentally and socially important More than half of Slovenia is covered with forests and more than 70 percent of the total land is made of high mountains or areas with very difficult agricultural production conditions. With the exception of the eastern part of the country, meadows and pastures dominate the agricultural land, leaving little land for production. The agricultural sector is characterized by a differentiated system of part-time agricultural labor activities serving as a social buffer, full-time intensive private family farming often with non-farm incomes, and a few large state agricultural enterprises (the so-called "social" sector), mostly developed during the post-war period in the flat land. Over the past years, the Slovenian agricultural sector has remained relatively unreformed Considering the higher level of competition that Slovenia will face as part of a single European market, the process of strengthening the agricultural economy appears slow. In particular, the agricultural and food sector has undergone no significant adjustment since Slovenia achieved independence in 1991. The candidacy to the EU is becoming a major factor in the shaping of agriculture and agro-industry policies in Slovenia. While in most sectors, Slovenia's bid to join the EU provides an opportunity for more radical reforms, in agriculture an early adoption of some specific and potentially costly regulations --e.g., the price structure of the Common Agricultural Policy (CAP)-- could become a significant impediment, both economically and ecologically.

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Slovenia's agri-food sector is facing three major challenges that have not been addressed so far. If not addressed in a comprehensive way, the economic development of the sector could be negatively affected when facing competition in the single market. These three challenges are: >

To push for higher value added farm products: this requires market-based incentives to farmers and agro-industry in order to add value to raw agricultural products. Until now the large majority of the agricultural and food policy favors raw commodities for which, Slovenia has no obvious comparative advantage as a price-taker on international markets. The low level competition currently faced by the agricultural and agro-industrial sector has resulted in (i) a clear preference given to a rather small domestic market; and (ii) an absence of interest in developing food products with higher value added;

>

To improve the performance of land and capital markets: factor markets ir. the agricultural sector are neither efficiently operated nor well developed. This is in particular true for land and credit markets. In the coming years, farmers and agro-industries (marketing and processing) will need to adjust their scale of operation and the type of production to the new market environment. For that purpose they will need efficient and competitive providers of factors. The cooperative sector in particular with its privileged links with the credit cooperatives needs a major shake-up based on more open and effective banking regulations and on a revision of the legislation for cooperatives; and

>

To move away from commodity-based policies and favor rural development: the current commodity-based and highly protected agricultural policy would need to be scaled-down. A new policy aimed at protecting the sensitive eco-systems and reducing market distortions imposed by the state intervention system should be prepared with a new focus on rural (offfarm) employment and rural development.

The transition toward the CAP and, particularly, the speed of the transition, is a crucialfactor that must be carefully assessed in view of the anticipated reforms of the CAP. In this respect, support to rural development should become progressively de-coupled from agricultural production. The government could consider elaborating a rural development policy de-coupled from the traditional and largely distortive policy of protection, price support and market intervention. In addition, tourism represents a major strength for the Slovenian economy; the image of Slovenia -- an ecologically protected garden of Europe -- is already being promoted. Along these two lines, a medium-term strategy for Slovenia can be built with a well-designed de-coupled policy (i.e., de-coupled from market intervention) and promote an economically sustainable protection of the environment. Sustainable development in Slovenia is, therefore, not so much an agricultural development issue, but, to a large extent, an issue of sustainability in rural development that encompasses, simultaneously, social, economic and ecological aspects. The authorities now face a difficult challenge of addressing simultaneously the increasingly pressing needs for harmonization to prepare the country to be in line with the acquis communautaire, and the equally pressing needs to protect its fragile eco-systems. These two objectives, with the recent attention paid to rural development, are difficult to balance but remain compatible nonetheless.

Improving Economic Infrastructure and the Delivery of Public Services Slovenia's physical stock of infrastructure and its infrastructure policies are not adequately suited to its needs. The provision of services continues to be, almost exclusively, dominated by the public sector. Tariff structures are distorted, especially in the municipal sector where tariffs do not cover

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all the costs and cross subsidization-from businessto households-still exists. The financialviability of sub-sectors-railways and municipal services- is depressed due in part to significant investmentdelays during the transition. In the energy sector, for example,the main legaciesof the past are high-energy intensity, insufficient capacity, maintenance and renewal, as well as inadequate environmental performance. The transportation sector is also confronted with several problems. Traffic flows are stronglyconcentratedon road transportation,exposingthe countryto significantenvironmentalrisks, and has been associatedwith a low level of road safety. Severalfactorsexplain the relatively small share of the railway sector in overall total transportation in Slovenia. The geographical characteristics of the country(short distancesbetweenmajor destinationsin the country)as well as the railway's technical and technologicalpatterns, especiallyits poor accessibilityare two factors.As far as telecommunicationsare concerned,its penetrationrate is relatively high in comparisonto other transition economies, although furthermodernizationis necessary.In the municipalinfrastructuresector,some services,such as water, is abundantly supplied with limited regard to economic or environmentalcosts while others, such as wastewatertreatment,are largely under-supplied. In order to achieve the strategic objectivesof municipalinfrastructuredevelopment,a whole range of coordinatedpolicy measures has to be designed and put into operation. Their common denominatoris a more commercialapproachto municipalinfrastructureoperationand developmentthan exhibited in Slovenia thus far. Market-basedpolicies and practicesfor infrastructureservices are the corner stone of the reform: this means the introductionof pricing policies that reflect real costs of production, the introduction of further competition and private sector involvement in provision and development,and theproper regulatoryframeworkto operatepublicutilities. > Price and tariff reform. Price reform and effective collection of tariffs are crucial in both balancingthe supply and demand for infrastructureservicesand achievingfinancialviability of and accountabilityof infrastructureservice providers. In the past, the overall level of prices and tariffs for servicesprovidedby public utilities tended to be below the level which allows cost recovery. As a result of the government'sgeneral policy of containinginflation, this is still the case -with end-user prices of many servicesprovided by utilities, including gas, transport fuels, electricity, municipal services, fixed telephony services and public transport. Prices for domestic coal are, however,higher than import prices; it is part of the strategyfor the gradual closing-downof non-profitablecoal mines. The gap between actual and cost recovery prices and tariffs has been narrowed over the years. Proper pricing of public services will encourage efficient use of the services and set the right incentivesfor private sector participationin deliveryand investmentin the sector; > Private sector involvement. There is a need to increaseprivate sector participation in the

delivery of servicesand the investmentin economicinfrastructure. An importantpolicy for cost-effectiveprovisionof municipalinfrastructureservicesis the introductionof competition whereverpossible. This private entry into variousmunicipal infrastructuresectors and subsectors could take two forms each dependent on the specific characteristics of individual modes of infrastructure: (i) Competitionwithin the market, where firms compete to provide the same service,such as transportationservicebetweentwo points. This form of competition is typically more feasible for the supply of infrastructureservicesthan that of infrastructure per se. This form of competition,however,has rather limitedprospects in the area of public utilities due to regional monopolycharacteristics;and (b) Competitionfor the market, where firms competefor the right to provide servicefor a givenperiod of time under concessionor lease contract. This form of competition can bring efficiency gains in many areas of infrastructure provision of management, particularly in small countries like Slovenia. Concessions and leases should become an important instrument of competition in all segmentsof municipalserviceprovision; and

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> An adequate regulatory and supervisory framework. Appropriate legislation provides another important condition to improve the financial viability of municipal infrastructure service providers. Although the transformation of enterprises in the municipal infrastructure sector to join-stock has been formally completed in Slovenia, the process of actual separation of ownership and management functions remains incomplete. Further adjustments of the legal framework are needed to define operational responsibilities and accountability for managers and those within the government who performnan ownership role. It is also necessary that the same rules of the game apply to all participants: state-owned enterprises are to be subject to the same market discipline of private sector enterprise. Moreover, infrastructure service providers must be properly supervised, particularly in situations of natural monopoly or exclusive rights. Rules for evaluating their performance, and for setting their tariff structures, must be transparent and balanced for both, investors' and public interests alike. At present, Slovenia pursues a policy of informal supervision by the line ministries, with authority stemming from the state's part of ownership in most service providers. This will not be sufficient where private companies enter the market. Slovenia's accession to the EUposes unique challenges and opportunities for the government to overcome institutional and policy inertia and to build consensus for a substantial program of structural reform. To the extent that legal harmonization is a prerequisite for accession, the government could use the prospect of membership as a means to overcome vested interests in implementing needed reforms. Moreover, the EU accession process and its regulatory procedures and directives provide a policy model, with further private sector involvement and market-based policies, thereby setting the path for accelerating the design and passage of relevant legislation.

Concluding Remarks Slovenia's development strategy should consist of three different types of policies and/or reforms: (i) "win-win" policies and reforms where early implementation is desirable on its own right, regardless of Slovenia's accession to the EU; (ii) policies and reformnswhich are not a formal EU requirement but are nevertheless essential to the growth and stabilization strategy (such as privatization and pension reform); and (iii) policies and reforms, required by the accession process, whose adoption will demand more time and careful sequencing of actions in order to maximize their benefits. Examples of the latter include the adoption of the CAP and the full set of EU environmental standards. An example of the first type of (win-win) reforms is deregulation of infrastructure -energy, telecommunications, transport, for instance- where EU directives envisage an enhanced role for markets and private-sector participation. Early adaptation of an institutional and regulatory frarnework for competition in infrastructure services is likely to attract substantial private investment and help to improve Slovenia's competitiveness. Another examnpleinvolves the financial sector, where a move toward enhancing competition as well as the regulatory and supervisory capacities of state agencies will contribute to financial deepening and integration during the time leading to accession. Close links between Slovenia and the EU supervisory agencies will help with the licensing of foreign institutions to operate in Slovenia, as well as the provision of services (including cross-border). Increased competition will also help bring down the cost of capital and encourage investment in the sector. The second set conprises those reforms that Slovenia needs to inplement even if they are not a formal requirement of accession. Many large, socially-sensitive or politically powerful state-owned enterprises have avoided major restructuring; their losses continue to be a drag on the growth potential of the economy. Privatization, while persistent, has been slow and biased towards the status-quo,

Summary Report

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particularly in key sectors, which remain dominated by the public sector. Without faster privatization, state-owned firms and banks could find it increasingly difficult to compete in a European single market and could thus create future fiscal and unemployment pressures. Moreover, public finances remain vulnerable to adverse trends in social spending, already representing the largest share of public expenditures. Speeding up the pace of reform in these areas (social security, privatization and restructuring) is critical to increasing domestic savings and maintaining the dynamic supply response of the economy. The third type of policy touches on those areas where meeting EU standards as set by the acquis communautaire will require a gradual and phased approach. Indeed, Slovenia will derive substantial environmental benefits from meeting some EU standards, which will also enhance the health of the population and further attract tourism. In certain areas like air-quality, the benefits are likely to be large relative to the costs. In other areas, such as water quality and wastewater treatment, the direct benefits are smaller, less immediate and difficult to measure, while the necessary investments are of such a magnitude that early compliance may not be financially or technically possible. There are other areas where EU environmental legislation is linked to the functioning of the single market, such as the management of dangerous chemicals, waste management, and fuel standards. In these cases, the benefits of being able to take advantage of access to the EU are large and immediate relative to the likely cost of compliance. A strategy to first meet the most urgent environmental goals will probably obtain strong public support and hence offer policy-makers an opportunity to take bold decisions that may be otherwise politically difficult. It will also help with future access to structural or transitional funding for environmental investments. Membership in the EU is the most important development agenda for Slovenia. Accession, however, goes significantly beyond simple implementation of specific economic instruments or acts of European law. It is, first and foremost, an issue of creating the proper conditions under which Slovenia will be capable of reaping the benefits of integration. Adoption of the acquis should be viewed as an instrument to increase the well-being of the population, to speed up restructuring, and to modernize the economic and the legal systems. Misaligmnent vis-a-vis such requirements will undermine the smooth functioning of the economy. Joining the EU is an enormous task that requires the focus and full commitment of the government and society at large. At the turn of the millennium, Slovenia faces another dual challenge: that of completing the systemic transformation of its economy and joining the enlarged EU, not only as soon as possible, but as the leader of the first round candidates. These are critical challenges that will define Slovenia's future economic development not to mention the future welfare of its people. The EU pre-accession agenda has been clearly identified. The responsibility rests with the Government to make the most out of the accession process and, out of full EU membership, to create the appropriate environment for Slovenia's prosperity.

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